UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549


FORM 10-K





(X)
      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934For
      the fiscal year ended December 31, 2007,or(  )
      TRANSITION REPORT PURSUANT TO SECTION 13 or 15 (d) OF THE SECURITIES
      EXCHANGE ACT OF 1934For
      the transition period from ______ to ______Commission
      file number0-23863PEOPLES
      FINANCIAL SERVICES CORP.(Exact
      name of registrant as specified in its charter)PENNSYLVANIA
            23-2391852(State
      of incorporation)
            (IRS
      Employer Identification No.)50
      MAIN STREET, HALLSTEAD, PA
            18822(Address
      of principal executive offices)
            (Zip
      code)(570)
      879-2175(Registrant’s
      telephone number including area code)Securities
      registered pursuant to Section 12(b) of the Act:Title
      of each class
            Name
      of each exchange on which registeredNone
            NoneSecurities
      registered pursuant to Section 12(g) of the Act:COMMON
      STOCK ($2 Par Value)(Title
      of Class)Indicate
      by check mark if the registrant is a well-known seasoned issuer, as
      defined in Rule 405 of the Securities Act. Yes __ No XIndicate
      by check mark if the registrant is not required to file reports pursuant
      to Section 13 or Section 15(d) of the Act.  Yes___  No
      XIndicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months or for such shorter period that the
      registrant was required to file such reports, and (2) has been subject to
      such filing requirements for the past 90 days Yes X
No__Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment to this Form 10-K.  [X]Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company
      (as defined in Rule 12b-2 of the Exchange Act).Large
      accelerated filer ____­
            Accelerated
      filer X
            Non-accelerated
      filer _____
            Smaller
      reporting company _____Indicate
      by check mark whether the registrant is a shell company (as defined in
      Rule 12b-2 of the Exchange Act). Yes __ No XThe
      aggregate market value of voting stock held by non-affiliates of the
      registrant is $
      79,813,548The
      aggregate dollar amount of the voting stock set forth equals the number of
      shares of the registrant’s Common Stock outstanding, reduced by the amount
      of Common stock held by executive officers, directors, and shareholders
      owning in excess of 10% of the registrant’s Common Stock, multiplied by
      the last sale price for the registrant’s Common Stock at June 30, 2007.
      The information provided shall in no way be construed as an admission that
      the officer, director, or 10% shareholder in the registrant may be deemed
      an affiliate of the registrant or that such person is the beneficial owner
      of the shares reported as being held by him and any such inference is
      hereby disclaimed. The information provided herein is included solely for
      the record keeping purpose of the Securities and Exchange
      Commission.Number
      of shares outstanding as of December 31, 2007
            COMMON
      STOCK
              ($2
      Par Value)
              (Title
      of Class)
            3,138,493
              (Outstanding
      Shares)DOCUMENTS
      INCORPORATED BY REFERENCEPortions
      of the 2008 Proxy Statement for the Registrant are incorporated by
      reference into Part III of this
report.





1


TABLE OF
CONTENTS





PagePart
      I
            
            
            NumberItem
      1
            Business
            3 -
      14Item
      1A
            Risk
      Factors
            14
      - 16Item
      1B
            Unresolved
      Staff Comments
            16Item
      2
            Properties
            16
      – 17Item
      3
            Legal
      Proceedings
            17Item
      4
            Submission
      of Matters to a Vote of Security Holders
            17Part
      IIItem
      5
            Market
      for Registrant's Common Equity and Related Stockholder
    Matters
            18
      - 19Item
      6
            Selected
      Financial Data
            20Item
      7
            Management's
      Discussion and Analysis of Financial Condition and
            21
      - 43Results
      of OperationsItem
      7A
            Quantitative
      and Qualitative Disclosures About Market Risk
            43Item
      8
            Financial
      Statements and Supplementary Data
            44Report
      of Independent Registered Public Accounting Firm
            44Consolidated
      Balance Sheets
            45Consolidated
      Statements of Income
            46Consolidated
      Statements of Stockholders' Equity
            47Consolidated
      Statements of Cash Flows
            48
      - 49Notes
      to Consolidated Financial Statements
            50
      - 82Item
      9
            Changes
      In and Disagreements with Accountants on Accounting and
              Financial
      Disclosure
            83Item
      9A
            Controls
      and Procedures
            83
      - 85Item
      9B
            Other
      Information
            85Part
      IIIItem
      10
            Directors,
      Executive Officers and Corporate Governance
            86Item
      11
            Executive
      Compensation
            86Item
      12
            Security
      Ownership of Certain Beneficial Owners and Management
            86and
      Related Stockholder MattersItem
      13
            Certain
      Relationships and Related Transactions, and Director
      Independence
            86Item
      14
            Principal
      Accountant Fees and Services
            86Part
      IVItem
      15
            Exhibits
      and Financial Statement Schedules
            87Signatures
            88


2


PART
I





ITEM 1 BUSINESS





BRIEF HISTORY


Peoples
Financial Services Corp. (“PFSC” or the “Company”) was incorporated under the
laws of the Commonwealth of Pennsylvania on February 6, 1986, and is a one-bank
holding company headquartered in Hallstead, Pennsylvania.





The
Company is engaged primarily in commercial and retail banking services and in
businesses related to banking services through its subsidiaries, Peoples
National Bank (“PNB” or the “Bank”), Peoples Advisors, LLC (“Advisors”) and
Peoples Financial Capital Corporation.  The Bank has two wholly owned
subsidiaries, Peoples Financial Leasing, LLC and Peoples Investment Holdings,
LLC.  PNB was chartered in Hallstead, Pennsylvania in 1905 under the
name of The First National Bank of Hallstead. In 1965, the Hop Bottom National
Bank (chartered in 1910) merged with The First National Bank of Hallstead to
form Peoples National Bank of Susquehanna County. In 2001, the Bank changed its
name to Peoples National Bank.  Advisors was formed in 2006 as a
member-managed limited liability company for the purpose of providing investment
advisory services to the general public. Peoples Financial Leasing, LLC, formed
in 2007, is a subsidiary of the Bank and provides employee leasing services to
the Bank. Peoples Investment Holdings, LLC, formed in 2007, is also a subsidiary
of the Bank and its main activities are the maintenance and management of its
intangible investments and the collection and distribution of the income from
such investments or from tangible investments located outside of Delaware.
Finally, Peoples Financial Capital Corporation which was also formed in 2007 is
a subsidiary of the Company and its main activities are the maintenance and
management of its intangible investments and the collection and distribution of
the income from such investments or from tangible investments located outside of
Delaware.





OPERATING
SEGMENTS


The
Company has one reportable operating segment, Community Banking, which consists
of commercial and retail banking, and other non-reportable operating segments,
as described in Note 1 of the Notes to Consolidated Financial Statements
included on page 59 of this Report. The Segment Reporting information in Note 1
is incorporated by reference into this Item 1.





SUPERVISION AND
REGULATION


The
Company and its subsidiaries are extensively regulated under federal and state
law. Generally, these laws and regulations are intended to protect depositors,
not shareholders. The following is a summary description of certain provisions
of law that affect the regulation of bank holding companies and banks. This
discussion is qualified in its entirety by reference to applicable laws and
regulations. Changes in law and regulation may have a material effect on the
business and prospects of the Company, PNB, and Advisors.





The
Company is a bank holding company within the meaning of the Bank Holding Company
Act of 1956, as amended, and is subject to regulation, supervision, and
examination by the Federal Reserve Board (“FRB”). The Company is required to
file annual and quarterly reports with the FRB and to provide the FRB with such
additional information as the FRB may require. The FRB also conducts
examinations of the Company.





With
certain limited exceptions, the Company is required to obtain prior approval
from the FRB before acquiring direct or indirect ownership or control of more
than 5% of any voting securities or substantially all of the assets of a bank or
bank holding company, or before merging or consolidating with another bank
holding company. Additionally, with certain exceptions, any person or entity
proposing to acquire control through direct or indirect ownership of 25% or more
of any voting securities of the Company is required to give 60 days written
notice of the acquisition to the FRB, which may prohibit the transaction, and to
publish notice to the public.





The
Company’s banking subsidiary is a federally chartered national banking
association regulated by the Office of the Comptroller of the Currency (“OCC”).
The OCC may prohibit an institution over which it has supervisory authority from
engaging in activities or investments that the agency believes constitute unsafe
or unsound banking practices. Federal banking regulators have extensive
enforcement authority over the institutions they regulate to prohibit or correct
activities that violate law, regulation or a regulatory agreement or which are
deemed to constitute unsafe or unsound practices.


3





Enforcement
actions may include:


·
            the
      appointment of a conservator or receiver;·
            the
      issuance of a cease and desist order;·
            the
      termination of deposit insurance, the imposition of civil money penalties
      on the institution, its directors, officers, employees and institution
      affiliated parties;·
            the
      issuance of directives to increase capital;·
            the
      issuance of formal and informal agreements;·
            the
      removal of or restrictions on directors, officers, employees and
      institution-affiliated parties; and·
            the
      enforcement of any such mechanisms through restraining orders or any other
      court actions.





PNB is
subject to certain restrictions on extensions of credit to executive officers,
directors, principal shareholders or any related interests of such persons which
generally require that such credit extensions be made on substantially the same
terms as are available to third persons dealing with PNB and not involving more
than the normal risk of repayment. Other laws tie the maximum amount that may be
loaned to any one customer and its related interests to capital levels of the
Bank.





Limitations on Dividends and Other
Payments


The
Company’s current ability to pay dividends is largely dependent upon the receipt
of dividends from its banking subsidiary, PNB. Both federal and state laws
impose restrictions on the ability of the Company to pay dividends. The FRB has
issued a policy statement that provides that, as a general matter, insured banks
and bank holding companies may pay dividends only out of prior operating
earnings. Under the National Bank Act, a national bank, such as PNB, may pay
dividends only out of the current year’s net profits and the net profits of the
last two years. In addition to these specific restrictions, bank regulatory
agencies, in general, also have the ability to prohibit proposed dividends by a
financial institution that would otherwise be permitted under applicable
regulations if the regulatory body determines that such distribution would
constitute an unsafe or unsound practice.





Permitted Non-Banking
Activities


Generally,
a bank holding company may not engage in any activities other than banking,
managing, or controlling its bank and other authorized subsidiaries, and
providing service to those subsidiaries. With prior approval of the FRB, the
Company may acquire more than 5% of the assets or outstanding shares of a
company engaging in non-bank activities determined by the FRB to be closely
related to the business of banking or of managing or controlling banks. The FRB
provides expedited procedures for expansion into approved categories of non-bank
activities.





Subsidiary
banks of a bank holding company are subject to certain quantitative and
qualitative restrictions:


·
            on
      extensions of credit to the bank holding company or its
      subsidiaries;·
            on
      investments in their securities; and·
            on
      the use of their securities as collateral for loans to any
      borrower.





These
regulations and restrictions may limit the Company’s ability to obtain funds
from PNB for its cash needs, including funds for the payment of dividends,
interest and operating expenses. Further, subject to certain exceptions, a bank
holding company and its subsidiaries are prohibited from engaging in certain
tie-in arrangements in connection with any extension of credit, lease or sale of
property or furnishing of services. For example, PNB may not generally require a
customer to obtain other services from itself or the Company, and may not
require that a customer promise not to obtain other services from a competitor
as a condition to an extension of credit to the customer.





Under FRB
policy, a bank holding company is expected to act as a source of financial
strength to its subsidiary banks and to make capital injections into a troubled
subsidiary bank, and the FRB may charge the bank holding company with engaging
in unsafe and unsound practices for failure to commit resources to a subsidiary
bank when required. A required capital injection may be called for at a time
when the holding company does not have the resources to provide it. In addition,
depository institutions insured by the FDIC can be held liable for any losses
incurred by, or reasonably anticipated to be incurred by, the FDIC in connection
with the default of or assistance provided to, a commonly controlled
FDIC-insured depository institution. Accordingly, in the event that any insured
subsidiary of the company causes a loss to the FDIC, other insured subsidiaries
of the company could be required to compensate the FDIC by reimbursing it for
the estimated amount of such loss. Such cross guarantee liabilities generally
are superior in priority to the obligation of the depository institutions to its
stockholders due solely to their status as stockholders and obligations to other
affiliates.


4





Pennsylvania Law


As a
Pennsylvania bank holding company, the Company is subject to various
restrictions on its activities as set forth in Pennsylvania law. This is in
addition to those restrictions set forth in federal law. Under Pennsylvania law,
a bank holding company that desires to acquire a bank or bank holding company
that has its principal place of business in Pennsylvania must obtain permission
from the Pennsylvania Department of Banking.





Interstate Banking
Legislation


The
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 were enacted
into law on September 29, 1994. The law provides that, among other things,
substantially all state law barriers to the acquisition of banks by out-of-state
bank holding companies were eliminated effective September 29, 1995. The law
also permits interstate branching by banks effective as of June 1, 1997, subject
to the ability of states to opt-out completely or to set an earlier effective
date.





FIRREA
(Financial Institution Reform, Recovery, and Enforcement Act)


FIRREA
was enacted into law in order to address the financial condition of the Federal
Savings and Loan Insurance Corporation, to restructure the regulation of the
thrift industry, and to enhance the supervisory and enforcement powers of the
federal bank and thrift regulatory agencies. As the primary federal regulator of
the Bank, the OCC is responsible for the supervision of the Bank. When dealing
with capital requirements, the OCC and FDIC have the flexibility to impose
supervisory agreements on institutions that fail to comply with regulatory
requirements. The imposition of a capital plan, termination of deposit
insurance, and removal or temporary suspension of an officer, director or other
institution-affiliated person may cause enforcement actions.





There
are three levels of civil penalties under FIRREA.


·
            The
      first tier provides for civil penalties of up to $5,000 per day for any
      violation of law or regulation.·
            The
      second tier provides for civil penalties of up to $25,000 per day if more
      than a minimal loss or a pattern is involved.·
            Finally,
      civil penalties of up to $1 million per day may be assessed for knowingly
      or recklessly causing a substantial loss to an institution or taking
      action that results in a substantial pecuniary gain or other
      benefit.





Criminal
penalties are increased to $1 million per violation and may be up to $5 million
for continuing violations or for the actual amount of gain or loss. These
penalties may be combined with prison sentences of up to five
years.





FDICIA
(Federal Deposit Insurance Corporation Improvement Act of 1991)


In
December 1991, Congress enacted FDICIA which substantially revised the bank
regulatory and funding provisions of the Federal Deposit Insurance Act and made
significant revisions to several other federal banking statutes. FDICIA provides
for, among other things:


·
            publicly
      available annual financial condition and management reports for financial
      institutions, including audits by independent
  accountants;·
            the
      establishment of uniform accounting standards by federal banking
      agencies;·
            the
      establishment of a “prompt corrective action” system of regulatory
      supervision and intervention, based on capitalization levels, with more
      scrutiny and restrictions placed on depository institutions with lower
      levels of capital;·
            additional
      grounds for the appointment of a conservator or receiver;
    and·
            restrictions
      or prohibitions on accepting brokered deposits, except for institutions
      which significantly exceed minimum capital
  requirements.





FDICIA
also provides for increased funding of the FDIC insurance funds and the
implementation of risk-based premiums.





A central
feature of FDICIA is the requirement that the federal banking agencies take
“prompt corrective action” with respect to depository institutions that do not
meet minimum capital requirements. Pursuant to FDICIA, the federal bank
regulatory authorities have adopted regulations setting forth a five-tiered
system for measuring the capital adequacy of the depository institutions that
they supervise. Under these regulations, a depository institution is classified
in one of the following capital categories:


·
            "well
      capitalized";·
            "adequately
      capitalized";·
            "under
      capitalized";·
            "significantly
      undercapitalized"; and·
            "critically
      undercapitalized".





5





PNB is
currently classified as “well capitalized.” An institution may be deemed by the
regulators to be in a capitalization category that is lower than is indicated by
its actual capital position if, among other things, it receives an
unsatisfactory examination rating with respect to asset quality, management,
earnings or liquidity.





FDICIA
generally prohibits a depository institution from making any capital
distribution (including payment of a cash dividend) or paying any management
fees to its holding company if the depository institution would thereafter be
undercapitalized. Undercapitalized depository institutions are subject to growth
limitations and are required to submit capital restoration plans. If a
depository fails to submit an acceptable plan, it is treated as if it is
“significantly undercapitalized”. Significantly undercapitalized depository
institutions may be subject to a number of other requirements and restrictions,
including orders to sell sufficient voting stock to become adequately
capitalized, requirements to reduce total assets and stop accepting deposits
from correspondent banks. Critically undercapitalized institutions are subject
to the appointment of a receiver or conservator; generally within 90 days of the
date such institution is determined to be critically under
capitalized.





FDICIA
provides the federal banking agencies with significantly expanded powers to take
enforcement action against institutions that fail to comply with capital or
other standards. Such actions may include the termination of deposit insurance
by the FDIC or the appointment of a receiver or conservator for the institution.
FDICIA also limits the circumstances under which the FDIC is permitted to
provide financial assistance to an insured institution before appointment of a
conservator or receiver.





Under
FDICIA, each federal banking agency is required to prescribe, by regulation,
non-capital safety and soundness standards for institutions under its authority.
The federal banking agencies, including the OCC, have adopted standards
covering:


·
            internal
      controls;·
            information
      systems and internal audit systems;·
            loan
      documentation;·
            credit
      underwriting;·
            interest
      rate exposure;·
            asset
      growth; and·
            compensation
      fees and benefits.





Any
institution that fails to meet these standards may be required by the agency to
develop a plan acceptable to the agency, specifying the steps that the
institutions will take to meet the standards. Failure to submit or implement
such a plan may subject the institution to regulatory sanctions. The Company, on
behalf of PNB, believes that it meets substantially all the standards that have
been adopted. FDICIA also imposed new capital standards on insured depository
institutions. Before establishing new branch offices, PNB must meet certain
minimum capital stock and surplus requirements and must obtain OCC
approval.





Risk-Based
Capital Requirements


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





A banking
organization’s risk-based capital ratios are obtained by dividing its qualifying
capital by its total risk adjusted assets. The regulators measure risk-adjusted
assets, which include off-balance-sheet items, against both total qualifying
capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and
Tier 1 capital.


·
            "Tier
      1", or core capital, includes common equity, perpetual preferred stock
      (excluding auction rate issues) and minority interest in equity accounts
      of consolidated subsidiaries, less goodwill and other intangibles, subject
      to certain exceptions.·
            "Tier
      2", or supplementary capital, includes, among other things, limited life
      preferred stock, hybrid capital instruments, mandatory convertible
      securities, qualifying subordinated debt, and the allowance for loan and
      lease losses, subject to certain limitations and less restricted
      deductions. The inclusion of elements of Tier 2 capital is subject to
      certain other requirements and limitations of the federal banking
      agencies.





6





Banks and
bank holding companies subject to the risk-based capital guidelines are required
to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and
a ratio of total capital to risk-weighted assets of at least 8%. The appropriate
regulatory authority may set higher capital requirements when particular
circumstances warrant. As of December 31, 2007, PFSC’s ratio of Tier 1 capital
to risk-weighted assets stood at 13.64% and its ratio of total capital to
risk-weighted assets stood at 14.42%. In addition to risk-based capital, banks
and bank holding companies are required to maintain a minimum amount of Tier 1
capital to total assets, referred to as the leverage capital ratio, of at least
4.00%. As of December 31, 2007, the Company’s leverage-capital ratio was
10.14%.





Failure
to meet applicable capital guidelines could subject a banking organization to a
variety of enforcement actions including:


·
            limitations
      on its ability to pay dividends;·
            the
      issuance by the applicable regulatory authority of a capital directive to
      increase capital, and in the case of depository institutions, the
      termination of deposit insurance by the FDIC, as well as to the measures
      described under FDICIA as applicable to under capitalized
      institutions.





In
addition, future changes in regulations or practices could further reduce the
amount of capital recognized for purposes of capital adequacy. Such a change
could affect the ability of PNB to grow and could restrict the amount of
profits, if any, available for the payment of dividends to the
Company.





Interest Rate
Risk


In August
1995 and May 1996, the federal banking agencies adopted final regulations
specifying that the agencies will include, in their evaluations of a bank’s
capital adequacy, an assessment of the bank’s interest rate risk (“IRR”)
exposure. The standards for measuring the adequacy and effectiveness of a
banking organization’s IRR management includes a measurement of Board of
Directors and senior management oversight, and a determination of whether a
banking organization’s procedures for comprehensive risk management are
appropriate to the circumstances of the  specific banking
organization. PNB has internal IRR models that are used to measure and monitor
IRR. In addition, an outside source also assesses IRR using its model on a
quarterly basis. Additionally, the regulatory agencies have been assessing IRR
on an informal basis for several years. For these reasons, the Company does not
expect the IRR evaluation in the agencies’ capital guidelines to result in
significant changes in capital requirements for PNB.





FDIC Insurance
Assessments


As a FDIC
member institution, PNB’s deposits are insured to a maximum of $100,000
($250,000 for retirement accounts) per depositor through the Bank Insurance Fund
(“BIF”) that is administered by the FDIC and each institution is required to pay
semi-annual deposit insurance premium assessments to the FDIC.  PNB’s
assessment for 2007 was $37,303. These figures can be compared to FDIC
assessments in 2006 of $37,678 and in 2005 of $37,634. Prior to 1997, only
thrift institutions were subject to assessments to raise funds to pay the
financing corporate bonds. On September 30, 1996, as part of the Omnibus Budget
Act, Congress enacted the Deposit Insurance Funds Act of 1996, which
recapitalized the Savings Association Insurance Fund (“SAIF”) and provided that
BIF deposits would be subject to 1/5 of the assessment to which SAIF deposits
are subject for FICO bond payments through 1999. Beginning in 2000, BIF deposits
and SAIF deposits were subject to the same assessment for FICO bonds. The FICO
assessment for PNB for 2007 was $.0116 for each $100 of BIF
deposits.





The FDIC
adopted a risk-based deposit insurance assessment system that requires all
FDIC-insured institutions to pay quarterly premiums beginning in
2007.  Annual premiums range from 5 and 7 basis points of deposits for
well-capitalized banks with the highest examination ratings to 43 basis points
for undercapitalized institutions.  The Bank has been able to offset
the premium with an assessment credit of $218,000 for premiums paid prior to
1996. As of December 31, 2007, $70,000 of this credit remains to be used. Once
the credit is extinguished, FDIC premiums will increase by approximately
$120,000 for the remainder of 2008.





Community Reinvestment
Act


The
Community Reinvestment Act of 1977, (“CRA”) is designed to create a system for
bank regulatory agencies to evaluate a depository institution’s record in
meeting the credit needs of its community. Until May 1995, a depository
institution was evaluated for CRA compliance based on twelve assessment
factors.





The CRA
regulations were completely revised as of July 1, 1995, (the revised CRA
regulation) to establish new performance-based standards for use in examining
for compliance.





The Bank
had its last CRA compliance examination in 2005 and received a “satisfactory”
rating.


7





Concentration


Payment
risk is a function of the economic climate in which the Bank’s lending
activities are conducted. Economic downturns in the economy generally or in a
particular sector could cause cash flow problems for customers and make loan
payments more difficult. The Bank attempts to minimize this risk by avoiding
loan concentrations to a single customer or to a small group of customers whose
loss would have a materially adverse effect on the financial condition of the
Bank.





Monetary Policy


The
earnings of a bank holding company are affected by the policies of regulatory
authorities, including the FRB, in connection with the FRB’s regulation of the
money supply. Various methods employed by the FRB are:


·
            open
      market operations in United States Government
  securities;·
            changes
      in the discount rate on member bank borrowings; and·
            changes
      in reserve requirements against member bank
  deposits.





These
methods are used in varying combinations to influence overall growth and
distribution of bank loans, investments, and deposits, and their use may also
affect interest rates charged on loans or paid on deposits. The monetary
policies of the FRB have had a significant effect on the operating results of
commercial banks in the past and are expected to do so in the
future.





RECENT
LEGISLATION


USA Patriot Act of
2001


In
October 2001, the USA Patriot Act of 2001 was enacted in response to the
terrorist attacks in New York, Pennsylvania and Washington D.C., which occurred
on September 11, 2001. The Patriot Act is intended to strengthen U.S. law
enforcement’s and the intelligence communities’ abilities to work cohesively to
combat terrorism on a variety of fronts. The potential impact of the Patriot Act
on financial institutions of all kinds is significant and wide ranging. The
Patriot Act contains sweeping anti-money laundering and financial transparency
laws and imposes various regulations, including standards for verifying client
identification at account opening, and rules to promote cooperation among
financial institutions, regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.





Financial Services Modernization
Legislation


In
November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLB, was enacted. The
GLB repeals provisions of the Glass-Steagall Act which restricted the
affiliation of Federal Reserve member banks with firms “engaged principally” in
specified securities activities, and which restricted officer, director or
employee interlocks between a member bank and any company or person “primarily
engaged” in specified securities activities.





The
GLB also permits national banks to engage in expanded activities through the
formation of financial subsidiaries. A national bank may have a subsidiary
engaged in any activity authorized for national banks directly or any financial
activity, except for insurance underwriting, insurance investments, real estate
investment or development, or merchant banking, which may only be conducted
through a subsidiary of a financial holding company. Financial activities
include all activities permitted under new sections of the Bank Holding Company
Act or permitted by regulation.





To the
extent that the GLB permits banks, securities firms and insurance companies to
affiliate, the financial services industry may experience further consolidation.
The GLB is intended to grant to community banks certain powers as a matter of
right that larger institutions have accumulated on an ad hoc basis and which
unitary savings and loan holding companies already possess. Nevertheless, the
GLB may have the result of increasing the amount of competition that the
Registrant faces from larger institutions and other types of companies offering
financial products, many of which may have substantially more financial
resources than the Registrant has.





Sarbanes-Oxley Act of
2002


On July
30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002, or the
SOA. The stated goals of the SOA are to increase corporate responsibility, to
provide for enhanced penalties for accounting and auditing improprieties at
publicly traded companies and to protect investors by improving the accuracy and
reliability of corporate disclosures pursuant to the securities
laws.


8





The SOA
is the most far-reaching U.S. securities legislation enacted in some time. The
SOA generally applies to all companies, both U.S. and non-U.S., that file or are
required to file periodic reports with the Securities and Exchange Commission
(the “SEC”) under the Securities Exchange Act of 1934, or the Exchange
Act.  The legislation includes provisions, among other things,
governing the services that can be provided by a public company’s independent
auditors and the procedures for approving such services, requiring the chief
executive officer and principal accounting officer to certify certain matters
relating to the company’s periodic filings under the Exchange Act, requiring
expedited filings of reports by insiders of their securities transactions and
containing other provisions relating to insider conflicts of interest,
increasing disclosure requirements relating to critical financial accounting
policies and their application, increasing penalties for securities law
violations, and creating a new public accounting oversight board, a regulatory
body subject to SEC jurisdiction with broad powers to set auditing, quality
control and ethics standards for accounting firms.





The
Company does not believe that the application of these rules to the Company have
a material effect on its results of operations.





Regulation W


Transactions
between a bank and its “affiliates” are quantitatively and qualitatively
restricted under the Federal Reserve Act. The Federal Deposit Insurance Act
applies Sections 23A and 23B to insured nonmember banks in the same manner and
to the same extent as if they were members of the Federal Reserve System. The
Federal Reserve Board has also recently issued Regulation W, which co-defies
prior regulations under Sections 23A and 23B of the Federal Reserve Act and
interpretative guidance with respect to affiliate transactions. Regulation W
incorporates the exemption from the affiliate transaction rules but expands the
exemption to cover the purchase of any type of 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 under common control with the bank. The
Company is considered to be an affiliate of the Bank. In general, subject to
certain specified exemptions, a bank or its subsidiaries are limited in their
ability to engage in “covered transactions” with affiliates:


·
            to
      an amount equal to 10% of the bank's capital and surplus, in the case of
      covered transactions with any one affiliate; and·
            to
      an amount equal to 20% of the bank's capital and surplus, in the case of
      covered transactions with all
affiliates.





In
addition, a bank and its subsidiaries may engage in covered transactions and
other specified transactions only on terms and under circumstances that are
substantially the same, or at least as favorable to the bank or its subsidiary,
as those prevailing at the time for comparable transactions with nonaffiliated
companies. A “covered transaction” includes:


·
            a
      loan or extension of credit to an affiliate;·
            a
      purchase of, or an investment in, securities issued by an
      affiliate;·
            a
      purchase of assets from an affiliate, with some
  exceptions;·
            the
      acceptance of securities issued by an affiliate as collateral for a loan
      or extension of credit to any party; and·
            the
      issuance of a guarantee, acceptance or letter of credit on behalf of an
      affiliate.





Regulation
W generally excludes all non-bank and non-savings association subsidiaries of
banks from treatment as affiliates, except to the extent that the Federal
Reserve Board decides to treat these subsidiaries as affiliates.





Concurrently
with the adoption of Regulation W, the Federal Reserve Board has proposed a
regulation which would further limit the amount of loans that could be purchased
by a bank from an affiliate to not more than 100% of the bank’s capital and
surplus.





Legislation and Regulatory
Changes


From time
to time, legislation is enacted that affects the cost of doing business or
limits the activities of a financial institution. We cannot predict the
likelihood of any major changes or the impact those changes may have on the
Company.





MARKET AREAS


The PNB
market areas are in the northeastern part of Pennsylvania with the primary focus
being Susquehanna and Wyoming Counties. With the addition of an office in
Conklin, Broome County, New York in 2003, and offices in the Village of Deposit
and Town of Chenango, both in Broome County, New York, in 2005, Broome County is
part of the Bank’s market area, particularly the Southern Tier that encompasses
the towns of Conklin, Kirkwood, Windsor, and Deposit. In addition, parts of
Lackawanna, Wayne, and Bradford Counties in Pennsylvania that border Susquehanna
and Wyoming Counties are also considered part of the PNB market
area.


9





The PNB
market area is situated between:


·
            the
      city of Binghamton, Broome County, New York, located to the
      north;·
            the
      city of Scranton, Lackawanna County, Pennsylvania, to the south;
      and·
            Wilkes-Barre,
      Luzerne County, Pennsylvania, to the
southwest.





Susquehanna
County could best be described as a bedroom county with a high percentage of its
residents commuting to work in Broome County, New York, or to the Scranton,
Pennsylvania, area. The southern part of Susquehanna County tends to gravitate
south for both employment and shopping, while the northern part of the county
goes north to Broome County, New York. The western part of Susquehanna County
gravitates south and west to and through Wyoming County. Wyoming County is home
to a Proctor & Gamble manufacturing facility. This is an economic stimulus
to Wyoming County and the surrounding areas.





Our
offices are located in counties that would be considered sparsely populated, as
they are made up of many small towns and villages. The latest population figures
show Susquehanna County at approximately 42,000 and Wyoming County at
approximately 30,000 residents. Both counties are experiencing growth, but not
robust growth. Broome County has approximately 208,000 residents. The economy of
Broome County has lost many manufacturing jobs in the past fifteen years. This
trend continues. Fortunately, the new employment centers are in the Town of
Conklin and the neighboring Town of Kirkwood. Both towns border Susquehanna
County, Pennsylvania. Interstate 81 runs north and south through the eastern
half of Susquehanna County and has brought an influx of people from New Jersey
and the Philadelphia area. These people have purchased homes and land to build
homes that are used as vacation/recreation retreats and, quite often, become
retirement homes.





BUSINESS


Lending
Activities


PNB
provides a full range of retail and commercial banking services designed to meet
the borrowing and depository needs of small and medium sized businesses and
consumers in its market areas. A significant amount of PNB’s loans are to
customers located within its service areas. PNB has no foreign loans or highly
leveraged transaction loans, as defined by the FRB. A majority of the loans in
PNB’s portfolio have been originated by PNB. Policies adopted by the Board of
Directors are the basis by which PNB conducts its lending activities. These loan
policies grant individual lending officers authority to make secured and
unsecured loans in specific dollar amounts. Larger loans must be approved by
senior officers or by the Board of Directors. PNB’s management information
systems and loan review policies are designed to monitor lending to ensure
adherence to PNB’s loan policies.





The
commercial loans offered by PNB include:


·
            commercial
      real estate loans;·
            working
      capital;·
            equipment
      and other commercial loans;·
            construction
      loans;·
            SBA
      guaranteed loans; and·
            agricultural
      loans.





PNB’s
commercial real estate loans are used primarily to provide financing for retail
operations, manufacturing operations, farming operations, multi-family housing
units, and churches. Commercial real estate secured loans are generally written
for a term of 15 years or less or amortized over a longer period with balloon
payments at shorter intervals. Personal guarantees are obtained on nearly all
commercial loans. Credit analysis, loan review, and an effective collections
process are also used to minimize any potential losses. PNB employs four
full-time commercial lending officers. These four people are augmented by branch
managers who are authorized to make smaller, less complex, commercial
loans.





Payment
risk is a function of the economic climate in which PNB’s lending activities are
conducted; economic downturns in the economy generally or in a particular sector
could cause cash flow problems for customers and make loan payments more
difficult. PNB attempts to minimize this risk by avoiding concentrations of
credit to single borrowers or borrowers in a particular industry. Interest rate
risk would occur if PNB were to make loans at fixed rates in an environment in
which rates were rising thereby preventing PNB from making loans at the higher
prevailing rates. PNB attempts to mitigate this risk by making adjustable rate
commercial loans and, when extending fixed rate commercial loans, fixing loan
maturities at five years or less. Finally, collateral risk can occur if PNB’s
position in collateral taken as security for loan repayment is not adequately
secured. PNB attempts to minimize collateral risk by avoiding loan
concentrations to particular borrowers, by perfecting liens on collateral and by
obtaining appraisals on property prior to extending loans.


10





Consumer
loans offered by PNB include:


·
            residential
      real estate loans;·
            automobile
      loans;·
            manufactured
      housing loans;·
            personal
      installment loans secured and unsecured for almost any
      purpose;·
            student
      loans; and·
            home
      equity loans (fixed-rate term and open ended revolving lines of
      credit).





PNB
offers credit cards as an agent bank through another correspondent
bank.





Risks
applicable to consumer lending are similar to those applicable to commercial
lending. PNB attempts to mitigate payment risk in consumer lending by limiting
consumer lending products to a term of five years or less. To the extent that
PNB extends unsecured consumer loans, there is greater collateral risk; however,
credit checks and borrower history are obtained in all consumer loan
transactions.





Residential
mortgage products include adjustable-rate as well as conventional fixed-rate
loans. Terms vary from 1, 5, and 10-year adjustable rate loans to 5, 10, 15, 20,
and 30-year fully amortized fixed rate loans. Bi-weekly payment plans are also
available. Personal secured and unsecured revolving lines of credit with
variable interest rates and principal amounts ranging from $1,000 to $10,000 are
offered to credit-worthy customers. The largest segment of PNB’s installment
loan portfolio is fixed-rate loans. Most are secured either by automobiles,
motorcycles, snowmobiles, boats, other personal property, or by liens filed
against real estate. These loans are generally available in terms of up to 15
years with automobile loans having maturities of up to 60 months and real estate
loans having maturities up to 15 years. Loans secured by other collateral
usually require a maturity of less than 60 months. Home equity products include
both fixed-rate term products and also an open-end revolving line of credit with
a maximum loan-to-value ratio of 80% of current appraisal. A special MGIC
program now offered through the Bank, allows for loans of up to 100% of the
appreciated value for qualified applicants. Credit checks, credit scoring, and
debt-to-income ratios within preset parameters are used to qualify
borrowers.





Mortgage
loans have historically had a longer average life than commercial or consumer
loans. Accordingly, payment and interest rate risks are greater in some respects
with mortgage loans than with commercial or consumer lending. Deposits, which
are used as the primary source to fund mortgage lending, tend to be of shorter
duration than the average maturities on residential mortgage loans and are more
susceptible to interest rate changes. Historical records indicate that our
mortgage loans, no matter what maturity, have an average life of less than seven
years. In 2003, the Bank started selling mortgages in the secondary market.
Mortgages are also written with adjustable rates. Mortgage lending is also
subject to economic downturns, in that increases in unemployment could adversely
affect the ability of borrowers to repay mortgage loans and decreases in
property values could affect the value of the real estate serving as collateral
for the loan.





Loan
growth was consistent in 2007 when compared to 2006 and
2005.  Industry standard debt-to-income ratios and credit checks are
used to qualify borrowers on all consumer loans. Managers, assistant managers,
and customer service officers have retail lending authorities at each of the
full-service branch office locations. PNB has centralized loan administration at
its operations/administrative offices where mortgage underwriting and loan
review and analysis take place.





Loan Approval


Individual
loan authorities are established by PNB’s Board of Directors upon recommendation
by the chief credit officer. In establishing an individual’s loan authority, the
experience of the lender is taken into consideration, as well as the type of
lending in which the individual is involved. The President of PNB, along with
members of senior management (loan committee), has the authority to approve new
loans over $250,000 up to $2,000,000 and all aggregate loans $325,000 to
$2,500,000 following an analysis and review by credit analysts and commercial
lender.  The full Board of Directors reviews on a monthly basis, all
loans approved by individual lenders and the officers’ loan committee. All loan
requests which are either complex in nature or exceed $2,000,000 new or
$2,500,000 aggregate must be analyzed and reviewed by the loan committee and
presented with a recommendation to the full Board of Directors for approval or
denial.





PNB
generally requires that loans secured by first mortgages or real estate have
loan-to-value ratios of less than 80% for loans secured by raw land or improved
property. In addition, in some instances for qualified borrowers, private
mortgage insurance is available for purchase that allows loan-to-value ratios to
go as high as 100%. PNB also participates in a guaranteed mortgage insurance
program. This allows PNB to make loans on real estate up to 100% of the value of
the property. Adjustable rate mortgage products, as well as conventional
fixed-rate products, are also available at PNB.


11


Deposit
Activities


PNB also
offers a full range of deposit and personal banking services insured by the
FDIC, including commercial checking and small business checking products, cash
management services, retirement accounts such as Individual Retirement Accounts
(“IRA”), retail deposit services such as certificates of deposit, money market
accounts, savings accounts, a variety of checking account products, automated
teller machines (“ATM’s”), point of sale and other electronic services such as
automated clearing house (“ACH”) originations, and other personal miscellaneous
services.





These
miscellaneous services would include:


·
            safe
      deposit boxes;·
            night
      depository services;·
            traveler’s
      checks;·
            merchant
      credit cards;·
            direct
      deposit of payroll and other checks;·
            U.S.
      Savings Bonds;·
            official
      bank checks; and·
            money
      orders.





The
principal sources of funds for PNB are core deposits that include demand
deposits, interest bearing transaction accounts, money market accounts, savings
deposits, and certificates of deposit. These deposits are solicited from
individuals, businesses, non-profit entities, and government authorities.
Substantially all of PNB’s deposits are from the local market areas surrounding
each of its offices.





Investment
Products


In 1999,
PNB entered into an agreement with T.H.E. Financial Services to hire a joint
employee to sell investment products. An agent was hired and has an office
located in Hallstead, Pennsylvania.   In September of 2003,
T.H.E. Financial Services was acquired by Financial Network Investment
Corporation (FNIC) of Torrance, California.  PNB signed a contract
dated September 29, 2003 with FNIC.  PNB discontinued broker-dealer
services with FNIC and contracted with Uvest Financial Services, Charlotte,
North Carolina, effective September 6, 2005.  In 2005, Peoples
Financial Services Corp. formed Peoples Advisors, LLC (“Advisors”) as a
member-managed limited liability company under the laws of the Commonwealth of
Pennsylvania, to be a wholly owned subsidiary of the Corporation, for the
purpose of providing investment advisory services to the general
public.





Insurance
Products


In April
of 2001, PNB purchased a 20% equity interest in Community Bankers Insurance
Agency (CBIA). This investment gave the Bank a referral avenue to provide
insurance. In May of 2007, PNB sold the 20% equity interest in
CBIA.





Investment Portfolio and
Activities


PNB’s
investment portfolio has several objectives.


·
            A
      key objective is to provide a balance in PNB's asset mix of loans and
      investments consistent with its liability structure, and to assist in
      management of interest rate risk. The investments augment PNB's capital
      position in the risk-based capital formula, providing the necessary
      liquidity to meet fluctuations in credit demands of the community and also
      fluctuations in deposit levels.·
            In
      addition, the portfolio provides collateral for pledging against public
      funds, and a reasonable allowance for control of tax
      liabilities.·
            Finally,
      the investment portfolio is designed to provide income for
      PNB.





In view
of the above objectives, the portfolio is treated conservatively by management
and only securities that pass those criteria are purchased.





Competition


PNB
operates in a fairly competitive environment, competing for deposits and loans
with commercial banks, thrifts, credit unions, and finance and mortgage
companies. Some of these competitors possess substantially greater financial
resources than those available to PNB. Also, certain of these institutions have
significantly higher lending limits than PNB and may provide various services
for their customers that are not presently available at
PNB.  Financial institutions generally compete on the basis of rates
and service. PNB is subject to increasing competition from credit unions,
finance companies, and mortgage companies that may not be subject to the same
regulatory restrictions and taxations as commercial banks.


12


PNB will
seek to remain competitive with interest rates that it charges on its loans and
offers on deposits. It also believes that its success has been, and will
continue to be, due to its emphasis on community involvement, customer services,
and relationships. With consolidation continuing in the financial industry, and
particularly in PNB’s markets, smaller profitable banks are gaining
opportunities where larger institutions exit markets that are only marginally
profitable for them.





The
financial services industry in the Company’s service area is extremely
competitive. The Company’s competitors within its service area include banks and
bank holding companies with substantially greater resources. Many competitors
have substantially higher legal lending limits.





In
addition, savings banks, savings and loan associations, credit unions, money
market and other mutual funds, mortgage companies, leasing companies, finance
companies, and other financial services companies offer products and services
similar to those offered by the Company and PNB, on competitive
terms.





Although
the Company has not done so, many bank holding companies have elected to become
financial holding companies under the Gramm-Leach-Bliley Act, which gives them a
broader range of products with which we must compete. Although the long-range
effects of this development cannot be predicted, most probably it will further
narrow the differences and intensify competition among commercial banks,
investment banks, insurance firms and other financial services
companies.





SEASONALITY


Management
does not feel that the deposits or the business of PNB in general are seasonal
in nature. The deposits may, however, vary with local and national economic
conditions but should not have a material effect on planning and policy
making.





CRITICAL ACCOUNTING
POLICIES


Disclosure
of the Company’s significant accounting policies is included in Note 1 to the
Consolidated Financial Statements. Some of these policies are particularly
sensitive requiring significant judgments, estimates and assumptions to be made
by management. Additional information is contained in Management’s Discussion
and Analysis for these issues, including the provision and allowance for loan
losses, which are located in Note 3 to the Consolidated Financial Statements;
the valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans and determination of other-than-temporary impairment
losses on securities, which is located in Note 2 to the Consolidated Financial
Statements.





Significant
estimates are made by management in determining the allowance for loan losses.
Consideration is given to a variety of factors in establishing this estimate. In
estimating the allowance for loan losses, management considers current economic
conditions, diversification of the loan portfolio, delinquency statistics,
results of internal loan review, financial and managerial strengths of
borrowers, adequacy of collateral, if collateral dependent, or present value of
future cash flows and other relevant factors.   In estimating the
valuation of real estate acquired in connection with foreclosure or in
satisfaction of loans, management considers current economic conditions and
appraised values of collateral, if collateral dependent.  When
determining if there is other-than-temporary impairment losses on securities,
management considers (1) the length of time and the extent to which the fair
value has been less than costs (2) the financial condition and near-term
prospects of the issuer and (3) the intent and ability of the Company to retain
its investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value.





INTERNET ADDRESS
DISCLOSURES


PNB’s
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports
on Form 8-K and amendments to those reports can be found via a link to the SEC
Web page through our Website located at  www.peoplesnatbank.com.   This
website is available free of charge.





PNB has
posted its Code of Ethics for the chief executive officer, chief operation and
financial officer, and controller. This policy can be found at our Website
located at www.peoplesnatbank.com.
Copies are also available upon request and free of charge for Shareholders
without Web access.


13





STATISTICAL
DISCLOSURES


The
following statistical disclosures are included in Management’s Discussion and
Analysis, Item 7 hereof, and are incorporated by reference in this Item
1:


·
            Interest
      Rate Sensitivity Analysis;·
            Interest
      Income and Expense, Volume and Rate Analysis;·
            Investment
      Portfolio;·
            Loan
      Maturity and Interest Rate Sensitivity;·
            Loan
      Portfolio;·
            Allocation
      of Allowance for Loan Losses;·
            Deposits;
      and·
            Short-term
      Borrowings.





ITEM
1A RISK FACTORS


Changes
in interest rates could reduce our income, cash flows and asset
values.


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





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


Deterioration
in local, regional, national or global economic conditions could cause us to
experience a reduction in deposits and new loans, an increase in the number of
borrowers who default on their loans and a reduction in the value of the
collateral securing their loans, all of which could adversely affect our
performance and financial condition.  Unlike larger banks that are
more geographically diversified, we provide banking and financial services
locally.  Therefore, we are particularly vulnerable to adverse local
economic conditions.





Our
financial condition and results of operations would be adversely affected if our
allowance for loan losses is not sufficient to absorb actual losses or if we are
required to increase our allowance.


Despite
our underwriting criteria, we may experience loan delinquencies and
losses.  In order to absorb losses associated with nonperforming
loans, we maintain an allowance for loan losses based on, among other things,
historical experience, an evaluation of economic conditions, and regular reviews
of delinquencies and loan portfolio quality.  Determination of the
allowance inherently involves a high degree of subjectivity and requires us to
make significant estimates of current credit risks and future trends, all of
which may undergo material changes.  At any time, there are likely to
be loans in our portfolio that will result in losses but that have not been
identified as non-performing or potential problem credits.  We cannot
be sure that we will be able to identify deteriorating credits before they
become nonperforming assets or that we will be able to limit losses on those
loans that are identified.  We may be required to increase our
allowance for loan losses for any of several reasons.  Regulators, in
reviewing our loan portfolio as part of a regulatory examination, may request
that we increase our allowance for loan losses.  Changes in economic
conditions affects borrowers, new information regarding existing loans,
identification of additional problem loans and other factors, both within and
outside of our control, may require an increase in our allowance.  In
addition, if charge-offs in future periods exceed our allowance for loan losses,
we will need additional increases in our allowance for loan
losses.  Any increase in our allowance for loan losses will result in
a decrease in our net income and, possibly, our capital, and may materially
affect our results of operations in the period in which the allowance is
increased.


14





Competition
may decrease our growth or profits.


We face
substantial competition in all phases of our operations from a variety of
different competitors, including commercial banks, credit unions, consumer
finance companies, insurance companies and money market funds.  There
is very strong competition among financial services providers in our principal
service area.  Our competitors may have greater resources, higher
lending limits or larger branch systems than we do.  Accordingly, they
may be able to offer a broader range of products and services as well as better
pricing for those products and services than we can.  In addition,
some of the financial services organizations with which we compete are not
subject to the same degree of regulation as is imposed on federally insured
financial institutions.  As a result, those non-bank competitors may
be able to access funding and provide various services more easily or at less
cost than we can, adversely affecting our ability to compete
effectively.





We
may be adversely affected by government regulation.


The
banking industry is heavily regulated.  Banking regulations are
primarily intended to protect the federal deposit insurance funds and
depositors, not shareholders.  Changes in the laws, regulations, and
regulatory practices affecting the banking industry may increase our cost of
doing business or otherwise adversely affect us and create competitive
advantages for others.  Regulations affecting banks and financial
services companies undergo continuous change, and we cannot predict the ultimate
effect of these changes, which could have a material adverse effect on our
profitability or financial condition.





We
rely on our management and other key personnel, and the loss of any of them may
adversely affect our operations.


We are,
and will continue to be, dependent upon the services of our management
team.  The unexpected loss of services of any key management personnel
could have an adverse effect on our business and financial condition because of
their skills, knowledge of our market, years of industry experience and the
difficulty of promptly finding qualified replacement personnel.





Environmental
liability associated with lending activities could result in
losses.


In the
course of our business, we may foreclose on and take title to properties
securing our loans.  If hazardous substances were discovered on any of
these properties, we could be liable to governmental entities or third parties
for the costs of remediation of the hazard, as well as for personal injury and
property damage.  Many environmental laws can impose liability
regardless of whether we knew of, or were responsible for, the
contamination.  In addition, if we arrange for the disposal of
hazardous or toxic substances at another site, we may be liable for the costs of
cleaning up and removing those substances from the site even if we neither own
nor operate the disposal site.  Environmental laws may require us to
incur substantial expenses and may materially limit use of properties we acquire
through foreclosure, reduce their value or limit our ability to sell them in the
event of a default on the loans they secure.  In addition, future laws
or more stringent interpretations or enforcement policies with respect to
existing laws may increase our exposure to environmental liability.





Failure
to implement new technologies in our operations may adversely affect our growth
or profits.


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





An
investment in our common stock is not an insured deposit.


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


15





Our
legal lending limits are relatively low and restrict our ability to compete for
larger customers.


At
December 31, 2007, our lending limit per borrower was approximately $6.0
million, or approximately 15% of our capital.  Accordingly, the size
of loans that we can offer to potential borrowers (without participation by
other lenders) is less than the size of loans that many of our competitors with
larger capitalization are able to offer.  Our legal lending limit also
impacts the efficiency of our lending operation because it tends to lower our
average loan size, which means we have to generate a higher number of
transactions to achieve the same portfolio volume.  We may engage in
loan participations with other banks for loans in excess of our legal lending
limits.  However, there can be no assurance that such participations
will be available at all or on terms which are favorable to us and our
customers.





Market
conditions may adversely affect our fee based investment business.


The
Company receives fee based revenues from commissions from the sale of securities
and investment advisory fees.  In the event of decreased stock market
activity, the volume of trading facilitated by Uvest Financial Services will in
all likelihood decrease resulting in decreased commission revenue on purchases
and sales of securities.  In addition, investment advisory fees, which
are generally based on a percentage of the total value of an investment
portfolio, will decrease in the event of decreases in the values of the
investment portfolios, for example, as a result of overall market
declines.





ITEM
1B UNRESOLVED STAFF COMMENTS





NONE.





ITEM
2 PROPERTIES





PNB has
four full-service banking offices in Susquehanna County that are located
in:


·
            Borough
      of Susquehanna Depot;·
            Hallstead
      Plaza, Great Bend Township;·
            Borough
      of Hop Bottom; and·
            Montrose,
      Bridgewater Township.





PNB’s
presence in Wyoming County, Pennsylvania had been limited to a de novo branch in
Nicholson, which opened in 1992, until the purchase of the two Mellon bank
offices in 1997. The Wyoming County locations are:


·
            Borough
      of Nicholson;·
            Meshoppen
      Township; and·
            Tunkhannock
      Borough.





The
administrative/operations office of the Company and PNB is located at 50 Main
Street, Hallstead, Pennsylvania. The following departments are located at that
office:


·
            commercial,
      mortgage and consumer lending operations;·
            executive
      offices;·
            marketing
      department;·
            human
      resources department;·
            deposit
      account support services;·
            data
      processing services; and·
            corporate
      accounting.





16





PNB began
expanding its branch locations into New York in 2002. The latest updates on
these expansions are:


·
            The
      Bank had an office located in the Price Chopper Super Market in Norwich,
      Chenango County, New York. This office was purchased from Mohawk Community
      Bank, Amsterdam, New York, in March of 2002. A decision was made to close
      this office effective March 31, 2003, because of its distance from
      Hallstead, high lease payments, and lack of growth opportunity for our
      Bank in that area.·
            Subsequently,
      real estate was purchased in Conklin, New York, approximately 10 miles
      from Hallstead. Regulators approved permission to establish an office at
      that site and the official opening date was March 17, 2003.  The
      office is located at 1026 Conklin Road and is approximately ten miles from
      the Administrative Office of PNB.·
            Also,
      on December 12, 2002, property was purchased at 108 Second Street, Town of
      Sanford, Village of Deposit, Broome County, New York. Regulatory approval
      was received to establish this second New York State office, and the
      official opening date of this office, which is located approximately 25
      miles from the Administrative Office, was April 18,
  2005.·
            The
      application was approved for the third New York State office located on
      Front Street in the Town of Chenango, Broome County.  This
      office, which was officially opened on June 6, 2005, is approximately 20
      miles from the Administrative
Office.





All
offices are owned in fee title by PNB with the exception of the Hallstead Plaza,
Meshoppen and Town of Chenango offices. The Hallstead Plaza and Meshoppen
offices are subject to ground leases; and the Front Street office is subject to
a building lease. Each lease is either long-term expiring in September 2028 or
includes renewal options. Current lease payments range from $2,725 to $38,496
annually. The leases provide that the Bank pay property taxes, insurance, and
maintenance costs. Nine of the ten offices provide drive-up banking services and
eight offices have 24-hour ATM services.





ITEM
3 LEGAL PROCEEDINGS





The
Company is a defendant in various lawsuits wherein various amounts are
claimed.  In the opinion of the Company’s management, these suits are
without merit and should not result in judgments, which, in the aggregate, would
have a material adverse effect on the Company’s consolidated financial
statements.






ITEM
4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS




NONE.


17





PART II





ITEM 5 MARKET FOR REGISTRANT'S COMMON
EQUITY AND RELATED STOCKHOLDER MATTERS





The
Company’s Common Stock is not listed on an exchange or quoted on the National
Association of Securities Dealers, Inc. Automated Quotation system (NASDAQ). The
Company’s common stock is traded sporadically in the over-the-counter market
and, accordingly, there is no established public trading market at this time.
The Company’s stock is listed on the OTC Bulletin Board under the symbol PFIS.
The cusip number is 711040-10-5. The investment firms of Ferris, Baker Watts,
Incorporated from Baltimore, Maryland, and Ryan Beck from Livingston, New
Jersey, make a limited market in the Company’s common stock. The Company, and
previously the Bank, have continuously paid dividends for more than 90 years and
it is the intention to pay dividends in the future. However, future dividends
must necessarily depend upon earnings, financial condition, appropriate legal
restrictions, and other factors at the time that the Board of Directors
considers dividend payments. As of December 31, 2007, there were 47,593
outstanding options to purchase the Company’s common stock. See Note 8 of the
Consolidated Financial Statements for more information. Book value of common
stock at December 31, 2007, was $13.64 and on December 31, 2006, it was $13.16.
As of December 31, 2007, the Company had approximately 1,076 shareholders of
record. At such date, 3,138,493 shares of Common Stock were
outstanding.





The
following table reflects high and low bid prices for shares of the Company’s
Common Stock to the extent such information is available, and the dividends
declared with respect thereto during the preceding two years.





COMPANY
STOCK


2007
            
            
            2006Price
      Range
            
            
            Dividends
            
            
            Price
      Range
            
            
            DividendsLow
            
            
            High
            
            
            Declared
            
            
            Low
            
            
            High
            
            
            DeclaredFirst
      Quarter
            
            $
            25.50
            
            
            $
            28.00
            
            
            $
            .19
            
            
            $
            29.05
            
            
            $
            31.50
            
            
            $
            .19Second
      Quarter
            
            $
            26.05
            
            
            $
            30.50
            
            
            $
            .19
            
            
            $
            28.90
            
            
            $
            29.25
            
            
            $
            .19Third
      Quarter
            
            $
            27.60
            
            
            $
            30.00
            
            
            $
            .19
            
            
            $
            26.35
            
            
            $
            28.90
            
            
            $
            .19Fourth
      Quarter
            
            $
            26.30
            
            
            $
            30.00
            
            
            $
            .19
            
            
            $
            26.00
            
            
            $
            26.50
            
            
            $
            .19








18





The
following table discloses the number of outstanding options, warrants and rights
granted by the Company to participants in equity compensation plans, as well as
the number of securities remaining available for future issuance under these
plans. The table provides this information separately for equity compensation
plans that have and have not been approved by security holders.





(a)
            
            
            (b)
            
            
            (c)Number
      of securities to
              be
      issued upon exercise
              of
      outstanding options,
              warrants
      and rights
            
            
            Weighted-average
      exercise
              price
      of outstanding options,
              warrants
      and rights
            
            
            Number
      of securities remaining
              available
      for future issuance under
              equity
      compensation plans
              {excluding
      securities reflected in column (a) }*Equity
      compensation plans
              approved
      by stockholders
            
            
            47,593
            
            
            $
            20.75
            
            
            
            85,751Equity
      compensation plans
              not
      approved by stockholders
            
            
            0
            
            
            
            0
            
            
            
            0Total
            
            
            47,593
            
            
            $
            20.75
            
            
            
            85,751




*
Securities for future issuance are reserved and issued at the discretion of the
Board of Directors on an annual basis.





The
following table discloses the purchases made by the Company of shares of its
common stock in the fourth quarter of 2007.





MONTH
            
            Total
      number of shares purchased
            
            
            Average
      price paid per share
            
            
            Total
      number of shares purchased as part of publicly announced plans or
      programs
            
            
            Maximum
      number of shares that may yet be purchased under the plans or programs
      (1)October
      1, 2007 – October 31, 2007
            
            
            0
            
            
            $
            0
            
            
            
            0
            
            
            
            85,751November
      1, 2007 – November 30, 2007
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            85,751December
      1, 2007 – December 31, 2007
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            85,751Total
            
            
            0
            
            
            $
            0
            
            
            
            0





(1) On
December 27, 1995, the Board of Directors authorized the repurchase of 187,500
shares of the Corporation’s common stock from shareholders.  On July
2, 2001, the Board of Directors authorized the repurchase of an additional 5%,
or 158,931 shares of the Corporation’s common stock
outstanding.  Neither repurchase program stipulated an expiration
date.





The
performance graph formerly included in the Company’s Proxy Statement can now be
found in the Company’s Annual Report to its shareholders.
























19


ITEM 6 SELECTED FINANCIAL
DATA





Consolidated
      Financial Highlights
            
            At
      and For the Years Ended December 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003(Dollars
      In Thousands, except Per Share Data)Net
      Income
            
            $
            4,871
            
            
            $
            4,129
            
            
            $
            4,476
            
            
            $
            4,453
            
            
            $
            5,564Return
      of Average Assets
            
            
            1.17
            %
            
            
            1.03
            %
            
            
            1.16
            %
            
            
            1.18
            %
            
            
            1.54
            %Return
      on Average Equity
            
            
            11.38
            %
            
            
            10.32
            %
            
            
            11.37
            %
            
            
            10.84
            %
            
            
            14.18
            %Shareholders'
      ValueEarnings
      per Share, Basic
            
            $
            1.55
            
            
            $
            1.31
            
            
            $
            1.42
            
            
            $
            1.41
            
            
            $
            1.76Earnings
      per Share, Diluted
            
            
            1.55
            
            
            
            1.31
            
            
            
            1.41
            
            
            
            1.40
            
            
            
            1.75Regular
      Cash Dividends
            
            
            0.76
            
            
            
            0.76
            
            
            
            0.76
            
            
            
            0.73
            
            
            
            0.65Special
      Cash Dividends
            
            
            0.00
            
            
            
            0.00
            
            
            
            1.00
            
            
            
            0.00
            
            
            
            0.00Book
      Value
            
            
            13.64
            
            
            
            13.16
            
            
            
            12.55
            
            
            
            13.42
            
            
            
            12.98Market
      Value at End of the Year
            
            
            26.30
            
            
            
            26.00
            
            
            
            31.45
            
            
            
            36.00
            
            
            
            32.40Market
      Value/Book Value Ratio
            
            
            192.82
            %
            
            
            197.57
            %
            
            
            250.60
            %
            
            
            268.26
            %
            
            
            249.61
            %Price
      Earnings Multiple
            
            
            16.97
            X
            
            
            19.85
            X
            
            
            22.14
            X
            
            
            25.59
            X
            
            
            18.41
            XDividend
      Payout Ratio
            
            
            48.92
            %
            
            
            57.93
            %
            
            
            53.50
            %
            
            
            51.91
            %
            
            
            36.96
            %Dividend
      Yield
            
            
            2.89
            %
            
            
            2.94
            %
            
            
            2.42
            %
            
            
            2.03
            %
            
            
            2.07
            %Safety and
      SoundnessStockholders'
      Equity/Asset Ratio
            
            
            9.85
            %
            
            
            9.91
            %
            
            
            10.13
            %
            
            
            11.16
            %
            
            
            11.06
            %Allowance
      for Loan Loss as a Percent of Loans
            
            
            0.84
            %
            
            
            0.66
            %
            
            
            0.92
            %
            
            
            1.12
            %
            
            
            0.89
            %Net
      Charge Offs/Total Loans
            
            
            (0.13
            %)
            
            
            0.33
            %
            
            
            0.29
            %
            
            
            0.17
            %
            
            
            0.06
            %Allowance
      for Loan Loss/Nonaccrual Loans
            
            
            620.51
            %
            
            
            402.70
            %
            
            
            206.62
            %
            
            
            132.77
            %
            
            
            212.70
            %Allowance
      for Loan Loss/Non-performing Loans
            
            
            504.32
            %
            
            
            248.89
            %
            
            
            183.74
            %
            
            
            116.29
            %
            
            
            192.20
            %Balance Sheet
      HighlightsTotal
      Assets
            
            $
            434,434
            
            
            $
            416,268
            
            
            $
            391,198
            
            
            $
            379,375
            
            
            $
            371,289Total
      Investments
            
            
            112,746
            
            
            
            110,302
            
            
            
            108,313
            
            
            
            113,598
            
            
            
            116,126Net
      Loans
            
            
            289,163
            
            
            
            269,383
            
            
            
            256,870
            
            
            
            242,075
            
            
            
            234,274Allowance
      for Loan Losses
            
            
            2,451
            
            
            
            1,792
            
            
            
            2,375
            
            
            
            2,739
            
            
            
            2,093Short-term
      Borrowings
            
            
            22,848
            
            
            
            12,574
            
            
            
            17,842
            
            
            
            14,614
            
            
            
            7,085Long-term
      Borrowings
            
            
            38,534
            
            
            
            36,525
            
            
            
            34,770
            
            
            
            46,034
            
            
            
            41,952Total
      Deposits
            
            
            327,430
            
            
            
            323,613
            
            
            
            296,962
            
            
            
            274,775
            
            
            
            279,700Stockholders'
      Equity
            
            
            42,805
            
            
            
            41,240
            
            
            
            39,616
            
            
            
            42,354
            
            
            
            41,076





20


ITEM
7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





This
consolidated review and analysis of Peoples Financial Services Corp. (the
Company) is intended to assist the reader in evaluating the Company’s
performance for the years ending December 31 2007, 2006, and 2005. The
information should be read in conjunction with the consolidated financial
statements and the accompanying notes to those statements.





Peoples
Financial Services Corp. (the Company) is the one-bank holding company of
Peoples National Bank (the Bank), which is wholly owned by the Company. The
Company and the Bank derive their primary income from the operation of a
commercial bank, including earning interest on loans and investment securities.
The Bank incurs interest expense in relation to deposits and other borrowings.
The Bank operates ten full-service branches in the Hallstead Shopping Plaza, Hop
Bottom, Montrose, Susquehanna, Nicholson, Tunkhannock, and Meshoppen,
Pennsylvania and Conklin, Village of Deposit and Town of Chenango, Broome
County, New York. The Bank has on-site automated teller machines at all offices
except Hop Bottom and Meshoppen. The administrative offices and operations
offices are located in Hallstead, Pennsylvania. Principal market areas are
Susquehanna and Wyoming Counties in Pennsylvania and the Southern Tier of Broome
County, New York and the bordering areas of those counties. As of December 31,
2007, the Bank employed 105 full-time employees and 23 part-time
employees.





Forward
Looking Statements


When used
in this discussion, the words “believes”, “anticipates”, “contemplated”,
“expects”, or similar expressions are intended to identify forward looking
statements. Such statements are subject to certain risks and uncertainties that
could cause actual results to differ materially from those projected. Those
risks and uncertainties include changes in interest rates, the ability to
control costs and expenses, and general economic conditions. The Company
undertakes no obligation to publicly release the results of any revisions to
those forward looking statements that may be made to reflect events or
circumstances after this date or to reflect the occurrence of unanticipated
events.





Critical
Accounting Policies


Note 1 to
the Company’s consolidated financial statements lists significant accounting
policies used in the development and presentation of its financial statements.
This discussion and analysis, the significant accounting policies, and other
financial statement disclosures identify and address key variables and other
qualitative and quantitative factors that are necessary for an understanding and
evaluation of the Company and its results of operations.





The
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States, which require the Company to
make estimates and assumptions. The Company believes that its determination of
the allowance for loan losses involves a higher degree of judgment and
complexity than the Company’s other significant accounting policies. Further,
these estimates can be materially impacted by changes in market conditions or
the actual or perceived financial condition of the Company’s borrowers,
subjecting the Company to significant volatility of earnings.





The
allowance for loan losses is established through the provision for loan losses,
which is a charge against earnings. Provisions for loan losses are made to
reserve for estimated probable losses on loans. The allowance for loan losses is
a significant estimate and is regularly evaluated by the Company for adequacy by
taking into consideration factors such as changes in the nature and volume of
the loan portfolio, trends in actual and forecasted credit quality, including
delinquency, charge-off and bankruptcy rates, and current economic conditions
that may affect a borrower’s ability to pay. The use of different estimates of
assumptions could produce a different provision for loan losses. For additional
discussion concerning the Company’s allowance for loan losses and related
matters, see “Provision for Loan Losses”.





The
Company considers current economic conditions and the appraised value of any
underlying collateral when determining the estimated value of foreclosed
properties. In determining the necessity of recording an other-than-temporary
impairment on securities owned by the Company, three main characteristics are
considered; the length of time and extent to which a security has been “under
water”, the financial condition and current outlook of the issuer and finally,
the intent and ability of the Company to hold the security until such a time in
which there is a full recovery in fair value.


21





Prior to
January 1, 2006 and as previously permitted by SFAS No. 123, the Company
accounted for stock-based compensation in accordance with Accounting Principles
Board Opinion (APB) No. 25. Under APB No. 25, no compensation expense was
recognized in the income statement related to any option granted under the
Company stock option plans. The pro forma impact to net income and earnings per
share that would have occurred if compensation expense had been recognized,
based on the estimated fair value of the options on the date of the grant, is
disclosed in the notes to the consolidated financial statements for 2005. In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement
No. 123(R), “Share-Based Payment.” Statement No. 123(R) replaced Statement No.
123, “Accounting for Stock-Based Compensation,” and superseded APB Opinion No.
25, “Accounting for Stock Issued to Employees.”  Statement No. 123(R)
requires compensation costs related to share-based payment transactions to be
recognized in the financial statements over the period that an employee provides
service in exchange for the award.  Public companies were required to
adopt the new standard using a modified prospective method and were given the
option of restating prior periods using the modified retrospective
method.  The Bank did not elect to use the modified retrospective
method.  Under the modified prospective method, companies are required
to record compensation cost for new and modified awards over the related vesting
period of such awards prospectively and record compensation cost prospectively
for the unvested portion, at the date of adoption, of previously issued and
outstanding awards over the remaining vesting period of such
awards.  No change to prior periods presented is permitted under the
modified prospective method.  Statement No. 123(R) became effective
for annual reporting periods beginning after December 15,
2005.  Adopting Statement No. 123(R) on January 1, 2006 using the
modified prospective method, the Company incurred total stock-based compensation
expense, net of related tax effects, in the amount of $3,000 for the years ended
December 31, 2007 and 2006 respectively.





RESULTS OF
OPERATIONS


Net
Interest Income


Net
interest income is the main source of the Company’s income. It is the difference
between interest earned on assets and interest paid on liabilities. The
discussion of net interest income should be read in conjunction with Table 2:
“Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates
and Interest Differential”, and Table 3: “Rate/Volume Analysis of Changes in Net
Interest Income.”





The
following table shows the net interest income on a fully-tax-equivalent basis
for each of the three years ended December 2007, 2006, and 2005.





TABLE
1





NET
INTEREST INCOME


Year-Ended
      December 31,(In
      Thousands)
            
            2007
            
            
            2006
            
            
            2005Total
      Interest Income
            
            $
            24,611
            
            
            $
            22,698
            
            
            $
            20,672Tax
      Exempt Loans
            
            
            486
            
            
            
            439
            
            
            
            389Non-Taxable
      Securities
            
            
            885
            
            
            
            764
            
            
            
            785Total Tax
      Equivalent Adjustment
            
            
            1,371
            
            
            
            1,203
            
            
            
            1,174Total
      Tax Equivalent Interest Income
            
            
            25,982
            
            
            
            23,901
            
            
            
            21,846Total
      Interest Expense
            
            
            11,105
            
            
            
            10,797
            
            
            
            8,248Net
      Interest Income (Fully Tax Equivalent Basis)
            
            $
            14,877
            
            
            $
            13,104
            
            
            $
            13,598





Table 2
includes the average balances, interest income and expense, and the average
rates earned and paid for assets and liabilities.  For yield
calculation purposes, non-accruing loans are included in average loan balances.
Table 3 analyzes the components contributing to the changes in net interest
income and indicates the impact in either changes in rate or changes in
volume.


22





Distribution
of Assets, Liabilities and Stockholders' Equity


Interest
Rates and Interest Differential


TABLE
2





Year
      Ended
              December
      31, 2007
            
            
            Year
      Ended
              December
      31, 2006
            
            
            Year
      Ended
              December
      31, 2005(Dollars
      In Thousands)
            
            Average
            
            
            
            Yield/
            
            
            Average
            
            
            
            Yield/
            
            
            Average
            
            
            
            
            Yield/ASSETS
            
            Balance
            
            Interest
            
            Rate
            
            
            Balance
            
            Interest
            
            Rate
            
            
            Balance
            
            
            Interest
            
            RateLoansReal
      Estate
            
            $
            115,490
            
            $
            7,615
            
            6.59
            %
            
            $
            110,972
            
            $
            7,136
            
            6.43
            %
            
            $
            108,887
            
            
            $
            6,814
            
            6.26
            %Installment
            
            
            17,143
            
            
            1,442
            
            8.41
            %
            
            
            17,210
            
            
            1,417
            
            8.23
            %
            
            
            17,587
            
            
            
            1,304
            
            7.41
            %Commercial
            
            
            123,854
            
            
            9,424
            
            7.61
            %
            
            
            118,904
            
            
            8,532
            
            7.18
            %
            
            
            104,317
            
            
            
            7,058
            
            6.77
            %Tax
      Exempt
            
            
            21,165
            
            
            943
            
            6.75
            %
            
            
            20,051
            
            
            853
            
            6.45
            %
            
            
            19,136
            
            
            
            757
            
            5.99
            %Other
      Loans
            
            
            467
            
            
            57
            
            12.21
            %
            
            
            473
            
            
            58
            
            12.26
            %
            
            
            632
            
            
            
            53
            
            8.39
            %Total
      Loans
            
            
            278,119
            
            
            19,481
            
            7.18
            %
            
            
            267,610
            
            
            17,996
            
            6.89
            %
            
            
            250,559
            
            
            
            15,986
            
            6.54
            %Investment
      Securities  (AFS)Taxable
            
            
            65,438
            
            
            3,351
            
            5.12
            %
            
            
            65,202
            
            
            3,032
            
            4.65
            %
            
            
            72,358
            
            
            
            3,086
            
            4.26
            %Non-Taxable
            
            
            44,192
            
            
            1,717
            
            5.89
            %
            
            
            39,435
            
            
            1,484
            
            5.70
            %
            
            
            39,386
            
            
            
            1,523
            
            5.86
            %Total
      Securities
            
            
            109,630
            
            
            5,068
            
            5.43
            %
            
            
            104,637
            
            
            4,516
            
            5.05
            %
            
            
            111,744
            
            
            
            4,609
            
            4.83
            %Time
      Deposits With Other Banks
            
            
            315
            
            
            18
            
            5.71
            %
            
            
            932
            
            
            53
            
            5.69
            %
            
            
            0
            
            
            
            0
            
            0.00
            %Fed
      Funds Sold
            
            
            723
            
            
            44
            
            6.09
            %
            
            
            2,467
            
            
            133
            
            5.39
            %
            
            
            2,093
            
            
            
            77
            
            3.68
            %Total
      Earning Assets
            
            
            388,787
            
            
            24,611
            
            6.68
            %
            
            
            375,646
            
            
            22,698
            
            6.36
            %
            
            
            364,396
            
            
            
            20,672
            
            6.00
            %Less:
      Allowance for Loan Losses
            
            
            (2,025
            
            
            
            
            
            
            
            
            (2,344
            
            
            
            
            
            
            
            
            (2,601
            )Cash
      and Due from Banks
            
            
            6,639
            
            
            
            
            
            
            
            
            6,768
            
            
            
            
            
            
            
            
            6,526Premises
      and Equipment, Net
            
            
            5,712
            
            
            
            
            
            
            
            
            7,816
            
            
            
            
            
            
            
            
            5,565Other
      Assets
            
            
            17,690
            
            
            
            
            
            
            
            
            12,899
            
            
            
            
            
            
            
            
            12,167Total
      Assets
            
            $
            416,803
            
            
            
            
            
            
            
            $
            400,785
            
            
            
            
            
            
            
            $
            386,053LIABILITIES
      AND
              STOCKHOLDERS’
      EQUITYDepositsInterest
      Bearing Demand
            
            $
            25,341
            
            
            290
            
            1.14
            %
            
            $
            25,462
            
            
            262
            
            1.03
            %
            
            $
            24,207
            
            
            
            169
            
            0.70
            %Regular
      Savings
            
            
            106,969
            
            
            3,311
            
            3.10
            %
            
            
            95,360
            
            
            3,135
            
            3.29
            %
            
            
            72,597
            
            
            
            1,258
            
            1.73
            %Money
      Market  Savings
            
            
            35,355
            
            
            1,089
            
            3.08
            %
            
            
            37,747
            
            
            1,446
            
            3.83
            %
            
            
            37,232
            
            
            
            911
            
            2.45
            %Time
            
            
            102,643
            
            
            4,329
            
            4.22
            %
            
            
            102,195
            
            
            3,905
            
            3.82
            %
            
            
            107,115
            
            
            
            3,448
            
            3.22
            %Total
      Interest Bearing Deposits
            
            
            270,308
            
            
            9,019
            
            3.34
            %
            
            
            260,764
            
            
            8,748
            
            3.35
            %
            
            
            241,151
            
            
            
            5,786
            
            2.40
            %Other
      Borrowings
            
            
            50,183
            
            
            2,086
            
            4.16
            %
            
            
            48,878
            
            
            2,049
            
            4.19
            %
            
            
            57,987
            
            
            
            2,462
            
            4.25
            %Total
      Interest Bearing Liabilities
            
            
            320,491
            
            
            11,105
            
            3.46
            %
            
            
            309,642
            
            
            10,797
            
            3.49
            %
            
            
            299,138
            
            
            
            8,248
            
            2.76
            %Net
      Interest Spread
            
            
            
            
            $
            13,506
            
            3.22
            %
            
            
            
            
            $
            11,901
            
            2.88
            %
            
            
            
            
            
            $
            12,424
            
            3.24
            %Non-Interest
      BearingDemand
      Deposits
            
            
            52,613
            
            
            
            
            
            
            
            
            49,888
            
            
            
            
            
            
            
            
            45,574Accrued
      Expenses andOther
      Liabilities
            
            
            2,604
            
            
            
            
            
            
            
            
            2,135
            
            
            
            
            
            
            
            
            1,959Stockholder's
      Equity
            
            
            41,095
            
            
            
            
            
            
            
            
            39,120
            
            
            
            
            
            
            
            
            39,382Total
      Liabilities andStockholder's
      Equity
            
            $
            416,803
            
            
            
            
            
            
            
            $
            400,785
            
            
            
            
            
            
            
            $
            386,053Interest
      Income/Earning Assets
            
            
            
            
            
            
            
            6.68
            %
            
            
            
            
            
            
            
            6.36
            %
            
            
            
            
            
            
            
            
            6.00
            %Interest
      Expense/Earning Assets
            
            
            
            
            
            
            
            2.86
            %
            
            
            
            
            
            
            
            2.87
            %
            
            
            
            
            
            
            
            
            2.26
            %Net
      Interest Margin
            
            
            
            
            
            
            
            3.82
            %
            
            
            
            
            
            
            
            3.49
            %
            
            
            
            
            
            
            
            
            3.73
            %


23


TABLE
3





Rate/Volume Analysis of Changes in
Net Interest Income


2007
      to 2006
            
            
            2006
      to 2005(In
      Thousands)
            
            Increase
              (Decrease)
            
            
            Change Due to Rate
            
            
            Volume
            
            
            Increase
              (Decrease)
            
            
            Change Due to Rate
            
            
            VolumeInterest
      IncomeReal
      Estate Loans
            
            $
            479
            
            
            $
            181
            
            
            $
            298
            
            
            $
            322
            
            
            $
            183
            
            
            $
            139Installment
      Loans
            
            
            25
            
            
            
            31
            
            
            
            (6
            )
            
            
            113
            
            
            
            144
            
            
            
            (31
            )Commercial
      Loans
            
            
            892
            
            
            
            515
            
            
            
            377
            
            
            
            1,474
            
            
            
            427
            
            
            
            1,047Tax
      Exempt Loans
            
            
            90
            
            
            
            15
            
            
            
            75
            
            
            
            96
            
            
            
            37
            
            
            
            59Other
      Loans
            
            
            (1
            )
            
            
            0
            
            
            
            (1
            )
            
            
            5
            
            
            
            24
            
            
            
            (19
            )Total
      Loans
            
            
            1,485
            
            
            
            742
            
            
            
            743
            
            
            
            2,010
            
            
            
            815
            
            
            
            1,195Investment
      Securities (AFS)Taxable
            
            
            319
            
            
            
            307
            
            
            
            12
            
            
            
            (54
            )
            
            
            279
            
            
            
            (333
            )Non-Taxable
            
            
            233
            
            
            
            (47
            )
            
            
            280
            
            
            
            (39
            )
            
            
            (42
            )
            
            
            3Total
      Securities (AFS)
            
            
            552
            
            
            
            260
            
            
            
            292
            
            
            
            (93
            )
            
            
            237
            
            
            
            (330
            )Time
      Deposits with Other Banks
            
            
            (35
            )
            
            
            0
            
            
            
            (35
            )
            
            
            53
            
            
            
            0
            
            
            
            53Fed
      Funds Sold
            
            
            (89
            )
            
            
            20
            
            
            
            (109
            )
            
            
            56
            
            
            
            36
            
            
            
            20Total
      Interest Income
            
            
            1,913
            
            
            
            1,022
            
            
            
            891
            
            
            
            2,026
            
            
            
            1,088
            
            
            
            938Interest
      ExpenseInterest
      Bearing Demand Deposits
            
            
            28
            
            
            
            29
            
            
            
            (1
            )
            
            
            93
            
            
            
            80
            
            
            
            13Regular
      Savings Deposits
            
            
            176
            
            
            
            (183
            )
            
            
            359
            
            
            
            1,877
            
            
            
            1,129
            
            
            
            748Money
      Market Savings Deposits
            
            
            (357
            )
            
            
            (283
            )
            
            
            (74
            )
            
            
            535
            
            
            
            515
            
            
            
            20Time
      Deposits
            
            
            424
            
            
            
            405
            
            
            
            19
            
            
            
            457
            
            
            
            645
            
            
            
            (188
            )Total
      Interest Bearing Deposits
            
            
            271
            
            
            
            (32
            )
            
            
            303
            
            
            
            2,962
            
            
            
            2,369
            
            
            
            593Other
      Borrowings
            
            
            37
            
            
            
            (17
            )
            
            
            54
            
            
            
            (413
            )
            
            
            (31
            )
            
            
            (382
            )Total
      Interest Expense
            
            
            308
            
            
            
            (49
            )
            
            
            357
            
            
            
            2,549
            
            
            
            2,338
            
            
            
            211Net
      Interest Spread
            
            $
            1,605
            
            
            $
            1,071
            
            
            $
            534
            
            
            $
            (523
            )
            
            $
            (1,250
            )
            
            $
            727








Interest
income on total loans increased in 2007. This increase of $1,485,000 is shown in
Table 3. Although the increase due to rate was close at $742,000 in 2007
compared to $815,000 in the 2006, the increase in loan income due to volume was
$452,000 less in 2007 at $743,000 compared to $1,195,000 in
2006.  Higher interest rates had a positive impact on the Bank’s
interest income in both years.  To view the loan portfolio growth
numbers and interest yields see Table 2 which shows the average balance in loans
grew from $267,610,000 in 2006 to $278,119,000 in 2007 and the yield grew from
6.89% in 2006 to 7.18% in 2007.





In 2007,
interest income on securities increased $552,000 year over year from
2006.  Table 3 shows that higher rates added $260,000 to interest
income, and the increase in the average balance added $292,000 to
income.  The average investments as shown in Table 2 were $109,630,000
in 2007 compared to $104,637,000 in 2006. In comparison, in 2006 interest income
on securities decreased $93,000 year over year with a $237,000 gain due to
higher rates and a decrease of $330,000 due to volume.  The average
balances on securities were $111,744,000 in 2005 compared to $104,637,000 in
2006.





Interest
income from federal funds sold decreased $89,000 from 2006 to 2007 because of
lower balances maintained in 2007.  Interest income from time deposits
with other banks also decreased in 2007 due to lower balances.  This
compares to 2006 when interest income from federal funds sold increased $56,000
from 2005 to 2006 because of higher interest rates and higher balances as shown
in Table 3. Average federal funds sold were $2,093,000 in 2005 compared to
$2,467,000 in 2006.


24





Interest
income from time deposits with other banks increased $53,000 in 2006 strictly
due to growth as there were none held during 2005.





On the
interest expense side, overall expenses increased by $308,000. Of this total,
$271,000 was attributable to deposit costs and $37,000 was due to other
borrowings.   To break this down further, the deposit interest
costs increased overall by $271,000 which is comprised of both a $32,000 in cost
savings due to rate decreases and an increase of $303,000 due to growth in
deposits.  The average balance in interest earning deposits was
$270,308,000 in 2007 as compared to $260,764,000 in 2006. Other borrowed funds
costs also increased in 2007. Of the $37,000 increase $54,000 was due to the
growth in borrowed funds and $17,000 was saved due to lower
rates.  The average balance of borrowed funds was $50,183,000 in 2007
compared to $48,878,000 in 2006.  Compare those results to 2006 when
interest expense increased by $2,549,000. Of that total increase, $2,338,000 was
attributable to higher rates while $211,000 was attributable to growth. To break
this down further, the deposit interest costs increased overall by $2,962,000
with $2,369,000 of the increase due to rate while the costs for other borrowed
funds decreased over all by $413,000 with $31,000 of that decrease due to rate
and the additional decrease of $382,000 due to loss of volume. In 2006, the
average balance of deposits was $260,764,000 compared to the 2005 average
balance of $241,151,000.





The last
line in Table 3 shows that the net interest spread increased $1,605,000 in 2007
compared to a decrease of $523,000 in the 2006. Table 3 shows the positive
impact of higher interest rates and loan growth in 2007. For comparison, in 2006
the net interest spread decreased $523,000 compared to a decrease of $251,000 in
2005.  The loss of $523,000 in net interest spread in 2006 was due to
the impact of interest rate which caused a decrease of $1,250,000 while growth
contributed a positive influence of $727,000.





PROVISION FOR LOAN
LOSSES


The
provision and allowance for loan losses are based on management’s ongoing
assessment of the Company’s credit exposure and consideration of other relevant
factors. The allowance for loan losses is a valuation reserve that is available
to absorb future loan charge-offs. The provision for loan losses is the amount
charged to earnings on an annual basis. The factors considered in management’s
assessment of the reasonableness of the allowance for loan losses include
prevailing and anticipated economic conditions, assigned risk ratings on loan
exposures, the results of examinations and appraisals of the loan portfolio
conducted by federal regulatory authorities and an independent loan review firm,
the diversification and size of the loan portfolio, the level of and inherent
risk in non-performing assets, and any other factors deemed relevant by
management.





The
provision for loan losses was $280,000, $302,000 and $392,000 for the years
2007, 2006, and 2005, respectively. Net charge-offs (recoveries) for 2007 were
($379,000) compared to $885,000 in 2006. As of December 31, 2007, the allowance
for loan loss was .84% of loans and at December 31, 2006, the ratio was .66% of
loans. After allocation of reserves to all non-accrual and special-mention
loans, as well as applying a percentage to outstanding loans based on the loss
history of such loans in each category, the opinion of management was that the
allowance for loan losses was proper and sufficient.  The allowance
for loan losses is maintained at a level considered adequate to provide for
losses that can be reasonably anticipated.  Management’s periodic
evaluation of the adequacy of the allowance is based on the Bank’s past loan
loss experience, known or inherent risks in the portfolio, adverse situations
that may affect the borrower’s ability to repay, the estimated value of any
underlying collateral, composition of the loan portfolio, current economic
conditions and other relevant factors.  Management believed that
certain risks, primarily current economic conditions, warranted an increase in
the allowance for loan losses for the year ended December 31, 2007. The ratio of
allowance for loan loss to non-performing loans was 504.32% at year end 2007
compared to 248.89% at year end 2006 and 183.74% at year end
2005.


25





The
following table analyzes the increase in total other income by comparing the
years 2007, 2006 and 2005.





TABLE
4





NON-INTEREST
INCOME


Year
      Ended
                December
      31,
              
              
              Variance
      2007
              
              
              Variance
      2006(Dollars
      In Thousands)
              
              2007
              
              
              2006
              
              
              2005
              
              
              Amount
                Of
              
              
              Percent
                Of
      Change
              
              
              Amount
                Of
      Change
              
              
              Percent
                Of
      ChangeCustomer
      Service Fees
              
              $
              1,947
              
              
              $
              1,770
              
              
              $
              1,749
              
              
              $
              177
              
              
              
              10.00
              %
              
              $
              21
              
              
              
              1.20
              %Investment
      Division Commission Income
              
              
              340
              
              
              
              260
              
              
              
              201
              
              
              
              80
              
              
              
              30.77
              %
              
              
              59
              
              
              
              29.35
              %Earnings
      on Investment on Life Insurance
              
              
              297
              
              
              
              281
              
              
              
              263
              
              
              
              16
              
              
              
              5.69
              %
              
              
              18
              
              
              
              6.84
              %Other
      Income
              
              
              626
              
              
              
              437
              
              
              
              382
              
              
              
              189
              
              
              
              43.25
              %
              
              
              55
              
              
              
              14.40
              %Gains
      on Sale of Interest in Insurance Agency
              
              
              220
              
              
              
              0
              
              
              
              0
              
              
              
              220
              
              
              
              100.00
              %
              
              
              0
              
              
              
              0.00
              %Gains
      (Losses) on Security Sales
              
              
              (122
              )
              
              
              42
              
              
              
              222
              
              
              
              (164
              )
              
              
              (390.48
              )%
              
              
              (180
              )
              
              
              (81.08
              %)TOTAL
      Other Income
              
              $
              3,308
              
              
              $
              2,790
              
              
              $
              2,817
              
              
              $
              518
              
              
              
              18.57
              %
              
              $
              (27
              )
              
              
              (0.96
              %)





OTHER INCOME


Non-Interest
Income


There was
an overall increase in non-interest income of $518,000 in 2007.  This
represents an increase of 18.57% in 2007 when compared to $2,790,000 in 2006.
For comparison, there was an overall decrease in non-interest income of $27,000,
or 0.96% in 2006 when compared to $2,817,000 in 2005.





The
non-interest income items that result in these variations are discussed as
follows:





Non-interest
income includes items that are not related to interest rates, but rather to
services rendered and activities conducted in conjunction with the operation of
a commercial bank. Service charges earned on deposit accounts is the largest
single item in this category and represents fees related to deposit accounts
including overdraft fees, minimum balance fees, and transaction fees. In 2007,
service charges and fees increased $177,000, or 10.00% compared to an increase
of $21,000 in 2006, when compared to 2005, or 1.20%.





A
component of customer service fees which showed a substantial increase in 2007
when compared to 2006 was overdraft fees. Net overdraft fees in 2007 were
$1,322,000 compared to $1,189,000 in 2006, an increase of $133,000, or 11.19%.
The higher net overdraft amount in 2007 was due to an increase in charged
overdrafts. Fees which were subsequently returned to the customer remained
fairly level in 2007 when compared to 2006.





In 2006,
customer service fees reflected a decrease in income realized on overdraft fees.
Net overdraft fees were $1,189,000 in 2006 compared to $1,212,000 in 2005, a
decrease of $23,000, or 1.9%.  This decrease was due to a processing
change in 2006.  The actual overdraft fees increased in 2006 while the
fees which were refunded increased at a greater rate, thus causing the overall
decrease.





Commissions
earned by the Investment Division were $340,000 in 2007, compared to $260,000 in
2006, an increase of $80,000, or 30.77%. A strategy was implemented in 2006 in
which the investment division eliminated up front, one time transaction fees in
favor of asset management fees which are earned over the life of an account. The
payoff has been a steady income stream from an increasing customer base. It is
the goal of the Company to continue to grow and cultivate this
area.





By
comparison, commissions earned by the Investment Division were $260,000 in 2006,
compared to $201,000 in 2005, an increase of $59,000, or 29.35%.  As
the Investment Division grew and became more established, so did the commissions
earned on the assets managed. Also contributing to the increase in commissions
in 2006 was the increase experienced in the overall stock market as well as the
relative stability of the bond market.





Earnings
on investment in life insurance were $297,000 in 2007, compared to $281,000 in
2006, an increase of $16,000, or 5.69%.  As was the case in the prior
year, the increase was due to the overall increase in the crediting rate applied
to the balances held in BOLI. The increased crediting rates discussed for a
portion of 2006 were in effect for the entire year in 2007.


26





Earnings
on investment in life insurance were $281,000 in 2006, compared to $263,000 in
2005, an increase of $18,000, or 6.84%.  This was due to the overall
increase in the crediting rate applied to the balances held in
BOLI.  One of the BOLI products owned by the Company increased by 151
basis points during the latter seven months of 2006, one increased by 25 basis
points for the final three months of 2006 and the third BOLI product decreased
by 40 basis points.  Each BOLI instrument owned by the Company had a
value of between $2 million and $2.6 million at that time.





Other
income was $626,000 in 2007, compared to $437,000 in 2006, an increase of
$189,000, or 43.25%.  This was again partially due to income
recognized through the operation of the insurance agency which was $65,000 in
2007, compared to $13,000 in 2006. Various sundry accounts contribute to the
balance of the increase in other income for 2007 when compared to
2006.





Other
income was $437,000 in 2006, compared to $382,000 in 2005, an increase of
$55,000, or 14.40%.  This was primarily due to income recognized
through the operation of the insurance agency which was $13,000 in 2006,
compared to a loss of $16,000 in 2005.  This increase accounted for
the majority of the overall increase in other income in 2006.





Gain on
sale of interest in insurance agency was $220,000 for 2007 compared to $0 in
2006.  The Company realized this gain through the sale of its 20%
interest in Community Bankers Insurance Agency (CBIA) in May of 2007. There was
no comparable gain in 2006. The Company does not expect the sale of the
insurance agency to have a significant impact on future earnings.





In 2007,
The Company had $122,000 in realized losses through sales of available-for-sale
securities compared to a gain of $42,000 in 2006.  This is a decrease
of $164,000, or 390.48%.  Comparing 2006 to 2005, the Company had
$42,000 in realized gains through sales of available-for-sale securities
compared to $222,000 in 2005.  This was a decrease of $180,000, or
81.08%. The decreases experienced over the past two years are due to fewer
available gains through the sale of investment securities.  Unlike
prior years, when investment sales were initiated in 2006 and 2007, market
yields were often higher than the yield on the security sold, the result being
an incurred loss on the security sales.





TABLE
5





NON-INTEREST
EXPENSE


(Dollars
      In Thousands)
            
            Year
      Ended
              December
      31,
            
            
            Variance
      2007
            
            
            Variance
      20062007
            
            
            2006
            
            
            2005
            
            
            Amount
      Of Change
            
            
            Percent
      Of Change
            
            
            Amount
      Of Change
            
            
            Percent
      Of ChangeSalaries
      and Benefits
            
            $
            4,767
            
            
            $
            4,498
            
            
            $
            4,199
            
            
            
            269
            
            
            
            5.98
            %
            
            $
            299
            
            
            
            7.12
            %Occupancy
      Expenses
            
            
            788
            
            
            
            674
            
            
            
            564
            
            
            
            114
            
            
            
            16.91
            %
            
            
            110
            
            
            
            19.50
            %Furniture
      and Equipment Expense
            
            
            508
            
            
            
            484
            
            
            
            427
            
            
            
            24
            
            
            
            4.96
            %
            
            
            57
            
            
            
            13.35
            %FDIC
      Insurance and Assessments
            
            
            151
            
            
            
            127
            
            
            
            141
            
            
            
            24
            
            
            
            18.90
            %
            
            
            (14
            )
            
            
            (9.93
            %)Professional
      Fees and Outside Services
            
            
            371
            
            
            
            337
            
            
            
            471
            
            
            
            34
            
            
            
            10.09
            %
            
            
            (134
            )
            
            
            (28.45
            %)Prepayment
      Penalty – FHLB
            
            
            0
            
            
            
            0
            
            
            
            808
            
            
            
            0
            
            
            
            0.00
            %
            
            
            (808
            )
            
            
            (100.00
            %)Computer
      Services and Supplies
            
            
            785
            
            
            
            774
            
            
            
            778
            
            
            
            11
            
            
            
            1.42
            %
            
            
            (4
            )
            
            
            (0.51
            %)Taxes,
      Other Than Payroll and Income
            
            
            386
            
            
            
            370
            
            
            
            324
            
            
            
            16
            
            
            
            4.32
            %
            
            
            46
            
            
            
            14.20
            %Impairment
      Charge-Other Real Estate
            
            
            575
            
            
            
            0
            
            
            
            0
            
            
            
            575
            
            
            
            100.00
            %
            
            
            0
            
            
            
            0.00
            %Amortization
      Expense-Deposit Premiums
            
            
            255
            
            
            
            299
            
            
            
            262
            
            
            
            (44
            )
            
            
            (14.72
            %)
            
            
            37
            
            
            
            14.12
            %Stationary
      and Printing Supplies
            
            
            339
            
            
            
            247
            
            
            
            216
            
            
            
            92
            
            
            
            37.25
            %
            
            
            31
            
            
            
            14.35
            %Other
      Operating Expenses
            
            
            1,641
            
            
            
            1,678
            
            
            
            1,198
            
            
            
            (37
            )
            
            
            (2.20
            %)
            
            
            480
            
            
            
            40.06
            %Total
      Non-Interest Expense
            
            $
            10,566
            
            
            $
            9,488
            
            
            $
            9,388
            
            
            $
            1,078
            
            
            
            11.36
            %
            
            $
            100
            
            
            
            1.07
            %





27





OTHER EXPENSES


Non-Interest
Expense


Total
non-interest expense increased $1,078,000 from $9,488,000 in 2006 to $10,566,000
in 2007. This is an increase of 11.36%. In September 2007, the Company incurred
an impairment charge to other real estate owned in the amount of $575 thousand.
The charge became necessary in relation to reasonable estimates obtained on the
value of a commercial real estate property that the Bank took a deed in lieu of
foreclosure on in August of 2006.  Excluding this amount from the
total, other expenses increased 5.30% or $503 thousand in 2007. For comparison,
there was an increase in non-interest expense of $100,000, or 1.07% in 2006 when
compared to $9,388,000 in 2005.





Non-interest
expense includes all other expenses associated with the Company. Salaries and
related benefits is the largest expense in this category and it increased
$269,000, or 5.98%, over the year-end 2006. The full-time equivalent number of
employees was 111 as of December 31, 2007, compared to 109 as of December 31,
2006.  Aside from this nominal increase to full-time equivalents,
normal yearly pay increases and increased health insurance costs contributed to
the overall increase in salary and benefit expense.





For
comparison, salaries and related benefits increased $299,000, or 7.12%, in 2006
over year-end 2005. The full-time equivalent number of employees was 109 as of
December 31, 2006, compared to 114 as of December 31, 2005. Normal yearly pay
increases and increased health insurance costs contributed to the overall
increase in salary and benefit expense.





Occupancy
expense increased 16.91%, or $114,000, in 2007 in comparison to fiscal year
2006.  Every category of expense related to building occupancy
increased in 2007 when compared to 2006.  These categories include
utilities, property taxes, repairs and depreciation.  The category
which increased most substantially however was repairs and maintenance to
buildings. The Company hired a new facilities manager in 2007 and one of the
areas of focus was various projects aimed at improving the overall condition of
Company facilities. This category alone increased by $90,000 which accounts for
the majority of year over year increases between 2007 and 2006.





This
compares to 2006 when occupancy expense increased 19.50%, or $110,000, when
compared to 2005. Every category of expense related to building occupancy
increased in 2006 when compared to 2005.  These categories include
utilities, property taxes, repairs and depreciation.  Two new offices
located in New York State were opened in 2005, one in April and the second in
June.  Thus, 2006 was the first full year of operation for those
offices and a full year of occupancy costs were incurred in 2006 versus a
partial year for each of those offices in 2005.





Furniture
and equipment expense increased in 2007 to $508,000, or 4.96%, compared to 2006
at $484,000.  The increase in 2007 is associated with new furniture
and equipment booked mid-year 2006 as replacements for furniture and equipment
destroyed during the June flooding of that year. While the equipment was
depreciated for a partial year in 2006, it was depreciated for a full year in
2007. As a result, related depreciation expense increased in
2007.  Depreciation expense on furniture and equipment was $414,000 in
2007, compared to $392,000 in 2006, an increase of $22,000, or
5.61%.





For
comparison, furniture and equipment expense increased in 2006 to $484,000, or
13.35%, compared to 2005 at $427,000. The increase in 2006 is associated with
increased depreciation expense incurred.  Flooding occurred in the
region in June 2006, and significant damages were experienced as a
result.  Six of the Company’s twelve offices were affected and as
such, unexpected investment was made in new furniture and
equipment.  Much of the furniture and equipment replaced was older,
and in some cases, fully depreciated.  The new furniture and equipment
booked in 2006 caused the related depreciation expense to increase
significantly.  Depreciation expense on furniture and equipment was
$392,000 in 2006, compared to $328,000 in 2005, an increase of $64,000, or
19.51%.





FDIC
insurance and assessments were $151,000 in 2007 which compares to $127,000 in
2006, an increase of $24,000, or 18.90%. The increase is due to the new
risk-based deposit assessment system adopted by the FDIC beginning in 2007.
Under this system, all FDIC insured institutions are required to pay deposit
premiums. The additional premiums due were offset by credits issued for premiums
paid by the Company prior to 1996. Those credits for 2007 were in the amount of
$148,000.





For
comparison, FDIC insurance and assessments were $127,000 in 2006 which compared
to $141,000 in 2005, a decrease of $14,000, or 9.93%.  The decrease in
2006 was considered to be immaterial.


28





Professional
fees and outside services were $371,000 in 2007 which compares to $337,000 in
2006, an increase of $34,000, or 10.09%. The increase is not considered material
or the result of a trend. Loan review fees paid in January 2007 in the amount of
$12 thousand which were not incurred in the same period in 2006 are the reason
for a substantial portion of the increase between periods. Professional fees
were budgeted at $330,000 for 2007.





For
comparison, professional fees and outside services were $337,000 in 2006 which
compared to $471,000 in 2005, a decrease of $134,000, or 28.45%.  The
decrease in 2006 was due to fewer costs associated with Sarbanes-Oxley Section
404 compliance in 2006 when compared to 2005.  Professional fees were
budgeted at $347,000 for 2006.





Computer
services and supplies is another component of other expenses. This category
covers the expense of data processing for the Company.  In 2007, the
expense was $785,000 compared to $774,000 in 2006, an increase of $11,000, or
1.42%.  These increases are deemed to be immaterial and in line with
the previous years’ expenditures as well as budgeted expectations.





For
comparison, in 2006, computer services and supplies was $774,000 compared to
$778,000 in 2005, a decrease of $4,000, or .51%.  These costs were in
line with previous years’ expenditures.





Taxes,
other than payroll and income, are another significant component of non-interest
expense.  In 2007, this expense increased by $16,000, or 4.32%, to
$386,000, compared to 2006 at $370,000.  This increase is not
considered to be significant and it should be noted that shares tax owed to
Pennsylvania will grow as a proportion of the overall growth in Company
assets.  The Company implemented a strategy in 2007 which will limit
this tax burden for future periods. The results of this strategy are as yet
undetermined.





For
comparison, taxes, other than payroll and income, increased in 2006, to
$370,000, compared to $324,000 in 2005, an increase of $46,000, or
14.20%.  In 2006, shares tax owed to Pennsylvania grew in proportion
to the overall growth in Company assets.





Amortization
expense-deposit acquisition premiums decreased by $44,000, or 14.72%, to
$255,000, compared to 2006 at $299,000.  This decrease was due to the
write-off of $38,000 of deposit premiums in December of 2006. The write-off and
subsequent elimination of monthly amortization of those premiums accounts for
the decrease.





For
comparison, amortization expense-deposit acquisition premiums, increased in
2006, to $299,000, compared to $262,000 in 2005, an increase of $37,000, or
14.12%.  As previously stated, $38,000 of deposit premiums was written
off in December of 2006. This accounted for the variation from 2005 to
2006.





Stationary
and printing supplies increased by $92,000, or 37.25%, to $339,000, compared to
2006 at $247,000.  This increase was due in part to a classification
change in which certain computer printing supplies were charged to stationary
and printing supplies in 2007 where in previous years these expenses were
charged to computer supplies. Additionally, the Company has purchased equipment
in relation to a remote deposit capture system instituted in 2007. These charges
are reflected in this increase.





For
comparison, stationary and printing supplies increased in 2006, to $247,000,
compared to $216,000 in 2005, an increase of $31,000, or 14.35%.  This
increase was considered normal due to the addition of two branch offices in
2005. The increase in 2006 reflected the additional stationary and printing
supply costs of these offices for a full calendar year.





Every
other non-interest expense is in the category of other. In 2007, this expense
decreased $37,000, or 2.20%, to $1,641,000. The remaining components in this
figure were: directors’ and associate directors’ fees and company education
costs of $371,000; postage at $171,000; and advertising at $154,000. All were
deemed to be in line with budget.





This
compares to 2006 when this expense increased $480,000, or 40.06%, to $1,678,000.
Of the $480,000 increase experienced in other non-interest expense in 2006,
$192,000 of this increase was directly attributable to flood expenses incurred
as the result of regional flooding in June 2006.  As previously
stated, six of the Company’s twelve offices suffered damage as a result of the
flooding.  Events of this nature are deemed to be
non-recurring.


29





FEDERAL INCOME
TAXES


The
provision for income taxes in 2007 was $1,097,000, compared to $772,000 in 2006
and $985,000 in 2005. The effective tax rate, which is the ratio of income tax
expense to income before taxes, was 18% in 2007, 16% in 2006, and 18% in 2004.
The tax rate for all periods was substantially less than the federal statutory
rate of 34% primarily due to tax-exempt securities and tax-exempt loan income.
The effective tax rate increased slightly in 2007 after falling slightly in 2006
relative to 2005. Please refer to Note 9 of the Notes to Consolidated Financial
Statements included as part of this report for further analysis of federal
income tax expense for 2007.





QUARTERLY RESULTS


Table 6
shows the quarterly results of operations for the Company for 2007 and
2006.  Interest income increased steadily throughout
2007.  This was due primarily to increases in loan balances which were
up 7.34% in 2007. Although the Federal Reserve Bank decreased the federal funds
rate late in 2007, much of the loan portfolio remained unaffected by those rate
decreases, as well as the corresponding decrease to the prime rate. A
significant portion of the loan portfolio including residential mortgages is
tied to longer term treasury rates which remained somewhat steady through
2007.





Interest
expense decreased throughout 2007 as the Federal Reserve Bank acted aggressively
through the latter half of 2007 to cut short term interest
rates.  Many deposit accounts are tied to indexes which reflect
closely the short-end of the yield curve (Fed Funds) and therefore, as rates go
down, so does the resulting interest expense.  The decrease in short
term interest rates, as well as the relatively slow deposit growth rate (1.18%
for 2007) played key roles in the decreased interest expense in
2007.





Table 6
also shows that fluctuations were experienced in gains and losses through sales
of available-for-sale securities in 2007 when compared to 2006.  This
was due to activity in the investment portfolio aimed at positioning the
portfolio for future periods. The sales of lower yielding securities for higher
current market rate securities led to the incurred losses.





Other
income remained somewhat steady throughout 2007 as did other expenses with the
only exception coming in the third quarter when the Company took an impairment
charge to other real estate owned in the amount of $575 thousand.





As a
result of increased earnings through net interest income, earnings per common
share increased steadily throughout 2007. Again, the only exception to this
increase came in the third quarter of 2007.








30





TABLE
6





Quarterly Results of
Operations


(In
Thousands, Except for Per Share Data)


Quarter
      Ended 200731-Mar
            
            
            30-Jun
            
            
            30-Sep
            
            
            31-DecInterest
      Income
            
            $
            6,006
            
            
            $
            6,036
            
            
            $
            6,193
            
            
            $
            6,376Interest
      Expense
            
            
            2,857
            
            
            
            2,807
            
            
            
            2,805
            
            
            
            2,636Net
      Interest Income
            
            
            3,149
            
            
            
            3,229
            
            
            
            3,388
            
            
            
            3,740Provision
      for Loan Losses
            
            
            (120
            )
            
            
            (120
            )
            
            
            (40
            )
            
            
            0Securities
      Gains/Losses
            
            
            29
            
            
            
            (165
            )
            
            
            44
            
            
            
            (30
            )Other
      Income
            
            
            772
            
            
            
            1,013
            
            
            
            783
            
            
            
            862Other
      Expense
            
            
            (2,440
            )
            
            
            (2,471
            )
            
            
            (3,095
            )
            
            
            (2,560
            )Income
      Before taxes
            
            
            1,390
            
            
            
            1,486
            
            
            
            1,080
            
            
            
            2,012Income
      Taxes
            
            
            267
            
            
            
            197
            
            
            
            196
            
            
            
            437Net
      Income
            
            $
            1,123
            
            
            $
            1,289
            
            
            $
            884
            
            
            $
            1,575Basic
      Earnings per share
            
            $
            0.36
            
            
            $
            0.41
            
            
            $
            0.28
            
            
            $
            0.50Diluted
      Earnings per share
            
            $
            0.36
            
            
            $
            0.41
            
            
            $
            0.28
            
            
            $
            0.50Quarter
      Ended 200631-Mar
            
            
            30-Jun
            
            
            30-Sep
            
            
            31-DecInterest
      Income
            
            $
            5,395
            
            
            $
            5,661
            
            
            $
            5,866
            
            
            $
            5,776Interest
      Expense
            
            
            (2,383
            )
            
            
            (2,594
            )
            
            
            (2,822
            )
            
            
            (2,998
            )Net
      Interest Income
            
            
            3,012
            
            
            
            3,067
            
            
            
            3,044
            
            
            
            2,778Provision
      for Loan Losses
            
            
            (60
            )
            
            
            (60
            )
            
            
            (60
            )
            
            
            (122
            )Securities
      Gains/Losses
            
            
            (17
            )
            
            
            8
            
            
            
            15
            
            
            
            36Other
      Income
            
            
            672
            
            
            
            645
            
            
            
            675
            
            
            
            756Other
      Expense
            
            
            (2,334
            )
            
            
            (2,493
            )
            
            
            (2,510
            )
            
            
            (2,151
            )Income
      Before taxes
            
            
            1,273
            
            
            
            1,167
            
            
            
            1,164
            
            
            
            1,297Income
      Taxes
            
            
            (228
            )
            
            
            (175
            )
            
            
            (179
            )
            
            
            (190
            )Net
      Income
            
            $
            1,045
            
            
            $
            992
            
            
            $
            985
            
            
            $
            1,107Basic
      Earnings per share
            
            $
            0.33
            
            
            $
            0.32
            
            
            $
            0.31
            
            
            $
            0.35Diluted
      Earnings per share
            
            $
            0.33
            
            
            $
            0.31
            
            
            $
            0.31
            
            
            $
            0.35








RETURN ON AVERAGE ASSETS AND AVERAGE
EQUITY


Return on
average assets (ROA) measures the Company’s net income in relation to its total
average assets. The Company’s ROA for 2007 was 1.17%, compared to 1.03% in
2006.





Return on
average equity (ROE) indicates how effectively the Company can generate net
income on the capital invested by its stockholders. ROE is calculated by
dividing net income by average stockholders’ equity. For purposes of calculating
ROE as of December 31, 2007, average stockholders’ equity does not include the
effect of unrealized gains (losses), net of income taxes, on securities
available for sale, reflected as accumulated other comprehensive income.
Reference should be made to Note 2 in the Notes to Consolidated Financial
Statements for an analysis of securities available for sale. The Company’s ROE
for 2007 was 11.85%, compared to 10.32% for 2006.





FINANCIAL
CONDITION


The
Company’s financial condition can be evaluated in terms of trends in its sources
and uses of funds. The following table illustrates how the Company has managed
its sources and uses of funds that are directly affected by outside economic
factors, such as interest rate fluctuations:





31


TABLE
7





Sources, Uses of
Funds


(Dollars
In Thousands)


2007
            
            
            
            
            
            
            
            
            2006
            
            
            
            
            
            2005Average
            
            
            Increase/(Decrease)
            
            
            Average
            
            
            Increase/(Decrease)
            
            
            AverageFunding
      Uses
            
            Balance
            
            
            Amount
            
            
            Percent
            
            
            Balance
            
            
            Amount
            
            
            Percent
            
            
            BalanceReal
      Estate Loans
            
            $
            115,490
            
            
            $
            4,518
            
            
            
            4.07
            %
            
            $
            110,972
            
            
            $
            2,085
            
            
            
            1.91
            %
            
            $
            108,887Consumer
      Loans
            
            
            17,143
            
            
            
            (67
            )
            
            
            (0.39
            )%
            
            
            17,210
            
            
            
            (377
            )
            
            
            (2.14
            )%
            
            
            17,587Commercial
      Loans
            
            
            123,854
            
            
            
            4,950
            
            
            
            4.16
            %
            
            
            118,904
            
            
            
            14,587
            
            
            
            13.98
            %
            
            
            104,317Tax
      Exempt Loans
            
            
            21,165
            
            
            
            1,114
            
            
            
            5.56
            %
            
            
            20,051
            
            
            
            915
            
            
            
            4.78
            %
            
            
            19,136Other
      Loans
            
            
            467
            
            
            
            (6
            )
            
            
            (1.27
            )%
            
            
            473
            
            
            
            (159
            )
            
            
            (25.16
            )%
            
            
            632Total
      Loans
            
            
            278,119
            
            
            
            10,509
            
            
            
            3.93
            %
            
            
            267,610
            
            
            
            17,051
            
            
            
            6.81
            %
            
            
            250,559Less
      Allowance for Loan Loss
            
            
            (2,025
            )
            
            
            319
            
            
            
            
            
            
            
            (2,344
            )
            
            
            257
            
            
            
            
            
            
            
            (2,601
            )Total
      Loans with Loan Loss
            
            
            276,094
            
            
            
            10,828
            
            
            
            4.08
            %
            
            
            265,266
            
            
            
            17,308
            
            
            
            6.98
            
            
            
            247,958Taxable
      Securities (Include CDS)
            
            
            65,438
            
            
            
            (696
            )
            
            
            (1.05
            )%
            
            
            66,134
            
            
            
            (6,224
            )
            
            
            (8.60
            )%
            
            
            72,358Non-Taxable
      Securities
            
            
            44,192
            
            
            
            4,757
            
            
            
            12.06
            %
            
            
            39,435
            
            
            
            49
            
            
            
            0.12
            %
            
            
            39,386Total
      Securities
            
            
            109,630
            
            
            
            4,061
            
            
            
            3.85
            %
            
            
            105,569
            
            
            
            (6,175
            )
            
            
            (5.53
            )%
            
            
            111,744Time
      Deposit with Other Banks
            
            
            315
            
            
            
            315
            
            
            
            100.00
            %
            
            
            0
            
            
            
            0
            
            
            
            0
            %Fed
      Funds Sold
            
            
            723
            
            
            
            (1,744
            )
            
            
            (70.69
            )%
            
            
            2,467
            
            
            
            374
            
            
            
            17.87
            %
            
            
            2,093Total
      Uses
            
            $
            386,762
            
            
            $
            13,460
            
            
            
            3.61
            %
            
            $
            373,302
            
            
            $
            11,507
            
            
            
            3.18
            %
            
            $
            361,7952007
            
            
            
            
            
            
            
            
            
            
            2006
            
            
            
            
            
            
            2005Average
            
            
            Increase/(Decrease)
            
            
            Average
            
            
            Increase/(Decrease)
            
            
            AverageFunding
      Sources
            
            Balance
            
            
            Amount
            
            
            Percent
            
            
            Balance
            
            
            Amount
            
            
            Percent
            
            
            BalanceInterest
      Bearing Demand Deposits
            
            $
            25,341
            
            
            $
            (121
            )
            
            
            (0.48
            )%
            
            $
            25,462
            
            
            $
            1,255
            
            
            
            5.18
            %
            
            $
            24,207Regular
      Savings Deposits
            
            
            106,969
            
            
            
            11,609
            
            
            
            12.17
            %
            
            
            95,360
            
            
            
            22,763
            
            
            
            31.36
            %
            
            
            72,597Money
      Market Savings Deposits
            
            
            35,355
            
            
            
            (2,392
            )
            
            
            (6.34
            )%
            
            
            37,747
            
            
            
            515
            
            
            
            1.38
            %
            
            
            37,232Time
      Deposits
            
            
            102,643
            
            
            
            448
            
            
            
            0.44
            %
            
            
            102,195
            
            
            
            (4,920
            )
            
            
            (4.59
            )%
            
            
            107,115Total
      Interest Bearing Deposits
            
            
            270,308
            
            
            
            9,544
            
            
            
            3.66
            %
            
            
            260,764
            
            
            
            19,613
            
            
            
            8.13
            %
            
            
            241,151Other
      BorrowingsShort-Term
      Funds Borrowed
            
            
            12,129
            
            
            
            (474
            )
            
            
            (3.76
            )%
            
            
            12,603
            
            
            
            556
            
            
            
            4.62
            %
            
            
            12,047Long-Term
      Funds Borrowed
            
            
            38,054
            
            
            
            1,779
            
            
            
            4.90
            %
            
            
            36,275
            
            
            
            (9,665
            )
            
            
            (21.04
            )%
            
            
            45,940Total
      Funds Borrowed
            
            
            50,183
            
            
            
            1,305
            
            
            
            2.67
            %
            
            
            48,878
            
            
            
            (9,109
            )
            
            
            (15.71
            )%
            
            
            57,987Total Deposits and
      Funds Borrowed
            
            
            320,491
            
            
            
            10,849
            
            
            
            3.50
            %
            
            
            309,642
            
            
            
            10,504
            
            
            
            3.51
            %
            
            
            299,138Other
      Sources, net
            
            
            66,271
            
            
            
            2,611
            
            
            
            4.10
            %
            
            
            63,660
            
            
            
            1,003
            
            
            
            1.60
            %
            
            
            62,657Total
      Sources
            
            $
            386,762
            
            
            $
            13,460
            
            
            
            3.61
            %
            
            $
            373,302
            
            
            $
            11,507
            
            
            
            3.18
            %
            
            $
            361,795





32


Total
Sources of funds were up $13,460,000 in average balances for 2007 which is a
3.61% increase. The primary source of the increase was in regular savings
deposits with an increase of $11,609,000 or 12.17%. Savings Deposits ended the
2007 year with an average balance of $106,969,000 compared to $95,360,000 in
2006.  Borrowed Funds were up slightly, $1,305,000 or 2.67% ending the
year with an average balance of $50,183,000 compared to an average balance of
$48,878,000 for 2006 and an average balance of $57,987,000 in 2005.





On the
Asset side, the increase in funding was used to invest in both loans and
investments. The average balance in Loans less the Loan Loss Allowance for 2007
was $276,094,000 compared to an average balance of $265,266,000 in 2006 and
$247,958,000 in 2005.  Real Estate loans were $4,518,000 or 4.07%
higher in average balances in 2007 averaging $115,490,000 and 2006 averaging
$110,972,000. Commercial loans also were up in 2007 ending the year with an
average balance of $123,854,000 which is an increase of $4,950,000 over 2006
ending average balance of $118,904,000.  Securities ended the 2007
year with an average balance of $109,630,000 compared to $105,569,000 million in
2006, an increase of $4,061,000.





Loan Portfolio
Types


In 2007,
loans to commercial borrowers helped fuel the growth in net loans. Residential
mortgage loans increased only slightly with lower interest rates and mortgage
finance companies making growth in this part of our loan portfolio
tougher.





TABLE
8





Loan
Portfolio


(In
Thousands)





December
      31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Commercial
            
            $
            156,358
            
            
            $
            140,931
            
            
            $
            132,054
            
            
            $
            119,641
            
            
            $
            112,617Residential
      Real Estate Mortgage
            
            
            116,922
            
            
            
            112,883
            
            
            
            109,034
            
            
            
            106,454
            
            
            
            105,949Consumer
            
            
            17,889
            
            
            
            16,947
            
            
            
            17,780
            
            
            
            18,375
            
            
            
            17,525Total
      Loans
            
            
            291,169
            
            
            
            270,761
            
            
            
            258,868
            
            
            
            244,470
            
            
            
            236,091Deferred
      Loan Fees and Costs
            
            
            445
            
            
            
            414
            
            
            
            377
            
            
            
            344
            
            
            
            276Total
      Loans, net of Deferred
            
            
            291,614
            
            
            
            271,175
            
            
            
            259,245
            
            
            
            244,814
            
            
            
            236,367Allowance
      for Loan Loss
            
            
            (2,451
            )
            
            
            (1,792
            )
            
            
            (2,375
            )
            
            
            (2,739
            )
            
            
            (2,093
            )Net
      Loans
            
            $
            289,163
            
            
            $
            269,383
            
            
            $
            256,870
            
            
            $
            242,075
            
            
            $
            234,274





Loans
continued to increase in 2007, ending the year with $289,163,000 in net loans
compared to $269,383,000 at year-end 2006, an increase of 7.34%. Commercial
loans grew 10.95% to close the year at $156,358,000, compared to $140,931,000 at
year-end 2006.





Residential
mortgages were up 3.58% to $116,922,000, compared to $112,883,000 on December
31, 2006, an increase of $4,039,000.  Although our mortgage portfolio
grew modestly in 2007, there was an additional $6,086,000 mortgage loans sold to
Fannie Mae.  The Bank will continue to sell mortgages on the secondary
market in order to attract and retain mortgage loans by offering more
competitive rates and terms.





The
continued growth in commercial lending was due, in part, to a concerted effort
on our part to continue to increase our exposure to this business
segment.





Loan Maturities


Table 9
shows the breakdown in maturity and type of our loan portfolio, including
non-accrual loans.





The Bank
has 9.31% of its loans maturing within the next year. Of those maturing within
one year, the majority are commercial loans with the remainder split between
mortgages and consumer loans. In the one-to-five year maturity range, the Bank
has 21.07% of its loan portfolio maturing. The over-five-year maturity group
makes up 69.62% of the portfolio.


33





For
comparison, at December 31, 2006, the Bank had 9.66% of its loans maturing
within one year. Of those maturing within one year, the majority again were
commercial loans with the remainder split between mortgages and consumer loans.
In the one-to-five year maturity range, the Bank had 21.79% of its portfolio.
The over-five-year maturity group made up 68.55% of the portfolio.





TABLE
9


(In
Thousands)


One
      Year
            
            
            Over
      One Year
            
            
            Over
            
            
            TotalOr
      Less
            
            
            Within
      Five Years
            
            
            Five
      Years
            
            
            LoansCommercial
            
            $
            16,996
            
            
            $
            35,247
            
            
            $
            104,115
            
            
            $
            156,358Real-Estate
      Construction
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Real-Estate
      Mortgage
            
            
            4,850
            
            
            
            18,071
            
            
            
            94,001
            
            
            
            116,922Installment
            
            
            5,255
            
            
            
            8,044
            
            
            
            4,590
            
            
            
            17,889Total
            
            $
            27,101
            
            
            $
            61,362
            
            
            $
            202,706
            
            
            $
            291,169Total
      Loans with Predetermined Rates
            
            $
            17,553
            
            
            $
            30,117
            
            
            $
            33,183
            
            
            $
            80,853Total
      Loans with Variable Rates
            
            
            9,548
            
            
            
            31,245
            
            
            
            169,523
            
            
            
            210,316Total
            
            $
            27,101
            
            
            $
            61,362
            
            
            $
            202,706
            
            
            $
            291,169





TABLE
10





Non-performing
Loans





(Dollars
      In Thousands)
            
            December
      31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Non-accrual
      and Restructured
            
            $
            395
            
            
            $
            445
            
            
            $
            1,105
            
            
            $
            2,063
            
            
            $
            984Loans
      Past Due 90 or More Days, Accruing Interest
            
            
            91
            
            
            
            275
            
            
            
            0
            
            
            
            130
            
            
            
            105Total
      Nonperforming Loans
            
            
            486
            
            
            
            720
            
            
            
            1,105
            
            
            
            2,193
            
            
            
            1,089Foreclosed
      Assets
            
            
            4,675
            
            
            
            5,062
            
            
            
            117
            
            
            
            257
            
            
            
            115Total
      Nonperforming Assets
            
            $
            5,161
            
            
            $
            5,782
            
            
            $
            1,222
            
            
            $
            2,450
            
            
            $
            1,204Nonperforming
      Loans to Total Loans at Period-end
            
            
            0.17
            %
            
            
            0.27
            %
            
            
            0.43
            %
            
            
            0.91
            %
            
            
            0.47
            %Nonperforming
      Assets to Period-end Loans and Foreclosed Assets
            
            
            1.74
            %
            
            
            2.10
            %
            
            
            0.47
            %
            
            
            1.01
            %
            
            
            0.52
            %Interest
      Income That Would Have Been Recorded UnderOriginal
      Terms
            
            $
            32
            
            
            $
            84
            
            
            $
            59
            
            
            $
            94
            
            
            $
            62Interest
      Income Recorded During the Period
            
            $
            15
            
            
            $
            7
            
            
            $
            9
            
            
            $
            29
            
            
            $
            3Commitments
      To Lend Additional funds
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0








34


Allowance for Loan
Losses


The
balance in the allowance for loan losses is based on management’s assessment of
the risk in the loan portfolio. Allocations to specific commercial loans are
made in adherence to SFAS 114, Accounting by Creditors for Impairments of a
Loan. These allocations are based upon the present value of expected future cash
flows or the fair value of the underlying collateral. In addition, management
reviews the other components of the loan portfolio through the loan review
function and assigns internal grades to loans based upon the perceived risks
inherent in each loan. In that determination, management reviews a number of
factors including historical analysis of similar credits, delinquency reports,
ratio analysis as compared to peers, concentration of credit risks, local
economic conditions, and regulatory evaluation of the allowance for loan losses.
The allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated.  Management’s
periodic evaluation of the adequacy of the allowance is based on the Bank’s past
loan loss experience, known or inherent risks in the portfolio, adverse
situations that may affect the borrower’s ability to repay, the estimated value
of any underlying collateral, composition of the loan portfolio, current
economic conditions and other relevant factors.  Management believed
that certain risks, primarily current economic conditions, warranted an increase
in the allowance for loan losses for the year ended December 31, 2007 and as
such, the Company allotted $280,000 for provision for loan losses in 2007. This
evaluation is reviewed monthly by management and by the Board of Directors.
Management believes that on December 31, 2007, the allowance for loan losses was
adequate to absorb potential losses in the loan portfolio. However, this
judgment is subjective and a significant degradation in loan quality could
require a change in the estimates and therefore, a change in net
income.





The
following is a summary of loans charged off, recoveries and provisions to the
allowance for loan losses for the periods presented.





TABLE
11





Summary of Loan Loss
Experience


(Dollars
In Thousands)





Year
      Ended,Dec
      2007
            
            Dec
      2006
            
            Dec
      2005
            
            Dec
      2004
            
            Dec
      2003Average
      Total Loans
            $
            278,119
            
            $
            267,610
            
            $
            250,559
            
            $
            241,037
            
            $
            229,293Balance
      at Beginning of Period
            $
            1,792
            
            $
            2,375
            
            $
            2,739
            
            $
            2,093
            
            $
            1,935Charge
      OffsCommercial
            
            0
            
            
            797
            
            
            633
            
            
            335
            
            
            94Residential
      Real Estate
            
            0
            
            
            21
            
            
            31
            
            
            0
            
            
            10Installment
            
            73
            
            
            98
            
            
            129
            
            
            108
            
            
            81Total
      Charge Offs
            
            73
            
            
            916
            
            
            793
            
            
            443
            
            
            185RecoveriesCommercial
            
            422
            
            
            5
            
            
            0
            
            
            12
            
            
            21Residential
      Real Estate
            
            3
            
            
            5
            
            
            0
            
            
            0
            
            
            5Installment
            
            27
            
            
            21
            
            
            37
            
            
            27
            
            
            28Total
      Recoveries
            
            452
            
            
            31
            
            
            37
            
            
            39
            
            
            54Net
      Charge-Offs (Recoveries)
            
            (379
            )
            
            885
            
            
            756
            
            
            404
            
            
            131Provision
      for Loan Losses
            
            280
            
            
            302
            
            
            392
            
            
            1050
            
            
            289Balance
      at End of Period
            $
            2,451
            
            $
            1,792
            
            $
            2,375
            
            $
            2,739
            
            $
            2,093Allowance
      for Credit Losses to Period-end Total Loans
            
            0.84
            %
            
            0.66
            %
            
            0.92
            %
            
            1.12
            %
            
            0.89
            %Allowance
      for Credit Losses to Non-accrual Loans
            
            620.51
            %
            
            402.70
            %
            
            206.62
            %
            
            132.77
            %
            
            212.70
            %Net
      Charge-Offs (Recoveries) to Average Loans
            
            (0.14
            %)
            
            0.33
            %
            
            0.29
            %
            
            0.17
            %
            
            0.06
            %





35


TABLE
12





The
following table details the allocation of the allowance for loan losses to
various categories:


Allocation
      of Allowance(Dollars
      In Thousands)
            
            Dec
      2007
            
            
            %
      of Loan Type
              to
      Total Loans
            
            
            Dec
      2006
            
            
            %
      of Loan Type
              to
      Total Loans
            
            
            Dec
      2005
            
            
            %
      of Loan Type
              to
      Total LoansCommercial
            
            $
            1,428
            
            
            
            53.70
            %
            
            $
            1,429
            
            
            
            52.05
            %
            
            $
            2,035
            
            
            
            58.56
            %Real
      Estate Mortgage
            
            
            738
            
            
            
            40.15
            %
            
            
            274
            
            
            
            41.69
            %
            
            
            286
            
            
            
            38.11
            %Consumer
            
            
            285
            
            
            
            6.15
            %
            
            
            89
            
            
            
            6.26
            %
            
            
            54
            
            
            
            3.33
            %Non
      Performing
            
            
            0
            
            
            
            N/A
            
            
            
            0
            
            
            
            N/A
            
            
            
            0
            
            
            
            N/ATotal
      Allowance for Loan Losses
            
            $
            2,451
            
            
            
            100.00
            %
            
            $
            1,792
            
            
            
            100.00
            %
            
            $
            2,375
            
            
            
            100.00
            %








(Dollars
      In Thousands)
            Dec
      2004
            
            %
      of Loan Type
              to
      Total loans
            
            
            Dec
      2003
            
            %
      of Loan Type
              to
      Total LoansCommercial
            $
            2,366
            
            
            48.94
            %
            
            $
            1,677
            
            
            47.70
            %Real
      Estate Mortgage
            
            272
            
            
            43.54
            %
            
            
            283
            
            
            44.88
            %Consumer
            
            101
            
            
            7.52
            %
            
            
            133
            
            
            7.42
            %Non
      Performing
            
            0
            
            
            N/A
            
            
            
            0
            
            
            N/ATotal
      Allowance for Loan Losses
            $
            2,739
            
            
            100.00
            %
            
            $
            2,093
            
            
            100.00
            %





Management
believes the allowance is adequate to cover the inherent risks associated with
the loan portfolio. While allocations have been established for particular loan
categories, management considers the entire allowance to be available to absorb
losses in any category.





SECURITIES


The
Company’s securities portfolio is classified, in its entirety, as
“available-for-sale” as shown in Table 13. Management believes that a portfolio
classification of all available-for-sale allows complete flexibility in the
investment portfolio. Using this classification, the Company intends to hold
these securities for an indefinite amount of time but not necessarily to
maturity. Such securities are carried at fair value with the unrealized holding
gains or losses, net of taxes, reported as a component of the Company’s
stockholders’ equity on the balance sheet. The portfolio is structured to
provide maximum return on investments while providing a consistent source of
liquidity and meeting strict risk standards.





Securities
available-for-sale increased by $2,444,000 in 2007. The securities
available-for-sale portfolio is comprised of U.S. Government Agency securities,
mortgage-backed securities, high-grade municipal securities, corporate-debt
securities, and equity securities. At December 31, 2007, the unrealized loss on
securities available-for-sale included in stockholders’ equity totaled $
1,390,000, net of tax, compared to unrealized losses of $395,000, net of tax, at
December 31, 2006. The weighted-average maturity of the securities
available-for-sale portfolio was ten years at December 31, 2007, with a
weighted-average yield of 4.75%.





At
December 31, 2007, the Company had 68 obligations of state and political
subdivisions, 36 mortgage-backed securities, 5 corporate debt securities, 2
preferred equity securities, and 18 common equity securities in an unrealized
loss position.  The Company had $526,000 of unrealized losses on
variable-rate preferred stock issuances of FHLMC with a cost basis of $2,367,000
at December 31, 2007.  Substantially all of the decline in value of
those securities occurred in late 2007, and the Company has concluded that the
impairment of such securities at December 31, 2007 was the result of the recent
issuance of new higher-yielding preferred stock by those government-sponsored
agencies in response to the current housing market decline.  Also,
these securities continue to have a high yield and the dividends received are
tax exempt.  As such, the Company believes it is too soon to conclude
that such unrealized losses were other than temporary.


36





At
December 31, 2007, 18 common equity securities had totaled unrealized losses of
$442,000.  These securities have traditionally been high-performing
stocks.  As a result of recent market volatility in financial stocks
from news of sub-prime lending problems, the fair value of most of the stocks
held are “under water” as of December 31, 2007, and as such, are considered to
be impaired.  The Company does not invest in bank stocks with the
intent to turn them over for a profit in the near-term.  We invest in
those stocks that we believe to have potential to appreciate in value over the
long-term, while providing for a reasonable dividend yield.  We buy
and hold those stocks that we believe have potential to be an acquirer or to be
acquired, providing additional value.  Also, the purchase and holding
of these stocks will provide long-term capital gains to offset capital
losses.  Stocks can be cyclical in nature and will experience some
down periods.  Historically, bank stocks have sustained cyclical
losses, followed by periods of substantial gains, therefore we believe that both
unrealized losses and gains are likely to be temporary, when observing
performance in the banking sector.





In
management’s opinion, the unrealized losses on all other securities reflect
changes in interest rates subsequent to the acquisition of specific
securities.  The Company has the intent and the ability to hold such
securities until maturity or market price recovery.  Management
believes that the unrealized losses represent temporary impairment of the
securities.




Table 13
shows the amortized cost and average yield of securities by maturity or call
date at December 31, 2007.  Since the below table is by maturity or call
date, it will not match the maturity schedule in the 2007 consolidated financial
statements Note 2, which is done by contractual maturity.





TABLE
13





Securities
by Maturities


(Amortized
Cost)


1
      Year or Less
            
            
            1-5
      Years
            
            
            5-10
      Years
            
            
            Over
      10 Years
            
            
            Total(Dollars
      In Thousands)
            
            
            
            
            Average
            
            
            
            
            
            Average
            
            
            
            
            
            Average
            
            
            
            
            
            Average
            
            
            
            
            
            AverageBalance
            
            
            Yield
            
            
            Balance
            
            
            Yield
            
            
            Balance
            
            
            Yield
            
            
            Balance
            
            
            Yield
            
            
            Balance
            
            
            YieldAvailable-for-SaleUS
      Government Agency
            
            $
            0
            
            
            0.00
            %
            
            $
            0
            
            
            
            0
            
            
            $
            0
            
            
            
            0.00
            %
            
            $
            1,999
            
            
            6.13
            %
            
            $
            1,999
            
            
            6.13
            %State/County/Municipal
      Obligations
            
            
            0
            
            
            0.00
            %
            
            
            10,998
            
            
            
            3.50
            %
            
            
            7,764
            
            
            
            4.02
            %
            
            
            26,595
            
            
            4.13
            %
            
            
            45,357
            
            
            3.96
            %Taxable
      Municipals
            
            
            0
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            1,995
            
            
            5.99
            %
            
            
            1,995
            
            
            5.99
            %Mortgage-Backed
      Securities
            
            
            5,478
            
            
            5.21
            %
            
            
            17,129
            
            
            
            5.09
            %
            
            
            10,357
            
            
            
            5.13
            %
            
            
            12,292
            
            
            5.59
            %
            
            
            45,256
            
            
            5.25
            %Corporate/Other
      Securities
            
            
            0
            
            
            0.00
            %
            
            
            4,251
            
            
            
            5.39
            %
            
            
            5,161
            
            
            
            5.21
            %
            
            
            2,081
            
            
            6.02
            %
            
            
            11,493
            
            
            5.42
            %Preferred
      Equity Securities
            
            
            0
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            2,367
            
            
            5.16
            %
            
            
            2,367
            
            
            5.16
            %Common
      Equity Securities
            
            
            0
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            0
            
            
            
            0.00
            %
            
            
            6,384
            
            
            4.71
            %
            
            
            6,384
            
            
            4.71
            %TOTAL
      Available-for-Sale
            
            $
            5,478
            
            
            5.21
            %
            
            $
            32,378
            
            
            
            4.59
            %
            
            $
            23,282
            
            
            
            4.78
            %
            
            $
            53,713
            
            
            4.57
            %
            
            $
            114,851
            
            
            4.75
            %








37





Table 14
shows the balance of securities for the past three years on December 31. More
details on securities can be found in Note 3 of the Consolidated Financial
Statements.





TABLE
14





Securities
(Fair Value)





(In
      Thousands)
            
            December
      31,2007
            
            
            2006
            
            
            2005U.
      S. Government/Agency Obligations
            
            $
            2,002
            
            
            $
            11,118
            
            
            $
            24,604State/Municipal
      Obligations
            
            
            44,505
            
            
            
            30,338
            
            
            
            40,477Taxable
      Municipal
            
            
            1,994
            
            
            
            0
            
            
            
            0Mortgage-backed
      Securities
            
            
            45,168
            
            
            
            57,847
            
            
            
            25,563Other
      Securities
            
            
            19,077
            
            
            
            10,999
            
            
            
            17,669Total  Securities
      Available-for-Sale
            
            $
            112,746
            
            
            $
            110,302
            
            
            $
            108,313





DEPOSITS


Table 15
shows average deposits and other borrowings balances and rates for 2007, 2006
and 2005. The Company experienced growth of $9,544,000 in average interest
bearing deposits and $2,725,000 in average non-interest bearing deposits during
2007 compared to an increase of $19,613,000 in average interest bearing deposits
and $4,314,000 in average non-interest bearing deposits in
2006.  Average savings accounts increased the most with an increase of
$11,609,000 during 2007 due to the continued popularity of the certificate
savings product.  Average time deposits increased $448,000 in 2007
compared to a decrease of $4,920,000 in 2006.  In 2007, average other
borrowings increased slightly averaging $50,183,000 compared to the average
balance of $48,878,000 in 2006.





TABLE
15





Average Deposits and Other
Borrowings


(Dollars
      In Thousands)2007
            
            
            2006
            
            
            2005Amount
            
            
            Rate
            
            
            Diff
      $
            
            
            Amount
            
            
            Rate
            
            
            Diff
      $
            
            
            Amount
            
            
            RateInterest
      Bearing Demand Deposits
            
            $
            25,341
            
            
            
            1.14
            %
            
            $
            (121
            )
            
            $
            25,462
            
            
            
            1.03
            %
            
            $
            1,255
            
            
            $
            24,207
            
            
            
            0.70
            %Savings
      Deposits
            
            
            106,969
            
            
            
            3.10
            %
            
            
            11,609
            
            
            
            95,360
            
            
            
            3.29
            %
            
            
            22,763
            
            
            
            72,597
            
            
            
            1.73
            %Money
      Market Savings
            
            
            35,355
            
            
            
            3.08
            %
            
            
            (2,392
            )
            
            
            37,747
            
            
            
            3.83
            %
            
            
            515
            
            
            
            37,232
            
            
            
            2.45
            %Time
      Deposits
            
            
            102,643
            
            
            
            4.22
            %
            
            
            448
            
            
            
            102,195
            
            
            
            3.82
            %
            
            
            (4,920
            )
            
            
            107,115
            
            
            
            3.22
            %Total
      Interest Bearing Deposits
            
            
            270,308
            
            
            
            3.34
            %
            
            
            9,544
            
            
            
            260,764
            
            
            
            3.35
            %
            
            
            19,613
            
            
            
            241,151
            
            
            
            2.40
            %Other
      Borrowings
            
            
            50,183
            
            
            
            4.16
            %
            
            
            1,305
            
            
            
            48,878
            
            
            
            4.19
            %
            
            
            (9,109
            )
            
            
            57,987
            
            
            
            4.25
            %Total
      Interest Bearing Liabilities
            
            
            320,491
            
            
            
            3.46
            %
            
            
            10,849
            
            
            
            309,642
            
            
            
            3.49
            %
            
            
            10,504
            
            
            
            299,138
            
            
            
            2.76
            %Non-Interest
      Bearing Demand Deposits
            
            
            52,613
            
            
            
            
            
            
            
            2,725
            
            
            
            49,888
            
            
            
            
            
            
            
            4,314
            
            
            
            45,574Total
            
            $
            373,104
            
            
            
            2.98
            %
            
            $
            13,574
            
            
            $
            359,530
            
            
            
            3.01
            %
            
            $
            14,818
            
            
            $
            344,712
            
            
            
            2.98
            %





38





MATURITIES OF TIME
DEPOSITS


The
maturities on the time deposits of $100,000 and over are distributed over all
four categories, showing no particular period with a concentration that would
pose a liquidity risk to the Bank.  Table 16 shows the dollar amount
of large time deposits in each time category as well as the overall percentage
of each category.





TABLE
16





Maturities





(Dollars
      In Thousands)
            
            December
      31,
              2007Amount
            
            
            PercentThree
      Months or Less
            
            $
            6,961
            
            
            
            26.85
            %Over
      Three Month through Six Months
            
            
            9,960
            
            
            
            38.41
            %Over
      Six Months through Twelve Months
            
            
            4,599
            
            
            
            17.73
            %Over
      Twelve Months
            
            
            4,410
            
            
            
            17.01
            %Total
            
            $
            25,930
            
            
            
            100.00
            %





SHORT AND LONG-TERM
BORROWINGS


Short-term
borrowings, which are overnight or less than 30-day borrowings, consist of
securities sold under agreements to repurchase, Federal Home Loan Bank advances,
and U.S. Treasury tax and loan notes. Long-term borrowings consist of notes from
the Federal Home Loan Bank. These notes are secured under terms of a blanket
collateral agreement by a pledge of qualifying investment and mortgage-backed
securities, certain mortgage loans and a lien on FHLB stock. For more details on
short and long-term borrowings see Notes 6 and 7 of the Notes to Consolidated
Financial Statements.





TABLE
17





Borrowed
Funds





(In
      Thousands)
            December
      31,2007
            
            
            2006Other
      Short-Term Borrowings
            $
            22,848
            
            
            $
            12,574FHLB
      Long-Term Borrowings
            
            38,534
            
            
            
            36,525Total
            $
            61,382
            
            
            $
            49,099





CAPITAL
ACCOUNTS


Total
stockholders’ equity increased 3.79%, or $1,565,000, from year-end 2006 to
finish at $42,805,000. A common ratio used to determine the effective use of
capital is the return on average equity. For the year ended December 31, 2007,
this ratio was 11.85%, compared to 10.32% at December 31, 2006. The Bank’s goal
is to maintain a strong capital position as well as to make the best use of
capital in the overall growth of the organization. At year-end 2007, the
equity-to-assets ratio was 9.85%, compared to 9.91% at year-end 2006. It is the
goal of management to implement ways to better leverage our capital with a
capital-to-assets ratio closer to 8%.





The 2007
results are comparable to the results experienced in 2006 when total
stockholders’ equity increased 4.10% or $1,624,000 over year-end 2005. The
return on average equity for the year ended December 31, 2006 ratio was 10.32%,
compared to 11.37% at December 31, 2005.  At year-end 2006, the
equity-to-assets ratio was 9.91% compared to 10.13% at year-end
2005.


39





Net
income increased capital by $4,871,000 in 2007 and dividends reduced that number
by $2,383,000. The securities portfolio decreased in value by $995,000, net of
tax in 2007. Since all of our securities are available-for-sale, changes in
market values adjusted for taxes are reflected in the equity portion of the
balance sheet. A total of $69,000 in net treasury stock issued increased the
capital account to equal the total net change.  From time to time, the
Company has purchased PFSC stock in the open market or from individuals to
leverage the capital account and to provide stock for our dividend reinvestment
plan and stock compensation plan. During the year 2007, 3,500 shares were
purchased in this manner. There were 8,119 shares issued from the treasury stock
account by individuals exercising options. The investment banking firms of
Ferris, Baker Watts, Incorporated and Ryan Beck & Co. have been known to
make markets in PFSC common stock.





Net
Income increased capital by $4,129,000 in 2006 and dividends reduced that number
by $2,392,000. The securities portfolio increased in value by $566,000 in 2006.
Again, since all of our securities were available-for-sale, changes in market
values adjusted for taxes are reflected in the equity portion of the balance
sheet. A total of $682,000 in net treasury stock purchases reduced the capital
account to equal the total net change.





The
following table represents the Company’s capital position as it compares to the
regulatory guidelines at December 31, 2007.





TABLE
18





Capital
      RatiosDecember
      31
            
            December
      31
            
            Regulatory2007
            
            2006
            
            RequirementTier
      1 capital to risk-weighted assets
            
            13.64
            %
            
            13.99
            %
            
            4.00
            %Total  capital
      to risk-weighted assets
            
            14.42
            %
            
            14.64
            %
            
            8.00
            %Tier
      1 capital to average assets-leverage ratio
            
            10.14
            %
            
            9.77
            %
            
            4.00
            %





INTEREST RATE
SENSITIVITY


The
operations of the Company do not subject it to foreign currency risk or
commodity price risk. The Company does not utilize interest rate swaps, caps, or
hedging transactions. In addition, the Company has no market risk sensitive
instruments entered into for trading purposes. However, the Company is subject
to interest rate risk and employs several different methods to manage and
monitor the risk.





Interest
rate sensitivity refers to the relationship between market interest rates and
the earnings volatility of the Company due to the repricing characteristics of
assets and liabilities. The responsibility for monitoring interest rate
sensitivity and policy decisions has been given to the Asset/Liability Committee
(ALCO) of the Bank. The tools used to monitor sensitivity are the Statement of
Interest Sensitivity Gap and the Interest Rate Shock Analysis. The Bank uses a
software model to measure and analyze interest rate risk. In addition, an
outside source does a quarterly analysis to make sure our internal analysis is
current and correct. The Statement of Interest Sensitivity Gap is a good
assessment of current position and is a very useful tool for the ALCO in
performing its job. This report is monitored in an effort to “match” maturities
or repricing opportunities of assets and liabilities in order to attain the
maximum interest within risk tolerance policy guidelines. The statement does,
although, have inherent limitations in that certain assets and liabilities may
react to changes in interest rates in different ways with some categories
reacting in advance of changes and some lagging behind the changes. In addition,
there are estimates used in determining the actual propensity to change of
certain items such as deposits without maturities.





40





The
following sets forth the Company’s interest sensitivity analysis as of December
31, 2007:





TABLE
19





Statement of Interest Sensitivity
Gap


(Dollars
In Thousands)


Maturity
      or Repricing In:3
      Months
            
            
            3-6
      Months
            
            
            6-12
      Months
            
            
            1-5
      Years
            
            
            Over
      5 YearsRATE
      SENSITIVE ASSETSInterest
      Bearing Deposits With Other Banks
            
            $
            555
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0
            
            
            $
            0Loans
            
            
            98,439
            
            
            
            9,514
            
            
            
            29,455
            
            
            
            82,848
            
            
            
            71,358Securities
            
            
            5,211
            
            
            
            4,599
            
            
            
            7,188
            
            
            
            39,874
            
            
            
            55,874Federal
      Funds Sold
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Total
      Rate Sensitive Assets
            
            
            104,205
            
            
            
            14,113
            
            
            
            36,643
            
            
            
            122,722
            
            
            
            127,232Cumulative
      Rate Sensitive Assets
            
            $
            104,205
            
            
            $
            118,318
            
            
            $
            154,961
            
            
            $
            277,683
            
            
            $
            404,915RATE
      SENSITIVE LIABILITIESInterest
      Bearing Checking
            
            $
            261
            
            
            $
            261
            
            
            $
            522
            
            
            $
            4,177
            
            
            $
            22,016Money
      Market Deposits
            
            
            354
            
            
            
            353
            
            
            
            708
            
            
            
            5,661
            
            
            
            29,837Regular
      Savings
            
            
            1,318
            
            
            
            952
            
            
            
            1,905
            
            
            
            15,239
            
            
            
            80,322CDs
      and IRAs
            
            
            25,609
            
            
            
            36,275
            
            
            
            16,372
            
            
            
            27,644
            
            
            
            3,913Short-term
      Borrowings
            
            
            22,848
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Long-term
      Borrowings
            
            
            410
            
            
            
            306
            
            
            
            3,127
            
            
            
            16,561
            
            
            
            18,130Total
      Rate Sensitive Liabilities
            
            
            50,800
            
            
            
            38,147
            
            
            
            22,634
            
            
            
            69,282
            
            
            
            154,218Cumulative
      Rate Sensitive Liabilities
            
            $
            50,800
            
            
            $
            88,947
            
            
            $
            111,581
            
            
            $
            180,863
            
            
            $
            335,081Period
      Gap
            
            $
            53,405
            
            
            $
            (24,034
            )
            
            $
            14,009
            
            
            $
            53,440
            
            
            $
            (26,986
            )Cumulative
      Gap
            
            $
            53,405
            
            
            $
            29,371
            
            
            $
            43,380
            
            
            $
            96,820
            
            
            $
            69,834Cumulative
      RSA to RSL
            
            
            205.13
            %
            
            
            133.02
            %
            
            
            138.88
            %
            
            
            153.53
            %
            
            
            120.84
            %Cumulative
      Gap to Total Assets
            
            
            12.29
            %
            
            
            6.76
            %
            
            
            9.99
            %
            
            
            22.29
            %
            
            
            16.07
            %





The Federal Reserve’s Open Market Committee (FOMC), kept rates
steady through the first half of 2007.  However, the latter half of
2007 was a different story. As issues surrounding sub-prime real estate lending
and credit concerns gripped the financial sector of the economy, the FOMC acted
quickly to reverse the tightening course charted since June of 2004 and began an
easing cycle which continued through the end of 2007 and into 2008. For the year
ended December 31, 2007, the overnight Fed Funds Rate was decreased a total of
100 basis points ending the year at 4.25%.  The effect of the easing
has been a steeper yield curve throughout late 2007.  While the short
end of the curve has moved down in conjunction with the Fed Funds Rate, the long
end of the curve, which is not controlled by the FOMC, has remained
steady.  The result of this steeper curve is that the net interest
margin in 2007 increased to 3.82% when compared to the net interest margin of
3.49% for the year ended December 31, 2006. The increase to the net interest
margin is the result of more liability rates resetting at lower levels and
reacting more swiftly to moves by the FOMC. The asset side of the Company’s
balance sheet has remained less reactive to rate movements. While this has
presented a positive opportunity to the Company in the near-term, it also
presents some challenges. As customers seek more competitive rates on their
deposits, the Company has implemented higher rate, short-term deposit
alternatives for customers. This has helped to mitigate the loss of deposits to
competitors.





Compare
these results to 2006 when the Fed Funds rate was increased 100 basis points.
The result was a net interest margin that fell to 3.49% for the year ended
December 31, 2006 compared to 3.73% for the year ended 2005.


41





LIQUIDITY


The
liquidity of the Company is reflected in its capacity to have sufficient amounts
of cash available to fund the needs of customer withdrawal requests, accommodate
loan demand, and maintain regulatory reserve requirements; that is to conduct
banking business. Additional liquidity is obtained by either increasing
liabilities or by decreasing assets. The primary source for increasing
liabilities is the generation of additional deposit accounts, which are managed
through our system of branches. In addition, loan payments on existing loans or
investments available-for-sale can generate additional liquidity. Other sources
include income from operations, decreases in federal funds sold or
interest-bearing deposits in other banks, securities sold under agreements to
repurchase, and borrowings from the Federal Home Loan Bank. On December 31,
2007, the Bank had a borrowing capacity from the Federal Home Loan Bank of
approximately $181,852,000.  During the Year 2007, modest increases in
deposits as well as increased dependence on overnight borrowings at the Federal
Home Loan Bank provided the majority of additional cash with operating
activities also contributing to liquidity. The funds were used primarily to
grant loans to customers, purchase additional investment securities, and to pay
dividends to our shareholders.





The
following table represents the aggregate on-and-off balance sheet contractual
obligations to make future payments.





TABLE
20





Contractual
      Obligations(In
      Thousands)
            
            December
      31, 2007Less
      than 1 year
            
            
            1-3
      Years
            
            
            4-5
      Years
            
            
            Over
      5 years
            
            
            TotalTime
      Deposits
            
            $
            78,225
            
            
            $
            15,131
            
            
            $
            12,512
            
            
            $
            3,944
            
            
            $
            109,812Long-term
      Debt
            
            
            3,843
            
            
            
            4,355
            
            
            
            12,206
            
            
            
            18,130
            
            
            
            38,534Operating
      Leases
            
            
            71
            
            
            
            111
            
            
            
            69
            
            
            
            408
            
            
            
            659Standby
      Letters of Credit
            
            
            2,999
            
            
            
            1551
            
            
            
            0
            
            
            
            0
            
            
            
            4,550$
            85,138
            
            
            $
            21,148
            
            
            $
            24,787
            
            
            $
            22,482
            
            
            $
            153,555





The
Company is not aware of any known trends or any known demands, commitments,
events or uncertainties, which would result in any material increase or decrease
in liquidity.





OFF-BALANCE-SHEET
ARRANGEMENTS


The
financial statements do not reflect various off-balance sheet arrangements that
are made in the normal course of business, which may involve some liquidity
risk. These commitments consist mainly of unfunded loans and letters of credit
made under the same standards as on-balance-sheet instruments. Unused
commitments, at December 31, 2007, totaled $40,072,000. Because these
instruments have fixed maturity dates, and because many of them will expire
without being drawn upon, they do not generally present any significant
liquidity risk. Management believes that any amounts actually drawn upon can be
funded in the normal course of operations.





The
Company has no investment in or financial relationship with any unconsolidated
entities that are reasonably likely to have a material effect on liquidity or
the availability of capital resources.





SUBSEQUENT EVENTS


NONE


42





EFFECTS OF
INFLATION


The
majority of assets and liabilities of a financial institution are monetary in
nature and, therefore, differ greatly from commercial and industrial companies
that have significant investments in fixed assets or inventories. The precise
impact of inflation upon the Company is difficult to measure. Inflation may
affect the borrowing needs of consumers, thereby impacting the growth rate of
the Company’s assets. Inflation may also affect the general level of interest
rates, which can have a direct bearing on the Company.





Management
believes that the most significant impact on financial results is the Company’s
ability to react to changes in interest rates. As discussed previously,
management is attempting to maintain a position that is within conservative
parameters for interest sensitive assets and liabilities in order to be
protected against wide interest rate fluctuations.





ITEM
7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





As
previously stated in this document, the Federal Reserve Bank decreased the Fed
Funds Rate a total of 100 basis points in 2007.  While short-term
rates decreased, longer rates have remained somewhat stationary.  This
has caused a steeper yield curve which can have an effect of increasing the
Bank’s earnings growth.  This is due to the payment of lower,
short-term deposit interest while at the same time experiencing little or no
deterioration to interest income from longer maturity loans.  With
this being said, the Bank monitors this interest sensitivity on a monthly
basis.  The model used by the Bank shows interest rate sensitivity
exceptions in the twelve-month period testing at the negative 200 and 300 basis
point scenarios. The results of the latest simulation follow. The simulation
shows a possible increase in net interest income of 3.90%, or $621,000, in a
+200 basis point rate shock scenario over a one-year period.  A
decrease of 11.80% or $1,880,000 is shown in the model at a -200 basis point
rate shock.  The Bank will continue to monitor this rate sensitivity
going forward.  See previous discussions on Interest Rate
Sensitivity.





Equity
value at risk is monitored regularly and is within established policy
limits.





The
Company is not a party to any forward contract, interest rate swap, option
interest, or similar derivations instruments. The Company does not deal in
foreign currency.


43





ITEM
8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA








REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders




Peoples
Financial Services Corp.




Hallstead,
Pennsylvania




We have
audited the accompanying consolidated balance sheets of Peoples Financial
Services Corp. and subsidiaries as of December 31, 2007 and 2006, and the
related consolidated statements of income, stockholders’ equity and cash flows
for each of the years in the three-year period ended December 31,
2007.  Peoples Financial Service Corp.’s management is responsible for
these consolidated financial statements.  Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.




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




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Peoples Financial Services
Corp. and subsidiaries as of December 31, 2007 and 2006, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2007 in conformity with accounting principles
generally accepted in the United States of America.




As
discussed in Note 1 to the consolidated financial statements, in 2006, Peoples
Financial Services Corp. and subsidiaries changed its method of accounting for
share-based compensation in accordance with Statement of Financial Accounting
Standards No. 123(R).




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Peoples Financial Services Corp.’s internal
control over financial reporting as of December 31, 2007, based on criteria
established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), and our report dated March 14,
2008 expressed an unqualified opinion.









/s/ Beard
Miller Company LLP














Beard
Miller Company LLP


Allentown,
Pennsylvania


March 14,
2008







44
 Peoples
Financial Services Corp. and Subsidiaries


Consolidated
Balance Sheets


December
      31,2007
            
            
            2006(In
      Thousands, Except Share Data)ASSETSCash
      and due from banks
            
            $
            8,051
            
            
            $
            6,707Interest
      bearing deposits in other banks
            
            
            555
            
            
            
            3,446Federal
      funds sold
            
            
            0
            
            
            
            2,227Cash
      and Cash Equivalents
            
            
            8,606
            
            
            
            12,380Securities
      available for sale
            
            
            112,746
            
            
            
            110,302Loans
      receivable, net of allowance for loan losses 2007 $2,451;
              and
      2006 $1,792
            
            
            289,163
            
            
            
            269,383Premises
      and equipment, net
            
            
            5,872
            
            
            
            6,183Accrued
      interest receivable
            
            
            2,237
            
            
            
            1,855Intangible
      assets
            
            
            1,076
            
            
            
            1,331Other
      real estate owned
            
            
            4,675
            
            
            
            5,062Bank
      owned life insurance
            
            
            7,614
            
            
            
            7,317Other
      assets
            
            
            2,445
            
            
            
            2,455Total
      Assets
            
            $
            434,434
            
            
            $
            416,268LIABILITIES
      AND STOCKHOLDERS’ EQUITYLIABILITIESDeposits:Non-interest
      bearing
            
            $
            53,731
            
            
            $
            50,940Interest-bearing
            
            
            273,699
            
            
            
            272,673Total
      Deposits
            
            
            327,430
            
            
            
            323,613Short-term
      borrowings
            
            
            22,848
            
            
            
            12,574Long-term
      borrowings
            
            
            38,534
            
            
            
            36,525Accrued
      interest payable
            
            
            925
            
            
            
            703Other
      liabilities
            
            
            1,892
            
            
            
            1,613Total
      Liabilities
            
            
            391,629
            
            
            
            375,028STOCKHOLDERS’
      EQUITYCommon
      stock, par value $2 per share; authorized 12,500,000 shares;
      issued  3,341,251 shares; outstanding 3,138,493 shares and
      3,133,874 shares December 31, 2007 and 2006, respectively
            
            
            6,683
            
            
            
            6,683Surplus
            
            
            3,083
            
            
            
            3,046Retained
      earnings
            
            
            38,824
            
            
            
            36,336Accumulated
      other comprehensive loss
            
            
            (1,390
            )
            
            
            (395
            )Treasury
      stock, at cost, 202,758 and 207,377 shares at December 31, 2007 and 2006,
      respectively
            
            
            (4,395
            )
            
            
            (4,430
            )Total
      Stockholders’ Equity
            
            
            42,805
            
            
            
            41,240Total
      Liabilities and Stockholders’ Equity
            
            $
            434,434
            
            
            $
            416,268




See
notes to consolidated financial statements


45


Peoples
Financial Services Corp. and Subsidiaries


Consolidated
Statements of Income


Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands, Except Per Share Data)INTEREST
      INCOMELoans
      receivable, including fees
            
            $
            19,481
            
            
            $
            17,996
            
            
            $
            15,986Securities:Taxable
            
            
            3,351
            
            
            
            3,032
            
            
            
            3,086Tax-exempt
            
            
            1,717
            
            
            
            1,484
            
            
            
            1,523Other
            
            
            62
            
            
            
            186
            
            
            
            77Total
      Interest Income
            
            
            24,611
            
            
            
            22,698
            
            
            
            20,672INTEREST
      EXPENSEDeposits
            
            
            9,019
            
            
            
            8,748
            
            
            
            5,786Short-term
      borrowings
            
            
            640
            
            
            
            524
            
            
            
            319Long-term
      borrowings
            
            
            1,446
            
            
            
            1,525
            
            
            
            2,143Total
      Interest Expense
            
            
            11,105
            
            
            
            10,797
            
            
            
            8,248Net
      Interest Income
            
            
            13,506
            
            
            
            11,901
            
            
            
            12,424PROVISION
      FOR LOAN LOSSES
            
            
            280
            
            
            
            302
            
            
            
            392Net
      Interest Income after Provision for Loan Losses
            
            
            13,226
            
            
            
            11,599
            
            
            
            12,032OTHER
      INCOMECustomer
      service fees
            
            
            1,947
            
            
            
            1,770
            
            
            
            1,749Investment
      division commission income
            
            
            340
            
            
            
            260
            
            
            
            201Earnings
      on investment in life insurance
            
            
            297
            
            
            
            281
            
            
            
            263Other
      income
            
            
            626
            
            
            
            437
            
            
            
            382Realized
      gain on sale of interest in insurance agency
            
            
            220
            
            
            
            0
            
            
            
            0Net
      realized  gains (losses) on sales of securities available for
      sale
            
            
            (122
            )
            
            
            42
            
            
            
            222Total
      Other Income
            
            
            3,308
            
            
            
            2,790
            
            
            
            2,817OTHER
      EXPENSESSalaries
      and employee benefits
            
            
            4,767
            
            
            
            4,498
            
            
            
            4,199Occupancy
            
            
            788
            
            
            
            674
            
            
            
            564Equipment
            
            
            508
            
            
            
            484
            
            
            
            427FDIC
      insurance and assessments
            
            
            151
            
            
            
            127
            
            
            
            141Professional
      fees and outside services
            
            
            371
            
            
            
            337
            
            
            
            471Prepayment
      penalty – FHLB
            
            
            0
            
            
            
            0
            
            
            
            808Computer
      service and supplies
            
            
            785
            
            
            
            774
            
            
            
            778Taxes,
      other than payroll and income
            
            
            386
            
            
            
            370
            
            
            
            324Impairment
      charge-other real estate owned
            
            
            575
            
            
            
            0
            
            
            
            0Amortization
      expense – deposit acquisition premiums
            
            
            255
            
            
            
            299
            
            
            
            262Stationary
      and printing supplies
            
            
            339
            
            
            
            247
            
            
            
            216Other
            
            
            1,641
            
            
            
            1,678
            
            
            
            1,198Total
      Other Expenses
            
            
            10,566
            
            
            
            9,488
            
            
            
            9,388Income
      before Income Taxes
            
            
            5,968
            
            
            
            4,901
            
            
            
            5,461FEDERAL
      INCOME TAXES
            
            
            1,097
            
            
            
            772
            
            
            
            985Net
      Income
            
            $
            4,871
            
            
            $
            4,129
            
            
            $
            4,476EARNINGS
      PER SHAREBasic
            
            $
            1.55
            
            
            $
            1.31
            
            
            $
            1.42Diluted
            
            $
            1.55
            
            
            $
            1.31
            
            
            $
            1.41


See
notes to consolidated financial statements


46


Peoples
Financial Services Corp. and Subsidiaries


Years
Ended December 31, 2007, 2006 and 2005





Common
              Stock
            
            
            Surplus
            
            
            Retained
              Earnings
            
            
            Accumulated
              Other
              Comprehensive
              Income(Loss)
            
            
            Treasury
              Stock
            
            
            Total(In
      Thousands, Except Share Data)Balance
      - December 31, 2004
            
            $
            6,683
            
            
            $
            2,821
            
            
            $
            35,665
            
            
            $
            618
            
            
            $
            (3,433
            )
            
            $
            42,354Comprehensive
      income:Net income
            
            
            0
            
            
            
            0
            
            
            
            4,476
            
            
            
            0
            
            
            
            0
            
            
            
            4,476Net change in unrealized gains
      (losses) on
              securitiesavailable
      for sale, net of
              reclassification
      adjustment and taxes
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            (1,579
            )
            
            
            0
            
            
            
            (1,579
            )Total Comprehensive
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,897Cash dividends declared, ($1.76
      per share)
            
            
            0
            
            
            
            0
            
            
            
            (5,542
            )
            
            
            0
            
            
            
            0
            
            
            
            (5,542
            )Shares issued from treasury
      related to stock purchase plans  (10,084 shares)
            
            
            0
            
            
            
            174
            
            
            
            0
            
            
            
            0
            
            
            
            89
            
            
            
            263Purchase of treasury stock
      (10,215 shares)
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            (356
            )
            
            
            (356
            )Balance
      - December 31, 2005
            
            
            6,683
            
            
            
            2,995
            
            
            
            34,599
            
            
            
            (961
            )
            
            
            (3,700
            )
            
            
            39,616Comprehensive
      income:Net income
            
            
            0
            
            
            
            0
            
            
            
            4,129
            
            
            
            0
            
            
            
            0
            
            
            
            4,129Net change in
      unrealized gains (losses) on
              securities
      available
      for sale, net of
              reclassification adjustment and taxes
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            566
            
            
            
            0
            
            
            
            566Total Comprehensive
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,695Stock
      option expense
            
            
            0
            
            
            
            3
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            3Cash dividends declared, ($0.76
      per share)
            
            
            0
            
            
            
            0
            
            
            
            (2,392
            )
            
            
            0
            
            
            
            0
            
            
            
            (2,392
            )Shares issued from treasury
      related to stock purchase plans (4,783 shares)
            
            
            0
            
            
            
            48
            
            
            
            0
            
            
            
            0
            
            
            
            53
            
            
            
            101Purchase of treasury stock
      (26,579 shares)
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            (783
            )
            
            
            (783
            )Balance
      - December 31, 2006
            
            
            6,683
            
            
            
            3,046
            
            
            
            36,336
            
            
            
            (395
            )
            
            
            (4,430
            )
            
            
            41,240Comprehensive
      income:Net income
            
            
            0
            
            
            
            0
            
            
            
            4,871
            
            
            
            0
            
            
            
            0
            
            
            
            4,871Net change in unrealized gains
      (losses) on
              securitiesavailable
      for sale, net of
              reclassification
      adjustment and taxes
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            (995
            )
            
            
            0
            
            
            
            (995
            )Total Comprehensive
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            3,876Stock
      option expense
            
            
            0
            
            
            
            3
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            3Cash dividends declared, ($0.76
      per share)
            
            
            0
            
            
            
            0
            
            
            
            (2,383
            )
            
            
            0
            
            
            
            0
            
            
            
            (2,383
            )Shares issued from treasury
      related to stock purchase plans (8,119 shares)
            
            
            0
            
            
            
            34
            
            
            
            0
            
            
            
            0
            
            
            
            129
            
            
            
            163Purchase of treasury stock
      (3,500 shares)
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            (94
            )
            
            
            (94
            )Balance
      - December 31, 2007
            
            $
            6,683
            
            
            $
            3,083
            
            
            $
            38,824
            
            
            $
            (1,390
            )
            
            $
            (4,395
            )
            
            $
            42,805


See
notes to consolidated financial statements
 47
 Peoples
Financial Services Corp. and Subsidiaries


CONSOLIDATED
STATEMENTS OF CASH FLOWS


Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
            
            $
            4,871
            
            
            $
            4,129
            
            
            $
            4,476Adjustments
      to reconcile net income to net cash provided by
              operating
      activities:Depreciation
      and amortization
            
            
            891
            
            
            
            900
            
            
            
            753Provision
      for loan losses
            
            
            280
            
            
            
            302
            
            
            
            392Losses
      on sales or retirements of equipment
            
            
            0
            
            
            
            9
            
            
            
            0Gain on
      sale of other real estate owned
            
            
            0
            
            
            
            (59
            )
            
            
            (85
            )Impairment
      charge-other real estate owned
            
            
            575
            
            
            
            0
            
            
            
            0Amortization
      of securities’ premiums and accretion of discounts, net
            
            
            380
            
            
            
            417
            
            
            
            578Amortization
      of deferred loan costs
            
            
            254
            
            
            
            267
            
            
            
            234Gain
      on sale of interest in insurance agency
            
            
            (220
            )
            
            
            0
            
            
            
            0(Gain) loss
      on sales of securities available for sale, net
            
            
            122
            
            
            
            (42
            )
            
            
            (222
            )Stock
      option expense
            
            
            3
            
            
            
            3
            
            
            
            0Deferred
      income taxes (benefit)
            
            
            (83
            )
            
            
            14
            
            
            
            274Net
      earnings on investment in life insurance
            
            
            (297
            )
            
            
            (281
            )
            
            
            (263
            )Proceeds
      from the sale of loans originated for sale
            
            
            6,127
            
            
            
            3,037
            
            
            
            2,076Net
      gain on sale of loans originated for sale
            
            
            (38
            )
            
            
            (27
            )
            
            
            (33
            )Loans
      originated for sale
            
            
            (6,166
            )
            
            
            (3,090
            )
            
            
            (2,180
            )(Increase)
      decrease in assets:Accrued
      interest receivable
            
            
            (382
            )
            
            
            (28
            )
            
            
            160Other
      assets
            
            
            275
            
            
            
            (157
            )
            
            
            (693
            )Increase
      in liabilities:Accrued
      interest payable
            
            
            222
            
            
            
            81
            
            
            
            72Other
      liabilities
            
            
            279
            
            
            
            227
            
            
            
            338Net
      Cash Provided by Operating Activities
            
            
            7,093
            
            
            
            5,702
            
            
            
            5,877CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from sale of interest in insurance agency
            
            
            551
            
            
            
            0
            
            
            
            0Proceeds
      from sale of available for sale securities
            
            
            60,489
            
            
            
            60,977
            
            
            
            27,122Proceeds
      from maturities of and principal repayments on
              available
      for sale securities
            
            
            16,220
            
            
            
            12,555
            
            
            
            16,960Purchase
      of available for sale securities
            
            
            (81,163
            )
            
            
            (73,973
            )
            
            
            (41,545
            )Net
      increase in loans
            
            
            (20,555
            )
            
            
            (18,868
            )
            
            
            (15,157
            )Purchase
      of premises and equipment
            
            
            (325
            )
            
            
            (1,016
            )
            
            
            (1,424
            )Proceeds
      from sale or retirements of equipment
            
            
            0
            
            
            
            60
            
            
            
            0Proceeds
      from sale of other real estate
            
            
            130
            
            
            
            183
            
            
            
            342Net
      Cash Used in Investing Activities
            
            
            (24,653
            )
            
            
            (20,082
            )
            
            
            (13,702
            )CASH
      FLOWS FROM FINANCING ACTIVITIESIncrease
      in deposits
            
            
            3,817
            
            
            
            26,651
            
            
            
            22,187Proceeds
      from long-term borrowings
            
            
            11,275
            
            
            
            3,100
            
            
            
            12,200Repayment
      of long-term borrowings
            
            
            (9,266
            )
            
            
            (1,345
            )
            
            
            (23,464
            )Net
      increase (decrease) in short-term borrowings
            
            
            10,274
            
            
            
            (5,268
            )
            
            
            3,228Proceeds
      from sale of treasury stock
            
            
            163
            
            
            
            101
            
            
            
            263Purchase
      of treasury stock
            
            
            (94
            )
            
            
            (783
            )
            
            
            (356
            )Cash
      dividends paid
            
            
            (2,383
            )
            
            
            (2,392
            )
            
            
            (5,542
            )Net
      Cash Provided by Financing Activities
            
            
            13,786
            
            
            
            20,064
            
            
            
            8,516Increase
      (Decrease) in Cash and Cash Equivalents
            
            
            (3,774
            )
            
            
            5,684
            
            
            
            691CASH
      AND CASH EQUIVALENTS - BEGINNING
            
            
            12,380
            
            
            
            6,696
            
            
            
            6,005CASH
      AND CASH EQUIVALENTS - ENDING
            
            $
            8,606
            
            
            $
            12,380
            
            
            $
            6,696


See
notes to consolidated financial statements
 48
 Peoples
Financial Services Corp. and Subsidiaries





CONSOLIDATED
STATEMENTS OF CASH FLOWS (CONTINUED)







Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)SUPPLEMENTARY
      CASH FLOWS INFORMATIONInterest
      paid
            
            $
            10,833
            
            
            $
            10,716
            
            
            $
            8,176Income
      taxes paid
            
            $
            805
            
            
            $
            605
            
            
            $
            957SUPPLEMENTARY
      DISCLOSURES OF NONCASH INVESTING AND FINANCING ACTIVITIESForeclosed
      real estate acquired in settlement of loans
            
            $
            318
            
            
            $
            5,068
            
            
            $
            117Securities
      acquired in settlement of loans
            
            $
            0
            
            
            $
            1,065
            
            
            $
            0





See
notes to consolidated financial statements
 49
 Peoples
Financial Services Corp. and Subsidiaries


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation




The
consolidated financial statements include the accounts of Peoples Financial
Services Corp. (the “Company”) and its wholly-owned subsidiaries, Peoples
National Bank (the “Bank”), Peoples Advisors, LLC and Peoples Financial Capital
Corporation. The Bank has two wholly owned subsidiaries, Peoples Financial
Leasing, LLC and Peoples Investment Holdings, LLC. Peoples Financial Capital
Corporation, Peoples Investment Holdings, LLC, and Peoples Financial Leasing,
LLC were all incorporated in April of 2007. All significant intercompany
accounts and transactions have been eliminated in consolidation.




Nature
of Operations




The
Company provides a variety of financial services, through the Bank, to
individuals, small businesses and municipalities through its seven Pennsylvania
offices located in Hallstead, Hop Bottom, Susquehanna, Montrose, Nicholson,
Meshoppen and Tunkhannock, which are small communities in a rural
setting.  In 2002, the Company started operating in New York with an
office located in Norwich.  The Company opened an office in Conklin,
New York, in March 2003 at which time the Norwich office was closed and its
deposits transferred to the Conklin office.  The Company opened two
new offices in 2005, Deposit, New York, April 2005, and the Town of Chenango,
New York, June 2005.  The Bank’s primary deposits are checking
accounts, savings accounts and certificates of deposit.  Its primary
lending products are single-family residential loans and loans to small
businesses.  As a national bank, the Bank is subject to regulation of
the Office of the Comptroller of the Currency and the Federal Deposit Insurance
Corporation.  The Company is subject to regulation of the Federal
Reserve Bank.  Peoples Advisors, LLC is a member-managed liability
company under the laws of the Commonwealth of Pennsylvania for the purpose of
providing investment advisory services to the general public. Peoples Financial
Leasing, LLC provides employee leasing services to the Bank. Peoples Investment
Holdings, LLC is incorporated in the state of Delaware and maintains and manages
the intangible investments of the Bank and the collection and distribution of
the income from such investments or from tangible investments located outside of
Delaware. Peoples Financial Capital Corporation is also incorporated in the
state of Delaware and maintains and manages the intangible investments of the
Company and the collection and distribution of the income from such investments
or from tangible investments located outside of Delaware.




Estimates




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.




50
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Material
estimates that are particularly susceptible to significant change in the near
term relate to the determination of the allowance for loan losses, the valuation
of real estate acquired in connection with foreclosures or in satisfaction of
loans and determination of other-than-temporary impairment losses on
securities.




Significant
Group Concentrations of Credit Risk




Most of
the Company’s activities are with customers located primarily in northern
Lackawanna, Susquehanna and Wyoming Counties of Pennsylvania, and Broome
County of New York.  Note 2 discusses the types of securities in which
the Company invests.  The concentrations of credit by type of loan are
set forth in Note 3.  The Company does not have any significant
concentrations to any one industry or customer.  Although the Company
has a diversified loan portfolio, its debtors’ ability to honor their contracts
is influenced by the region’s economy.




Presentation
of Cash Flows




For
purposes of cash flows, cash and cash equivalents include cash on hand and
amounts due from banks, interest-bearing deposits in other banks and federal
funds sold.




Securities




Securities
classified as available-for-sale are those securities that the Company intends
to hold for an indefinite period of time, but not necessarily to
maturity.  Any decision to sell a security classified as
available-for-sale would be based on various factors, including significant
movements in interest rates, changes in the maturity mix of the Company’s assets
and liabilities, liquidity needs, regulatory capital considerations and other
similar factors.  Securities available-for-sale are carried at fair
value.  Unrealized gains or losses are reported as increases or
decreases in other comprehensive income, net of the related deferred tax
effect.  Realized gains or losses, determined on the basis of the cost
of the specific securities sold, are included in earnings.  Premiums
and discounts are recognized in interest income using the interest method over
the period to maturity.




Common
equity securities include restricted investments, primarily Federal Home Loan
Bank and Federal Reserve Bank stock which are carried at cost and investments in
bank stocks which are carried at fair value.  Federal law requires a
member institution of the Federal Home Loan Bank and the Federal Reserve Bank to
hold stock according to a predetermined formula.




Declines
in the fair value of available-for-sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized
losses.  In estimating other-than-temporary impairment losses,
management considers (1) the length of time and the extent to which the fair
value has been less than cost, (2) the financial condition and near-term
prospects of the issuer, and (3) the intent and ability of the Company to retain
its investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value.




51
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Loans
Receivable




Loans
receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are stated at their outstanding
unpaid principal balances, net of an allowance for loan losses and any deferred
fees or costs.  Interest income is accrued on the unpaid principal
balance.  Loan origination fees, net of certain direct origination
costs, are deferred and recognized over the contractual life of the related loan
as an adjustment to the yield.




The
accrual of interest is generally discontinued when the contractual payment of
principal or interest has become 90 days past due or management has serious
doubts about further collectibility of principal or interest, even though the
loan is currently performing.  A loan may remain on accrual status if
it is in the process of collection and is either guaranteed or well
secured.  When a loan is placed on non-accrual status, unpaid interest
credited to income in the current year is reversed and unpaid interest accrued
in prior years is charged against the allowance for loan
losses.  Interest received on non-accrual loans generally is either
applied against principal or reported as interest income, according to
management’s judgment as to the collectibility of
principal.  Generally, loans are restored to accrual status when the
obligation is brought current, has performed in accordance with the contractual
terms for a reasonable period of time and the ultimate collectibility of the
total contractual principal and interest is no longer in doubt.




Loans
Held for Sale




Loans
originated and intended for sale in the secondary market are carried at the
lower of aggregate cost or fair value, as determined by aggregate outstanding
commitments from investors or current investor yield
requirements.  Net unrealized losses are recognized through a
valuation allowance by charges to income.  The Company had mortgages
of $77,000 and $80,000 held for sale at December 31, 2007 and 2006,
respectively.




Allowance
for Loan Losses




The
allowance for loan losses is established through provisions for loan losses
charged against income.  Loans deemed to be uncollectible are charged
against the allowance for loan losses, and subsequent recoveries, if any, are
credited to the allowance.




The
allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated.  Management’s
periodic evaluation of the adequacy of the allowance is based on the Bank’s past
loan loss experience, known or inherent risks in the portfolio, adverse
situations that may affect the borrower’s ability to repay, the estimated value
of any underlying collateral, composition of the loan portfolio, current
economic conditions and other relevant factors.  This evaluation is
inherently subjective as it requires estimates that are susceptible to
significant revision as more information becomes available.




52
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





The
allowance consists of specific, general and unallocated
components.  The specific component relates to loans that are
classified as either doubtful, substandard or special mention.  For
such loans that are also classified as impaired, an allowance is established
when the discounted cash flows (or collateral value or observable market price)
of the impaired loan is lower than the carrying value for that
loan.  The general component covers non-classified loans and is based
on historical loss experience adjusted for qualitative factors.  An
unallocated component is maintained to cover uncertainties that could affect
management’s estimate of probable losses.  The unallocated component
of the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.




A loan is
considered impaired when, based on current information and events, it is
probable that the Bank will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls generally are not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower,
including the length of the delay, the reasons for the delay, the borrower’s
prior payment record and the amount of the shortfall in relation to the
principal and interest owed.  Impairment is measured on a loan-by-loan
basis for commercial and construction loans by either the present value of
expected future cash flows discounted at the loan’s effective interest rate, the
loan’s obtainable market price or the fair value of the collateral if the loan
is collateral dependent.




Large
groups of smaller balance homogeneous loans are collectively evaluated for
impairment.  Accordingly, the Bank does not separately identify
individual consumer and residential loans for impairment disclosures, unless
such loans are the subject of a restructuring agreement.




Premises
and Equipment




Premises
and equipment are stated at cost less accumulated
depreciation.  Depreciation is computed using the straight-line and
various accelerated methods over the following estimated useful lives of the
related assets:




YearsBuildings
      and improvements
            7 -
      40Furniture,
      fixtures and equipment
            3 -
      10





Maintenance,
repairs and minor replacements are expensed when incurred.  Gains and
losses on routine dispositions are reflected in current operations.




53
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)







Transfers
of Financial Assets




Transfers
of financial assets, which include loan participation sales, are accounted for
as sales, when control over the assets has been surrendered.  Control
over transferred assets is deemed to be surrendered when (1) the assets
have been isolated from the Company, (2) the transferee obtains the right (free
of conditions that constrain it from taking advantage of that right) to pledge
or exchange the transferred assets and (3) the Company does not maintain
effective control over the transferred assets through an agreement to repurchase
them before their maturity.




Intangible
Assets




The Bank
has core deposit acquisition premiums which are being amortized over an
estimated life of fifteen years using the straight-line method.  These
intangible assets were $1,076,000 and $1,331,000 net of accumulated amortization
of $2,811,000 and $2,556,000 at December 31, 2007 and 2006,
respectively.  Amortization expense was $255,000 for 2007, $299,000
for 2006 and $262,000 for 2005. Amortization expense is estimated to be $258,000
per year for the next four years.  The fluctuation in the 2006 expense
is due to the impairment on the Norwich Branch deposit acquisition recognized in
the fourth quarter of 2006 which totaled $38,000.




Other
Real Estate Owned




Other
real estate owned is comprised of property acquired through a foreclosure
proceeding or acceptance of a deed-in-lieu of foreclosure and loans classified
as in-substance foreclosure.  The Company includes such properties in
other assets.  A loan is classified as in-substance foreclosure when
the Company has taken possession of the collateral regardless of whether formal
foreclosure proceedings take place.  Foreclosed assets initially are
recorded at fair value, net of estimated selling costs, at the date of
foreclosure establishing a new cost basis.  Subsequent declines in the
recorded value of the property prior to its disposal and costs to maintain the
assets are included in other expense.  In addition, any gain or loss
realized upon disposal is included in other income or expense.




Bank
Owned Life Insurance




The
Company invests in bank owned life insurance (“BOLI”) as a source of funding for
employee benefit expenses.  BOLI involves the purchasing of life
insurance by the Bank on a chosen group of employees.  The Company is
the owner and beneficiary of the policies.  This life insurance
investment is carried at the cash surrender value of the underlying
policies.




54
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)







Income
Taxes




Deferred
income taxes are provided on the liability method whereby deferred tax assets
are recognized for deductible temporary differences and deferred tax liabilities
are recognized for taxable temporary differences.  Temporary
differences are the differences between the reported amounts of assets and
liabilities and their tax basis.  Deferred tax assets are reduced by a
valuation allowance when, in the opinion of management, it is more likely than
not that some portion of the deferred tax assets will not be
realized.  Deferred tax assets and liabilities are adjusted for the
effects of changes in tax laws and rates on the date of
enactment.  Peoples Financial Services Corp. and its subsidiaries file
a consolidated federal income tax return.




Advertising




The
Company follows the policy of charging marketing and advertising costs to
expense as incurred.  Advertising expense for the years ended
December 31, 2007, 2006, and 2005 was $154,000, $167,000 and $151,000,
respectively.




Earnings
per Common Share




Basic
earnings per share represents income available to common stockholders divided by
the weighted-average number of common shares outstanding during the
period.  Diluted earnings per share reflects additional common shares
that would have been outstanding if dilutive potential common shares had been
issued, as well as any adjustment to income that would result from the assumed
issuance.  Potential common shares that may be issued by the Company
relate solely to outstanding stock options, and are determined using the
treasury stock method.








55
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Earnings
per Common Share (Continued)




The
following table shows the amounts used in computing earnings per share for the
years ended December 31, 2007, 2006 and 2005:




Income
      Numerator
            
            
            Common
      Shares Denominator
            
            
            EPS(In
      Thousands, Except Per Share Data)2007:Basic EPS
            
            $
            4,871
            
            
            
            3,136
            
            
            $
            1.55Dilutive effect of potential
      common stock,
              stock options (9,984
      options)
            
            
            0
            
            
            
            10
            
            
            
            .00Diluted EPS
            
            $
            4,871
            
            
            
            3,146
            
            
            $
            1.552006:Basic EPS
            
            $
            4,129
            
            
            
            3,144
            
            
            $
            1.31Dilutive
      effect of potential common stock,
              stock options (12,074
      options)
            
            
            0
            
            
            
            12
            
            
            
            .00Diluted EPS
            
            $
            4,129
            
            
            
            3,156
            
            
            $
            1.312005:Basic EPS
            
            $
            4,476
            
            
            
            3,151
            
            
            $
            1.42Dilutive
      effect of potential common stock,
              stock options (17,019
      options)
            
            
            0
            
            
            
            17
            
            
            
            .01Diluted EPS
            
            $
            4,476
            
            
            
            3,168
            
            
            $
            1.41








Comprehensive
Income




Accounting
principles generally accepted in the United States of America require that
recognized revenue, expenses, gains and losses be included in net
income.  Although certain changes in assets and liabilities, such as
unrealized gains and losses on available-for-sale securities, are reported as a
separate component of the equity section of the balance sheet, such items, along
with net income, are components of comprehensive income.




56
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Comprehensive
Income (Continued)




The
components of other comprehensive income and related tax effects for the years
ended December 31, 2007, 2006 and 2005 are as follows:




2007
            
            
            2006
            
            
            2005(In
      Thousands)Unrealized
      holding gains (losses) on available for sale securities
            
            $
            (1,629
            )
            
            $
            900
            
            
            $
            (2,170
            )Reclassification
      adjustment for (gains) losses realized in net income
            
            
            122
            
            
            
            (42
            )
            
            
            (222
            )Net
      Unrealized Gains (Losses)
            
            
            (1,507
            )
            
            
            858
            
            
            
            (2,392
            )Tax
      effect
            
            
            512
            
            
            
            (292
            )
            
            
            813Net
      of Tax Amount
            
            $
            (995
            )
            
            $
            566
            
            
            $
            (1,579
            )




Stock-Based
Compensation





Prior to
January 1, 2006, the Company’s stock option plan was accounted for under the
recognition and measurement provisions of APB Opinion No. 25 (Opinion 25), Accounting for Stock Issued to
Employees, and related Interpretations, as permitted by FASB Statement
No. 123, Accounting for Stock
Based Compensation (as amended by SFAS No. 148, Accounting for Stock-Based
Compensation Transition and Disclosure) (collectively SFAS 123). No
stock-based employee compensation cost was recognized in the Company’s
consolidated statements of income through December 31, 2005, as all options
granted under the plan had an exercise price equal to the market value of the
underlying common stock on the date of grant. Effective January 1, 2006, the
Company adopted the fair value recognition provisions of FASB Statement No.
123(R), Share-Based
Payment (SFAS 123(R)), using the modified-prospective transition method.
Under that transition method, compensation cost recognized in 2007 includes: (a)
compensation cost for all share-based payments granted prior to, but not yet
vested as of January 1, 2006 based on the grant date fair value calculated in
accordance with the original provisions of SFAS 123, and (b) compensation cost
for all share-based payments granted subsequent to December 31, 2005, based on a
grant-date fair value estimated in accordance with the provisions of SFAS
123(R).





As of
December 31, 2006, the Company had 4,100 stock options not fully vested and
there was approximately $4,000 of total unrecognized compensation cost related
to these non-vested options.  The cost is expected to be recognized
monthly on a straight-line basis through December 31, 2008.  For the
year ended December 31, 2006 there were no stock options granted.  For
the year ended December 31, 2006 there was stock option expense of $3,000
included in salaries and employee benefits in the accompanying consolidated
statement of income related to share based payments granted prior to, but not
yet vested as of January 1, 2006.  Therefore, as a result of adopting
Statement No. 123(R) the Company’s net income for the year ended December 31,
2006 was $3,000 lower than if the Company had continued to account for
share-based compensation under Opinion No. 25.  Basic earnings per
share and diluted earnings per share for the year ended December 31, 2006 were
not affected by the adoption.


57
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Stock-Based
Compensation (Continued)





As of
December 31, 2007, the Company had 3,850 stock options not fully vested and
there was approximately $1,000 of total unrecognized compensation cost related
to these non-vested options. The cost is expected to be recognized monthly on a
straight-line basis through December 31, 2008.  For the year ended
December 31, 2007 there were no stock options granted.  For the year
ended December 31, 2007 there was stock option expense of $3,000 included in
salaries and employee benefits in the accompanying consolidated statement of
income related to share based payments granted prior to, but not yet vested as
of January 1, 2006.  Therefore, as a result of adopting Statement No.
123(R) the Company’s net income for the year ended December 31, 2007 was $3,000
lower than if the Company had continued to account for share-based compensation
under Opinion No. 25.  Basic earnings per share and diluted earnings
per share for the year ended December 31, 2007 were not affected by the
adoption.





The
following table illustrates the effect on net income and earnings per share if
the Company had applied the fair value recognition provisions of SFAS 123 to
options granted under the Company’s stock option plan for the year ended
December 31, 2005.  For purposes of this pro forma disclosure, the
value of the options is estimated using the Black-Scholes option-pricing model
and is being amortized to expense over the options’ vesting
periods.  The following weighted average assumptions were used with
the Black-Scholes model for options granted in 2005:  risk free
interest rate of 4.31%; volatility of 20%; dividend yield of 2.47%; and an
expected life of six years.  The weighted-average fair value of
options granted was $6.43 per share in 2005.





2005Net
      income as reported
            
            $
            4,476Total
      stock-based compensation cost, net of tax, which would have been included
      in the determination of net income if the fair value based method had been
      applied to all awards
            
            
            (26
            )Pro
      forma net income
            
            $
            4,450Basic
      earnings per share:As reported
            
            $
            1.42Pro forma
            
            $
            1.41Diluted
      earnings per share:As reported
            
            $
            1.41Pro forma
            
            $
            1.40


58
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





Segment
Reporting




The Bank
acts as an independent community financial services provider and offers
traditional banking and related financial services to individual, business and
government customers.  Through its branch and automated teller machine
network, the Bank offers a full array of commercial and retail financial
services, including:  the taking of time, savings and demand deposits;
the making of commercial, consumer and mortgage loans; and the providing of
other financial services.




Management
does not separately allocate expenses, including the cost of funding loan
demand, between the commercial and retail operations of the Bank.  As
such, discrete information is not available and segment reporting would not be
meaningful.




Peoples
Advisors, LLC provides investment advisory services to the general
public.  This company is included in the banking and financial
services segment of the Bank.




Peoples
Financial Leasing, LLC provides employee leasing services to the
Bank.




Peoples
Investment Holdings, LLC manages the intangible investments of the Bank and the
collection and distribution of the income from such investments or from tangible
investments located outside of Delaware.




Peoples
Financial Capital Corporation maintains and manages the intangible investments
of the Company and the collection and distribution of the income from such
investments or from tangible investments located outside of
Delaware.




Off-Balance
Sheet Financial Instruments




In the
ordinary course of business, the Company has entered into off-balance sheet
financial instruments consisting of commitments to extend credit and standby
letters of credit.  Such financial instruments are recorded in the
consolidated financial statements when they are funded.




New
Accounting Standards





In
September 2006, the FASB reached consensus on the guidance provided by Emerging
Issues Task Force Issue 06-4 (EITF 06-4), Accounting for Deferred Compensation
and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance
Arrangements.The guidance is applicable to endorsement
split-dollar life insurance arrangements, whereby the employer owns and controls
the insurance policy that are associated with a postretirement benefit, EITF
06-4 requires that for a split-dollar life insurance arrangement within the
scope of the Issue, an employer should recognize a liability for future benefits
in accordance with FASB No. 106 (if, in substance, a postretirement benefit plan
exists) or, Accounting Principles Board Opinion No. 12 (if the arrangement is,
in substance, an individual deferred compensation contract) based on the
substantive agreement with the employee.  EITF 06-4 is effective for
fiscal years beginning after December 15, 2007.  As a result of
adopting this standard, the Company will record a cumulative effect adjustment
of $71,000 effective January 1, 2008.  In addition, there will be an
ongoing monthly benefit expense of approximately $1,200 in connection with the
postretirement cost of insurance for split-dollar life insurance
coverage.


59
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





On
September 7, 2006, the Task Force reached a conclusion on EITF Issue
No. 06-5, “Accounting for Purchases of Life Insurance – Determining the
Amount That Could Be Realized in Accordance with FASB Technical Bulletin
No. 85-4, Accounting for Purchases of Life Insurance” (“EITF 06-5”). The
scope of EITF 06-5 consists of six separate issues relating to accounting for
life insurance policies purchased by entities protecting against the loss of
“key persons.” The six issues are clarifications of previously issued guidance
on FASB Technical Bulletin No. 85-4. EITF 06-5 is effective for fiscal
years beginning after December 15, 2006. Adoption of EITF 06-5 did not have
a material impact on the Company’s consolidated financial
statements.





In May
2007, the FASB issued FASB Staff Position (“FSP”) FIN 48-1, “Definition of
Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 provides
guidance on how to determine whether a tax position is effectively settled for
the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is
effective retroactively to January 1, 2007. The implementation of this standard
did not have a material impact on our consolidated financial position or results
of operations.





FASB
Statement No. 141 (R) “Business Combinations” was issued in December of 2007.
This Statement establishes principles and requirements for how the acquirer of a
business recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree. The Statement also provides guidance for recognizing and measuring the
goodwill acquired in the business combination and determines what information to
disclose to enable users of the financial statements to evaluate the nature and
financial effects of the business combination. The guidance will become
effective as of the beginning of a company’s fiscal year beginning after
December 15, 2008. This new pronouncement will impact the Company’s
accounting for business combinations completed beginning January 1,
2009.





FASB
Statement No. 160 “Noncontrolling Interests in Consolidated Financial
Statements—an amendment of ARB No. 51” was issued in December of 2007. This
Statement establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary. The
guidance will become effective as of the beginning of a company’s fiscal year
beginning after December 15, 2008. The Company believes that this new
pronouncement will have an immaterial impact on the Company’s consolidated
financial statements in future periods.





Staff
Accounting Bulletin No. 110 (SAB 110) amends and replaces Question 6 of
Section D.2 of Topic 14, “Share-Based Payment,” of the Staff Accounting Bulletin
series. Question 6 of Section D.2 of Topic 14 expresses the views of the staff
regarding the use of the “simplified” method in developing an estimate of
expected term of “plain vanilla” share options and allows usage of the
“simplified” method for share option grants prior to December 31, 2007. SAB
110 allows public companies which do not have historically sufficient experience
to provide a reasonable estimate to continue use of the “simplified” method for
estimating the expected term of “plain vanilla” share option grants after
December 31, 2007.  SAB 110 is effective January 1,
2008.  The Company does not expect SAB 110 to have a material impact
on its consolidated financial statements.


60
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





New
Accounting Standards (Continued)





Staff
Accounting Bulletin No. 109 (SAB 109), "Written Loan Commitments Recorded at
Fair Value Through Earnings" expresses the views of the staff regarding written
loan commitments that are accounted for at fair value through earnings under
generally accepted accounting principles. To make the staff's views consistent
with current authoritative accounting guidance, the SAB revises and rescinds
portions of SAB No. 105, "Application of Accounting Principles to Loan
Commitments."  Specifically, the SAB revises the SEC staff's views on
incorporating expected net future cash flows related to loan servicing
activities in the fair value measurement of a written loan commitment. The SAB
retains the staff's views on incorporating expected net future cash flows
related to internally-developed intangible assets in the fair value measurement
of a written loan commitment. The staff expects registrants to apply the views
in Question 1 of SAB 109 on a prospective basis to derivative loan commitments
issued or modified in fiscal quarters beginning after December 15, 2007. The
Company does not expect SAB 109 to have a material impact on its consolidated
financial statements.





In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements,which defines fair value, establishes a framework for measuring fair
value under U.S. GAAP, and expands disclosures about fair value
measurements.  SFAS No. 157 applies to other accounting pronouncements
that require or permit fair value measurements.  In December 2007, the
FASB issued proposed FASB Staff Position (FSP) 157-b, “Effective Date of FASB
Statement No. 157,” that would permit a one-year deferral in applying the
measurement provisions of Statement No. 157 to non-financial assets and
non-financial liabilities (non-financial items) that are not recognized or
disclosed at fair value in an entity’s financial statements on a recurring basis
(at least annually).  Therefore, if the change in fair value of a
non-financial item is not required to be recognized or disclosed in the
financial statements on an annual basis or more frequently, the effective date
of application of Statement 157 to that item is deferred until fiscal years
beginning after November 15, 2008 and interim periods within those fiscal
years.  This deferral does not apply, however, to an entity that
applies Statement 157 in interim or annual financial statements before proposed
FSP 157-b is finalized.  The Company does not expect that the adoption
of FASB No. 157 and FSP 157-b will have a material impact on the Company’s
consolidated financial position, results of operations and cash
flows.


61
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option of Financial
Assets and Financial Liabilities.SFAS No. 159 provides
companies with an option to report many financial instruments and certain other
items at fair value that are not currently required to be measured at fair
value.  The objective of SFAS No. 159 is to reduce both complexity in
accounting for financial instruments and the volatility in earnings caused by
measuring related assets and liabilities differently.  The FASB
believes that SFAS No. 159 helps to mitigate accounting-induced volatility by
enabling companies to report related assets and liabilities at fair value, which
would likely reduce the need for companies to comply with detailed rules for
hedge accounting.  SFAS No. 159 also establishes presentation and
disclosure requirements designed to facilitate comparisons between companies
that choose different measurement attributes for similar types of assets and
liabilities, and would require entities to display the fair value of those
assets and liabilities for which the company has chosen to use fair value on the
face of the balance sheet.  The new statement does not eliminate
disclosure requirements included in other accounting standards, including
requirements for disclosures about fair value measurements included in SFAS No.
157, Fair Value
Measurements.This statement is effective as of the beginning
of an entity’s first fiscal year beginning after November 15,
2007.  The Company is in the process of evaluating the impact, if any,
that the adoption of SFAS No. 159 will have on the Company’s consolidated
financial statements.





Reclassifications





Certain
amounts in the 2006 and 2005 financial statements have been reclassified to
conform to 2007 presentation.  Those reclassifications had no effect
on net income.


62
 Peoples
Financial Services Corp. and Subsidiaries





NOTE
2 – SECURITIES









At
December 31, 2007 and 2006, the amortized cost and fair values of
securities available-for-sale are as follows:





Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
            
            
            Gross
              Unrealized
              Losses
            
            
            Fair
              Value(In
      Thousands)December
      31, 2007:U.S. Government agencies
      and
              corporations
            
            $
            1,999
            
            
            $
            3
            
            
            $
            0
            
            
            $
            2,002Obligations of state and
      political
              subdivisions
            
            
            45,357
            
            
            
            28
            
            
            
            (880
            )
            
            
            44,505Taxable
      obligations of state and political subdivisions
            
            
            1,995
            
            
            
            0
            
            
            
            (1
            )
            
            
            1,994Corporate debt
      securities
            
            
            11,493
            
            
            
            35
            
            
            
            (263
            )
            
            
            11,265Mortgage-backed
      securities
            
            
            45,256
            
            
            
            241
            
            
            
            (329
            )
            
            
            45,168Preferred equity
      securities
            
            
            2,367
            
            
            
            0
            
            
            
            (526
            )
            
            
            1,841Common equity
      securities
            
            
            6,384
            
            
            
            29
            
            
            
            (442
            )
            
            
            5,971Total
            
            $
            114,851
            
            
            $
            336
            
            
            $
            (2,441
            )
            
            $
            112,746December
      31, 2006:U.S. Government agencies
      and
              corporations
            
            $
            11,110
            
            
            $
            8
            
            
            $
            0
            
            
            $
            11,118Obligations of state and
      political
              subdivisions
            
            
            30,430
            
            
            
            96
            
            
            
            (188
            )
            
            
            30,338Corporate debt
      securities
            
            
            3,404
            
            
            
            0
            
            
            
            (147
            )
            
            
            3,257Mortgage-backed
      securities
            
            
            58,538
            
            
            
            62
            
            
            
            (753
            )
            
            
            57,847Preferred equity
      securities
            
            
            2,366
            
            
            
            167
            
            
            
            0
            
            
            
            2,533Common equity
      securities
            
            
            5,052
            
            
            
            157
            
            
            
            0
            
            
            
            5,209Total
            
            $
            110,900
            
            
            $
            490
            
            
            $
            (1,088
            )
            
            $
            110,302





63
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
2 – SECURITIES (CONTINUED)





The
amortized cost and fair value of securities as of December 31, 2007, by
contractual maturity, are shown below.  Expected maturities may differ
from contractual maturities because borrowers may have the right to prepay
obligations with or without any penalties.





Amortized
                Cost
            
            
            Fair
                Value(In
      Thousands)Due
      after one year through five years
            $
            4,881
            
            
            $
            4,736Due
      after five years through ten years
            
            7,660
            
            
            
            7,527Due
      after ten years
            
            48,303
            
            
            
            47,50360,844
            
            
            
            59,766Mortgage-backed
      securities
            
            45,256
            
            
            
            45,168Equity
      securities
            
            8,751
            
            
            
            7,812$
            114,851
            
            
            $
            112,746





Proceeds
from sale of available-for-sale securities during 2007, 2006 and 2005 were
$60,489,000, $60,977,000, and $27,122,000, respectively.  Gross gains
realized on these sales were $186,000, $663,000, and $463,000,
respectively.  Gross losses on these sales were $308,000, $621,000,
and $241,000, respectively.




Securities
with a carrying value of $33,189,000 and $32,842,000 at December 31, 2007
and 2006, respectively, were pledged to secure public deposits and repurchase
agreements as required or permitted by law.




64
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
2 – SECURITIES (CONTINUED)





The
following tables show our investments’ gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position at December 31, 2007 and
2006 (in thousands):




December
31, 2007:




Less
      Than 12 Months
            
            
            12
      Months or More
            
            
            TotalFair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            Unrealized
      LossesObligations
      of state and political subdivisions
            
            $
            27,688
            
            
            $
            (746
            )
            
            $
            12,447
            
            
            $
            (134
            )
            
            $
            40,135
            
            
            $
            (880
            )Taxable
      obligations of state and political subdivisions
            
            
            491
            
            
            
            (1
            )
            
            
            0
            
            
            
            0
            
            
            
            491
            
            
            
            (1
            )Corporate
      debt securities
            
            
            6,942
            
            
            
            (126
            )
            
            
            2,207
            
            
            
            (137
            )
            
            
            9,149
            
            
            
            (263
            )Mortgage-backed
      securities
            
            
            4,099
            
            
            
            (23
            )
            
            
            20,438
            
            
            
            (306
            )
            
            
            24,537
            
            
            
            (329
            )Preferred
      equity securities
            
            
            1,841
            
            
            
            (526
            )
            
            
            0
            
            
            
            0
            
            
            
            1,841
            
            
            
            (526
            )Common
      equity securities
            
            
            1,383
            
            
            
            (442
            )
            
            
            0
            
            
            
            0
            
            
            
            1,383
            
            
            
            (442
            )Total
      Temporarily Impaired Securities
            
            $
            42,444
            
            
            $
            (1,864
            )
            
            $
            35,092
            
            
            $
            (577
            )
            
            $
            77,536
            
            
            $
            (2,441
            )





December
31, 2006:





Less
      Than 12 Months
            
            
            12
      Months or More
            
            
            TotalFair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            Unrealized
      LossesObligations
      of state and political subdivisions
            
            $
            7,850
            
            
            $
            (38
            )
            
            $
            10,920
            
            
            $
            (150
            )
            
            $
            18,770
            
            
            $
            (188
            )Corporate
      debt securities
            
            
            0
            
            
            
            0
            
            
            
            3,257
            
            
            
            (147
            )
            
            
            3,257
            
            
            
            (147
            )Mortgage-backed
      securities
            
            
            13,686
            
            
            
            (49
            )
            
            
            22,228
            
            
            
            (704
            )
            
            
            35,914
            
            
            
            (753
            )Total
      Temporarily Impaired Securities
            
            $
            21,536
            
            
            $
            (87
            )
            
            $
            36,405
            
            
            $
            (1,001
            )
            
            $
            57,941
            
            
            $
            (1,088
            )





65
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
2 - SECURITIES (CONTINUED)





At
December 31, 2007, the Company had 68 obligations of state and political
subdivisions, 36 mortgage-backed securities, 5 corporate debt securities, 2
preferred equity securities, and 18 common equity securities in an unrealized
loss position.  The Company had $526,000 of unrealized losses on
variable-rate preferred stock issuances of FHLMC with a cost basis of $2,367,000
at December 31, 2007.  Substantially all of the decline in value of
those securities occurred in late 2007, and the Company has concluded that the
impairment of such securities at December 31, 2007 was the result of the recent
issuance of new higher-yielding preferred stock by those government-sponsored
agencies in response to the current housing market decline.  Also,
these securities continue to have a high yield and the dividends received are
tax exempt.  As such, the Company believes it is too soon to conclude
that such unrealized losses were other than temporary.





At
December 31, 2007, 18 common equity securities had totaled unrealized losses of
$442,000.  These securities have traditionally been high-performing
stocks.  As a result of recent market volatility in financial stocks
from news of sub-prime lending problems, the fair value of most of the stocks
held are “under water” as of December 31, 2007, and as such, are considered to
be impaired.  The Company does not invest in bank stocks with the
intent to turn them over for a profit in the near-term.  We invest in
those stocks that we believe to have potential to appreciate in value over the
long-term, while providing for a reasonable dividend yield.  We buy
and hold those stocks that we believe have potential to be an acquirer or to be
acquired, providing additional value.  Also, the purchase and holding
of these stocks will provide long-term capital gains to offset capital
losses.  Stocks can be cyclical in nature and will experience some
down periods.  Historically, bank stocks have sustained cyclical
losses, followed by periods of substantial gains, therefore we believe that both
unrealized losses and gains are likely to be temporary, when observing
performance in the banking sector.





In
management’s opinion, the unrealized losses on all other securities reflect
changes in interest rates subsequent to the acquisition of specific
securities.  The Company has the intent and the ability to hold such
securities until maturity or market price recovery.  Management
believes that the unrealized losses represent temporary impairment of the
securities.





Management
evaluates securities for other-than-temporary impairment at least on a quarterly
basis, and more frequently when economic or market concerns warrant such
evaluation.  Consideration is given to (1) the length of time and the
extent to which the fair value has been less than cost, (2) the financial
condition and near-term prospects of the issuer, and (3) the intent and ability
of the Company to retain its investment in the issuer for a period of time
sufficient to allow for any anticipated recovery in fair value.














66
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
3 - LOANS RECEIVABLE





The
composition of loans receivable at December 31, 2007 and 2006 is as
follows:







December
      31,2007
            
            
            2006(In
      Thousands)Commercial
            $
            63,091
            
            
            $
            60,326Real
      Estate:Commercial
            
            93,267
            
            
            
            80,605Residential
            
            116,922
            
            
            
            112,883Consumer
            
            17,889
            
            
            
            16,947291,169
            
            
            
            270,761Unearned
      net loan origination fees and costs
            
            445
            
            
            
            414Allowance
      for loan losses
            
            (2,451
            )
            
            
            (1,792
            )$
            289,163
            
            
            $
            269,383








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







Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)Balance,
      beginning
            
            $
            1,792
            
            
            $
            2,375
            
            
            $
            2,739Provision for loan
      losses
            
            
            280
            
            
            
            302
            
            
            
            392Recoveries
            
            
            452
            
            
            
            31
            
            
            
            37Loans charged off
            
            
            (73
            )
            
            
            (916
            )
            
            
            (793
            )Balance,
      ending
            
            $
            2,451
            
            
            $
            1,792
            
            
            $
            2,375







The total
recorded investment in impaired loans was $395,000 and $445,000 at
December 31, 2007 and 2006, respectively, none of which required an
allowance for loan losses.  For the years ended December 31,
2007, 2006 and 2005, the average balance of these impaired loans was $496,000,
$449,000, and $1,113,000, respectively.  The Company recognizes income
on impaired loans under the cash basis when the collateral on the loan is
sufficient to cover the outstanding obligation to the Company.  If
these factors do not exist, the Company will record all payments as a reduction
of principal on such loans.  Interest income recognized for the time
that the loans were impaired was $15,000, $7,000, and $9,000 in 2007, 2006 and
2005, respectively.




67
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
3 - LOANS RECEIVABLE (CONTINUED)





Loans on
which the accrual of interest has been discontinued amounted to $395,000 and
$445,000 at December 31, 2007 and 2006, respectively.  Loan
balances past due 90 days or more and still accruing interest, and which
management expects will eventually be paid in full, amounted to $91,000 and
$275,000 at December 31, 2007 and 2006, respectively.  If
interest on non-accrual loans had been accrued throughout the period, interest
income for the years ended December 31, 2007, 2006 and 2005, would have
increased approximately $32,000, $84,000 and $59,000
respectively.  The amount of interest income on these loans that was
included in net income for the years ended December 31, 2007, 2006 and 2005, was
$15,000, $7,000 and  respectively.




Loans
outstanding to directors, executive officers, principal stockholders or to their
affiliates totaled $2,740,000 and $390,000 at December 31, 2007 and 2006,
respectively.  Advances and repayments during 2007 totaled $3,470,000
and $1,120,000, respectively.  These loans are made during the
ordinary course of business at the Company’s normal credit
terms.  There were no related party loans that were classified as
non-accrual, past due, or restructured or were considered a potential credit
risk at December 31, 2007 and 2006.





The
Company has signed a participating member agreement to sell residential
mortgages to Fannie Mae. The balance of loans sold as of December 31, 2007 to
Fannie Mae is $6,094,000.  The Company continues to service loans that
were sold to the FHLB of Pittsburgh (“FHLB”).  The agreement, with
FHLB, included a maximum credit enhancement of $178,000 which the Company may be
required to pay if realized losses on any of the sold mortgages exceed the
amount held in the FHLB’s Spread Account.  The FHLB is funding the
Spread Account at 0.25% of the outstanding balance of loans sold. The balance of
loans sold as of December 31, 2007 to FHLB is $7,153,000.  The
Company’s historical losses on residential mortgages have been lower than the
amount being funded to the Spread Account.  As such, the Company does
not anticipate recognizing any losses and accordingly, has not recorded a
liability for the credit enhancement.  As compensation for the credit
enhancement, the FHLB is paying the Company 0.10% of the outstanding loan
balance in the portfolio on a monthly basis.





The
Company retains the servicing on the loans sold to Fannie Mae and FHLB and
receives a fee based upon the principal balance outstanding.  During
the years ended 2007 and 2006, the Company recognized $64,000 and $47,000,
respectively, of servicing assets and amortized $13,000 and $25,000,
respectively. The balance outstanding was $83,000 and $32,000 at December 31,
2007 and 2006, respectively.  The fair value of the servicing assets
was $83,000 and $32,000 at December 31, 2007 and 2006, respectively, and was
based on market quotes for pools of the mortgages stratified by rate and
maturity date.


68
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
4 - PREMISES AND EQUIPMENT





Premises
and equipment at December 31, 2007 and 2006 are comprised of the
following:




2007
            
            
            2006(In
      Thousands)Land
            $
            398
            
            
            $
            398Building
      and improvements
            
            6,500
            
            
            
            6,414Furniture,
      fixtures and equipment
            
            5,805
            
            
            
            5,56712,703
            
            
            
            12,379Accumulated
      depreciation
            
            (6,831
            )
            
            
            (6,196
            )$
            5,872
            
            
            $
            6,183





Depreciation
expense was $636,000, $601,000, and $491,000 for the years ended
December 31, 2007, 2006 and 2005, respectively.




NOTE
5 – DEPOSITS





The
composition of deposits at December 31, 2007 and 2006 were as
follows:







2007
            
            
            2006(In
      Thousands)Demand:Non-interest
    bearing
            
            $
            53,731
            
            
            $
            50,940Interest bearing
            
            
            64,150
            
            
            
            66,560Savings
            
            
            99,737
            
            
            
            108,282Time:$100,000 and over
            
            
            25,930
            
            
            
            16,923Less than
$100,000
            
            
            83,882
            
            
            
            80,908$
            327,430
            
            
            $
            323,613







At
December 31, 2007, the scheduled maturities of time deposits are as follows
(in thousands):




2008
            $
            78,2252009
            
            9,7362010
            
            5,3952011
            
            5,6902012
            
            6,822Thereafter
            
            3,944$
            109,812





69
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
6 - SHORT-TERM BORROWINGS





Securities
sold under agreements to repurchase and Federal Home Loan Bank advances
generally represent overnight or less than 30-day borrowings.  U.S.
Treasury tax and loan notes for collections made by the Bank are payable on
demand.  Short-term borrowings consisted of the following at
December 31, 2007, 2006 and 2005:







At
      and for the year ended December 31, 2007Ending
              Balance
            
            
            Average
              Balance
            
            
            Maximum
              Month-End
              Balance
            
            
            Average
              Rate(In
      Thousands)Securities
      sold under agreements to repurchase
            
            $
            10,281
            
            
            $
            10,269
            
            
            $
            11,722
            
            
            
            3.01
            %Federal
      Home Loan Bank
            
            
            11,965
            
            
            
            6,029
            
            
            
            12,716
            
            
            
            5.07
            %U.S.
      Treasury tax and loan notes
            
            
            602
            
            
            
            503
            
            
            
            1,014
            
            
            
            4.39
            %$
            22,848
            
            
            $
            16,801
            
            
            $
            25,452
            
            
            
            3.79
            %










At
      and for the year ended December 31, 2006Ending
              Balance
            
            
            Average
              Balance
            
            
            Maximum
              Month-End
              Balance
            
            
            Average
      Rate(In
      Thousands)Securities
      sold under agreements to repurchase
            
            $
            11,591
            
            
            $
            10,946
            
            
            $
            13,394
            
            
            
            4.07
            %Federal
      Home Loan Bank
            
            
            0
            
            
            
            1,239
            
            
            
            6,510
            
            
            
            4.83
            %U.S.
      Treasury tax and loan notes
            
            
            983
            
            
            
            418
            
            
            
            1,019
            
            
            
            4.46
            %$
            12,574
            
            
            $
            12,603
            
            
            $
            20,923
            
            
            
            4.16
            %







At
      and for the year ended December 31, 2005Ending
              Balance
            
            
            Average
              Balance
            
            
            Maximum
              Month-End
              Balance
            
            
            Average
      Rate(In
      Thousands)Securities
      sold under agreements to repurchase
            
            $
            10,030
            
            
            $
            10,537
            
            
            $
            13,870
            
            
            
            2.58
            %Federal
      Home Loan Bank
            
            
            7,220
            
            
            
            1,114
            
            
            
            7,220
            
            
            
            3.21
            %U.S.
      Treasury tax and loan notes
            
            
            592
            
            
            
            397
            
            
            
            989
            
            
            
            2.83
            %$
            17,842
            
            
            $
            12,048
            
            
            $
            22,079
            
            
            
            2.65
            %







70
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
6 - SHORT-TERM BORROWINGS (CONTINUED)




The Bank
has an agreement with the Federal Home Loan Bank (FHLB) which allows for
borrowings up to a percentage of qualifying assets.  At
December 31, 2007, the Bank had a maximum borrowing capacity for short-term
and long-term advances of approximately $181,852,000, of which $50,499,000 was
outstanding in short and long-term borrowings.  All advances from FHLB
are secured by qualifying assets of the Bank.




Securities
sold under repurchase agreements are retained under the Bank’s control at its
safekeeping agent.  The Bank may be required to provide additional
collateral based on the fair value of the underlying securities.




The Bank
has a $7,000,000 line of credit for the sale of federal funds with Atlantic
Central Bankers Bank of which $0 was outstanding at December 31, 2007 and
2006.  These borrowings are unsecured.




NOTE
7 - LONG-TERM BORROWINGS




Long-term
debt consisted of advances from the Federal Home Loan Bank under various
notes.




Due
              
              Convertible
              
              
              Strike
                Rate
              
              
              Current
                Interest
                Rate
              
              
              2007
              
              
              2006(Dollars
      In Thousands)September
      2011
              
              
              N/A
              
              
              
              N/A
              
              
              
              5.05
              
              
              $
              696
              
              
              $
              860February
      2016
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.86
              
              
              
              936
              
              
              
              1,028February
      2016
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.86
              
              
              
              936
              
              
              
              1,027October
      2011
              
              January
      2008
              
              
              
              8.0
              
              
              
              4.47
              
              
              
              2,500
              
              
              
              2,500January
      2007
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.06
              
              
              
              0
              
              
              
              7,500September
      2012
              
              March
      2008
              
              
              
              8.0
              
              
              
              3.69
              
              
              
              5,000
              
              
              
              5,000February
      2009
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.80
              
              
              
              477
              
              
              
              865February
      2013
              
              February
      2008
              
              
              
              8.0
              
              
              
              3.59
              
              
              
              5,000
              
              
              
              5,000February
      2008
              
              
              N/A
              
              
              
              N/A
              
              
              
              2.69
              
              
              
              107
              
              
              
              737June
      2014
              
              March
      2008
              
              
              
              8.0
              
              
              
              4.47
              
              
              
              5,000
              
              
              
              5,000January
      2015
              
              January
      2008
              
              
              
              8.0
              
              
              
              4.31
              
              
              
              5,000
              
              
              
              5,000November
      2015
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.67
              
              
              
              1,822
              
              
              
              2,008February
      2017
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.99
              
              
              
              3,060
              
              
              
              0August
      2008
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.86
              
              
              
              2,500
              
              
              
              0August
      2010
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.85
              
              
              
              2,500
              
              
              
              0December
      2011
              
              
              N/A
              
              
              
              N/A
              
              
              
              4.12
              
              
              
              3,000
              
              
              
              0$
              38,534
              
              
              $
              36,525







71
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
7 - LONG-TERM BORROWINGS (CONTINUED)





Detail of long-term debt
at December 31, 2007 and 2006 is as follows:





On
convertible rate notes, the Federal Home Loan Bank has the option to convert the
notes at rates ranging from the three-month LIBOR (5.01% at December 31,
2007) plus .13% to plus .28% on a quarterly basis, if greater than the
applicable strike rate, commencing on the conversion date.  If
converted, the Bank has the option to repay these advances at each of the option
dates without penalty.




On
September 26, 2005, the Bank prepaid $10 million of fixed rate, high cost
Federal Home Loan Bank (FHLB) advances in order to improve future net interest
income.  The FHLB advances were replaced with lower cost borrowings
and certificates of deposits.  The Bank expensed prepayment fees of
$808,000 associated with this transaction.





Maturities
of long-term debt, by contractual maturity, in years subsequent to
December 31, 2007 are as follows (in thousands):





2008
            $
            3,8432009
            
            9412010
            
            3,4142011
            
            6,4092012
            
            5,797Thereafter
            
            18,130$
            38,534








The notes
are secured under terms of a blanket collateral agreement by a pledge of
qualifying investment and mortgage-backed securities, certain mortgage loans and
a lien on FHLB stock.









72
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
8 - STOCK PURCHASE PLANS





The
Company has a stock option plan covering non-employee directors and a stock
incentive plan for all officers and key employees.  The Plan is
administered by a committee of the Board of Directors.  Under the
Plan, 187,500 shares of common stock are reserved for possible
issuance.  The number of shares available is subject to future
adjustment in the event of specified changes in the Company’s capital
structure.  Under the Plan, the exercise price cannot be less than
100% of the fair market value on the date of grant.  The vesting
period of options granted is at the discretion of the Board of
Directors.  Options granted during 2005, 2004 and 2003 expire in ten
years.   There are 85,751 shares available for grant under this
stock option plan as of December 31, 2007.




A summary
of transactions under this Plan were as follows:




2007
            
            
            2006
            
            
            2005Options
            
            
            Weighted
              Average
              Price
            
            
            Options
            
            
            Weighted
              Average
              Price
            
            
            Options
            
            
            Weighted
              Average
              PriceOutstanding,
      beginning of year
            
            
            56,467
            
            
            $
            20.03
            
            
            
            61,500
            
            
            $
            19.80
            
            
            
            64,035
            
            
            $
            18.83Granted
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            4,500
            
            
            
            30.75Exercised
            
            
            (8,119
            )
            
            
            16.54
            
            
            
            (4,783
            )
            
            
            16.40
            
            
            
            (6,285
            )
            
            
            17.04Forfeited
            
            
            (750
            )
            
            
            30.78
            
            
            
            (250
            )
            
            
            34.10
            
            
            
            (750
            )
            
            
            25.46Outstanding,
      end of year
            
            
            47,593
            
            
            $
            20.75
            
            
            
            56,467
            
            
            $
            20.03
            
            
            
            61,500
            
            
            $
            19.80Exercisable,
      end of year
            
            
            43,743
            
            
            $
            20.15
            
            
            
            52,367
            
            
            $
            19.44
            
            
            
            57,150
            
            
            $
            19.22





The
weighted-average remaining contractual life of the options outstanding is
approximately 4 years at December 31, 2007.  The weighted-average
remaining contractual life of options exercisable at December 31, 2007 is
approximately 4 years.  Stock options outstanding at December 31,
2007 are exercisable at prices ranging from $14.80 to $34.10 a
share.  At December 31, 2007 the aggregate intrinsic value of options
outstanding was $335,000 and the aggregate intrinsic value of options
exercisable was $335,000.  At December 31, 2006, the aggregate
intrinsic value of options outstanding was $401,000 and the aggregate intrinsic
value of options exercisable was $401,000.  At December 31, 2005, the
aggregate intrinsic value of options outstanding was $726,000 and the aggregate
intrinsic value of options exercisable was $706,000.




73
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
8 - STOCK PURCHASE PLANS





During
1999, the Company implemented a Dividend Reinvestment and Stock Purchase
Plan.  Under the Plan, the Company registered with the Securities and
Exchange Commission 100,000 shares of the common stock to be sold pursuant to
the Plan.  Participation is available to all common
stockholders.  The Plan provides each participant with a simple and
convenient method of purchasing additional common shares without payment of any
brokerage commission or other service fees.  The Plan may purchase
shares on the open market if available or they may be issued from treasury
shares.  A participant in the Plan may elect to reinvest dividends on
all or part of their shares to acquire additional common stock.  A
participant may withdraw from the Plan at any time.  Effective in
2005, the Plan was amended to permit stockholders participating in the Plan to
purchase additional shares of common stock with voluntary cash payments of a
minimum of $100 and a maximum of $850 each calendar month.  As of
December 31, 2007, there are 78,728 remaining shares available for issuance
under the Dividend Reinvestment and Stock Purchase Plan.





NOTE
9 - INCOME TAXES





In July
2006, the Financial Accounting Standards Board (FASB) issued Interpretation No.
48, Accounting for Uncertainty
in Income Taxes (FIN 48).   FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprise’s
financial statements in accordance with FASB Statement 109, Accounting for Income
Taxes.  FIN 48 is effective for fiscal years beginning after
December 15, 2006.  The Company adopted FIN 48 as of January 1,
2007.  The Company has evaluated its tax positions as of January 1,
2007.  A tax position is recognized as a benefit only if it is “more
likely than not” that the tax position would be sustained in a tax examination,
with a tax examination being presumed to occur.  The amount recognized
is the largest amount of tax benefit that has a likelihood of being realized on
examination of more than 50 percent.  For tax positions not meeting
the “more likely than not” test, no tax benefit is recorded.  Under
the “more-likely-than-not” threshold guidelines, the Company believes no
significant uncertain tax positions exist, either individually or in the
aggregate, that would give rise to the non-recognition of an existing tax
benefit.  As of January 1, 2007, the Company had no material
unrecognized tax benefits or accrued interest and penalties.  The
Company’s policy is to account for interest as a component of interest expense
and penalties as a component of other expense.  The Company and its
subsidiaries are subject to U.S. federal income tax as well as income tax of the
Commonwealth of Pennsylvania and State of New York.  The Company is no
longer subject to examination by U.S. Federal taxing authorities for years
before 2003 and for all state income taxes through 2003.




The
provision for federal income taxes consists of the following:







Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)Current
            
            $
            1,180
            
            
            $
            758
            
            
            $
            711Deferred
            
            
            (83
            )
            
            
            14
            
            
            
            274$
            1,097
            
            
            $
            772
            
            
            $
            985





74
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
9 - INCOME TAXES (CONTINUED)





The
components of the net deferred tax asset at December 31, 2007 and 2006 are
as follows:







2007
            
            
            2006(In
      Thousands)Deferred
      tax asset:Allowance
      for loan losses
            $
            678
            
            
            $
            481Deferred
      loan fees
            
            4
            
            
            
            6Deferred
      compensation
            
            374
            
            
            
            383Other
            
            32
            
            
            
            25Impairment
      on security
            
            216
            
            
            
            216Capital
      loss carry forward
            
            3
            
            
            
            97Stock
      option expense
            
            2
            
            
            
            1Alternative
      minimum tax credit
            
            27
            
            
            
            221Impairment
      charge—other real estate owned
            
            196
            
            
            
            0Unrealized
      loss on available for sale securities
            
            715
            
            
            
            2032,247
            
            
            
            1,633Deferred
      tax liabilities:Depreciation
            
            (221
            )
            
            
            (213
            )Section
      481 Adjustment-Prepaid Expenses
            
            (85
            )
            
            
            (91
            )Section
      481 Adjustment-Deferred Loan Costs
            
            (239
            )
            
            
            (223
            )(545
            )
            
            
            (527
            )Net
      Deferred Tax Asset
            $
            1,702
            
            
            $
            1,106







A
reconciliation of the provision for income taxes and the amount that would have
been provided at statutory rates for the years ended December 31 is as
follows:





2007
            
            
            2006
            
            
            2005Amount
            
            
            %
      of
              Pretax
              Income
            
            
            Amount
            
            
            %
      of
              Pretax
              Income
            
            
            Amount
            
            
            %
      of
              Pretax
              Income(Dollars
      in Thousands)Federal
      income tax at statutory rate
            
            $
            2,029
            
            
            
            34
            %
            
            $
            1,666
            
            
            
            34
            %
            
            $
            1,857
            
            
            
            34
            %Tax
      exempt interest
            
            
            (907
            )
            
            
            (15
            )
            
            
            (866
            )
            
            
            (18
            )
            
            
            (778
            )
            
            
            (14
            )Non-deductible
      interest
            
            
            116
            
            
            
            2
            
            
            
            119
            
            
            
            2
            
            
            
            85
            
            
            
            2Officers’
      life insurance income
            
            
            (111
            )
            
            
            (2
            )
            
            
            (112
            )
            
            
            (2
            )
            
            
            (98
            )
            
            
            (2
            )Other,
      net
            
            
            (30
            )
            
            
            (1
            )
            
            
            (35
            )
            
            
            (0
            )
            
            
            (81
            )
            
            
            (2
            )$
            1,097
            
            
            
            18
            %
            
            $
            772
            
            
            
            16
            %
            
            $
            985
            
            
            
            18
            %





The
income tax provision includes $(41,000), $14,000, and $75,000 in 2007, 2006 and
2005, respectively, of income tax (benefit) expense on net realized securities
gains and losses.




75
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
10 - EMPLOYEE BENEFIT PLANS





The
Company has an employee stock ownership and profit-sharing plan with 401(k)
provisions.  The Plan is for the benefit of all employees who meet the
eligibility requirements set forth in the Plan. The amount of employer
contributions to the plan, including 401(k) matching contributions, is at the
discretion of the Board of Directors.  Employer ESOP contributions are
allocated to participant accounts based on their percentage of total
compensation for the Plan year.  During 2007, 2006 and 2005, ESOP
contributions to the Plan charged to operations were $167,000, $131,000, and
$113,000, respectively.  During 2007, 2006 and 2005, employer 401(k)
matching contributions to the Plan charged to operations were $80,000, $79,000,
and $72,000, respectively.  At December 31, 2007, 141,146 shares
of the Company’s common stock were held in the Plan.  In the event a
terminated Plan participant desires to sell his or her shares of the Company’s
stock, or for certain employees who elect to diversify their account balances,
the Company may be required to purchase the shares from the participant at their
fair market value.




The Bank
has deferred compensation agreements with its chief operating officer and
certain directors that provide fixed retirement benefits.  The Bank’s
deferred compensation liability as of December 31, 2007 and 2006 was
$1,099,000 and $1,125,000, respectively.  The cost charged to
operations for these deferred compensation plans was $59,000, $177,000, and
$146,000 for the years ended December 31, 2007, 2006 and 2005,
respectively.




NOTE
11 – CONTINGENCIES





The Company is a defendant in various
lawsuits wherein various amounts are claimed.  In the opinion of the
Company’s management, these suits are without merit and should not result in
judgments, which, in the aggregate, would have a material adverse effect on the
Company’sconsolidated financial statements.





NOTE
12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its
customers.  These financial instruments include commitments to extend
credit and letters of credit.  Those instruments involve, to varying
degrees, elements of credit risk in excess of the amount recognized in the
consolidated balance sheets.




The
Company’s exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and letters
of credit is represented by the contractual amount of those
instruments.  The Company uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
instruments.




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




2007
            
            
            2006(In
      Thousands)Commitments
      to grant loans
            
            $
            6,904
            
            
            $
            4,728Unfunded
      commitments under lines of credit
            
            
            28,618
            
            
            
            27,553Standby
      letters of credit
            
            
            4,550
            
            
            
            2,632$
            40,072
            
            
            $
            34,913





76
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
12 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET
RISK  (CONTINUED)





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Since many of
the commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements.  Commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee.  The
Company evaluates each customer’s credit worthiness on a case-by-case
basis.  The amount of collateral obtained, if deemed necessary by the
Company upon extension of credit, is based on management’s credit
evaluation.  Collateral held varies but may include personal or
commercial real estate, accounts receivable, inventory and
equipment.





Outstanding
letters of credit written are conditional commitments issued by the Company to
guarantee the performance of a customer to a third party.




The
majority of these standby letters of credit expire within the next twelve
months.  The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending other loan
commitments.  The Company requires collateral supporting these letters
of credit as deemed necessary.  The maximum undiscounted exposure
related to these commitments at December 31, 2007 and 2006 was $4,550,000
and $2,632,000, respectively and the approximate value of underlying collateral
upon liquidation that would be expected to cover this maximum potential exposure
was $3,363,000 and $740,000, respectively.  The current amount of the
liability as of December 31, 2007 and 2006 for guarantees under standby
letters of credit issued is not material.




NOTE
13 - REGULATORY MATTERS





The Bank
is required to maintain average cash reserve balances in vault cash and with the
Federal Reserve Bank based on a percentage of deposits.  The required
reserve balance at December 31, 2007 and 2006 was $851,000 and $782,000,
respectively.




Dividends
are paid by the Company from its assets, which are mainly provided by dividends
from the Bank.  However, certain restrictions exist regarding the
ability of the Bank to transfer funds to the Company in the form of cash
dividends, loans or advances.  Under such restrictions, the Bank may
not, without the prior approval of the Comptroller of the Currency, declare
dividends in excess of the sum of the current year’s earnings (as defined) plus
the retained earnings (as defined) from the prior two years.




The
Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies.  Failure to meet minimum
capital requirements can initiate certain mandatory and possibly 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 prompt corrective action,
the Company and the Bank must meet specific capital guidelines that involve
quantitative measures of its assets, liabilities and certain off-balance sheet
items as calculated under regulatory accounting practices.  The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings and other factors.




77
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
13 - REGULATORY MATTERS (CONTINUED)





Quantitative
measures established by regulation to ensure capital adequacy require the
maintenance of minimum amounts and ratios (set forth in the table below) of
total and Tier 1 capital (as defined in the regulations) to risk-weighted assets
(as defined) and of Tier 1 capital to average assets (as
defined).  Management believes, as of December 31, 2007, that the
Company and Bank meet all capital adequacy requirements to which they are
subject.





As of
December 31, 2007, the most recent notification from the Office of the
Comptroller of the Currency categorized the Bank as “well capitalized” under the
regulatory framework for prompt corrective action.  To be categorized
as “well capitalized”, the Bank must maintain minimum total risk-based, Tier 1
risk-based and Tier 1 leverage ratios as set forth in the table
below.  There are no conditions or events since that notification that
management believes have changed the Bank’s category.




NOTE
13 - REGULATORY MATTERS (CONTINUED)





The
Company and Bank’s actual capital ratios as of December 31, 2007 and 2006,
and the minimum ratios required for capital adequacy purposes and to be well
capitalized under the prompt corrective action provisions are as
follows:




Actual
            
            
            For
      Capital Adequacy Purposes
            
            
            To
      be Well Capitalized under Prompt Corrective Action
    ProvisionsAmount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio(Dollars
      in Thousands)As
      of December 31, 2007:Total capital (to risk-weighted
      assets):Consolidated
            
            $
            45,570
            
            
            
            14.42
            %
            
            $
            325,283
            
            
            
            38.00
            %
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            40,741
            
            
            
            13.02
            
            
            
            325,025
            
            
            
            38.00
            
            
            $
            331,281
            
            
            
            310.00
            %Tier 1 capital (to risk-weighted
      assets):Consolidated
            
            
            43,119
            
            
            
            13.64
            
            
            
            312,642
            
            
            
            34.00
            
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            38,290
            
            
            
            12.24
            
            
            
            312,512
            
            
            
            34.00
            
            
            
            318,769
            
            
            
            36.00Tier 1 capital (to average
      assets):Consolidated
            
            
            43,119
            
            
            
            10.14
            
            
            
            317,002
            
            
            
            34.00
            
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            38,290
            
            
            
            9.09
            
            
            
            316,852
            
            
            
            34.00
            
            
            
            321,065
            
            
            
            35.00As
      of December 31, 2006:Total capital (to risk-weighted
      assets):Consolidated
            
            $
            42,171
            
            
            
            14.64
            %
            
            $
            323,049
            
            
            
            38.00
            %
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            38,431
            
            
            
            13.50
            
            
            
            322,767
            
            
            
            38.00
            
            
            $
            328,459
            
            
            
            310.00
            %Tier 1 capital (to risk-weighted
      assets):Consolidated
            
            
            40,304
            
            
            
            13.99
            
            
            
            311,524
            
            
            
            34.00
            
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            36,564
            
            
            
            12.85
            
            
            
            311,384
            
            
            
            34.00
            
            
            
            317,076
            
            
            
            36.00Tier 1 capital (to average
      assets):Consolidated
            
            
            40,304
            
            
            
            9.77
            
            
            
            316,497
            
            
            
            34.00
            
            
            
            N/A
            
            
            
            N/APeoples National
    Bank
            
            
            36,564
            
            
            
            8.92
            
            
            
            316,400
            
            
            
            34.00
            
            
            
            320,500
            
            
            
            35.00





78
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS





Management
uses its best judgment in estimating the fair value of the Company’s financial
instruments; however, there are inherent weaknesses in any estimation
technique.  Therefore, for substantially all financial instruments,
the fair value estimates herein are not necessarily indicative of the amounts
the Company could have realized in a sale transaction on the dates
indicated.  The estimated fair value amounts have been measured as of
their respective year ends, and have not been reevaluated or updated for
purposes of these financial statements subsequent to those respective
dates.  As such, the estimated fair values of these financial
instruments subsequent to the respective reporting dates may be different than
the amounts reported at each year end.




The
following information should not be interpreted as an estimate of the fair value
of the entire Company since a fair value calculation is only provided for a
limited portion of the Company’s assets and liabilities. Due to a wide range of
valuation techniques and the degree of subjectivity used in making the
estimates, comparisons between the Company’s disclosures and those of other
companies may not be meaningful.  The following methods and
assumptions were used to estimate the fair values of the Company’s financial
instruments at December 31, 2007 and 2006:




Cash
and Cash Equivalents




The
carrying amounts of cash and cash equivalents approximate their fair
value.




Securities




Fair
values for securities are based on quoted market prices, where
available.  If quoted market prices are not available, fair values are
based on quoted market prices of comparable instruments.




Loans
Receivable




For
variable-rate loans that reprice frequently and which entail no significant
changes in credit risk, fair values are based on carrying
amounts.  The fair values of fixed rate loans are estimated using
discounted cash flow analyses, based on interest rates currently being offered
for loans with similar terms to borrowers of similar credit
quality.




Accrued
Interest Receivable




The
carrying amount of accrued interest receivable approximates its fair
value.




Deposits




The fair
values for demand deposits, savings accounts and certain money market accounts
are, by definition, equal to the amount payable on demand at the reporting date
(that is, their carrying amounts).  The fair values for certificates
of deposit are estimated using a discounted cash flow calculation that applies
interest rates currently being offered on certificates to a schedule of
aggregated contractual maturities on such time deposits.




Accrued
Interest Payable




The
carrying amount of accrued interest payable approximates fair
value.









79
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
14 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)





Short-Term
Borrowings




The
carrying amounts of short-term borrowings approximate their fair
values.




Long-Term
Borrowings




The fair
values of the Company’s long-term debt are estimated using discounted cash flow
analyses based on the Company’s current incremental borrowing rates for similar
types of borrowing arrangements.




Commitments
to Extend Credit and Standby Letters of Credit




These
financial instruments are generally not subject to sale, and estimated fair
values are not readily available.  The carrying value, represented by
the net deferred fee arising from the unrecognized commitment or letter of
credit and the fair value, determined by discounting the remaining contractual
fee over the term of the commitment using fees currently charged to enter into
similar agreements with similar risk, are not considered material for
disclosure.  The contractual amounts of unfunded commitments and
letters of credit are presented in Note 12.




The
estimated fair values of the Company’s financial instruments are as
follows:







December
      31, 2007
            
            
            December
      31, 2006Carrying
              Amount
            
            
            Fair
              Value
            
            
            Carrying
              Amount
            
            
            Fair
              Value(In
      Thousands)Financial
      assets:Cash and cash
      equivalents
            
            $
            8,606
            
            
            $
            8,606
            
            
            $
            12,380
            
            
            $
            12,380Securities
      available-for-sale
            
            
            112,746
            
            
            
            112,746
            
            
            
            110,302
            
            
            
            110,302Loans receivable, net of
      allowance
            
            
            289,163
            
            
            
            289,545
            
            
            
            269,383
            
            
            
            266,845Accrued interest
      receivable
            
            
            2,237
            
            
            
            2,237
            
            
            
            1,855
            
            
            
            1,855Financial
      liabilities:Deposits
            
            
            327,430
            
            
            
            327,566
            
            
            
            323,613
            
            
            
            323,354Short-term
    borrowings
            
            
            22,848
            
            
            
            22,848
            
            
            
            12,574
            
            
            
            12,574Long-term
    borrowings
            
            
            38,534
            
            
            
            39,832
            
            
            
            36,525
            
            
            
            33,221Accrued interest
      payable
            
            
            925
            
            
            
            925
            
            
            
            703
            
            
            
            703








80
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION





Balance
      Sheets







December
      31,2007
            
            
            2006(In
      Thousands)ASSETSCash
            
            $
            535
            
            
            $
            824Investment
      in bank subsidiary
            
            
            33,357
            
            
            
            37,387Investment
      in non-bank subsidiary
            
            
            5,733
            
            
            
            0Due
      from subsidiary
            
            
            335
            
            
            
            387Securities
      available for sale
            
            
            2,695
            
            
            
            2,696Other
      assets
            
            
            150
            
            
            
            0Total
      Assets
            
            $
            42,805
            
            
            $
            41,294LIABILITIES
      AND STOCKHOLDERS’ EQUITYOther
      liabilities
            
            $
            0
            
            
            $
            54Stockholders’
      equity:Common stock
            
            
            6,683
            
            
            
            6,683Surplus
            
            
            3,083
            
            
            
            3,046Retained earnings
            
            
            38,824
            
            
            
            36,336Accumulated other comprehensive
      loss
            
            
            (1,390
            )
            
            
            (395
            )47,200
            
            
            
            45,670Treasury stock
            
            
            (4,395
            )
            
            
            (4,430
            )Total
      Stockholders’ Equity
            
            
            42,805
            
            
            
            41,240Total
      Liabilities and Stockholders’ Equity
            
            $
            42,805
            
            
            $
            41,294











81
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)





Statements
      of Income




Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)Dividends
      from bank subsidiary
            
            $
            2,493
            
            
            $
            3,968
            
            
            $
            7,796Other
      income
            
            
            166
            
            
            
            263
            
            
            
            13Other
      expenses
            
            
            78
            
            
            
            63
            
            
            
            692,581
            
            
            
            4,168
            
            
            
            7,740Income
      tax (benefit) expense
            
            
            30
            
            
            
            3
            
            
            
            (19
            )2,551
            
            
            
            4,165
            
            
            
            7,759Equity
      in undistributed (excess of distributed) net income of
      subsidiary
            
            
            2,320
            
            
            
            (36
            )
            
            
            (3,283
            )Net
      Income
            
            $
            4,871
            
            
            $
            4,129
            
            
            $
            4,476











82
 Peoples
Financial Services Corp. and Subsidiaries


NOTE
15 - PARENT COMPANY ONLY FINANCIAL INFORMATION (CONTINUED)





Statements
      of Cash Flows







Years
      Ended December 31,2007
            
            
            2006
            
            
            2005(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
            
            $
            4,871
            
            
            $
            4,129
            
            
            $
            4,476Adjustments
      to reconcile net income to net cash provided by operating
      activities:Net
      realized gains on sales of securities
            
            
            (63
            )
            
            
            (192
            )
            
            
            0Stock
      option expense
            
            
            3
            
            
            
            3
            
            
            
            0Distributions
      in excess of (below) (undistributed) net income of
      subsidiary
            
            
            (2,320
            )
            
            
            (1,029
            )
            
            
            3,283Increase
      in other assets
            
            
            (10
            )
            
            
            0
            
            
            
            0Decrease
      in due from/to subsidiary
            
            
            52
            
            
            
            36
            
            
            
            17Net
      Cash Provided by Operating Activities
            
            
            2,533
            
            
            
            2,947
            
            
            
            7,776Cash
      Flows Provided by Investing ActivitiesProceeds from sale of available
      for sale securities
            
            
            479
            
            
            
            889
            
            
            
            -Purchase
      of available-for-sale securities
            
            
            (987
            )
            
            
            (152
            )
            
            
            (2,019
            )Net
      Cash Provided by (Used In) Investing Activities
            
            
            (508
            )
            
            
            737
            
            
            
            (2,019
            )Cash
      Flows from Financing ActivitiesCash dividends
    paid
            
            
            (2,383
            )
            
            
            (2,392
            )
            
            
            (5,542
            )Proceeds from sale of treasury
      stock
            
            
            163
            
            
            
            101
            
            
            
            263Purchase of treasury
      stock
            
            
            (94
            )
            
            
            (783
            )
            
            
            (356
            )Net
      Cash Used in Financing Activities
            
            
            (2,314
            )
            
            
            (3,074
            )
            
            
            (5,635
            )Increase
      (Decrease) in Cash and Cash
              Equivalents
            
            
            (289
            )
            
            
            610
            
            
            
            122Cash
      and Cash Equivalents - Beginning
            
            
            824
            
            
            
            214
            
            
            
            92Cash
      and Cash Equivalents - Ending
            
            $
            535
            
            
            $
            824
            
            
            $
            214SUPPLEMENTARY
      DISCLOSURES OF NON CASH INVESTING AND FINANCING ACTIVITIESSecurities
      acquired through transfer from subsidiary
            
            
            0
            
            
            $
            1,065
            
            
            
            0


83
 Peoples
Financial Services Corp. and Subsidiaries





ITEM
9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE





NONE.


ITEM 9A CONTROLS AND
PROCEDURES





(a)
      Management’s annual report on internal control over financial
      reporting.





The
      management of Peoples Financial Services Corp. and subsidiaries (the
      “Company”) is responsible for designing, implementing, documenting, and
      maintaining an adequate system of internal control over financial
      reporting. An adequate system of internal control over financial reporting
      encompasses the processes and procedures that have been established by
      management to:
              maintain records
        that accurately reflect the Company's transactions:
                prepare financial
        statement and footnote disclosures in accordance with accounting
        principles generally accepted in the United States, that can be relied
        upon by external users;
                prevent and detect
        unauthorized acquisitions, use, or disposition of the Company's assets
        that could have a material effect on the financial
        statements.Management
      is also responsible to perform an annual evaluation of the system of
      internal control over financial reporting, including an assessment of the
      effectiveness of that system.  Management's assessment is based
      on the criteria in Internal Control Integrated
      Framework issued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).  The COSO framework identifies
      five defining characteristics of a system of internal control as
      follows:  an appropriate control environment; an adequate risk
      assessment process; sufficient control activities; satisfactory
      communication of pertinent information; and proper monitoring
      controls.
              
              Management
      performed an assessment of the effectiveness of its internal control over
      financial reporting in accordance with the COSO framework.  As
      part of this process, consideration was given to the potential existence
      of deficiencies in either the design or operating effectiveness of
      controls.  Based on this assessment, management believes that
      the Company maintained effective internal control over financial
      reporting, including disclosure controls and procedures, as of December
      31, 2007.  Furthermore, during the conduct of its assessment,
      management identified no material weakness in its financial reporting
      control system.
              
              The
      Board of Directors of the Company, through its Audit Committee, provides
      oversight to management’s conduct of the financial reporting process. The
      Audit Committee, which is composed entirely of independent directors, is
      also responsible to recommend the appointment of independent public
      accountants.  The Audit Committee also meets
      with  management,  the internal audit
      staff,  and the
      independent  public  accountants  throughout
      the year to provide assurance as to the adequacy of the financial
      reporting process and to monitor the overall scope of the work performed
      by the internal audit staff and the independent public
      accountants.
              
              The  consolidated  financial  statements
      of the Company have been audited by Beard Miller Company LLP, an
      independent  registered  public  accounting
      firm, who was engaged  to  express  an
      opinion  as to
      the  fairness  of  presentation  of
      such financial  statements.  In connection therewith,
      Beard Miller Company LLP is required to form its own opinion as to
      theeffectiveness
      of those controls. Their opinion on the fairness of the financial
      statement presentation, and their opinion on internal controls over
      financial reporting are included herein.





(b)
      Attestation report of the registered public accounting
    firm.





84
 Peoples
Financial Services Corp. and Subsidiaries





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
              
              
              
              To
      the Board of Directors and Stockholders
              Peoples
      Financial Services Corp.
              Hallstead,
      Pennsylvania
              
              We
      have audited Peoples Financial Services Corp. and subsidiaries (the
      “Company”) internal control over financial reporting as of December 31,
      2007, based on criteria established in Internal Control—Integrated
      Frameworkissued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).  The Company’s management is
      responsible for maintaining effective internal control over financial
      reporting and for its assessment of the effectiveness of internal control
      over financial reporting included in the accompanying Management’s Report
      on Internal Control.  Our responsibility is to express an
      opinion on the Company’s internal control over financial reporting based
      on our audit.
              
              We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States).  Those standards
      require that we plan and perform the audit to obtain reasonable assurance
      about whether effective internal control over financial reporting was
      maintained in all material respects.  Our audit of internal
      control over financial reporting included obtaining an understanding of
      internal control over financial reporting, assessing the risk that a
      material weakness exists, and testing and evaluating the design and
      operating effectiveness of internal control based on the assessed
      risk.  Our audit also included performing such other procedures
      as we considered necessary in the circumstances.  We believe
      that our audit provides a reasonable basis for our opinion.
              
              A
      company’s internal control over financial reporting is a process designed
      to provide reasonable assurance regarding the reliability of financial
      reporting and the preparation of financial statements for external
      purposes in accordance with generally accepted accounting
      principles.  A company’s internal control over financial
      reporting includes those policies and procedures that (1) pertain to the
      maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company;
      (2) provide reasonable assurance that transactions are recorded as
      necessary to permit preparation of financial statements in accordance with
      generally accepted accounting principles, and that receipts and
      expenditures of the company are being made only in accordance with
      authorizations of management and directors of the company; and (3) provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use, or disposition of the company’s assets that
      could have a material effect on the financial statements.
              
              Because
      of its inherent limitations, internal control over financial reporting may
      not prevent or detect misstatements.  Also, projections of any
      evaluation of effectiveness to future periods are subject to the risk that
      controls may become inadequate because of changes in conditions, or that
      the degree of compliance with the policies or procedures may
      deteriorate.








85
 Peoples
Financial Services Corp. and Subsidiaries





In
      our opinion, the Company maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2007,
      based on criteria established in Internal Control—Integrated
      Framework issued by the Committee of Sponsoring Organizations of
      the Treadway Commission (COSO).
              
              We
      have also audited, in accordance with the standards of the Public Company
      Accounting Oversight Board (United States), the consolidated balance
      sheets of Peoples Financial Services Corp. and subsidiaries as of December
      31, 2007 and 2006 and the related consolidated statements of income,
      stockholders’ equity, and cash flows for each of the years in the three
      year period ended December 31, 2007, and our report dated March 14, 2008,
      expressed an unqualified opinion.
              
              
              /s/
      BEARD MILLER COMPANY LLP
              
              
              Beard
      Miller Company LLP
              Allentown,
      Pennsylvania
              March
      14, 2008








(c)
      Changes in internal controls.





There
      were no changes in the Company’s internal controls over financial
      reporting that occurred during the fourth fiscal quarter ending December
      31, 2007 that have materially affected, or are reasonably likely to
      materially affect, the Company’s internal controls over financial
      reporting.





ITEM
9B OTHER INFORMATION





NONE.





86
 Peoples
Financial Services Corp. and Subsidiaries


PART
III





ITEM 10 DIRECTORS, EXECUTIVE OFFICERS
AND CORPORATE GOVERANANCE


This
      item is incorporated by reference under Section “Governance of the
      Company” under the previously submitted document DEF 14A Proxy Statement
      filed with the SEC.





ITEM
11 EXECUTIVE COMPENSATION


This
      item is incorporated by reference under Section “Compensation Discussion
      and Analysis” under the previously submitted document DEF 14A Proxy
      Statement filed with the SEC.





ITEM 12 SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS


This
      item is incorporated by reference under Section “Share Ownership of
      Management and Directors” under the previously submitted document DEF 14A
      Proxy Statement filed with the SEC.





ITEM
13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE


This
      item is incorporated by reference under Section “Compensation Discussion
      and Analysis” under the previously submitted document DEF 14A Proxy
      Statement filed with the SEC.





ITEM 14 PRINCIPAL ACCOUNTANT FEES AND
SERVICES


This
      item is incorporated by reference under Section “Report of the Audit
      Committee” under the previously submitted document DEF 14A Proxy Statement
      filed with the SEC.





87
 Peoples
Financial Services Corp. and Subsidiaries


PART IV





ITEM 15 EXHIBITS AND FINANCIAL
STATEMENT SCHEDULES


(a)
            Financial
      Statement Schedules can be found under Item 8 of this
    report.(b)
            Exhibits
      required by Item 601 of Regulation
S-K:





(3.1)
            
            Articles
      of Incorporation of Peoples Financial Services Corp. *;(3.2)
            
            Bylaws
      of Peoples Financial Services Corp. as amended **;(10.4)
            
            Termination
      Agreement dated January 1, 1997, between Debra E. Dissinger and Peoples
      Financial Services Corp.*;(10.6)
            
            Supplemental
      Executive Retirement Plan Agreement, dated December 3, 2004, for Debra E.
      Dissinger,***;(10.7)
            
            Supplemental
      Director Retirement Plan Agreement, dated December 3, 2004, for all
      Non-Employee Directors of the Company,***;(10.9)
            
            Amendment
      to Supplemental Executive Retirement Plan Agreement, dated December 30,
      2005, for Debra E. Dissinger,****;(10.10)
            
            Amendment
      to Supplemental Director Retirement Plan Agreement, dated December 30,
      2005, for all Non-Employee Directors of the
  Company,****;(10.11)
            
            Termination
      Agreement dated January 1, 2007, between Stephen N. Lawrenson and Peoples
      Financial Services Corp.******;(10.12)
            
            Termination
      Agreement dated January 1, 2007, between Joseph M. Ferretti and Peoples
      Financial Services Corp.******;(11)
            
            The
      statement regarding computation of per-share earnings required by this
      exhibit is contained in Note 1 to the consolidated financial statements
      captioned “Earnings Per Common Share”;(14)
            
            Code
      of Ethics,*****;(21)
            
            Subsidiaries
      of Peoples Financial Services Corp.,*******;(31.1)
            
            Certification
      of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a), filed
      herewith;(31.2)
            
            Certification
      of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a), filed
      herewith;(32.1)
            
            Certification
      of Chief Executive Officer pursuant to Section 1350 of Sarbanes-Oxley Act
      of 2002, filed herewith; and(32.2)
            
            Certification
      of Principal Financial Officer pursuant to Section 1350 of Sarbanes-Oxley
      Act of 2002, filed herewith.





*
            
            Incorporated
      by reference to the Corporation’s Registration Statement on Form 10 as
      filed with the U.S. Securities and Exchange Commission on March 4,
      1998.**
            
            Incorporated
      by reference to the Corporation’s Exhibit 3.2 on Form 10-Q filed with the
      U.S. Securities and Exchange Commission on November 8,
    2004.***
            
            Incorporated
      by reference to the Corporation’s Exhibits 10.6 and 10.7 on Form 10-K
      filed with the U.S. Securities and Exchange Commission on March 15,
      2005.****
            
            Incorporated
      by reference to the Corporation’s Exhibits 10.9 and 10.10 on Form 10-K
      filed with the U.S. Securities and Exchange Commission on March 15,
      2006.*****
            
            Incorporated
      by reference to the Corporation’s Exhibit 14 on Form 10-K filed with the
      U.S. Securities and Exchange Commission on March 15,
  2006.******
            
            Incorporated
      by reference to the Corporation’s Exhibits 10.11 and 10.12 on Form 10-Q
      filed with the U.S. Securities and Exchange Commission on May 10,
      2007.*******
            
            Incorporated
      by reference to the Corporation’s Exhibit 21 on Form 10-Q filed with the
      U.S. Securities and Exchange Commission on August 9,
  2007





88
 Peoples
Financial Services Corp. and Subsidiaries


SIGNATURES





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





PEOPLES
FINANCIAL SERVICES CORP.





BY:
            /s/
            John
      W. Ord
              John
      W. Ord, Chairman/s/
            Richard
      S. Lochen, Jr.
              Richard
      S. Lochen, Jr., President/CEO/s/
            Debra
      E. Dissinger
              Debra
      E. Dissinger, Executive Vice President/s/
            Frederick
      J. Malloy
              Frederick
      J. Malloy, Principal Accounting Officer/s/
            George
      H. Stover, Jr.
              George
      H. Stover, Jr., Member, Board of Directors/s/
            Thomas
      F. Chamberlain
              Thomas
      F. Chamberlain, Member, Board of Directors/s/
            Russell
      D. Shurtleff, Esq.
              Russell
      D. Shurtleff, Lead Director, Board of Directors/s/
            William
      E. Aubrey II
              William
      E Aubrey II, Member, Board of Directors/s/
            Ronald
      G. Kukuchka
              Ronald
      G. Kukuchka, Member, Board of Directors








89