NORWOOD
FINANCIAL CORP SUMMARY OF SELECTED FINANCIAL DATA
 (dollars
in thousands, except per share data)
 
 
 
 For
      the years ended December 31,
              2009
              2008
              2007
              2006
              2005Net
      interest income
              $19,109
              $18,401
              $17,272
              $16,183
              $15,263Provision
      for loan losses
              1,685
              735
              315
              220
              350Other
      income
              4,929
              4,105
              3,507
              3,517
              3,506Net
      realized gains (losses) on sales of securities
              463
              (18)
              17
              66
              42Other
      expenses
              13,471
              12,240
              11,341
              10,957
              10,623Income
      before income taxes
              9,345
              9,513
              9,140
              8,589
              7,838Income
      tax expense
              2,282
              2,836
              2,629
              2,679
              2,341NET
      INCOME
              $7,063
              $6,677
              $6,511
              $5,910
              $5,497Net
      income per share-Basic
              $2.57
              $2.44
              $2.34
              $2.11
              $1.96Diluted
              2.55
              2.41
              2.30
              2.07
              1.92Cash
      dividends declared
              1.09
              1.02
              0.94
              0.85
              0.71Dividend
      pay-out ratio
              42.41%
              41.80%
              40.17%
              40.28%
              36.41%Return
      on average assets
              1.38%
              1.36%
              1.39%
              1.33%
              1.31%Return
      on average equity
              11.40%
              11.79%
              12.10%
              11.85%
              11.72%Balances
      at Year-EndTotal
      assets
              $529,696
              $504,296
              $480,610
              $454,356
              $433,556Loans
      receivable
              363,474
              349,404
              331,296
              315,567
              290,890Allowance
      for loan losses
              5,453
              4,233
              4,081
              3,828
              3,669Total
      deposits
              391,473
              359,635
              370,000
              358,103
              340,603Shareholders’
      equity
              64,471
              58,690
              55,819
              52,231
              48,108Trust
      assets under management
              99,373
              90,069
              101,714
              96,879
              86,972Book
      value per share
              $23.25
              $21.45
              $20.27
              $18.67
              $17.07Tier
      1 Capital to risk-adjusted assets
              16.97%
              16.22%
              16.26%
              15.67%
              15.29%Total
      Capital to risk-adjusted assets
              18.27%
              17.50%
              17.60%
              16.99%
              16.63%Allowance
      for loan losses to total loans
              1.50%
              1.21%
              1.23%
              1.21%
              1.26%Non-performing
      assets to total assets
              1.02%
              0.54%
              0.03%
              0.09%
              0.08%










William W. Davis, Jr.
 President & CEO
 We are
truly pleased to report to you that your company had a very solid financial
performance in 2009. We had record earnings of $7,063,000 for the year ended
December 31, 2009, an increase of $386,000 or 5.8% over the prior year. Earnings
per share on a fully diluted basis were $2.55 increasing from $2.41 in 2008.
With the increase in earnings and our continued strong capital position, we
declared cash dividends of $1.09 per share compared to $1.02 per share in 2008.
This marks the eighteenth consecutive year of increased cash dividends for our
stockholders. The return on average assets for the year was 1.38% with a return
on average equity of 11.40%.
 We ended
the year with record levels of total assets, $529.7 million, loans receivable of
$363.5 million, total deposits of $391.5 million and stockholders’ equity of
$64.5 million. The Company’s capital position remains strong and is at the top
level of its peer group in all measures of regulatory capital.
 Loans
receivable increased $14.1 million or 4.0% from the prior year-end. The increase
in loans centered in commercial real estate. With the low interest rate
environment, we experienced significant volume of residential mortgage
refinancing activity in 2009. During the year, the Company sold $21.6 million of
fixed rate residential mortgages for purposes of interest rate risk management.
As a result of the general slowdown in the local economy, higher unemployment
and a softer real estate market, we experienced an increase in non-performing
loans. As of December 31, 2009, total non-performing loans were $5,015,000 and
represented 1.38% of total loans compared to $2,087,000 or .60% as of December
31, 2008. The increase was principally due to one commercial real estate loan
and a home equity loan in which the Bank is in a first lien position. Net
charge-offs for the year totaled $465,000 compared to $583,000 in 2008. With the
increase in non-performing loans, higher unemployment, soft real estate market
and slow economy, the Company increased its provision for loan losses to
$1,685,000 for the year 2009 compared to $735,000 for the year 2008. As of
December 31, 2009, the allowance for loan losses totaled $5,453,000 and 1.50% of
total loans increasing from $4,233,000 and 1.21% of loans at December 31,
2008.
 For the
year, net interest income (fully taxable equivalent) totaled $19,872,000 an
increase of $842,000 or 4.4% over 2008. The net interest margin (fte) decreased
four basis points to 4.03% in 2009.
  “We ended the year with record levels
of total assets, loans receivable, total deposits and stockholders’
equity.”
 Other
income for 2009 totaled $5,392,000 compared to $4,087,000 in 2008, an increase
of $1,305,000. The earnings and the receipt of proceeds on bank owned life
insurance policies totaled $1,196,000 in 2009 compared to $345,000 in 2008.
Gains on the sales of investment securities totaled $463,000 on sales of $15.4
million for the 2009 period compared to $18,000 in losses in the 2008 period.
The Company also had a $150,000 gain on the sale of deposits related to a branch
closure in the 2009 period. The 2009 period includes $481,000 in gains on the
sales of $21.6 million of mortgage loans and servicing rights compared to
$499,000 in similar gains on sales of $14.4 million of mortgage loans and
servicing rights in the 2008 period.
  
  
 For the
year ended December 31, 2009, other expense totaled $13,471,000 compared to
$12,240,000 for the similar period in 2009, an increase of $1,231,000. The
increase was due in part to higher FDIC insurance assessments, which increased
$620,000 including the special assessment of $225,000. This was partially offset
by a lower level of foreclosed real estate costs, which totaled $436,000 in the
2009 period and $582,000 in 2008.
 We
strongly encourage you to read the financial section of this Annual Report for a
more detailed analysis of our results.
 Our
success even in the current challenging economic climate is the result of
staying focused on fundamentals. We appreciate our customers and the faith they
have put in us by continually giving us the opportunity to manage their deposits
and loans knowing that we strive to offer them competitive rates, advanced
technology and provide outstanding service for all of the products we offer. We
believe that due to our commitment to our customers that the Bank has grown and
our customers know they can Bank with Confidence at Wayne Bank. We have been
their bank of choice for almost 140 years and we have served many generations of
families by financing their homes, helping to send their children to college,
and lending them the funds they need to maintain their property, all of which
improves their lifestyle, which benefits the people we serve, the Bank and the
local community.
 Wayne
Bank’s operations managers, following a strategic plan to upgrade the Bank’s
automated record keeping and
 
  customer
service delivery systems, are finalizing decisions necessary to enable a smooth
transition to new systems early in 2011. Our goals are to improve customer
service delivery, achieve operational efficiencies and support the Bank’s growth
plans in the future. Integral with the planning is achieving assurance that all
environmental controls for maximizing customer privacy, maintaining accounting
accuracy and protecting the security of all of the Bank’s data are
included.
 During
the past year, over 140 financial institutions failed nationwide. The reasons
are varied for the financial fallout beginning with loans made to consumers who
could ill afford them, as well as promoting creative and exotic varieties of
‘interest only loans’ or ‘pick a payment’ loan choices. Unlike many of these
larger financial institutions and mortgage brokerage firms, Wayne Bank never
wavered from our high standards of lending to consumers and businesses alike. It
has been in both our best interest and our customers’ best interest
 
  to
continue to do the analytical legwork to ensure borrowers have the ability to
make their loan payments. We strive to promote a win-win situation for our
customers and the Bank. Our strong credit culture served us well in 2009. Wayne
Bank continues to focus on the fundamentals which includes maintaining a strong
capital position, making solid loans and marketing our services to increase our
deposit base which allows us to build strong relationships from our core
customers. We are pleased to note that we did not participate in the Treasury’s
Troubled Asset Relief Program “TARP”. Contrary to public opinion about the
banking industry, Wayne Bank has “money to lend” and is continuing its efforts
of strong loan activity in the communities it serves.
 Unemployment
rates have been at record-breaking levels, and the ripple effect from the
unemployed can negatively influence seemingly strong portfolios in a short time.
We take every precaution to ensure our loan portfolio is solid and secure by
monitoring payments for timeliness
  
  
  
  and
consistently reviewing the business’ credit stability and financial outlook to
make sure everything aligns with our high standards.
 Due to
the difficult economy, the Bank decided to become more active in the Small
Business Administration (SBA) and the United States Department of Agriculture
(USDA) programs. Both government agencies offer a guaranty on certain loans made
to small businesses that qualify. Wayne Bank assisted two companies in 2009 with
the America’s Recovery Capital or ARC Loan Program.
 There
were a number of extremely positive highlights during the year including Wayne
Bank being recognized in the Independent Community Banker’s Annual Showcase of
Top Performing Community Banks. We are pleased to note that Wayne Bank ranked
number 15 in banks with assets over $500 million with a Return on Assets of
1.39% in the listing of “Newest Top Performing Community Banks”. Wayne Bank also
ranked within the top 3% out of 5,000 community banks in the country based on
Return on Equity (ROE). Most notably, Norwood Financial Corp was listed among
the Russell 3000®Index
and Russell 2000®Index
when Russell Investments reconstituted its comprehensive set of U.S. and global
equity indexes on June 29, 2009. Russell indexes are widely used by investment
managers and institutional investors for both index funds and as benchmarks for
passive and active investment strategies.
 
 
 
 Throughout
the year, many local, non-profit organizations benefited from Wayne Bank’s
strong support of community events that assist our customers. Since the requests
are many and grow, year after year, we generally try to support causes that
benefit the greatest number of people, especially children and families. Wayne
Bank contributed to almost 200 local organizations ranging from fire companies,
youth sports, the arts and musical events, fundraisers for the Chambers of
Commerce, the Greater Honesdale Partnership, Kiwanis Club of the Poconos and the
Wayne County YMCA, to name a few. Wayne Bank does a tremendous job of giving
 
 community
is through the Educational Tax Credit program that the State of Pennsylvania
offers to businesses to lend support to pre-approved non-profit organizations.
Wayne Bank contributed over $75,000 to five approved non-profit organizations
through the Educational Tax Credit Program strongly enhancing the efforts of
these organizations to provide services to families and children throughout our
market area.
 Teach
Children to Save is a national campaign that raises awareness about the
important role that banks and bankers play in helping young people develop
lifelong savings habits. Wayne Bank’s employees presented interactive
lessons on the importance of saving money to almost 600 students from two school
districts in Northeastern Pennsylvania, in honor of the Teach Children to Save
Program.The Monroe County branches hosted a Teen Works program, in conjunction
with the United Way of Monroe County and Consumer Credit Counseling Service
(CCCS) of Northeastern Pennsylvania. Take Our Daughters and Sons to Work Day, a
national event that gives children the opportunity to take part in their
parent’s workday was held at Wayne Bank’s corporate office in Honesdale. Bank
employees planned and organized a variety of activities for the kids. This event
is just one more way in which Wayne Bank and its employees support the youth in
our communities.
 Unfortunately,
during the course of the year, the Bank experienced some very sad and tragic
losses. Wayne Wilcha, Senior Vice President, Wealth Management and Trust Officer
passed away. He will be greatly missed by the Bank and all the community
organizations he helped. The Bank also mourned the loss of JoAnne Greco, who had
been the Head Teller in Wayne Bank’s Milford office and Magdalena Rusek who was
a Teller in the Tannersville office.
 As most
of you are aware, I announced my retirement as President and Chief Executive
Officer as of December 31. It is with great pleasure that the Board appointed
Mr. Lewis J. Critelli as President and Chief Executive Officer. Lew has been a
director of the Company since April and most recently was Executive Vice
President and Chief Financial Officer. Lew has been with the Bank since 1995 and
his vast experience overseeing the financial and operational areas of the Bank
are beyond reproach.
 Throughout
the year, a number of employees were recognized and promoted based on excellence
in their respective






areas of
expertise.  Edward C. Kasper has been elevated to the position of
Executive Vice President, and Senior Loan Officer.  Ed has a been in
charge of the Corporate Banking Division since 1997 and was previously the
Senior Vice President, and Senior Loan Officer. Kenneth C. Doolittle was
promoted to Executive Vice President. Ken brings 30 years of banking experience
to our institution and oversees retail lending and operations that relate to the
Retail Division of the Bank. John Carmody was promoted to Senior Vice President,
and Commercial Loan Officer. John has been a Vice President and Commercial Loan
Officer since 2004 and has been with the Bank for 14 years. Diane Wylam joined
the Bank as Vice President & Senior Trust Officer and she oversees the
Wealth Management and
 
 
 “We
are proud of all our accomplishments which are a direct result of the teamwork
of all board members, officers and employees of the Bank, all of whom I deeply
respect.”
 
 
 Trust
Services Division. Diane is an attorney and previously held the position of
Senior Trust Officer with fourteen years of experience in charge of the Trust
area for two local financial institutions. Sandra Halas has been promoted from
Assistant Vice President, to Vice President & Trust Officer. Sandra has been
with Wayne Bank since 2001 when she started as a Trust Specialist. Nicholas
Holzman, Credit Analyst in the Commercial Lending Division was promoted to an
Officer of the Bank, and Ryan French joined the Bank as Assistant Vice
President, Director of Human Resources.
 This
Annual Report reflects and focuses on people, their achievements, their
commitments and their willingness to share their talents. We are very proud of
all that we have accomplished, especially this past year, together. It is
significant to note that an important attribute that we see prevalent at the
 
 
   Bank is
loyalty, which makes our staff consistently strong and knowledgeable due to
their longevity with the Bank. We achieved many milestones during 2009 due to
this loyalty such as Diane Richter who manages the Willow Avenue branch, who
attained thirty-five years of service to Wayne Bank. Additionally, Nancy Hart,
Vice President and Controller, reached thirty years of service, as well as
twenty years of service accomplished by Barbara Ridd,Vice President; Sally Rapp,
Human Resources Officer; and William Murray, Mortgage Loan Originator, achieved
fifteen years of service. Nancy Worobey, who managed the Lakewood Community
office retired at the end of the year after thirteen years of service.
Additionally, seven employees achieved 10 years of service, and six employees
were honored for achieving 5 years of service.
 In
closing, I would like to take this opportunity to thank each and every
stockholder for your wonderful support over the past 13 1/2 years. It is with
great satisfaction and admiration I am turning the reins over to Lew Critelli
who has been by my side during my entire tenure. I will continue to be a
Director on the Board and active in the local community to lend support wherever
I can as Norwood Financial Corp and Wayne Bank is buried deeply within my
heart.





















































2009
              CONSOLIDATED
      FINANCIAL REPORTMANAGEMENT’S
      DISCUSSION & ANALYSIS
            10MANAGEMENT’S
      REPORT ON INTERNAL CONTROL OVER
              FINANCIAL
      REPORTING
            30REPORTS
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
            31CONSOLIDATED
      BALANCE SHEETS
            34CONSOLIDATED
      STATEMENTS OF INCOME
            35CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY
            36CONSOLIDATED
      STATEMENTS OF CASH FLOWS
            37NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS
            38INVESTOR
      INFORMATION
            64














MANAGEMENT’S
DISCUSSION AND ANALYSIS





Introduction


This
Management’s Discussion and Analysis and related financial data are presented to
assist in the understanding and evaluation of the financial condition and
results of operations for Norwood Financial Corp (the Company) and its
subsidiary Wayne Bank (the Bank) as of December 31, 2009 and 2008 and for the
years ended December 31, 2009, 2008, and 2007. This section should be read in
conjunction with the consolidated financial statements and related
footnotes.





Forward-Looking Statements


The
Private Securities Litigation Reform Act of 1995 contains safe harbor provisions
regarding forward-looking statements. When used in this discussion, the words
believes, anticipates, contemplates, expects, and similar expressions are
intended to identify forward-looking statements. Such statements are subject to
certain risks and uncertainties, which 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, demand for real
estate, changes in regulatory environment and general economic conditions. The
Company undertakes no obligation to publicly release the results of any
revisions to those forward-looking statements which may be made to reflect
events or circumstances after the date hereof or to reflect the occurrence of
unanticipated events.





Critical Accounting Policies


Note 2 to
the Company’s consolidated financial statements (incorporated by reference in
Item 8 of the Form 10-K) 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.





Material
estimates that are particularly susceptible to significant change in the near
term relate to the determination of the allowance for loan losses, the potential
impairment of restricted stock, accounting for stock options, the valuation of
deferred tax assets and the determination of other-than-temporary impairment
losses on securities. Please refer to the discussion of the allowance for loan
losses calculation under “Non-performing Assets and Allowance for Loan Losses”
in the “Financial Condition” section.





The
deferred income taxes reflect temporary differences in the recognition of the
revenue and expenses for tax reporting and financial statement purposes,
principally because certain items are recognized in different periods for
financial reporting and tax return purposes. Although realization is not
assured, the Company believes it is more likely than not that all deferred tax
assets will be realized.





In
estimating other-than-temporary impairment losses on securities, the Company
considers 1) the length of time and extent to which the fair value has been less
than cost and 2) the financial condition of the issuer. The Company does not
have the intent to sell these securities and it is more likely than not that it
will not sell the securities before recovery of their cost basis. The Company
believes that the unrealized losses at December 31, 2009 and 2008 represent
temporary impairment of the securities.





Emergency Economic Stabilization Act of 2008


In
response to recent unprecedented market turmoil, the Emergency Economic
Stabilization Act (“EESA”) was enacted on October 3, 2008. EESA authorizes the
Secretary of the Treasury to purchase up to $700 billion in troubled assets from
financial institutions under the Troubled Asset Relief Program or
TARP.


10


Among
many provisions, the EESA increased the maximum deposit insurance amount up to
$250,000 until December 31, 2009 which has been extended to June 30, 2010 and
removes the statutory limits on the FDIC’s ability to borrow from the Treasury
during this period. The FDIC may not take the temporary increase in deposit
insurance coverage into account when setting assessments. EESA allows financial
institutions to treat any loss on the preferred stock of the Federal National
Mortgage Association or Federal Home Loan Mortgage Corporation as an ordinary
loss for tax purposes.





Pursuant
to his authority under EESA, the Secretary of the Treasury created the TARP
Capital Purchase Plan (CPP) under which the Treasury Department will invest up
to $250 billion in senior preferred stock of U.S. banks and savings associations
or their holding companies. Qualifying financial institutions may issue senior
preferred stock with a value equal to not less than 1% of risk-weighted assets
and not more than the lesser of $25 billion or 3% of risk-weighted assets. The
senior preferred stock will pay dividends at the rate of 5% per annum until the
fifth anniversary of the investment and thereafter at the rate of 9% per annum.
The senior preferred may be redeemed at any time in whole or in part by the
financial institution. No dividends may be paid on common stock unless dividends
have been paid on the senior preferred stock. Until the third anniversary of the
issuance of the senior preferred, the consent of the U.S. Treasury will be
required for any increase in the dividends on the common stock or for any stock
repurchases unless the senior preferred has been redeemed in its entirety or the
Treasury has transferred the senior preferred to third parties. The senior
preferred will not have voting rights other than the right to vote as a class on
the issuance of any preferred stock ranking senior, any change in its terms or
any merger, exchange or similar transaction that would adversely affect its
rights. Prior to issuance, the financial institution and its senior executive
officers must modify or terminate all benefit plans and arrangements to comply
with EESA. Senior executives must also waive any claims against the Department
of Treasury. In connection with the issuance of the senior preferred,
participating institutions must issue the Secretary immediately exercisable
10-year warrants to purchase common stock with an aggregate market price equal
to 15% of the amount of senior preferred.





Due to
its strong capital position, the Company decided not to participate in the
CPP.





Results of Operations – Summary


Net
income for the Company for the year-ended December 31, 2009 totaled $7,063,000,
an increase of $386,000 or 5.8% over the $6,677,000 earned in 2008. The
resulting basic and diluted earnings per share were $2.57 and $2.55,
respectively, increasing from $2.44 and $2.41 respectively in 2008. The return
on average assets (ROA) for the year ended December 31, 2009 was 1.38% with a
return on average equity (ROE) of 11.40% compared to an ROA of 1.36% and an ROE
of 11.79% for the prior year. The increase in earnings was attributable to an
increase in net interest income on a fully taxable equivalent basis (fte) of
$842,000 and $816,000 of tax-exempt proceeds from a bank-owned life insurance
(BOLI) policy which is $1,371,000 net of tax. This was partially offset by a
$950,000 increase in the provision for loan losses and $620,000 in higher FDIC
insurance assessments, the net of which is $1,036,000 after tax.





Net
interest income on a fully taxable equivalent basis (fte) totaled $19,872,000 in
2009, an increase of $842,000 as compared to the prior year. Net interest income
was favorably impacted by a $25.1 million increase in average earning assets for
2009 compared to average earning assets in 2008. The net interest margin
decreased 4 basis points to 4.03% for 2009. The decrease in margin was due to
the low interest rate environment in 2009 with an average prime rate of 3.25%
and federal funds rate of .25% compared to 5.09% and 1.84%, respectively in
2008. As a result, the yield on earning assets (fte) for 2009 was 5.60% compared
to 6.14% in 2008. This impact on the yield on earning assets was partially
offset by a 63 basis point decrease in the cost of interest-bearing
liabilities.





11


Loans
receivable increased $14.1 million or 4.0% from the prior year-end. The increase
in loans was centered in commercial real estate. The Company experienced a
significant volume of residential mortgage refinancing activity in 2009. During
the year, the Company sold $21.7 million of fixed rate residential mortgages for
purposes of interest rate risk management. As a result of the general slow down
in the local economy, higher unemployment and a softer real estate market, the
Company did experience an increase in non-performing loans in 2009. As of
December 31, 2009, total non-performing loans were $5,015,000 and represented
1.38% of total loans compared to $2,087,000 or .60% as of December 31, 2008. The
increase was principally due to one commercial real estate loan and a home
equity loan in which the Bank is in a first lien position. For the year ended
December 31, 2009, net charge-offs totaled $465,000 compared to $583,000 in
2008. With the increase in non-performing loans, higher unemployment, soft real
estate market and slow economy, the Company increased its provision for loan
losses to $1,685,000 for the year 2009 compared to $735,000 for the year 2008.
As of December 31, 2009, the allowance for loan losses totaled $5,453,000 and
1.50% of total loans increasing from $4,233,000 and 1.21% of loans at December
31, 2008.





Other
income for 2009 totaled $5,392,000 compared to $4,087,000 in 2008, an increase
of $1,305,000. The earnings and proceeds on bank owned life insurance policies
totaled $1,196,000 in 2009 compared to $344,000 in 2008. Gains on the sales of
investment securities totaled $463,000 on sales of $15.4 million for the 2009
period compared to $18,000 in losses in the 2008 period. The Company also had a
$150,000 gain on the sale of deposits related to a branch closure in the 2009
period. The 2009 period includes $481,000 in gains on the sales of $21.6 million
of mortgage loans and servicing rights compared to $499,000 in similar gains on
sales of $14.4 million of mortgage loans and servicing rights in the 2008
period.





For the
year ended December 31, 2009, other expense totaled $13,471,000 compared to
$12,240,000 for the similar period in 2009, an increase of $1,231,000. The
increase was due in part to higher FDIC insurance assessments which increased
$620,000 including the special assessment of $225,000. This was partially offset
by a lower level of foreclosed real estate costs which totaled $436,000 in the
2009 period and $582,000 in 2008. Income tax expense for the year 2009 totaled
$2,282,000 for an effective tax rate of 24.4% compared to $2,836,000 of federal
income tax expense and an effective tax rate of 29.8% for the prior year. The
reduction in the effective tax rate is principally due to the receipt of
$816,000 in tax exempt BOLI proceeds in 2009.





The
following table sets forth changes in net income (in thousands):





Net
      income 2008
            
            $
            6,677Net
      interest income
            
            
            708Provision
      for loan losses
            
            
            (950
            )Earnings
      and proceeds on BOLI
            
            
            852Net
      realized gains on sales of securities
            
            
            481Other
      income
            
            
            (28
            )Salaries
      and employee benefits
            
            
            (783
            )FDIC
      insurance assessments
            
            
            (620
            )Other
      expenses
            
            
            172Income
      tax expense
            
            
            554Net
      income for 2009
            
            $
            7,063





12


Net
income for the Company for the year-ended December 31, 2008 totaled $6,677,000,
an increase of $166,000, or 2.6% over the $6,511,000 earned in 2007. Basic and
diluted earnings per share were $2.44 and $2.41, respectively, increasing from
$2.34 and $2.30, respectively in 2007. The return on average assets (ROA) for
the year ended December 31, 2008 was 1.36% with a return on average equity (ROE)
of 11.79% compared to an ROA of 1.39% and ROE of 12.10% for the prior year. The
increase in earnings was principally attributable to an increase in net interest
income on a fully-taxable equivalent basis (fte) of $1,219,000 which offset an
increase in the provision for loan losses of $420,000 and $582,000 of write-down
and costs to maintain a property in foreclosed real estate.





Net
interest income (fte) totaled $19,030,000 in 2008, an increase of $1,219,000 or
6.8% over $17,811,000 in the prior year. Net interest income was favorably
impacted by a $20.5 million increase in average earning assets for 2008 compared
to average earning assets in 2007. The net interest margin increased 9 basis
points to 4.07% in 2008. The Company offset a 400 basis point decrease in prime
rate of interest by managing its cost of funds. During 2008, the cost of
interest-bearing liabilities declined 76 basis points to offset a 52 basis point
drop in earning asset yields.





Loans
receivable increased $18.1 million or 5.5% from the prior year end. The increase
in loans was centered in commercial real estate which increased $25.8 million,
which was partially offset by a lower level of construction financing and
commercial term loans. As a result of the general economic slow down and a
softer real estate market, the Company did experience an increase in
non-performing assts and net charge-offs in 2008. As of December 31, 2008, total
non-performing assets were $2,747,000 and represented .54% of total assets
compared to $163,000, or .03% as of December 31, 2007. The increase was
principally due to two credit facilities to one borrower, both of which have
been written-down to their net realizable value. Net charge-offs for the year
totaled $583,000 compared to $62,000 in 2007. The Company increased its
provision for loan losses to $735,000 in 2008 compared to $315,000 in
2007.





Other
income for the year-ended December 31, 2008 totaled $4,087,000 increasing
$563,000 from $3,524,000 in the prior year. The increase was principally due to
a $499,000 gain on the sale of $14.9 million of mortgage loans and servicing
rights compared to $23,000 in similar gains in 2007. For 2008, other expenses
totaled $12,240,000, an increase of $899,000 or 7.9% over the prior year. The
increase was principally due to a $582,000 write-down to current realizable
value of a foreclosed real estate property as well as costs to maintain the real
estate. Excluding costs related to foreclosed real estate, other expenses
increased 2.8%.





The
following table sets forth changes in net income (in thousands):





Net
      income 2007
            
            $
            6,511Net
      interest income
            
            
            1,129Provision
      for loan losses
            
            
            (420
            )Gain
      on sale of mortgage loans and servicing rights
            
            
            476Other
      income
            
            
            87Salaries
      and employee benefits
            
            
            (221
            )Foreclosed
      real estate owned
            
            
            (582
            )Other
      expense
            
            
            (96
            )Income
      tax expense
            
            
            (207
            )Net
      income for 2008
            
            $
            6,677





13


FINANCIAL
CONDITION





Total Assets


Total
assets as of December 31, 2009, were $529.7 million compared to $504.3 million
as of year-end 2008, an increase of $25.4 million or 5.0%. The increase in
assets was driven by an increase in loans and cash and cash
equivalents.





Loans Receivable


As of
December 31, 2009, loans receivable totaled $363.5 million compared to $349.4
million as of  year-end 2008, an increase of $14.1 million, or 4.0%.
Loan growth, principally in commercial real estate  was partially
offset by a lower level of home equity loans which is included in residential
real estate and a  net run-off in indirect automobile financing, which
is included in consumer loans to individuals.





Residential
real estate, which includes home equity lending, totaled $130.3 million as of
December 31, 2009, compared to $133.4 million as of year-end 2008, a decrease of
$3.1 million. The Company experienced a significant amount of residential
mortgage refinancing activity in 2009 as customers took advantage of the low
interest rate environment. The Company does not originate any non-traditional
mortgage products such as interest-only loans or option adjustable rate
mortgages and has no sub-prime mortgage exposure.  The Company
evaluates sales of its long-term fixed rate residential loan production for
interest rate risk management, with $21.7 million of 30 year fixed rate loans
sold into the secondary market during 2009.  In the current low
interest rate environment, the Company expects to continue selling mortgage
loans in 2010. The Company experienced a slow down and net decrease in home
equity lending in 2009.  Total outstandings decreased $6.5 million to
$47.2 million as of December 31, 2009. The decrease was due in part to consumers
paying off home equity loans with proceeds from mortgage refinancing. The slow
down in home equity lending is also indicative of lower real estate
values.





Commercial
loans consist principally of loans made to small businesses within the Company’s
market and are usually secured by real estate or other assets of the borrower.
Commercial real estate loans totaled $180.3 million as of December 31, 2009,
increasing from $159.5 million as of December 31, 2008, an increase of $20.8
million or 13.0%. The terms for commercial real estate loans are typically 15 to
20 years, with adjustable rates based on a spread to the prime rate or fixed for
the initial three to five year period then adjusting to a spread to the prime
rate. The majority of the Company’s commercial real estate portfolio is owner
occupied and includes the personal guarantees of the principals. The growth in
commercial real estate lending in 2009 was centered in loans to the hospitality
lodging industry and summer camps all within the Bank’s primary market area.
Commercial loans consisting principally of lines of credit and term loans
secured by equipment or other assets decreased $1.8 million to $24.1 million as
of December 31, 2008. The decrease was principally due to pay-offs in equipment
loans and lower usage on lines of credit.





The
Company’s indirect lending portfolio (included in consumer loans to individuals)
declined  $1.6 million to $8.4 million as of December 31,
2009.  The Company has de-emphasized indirect  automobile
lending and as a result of the soft economy has also experienced a general slow
down in


other
indirect financing.





Allowance forLoan Losses and Non-Performing Assets


The
allowance for loan losses totaled $5,453,000 as of December 31, 2009 and
represented 1.50% of total loans receivable compared to $4,233,000 and 1.21% of
total loans as of year end 2008. Net charge-offs for 2009 totaled $465,000 and
represented .14% of average loans compared to $583,000 and .17% of average loans
in 2008.


14





As of
December 31, 2009, non-performing loans totaled $5,015,000 and represented 1.38%
of total loans compared to $2,087,000 or .60% as of December 31, 2008. With the
increase in non-performing loans, higher unemployment, soft real estate market
and a slow economy the Company increased the provision for loan losses to
$1,685,000 for the year ended December 31, 2009 compared to $735,000 for
2008.





The
Company’s loan review process assesses the adequacy of the allowance for loan
losses on a quarterly basis. The process includes a review of the risks inherent
in the loan portfolio. It includes an analysis of impaired loans and an
historical review of losses.  Other factors considered in the analysis
include; concentrations of credit in specific industries in the commercial
portfolio; the local and regional economic condition; trends in delinquencies,
internal risk rating classification, large dollar loans of over $2 million and
growth in the portfolio.





The
Company has limited exposure to higher-risk loans. There are no option ARM
products, interest only loans, subprime loans or loans with initial teaser rates
in its residential real estate portfolio. The Bank has $16.3 million of junior
lien home equity loans. For 2009 net charge-offs for this portfolio totaled
$35,000.





As of
December 31, 2009, the Company considered its concentration of credit risk
profile to be acceptable. The two highest concentrations are in the hospitality
lodging industry and summer camps. In 2009 there were no losses in either
portfolio and no delinquent loans at December 31, 2009.





Due to
weaker economic conditions the Company has seen an increase in its internally
adversely classified loans. The Company assesses a loss factor against the
classified loans, which is based on prior experience. Classified loans which are
considered impaired are measured on a loan by loan basis. The Company values
such loans by either the present value of expected cash flows, the loans
obtainable market price or the fair value of collateral if the loan is
collateral dependent.





At
December 31, 2009, the recorded investment in impaired loans, not requiring an
allowance for loan losses was $6,962,000 (net of charge-offs against the
allowance for loan losses of $154,000) and those impaired loans requiring an
allowance totaled $1,065,000 (net of a charge-off against the allowance for loan
losses of $480,000). The recorded investment in impaired loans not requiring
allowance for loan losses was $2,976,000 (net of $360,000) and $-0- requiring an
allowance for loan losses as of December 31, 2008.





Non-performing
assets consist of non-performing loans and real estate owned as a result of
foreclosure, which is held for sale. Loans are placed on non-accrual status when
management believes that a borrower’s financial condition is such that
collection of interest is doubtful. Commercial and real estate related loans are
generally placed on non-accrual when interest is 90 days delinquent. When loans
are placed on non-accrual, accrued interest is reversed from current
earnings.





As of
December 31, 2009, non-performing loans totaled $5,015,000 and represented 1.38%
of total loans increasing from $2,087,000 and .60% of total loans as of December
31, 2008. The increase was principally due to one commercial real estate loan
and a home equity loan in which the Bank is in first lien position. Foreclosed
real estate owned totaled $392,000 as of December 31, 2009 and $660,000 as of
December 31, 2008. The decrease is principally due to a write-down on a property
which consists of undeveloped residential building lots in Monroe
County.


15


As a
result of its analysis, after applying these factors, management considers the
allowance as of December 31, 2009, adequate. However, there can be no assurance
that the allowance for loan losses will be adequate to cover significant losses,
if any that might be incurred in the future.





The
following table sets forth information with respect to the Company’s allowance
for loan losses at the dates indicated:





Year
      ended December 31,(dollars
      in thousands)2009
            
            2008
            
            2007
            
            2006
            
            2005Allowance
      balance at beginning of period
            
            $
            4,233
            
            $
            4,081
            
            $
            3,828
            
            $
            3,669
            
            $
            3,448Charge-offs:Commercial
      and all other
            
            
            (17
            )
            
            (7
            )
            
            —
            
            
            —
            
            
            (4
            )Real
      Estate
            
            
            (358
            )
            
            (465
            )
            
            (4
            )
            
            —
            
            
            (6
            )Consumer
            
            
            (139
            )
            
            (171
            )
            
            (117
            )
            
            (150
            )
            
            (200
            )Total
            
            
            (514
            )
            
            (643
            )
            
            (121
            )
            
            (150
            )
            
            (210
            )Recoveries:Commercial
      and all other
            
            
            11
            
            
            —
            
            
            —
            
            
            18
            
            
            12Real
      Estate
            
            
            4
            
            
            1
            
            
            2
            
            
            2
            
            
            18Consumer
            
            
            34
            
            
            59
            
            
            54
            
            
            65
            
            
            46Lease
      Financing
            
            
            —
            
            
            —
            
            
            3
            
            
            4
            
            
            5Total
            
            
            49
            
            
            60
            
            
            59
            
            
            89
            
            
            81Provision
      expense
            
            
            1,685
            
            
            735
            
            
            315
            
            
            220
            
            
            350Allowance
      balance at end of period
            
            $
            5,453
            
            $
            4,233
            
            $
            4,081
            
            $
            3,828
            
            $
            3,669Allowance
      for loan losses as a percentof
      total loans outstanding
            
            
            1.50
            %
            
            1.21
            %
            
            1.23
            %
            
            1.21
            %
            
            1.26
            %Net
      loans charged off as a percent ofaverage
      loans outstanding
            
            
            .13
            %
            
            .17
            %
            
            .02
            %
            
            .02
            %
            
            .05
            %Allowance
      coverage of non-performing loans
            
            
            1.1
            x
            
            2.0
            x
            
            25.0
            x
            
            9.4
            x
            
            10.4
            x





The following table sets forth
information regarding non-performing assets.





December
      31,(dollars
      in thousands)2009
            
            2008
            
            2007
            
            2006
            
            2005Non-accrual
      loans:Commercial
      and all other
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —Real
      estate
            
            
            4,916
            
            
            2,087
            
            
            109
            
            
            392
            
            
            330Consumer
            
            
            —
            
            
            —
            
            
            2
            
            
            17
            
            
            11Total
            
            $
            4,916
            
            $
            2,087
            
            $
            111
            
            $
            409
            
            $
            341Accruing
      loans which are contractuallypast
      due 90 days or more
            
            
            99
            
            
            —
            
            
            52
            
            
            —
            
            
            12Total
      non-performing loans
            
            
            5,015
            
            
            2,087
            
            
            163
            
            
            409
            
            
            353Foreclosed
      real estate
            
            
            392
            
            
            660
            
            
            —
            
            
            —
            
            
            —Total
      non-performing assets
            
            $
            5,407
            
            $
            2,747
            
            $
            163
            
            $
            409
            
            $
            353Non-performing
      loans to total loans
            
            
            1.38
            %
            
            .60
            %
            
            .05
            %
            
            .13
            %
            
            .12
            %Non-performing
      loans to total assets
            
            
            .95
            %
            
            .41
            %
            
            .03
            %
            
            .09
            %
            
            .08
            %Non-performing
      assets to total assets
            
            
            1.02
            %
            
            .54
            %
            
            .03
            %
            
            .09
            %
            
            .08
            %





16


Securities


The
securities portfolio consists principally of issues of United States Government
agencies, including mortgage-backed securities, municipal obligations, and
corporate debt. In accordance with generally accepted accounting principles in
the United States, the Company classifies its investments into two categories:
held to maturity (HTM) and available for sale (AFS). The Company does not have a
trading account. Securities classified as HTM are those in which the Company has
the ability and the intent to hold the security until contractual maturity. As
of December 31, 2009, the HTM portfolio totaled $708,000 and consisted of two
municipal obligations. Securities classified as AFS are eligible to be sold due
to liquidity needs or interest rate risk management. These securities are
adjusted to and carried at their fair value with any unrealized gains or losses
recorded net of deferred income taxes, as an adjustment to capital and reported
in the equity section of the balance sheet as other comprehensive income (loss).
As of December 31, 2009, $130.6 million in securities were so classified and
carried at their fair value, with unrealized appreciation; net of tax, of
$2,090,000, included in accumulated other comprehensive income as a component of
stockholders’ equity.





As of
December 31, 2009, the average life of the portfolio was 2.6 years. The Company
has maintained  a relatively short average life in the portfolio in
order to generate cash flow to support loan growth and maintain liquidity
levels. Purchases for the year totaled $58.4 million with securities called,
maturities and cash flow of $44.1 million and proceeds from sales of $15.4
million. The purchases were funded principally by cash flow from the portfolio.
The carrying value of the securities portfolio is as follows:





2009
            
            2008(dollars
      in thousands)Carrying
              Value
            
            %
      of portfolio
            
            Carrying
              Value
            
            $
      of portfolioUS
      Government agencies
            
            $
            39,772
            
            30.3
            %
            $
            35,813
            
            
            27.5
            %States
      & political subdivisions
            
            
            32,343
            
            24.6
            %
            
            25,916
            
            
            19.8
            %Corporate
      Securities
            
            
            5,240
            
            4.0
            %
            
            5,625
            
            
            4.3
            %Mortgage-backed
      securities
            
            
            53,154
            
            40.5
            %
            
            62,318
            
            
            47.5
            %Equity
      securities
            
            
            776
            
            0.6
            %
            
            1,155
            
            
            0.9
            %Total
            
            $
            131,285
            
            100.0
            %
            $
            130,827
            
            
            100.0
            %





The
portfolio had $19.5 million of adjustable rate instruments, principally
adjustable rate mortgage backed securities as of December 31, 2009 compared to
$15.2 million at year end 2008. The portfolio contained no private label
mortgage backed securities, collateralized debt obligations (CDOs), trust
preferreds, structured notes, step-up bonds and no off-balance sheet derivatives
were in use. The U.S. Government agency portfolio consists principally of
callable notes with final maturities of generally less than five years. The
mortgage backed securities are pass-through bonds with the Fannie Mae (FNMA),
Freddie Mac (FHLMC), and Government National Mortgage Association (GNMA). The
Company has no exposure to common or preferred stock of FNMA or
FHLMC.





The
Company evaluates the securities in its portfolio for
other-than-temporary-impairment (OTTI) as fair value declines below cost. In
estimating OTTI management considers (1) the length of time and the extent of
the decline in fair value and (2)  the financial condition and
near-term prospects of the issuer. As of December 31, 2009 the Company held 21
securities which had a combined unrealized loss of $173,000. Management believes
that these losses are principally due to changes in interest rates and represent
temporary impairment as the Company does not have the intent to sell these
securities and it is more likely than not that it will not have to sell the
securities before recovery of their cost basis. The Company holds a small
portfolio of equity securities of other financial institutions the value of
which has


17


been
impacted by weakened conditions of the financial market. As a result, the
Company recorded an OTTI charge on two equity holdings totaling
$31,000.





FAIR
VALUE OF FINANCIAL INSTRUMENTS


The
Company uses fair value measurements to record fair value adjustments to certain
financial instruments and determine fair value disclosures. (see Note 16 of
Notes to the Consolidated Financial Statements).





Approximately
$130.6 million, which represents 24.7% of total assets at December 31, 2009
which consisted of financial instruments recorded at fair value on a recurring
basis. This amount consists of entirely of the Company’s available for sale
securities portfolio. The Company uses valuation methodologies involving
market-based or market derived information, collectively Level 1 and 2
measurements, to measure fair value. There were no transfers into or out of
Level 3 for any instruments for the years ending December 31, 2009 and
2008.





The
Company utilizes a third party provider to perform valuations of the
investments. Methods used to perform the valuations include:  pricing
models that vary based on asset class, available trade and bid information,
actual transacted prices, and proprietary models for valuations of state and
municipal obligations. In addition, the Company has a sample of fixed-income
securities valued by another independent source. The Company does not adjust
values received from its providers, unless it is evident that fair value
measurement is not consistent with generally accepted accounting
principles


in the
United States.





DEPOSITS


The
Company, through the eleven branches of the Bank, provides a full range of
deposit products to its retail and business customers. These products include
interest-bearing and non-interest bearing transaction accounts, statement
savings and money market accounts. Time deposits consist of certificates of
deposit (CDs) with terms of up to five years and include Individual Retirement
Accounts. The Bank participates in the Jumbo CD ($100,000 and over) markets with
local municipalities and school districts, which are typically awarded on a
competitive bid basis. The Company has no brokered deposits.





Total
deposits as of December 31, 2009, totaled $391.5 million increasing $31.9
million from $359.6 million as of year-end 2008. The increase was principally
due to a higher level of time deposits which increased by $30.5
million.





Time
deposits over $100,000, which consist principally of school district funds,
other public funds and short-term deposits from large commercial customers with
maturities generally less than one year, totaled $66.6 million as of December
31, 2009, compared to $45.1 million at year-end 2008. The growth was principally
due to a higher level of CDs with local school districts. These deposits are
subject to competitive bid and the Company bases its bid on current interest
rates, loan demand, investment portfolio structure and the relative cost of
other funding sources.





As of
December 31, 2009, non-interest bearing demand deposits totaled $59.8 million
compared to $56.8 million at year-end 2008. The increase is partially
attributable to a higher level of commercial deposits, as a result of growth in
the commercial loan portfolio. Cash management accounts in form of securities
sold under agreements to repurchase included in short-term borrowings, totaled
$25.6 million at year end 2009 compared to $23.4 million as of December 31,
2008. These balances represent commercial and municipal customers’ funds
invested in over-night securities. The Company considers these accounts as a
source of core funding.


18


MARKET
RISK


Interest
rate sensitivity and the repricing characteristics of assets and liabilities are
managed by the Asset and Liability Management Committee (ALCO). The principal
objective of the ALCO is to maximize net interest income within acceptable
levels of risk, which are established by policy. Interest rate risk is monitored
and managed by using financial modeling techniques to measure the impact of
changes in interest rates.





Net
interest income, which is the primary source of the Company’s earnings, is
impacted by changes in interest rates and the relationship of different interest
rates. To manage the impact of the rate changes, the balance sheet should be
structured so that repricing opportunities exist for both assets and liabilities
at approximately the same time intervals.  The Company uses net
interest simulation to assist in interest rate risk management. The process
includes simulating various interest rate environments and their impact on net
interest income. As of December 31, 2009, the level of net interest income at
risk in a 200 basis points increase or decrease was within the Company’s policy
limits, of a decline less than 8% of net interest income.





Imbalance
in repricing opportunities at a given point in time reflect interest-sensitivity
gaps measured as the difference between rate-sensitive assets and rate-sensitive
liabilities. These are static gap measurements that do not take into account any
future activity, and as such are principally used as early indications of
potential interest rate exposures over specific intervals.





At
December 31, 2009, the Bank had a positive 90 day interest sensitivity gap of
$26.3 million or 5.0% of total assets.  A positive gap indicates that
the balance sheet has a higher level of rate-sensitive assets (RSA) than
rate-sensitive liabilities (RSL) at the specific time interval. This would
indicate that in an increasing rate environment, the yield on interest-earning
assets would increase faster than the cost of interest-bearing liabilities in
the 90 day time frame. The level of RSA and RSL for an interval is managed by
ALCO strategies, including adjusting the average life of the investment
portfolio through purchase and sales, pricing of deposit liabilities to attract
long or short term time deposits, utilizing borrowings to fund loan growth, loan
pricing to encourage variable rate products and evaluation of loan sales of long
term fixed rate mortgages.





The
Company analyzes and measures the time periods in which RSA and RSL will mature
or reprice in accordance with their contractual terms and assumptions.
Management believes that the assumptions used are reasonable. The interest rate
sensitivity of assets and liabilities could vary substantially if differing
assumptions were used or if actual experience differs from the assumptions used
in the analysis. For example, although certain assets and liabilities may have
similar maturities or periods to repricing, they may react in differing degrees
to changes in market interest rates. The interest rates on certain types of
assets and liabilities may fluctuate in advance of changes in market interest
rates, while interest rates on other types may lag behind changes in market
rates. Interest rates may change at different rates changing the shape of the
yield curve. The level of rates on the investment securities may also be
affected by the spread relationship between different investments. This was
evident in 2009 as the spread between certain asset classes were at historical
highs in relation to treasuries due to market liquidity and credit concerns.
Further, in the event of a significant change in interest rates, prepayment and
early withdrawal levels would likely deviate significantly from those assumed.
Finally, the ability of borrowers to service their adjustable-rate debt may
decrease in the event of an interest rate increase. It should be noted that the
operating results of the Company are not subject to foreign currency exchange or
commodity price risk.


19


The
following table displays interest-sensitivity as of December 31, 2009 (in
thousands):






Rate
      Sensitivity Table
            
            3
      Months
            
            3-12
            
            
            
            OverOr
      Less
            
            Months
            
            1-3
      Years
            
            3
      Years
            
            TotalFederal
      funds sold andinterest-bearing
      deposits
            
            $
            10,607
            
            $
            —
            
            $
            250
            
            $
            —
            
            $
            10,857Securities
            
            
            24,388
            
            
            19,718
            
            
            25,868
            
            
            61,311
            
            
            131,285Loans
      Receivable
            
            
            81,986
            
            
            58,847
            
            
            90,962
            
            
            131,679
            
            
            363,474Total
      Rate Sensitive Assets (RSA)
            
            
            116,981
            
            
            78,565
            
            
            117,080
            
            
            192,990
            
            
            505,616Non-maturity
      interest-bearing deposits
            
            
            21,909
            
            
            24,279
            
            
            64,352
            
            
            28,328
            
            
            138,868Time
      Deposits
            
            
            63,042
            
            
            76,068
            
            
            39,326
            
            
            14,349
            
            
            192,785Other
            
            
            5,774
            
            
            13,641
            
            
            34,388
            
            
            15,000
            
            
            68,803Total
      Rate Sensitive Liabilities (RSL)
            
            
            90,725
            
            
            113,988
            
            
            138,066
            
            
            57,677
            
            
            400,456Interest
      sensitivity gap
            
            $
            26,256
            
            $
            (35,423
            )
            $
            (20,986
            )
            $
            135,313
            
            $
            105,160Cumulative
      gap
            
            
            26,256
            
            
            (9,167
            )
            
            (30,153
            )
            
            105,160RSA/RSL-cumulative
            
            
            128.9
            %
            
            95.5
            %
            
            91.2
            %
            
            126.3
            %As
      of December 31, 2008Interest
      sensitivity gap
            
            $
            20,390
            
            $
            (10,272
            )
            $
            (16,051
            )
            $
            102,259
            
            $
            96,326Cumulative
      gap
            
            
            20,390
            
            
            10,118
            
            
            (5,933
            )
            
            96,326RSA/RSL-cumulative
            
            
            123.1
            %
            
            105.5
            %
            
            98.1
            %
            
            125.1
            %





LIQUIDITY


Liquidity
is the ability to fund customers’ borrowing needs and their deposit withdrawal
requests while supporting asset growth. The Company’s primary sources of
liquidity include deposit generation, asset maturities, cash flow from payments
on loans and securities and access to borrowing from the Federal Home Loan Bank
and other correspondent banks.





As of
December 31, 2009, the Company had cash and cash equivalents of $17.4 million in
the form of cash, due from banks, balances with the Federal Reserve Bank,
short-term deposits with other institutions and Federal Funds sold. In addition,
the Company had total securities available for sale of $130.6 million, which
could be used for liquidity needs. This totals $148.0 million and represents
27.9% of total assets compared to $136.6 million and 27.1% of total assets as of
December 31, 2008. The Company also monitors other liquidity measures, all of
which were within the Company’s policy guidelines as of December 31, 2009. Based
upon these measures, the Company believes its liquidity position is
adequate.





The
Company maintains established lines of credit with the Federal Home Loan Bank of
Pittsburgh (FHLB), the Atlantic Central Bankers Bank (ACBB) and other
correspondent banks, which support liquidity needs. The total available under
all the lines was $39 million, with $-0- outstanding at December 31, 2009 and
$3.6 million outstanding at December 31, 2008. The maximum borrowing capacity
from FHLB was $197.6 million. As of December 31, 2009, the Company had $43
million in term borrowings from the FHLB.


20


OFF-BALANCE
SHEET ARRANGEMENTS


The
Company’s financial statements do not reflect various commitments 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, as of
December 31, 2009 totaled $58.2 million. They consisted of $17.7 million in
commercial real estate, construction and land developments loans, $14.9 million
in home equity lines of credit, $3.7 million in standby letters of credit and
$21.9 million in other unused commitments principally commercial lines of
credit. Because these instruments have fixed maturity dates and because many of
them will expire without being drawn upon, they do not represent 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.





The
following table represents the aggregate of on and off balance sheet contractual
obligations to make future payments (in thousands):





CONTRACTUAL
OBLIGATIONS





December
      31, 2009Total
            
            Less
      than 1 year
            
            1-3
      years
            
            4-5
      years
            
            Over
      5 yearsTime
      deposits
            
            $
            192,785
            
            $
            139,111
            
            $
            39,326
            
            $
            14,348
            
            $
            —Long-term
      debt
            
            
            43,000
            
            
            5,000
            
            
            23,000
            
            
            5,000
            
            
            10,000Operating
      leases
            
            
            3,347
            
            
            246
            
            
            523
            
            
            527
            
            
            2,051$
            239,132
            
            $
            144,357
            
            $
            62,849
            
            $
            19,875
            
            $
            12,051





RESULTS
OF OPERATIONS





NET
INTEREST INCOME


Net
interest income is the most significant source of revenue for the Company and
represented 78.0% of total revenue for the year ended December 31, 2009. Net
interest income (fte) totaled $19,872,000 for the year ended December 31, 2009
compared to $19,030,000 for 2008, an increase of $842,000 or 4.4%. The resulting
fte net interest spread and net interest margin were 3.60% and 4.03%
respectively in 2009 compared to 3.51% and 4.07%, respectively in
2008.





Interest
income (fte) for the year ended December 31, 2009 totaled $27,598,000 compared
to $28,724,000 for 2008. The fte yield on average earning assets for 2009 was
5.60%, decreasing 54 basis points from 6.14% in 2008. Interest income was
unfavorably impacted by the significant decrease in short-term interest rates.
During 2009, the prime interest rate averaged 3.25% compared to 5.09% during
2008. The Federal Funds rate and other short-term market rates showed a similar
lower trend. This decline in short-term rates impacts the Company’s floating
rate loans principally commercial real estate, lines of credit and home equity
lines of credit which are based on a spread to the prime rate. As of December
31, 2009, $58.1 million of loans were immediately repricable. The decrease in
yield was partially offset by a $25.1 million increase in average earning assets
for the year 2009 compared to 2008.





Interest
income (fte) earned on loans totaled $21,688,000 for the year ended December 31,
2009 with a resulting fte yield of 6.09% compared to $22,161,000 with an fte
yield of 6.61% in 2008. The


21


decrease
was due to the lower prime interest rate in 2009, partially offset by growth of
$21.2 million in average loans. The Company also established interest rate
floors on lines of credit to offset the decrease in prime rate. The securities
available-for-sale portfolio averaged $129.4 million in 2009 with interest
income (fte) of $5,830,000 and a yield (fte) of 4.51% compared to $130.9 million
with interest income (fte) of $6,473,000 and yield (fte) of 4.94% in 2008. The
decrease in yield in 2009 was principally due to higher yielding investments
maturing and reinvested at the current lower interest rates.





Federal
Funds sold and interest-bearing deposits with banks averaged $6.6 million at a
yield of .29% compared to $1.1 million at a yield of 2.53% in 2008. The increase
in Fed Funds at the current low yield had a negative impact on the margin in
2009.





Interest
expense for the year-ended December 31, 2009 totaled $7,726,000 with an average
cost of interest-bearing liabilities of 2.00% compared to interest expense of
$9,694,000 with an average cost of 2.63% in 2008. The decrease was principally
due to a lower level of short-term interest rates. In the lower rate
environment, the Company reduced rates paid on money market accounts, time
deposits and cash management accounts (included in short-term borrowings). The
cost of time deposits decreased 101 basis points to 2.80% in 2009 from 3.81% in
2008, as higher costing time deposits matured and were replaced at lower rates.
The rate on short-term borrowings principally cash management accounts declined
103 basis points to 1.11% in 2009 from 2.14% in 2008.





Net
interest income represented 81.9% of total revenue for the year ended December
31, 2008. Net interest income (fte) totaled $19,030,000 for the year ended
December 31, 2008 compared to $17,811,000 for 2007, an increase of $1,219,000 or
6.8%. The resulting fte net interest spread and net interest margin were 3.51%
and 4.07% respectively in 2008 compared to 3.27% and 3.98%, respectively in
2007.





Interest
income (fte) for the year ended December 31, 2008 totaled $28,724,000 compared
to $29,794,000 for 2007. The fte yield on average earning assets for 2008 was
6.14%, decreasing 52 basis points from 6.66% in 2007. Interest income was
unfavorably impacted by the significant decrease in short-term interest rates.
During 2008, the prime interest rate declined 400 basis points from 7.25% to
3.25%. This decline in short-term rates impacts the Company’s floating rate
loans principally commercial real estate, lines of credit and home equity lines
of credit. As of December 31, 2008, $67.1 million of loans were immediately
repricable. The decrease in yield was partially offset by a $20.5 million
increase in average earning assets for the year 2008 compared to
2007.





Interest
income (fte) earned on loans totaled $22,161,000 for the year ended December 31,
2008 with a resulting fte yield of 6.61% compared to $23,876,000 with an fte
yield of 7.38% in 2007. The decrease was due to the lower prime interest rate in
2008, partially offset by growth of $11.7 million in average loans. The
securities available-for-sale portfolio averaged $130.9 million in 2008 with
interest income (fte) of $6,473,000 and a yield (fte) of 4.94% compared to
$118.7 million with interest income (fte) of $5,623,000 and yield (fte) of 4.74%
in 2007. The increase in yield in 2008 was partially due to higher yielding
investments purchased in 2007 having a favorable impact in 2008.





Interest
expense for the year-ended December 31, 2008 totaled $9,694,000 with an average
cost of interest-bearing liabilities of 2.63% compared to interest expense of
$11,983,000 with an average cost of 3.39% in 2007. The decrease was principally
due to a lower level of short-term interest rates. In the lower rate
environment, the Company reduced rates paid on money market accounts and time
deposits. The cost of time deposits decreased 76 basis points to 3.81% in 2008
from 4.57% in 2007, as higher costing time deposits matured and were replaced at
lower rates. The Company also utilized short-term borrowings to replace higher
priced time deposits. Average short-term borrowings increased $9.9
million


22


to
average $32.3 million at an average cost of 2.14% in 2008 compared to $22.4
million at an average cost of 4.15% in 2007.





OTHER
INCOME


Other income for the year-ended
December 31, 2009 totaled $5,392,000 compared to $4,087,000 in 2008, an increase
of $1,305,000. The increase is partially due to the receipt of $816,000 in
proceeds from a death claim on a bank-owned life insurance policy. The Company
took advantage of the low interest rate environment and sold $15.4 million of
investment securities at a gain of $463,000 compared to $18,000 in losses in
2008. The Company also had a $150,000 gain on the sale of deposits related to a
branch closure in the 2009 period. Service charges and fees decreased $124,000
principally due to a lower volume of non-sufficient fund (NSF) fees. The decline
in NSF fees was also related to a branch closure.





Other income totaled $4,087,000 for the
year-ended December 31, 2008 compared to $3,524,000 in 2007. The increase was
principally due to $499,000 of gains on the sale of $14.4 million of mortgage
loans and servicing rights in 2008 compared to $23,000 of similar gains in 2007.
The loans were sold for interest-rate risk management purposes. Service charges
and fees increased $91,000 to $2,600,000 principally due to a higher volume of
non-sufficient fund fees (NSF). The Company offers title and settlement services
through a subsidiary of the Bank. Revenues (included in other) totaled $83,000
in 2008 compared to $29,000 in 2007 principally due to a higher level of
commercial real estate transactions. The Company recorded a $27,000
other-than-temporary-impairment charge on 1,000 shares of Wachovia Common stock
in 2008. The Company has no holdings of common or preferred stock of FNMA or
FHLMC.





Other
Income (dollars in thousands)


For the
year ended December 31





2009
            
            2008
            
            2007Service
      charges on deposit accounts
            
            $
            165
            
            $
            194
            
            $
            226ATM
      Fees
            
            
            273
            
            
            280
            
            
            241NSF
      Fees
            
            
            1,281
            
            
            1,424
            
            
            1,347Gain
      on sale of deposits
            
            
            150
            
            
            —
            
            
            —Safe
      deposit box rental
            
            
            52
            
            
            55
            
            
            55Loan
      related service fees
            
            
            390
            
            
            281
            
            
            236Debit
      card
            
            
            373
            
            
            376
            
            
            328Fiduciary
      activities
            
            
            354
            
            
            404
            
            
            423Commissions
      on mutual funds & annuities
            
            
            112
            
            
            105
            
            
            120Gain
      on sales of mortgage loans and servicing rights
            
            
            481
            
            
            499
            
            
            23Earnings
      on and proceeds from bank-owned life insurance
            
            
            1,196
            
            
            344
            
            
            333Other
      income
            
            
            102
            
            
            143
            
            
            1754,929
            
            
            4,105
            
            
            3,507Net
      realized gains (losses) on sales of securities
            
            
            463
            
            
            (18
            )
            
            17Total
            
            $
            5,392
            
            $
            4,087
            
            $
            3,524





OTHER
EXPENSES


Other
expenses totaled $13,471,000 compared to $12,240,000 for 2008, an increase of
$1,231,000. Salaries and employee benefit costs increased $783,000. The increase
included $267,000 related to a retirement plan which was funded by proceeds from
a BOLI policy included in other income.


The
Company also paid out a portion of its post-retirement life insurance
obligation, $136,000, which was offset by a reduction to federal income tax.
FDIC insurance assessments totaled $710,000, an increase of $620,000 over the
prior year. The increase includes a special assessment of $225,000 which was
based on five basis points of assets less Tier 1 capital as of June 30, 2009.
Instead of imposing additional special


23


assessment,
the FDIC required all banks to prepay their estimated risk-based assessment for
the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on December 30,
2009. The bank pre-paid $1,711,000 which is included in other assets and will be
amortized over 36 months. The efficiency ratio, which is total other expenses as
a percentage of net interest income (fte) plus other income for the year ended
December 31, 2009 was 53.3%.





Other
expenses totaled $12,240,000 for the year-ended December 31, 2008 compared to
$11,341,000 in 2007, an increase of $899,000 or 7.9%. The increase was
principally due to $582,000 of costs associated with a parcel of foreclosed real
estate. Excluding these costs, other expenses increased 2.8%.





Salaries
and employee benefits expense which represented 49.4% of total other expenses
increased $221,000 or 3.8% to $6,046,000 in 2008. Equipment expense decreased
$46,000 to $507,000. The decline was principally due to lower maintenance
expenses as the Bank utilized branch document image capture technology which
reduced back-office check processing costs. The same technology also reduced
courier expense (included in other) by $48,000. Data processing related costs
totaled $753,000, an increase of $63,000 principally due to branch and remote
deposit capture and enhancements to the Bank’s internet banking
system.  The efficiency ratio, which is total other expenses as a
percentage of net interest income (fte) plus other income for the year ended
December 31,2008 was 52.9%.





In 2008,
for 2009 the FDIC increased the assessment rate for most highly rated
institutions to between 12 and 14 basis points for the first quarter of 2009 and
to between 10 and 14 basis points thereafter. Assessment rates could be further
increased if an institution’s FHLB advances exceed 25% of deposits. The FDIC has
also established a program under which it fully guarantees all non-interest
bearing transaction accounts and senior unsecured debt of a bank or its holding
company. The Bank is participating in this program and will be assessed ten
basis points for non-interest bearing transaction account balances in excess of
$250,000 and 75 basis points of the amount of any debt issued. The Bank has no
plans to issue any debt.





INCOME
TAXES


Income
tax expense for the year ended December 31, 2009 totaled $2,282,000 for an
effective tax rate of 24.4% compared to an expense of $2,836,000 and an
effective tax rate of 29.8% for 2008. The decrease in the effective tax rate is
due to the receipt of $816,000 in proceeds from a BOLI policy which is exempt
from federal income taxes and a $136,000 reduction to tax related to
post-retirement life insurance benefits. Excluding these two items the effective
tax rate for 2009 was 27.8%.





Income
tax expense for the year ended December 31, 2008 totaled $2,836,000 for an
effective tax rate of 29.8% compared to an expense of $2,629,000 and an
effective tax rate of 28.8% for 2007.





CAPITAL
AND DIVIDENDS


Total
stockholders’ equity as of December 31, 2009, was $64.5 million, compared to
$58.7 million as of year-end 2008. The increase was principally due to retention
of earnings of $4,057,000 after cash dividends declared of $3,006,000.
Accumulated other comprehensive income increased $811,000 due to an increase in
the fair value of securities in the Company’s portfolio principally as a result
of a change in interest rates.  As of  December 31, 2009 the
Company had a leverage capital ratio of 11.87%, Tier 1 risk-based capital of
16.97% and total risk-based capital of 18.27% compared to, 11.45%, 16.22% and
17.50%, respectively, in 2008. Due to its strong capital position, the Company
elected not to participate in the Treasury Department’s TARP Capital Purchase
Program.


24





The
Company’s stock is traded on the Nasdaq Global market under the symbol, NWFL. As
of December 31, 2009, there were approximately 1,500 shareholders based on
transfer agent mailings.





The
following table sets forth the price range and cash dividends declared per share
regarding common stock for the period indicated:








Closing
      Price Range
            
            Cash
      dividendsHigh
            
            Low
            
            declared
      per shareYear
      2009First
      Quarter
            
            
            
            $
            29.45
            
            $
            22.95
            
            $
            .27Second
      Quarter
            
            
            
            
            32.00
            
            
            24.10
            
            
            .27Third
      Quarter
            
            
            
            
            33.25
            
            
            30.57
            
            
            .27Fourth
      Quarter
            
            
            
            
            31.10
            
            
            25.50
            
            
            .28Year
      2008First
      Quarter
            
            
            
            $
            31.99
            
            $
            28.90
            
            $
            .25Second
      Quarter
            
            
            
            
            31.00
            
            
            29.00
            
            
            .25Third
      Quarter
            
            
            
            
            30.75
            
            
            27.50
            
            
            .25Fourth
      Quarter
            
            
            
            
            32.00
            
            
            27.00
            
            
            .27





The book
value of the common stock was $23.25 as of December 31, 2009 compared to $21.45
as of December 31, 2008. As of year-end 2009, the stock price was $28.59,
compared to $27.50 as of December 31, 2008.





NON-GAAP
FINANCIAL MEASURES


This
annual report contains or references tax-equivalent interest income and net
interest income, which are non-GAAP financial measures. Tax-equivalent interest
income and net interest income are derived from GAAP interest income and net
interest income using an assumed tax rate of 34%. We believe the presentation of
interest income and net interest income on a tax-equivalent basis ensures
comparability of interest income and net interet income arising from both
taxable and tax-exempt sources and is consistent with industry practice.
Tax-equivalent net interest income is reconciled to GAAP net interest income on
page 28. Although the Company believes that these non-GAAP financial measures
enhance investors’ understanding of our business and performance, these
non-GAAP financial measures should not be considered an alternative to
GAAP measures.





CHANGE
IN AUDITORS


On August
11, 2009, the Company dismissed Beard Miller Company LLP (“BMC”) as the
Company’s independent public accountants, and engaged S.R. Snodgrass, A.C. to
serve as the Company’s independent public accountants. The appointment of
Snodgrass and the dismissal of BMC were approved by the Audit Committee of the
Company’s Board of Directors. BMC performed audits of the Company’s consolidated
financial statements for the years ended December 31, 2008 and 2007. BMC’s
reports did not contain an adverse opinion or disclaimer of opinion, and were
not qualified or modified as to uncertainty, audit scope or accounting
principles. During the two years ended December 31, 2008 and from December 31,
2008 through August 11, 2009, there were no disagreements or reportable events
between the Company and BMC on any matters of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure,
which, if not resolved to the satisfaction of BMC, would have caused them to
make a reference to the subject matter of the disagreements or reportable events
in connection with their reports.





25


STOCK
PERFORMANCE GRAPH


Set forth
below is a stock performance graph comparing the cumulative total shareholder
return on the Common Stock with (a) the cumulative total stockholder return on
stocks included in the Nasdaq Stock Market index and (b) the cumulative total
stockholder return on stocks included in the Nasdaq Bank index, as prepared by
the Center for Research in Securities Prices (“CRSP”) at the University of
Chicago. All three investment comparisons assume the investment of $100 at the
market close on December 31, 2004 and the reinvestment of dividends paid. The
graph provides comparison at December 31, 2004 and each fiscal year through
December 31, 2009.

















There can be
no assurance that the Company’s future stock performance will be the same or
similar to the historical performance shown in the above graph. The Company
neither makes nor endorses any predictions as to stock
performance.


26


NORWOOD
FINANCIAL CORP.


SUMMARY
OF QUARTERLY RESULTS (UNAUDITED)


(Dollars
in thousands, except per share amounts)








2009
            
            December
      31
            
            September
      30
            
            June
      30
            
            March
      31Interest
      income
            
            $
            6,722
            
            $
            6,680
            
            $
            6,743
            
            $
            6,690Interest
      expense
            
            
            1,895
            
            
            1,914
            
            
            1,908
            
            
            2,009Net
      interest income
            
            
            4,827
            
            
            4,766
            
            
            4,835
            
            
            4,681Provision
      for loan losses
            
            
            1,100
            
            
            140
            
            
            220
            
            
            225Other
      income
            
            
            1,885
            
            
            928
            
            
            996
            
            
            1,120Net
      realized gains on sales of securities
            
            
            40
            
            
            90
            
            
            172
            
            
            161Other
      expense
            
            
            3,702
            
            
            3,174
            
            
            3,320
            
            
            3,275Income
      before income taxes
            
            
            1,950
            
            
            2,470
            
            
            2,463
            
            
            2,462Income
      tax expense
            
            
            148
            
            
            695
            
            
            714
            
            
            725NET
      INCOME
            
            $
            1,802
            
            $
            1,775
            
            $
            1,749
            
            $
            1,737Basic
      earnings per share
            
            $
            0.65
            
            $
            0.64
            
            $
            0.64
            
            $
            0.64Diluted
      earnings per share
            
            $
            0.65
            
            $
            0.64
            
            $
            0.62
            
            $
            0.632008December
      31
            
            September
      30
            
            June
      30
            
            March
      31Interest
      income
            
            $
            6,934
            
            $
            7,059
            
            $
            6,953
            
            $
            7,149Interest
      expense
            
            
            2,207
            
            
            2,283
            
            
            2,379
            
            
            2,825Net
      interest income
            
            
            4,727
            
            
            4,776
            
            
            4,574
            
            
            4,324Provision
      for loan losses
            
            
            420
            
            
            130
            
            
            110
            
            
            75Other
      income
            
            
            890
            
            
            1,000
            
            
            953
            
            
            1,262Net
      realized gain (loss) on sales of securities
            
            
            —
            
            
            (27
            )
            
            9
            
            
            —Other
      expense
            
            
            2,946
            
            
            3,361
            
            
            2,972
            
            
            2,961Income
      before income taxes
            
            
            2,251
            
            
            2,258
            
            
            2,454
            
            
            2,550Income
      tax expense
            
            
            666
            
            
            666
            
            
            733
            
            
            771NET
      INCOME
            
            $
            1,585
            
            $
            1,592
            
            $
            1,721
            
            $
            1,779Basic
      earnings per share
            
            $
            0.58
            
            $
            0.58
            
            $
            0.63
            
            $
            0.65Diluted
      earnings per share
            
            $
            0.58
            
            $
            0.58
            
            $
            0.62
            
            $
            0.64








27


NORWOOD
FINANCIAL CORP. CONSOLIDATED AVERAGE BALANCE SHEETS WITH


RESULTANT
INTEREST AND RATES


(Tax-Equivalent
Basis, dollars in thousands)





Year
      Ended December 31
            2009
            
            
            2008
            
            
            2007Average
            
            
            
            
            
            
            
            Average
            
            
            
            
            
            
            
            AverageBalance
            
            Interest
            
            Ave
            
            
            Balance
            
            Interest
            
            Ave
            
            
            Balance
            
            Interest
            
            Ave(2)
            
            (1)
            
            Rate
            
            
            (2)
            
            (1)
            
            Rate
            
            
            (2)
            
            (1)
            
            RateASSETSInterest-earning
      assets:Federal
      funds sold
            $
            2,031
            
            $
            5
            
            0.25
            %
            
            $
            1,082
            
            $
            28
            
            2.59
            %
            
            $
            3,895
            
            $
            195
            
            5.01
            %Interest
      bearing deposits with banks
            
            4,552
            
            
            14
            
            0.31
            
            
            
            66
            
            
            1
            
            1.52
            
            
            
            483
            
            
            26
            
            5.38Securities
      held-to-maturity
            
            707
            
            
            61
            
            8.63
            
            
            
            706
            
            
            61
            
            8.64
            
            
            
            830
            
            
            74
            
            8.92Securities
      available for sale:Taxable
            
            100,120
            
            
            4,131
            
            4.13
            
            
            
            108,809
            
            
            5,207
            
            4.79
            
            
            
            99,399
            
            
            4,571
            
            4.60Tax-exempt
            
            29,283
            
            
            1,699
            
            5.80
            
            
            
            22,108
            
            
            1,266
            
            5.73
            
            
            
            19,320
            
            
            1,052
            
            5.45Total
      securities available for sale
            
            129,403
            
            
            5,830
            
            4.51
            
            
            
            130,917
            
            
            6,473
            
            4.94
            
            
            
            118,719
            
            
            5,623
            
            4.74Loans
      receivable (3)(4)
            
            356,345
            
            
            21,688
            
            6.09
            
            
            
            335,137
            
            
            22,161
            
            6.61
            
            
            
            323,444
            
            
            23,876
            
            7.38Total
      interest earning assets
            
            493,038
            
            
            27,598
            
            5.60
            
            
            
            467,908
            
            
            28,724
            
            6.14
            
            
            
            447,371
            
            
            29,794
            
            6.66Non-interest
      earning assets:Cash
      and due from banks
            
            6,935
            
            
            
            
            
            
            
            
            8,102
            
            
            
            
            
            
            
            
            8,128Allowance
      for loan losses
            
            (4,539
            )
            
            
            
            
            
            
            
            (4,013
            )
            
            
            
            
            
            
            
            (3,925
            )Other
      assets
            
            17,309
            
            
            
            
            
            
            
            
            17,687
            
            
            
            
            
            
            
            
            17,318Total
      non-interest earning assets
            
            19,705
            
            
            
            
            
            
            
            
            21,776
            
            
            
            
            
            
            
            
            21,521TOTAL
      ASSETS
            $
            512,743
            
            
            
            
            
            
            
            $
            489,684
            
            
            
            
            
            
            
            $
            468,892LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest
      Bearing Liabilities:Interest
      bearing demand and money market
            $
            98,968
            
            
            731
            
            0.74
            
            
            $
            102,358
            
            
            1,449
            
            1.42
            
            
            $
            90,392
            
            
            1,852
            
            2.05Savings
            
            44,526
            
            
            158
            
            0.35
            
            
            
            44,510
            
            
            208
            
            0.47
            
            
            
            45,858
            
            
            215
            
            0.47Time
            
            174,201
            
            
            4,876
            
            2.80
            
            
            
            160,462
            
            
            6,116
            
            3.81
            
            
            
            172,986
            
            
            7,900
            
            4.57Total
      interest bearing deposits
            
            317,695
            
            
            5,765
            
            1.81
            
            
            
            107,330
            
            
            7,773
            
            2.53
            
            
            
            309,235
            
            
            9,967
            
            3.22Short-term
      borrowings
            
            26,233
            
            
            292
            
            1.11
            
            
            
            32,328
            
            
            693
            
            2.14
            
            
            
            22,443
            
            
            932
            
            4.15Other
      borrowings
            
            43,000
            
            
            1,669
            
            3.88
            
            
            
            28,710
            
            
            1,228
            
            4.28
            
            
            
            22,315
            
            
            1,084
            
            4.86Total
      interest bearing liabilities
            
            386,928
            
            
            7,726
            
            2.00
            
            
            
            368,368
            
            
            9,694
            
            2.63
            
            
            
            353,994
            
            
            11,983
            
            3.39Non-interest
      bearing liabilities:Non-interest
      bearing demand deposits
            
            59,224
            
            
            
            
            
            
            
            
            59,759
            
            
            
            
            
            
            
            
            56,523Other
      liabilities
            
            4,615
            
            
            
            
            
            
            
            
            4,908
            
            
            
            
            
            
            
            
            4,545Total
      non-interest bearing liabilities
            
            63,839
            
            
            
            
            
            
            
            
            64,667
            
            
            
            
            
            
            
            
            61,068Stockholders’
      equity
            
            61,976
            
            
            
            
            
            
            
            
            56,649
            
            
            
            
            
            
            
            
            53,830Total
      Liabilities and Stockholders’ Equity
            $
            512,743
            
            
            
            
            
            
            
            $
            489,684
            
            
            
            
            
            
            
            $
            468,892Net
      Interest Income
              (tax
      equivalent basis)
            
            
            
            
            19,872
            
            3.60
            %
            
            
            
            
            
            19,030
            
            3.51
            %
            
            
            
            
            
            17,811
            
            3.27
            %Tax-equivalent
      basis adjustment
            
            
            
            
            (763
            )
            
            
            
            
            
            
            
            (629
            )
            
            
            
            
            
            
            
            (539
            )Net
      Interest Income
            
            
            
            $
            19,109
            
            
            
            
            
            
            
            $
            18,401
            
            
            
            
            
            
            
            $
            17,272Net
      interest margin
              (tax
      equivalent basis)
            
            
            
            
            
            
            4.03
            %
            
            
            
            
            
            
            
            4.07
            %
            
            
            
            
            
            
            
            3.98
            %


1
            Interest
      and yields are presented on a tax-equivalent basis using a marginal tax
      rate of 34%.


2
            Average
      balances have been calculated based on daily
  balances.


3
            Loan
      balances include non-accrual loans and are net of unearned
      income.


4
            Loan
      yields include the effect of amortization of deferred fees net of
      costs.


28


RATE/VOLUME
ANALYSIS


The following table shows the fully
taxable equivalent effect of changes in volumes and rates on interest income and
interest expense.








Increase/(D)ecrease(dollars
      in thousands)
            2009
      compared to 2008
            
            2008
      compared to 2007Variance
      due to
            
            Variance
      due toVolume
            
            Rate
            
            Net
            
            Volume
            
            Rate
            
            NetINTEREST EARNING
      ASSETS:Federal
      funds sold
            $
            14
            
            $
            (37
            )
            $
            (23
            )
            $
            (100
            )
            $
            (67
            )
            $
            (167
            )Interest
      bearing deposits
            
            14
            
            
            (1
            )
            
            13
            
            
            (14
            )
            
            (11
            )
            
            (25
            )Securities
      held to maturity
            
            0
            
            
            (0
            )
            
            0
            
            
            (11
            )
            
            (2
            )
            
            (13
            )Securities
      available for sale:Taxable
            
            (395
            )
            
            (681
            )
            
            (1,076
            )
            
            445
            
            
            191
            
            
            636Tax-exempt
      securities
            
            416
            
            
            17
            
            
            433
            
            
            158
            
            
            56
            
            
            214Total
      securities available for sale
            
            21
            
            
            (664
            )
            
            (643
            )
            
            603
            
            
            247
            
            
            850Loans
      receivable
            
            1,353
            
            
            (1,826
            )
            
            (473
            )
            
            840
            
            
            (2,555
            )
            
            (1,715
            )Total
      interest earning assets
            
            1,402
            
            
            (2,528
            )
            
            (1,126
            )
            
            1,318
            
            
            (2,388
            )
            
            (1,070
            )INTEREST
      BEARING LIABILITIESInterest-bearing
      demand and money market
            
            (47
            )
            
            (671
            )
            
            (718
            )
            
            222
            
            
            (625
            )
            
            (403
            )Savings
            
            0
            
            
            (50
            )
            
            (50
            )
            
            (6
            )
            
            (1
            )
            
            (7
            )Time
            
            490
            
            
            (1,730
            )
            
            (1,240
            )
            
            (543
            )
            
            (1,241
            )
            
            (1,784
            )Total
      interest-bearing deposits
            
            443
            
            
            (2,451
            )
            
            (2,008
            )
            
            (327
            )
            
            (1,867
            )
            
            (2,194
            )Short-term
      borrowings
            
            (113
            )
            
            (288
            )
            
            (401
            )
            
            316
            
            
            (555
            )
            
            (239
            )Other
      borrowings
            
            564
            
            
            (123
            )
            
            441
            
            
            284
            
            
            (140
            )
            
            144Total
      interest bearing liabilities
            
            894
            
            
            (2,862
            )
            
            (1,968
            )
            
            273
            
            
            (2,562
            )
            
            (2,289
            )Net
      interest income (tax-equivalent basis)
            $
            508
            
            $
            334
            
            $
            842
            
            $
            1,045
            
            $
            174
            
            $
            1,219








Changes in net interest income that
could not be specifically identified as either a rate or volume change were
allocated proportionately to changes in volume and changes in
rate.


29





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





TO
THE SHAREHOLDERS OF NORWOOD FINANCIAL CORP.





Management
of Norwood Financial Corp. and its subsidiary (Norwood) is responsible for
establishing and maintaining adequate internal control over financial reporting
as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange
Act  of 1934. Norwood’s internal control over financial reporting is
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of the consolidated financial statements for
external purposes in accordance with accounting principles generally accepted in
the United States of America.





Norwood’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
Norwood; (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 our receipts and expenditures
are being made only in accordance with authorizations of Norwood’s management
and directors; and (3) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use or disposition of Norwood’s
assets that could have a material effect on the consolidated 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.





Management
assessed the effectiveness of Norwood’s internal control over financial
reporting as of December 31, 2009. In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission in “Internal Control –
Integrated Framework.”  Based on our assessment and those
criteria, management determined that Norwood maintained effective internal
control over financial reporting as of December 31, 2009.





Norwood’s
Independent registered certified public accounting firm has audited the
effectiveness of Norwood’s internal control over financial reporting. Their
report appears on page 32.










William
      W. Davis, Jr.
              
              Lewis
      J. CritelliPresident
      and Chief
              
              Executive
      Vice President, SecretaryExeutive
      Officer
              
              and
      Chief Financial Officer


30

















REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Norwood Financial Corp.


Honesdale,
Pennsylvania





We have
audited the accompanying consolidated balance sheet of Norwood Financial Corp.
and its subsidiary as of December 31, 2009, and the related consolidated
statements of income, stockholders’ equity, and cash flows for the year then
ended. These financial statements are the responsibility of Norwood Financial
Corp. and its subsidiary’s management. Our responsibility is to express an
opinion on these financial statements based on our audits. The financial
statements of Norwood Financial Corp. and its subsidiary for the years ended
December 31, 2008 and 2007,were audited by other auditors whose report, dated
March 10, 2009, expressed an unqualified opinion on those
statements.





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 the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the 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 audit provides 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 Norwood Financial Corp. and
its subsidiary as of December 31, 2009, and the results of their operations and
their cash flows for the year then ended in conformity with U.S. generally
accepted accounting principles.





We have
also audited in accordance with the standards of the Public Company Accounting
Oversight Board (United States), Norwood Financial Corp. and its subsidiary’s
internal control over financial reporting as of December 31, 2009, based on
criteria established in Internal Control – Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission, and our report
dated March 9, 2010, expressed an unqualified opinion on the effectiveness of
Norwood Financial Corp.’s internal control over financial reporting. S.R.
Snodgrass, A. C.















2100
Corporate Drive


Suite
400


Wexford,
PA


March 9,
2010


31

















REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Norwood Financial Corp.


Honesdale,
Pennsylvania





We have
audited Norwood Financial Corp. and its subsidiary’s internal control over
financial reporting as of December 31, 2009, based on criteria established in
Internal Control – Integrated Framework issued by the  Committee of
Sponsoring Organizations of the Treadway Commission. Norwood Financial Corp. and
its subsidiary’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 Over Financial Reporting. 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 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 (a) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (b)
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 (c) 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.





In our
opinion, Norwood Financial Corp. and its subsidiary maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2009, based on criteria established in Internal Control – Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway
Commission.





We have
also audited in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the accompanying consolidated balance sheet of
Norwood Financial Corp. and its subsidiary as of December 31, 2009, and the
related consolidated statements of income, stockholders’ equity, and cash flows
for the year then ended and our report dated March 9, 2010, expressed an
unqualified opinion.














S.R.
Snodgrass, A. C.


2100
Corporate Drive


Suite
400


Wexford,
PA


March 9,
2010


32








REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Norwood Financial Corp.


Honesdale,
Pennsylvania





We have
audited the accompanying consolidated balance sheet of Norwood Financial Corp.
and its subsidiary as of December 31, 2008, and the related consolidated
statements of income, stockholders’ equity and cash flows for each of the years
in the two-year period ended December 31, 2008. Norwood Financial Corp. and its
subsidiary’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 audit 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 Norwood Financial Corp. and
its subsidiary as of December 31, 2008, and the results of their operations and
their cash flows for each of the years in the two-year period ended December 31,
2008 in conformity with accounting principles generally accepted in the United
States of America.

















Parente
Beard LLC


Lancaster,
Pennsylvania


March 10,
2009


33


CONSOLIDATED
BALANCE SHEETS





December
      31,
            
            December
      31,2009
            
            2008(In
      Thousands, Except Share Data)ASSETSCash
      and due from banks
            $
            6,498
            
            $
            6,463Interest
      bearing deposits with banks
            
            7,857
            
            
            17Federal
      funds sold
            
            3,000
            
            
            —Cash
      and cash equivalents
            
            17,355
            
            
            6,480Securities
      available for sale
            
            130,577
            
            
            130,120Securities
      held to maturity, fair value 2009:$722, 2008: $730
            
            708
            
            
            707Loans
      receivable (net of allowance for loan losses 2009 $5,453; 2008
      $4,233
            
            358,021
            
            
            345,171Investment
      in FHLB Stock, at cost
            
            3,538
            
            
            3,538Bank
      premises and equipment, net
            
            5,189
            
            
            5,490Bank
      owned life insurance
            
            7,889
            
            
            8,068Accrued
      interest receivables
            
            2,200
            
            
            2,179Foreclosed
      real estate owned
            
            392
            
            
            660Other
      assets
            
            3,827
            
            
            1,883Total
      Assets
            $
            529,696
            
            $
            504,296LIABILITIES
      AND STOCKHOLDERS’ EQUITYLiabilitiesDeposits:Non-interest
      bearing demand
            $
            59,820
            
            $
            56,839Interest
      bearing demand
            
            34,410
            
            
            35,322Money
      market deposit accounts
            
            60,035
            
            
            60,623Savings
            
            44,423
            
            
            44,577Time
            
            192,785
            
            
            162,274Total
      Deposits
            
            391,473
            
            
            359,635Short-term
      borrowings
            
            25,803
            
            
            38,126Other
      borrowings
            
            43,000
            
            
            43,000Accrued
      interest payable
            
            2,057
            
            
            2,247Other
      liabilities
            
            2,892
            
            
            2,598Total
      Liabilities
            
            465,225
            
            
            445,606Stockholders’
      EquityCommon
      stock, $.10 par value, authorized 10,000,000 shares, issued:
      2,840,287
            
            284
            
            
            284Surplus
            
            9,764
            
            
            9,972Retained
      earnings
            
            54,455
            
            
            50,398Treasury
      stock at cost: 2009: 68,436 shares, 2008: 104,310 shares
            
            (2,122
            )
            
            (3,243
            )Accumulated
      other comprehensive income
            
            2,090
            
            
            1,279Total
      Stockholders’ Equity
            
            64,471
            
            
            58,690Total
      Liabilities and Stockholders’ Equity
            $
            529,696
            
            $
            504,296





See
notes to consolidated financial statements


34


CONSOLIDATED
STATEMENTS OF INCOME





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands, Except per Share Data)INTEREST
      INCOMELoans
      receivable, including fees
            
            $
            21,523
            
            $
            21,983
            
            $
            23,720SecuritiesTaxable
            
            
            4,131
            
            
            5,207
            
            
            4,571Tax
      exempt
            
            
            1,162
            
            
            876
            
            
            743Other
            
            
            19
            
            
            29
            
            
            221Total
      interest income
            
            
            26,835
            
            
            28,095
            
            
            29,255INTEREST
      EXPENSEDeposits
            
            
            5,765
            
            
            7,773
            
            
            9,967Short-term
      borrowings
            
            
            292
            
            
            693
            
            
            932Other
      borrowings
            
            
            1,669
            
            
            1,228
            
            
            1,084Total
      Interest Expense
            
            
            7,726
            
            
            9,694
            
            
            11,983Net
      Interest Income
            
            
            19,109
            
            
            18,401
            
            
            17,272PROVISION
      FOR LOAN LOSSES
            
            
            1,685
            
            
            735
            
            
            315Net
      Interest Income After
              Provision
      for Loan Losses
            
            
            17,424
            
            
            17,666
            
            
            16,957OTHER
      INCOMEService
      charges and fees
            
            
            2,476
            
            
            2,600
            
            
            2,509Income
      from fiduciary activities
            
            
            354
            
            
            404
            
            
            423Net
      realized gains (losses) on sales
              of
      securities
            
            
            463
            
            
            (18
            )
            
            17Gain
      on sale of loans and servicing rights
            
            
            481
            
            
            499
            
            
            23Earnings
      on life insurance policies
            
            
            1,196
            
            
            344
            
            
            333Gain
      on sale of deposits
            
            
            150
            
            
            —
            
            
            —Other
            
            
            272
            
            
            258
            
            
            219Total
      Other Income
            
            
            5,392
            
            
            4,087
            
            
            3,524OTHER
      EXPENSESSalaries
      and employee benefits
            
            
            6,829
            
            
            6,046
            
            
            5,825Occupancy
            
            
            1,133
            
            
            1,118
            
            
            1,087Furniture
      and equipment
            
            
            458
            
            
            507
            
            
            553Data
      processing related operations
            
            
            788
            
            
            753
            
            
            690Federal
      Deposit Insurance Corporation insurance
              assessment
            
            
            710
            
            
            90
            
            
            43Advertising
            
            
            186
            
            
            213
            
            
            235Professional
      fees
            
            
            411
            
            
            331
            
            
            349Postage
      and telephone
            
            
            487
            
            
            521
            
            
            491Taxes,
      other than income
            
            
            484
            
            
            504
            
            
            414Foreclosed
      real estate owned
            
            
            436
            
            
            582
            
            
            —Amortization
      of intangible assets
            
            
            52
            
            
            52
            
            
            52Other
            
            
            1,497
            
            
            1,523
            
            
            1,602Total
      Other Expenses
            
            
            13,471
            
            
            12,240
            
            
            11,341Income
      before Income Taxes
            
            
            9,345
            
            
            9,513
            
            
            9,140INCOME
      TAX EXPENSE
            
            
            2,282
            
            
            2,836
            
            
            2,629Net
      income
            
            $
            7,063
            
            $
            6,677
            
            $
            6,511EARNINGS
      PER SHAREBASIC
            
            $
            2.57
            
            $
            2.44
            
            $
            2.34DILUTED
            
            $
            2.55
            
            $
            2.41
            
            $
            2.30





See
notes to consolidated financial statements


35





CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY





Years
      Ended December 31, 2009, 2008 and 2007AccumulatedOtherCommon
      Stock
            
            
            
            Retained
            
            Treasury
      Stock
            
            ComprehensiveShares
            
            Amount
            
            
            Surplus
            
            Earnings
            
            Shares
            
            Amount
            
            Income
      (Loss)
            
            
            Total(Dollars
      in Thousands, Except per Share Data)BALANCE-DECEMBER
      31, 2006
            
            2,840,872
            
            $
            284
            
            $
            10,149
            
            $
            43,125
            
            
            43,721
            
            $
            (1,283
            )
            
            $
            (44
            )
            $
            52,231Comprehensive
      Income:Net
      Income
            
            -
            
            
            -
            
            
            -
            
            
            6,511
            
            
            -
            
            
            -
            
            
            
            -
            
            
            6,511Change
      in unrealized gains onsecurities
      available for sale,net
      of reclassificationadjustment
      and tax effects
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            1,098
            
            
            1,098Total
      Comprehensive income
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            7,609Cash
      dividends declared $0.94 per share
            
            -
            
            
            -
            
            
            -
            
            
            (2,606
            )
            
            -
            
            
            -
            
            
            
            -
            
            
            (2,606
            )Acquisition
      of treasury  stock
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            72,875
            
            
            (2,313
            )
            
            
            -
            
            
            (2,313
            )Stock
      options exercised
            
            -
            
            
            -
            
            
            (404
            )
            
            -
            
            
            (24,720
            )
            
            745
            
            
            
            -
            
            
            341Tax
      benefit on stock options exercised
            
            -
            
            
            -
            
            
            162
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            162Sale
      of treasury stock for ESOP
            
            -
            
            
            -
            
            
            1
            
            
            -
            
            
            (4,620
            )
            
            143
            
            
            
            -
            
            
            144Compensation
      expense related tostock
      options
            
            -
            
            
            -
            
            
            251
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            251BALANCE
      - DECEMBER 31, 2007
            
            2,840,872
            
            
            284
            
            
            10,159
            
            
            47,030
            
            
            87,256
            
            
            (2,708
            )
            
            
            1,054
            
            
            55,819Comprehensive
      Income:Net
      Income
            
            -
            
            
            -
            
            
            -
            
            
            6,677
            
            
            -
            
            
            -
            
            
            
            -
            
            
            6,677Change
      in unrealized gains onsecurities
      available for sale,net
      of reclassificationadjustment
      and tax effects
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            225
            
            
            225Total
      Comprehensive Income
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            6,902Cash
      dividends declared $1.02 per share
            
            -
            
            
            -
            
            
            -
            
            
            (2,789
            )
            
            -
            
            
            -
            
            
            
            -
            
            
            (2,789
            )Acquisition
      of treasury  stock
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            50,632
            
            
            (1,583
            )
            
            
            -
            
            
            (1,583
            )Stock
      options exercised
            
            -
            
            
            -
            
            
            (455
            )
            
            -
            
            
            (27,979
            )
            
            875
            
            
            
            -
            
            
            420Tax
      benefit on stock options exercised
            
            -
            
            
            -
            
            
            134
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            
            134Sale
      of treasury stock for ESOP
            
            -
            
            
            -
            
            
            (20
            )
            
            -
            
            
            (5,599
            )
            
            173
            
            
            
            -
            
            
            153Compensation
      expense related tostock
      options
            
            -
            
            
            -
            
            
            154
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            154Cumulative
      effect of net periodicpostretirement
      benefit
            
            -
            
            
            -
            
            
            -
            
            
            (520
            )
            
            -
            
            
            -
            
            
            
            -
            
            
            (520
            )BALANCE
      - DECEMBER 31, 2008
            
            2,840,872
            
            
            284
            
            
            9,972
            
            
            50,398
            
            
            104,310
            
            
            (3,243
            )
            
            
            1,279
            
            
            58,690Comprehensive
      Income:Net
      Income
            
            -
            
            
            -
            
            
            -
            
            
            7,063
            
            
            -
            
            
            -
            
            
            
            -
            
            
            7,063Change
      in unrealized gains onsecurities
      available for sale,net
      of reclassificationadjustment
      and tax effects
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            811
            
            
            811Total
      Comprehensive Income
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            7,874Cash
      dividends declared $1.09 per share
            
            -
            
            
            -
            
            
            -
            
            
            (3,006
            )
            
            -
            
            
            -
            
            
            
            -
            
            
            (3,006
            )Acquisition
      of treasury  stock
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            2,519
            
            
            (68
            )
            
            
            -
            
            
            (68
            )Stock
      options exercised
            
            -
            
            
            -
            
            
            (492
            )
            
            -
            
            
            (32,528
            )
            
            1,009
            
            
            
            -
            
            
            517Tax
      benefit on stock options exercised
            
            -
            
            
            -
            
            
            164
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            164Sale
      of treasury stock for ESOP
            
            -
            
            
            -
            
            
            (14
            )
            
            -
            
            
            (5,865
            )
            
            180
            
            
            
            -
            
            
            166Compensation
      expense related tostock
      options
            
            -
            
            
            -
            
            
            134
            
            
            -
            
            
            -
            
            
            
            
            
            
            -
            
            
            134BALANCE-DECEMBER
      31, 2009
            
            2,840,872
            
            $
            284
            
            $
            9,764
            
            $
            54,455
            
            
            68,436
            
            $
            (2,122
            )
            
            $
            2,090
            
            $
            64,471


See
notes to consolidated financial statements.


36


CONSOLIDATED
STATEMENTS OF CASH FLOWS





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
            
            $
            7,063
            
            $
            6,677
            
            $
            6,511Adjustments
      to reconcile net income to net cash provided byoperating
      activities:Provision
      for loan losses
            
            
            1,685
            
            
            735
            
            
            315Depreciation
            
            
            546
            
            
            577
            
            
            566Amortization
      of intangible assets
            
            
            52
            
            
            52
            
            
            52Deferred
      income taxes
            
            
            (749
            )
            
            36
            
            
            (151
            )Net
      amortization of securities premiums and discounts
            
            
            156
            
            
            44
            
            
            113Net
      realized (gains) losses on sales of securities
            
            
            (463
            )
            
            18
            
            
            (17
            )Gain
      on sale of deposits
            
            
            (150
            )
            
            —
            
            
            —Gain
      on life insurance policy
            
            
            (816
            )
            
            —
            
            
            —Net
      increase in investment in life insurance
            
            
            (351
            )
            
            (301
            )
            
            (288
            )(Gain)
      loss on sale of bank premises and equipment andforeclosed
      real estate
            
            
            360
            
            
            540
            
            
            (1
            )Gain
      on sale of mortgage loans and servicing rights
            
            
            (481
            )
            
            (499
            )
            
            (23
            )Mortgage
      loans originated for sale
            
            
            (21,743
            )
            
            (866
            )
            
            (794
            )Proceeds
      from sale of mortgage loans originated for sale
            
            
            22,224
            
            
            881
            
            
            817Compensation
      expense related to stock options
            
            
            134
            
            
            154
            
            
            251Increase
      in accrued interest receivable and other assets
            
            
            (1,528
            )
            
            (68
            )
            
            (414
            )Increase
      (decrease) in accrued interest payable and other
    liabilities
            
            
            65
            
            
            (829
            )
            
            (3,228
            )Net
      Cash Provided by Operating Activities
            
            
            6,004
            
            
            7,151
            
            
            3,709CASH
      FLOWS FROM INVESTING ACTIVITIESSecurities
      available for sale:Proceeds
      from sales
            
            
            15,449
            
            
            67
            
            
            74Proceeds
      from maturities and principal reductions onmortgage-backed
      securities
            
            
            44,047
            
            
            39,319
            
            
            52,408Purchases
            
            
            (58,409
            )
            
            (45,254
            )
            
            (62,005
            )Securities
      held to maturity, proceeds from maturities
            
            
            —
            
            
            —
            
            
            250Increase
      in investment in FHLB stock
            
            
            —
            
            
            (1,466
            )
            
            (385
            )Net
      increase in loans
            
            
            (14,912
            )
            
            (33,523
            )
            
            (15,839
            )Proceeds
      from sale of mortgage loans
            
            
            —
            
            
            13,988
            
            
            —Proceeds
      from life insurance policy
            
            
            1,346
            
            
            —
            
            
            —Purchase
      of bank premises and equipment
            
            
            (248
            )
            
            (325
            )
            
            (288
            )Proceeds
      from sales of premises and equipment and foreclosed real
      estate
            
            
            121
            
            
            —
            
            
            1Net
      Cash Used in Investing Activities
            
            
            (12,606
            )
            
            (27,194
            )
            
            (25,784
            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase (decrease) in deposits
            
            
            35,594
            
            
            (10,365
            )
            
            11,897Deposits
      sold
            
            
            (3,606
            )
            
            —
            
            
            —Net
      increase (decrease) in short-term borrowings
            
            
            (12,323
            )
            
            11,440
            
            
            3,950Proceeds
      from other borrowings
            
            
            —
            
            
            25,000
            
            
            15,000Repayments
      of other borrowings
            
            
            —
            
            
            (5,000
            )
            
            (5,000
            )Stock
      options exercised
            
            
            517
            
            
            420
            
            
            341Tax
      benefit of stock options exercised
            
            
            164
            
            
            134
            
            
            162ESOP
      purchase of shares from treasury stock
            
            
            166
            
            
            153
            
            
            144Purchase
      of treasury stock
            
            
            (68
            )
            
            (1,583
            )
            
            (2,313
            )Cash
      dividends paid
            
            
            (2,967
            )
            
            (2,740
            )
            
            (2,559
            )Net
      Cash Provided by Financing Activities
            
            
            17,477
            
            
            17,459
            
            
            21,622Net
      Increase (Decrease) in Cash and Cash Equivalents
            
            
            10,875
            
            
            (2,584
            )
            
            (453
            )CASH
      AND CASH EQUIVALENTS – BEGINNING
            
            
            6,480
            
            
            9,064
            
            
            9,517CASH
      AND CASH EQUIVALENTS – ENDING
            
            $
            17,355
            
            $
            6,480
            
            $
            9,064


See
notes to consolidated financial statements.


37


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 - NATURE OF OPERATIONS


Norwood
Financial Corp. (Company) is a one bank holding company. Wayne Bank (Bank) is
a


wholly-owned
subsidiary of the Company. The Bank is a state-chartered bank located in
Honesdale, Pennsylvania. The Company derives substantially all of its income
from the bank related services which include interest earnings on commercial
mortgages, residential real estate mortgages, commercial and consumer loans, as
well as interest earnings on investment securities and fees from deposit
services to its customers. The Company is subject to regulation and supervision
by the Federal Reserve Board while the Bank is subject to regulation and
supervision by the Federal Deposit Insurance Corporation and the Pennsylvania
Department of Banking.





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


Principles
of Consolidation


The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary, the Bank, and the Bank’s wholly-owned subsidiaries, WCB
Realty Corp., Norwood Investment Corp. and WTRO Properties. All intercompany
accounts and transactions have been eliminated in consolidation.





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.
Material estimates that are particularly susceptible to significant change in
the near term relate to the determination of the allowance for loan losses, the
potential impairment of restricted stock, the valuation of deferred tax assets
and the determination of other-than-temporary impairment on
securities.





Significant
Group Concentrations of Credit Risk


Most of
the Company’s activities are with customers located within northeastern
Pennsylvania. Note 3 discusses the types of securities that the Company invests
in. Note 4 discusses the types of lending that the Company engages in. The
Company does not have any significant concentrations to any one industry or
customer.





Concentrations
of Credit Risk


The Bank
operates primarily in Wayne, Pike and Monroe Counties, Pennsylvania and,
accordingly, has extended credit primarily to commercial entities and
individuals in this area whose ability to honor their contracts is influenced by
the region’s economy. These customers are also the primary depositors of the
Bank. The Bank is limited in extending credit by legal lending limits to any
single borrower or group of borrowers.





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 movement in interest rates, changes in
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 and losses are
reported 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 a method which approximates the interest method over
the term of the security.


38





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


Bonds,
notes and debentures for which the Company has the positive intent and ability
to hold to maturity are reported at cost, adjusted for premiums and discounts
that are recognized in interest income using the interest method over the term
of the security.





Management
determines the appropriate classification of debt securities at the time of
purchase and re-evaluates such designation as of each balance sheet
date.





Declines
in the fair value of held to maturity and 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 of the Company to not sell the
securities and it is more likely than not that it will not have to sell the
securities before recovery of their cost basis.





Federal
law requires a member institution of the Federal Home Loan Bank (FHLB) system to
hold stock of its district FHLB according to a predetermined formula. This
restricted stock is carried at cost.





Restricted
stock which represents required investment in the common stock of correspondent
banks is carried at cost as of December 31, 2009 and 2008, consists of the
common stock of FHLB of Pittsburgh. In December 2008, the FHLB of Pittsburgh
notified member banks that it was suspending dividend payments and the
repurchase of excess capital stock.





Management
evaluates the restricted stock for impairment. Management’s determination of
whether these investments are impaired is based on their assessment of the
ultimate recoverability of their cost rather than by recognizing temporary
declines in value. The determination of whether a decline affects the ultimate
recoverability of their cost is influenced by criteria such as (1) the
significance of the decline in net assets of the FHLB as compared to the capital
stock amount for the FHLB and the length of time this situation has persisted,
(2) commitments by the FHLB to make payments required by law or regulation and
the level of such payments in relation to the operating performance of the FHLB,
and (3) the impact of legislative and regulatory changes on institutions and,
accordingly, on the customer base of the FHLB. Management believes no impairment
charge is necessary related to FHLB stock as of December 31, 2009.





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. Interest income is accrued on the unpaid principal balance. Loan
origination fees are deferred and recognized as an adjustment of the yield
(interest income) of the related loans. ­The Company is generally amortizing
these amounts over the contractual life of the loan.





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 collectability 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 nonaccrual status, unpaid interest credited to income in the
current year is reversed and unpaid interest accrued in prior
years


39





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


is
charged against the allowance for loan losses. Interest received on nonaccrual
loans generally is either ­applied against principal or reported as interest
income, according to management’s judgment as to the collectability 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 collectability of the total contractual
principal and interest is no longer in doubt.





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 Company’s past loan
loss experience, known and 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 material estimates that may be susceptible to significant
revision as more information becomes available.





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
of 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 Company 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 Company does not separately identify individual
consumer and residential real estate loans for impairment disclosures, unless
such loans are the subject of a restructuring agreement.





40


NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


Premises
and Equipment


Premises
and equipment are stated at cost less accumulated depreciation. Depreciation
expense is calculated principally on the straight-line method over the
respective assets estimated useful lives as follows:





YearsBuildings
      and improvements
            
            10
      - 40Furniture
      and equipment
            
            3
      - 10





Transfers
of Financial Assets


Transfers
of financial assets, including loan and 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.





Foreclosed
Real Estate


Real
estate properties acquired through, or in lieu of, loan foreclosure are to be
sold and are initially recorded at fair value less cost to sell at the date of
foreclosure establishing a new cost basis. After foreclosure, valuations are
periodically performed by management and the real estate is carried at the lower
of its carrying amount or fair value less cost to sell. Revenue and expenses
from operations and changes in the valuation allowance are included in other
expenses.





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. Income from the increase in cash surrender
value of the policies is included in other income on the income
statement.





Intangible
Assets


At
December 31, 2009 and 2008, the Company had intangible assets of $65,000 and
$117,000 arising from the purchase of deposits in 1996, which is net of
accumulated amortization of $715,000 and $663,000 which are included in other
assets. These intangible assets will continue to be amortized on a straight-line
basis over fifteen years. Amortization expense related to intangible assets was
$52,000 for each of the years ended December 31, 2009, 2008 and 2007. The
amortization expense will be $52,000 for the year ended December 31, 2010 and
$13,000 for the year ended December 31, 2011.





Income
Taxes


Deferred
income tax assets and liabilities are determined based on the differences
between financial statement carrying amounts and the tax basis of existing
assets and liabilities. These differences are measured at the enacted tax rates
that will be in effect when these differences reverse. 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. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes. The Company and
its subsidiary file a consolidated federal income tax return.


41





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


Generally
accepted accounting principles in the United States require an entity to analyze
each tax position taken in its tax returns and determine the likelihood that the
position will be realized. Only tax positions that are “more-likely-than-not” to
be realized can be recognized in an entity’s financial statements. For tax
positions that do not meet this recognition threshold, an entity will record an
unrecognized tax benefit for the difference between the position taken on the
tax return and the amount recognized in the financial statements. The Company
does not have any unrecognized tax benefits at December 31 2009 or 2008 or
during the years then ended. No unrecognized tax benefits are expected to arise
within the next twelve months.





Advertising
Costs


The
Company follows the policy of charging the costs of advertising to expense as
incurred.





Earnings
per 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.





Stock
Option Plans


Generally
accepted accounting principles in the United States require the value of
share-based payment transactions to be recognized as compensation costs in the
financial statements over the period that an employee provides service in
exchange for the award. The fair value of the share-based payments is estimated
using the Black-Scholes option-pricing model. The Company used the
modified-prospective transition 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 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.





Fair
Value Measurements


Generally
accepted accounting principles in the United States of America established a
fair value hierarchy that prioritizes the inputs to valuation methods used to
measure fair value. The hierarchy gives the highest priority to unadjusted
quoted prices in active markets for identical assets or liabilities (Level 1
measurements) and the lowest priority to unobservable inputs (Level 3
measurements). The three levels of the fair value hierarchy are as
follows:





Level
      1:
            
            Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date foridentical, unrestricted assets or liabilities.Level
      2:
            
            Quoted
      prices in markets that are not active, or inputs that are observable
      either directly or indirectly, for substantially the full term of the
      asset or liability.Level
      3:
            
            Prices
      or valuation techniques that require inputs that are both significant to
      the fair value measurement and are unobservable (i.e. supported with
      little or no market activity).





An
asset’s or liability’s level within the fair value hierarchy is based on the
lowest level of input that is significant to the fair value
measurement.


42





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


Cash
Flow Information


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





Cash
payments for interest for the period December 31, 2009, 2008 and 2007 were
$7,916,000, $10,645,000 and $11,679,000, respectively. Cash payments for income
taxes in 2009 were $2,441,000 compared to $3,138,000 in 2008 and $2,845,000 in
2007. Non-cash investing activity for 2009, 2008, and 2007 included foreclosed
mortgage loans transferred to real estate owned and repossession of other assets
of $296,000, $1,328,000 and $48,000, respectively.





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, letters of
credit and commitments to sell loans. Such financial instruments are recorded in
the balance sheets when they become receivable or payable.





Trust
Assets


Assets
held by the Company in a fiduciary capacity for customers are not included in
the financial statements since such items are not assets of the Company. Trust
income is reported on the accrual method.





Comprehensive
Income


Accounting
principles generally 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.





The
components of other comprehensive income and related tax effects are as
follows:





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands)Unrealized
      holding gains on available for sale securities
            
            $
            1,701
            
            $
            311
            
            $
            1,665Reclassification
      adjustment for gains (losses) realized in income
            
            
            463
            
            
            (18
            )
            
            17Net
      Unrealized Gains
            
            
            1,238
            
            
            329
            
            
            1,648Income
      tax expense
            
            
            427
            
            
            104
            
            
            550Net
      of Tax Amount
            
            $
            811
            
            $
            225
            
            $
            1,098





Segment
Reporting


The
Company acts as an independent community financial service provider and offers
traditional banking and related financial services to individual, business and
government customers. Through its branch and automated teller machine network,
the Company 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 safe deposit
services. The Company also performs personal, corporate, pension and fiduciary
services through its Trust Department.





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


43


NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


New
Accounting Standards


In June
2009, the Financial Accounting Standards Board (“FASB”) issued Accounting
Standards Update (“ASU”) No. 2009-01, Topic 105 - Generally Accepted Accounting
Principles - FASB Accounting Standards CodificationTM and the Hierarchy of
Generally Accepted Accounting Principles. The Codification is the single
source of authoritative nongovernmental U.S. generally accepted accounting
principles (GAAP).  The Codification does not change current GAAP, but
is intended to simplify user access to all authoritative GAAP by providing all
the authoritative literature related to a particular topic in one place. Rules
and interpretive releases of the SEC under federal securities laws are also
sources of authoritative GAAP for SEC registrants. The Company adopted this
standard for the interim reporting period ending September 30,
2009.





In June
2008, the FASB issued accounting guidance related to determining whether
instruments granted in share-based payment transactions are participating
securities, which is effective for financial statements issued for fiscal years
beginning after December 15, 2008, and interim periods within those years. This
guidance clarified that instruments granted in share-based payment transactions
can be participating securities prior to the requisite service having been
rendered. A basic principle of this guidance is that unvested share-based
payment awards that contain nonforfeitable rights to dividends or dividend
equivalents (whether paid or unpaid) are participating securities and are to be
included in the computation of EPS pursuant to the two-class method. All
prior-period EPS data presented (including interim financial statements,
summaries of earnings, and selected financial data) are required to be adjusted
retrospectively to conform with this guidance. This accounting guidance was
subsequently codified into ASC Topic 260, Earnings Per Share. The adoption of
this new guidance did not have a material impact on the Company.





In April
2009, the FASB issued new guidance impacting ASC Topic 820, Fair Value
Measurements and Disclosures. This ASC provides additional guidance in
determining fair values when there is no active market or where the price inputs
being used represent distressed sales. It reaffirms the need to use judgment to
ascertain if a formerly active market has become inactive and in determining
fair values when markets have become inactive. The adoption of this new guidance
did not have a material effect on the Company’s results of operations or
financial position.





In
September 2006, the FASB issued an accounting standard related to fair
value measurements, which was effective for the Company on January 1, 2008.
This standard defined fair value, established a framework for measuring fair
value, and expanded disclosure requirements about fair value measurements. On
January 1, 2008, the provisions of this accounting standard became
effective for the Company’s financial assets and financial liabilities and on
January 1, 2009 for nonfinancial assets and nonfinancial liabilities. This
accounting standard was subsequently codified into ASC Topic 820, Fair Value
Measurements and Disclosures. See Note 16 for the necessary
disclosures.





In August
2009, the FASB issued ASU No. 2009-05, Fair Value Measurements and Disclosures
(Topic 820) – Measuring Liabilities at Fair Value. This ASU provides amendments
for fair value measurements of liabilities. It provides clarification that in
circumstances in which a quoted price in an active market for the identical
liability is not available, a reporting entity is required to measure fair value
using one or more techniques. ASU 2009-05 also clarifies that when estimating a
fair value of a liability, a reporting entity is not required to include a
separate input or adjustment to other inputs relating to the existence of a
restriction that prevents the transfer of the liability. ASU 2009-05 is
effective for the first reporting period (including interim periods) beginning
after issuance or fourth quarter 2009. The Company has presented the necessary
disclosures in Note 16 herein.


44





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


In April
2009, the FASB issued new guidance impacting ASC 825-10-50, Financial
Instruments, which relates to fair value disclosures for any financial
instruments that are not currently reflected on the balance sheet of companies
at fair value. This guidance amended existing GAAP to require disclosures about
fair value of financial instruments for interim reporting periods of publicly
traded companies as well as in annual financial statements. This guidance is
effective for interim and annual periods ending after June 15,
2009.  The Company has presented the necessary disclosures in Note
16 herein.





In April
2009, the FASB issued new guidance impacting ASC 320-10, Investments — Debt and
Equity Securities, which provides additional guidance designed to create greater
clarity and consistency in accounting for and presenting impairment losses on
securities. This guidance is effective for interim and annual periods ending
after June 15, 2009. The Company has presented the necessary disclosures in Note
4 herein.





In
June 2009, the FASB issued an accounting standard related to the accounting
for transfers of financial assets, which is effective for fiscal years beginning
after November 15, 2009, and interim periods within those fiscal years.
This standard enhances reporting about transfers of financial assets, including
securitizations, and where companies have continuing exposure to the risks
related to transferred financial assets. This standard eliminates the concept of
a “qualifying special-purpose entity” and changes the requirements for
derecognizing financial assets. This standard also requires additional
disclosures about all continuing involvements with transferred financial assets
including information about gains and losses resulting from transfers during the
period. This accounting standard was subsequently codified into ASC Topic 860,
Transfers and Servicing. The adoption of this standard is not expected to have a
material effect on the Company’s results of operations or financial
position.





In
December 2007, the FASB issued an accounting standard related to
noncontrolling interests in consolidated financial statements, which is
effective for fiscal years beginning on or after December 15, 2008. This
standard establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary and for the deconsolidation of a subsidiary. It
clarifies that a noncontrolling interest in a subsidiary, which is sometimes
referred to as minority interest, is an ownership interest in the consolidated
entity that should be reported as equity in the consolidated financial
statements. Among other requirements, this statement requires consolidated net
income to be reported at amounts that include the amounts attributable to both
the parent and the noncontrolling interest. It also requires disclosure, on the
face of the consolidated income statement, of the amounts of consolidated net
income attributable to the parent and to the noncontrolling
interest.  This accounting standard was subsequently codified into ASC
810-10, Consolidation. The adoption of this standard did not have a material
effect on the Company’s financial statements.





On April
1, 2009, the FASB issued new authoritative accounting guidance under ASC
Topic 805, Business Combinations, which became effective for periods
beginning after December 15, 2008. ASC Topic 805 applies to all
transactions and other events in which one entity obtains control over one or
more other businesses. ASC Topic 805 requires an acquirer, upon initially
obtaining control of another entity,


45





NOTE
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


to
recognize the assets, liabilities and any non-controlling interest in the
acquiree at fair value as of the acquisition date. Contingent consideration is
required to be recognized and measured at fair value on the date of acquisition
rather than at a later date when the amount of that consideration may be
determinable beyond a reasonable doubt. This fair value approach replaces the
cost-allocation process required under previous accounting guidance whereby the
cost of an acquisition was allocated to the individual assets


acquired
and liabilities assumed based on their estimated fair value. ASC Topic 805
requires acquirers to expense acquisition-related costs as incurred rather than
allocating such costs to the assets acquired and liabilities assumed, as was
previously the case under prior accounting guidance. Assets acquired and
liabilities assumed in a business combination that arise from contingencies are
to be recognized at fair value if fair value can be reasonably estimated. If
fair value of such an asset or liability cannot be reasonably estimated, the
asset or liability would generally be recognized in accordance with ASC
Topic 450, Contingencies. Under ASC Topic 805, the requirements of ASC
Topic 420, Exit or Disposal Cost Obligations, would have to be met in order
to accrue for a restructuring plan in purchase accounting. Pre-acquisition
contingencies are to be recognized at fair value, unless it is a non-contractual
contingency that is not likely to materialize, in which case, nothing should be
recognized in purchase accounting and, instead, that contingency would be
subject to the probable and estimable recognition criteria of ASC
Topic 450, Contingencies. The adoption of this new guidance did not have a
material impact on the Company’s financial position or results of
operations.





In
June 2009, the FASB issued new authoritative accounting guidance under ASC
Topic 810, Consolidation, which amends prior guidance to change how a
company determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. The
determination of whether a company is required to consolidate an entity is based
on, among other things, an entity’s purpose and design and a company’s ability
to direct the activities of the entity that most significantly impact the
entity’s economic performance. The new authoritative accounting guidance
requires additional disclosures about the reporting entity’s involvement with
variable-interest entities and any significant changes in risk exposure due to
that involvement as well as its affect on the entity’s financial statements. The
new authoritative accounting guidance under ASC Topic 810 will be effective
January 1, 2010 and is not expected to have a significant impact on the
Company’s financial statements.





On
December 30, 2008, the FASB issued new authoritative accounting guidance under
ASC Topic 715, Compensation—Retirement Benefits, which provides guidance
related to an employer’s disclosures about plan assets of defined benefit
pension or other post-retirement benefit plans. Under ASC Topic 715,
disclosures should provide users of financial statements with an understanding
of how investment allocation decisions are made, the factors that are pertinent
to an understanding of investment policies and strategies, the major categories
of plan assets, the inputs and valuation techniques used to measure the fair
value of plan assets, the effect of fair value measurements using significant
unobservable inputs on changes in plan assets for the period and significant
concentrations of risk within plan assets. This guidance is effective fiscal
year ending after December 15, 2009. The adoption of this new guidance did not
have a material impact on the Company’s financial statements.


46





NOTE
3 – CHANGE IN ACCOUNTING PRINCIPLE


Generally
accepted accounting principles in the United States require the recognition of a
liability related to the postretirement benefits covered by an endorsement
split-dollar life insurance arrangement. The employer (who is also the
policyholder) has a liability for the benefit it is providing to its employee.
As such, if the policyholder has agreed to maintain the insurance policy in
force for the employee’s benefit during his or her retirement, then the
liability recognized during the employee’s active service period should be based
on the future cost of insurance to be incurred during the employee’s retirement.
Alternatively, if the policyholder has agreed to provide the employee with a
death benefit, then the liability for the future death benefit should be
recognized. For transition, an entity can choose to apply the guidance using
either the following approaches: (a) a change in accounting principle through
retrospective application to all periods presented or (b) a change in accounting
principle through a cumulative-effect adjustment to the balance in retained
earnings at the beginning of the year of adoption. The Company has chosen
approach (b) and recorded a cumulative effect adjustment as of January 1, 2008
to the balance of retained earnings of $520,000.  Net Periodic
Postretirement Benefit expense included in salaries and employee benefits was
$166,000 and $90,000 for the years ended December 31, 2009 and 2008,
respectively.





NOTE
4 - SECURITIES





December
      31, 2009Amortized
              Cost
            
            Gross
              Unrealized
              Gains
            
            Gross
              Unrealized
              Losses
            
            Fair
              Value(In
      Thousands)AVAILABLE
      FOR SALE:U.S.
      Government agencies
            
            $
            39,607
            
            $
            295
            
            $
            (130
            )
            $
            39,772States
      and political subdivisions
            
            
            30,872
            
            
            780
            
            
            (17
            )
            
            31,635Corporate
      obligations
            
            
            5,043
            
            
            200
            
            
            (3
            )
            
            5,240Mortgage-backed
      securities
            
            
            51,554
            
            
            1,618
            
            
            (18
            )
            
            53,154127,076
            
            
            2,893
            
            
            (168
            )
            
            129,801Equity
      securities
            
            
            330
            
            
            451
            
            
            (5
            )
            
            776127,406
            
            
            3,344
            
            
            (173
            )
            
            130,577HELD
      TO MATURITY:States
      and political subdivisions
            
            $
            708
            
            $
            14
            
            $
            —
            
            $
            722December
      31, 2008Amortized
              Cost
            
            Gross
              Unrealized
              Gains
            
            Gross
              Unrealized
              Losses
            
            Fair
              Value(In
      Thousands)AVAILABLE
      FOR SALE:U.S.
      Government agencies
            
            $
            34,989
            
            $
            836
            
            $
            (12
            )
            $
            35,813States
      and political subdivisions
            
            
            25,436
            
            
            110
            
            
            (337
            )
            
            25,209Corporate
      obligations
            
            
            6,065
            
            
            —
            
            
            (440
            )
            
            5,625Mortgage-backed
      securities
            
            
            61,198
            
            
            1,340
            
            
            (220
            )
            
            62,318127,688
            
            
            2,286
            
            
            (1,009
            )
            
            128,965Equity
      securities
            
            
            500
            
            
            754
            
            
            (99
            )
            
            1,155$
            128,188
            
            $
            3,040
            
            $
            (1,108
            )
            $
            130,120HELD
      TO MATURITY:States
      and political subdivisions
            
            $
            707
            
            $
            13
            
            $
            —
            
            $
            720





47


NOTE
4 - SECURITIES  (CONTINUED)


The
following tables show the Company’s investments’ gross unrealized losses and
fair value aggregated by length of time that individual securities have been in
a continuous unrealized loss position:





December
      31, 2009Less
      than 12 Months
            
            12
      Months or More
            
            TotalFair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              Losses(In
      Thousands)U.S.
      Government agencies
            
            $
            15,366
            
            $
            (130
            )
            $
            —
            
            $
            —
            
            $
            15,366
            
            $
            (130
            )States
      and political subdivisions
            
            
            1,413
            
            
            (17
            )
            
            —
            
            
            —
            
            
            1,413
            
            
            (17
            )Corporate
      obligations
            
            
            997
            
            
            (3
            )
            
            —
            
            
            —
            
            
            997
            
            
            (3
            )Mortgage-backed
      securities
            
            
            3,655
            
            
            (18
            )
            
            —
            
            
            —
            
            
            3,655
            
            
            (18
            )Equity
      securities
            
            
            49
            
            
            (3
            )
            
            5
            
            
            (2
            )
            
            54
            
            
            (5
            )$
            21,480
            
            $
            (171
            )
            $
            5
            
            $
            (2
            )
            $
            21,485
            
            $
            (173
            )December
      31, 2008Less
      than 12 Months
            
            12
      Months or More
            
            TotalFair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              Losses(In
      Thousands)U.S.
      Government agencies
            
            $
            988
            
            $
            (12
            )
            $
            —
            
            $
            —
            
            $
            988
            
            $
            (12
            )States
      and political subdivisions
            
            
            13,653
            
            
            (337
            )
            
            —
            
            
            —
            
            
            13,653
            
            
            (337
            )Corporate
      obligations
            
            
            3,886
            
            
            (180
            )
            
            1,739
            
            
            (260
            )
            
            5,625
            
            
            (440
            )Mortgage-backed
      securities
            
            
            13,610
            
            
            (220
            )
            
            —
            
            
            —
            
            
            13,610
            
            
            (220
            )Equity
      Securities
            
            
            20
            
            
            (3
            )
            
            69
            
            
            (96
            )
            
            89
            
            
            (99
            )$
            32,157
            
            $
            (752
            )
            $
            1,808
            
            $
            (356
            )
            $
            33,965
            
            $
            (1,108
            )





The
Company has 24 securities in the less than twelve month category and one
security in the twelve months or more category as of December 31, 2009 compared
to 67 securities in the less than twelve month category and 5 securities greater
than twelve months as of December 31, 2008. In management’s opinion, the
unrealized losses in the U.S. Government agencies and the mortgage-backed
securities reflect changes in interest rates subsequent to the acquisition of
specific securities. The unrealized losses in the State and Political
Subdivisions and Corporate Obligations also reflect a widening of spreads due to
liquidity and credit concerns in the financial markets. The Company holds a
small amount of equity securities in other financial institutions, the value of
which has been impacted by weakened conditions of the financial market. As a
result, the Company recorded an other-than-temporary-impairment charge on two
equity holdings totaling $31,000. Management believes that all other unrealized
losses represent temporary impairment of the securities, as it is the intent of
the Company to not sell the securities and it is more likely than not that it
will not have to sell the securities before recovery of their cost
basis





The
amortized cost and fair value of securities as of December 31, 2009 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 call or prepayment penalties.





Available
      for Sale
            
            Held
      to MaturityAmortized
              Cost
            
            Fair
              Value
            
            Amortized
              Cost
            
            Fair
              Value(In
      Thousands)Due
      in one year or less
            
            $
            1,285
            
            $
            1,284
            
            $
            —
            
            $
            —Due
      after one year through five years
            
            
            35,618
            
            
            36,087
            
            
            168
            
            
            179Due
      after five years through ten years
            
            
            25,628
            
            
            25,960
            
            
            540
            
            
            543Due
      after ten years
            
            
            12,991
            
            
            13,316
            
            
            —
            
            
            —75,522
            
            
            76,647
            
            
            708
            
            
            722Mortgage-backed
      securities
            
            
            51,554
            
            
            53,154
            
            
            —
            
            
            —$
            127,076
            
            $
            129,801
            
            $
            708
            
            $
            722








48


NOTE
4 - SECURITIES  (CONTINUED)


Gross
realized gains and gross realized losses on sales of securities available for
sale were $597,000 and $134,000, respectively, in 2009, $44,000 and $62,000,
respectively, in 2008, $40,000 and $23,000, respectively, in 2007. The proceeds
from the sales of securites totaled $15,449,000, $67,000 and $74,000 for the
years ended December 31, 2009, 2008 and 2007, respectively.





Securities
with a carrying value of $65,438,000 and $51,444,000 at December 31, 2009
and 2008, respectively, were pledged to secure public deposits, U.S. Treasury
demand notes, securities sold under agreements to repurchase and for other
purposes as required or permitted by law.





NOTE
5 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES


The
components of loans receivable at December 31 were as follows:





2009
            
            2008(In
      Thousands)Real
      estate:Residential
            
            $
            130,318
            
            $
            133,417Commercial
            
            
            180,266
            
            
            159,476Construction
            
            
            14,405
            
            
            14,856Commercial,
      financial and agricultural
            
            
            24,116
            
            
            25,886Consumer
      loans to individuals
            
            
            14,850
            
            
            16,087363,955
            
            
            349,722Unearned
      income and deferred fees
            
            
            (481
            )
            
            (318
            )Allowance
      for loan losses
            
            
            (5,453
            )
            
            (4,233
            )$
            358,021
            
            $
            345,171





The
following table presents changes in the allowance for loan losses:





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands)Balance,
      beginning
            
            $
            4,233
            
            $
            4,081
            
            $
            3,828Provision
      for loan losses
            
            
            1,685
            
            
            735
            
            
            315Recoveries
            
            
            49
            
            
            60
            
            
            59Loans
      charged off
            
            
            (514
            )
            
            (643
            )
            
            (121
            )Balance,
      ending
            
            $
            5,453
            
            $
            4,233
            
            $
            4,081





The
recorded investment in impaired loans, not requiring an allowance for loan
losses was $6,962,000 (net of charge-offs against the allowance for loan losses
of $154,000) and $2,976,000 (net of charge-offs against the allowance for loan
losses of $380,000) at December 31, 2009 and 2008, respectively. The
recorded investment in impaired loans requiring an allowance for loan losses was
$1,065,000 (net of a charge-off against the allowance for loan losses of
$480,000) and $-0- at December 31, 2009 and 2008, respectively. The
specific reserve related to impaired loans was $36,000 for 2009 and -0- for
2008. For the years ended December 31, 2009, 2008 and 2007, the average
recorded investment in these impaired loans was $3,585,221, $3,331,000 and
$3,127,000, and the interest income recognized on these impaired loans was
$139,000, $143,000 and $290,000, respectively.





Loans on
which the accrual of interest has been discontinued amounted to $4,916,000 and
$2,087,000 at December 31, 2009 and 2008, respectively. Loan balances past
due 90 days or more and still accruing interest, but which management expects
will eventually be paid in full, amounted to $99,000 and -0- at
December 31, 2009 and 2008, respectively. Interest income that would have
been recorded on loans accounted for on a non-accrual basis under the original
terms of the loans was $188,000, $31,000 and $6,000 for 2009, 2008 and 2007,
respectively.





49


NOTE
5 - LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)


The
Company’s primary business activity is with customers located in northeastern
Pennsylvania. Accordingly, the Company has extended credit primarily to
commercial entities and individuals in this area whose ability to honor their
contracts is influenced by the region’s economy. The Company does not have any
significant concentrations to any one industry or customer.





NOTE
6 - PREMISES AND EQUIPMENT


Components
of premises and equipment at December 31 are as follows:





2009
            
            2008(In
      Thousands)Land
      and improvements
            
            $
            925
            
            $
            925Buildings
      and improvements
            
            
            7,933
            
            
            7,948Furniture
      and equipment
            
            
            5,158
            
            
            5,05014,016
            
            
            13,923Accumulated
      depreciation
            
            
            (8,827
            )
            
            (8,433
            )$
            5,189
            
            $
            5,490





Depreciation
expense totaled $546,000, $577,000 and $566,000 for the years ended December 31,
2009, 2008 and 2007, respectively.





Certain
facilities are leased under various operating leases. Rental expense for these
leases was $284,000, $280,000, and $283,000, for the years ended
December 31, 2009, 2008 and 2007. Future minimum rental commitments under
noncancellable leases as of December 31, 2009 were as follows (in
thousands):





2010
            
            $   2462011
            
            2572012
            
            2662013
            
            2692014
            
            258Thereafter
            
            2,051$3,347





NOTE
7 - DEPOSITS


Aggregate
time deposits in denominations of $100,000 or more were $66,631,000 and
$45,095,000 at December 31, 2009 and 2008, respectively.





At
December 31, 2009, the scheduled maturities of time deposits are as follows
(in thousands):





2010
            
            $139,1102011
            
            25,7252012
            
            13,6012013
            
            11,7032014
            
            2,646$192,785





NOTE
8 - BORROWINGS


Short-term
borrowings at December 31 consist of the following:





2009
            
            2008(In
      Thousands)Securities
      sold under agreements to repurchase
            
            $
            25,606
            
            $
            23,404Federal
      funds purchased
            
            
            —
            
            
            3,600Short-term
      FHLB advances
            
            
            —
            
            
            11,000U.S.
      Treasury demand notes
            
            
            197
            
            
            122$
            25,803
            
            $
            38,126





50


NOTE
8 - BORROWINGS (CONTINUED)


The
outstanding balances and related information of short-term borrowings are
summarized as follows:





Years
      Ended December 31,2009
            
            2008(Dollars
      in Thousands)Average
      balance during the year
            
            $
            26,402
            
            $
            32,238Average
      interest rate during the year
            
            
            1.11
            %
            
            2.14
            %Maximum
      month-end balance during the year
            
            $
            35,323
            
            $
            42,061Weighted
      average interest rate at the end of the year
            
            
            .56
            %
            
            1.11
            %





Securities
sold under agreements to repurchase generally mature within one day to one year
from the transaction date. Securities with an amortized cost and fair value of
$26,910,000 and $27,240,000 at December 31, 2009 and $26,617,000 and
$27,314,000 at December 31, 2008 were pledged as collateral for these
agreements. The securities underlying the agreements were under the Company’s
control.





The
Company has a line of credit commitment available from the FHLB of Pittsburgh
for borrowings of up to $20,000,000 which expires in December 2011. There were
no borrowings under this line at December 31, 2009 and 2008. The Company
has a line of credit commitment available from Atlantic Central Bankers Bank for
$7,000,000. There were no borrowings under this line of credit at
December 31, 2009 and 2008. The Company has a line of credit commitment
available which has no expiration date from PNC Bank for $12,000,000. Borrowings
under this line of credit were $-0- at December 31, 2009 and $3,600,000 at
December 31, 2008.





The Bank
maintains a U. S. Treasury tax and loan note option account for the deposit of
withholding taxes, corporate income taxes and certain other payments to the
federal government. Deposits are subject to withdrawal and are evidenced by an
open-ended interest-bearing note. Borrowings under this note option account were
$197,000 and $122,000 at December 31, 2009 and 2008, respectively.





Other
borrowings consisted of the following at December 31, 2009 and
2008:





2009
            
            2008(In
      Thousands)Notes
      with the FHLB:Fixed
      rate note due September 2010 at 3.53%
            
            $
            5,000
            
            $
            5,000Convertible
      note due January 2011 at 5.24%
            
            
            3,000
            
            
            3,000Convertible
      note due August 2011 at 2.69%
            
            
            10,000
            
            
            10,000Fixed
      rate note due September 2011 at 4.06%
            
            
            5,000
            
            
            5,000Convertible
      note due October 2012 at 4.37%
            
            
            5,000
            
            
            5,000Convertible
      note due May 2013 at 3.015%
            
            
            5,000
            
            
            5,000Convertible
      note due January 2017 at 4.71%
            
            
            10,000
            
            
            10,000$
            43,000
            
            $
            43,000





51





NOTE
8 - BORROWINGS (CONTINUED)


The
convertible notes contain an option which allows the FHLB, at quarterly
intervals, to change the note to an adjustable-rate advance at three-month LIBOR
plus 11 to 19 basis points. If the notes are converted, the option allows the
Bank to put the funds back to the FHLB at no charge.





Contractual
maturities of other borrowings at December 31, 2009 are as follows (in
thousands):





2010
            
            $   5,0002011
            
            18,0002012
            
            5,0002013
            
            5,0002014
            
            --Thereafter
            
            10,000$43,000





The
Bank’s maximum borrowing capacity with the FHLB was $197,553,000 of which
$43,000,000 was outstanding at December 31, 2009. Advances from the FHLB
are secured by qualifying assets of the Bank.





NOTE
9 - EMPLOYEE BENEFIT PLANS


The
Company has a defined contributory profit-sharing plan which includes provisions
of a 401(k) plan. The plan permits employees to make pre-tax contributions up to
15% of the employee’s compensation. The amount of contributions to the plan,
including matching contributions, is at the discretion of the Board of
Directors. All employees over the age of 21 are eligible to participate in the
plan after one year of employment. Employee contributions are vested at all
times, and any Company contributions are fully vested after five years. The
Company’s contributions are expensed as the cost is incurred, funded currently,
and amounted to $373,000, $317,000, and $400,000 for the years ended
December 31, 2009, 2008 and 2007, respectively.





The
Company has a non-qualified supplemental executive retirement plan for the
benefit of certain executive officers. At December 31, 2009 and 2008, other
liabilities include $1,419,000 and $1,062,000 accrued under the Plan.
Compensation expense includes approximately $360,000, $96,000, $108,000,
relating to the supplemental executive retirement plan for 2009, 2008 and 2007,
respectively. To fund the benefits under this plan, the Company is the owner of
single premium life insurance policies on participants in the non-qualified
retirement plan. At December 31, 2009 and 2008, the cash value of these
policies was $7,889,000 and $8,068,000, respectively.





The
Company has a leveraged employee stock ownership plan (“ESOP”) for the benefit
of employees who meet the eligibility requirements which include having
completed one year of service with the Company and having attained age
twenty-one. The ESOP Trust purchased shares of the Company’s common stock with
proceeds from a loan from the Company. The Bank made cash contributions to the
ESOP on an annual basis sufficient to enable the ESOP to make the required loan
payments. The loan bears interest at the prime rate adjusted annually. Interest
is payable annually and principal payable in equal annual installments over ten
years. The loan was secured by the shares of the stock purchased and was paid
off in 2006.


52





NOTE
9 - EMPLOYEE BENEFIT PLANS  (CONTINUED)


As the
debt was repaid, shares were released from collateral and allocated to qualified
employees based on the proportion of debt service paid in the year. The shares
pledged as collateral are reported as unallocated ESOP shares in the
consolidated balance sheets. As shares are released from collateral, the Company
reports compensation expense equal to the current market price of the shares,
and the shares become outstanding for earnings per share computations. Dividends
on allocated ESOP shares are recorded as a reduction of retained earnings and
dividends on unallocated ESOP shares are recorded as a reduction of
debt.





Compensation
expense for the ESOP was $-0- for the years ended December 31, 2009, 2008,
and


2007,
respectively.





The
status of the ESOP shares at December 31 are as follows:





2009
            
            2008Allocated
      shares
            
            
            
            
            158,903
            
            
            157,591Shares
      released from allocation
            
            
            
            
            32,006
            
            
            33,318Unreleased
      shares
            
            
            
            
            —
            
            
            —Total
      ESOP shares
            
            
            
            
            190,909
            
            
            190,909Fair
      value of unreleased shares
            
            
            
            $
            —
            
            $
            —





NOTE
10 - INCOME TAXES


The
components of the provision for federal income taxes are as
follows:





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands)Current
            
            $
            3,031
            
            $
            2,800
            
            $
            2,780Deferred
            
            
            (749
            )
            
            36
            
            
            (151
            )$
            2,282
            
            $
            2,836
            
            $
            2,629





Deferred
income taxes reflect temporary differences in the recognition of revenue and
expenses for tax reporting and financial statement purposes, principally because
certain items, such as, the allowance for loan losses and loan fees are
recognized in different periods for financial reporting and tax return purposes.
A valuation allowance has not been established for deferred tax assets.
Realization of the deferred tax assets is dependent on generating sufficient
taxable income. Although realization is not assured, management believes it is
more likely than not that all of the deferred tax asset will be realized.
Deferred tax assets are recorded in other assets.





Income
tax expense of the Company is less than the amounts computed by applying
statutory federal income tax rates to income before income taxes because of the
following:





Percentage
      of Income
              before
      Income TaxesYears
      Ended December 31,2009
            
            2008
            
            2007Tax
      at statutory rates
            
            34.0
            %
            34.0
            %
            34.0
            %Tax
      exempt interest income, net of interest expense
    disallowance
            
            (5.0
            )
            (3.9
            )
            (3.4
            )Incentive
      stock options
            
            0.4
            
            0.5
            
            0.8Earnings
      on life insurance
            
            (4.1
            )
            (.7
            )
            (1.1
            )Other
            
            (0.9
            )
            (.1
            )
            (1.5
            )24.4
            %
            29.8
            %
            28.8
            %





53


NOTE
10 – INCOME TAXES (CONTINUED)


The
income tax provision includes $157,000 and $6,000 of income taxes relating to
realized securities gains for the years ended December 31, 2009 and 2008,
respectively, and $6,000 of income tax credit relating to realized securities
losses for the year ended December 31, 2008.





The net
deferred tax asset included in other assets in the accompanying balance sheets
includes the following amounts of deferred tax assets and
liabilities:





2009
            
            2008(In
      Thousands)Deferred
      tax assets:Allowance
      for loan losses
            
            $
            1,682
            
            $
            1,266Deferred
      compensation
            
            
            482
            
            
            361Intangible
      assets
            
            
            26
            
            
            47Other
            
            
            122
            
            
            59Foreclosed
      real estate valuation allowance
            
            
            126
            
            
            —Total
      Deferred Tax Assets
            
            
            2,438
            
            
            1,733Deferred
      tax liabilities:Premises
      and equipment
            
            
            268
            
            
            328Deferred
      loan fees
            
            
            277
            
            
            261Net
      unrealized gains on securities
            
            
            1,080
            
            
            653Total
      Deferred Tax Liabilities
            
            
            1,625
            
            
            1,242Net
      Deferred Tax Asset
            
            $
            813
            
            $
            491





No
valuation was established at December 31, 2009 and 2008, due to the Company’s
ability to carry back taxes paid in prior years and anticipated future taxable
income as evidenced by the Company’s


earnings
potential.





NOTE
11 - TRANSACTIONS WITH EXECUTIVE OFFICERS AND DIRECTORS


Certain
directors and executive officers of the Company, their families and their
affiliates are customers of the Bank. Any transactions with such parties,
including loans and commitments, were in the ordinary course of business at
normal terms, including interest rates and collateralization, prevailing at the
time and did not represent more than normal risks. At December 31, 2009 and
2008 such loans amounted to $5,314,000 and $5,960,000, respectively. During
2009, new loans to such related parties totaled $1,602,000 and repayments and
other reductions aggregated $2,248,000.





NOTE
12 - REGULATORY MATTERS AND STOCKHOLDERS’ EQUITY


The
Company and 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 must meet specific capital guidelines that involve quantitative measures
of the Company’s assets, liabilities and certain off-balance sheet items as
calculated under regulatory accounting practices. The Company’s capital amounts
and classification are also subject to qualitative judgments by the regulators
about components, risk-weightings and other factors.


54





NOTE
12 - REGULATORY MATTERS AND STOCKHOLDERS’
EQUITY  (CONTINUED)


Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain 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, and of Tier 1 capital to average assets. Management
believes, as of December 31, 2009 and 2008, that the Company and the Bank
meet all capital adequacy requirements to which they are subject.





As of
December 31, 2009, the most recent notification from the regulators has
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. There are no conditions or events since that
notification that management believes have changed the Bank’s
category.





The
Bank’s actual capital amounts and ratios are presented in the
table:








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, 2009:Total capital (to risk-weighted
      assets)
            
            $65,197
            
            17.85%
            
            $329,227
            
            38.00%
            
            $336,534
            
            310.00%Tier 1 capital (to risk-weighted
      assets)
            
            60,469
            
            16.55
            
            314,614
            
            34.00
            
            321,920
            
            36.00Tier 1 capital (to average
      assets)
            
            60,469
            
            11.53
            
            320,974
            
            34.00
            
            326,217
            
            35.00As
      of December 31, 2008:Total capital (to risk-weighted
      assets)
            
            $60,577
            
            17.24%
            
            $ >28,110
            
            >8.00%
            
            $>35,137
            
            >10.00%Tier 1 capital (to risk-weighted
      assets)
            
            56,051
            
            15.95
            
            >14,057
            
            >4.00
            
            321,085
            
            >6.00Tier 1 capital (to average
      assets)
            
            56,051
            
            11.20
            
            >20,018
            
            >4.00
            
            325,023
            
            >5.00





The
Company’s ratios do not differ significantly from the Bank’s ratios presented
above.





The Bank
is required to maintain average cash reserve balances in vault cash or with the
Federal Reserve Bank. The amount of these restricted cash reserve balances at
December 31, 2009 and 2008 was approximately $229,000 and $284,000,
respectively.





Under
Pennsylvania banking law, the Bank is subject to certain restrictions on the
amount of dividends that it may declare without prior regulatory approval. At
December 31, 2009, $53,808,000 of retained earnings were available for
dividends without prior regulatory approval, subject to the regulatory capital
requirements discussed above. Under Federal Reserve regulations, the Bank is
limited as to the amount it may lend affiliates, including the Company, unless
such loans are collateralized by specific obligations.





NOTE
13 - STOCK OPTION PLANS


The
Company’s shareholders approved the Norwood Financial Corp 2006 Stock Option
Plan at the Annual Meeting on April 26, 2006. An aggregate of 250,000 shares of
authorized but unissued Common Stock of the Company were reserved for future
issuance under the Plan. This includes up to 40,000 shares for awards to outside
directors. Under this plan, the Company granted 24,000 options, which included
4,000


55





NOTE
13 - STOCK OPTION PLANS  (CONTINUED)


options
granted to outside directors in 2009, 24,000 options in 2008 which included
4,000 options granted to outside directors and 22,000 options in 2007, which
included 4,000 options granted to outside directors.





Total
unrecognized compensation cost related to nonvested options under the Plan was
$158,000 as of December 31, 2009, $130,000 as of December 31, 2008 and $154,000
as of December 31, 2007. Salaries and employee benefits expense includes
$134,000, $154,000 and $251,000 of compensation costs related to options for the
years ended December 31, 2009, 2008 and 2007, respectively. Net income was
reduced by $127,000, $144,000 and $236,000 for the years ended December 31,
2009, 2008 and 2007, respectively.





A summary
of the Company’s stock option activity and related information for the years
ended December 31 follows:





2009
            
            2008
            
            2007Options
            
            Weighted
              Average
              Exercise
              Price
            
            Average
              Intrinsic
              Value
            
            Options
            
            Weighted
              Average
              Exercise
              Price
            
            Average
              Intrinsic
              Value
            
            Options
            
            Weighted
              Average
              Exercise
              Price
            
            Average
              Intrinsic
              PriceOutstanding,beginning
      of year
            176,443
            
            $
            25.78
            
            
            
            
            180,422
            
            $
            24.04
            
            
            
            
            183,645
            
            $
            21.81Granted
            27,000
            
            
            28.60
            
            
            
            
            24,000
            
            
            27.50
            
            
            
            
            22,000
            
            
            31.25Exercised
            (32,528
            )
            
            15.83
            
            
            
            
            (27,979
            )
            
            14.98
            
            
            
            
            (24,723
            )
            
            13.76Forfeited
            —
            
            
            .
      —
            
            
            
            
            —
            
            
            .
      —
            
            
            
            
            (500
            )
            
            31.50Outstanding,end
      of year
            170,915
            
            $
            28.07
            
            $
            286,464
            
            176,443
            
            $
            25.95
            
            $
            273,487
            
            180,422
            
            $
            24.04
            
            $
            1,301,000Exercisable,end
      of year
            146,915
            
            $
            27.98
            
            $
            259,461








Exercise
prices for options outstanding as of December 31, 2009 ranged from $10.36
to $31.50 per share. The weighted average remaining contractual life is 6.8
years.





The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing with the following weighted average
assumptions:





Years
      Ended December 31,2009
            
            2008
            
            2007Dividend
      yield
            
            
            2.89
            %
            
            2.79
            %
            
            2.75
            %Expected
      life
            
            
            7
      years
            
            
            7
      years
            
            
            7
      yearsExpected
      volatility
            
            
            27.39
            %
            
            25.08
            %
            
            24.17
            %Risk-free
      interest rate
            
            
            3.11
            %
            
            2.01
            %
            
            3.53
            %Weighted
      average fair value of options granted
            
            $
            6.77
            
            $
            5.43
            
            $
            6.99





The
expected volatility is based on historical volatility. The risk-free interest
rates for periods within the contractual life of the awards are based on the
U.S. Treasury yield curve in effect at the time of the grant. The expected life
is based on historical exercise experience. The dividend yield assumption is
based on the Company’s history and expectation of dividend payouts.





Proceeds
from stock option exercises totaled $517,000 in 2009. Shares issued in
connection with stock options exercises are issued from available treasury
shares. If no treasury shares are available, new shares are issued from
available authorized shares. During 2009, all the shares issued in connection
with stock option exercises, 32,528 shares in total, were issued from available
treasury shares.


56





NOTE
13 - STOCK OPTION PLANS  (CONTINUED)


As of
December 31, 2009, outstanding stock options consist of the
following:





Options
              Outstanding
            
            Average
              Exercise
              Price
            
            Remaining
              Life,
      Years
            
            Options
              Exercisable
            
            Average
              Exercise
              Price2,762
            
            $
            10.36
            
            1.0
            
            2,762
            
            $
            10.363,932
            
            
            16.98
            
            2.0
            
            3,932
            
            
            16.987,873
            
            
            19.05
            
            3.0
            
            7,873
            
            
            19.0519,198
            
            
            23.95
            
            4.0
            
            19,198
            
            
            23.9520,475
            
            
            30.00
            
            5.0
            
            20,475
            
            
            30.0024,675
            
            
            30.38
            
            6.3
            
            24,675
            
            
            30.3822,000
            
            
            31.50
            
            7.0
            
            22,000
            
            
            31.5022,000
            
            
            31.25
            
            8.0
            
            22,000
            
            
            31.2524,000
            
            
            27.50
            
            9.0
            
            24,000
            
            
            27.501,000
            
            
            28.90
            
            9.3
            
            —
            
            
            —23,000
            
            
            28.59
            
            10.0
            
            —
            
            
            —Total
            
            170,915
            
            $
            28.07
            
            6.8
            
            146,915
            
            $
            27.98





NOTE
14 - EARNINGS PER SHARE


The
following table sets forth the computations of basic and diluted earnings per
share:





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands, Except Per Share Data)Numerator,
      net income
            
            $
            7,063
            
            $
            6,677
            
            $
            6,511Denominator:Denominator
      for basic earnings per share, weightedaverage
      shares
            
            
            2,750
            
            
            2,740
            
            
            2,777Effect
      of dilutive securities, employee stock options
            
            
            16
            
            
            29
            
            
            49Denominator
      for diluted earnings per share, adjusted weighted averageshares
      and assumed conversions
            
            
            2,766
            
            
            2,769
            
            
            2,826Basic
      earnings per common share
            
            $
            2.57
            
            $
            2.44
            
            $
            2.34Diluted
      earnings per common share
            
            $
            2.55
            
            $
            2.41
            
            $
            2.30





Stock
options which had no intrinsic value because their effect would be anti-dilutive
and therefore would not be included in the diluted EPS calculation were 109,821,
89,150 and 44,025 for the years ended December 31, 2009, 2008 and 2007,
respectively.





NOTE
15 - OFF-BALANCE SHEET FINANCIAL INSTRUMENTS


The Bank
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 and interest rate
risk in excess of the amount recognized in the balance sheets.





The
Bank’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 Bank
uses the same credit policies in making commitments and conditional obligations
as it does for on-balance sheet instruments.


57





NOTE
15 - OFF-BALANCE SHEET FINANCIAL INSTRUMENTS (CONTINUED)


A summary
of the Bank’s financial instrument commitments is as follows:





December
      31,2009
            
            2008(In
      Thousands)Commitments
      to grant loans
            
            $
            17,713
            
            $
            19,254Unfunded
      commitments under lines of credit
            
            
            36,809
            
            
            36,980Standby
      letters of credit
            
            
            3,679
            
            
            1,897$
            58,201
            
            $
            58,131





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. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since some of the commitments are expected to expire without being
drawn upon, the total commitment amount does not necessarily represent future
cash requirements. The Bank evaluates each customer’s credit worthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the Bank upon extension of credit, is based on management’s credit evaluation of
the customer and generally consists of real estate.





Standby
letters of credit are conditional commitments issued by the Bank 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 Bank requires collateral supporting these
letters of credit when deemed necessary. Management believes that the proceeds
obtained through a liquidation of such collateral would be sufficient to cover
the maximum potential amount of future payments required under the corresponding
guarantees.





NOTE
16 – DISCLOSURES ABOUT FAIR VALUES 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 sales transaction on the dates indicated. The estimated fair value
amounts have been measured as of their respective year ends and have not been
re-evaluated or updated for purposes of these consolidated 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.





Generally
accepted accounting principles in the United States of America established a
fair value hierarchy that prioritizes the inputs to valuation methods used to
measure fair value. The hierarchy gives the highest priority to unadjusted
quoted prices in active markets for identical assets or liabilities (Level 1
measurements) and the lowest priority to unobservable inputs (Level 3
measurements). The three levels of the fair value hierarchy are as
follows:








Level
      1:
            
            Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or liabilities.Level
      2:
            
            Quoted
      prices in markets that are not active, or inputs that are observable
      either directly or indirectly, for substantially the full term of the
      asset or liability.Level
      3:
            
            Prices
      or valuation techniques that require inputs that are both significant to
      the fair value measurement and are unobservable (i.e. supported with
      little or no market activity).





58








NOTE
16 – DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
(CONTINUED)


An
asset’s or liability’s level within the fair value hierarchy is based on the
lowest level of input that is significant to the fair value
measurement.





For
financial assets measured at fair value on a recurring basis, the fair value
measurements by level within the fair value hierarchy used at December 31, 2009
and 2008 are as follows:





Fair
      Value Measurement Reporting Date usingDescription
            
            Total
            
            (Level
      1)
              Quoted
      Prices in
              Active
      Markets
              For
      Identical
              Assets
            
            (Level
      2)
              Significant
              Other
              Observable
              Inputs
            
            (Level
      3)
              Significant
              Underlying
              InputsDecember
      31, 2009Available
      for Sale:US
      Government agencies
            
            $
            39,772
            
            $
            —
            
            $
            39,772
            
            $
            —States
      and political subdivisions
            
            
            31,635
            
            
            —
            
            
            31,635
            
            
            —Corporate
      securities
            
            
            5,240
            
            
            —
            
            
            5,240
            
            
            —Mortgage-backed
      securities
            
            
            53,154
            
            
            —
            
            
            53,154
            
            
            —Equity
      securities
            
            
            776
            
            
            776
            
            
            —
            
            
            —Total
      available for sale
            
            
            130,577
            
            
            776
            
            
            129,801
            
            
            —Mortgage
      servicing rights
            
            
            179
            
            
            —
            
            
            —
            
            
            179Total
            
            $
            130,756
            
            $
            776
            
            $
            129,801
            
            $
            179December
      31, 2008Available
      for Sale:US
      Government agencies
            
            $
            35,813
            
            $
            —
            
            $
            35,813
            
            $
            —States
      and political subdivisions
            
            
            25,209
            
            
            —
            
            
            25,209
            
            
            —Corporate
      securities
            
            
            5,625
            
            
            —
            
            
            5,625
            
            
            —Mortgage-backed
      securities
            
            
            62,318
            
            
            —
            
            
            62,318Equity
      securities
            
            
            1,155
            
            
            1,155
            
            
            —
            
            
            —Total
            
            $
            130,120
            
            $
            1,155
            
            $
            128,965
            
            $
            —





For
financial assets measured at fair value on a nonrecurring basis, the fair value
measurements by level within the fair value hierarchy used at December 31, 2009
and 2008 are as follows:





Fair
      Value Measurement Reporting Date usingDescription
            
            Total
            
            (Level
      1)
              Quoted
      Prices in
              Active
      Markets
              For
      Identical
              Assets
            
            (Level
      2)
              Significant
              Other
              Observable
              Inputs
            
            (Level
      3)
              Significant
              Underlying
              InputsDecember
      31, 2009Impaired
      Loans
            
            $
            7,991
            
            $
            —
            
            $
            7,991
            
            $
            —Other
      real estate owned
            
            
            392
            
            
            —
            
            
            392
            
            
            —$
            8,383
            
            $
            —
            
            $
            8,383
            
            $
            —December
      31, 2008Impaired
      Loans
            
            $
            2,976
            
            $
            —
            
            $
            —
            
            $
            2,976





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.


59





NOTE
16 – DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
(CONTINUED)


The
following methods and assumptions were used to estimate the fair values of the
Company’s financial instruments at December 31, 2009 and 2008.





Cash
and cash equivalents (carried at cost):


The
carrying amounts reported in the consolidated balance sheet for cash and
short-term instruments approximate those assets’ fair values.





Securities:


The fair
value of securities available for sale (carried at fair value) and held to
maturity (carried at amortized cost) are determined by obtaining quoted market
prices on nationally recognized securities exchanges (Level 1), or matrix
pricing (Level 2), which is a mathematical technique used widely in the industry
to value debt securities without relying exclusively on quoted market prices for
the specific securities but rather by relying on the securities’ relationship to
other benchmark quoted prices. For certain securities which are not traded in
active markets or are subject to transfer restrictions, valuations are adjusted
to reflect illiquidity and/or non-transferability, and such adjustments are
generally based on available market evidence (Level 3). In the absence of such
evidence, management’s best estimate is used. Management’s best estimate
consists of both internal and external support on certain Level 3 investments.
Internal cash flow models using a present value formula that includes
assumptions market participants would use along with indicative exit pricing
obtained from broker/dealers (where available) are used to support fair values
of certain Level 3 investments, if applicable.





Loans
receivable (carried at cost):


The fair
values of loans are estimated using discounted cash flow analyses, using market
rates at the balance sheet date that reflect the credit and interest rate-risk
inherent in the loans. Projected future cash flows are calculated based upon
contractual maturity or call dates, projected repayments and prepayments of
principal. Generally, for variable rate loans that reprice frequently and with
no significant change in credit risk, fair values are based on carrying
values.





Impaired
loans (generally carried at fair value):


The Bank
has measures impairment generally based on the fair value of the loan’s
collateral. Fair value is generally determined based upon independent
third-party appraisals of the property or discounted cash flows based upon the
expected proceeds. These assets are included as either Level 2 or Level 3 fair
values, based upon the lowest level of input that is significant to the fair
value measurements. The fair value investment in impaired loans requiring an
allowance for loan losses was $1,029,000, which is net of a valuation allowance
of $36,000 and after a charge-off against the allowance for loan losses of
$480,000 and $6,292,000, net of a charge-off against the allowance for loan
losses of $154,000 not requiring an allowance for loan losses as of December 31,
2009. The fair value investment in impaired loans not requiring an allowance for
loan losses was $2,976,000, net of a charge-off against the allowance for loan
losses of $380,000 at December 31, 2008.





Other
real estate owned:


Real
estate properties acquired through, or in lieu of loan foreclosure are to be
sold and are carried at fair value less estimated cost to sell. Fair value is
based upon independent market prices, appraised value of the collateral or
management’s estimation of the value of the collateral. These assets are
included in Level 2 fair value based upon the lowest level of input that is
significant to the fair value measurement.


60





NOTE
16 – DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
(CONTINUED)


Restricted
investment in Federal Home Loan Bank stock (carried at cost):


Restricted
stock which represents required investment in the common stock of correspondent
banks is carried at cost and as of December 31, 2009 and 2008, consists of the
common stock of Federal Home Loan Bank of Pittsburgh. In December 2008, the FHLB
of Pittsburgh notified member banks that it was suspending dividend payments and
the repurchase of excess capital stock.





Management
evaluates the restricted stock for impairment. Management’s determination of
whether these investments are impaired is based on their assessment of the
ultimate recoverability of their cost rather than by recognizing temporary
declines in value. The determination of whether a decline affects the ultimate
recoverability of their cost is influenced by criteria such as (1) the
significance of the decline in net assets of the FHLB as compared to the capital
stock amount for the FHLB and the length of time this situation has persisted,
(2) commitments by the FHLB to make payments required by law or regulation and
the level of such payments in relation to the operating performance of the FHLB,
and (3) the impact of legislative and regulatory changes on institutions and,
accordingly, on the customer base of the FHLB. Management believes no impairment
charge is necessary related to FHLB stock as of December 31, 2009.





Accrued
interest receivable and payable (carried at cost):


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





Deposit
liabilities (carried at cost):


The fair
values disclosed for demand deposits (e.g., interest and noninterest checking,
passbook savings and money market accounts) are, by definition, equal to the
amount payable on demand at the reporting date (i.e., their carrying amounts).
Fair values for fixed-rate certificates of deposit are estimated using a
discounted cash flow calculation that applies interest rates currently being
offered in the market on certificates to a schedule of aggregated expected
monthly maturities on time deposits.





Short-term
borrowings (carried at cost):


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





Other
borrowings (carried at cost):


Fair
values of FHLB advances are estimated using discounted cash flow analysis, based
on quoted prices for new FHLB advances with similar credit risk characteristics,
terms and remaining maturity. These prices obtained from this active market
represent a market value that is deemed to represent the transfer price if the
liability were assumed by a third party.





Off-balance
sheet financial instruments (disclosed at cost):


Fair
values for the Company’s off-balance sheet financial instruments (lending
commitments and letters of credit) are based on fees currently charged in the
market to enter into similar agreements, taking into account, the remaining
terms of the agreements and the counterparties’ credit
standing.


61





NOTE
16 – DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS
(CONTINUED)


The
estimated fair values of the Bank’s financial instruments were as follows at
December 31, 2009 and December 31, 2008.





December
      31, 2009
            
            December
      31, 2008Carrying
            
            Fair
            
            Carrying
            
            FairAmount
            
            Value
            
            Amount
            
            Value(In
      Thousands)Financial
      assets:Cash
      and due from banks, interest-bearingdeposits
      with banks and federal funds sold
            
            $
            17,355
            
            $
            17,355
            
            $
            6,480
            
            $
            6,480Securities
            
            
            131,285
            
            
            131,299
            
            
            130,827
            
            
            130,840Loans
      receivable, net
            
            
            358,021
            
            
            368,180
            
            
            345,171
            
            
            363,219Investment
      in FHLB stock
            
            
            3,538
            
            
            3,538
            
            
            3,538
            
            
            3,538Accrued
      interest receivable
            
            
            2,200
            
            
            2,200
            
            
            2,179
            
            
            2,179Financial
      liabilities:Deposits
            
            
            391,473
            
            
            392,445
            
            
            359,635
            
            
            361,223Short-term
      borrowings
            
            
            25,803
            
            
            25,803
            
            
            38,126
            
            
            38,126Other
      borrowings
            
            
            43,000
            
            
            45,591
            
            
            43,000
            
            
            46,281Accrued
      interest payable
            
            
            2,057
            
            
            2,057
            
            
            2,247
            
            
            2,247Off-balance
      sheet financial instruments:Commitments
      to extend credit and  outstanding
              letters
      of credit
            
            
            --
            
            
            --
            
            
            --
            
            
            --














62


NOTE
17 - NORWOOD FINANCIAL CORP. (PARENT COMPANY ONLY) FINANCIAL
INFORMATION


BALANCE
SHEETS





December
      31,2009
            
            2008(In
      Thousands)ASSETSCash
      on deposit in bank subsidiary
            
            $
            697
            
            $
            216Securities
      available for sale
            
            
            359
            
            
            408Investment
      in bank subsidiary
            
            
            62,571
            
            
            57,440Other
      assets
            
            
            1,620
            
            
            1,363$
            65,247
            
            $
            59,427LIABILITIES
      AND STOCKHOLDERS’ EQUITYLiabilities
            
            $
            776
            
            $
            737Stockholders’
      equity
            
            
            64,471
            
            
            58,690$
            65,247
            
            $
            59,427





STATEMENTS
OF INCOME





Years
      Ended December 31,2009
            
            2008
            
            2007Income:
            
            (In
      Thousands)Dividends
      from bank subsidiary
            
            $
            3,005
            
            $
            3,990
            
            $
            4,156Other
      interest income
            
            
            19
            
            
            25
            
            
            30Net
      realized gain (loss) on sales of securities
            
            
            (134
            )
            
            (62
            )
            
            172,890
            
            
            3,953
            
            
            4,203Expenses
            
            
            176
            
            
            164
            
            
            1772,714
            
            
            3,789
            
            
            4,026Income
      tax benefit
            
            
            (99
            )
            
            (68
            )
            
            (51
            )2,813
            
            
            3,857
            
            
            4,077Equity
      in undistributed earnings of subsidiary
            
            
            4,250
            
            
            2,820
            
            
            2,434Net
      Income
            
            $
            7,063
            
            $
            6,677
            
            $
            6,511





STATEMENTS
OF CASH FLOWS





Years
      Ended December 31,2009
            
            2008
            
            2007(In
      Thousands)CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
            
            $
            7,063
            
            $
            6,677
            
            $
            6,511Adjustments
      to reconcile net income tonet
      cash provided by operating activities:Undistributed
      earnings of bank subsidiary
            
            
            (4,250
            )
            
            (2,820
            )
            
            (2,434
            )Net
      losses on sales of securities
            
            
            134
            
            
            —
            
            
            —Other,
      net
            
            
            (300
            )
            
            (190
            )
            
            (330
            )Net
      Cash Provided by Operating Activities
            
            
            2,647
            
            
            3,667
            
            
            3,747CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from sale of securities
            
            
            22
            
            
            17
            
            
            74Net
      Cash Provided by Investing Activities
            
            
            22
            
            
            17
            
            
            74CASH
      FLOWS FROM FINANCING ACTIVITIESStock
      options exercised
            
            
            517
            
            
            420
            
            
            341Tax
      benefit of stock options exercised
            
            
            164
            
            
            134
            
            
            162ESOP
      purchase of shares from treasury stock
            
            
            166
            
            
            153
            
            
            144Acquisition
      of treasury stock
            
            
            (68
            )
            
            (1,583
            )
            
            (2,313
            )Cash
      dividends paid
            
            
            (2,967
            )
            
            (2,740
            )
            
            (2,559
            )Net
      Cash Used in Financing Activities
            
            
            (2,188
            )
            
            (3,616
            )
            
            (4,225
            )Net
      Increase (Decrease) in Cash and Cash Equivalents
            
            
            481
            
            
            68
            
            
            (404
            )CASH
      AND CASH EQUIVALENTS - BEGINNING
            
            
            216
            
            
            148
            
            
            552CASH
      AND CASH EQUIVALENTS - ENDING
            
            $
            697
            
            $
            216
            
            $
            148











63





INVESTOR
INFORMATION





STOCK
LISTING


Norwood
Financial Corp. stock is traded on the Nasdaq Global Market under the symbol
NWFL. The following firms are known to make a market in the Company’s
stock:








Ferris
      Baker Watts
              Baltimore,
      MD
              410-659-4616
            
            Janney
      Montgomery Scott, LLC
              Scranton,
      PA  18503
              800-638-4417Boenning
      & Scattergood, Inc.
              West
      Conshohocken, PA
              800-496-1170
            
            Stifel
      Nicolaus
              800-793-7226





TRANSFER
AGENT


Illinois
Stock Transfer Company, 209 West Jackson Blvd., Suite 903, Chicago,
IL  60606. Stockholders who may have questions regarding their stock
ownership should contact the Transfer Agent at 312-427-2953.





DIVIDEND
CALENDAR


Dividends
on Norwood Financial Corp. common stock, if approved by the Board of Directors
are customarily paid on or about February 1, May 1, August 1 and November
1.





AUTOMATIC
DIVIDEND REINVESTMENT PLAN


The Plan,
open to all shareholders, provides the opportunity to have dividends
automatically reinvested into Norwood stock. Participants in the Plan may also
elect to make cash contributions to purchase additional shares of common stock.
Shareholders do not incur brokerage commissions for the transactions. Please
contact the transfer agent for additional information.





SEC
REPORTS AND ADDITIONAL INFORMATION


A
copy of the Company’s annual report on Form 10-K for its fiscal year ended
December 31, 2009 including financial statements and schedules thereto, required
to be filed with the Securities and Exchange Commission may be obtained upon
written request of any stockholder, investor or analyst by contacting Edward C.
Kasper, Executive Vice President and Secretary, Norwood Financial Corp., 717
Main Street, PO Box 269, Honesdale, PA  18431,
570-253-1455.


64




NORWOOD
FINANCIAL CORP DIRECTORY OF OFFICERS
 
 NORWOOD
      FINANCIAL CORP
              
              Barbara
      A. Ridd
              Vice
      President &John
      E. Marshall
              Chairman
      of the Board
              
              
              Assistant
      SecretaryWilliam
      W. Davis, Jr.
              President,
      Chief Executive
              
              Gary
      H. Sipe
              Vice
      PresidentOfficer
              
              Eli
      Tomlinson
              Vice
      PresidentLewis
      J. Critelli
              Executive
      Vice President,
              
              Diane
      Wylam
              Vice
      President andChief
      Financial Officer,
              
              
              Senior
      Trust OfficerTreasurer
      & Secretary
              
              Ryan
      J. French
              Assistant
      Vice PresidentEdward
      C. Kasper
              Executive
      Vice President
              
              Marianne
      M. Glamann
              Assistant
      Vice PresidentKenneth
      C. Doolittle
              Executive
      Vice President
              
              Wendy
      L. Davis
              Community
      Office ManagerJohn
      H. Sanders
              Senior
      Vice President
              
              Gary
      Henry
              Community
      Office MangerJoseph
      A. Kneller
              Senior
      Vice President
              
              Teresa
      Melucci
              Community
      Office ManagerSandra
      Mruczkewycz
              Community
      Office ManagerWAYNE
      BANK
              
              
              Rosie
      Demorizi-Ortiz
              Community
      Office ManagerJohn
      E. Marshall
              Chairman
      of the Board
              
              Terri
      Garringer
              Community
      Office ManagerWilliam
      W. Davis, Jr.
              President,
      Chief Executive
              
              Nancy
      M. Worobey
              Community
      Office ManagerOfficer
              
              Laurie
      J. Bishop
              Assistant
      Community OfficeLewis
      J. Critelli
              Executive
      Vice President,
              
              
              ManagerChief
      Financial Officer
              
              Christine
      Ferdinando
              Assistant
      Community&
      Secretary
              
              
              Office
      ManagerEdward
      C. Kasper
              Executive
      Vice President,
              
              Jill
      Hessling
              Assistant
      CommunitySenior
      Loan Officer/
              
              
              Office
      ManagerCorporate
      Bank
              
              William
      E. Murray
              Mortgage
      OriginatorKenneth
      C. Doolittle
              Executive
      Vice President
              
              Diane
      L. Richter
              Assistant
      CommunityOffice
      ManagerJohn
      H. Sanders
              Senior
      Vice President/
              
              Toni
      M. Stenger
              Assistant
      CommunityRetail
      Bank
              
              
              Office
      ManagerJoseph
      A. Kneller
              Senior
      Vice President
              
              Nicholas
      Holzman
              Credit
      AnalystJohn
      Carmody
              Senior
      Vice President
              
              Thomas
      Kowalski
              Resource
      Recovery ManagerJulie
      Kuen
              Electronic
      Banking OfficerKaryn
      Batzel
              Vice
      President
              
              Sally
      J. Rapp
              Human
      Resources OfficerRobert
      J. Behrens, Jr.
              Vice
      President
              
              Doreen
      A. Swingle
              Residential
      MortgageJoann
      Fuller
              Vice
      President
              
              
              Lending
      OfficerKaren
      Gasper
              Vice
      President andInternal
      Auditor
              
              NORWOOD
      INVESTMENT CORPCarolyn
      K. Gwozdziewycz
              Vice
      PresidentSandra
      Halas
              Vice
      President and
              
              William
      W. Davis, Jr.
              President,
      Chief ExecutiveTrust
      Officer
              
              
              OfficerNancy
      A. Hart
              Vice
      President, Controller,
              
              Lewis
      J. Critelli
              Executive
      Vice PresidentAssistant
      Treasurer &
              
              Kenneth
      C. Doolittle
              Executive
      Vice PresidentAssistant
      Secretary
              
              Scott
      C. Rickard
              Senior
      InvestmentRaymond
      C. Hebden
              Vice
      President
              
              
              Representative,
      InvestWilliam
      J. Henigan, Jr.
              Vice
      President
              
              
              Financial
      CorpJennifer
      Jaycox
              Vice
      PresidentWilliam
      R. Kerstetter
              Vice
      President
              
              MONROE
      COUNTY ASSOCIATE BOARDKelley
      J. Lalley
              Vice
      President &
              
              Michael
      J. Baxter
              James
      H. OttAssistant
      Secretary
              
              Sara
      Cramer
              Marvin
      PapillonLinda
      M. Moran
              Vice
      President
              
              Dr.
      Andrew A. Forte
              Ray
      PriceMary
      Alice Petzinger
              Vice
      President
              
              Ralph
      A. Matergia, Esq.
              Ron
      Sarajian