UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10‑Q10-Q


[X]☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934


For the quarterly period ended March 31,June 30, 2020
Or


[ ]☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934


For the transition period from_____________________ to ___________________


Commission file number 0‑132220-13222


CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)


PENNSYLVANIA23-2265045
(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)
PENNSYLVANIA                               23‑2265045
(State or other jurisdiction of incorporation or organization)(I.R.S. Employer Identification No.)


15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)


Registrant'sRegistrant’s telephone number, including area code: (570) 662‑2121


N/A
(Former Name, former address and former fiscal year, if changed since last report)


Securities registered pursuant to Section 12(b) of the Act:


     
Title of Each Class Trading Symbol(s) Name of Each Exchange on Which Registered


Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X__ No_____☒ No ☐


Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes __X__ No_____☒ No ☐


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer     ☐
Accelerated filer     ☒
Non-accelerated filer     ���
Smaller reporting company     ☒
Emerging growth company     ☐
Large accelerated filer____                                                      Accelerated filer  _X__

Non-accelerated filer____                                                      Smaller reporting company                                                                                    _X__

Emerging growth company____


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ◻☐


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes____Yes ☐ No  __X__☒


The number of outstanding shares of the Registrant’s Common Stock, as of April 30,July 31, 2020, was 3,879,378.3,933,376.



Citizens Financial Services, Inc.
Form 10-Q


INDEX


  PAGE
Part IFINANCIAL INFORMATION 
Item 1.Financial Statements (unaudited): 
 
Consolidated Balance Sheet as of March 31,June 30, 2020 and December 31, 2019
1
 
Consolidated Statement of Income for the Three and Six months Ended March 31,June 30, 2020 and 2019
2
 
Consolidated Statement of Comprehensive Income for the Three and Six months ended March 31,June 30, 2020 and 2019
3
 
Consolidated Statement of Changes in Stockholders’ Equity for the Three and Six months ended March 31,June 30, 2020 and 2019
4
 
Consolidated Statement of Cash Flows for the ThreeSix months ended March 31,June 30, 2020 and 2019
5
 
Notes to Consolidated Financial Statements
6-286-36
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
29-4837-59
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
4860
Item 4.
Controls and Procedures
4860
   
Part IIOTHER INFORMATION 
Item 1.
Legal Proceedings
4860
Item 1A.
Risk Factors
49-5060-62
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
5163
Item 3.
Defaults Upon Senior Securities
5163
Item 4.
Mine Safety Disclosures
5163
Item 5.
Other Information
5163
Item 6.
Exhibits
51-5263
 
Signatures
5364


CITIZENS FINANCIAL SERVICES, INC.      
CONSOLIDATED BALANCE SHEET      
(UNAUDITED)    �� 
       
  March 31,  December 31, 
(in thousands except share data) 2020  2019 
ASSETS:      
Cash and due from banks:      
  Noninterest-bearing $20,663  $17,727 
  Interest-bearing  858   793 
Total cash and cash equivalents  21,521   18,520 
Interest bearing time deposits with other banks  14,506   14,256 
Equity securities  649   701 
Available-for-sale securities  257,788   240,706 
Loans held for sale  2,006   815 
         
Loans (net of allowance for loan losses:        
  2020, $14,247 and 2019, $13,845)  1,079,473   1,101,724 
         
Premises and equipment  16,222   15,933 
Accrued interest receivable  4,587   4,555 
Goodwill  23,296   23,296 
Bank owned life insurance  28,284   28,128 
Other intangibles  1,294   1,346 
Other assets  15,103   16,359 
         
TOTAL ASSETS $1,464,729  $1,466,339 
         
LIABILITIES:        
Deposits:        
  Noninterest-bearing $204,489  $203,793 
  Interest-bearing  1,000,661   1,007,325 
Total deposits  1,205,150   1,211,118 
Borrowed funds  83,563   85,117 
Accrued interest payable  906   1,088 
Other liabilities  15,187   14,242 
TOTAL LIABILITIES  1,304,806   1,311,565 
STOCKHOLDERS' EQUITY:        
Preferred Stock        
  $1.00 par value; authorized 3,000,000 shares at March 31, 2020 and        
   December 31, 2019; none issued in 2020 or 2019  -   - 
Common stock        
$1.00 par value; authorized 25,000,000 shares at March 31, 2020 and December 31, 2019;     
       issued 3,938,668 at March 31, 2020 and December 31, 2019  3,939   3,939 
Additional paid-in capital  55,129   55,089 
Retained earnings  113,374   110,800 
Accumulated other comprehensive income (loss)  2,918   (629)
Treasury stock, at cost:  432,659 shares at March 31, 2020        
  and 413,607 shares at December 31, 2019  (15,437)  (14,425)
TOTAL STOCKHOLDERS' EQUITY  159,923   154,774 
TOTAL LIABILITIES AND        
   STOCKHOLDERS' EQUITY $1,464,729  $1,466,339 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.     




1
Index

CITIZENS FINANCIAL SERVICES, INC.      
CONSOLIDATED STATEMENT OF INCOME      
(UNAUDITED)      
  Three Months Ended 
  March 31, 
(in thousands, except share and per share data) 2020  2019 
INTEREST INCOME:      
Interest and fees on loans $13,638  $13,314 
Interest-bearing deposits with banks  95   104 
Investment securities:        
    Taxable  1,107   1,108 
    Nontaxable  389   357 
    Dividends  110   134 
TOTAL INTEREST INCOME  15,339   15,017 
INTEREST EXPENSE:        
Deposits  1,987   2,314 
Borrowed funds  462   788 
TOTAL INTEREST EXPENSE  2,449   3,102 
NET INTEREST INCOME  12,890   11,915 
Provision for loan losses  400   400 
NET INTEREST INCOME AFTER        
    PROVISION FOR LOAN LOSSES  12,490   11,515 
NON-INTEREST INCOME:        
Service charges  1,081   1,099 
Trust  198   232 
Brokerage and insurance  340   293 
Gains on loans sold  167   99 
Equity security (losses) gains, net  (254)  11 
Earnings on bank owned life insurance  156   151 
Other  163   148 
TOTAL NON-INTEREST INCOME  1,851   2,033 
NON-INTEREST EXPENSES:        
Salaries and employee benefits  5,414   5,029 
Occupancy  526   592 
Furniture and equipment  131   155 
Professional fees  325   442 
FDIC insurance  71   111 
Pennsylvania shares tax  275   275 
Amortization of intangibles  50   66 
Merger and acquisition  376   - 
Software expenses  247   227 
ORE expenses  32   107 
Other  1,474   1,318 
TOTAL NON-INTEREST EXPENSES  8,921   8,322 
Income before provision for income taxes  5,420   5,226 
Provision for income taxes  889   821 
NET INCOME $4,531  $4,405 
         
PER COMMON SHARE DATA:        
Net Income – Basic $1.29  $1.25 
Net Income – Diluted $1.29  $1.25 
         
Number of shares used in computation – basic  3,515,500   3,528,466 
Number of shares used in computation – diluted  3,515,500   3,528,466 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements.     

2

CITIZENS FINANCIAL SERVICES, INC.            
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME            
(UNAUDITED)            
  Three Months Ended 
  March 31, 
(in thousands)    2020     2019 
Net income    $4,531     $4,405 
Other comprehensive income (loss):              
      Change in unrealized gains (losses) on available              
                for sale securities  4,334       1,328     
      Income tax effect  (910)      (280)    
      Change in unrecognized pension cost  156       61     
      Income tax effect  (33)      (13)    
Other comprehensive income (loss), net of tax      3,547       1,096 
Comprehensive income     $8,078      $5,501 
                 
The accompanying notes are an integral part of these unaudited consolidated financial statements.         

CITIZENS FINANCIAL SERVICES, INC.
3CONSOLIDATED BALANCE SHEET
(UNAUDITED)


CITIZENS FINANCIAL SERVICES, INC. 
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY 
(UNAUDITED)                     
              Accumulated       
        Additional     Other       
  Common Stock  Paid-in  Retained  Comprehensive  Treasury    
(in thousands, except share data) Shares  Amount  Capital  Earnings  Income (Loss)  Stock  Total 
Balance, December 31, 2019  3,938,668  $3,939  $55,089  $110,800  $(629) $(14,425) $154,774 
Comprehensive income:                            
    Net income              4,531           4,531 
    Net other comprehensive income (loss)                  3,547       3,547 
Purchase of treasury stock (23,412 shares)                      (1,279)  (1,279)
Restricted stock, executive  and Board of Director awards (204 shares)          1           12   13 
Restricted stock vesting          40               40 
Cash dividend reinvestment paid from treasury stock (4,156 shares)          (1)  -       255   254 
Cash dividends, $0.55 per share              (1,957)          (1,957)
Balance, March 31, 2020  3,938,668  $3,939  $55,129  $113,374  $2,918  $(15,437) $159,923 
                             
Balance, December 31, 2018  3,904,212  $3,904  $53,099  $99,727  $(3,921) $(13,580) $139,229 
Comprehensive income:                            
    Net income              4,405           4,405 
    Net other comprehensive income (loss)                  1,096       1,096 
Purchase of treasury stock (5,762 shares)                      (330)  (330)
Restricted stock vesting          3               3 
Cash dividends, $0.441 per share              (1,558)          (1,558)
Balance, March 31, 2019  3,904,212  $3,904  $53,102  $102,574  $(2,825) $(13,910) $142,845 
                             
  
(in thousands except share data) 
June 30,
2020
  
December 31,
2019
 
ASSETS:      
Cash and due from banks:      
Noninterest-bearing $19,543  $17,727 
Interest-bearing  19,487   793 
Total cash and cash equivalents  39,030   18,520 
Interest bearing time deposits with other banks  14,256   14,256 
Equity securities  703   701 
Available-for-sale securities  272,360   240,706 
Loans held for sale  17,468   815 
         
Loans (net of allowance for loan losses:        
2020, $14,827 and 2019, $13,845)  1,348,806   1,101,724 
         
Premises and equipment  17,832   15,933 
Accrued interest receivable  5,950   4,555 
Goodwill  31,376   23,296 
Bank owned life insurance  32,228   28,128 
Other intangibles  1,421   1,346 
Other investment sale receivable  -   - 
Other assets  18,686   16,359 
         
TOTAL ASSETS $1,800,116  $1,466,339 
         
LIABILITIES:        
Deposits:        
Noninterest-bearing $278,612  $203,793 
Interest-bearing  1,234,672   1,007,325 
Total deposits  1,513,284   1,211,118 
Borrowed funds  85,135   85,117 
Accrued interest payable  888   1,088 
Other liabilities  17,714   14,242 
TOTAL LIABILITIES  1,617,021   1,311,565 
STOCKHOLDERS’ EQUITY:        
Preferred Stock $1.00 par value; authorized 3,000,000 shares at June 30, 2020 and December 31, 2019; NaN issued in 2020 or 2019  -   - 
Common stock $1.00 par value; authorized 25,000,000 shares at June 30, 2020 and December 31, 2019; issued 4,350,342 at June 30, 2020 and 3,938,668 at December 31, 2019  4,350   3,939 
Additional paid-in capital  75,863   55,089 
Retained earnings  115,000   110,800 
Accumulated other comprehensive income (loss)  2,907   (629)
Treasury stock, at cost:  424,597 shares at June 30, 2020 and 413,607 shares at December 31, 2019  (15,025)  (14,425)
TOTAL STOCKHOLDERS’ EQUITY  183,095   154,774 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY $1,800,116  $1,466,339 

The accompanying notes are an integral part of these unaudited consolidated financial statementsstatements.



4
1
Index



CITIZENS FINANCIAL SERVICES, INC.      
CONSOLIDATED STATEMENT OF CASH FLOWS      
(UNAUDITED) Three Months Ended 
  March 31, 
(in thousands) 2020  2019 
CASH FLOWS FROM OPERATING ACTIVITIES:      
  Net income $4,531  $4,405 
  Adjustments to reconcile net income to net        
   cash provided by operating activities:        
    Provision for loan losses  400   400 
    Depreciation and amortization  150   183 
    Amortization and accretion of investment securities  120   175 
    Deferred income taxes  (284)  464 
    Equity securities losses (gains), net  254   (11)
    Earnings on bank owned life insurance  (156)  (151)
    Originations of loans held for sale  (7,043)  (3,880)
    Proceeds from sales of loans held for sale  5,973   4,885 
    Realized gains on loans sold  (167)  (99)
    Increase in accrued interest receivable  (32)  (317)
    (Decrease) increase  in accrued interest payable  (182)  16 
    Other, net  1,169   (1,313)
      Net cash provided by operating activities  4,733   4,757 
CASH FLOWS FROM INVESTING ACTIVITIES:        
  Available-for-sale securities:        
    Proceeds from maturity and principal repayments  29,045   10,581 
    Purchase of securities  (41,915)  (12,855)
  Purchase of equity securities  (202)  - 
  Purchase of interest bearing time deposits with other banks  (250)  - 
  Proceeds from redemption of regulatory stock  3,300   2,580 
  Purchase of regulatory stock  (2,798)  (2,782)
  Net decrease (increase) in loans  22,003   (12,908)
  Purchase of premises and equipment  (507)  (105)
  Proceeds from sale of premises and equipment  -   1 
  Proceeds from sale of foreclosed assets held for sale  350   89 
      Net cash provided by (used in) investing activities  9,026   (15,399)
CASH FLOWS FROM FINANCING ACTIVITIES:        
  Net increase in deposits  (5,968)  (3,502)
  Proceeds from long-term borrowings  5,000   5,000 
  Repayments of long-term borrowings  -   (2,589)
  Net (decrease) increase in short-term borrowed funds  (6,554)  14,658 
  Purchase of treasury and restricted stock  (1,279)  (330)
  Dividends paid  (1,957)  (1,558)
      Net cash (used in) provided by financing activities  (10,758)  11,679 
          Net increase in cash and cash equivalents  3,001   1,037 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD  18,520   16,797 
CASH AND CASH EQUIVALENTS AT END OF PERIOD $21,521  $17,834 
         
Supplemental Disclosures of Cash Flow Information:        
    Interest paid $2,631  $3,086 
    Income taxes paid $-  $- 
    Loans transferred to foreclosed property $-  $3,805 
    Right of use asset and liability $-  $1,454 
         
The accompanying notes are an integral part of these unaudited consolidated financial statements. 

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED STATEMENT OF INCOME
(UNAUDITED)

 
Three Months Ended
June 30,
  
Six Months Ended
June 30,
 
(in thousands, except share and per share data) 2020  2019  2020  2019 
INTEREST INCOME:            
Interest and fees on loans $16,407  $13,776  $30,045  $27,090 
Interest-bearing deposits with banks  97   104   192   208 
Investment securities:                
Taxable  1,126   1,128   2,233   2,236 
Nontaxable  463   374   852   731 
Dividends  67   120   177   254 
TOTAL INTEREST INCOME  18,160   15,502   33,499   30,519 
INTEREST EXPENSE:                
Deposits  1,657   2,398   3,644   4,712 
Borrowed funds  217   768   679   1,556 
TOTAL INTEREST EXPENSE  1,874   3,166   4,323   6,268 
NET INTEREST INCOME  16,286   12,336   29,176   24,251 
Provision for loan losses  550   350   950   750 
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
  15,736   11,986   28,226   23,501 
NON-INTEREST INCOME:                
Service charges  914   1,174   1,995   2,273 
Trust  145   209   343   441 
Brokerage and insurance  249   261   589   554 
Gains on loans sold  260   64   427   163 
Equity security gains (losses), net  11   30   (243)  41 
Available for sale security gains, net  117   -   117   - 
Earnings on bank owned life insurance  178   154   334   305 
Other  195   135   358   283 
TOTAL NON-INTEREST INCOME  2,069   2,027   3,920   4,060 
NON-INTEREST EXPENSES:                
Salaries and employee benefits  5,895   5,004   11,309   10,033 
Occupancy  651   517   1,177   1,109 
Furniture and equipment  189   181   320   336 
Professional fees  438   316   763   758 
FDIC insurance  135   105   206   216 
Pennsylvania shares tax  259   275   534   550 
Amortization of intangibles  55   66   105   132 
Merger and acquisition  1,803   -   2,179   - 
Software expenses  246   208   493   455 
ORE expenses  159   109   191   216 
Other  1,583   1,456   3,057   2,754 
TOTAL NON-INTEREST EXPENSES  11,413   8,237   20,334   16,559 
Income before provision for income taxes  6,392   5,776   11,812   11,002 
Provision for income taxes  1,054   930   1,943   1,751 
NET INCOME $5,338  $4,846  $9,869  $9,251 
                 
PER COMMON SHARE DATA:                
Net Income – Basic $1.39  $1.36  $2.67  $2.60 
Net Income – Diluted $1.39  $1.36  $2.67  $2.60 
                 
Number of shares used in computation – basic  3,845,175   3,561,453   3,699,200   3,564,106 
Number of shares used in computation – diluted  3,846,204   3,562,835   3,699,714   3,564,801 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

5
2
Index

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(UNAUDITED)

     
  
Three Months Ended
June 30,
  
Six Months Ended,
June 30,
 
(in thousands) 2020  2019  2020  2019 
Net income $5,338  $4,846  $9,869  $9,251 
Other comprehensive income (loss):                
Change in unrealized gains (losses) on available for sale securities  400   3,088   4,735   4,416 
Income tax effect  (84)  (648)  (995)  (928)
Change in unrecognized pension cost  267   62   424   123 
Income tax effect  (56)  (14)  (90)  (27)
Change in unrealized gain (loss) on interest rate swaps  (566)  -   (566)  - 
Income tax effect  120   -   120   - 
Less:  Reclassification adjustment for investment security gains included in net income  (117)  -   (117)  - 
Income tax effect  25   -   25   - 
Other comprehensive income (loss), net of tax  (11)  2,488   3,536   3,584 
Comprehensive income $5,327  $7,334  $13,405  $12,835 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

3
Index

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
(UNAUDITED)

  Common Stock  Additional     
Accumulated
Other
       
(in thousands, except share data) Shares  Amount  
Paid-in
Capital
  
Retained
Earnings
  
Comprehensive
Income (Loss)
  
Treasury
Stock
  Total 
                      
Balance, March 31, 2020  3,938,668  $3,939  $55,129  $113,374  $2,918  $(15,437) $159,923 
                             
Comprehensive income:                            
Net income              5,338           5,338 
Net other comprehensive loss                  (11)      (11)
Stock dividend  38,318   38   1,878   (1,916)          - 
Issuance of Common stock  373,356   373   18,854               19,227 
Purchase of treasury stock (4,505 shares)                      (223)  (223)
Restricted stock, executive and Board of Director awards (6,447 shares)          (234)          326   92 
Restricted stock vesting          241               241 
Cash dividend reinvestment paid from treasury stock (6,120 shares)          (5)          309   304 
Cash dividends, $0.451 per share              (1,796)          (1,796)
Balance, June 30, 2020  4,350,342  $4,350  $75,863  $115,000  $2,907  $(15,025) $183,095 
                             
Balance, December 31, 2019  3,938,668  $3,939  $55,089  $110,800  $(629) $(14,425) $154,774 
                             
Comprehensive income:                            
Net income              9,869           9,869 
Net other comprehensive income                  3,536       3,536 
Stock dividend  38,318   38   1,878   (1,916)          - 
Issuance of Common stock  373,356   373   18,854               19,227 
Purchase of treasury stock (27,917 shares)                      (1,502)  (1,502)
Restricted stock, executive and Board of Director awards (6,651 shares)          (233)          338   105 
Restricted stock vesting          281               281 
Cash dividend reinvestment paid from treasury stock (10,276 shares)          (6)  -       564   558 
Cash dividends, $1.00 per share              (3,753)          (3,753)
Balance, June 30, 2020  4,350,342  $4,350  $75,863  $115,000  $2,907  $(15,025) $183,095 
                             
Balance, March 31
, 2019
  3,904,212   3,904   53,102   102,574   (2,825)  (13,910)  142,845 
                             
Comprehensive income:                            
Net income              4,846           4,846 
Net other comprehensive income                  2,488       2,488 
Stock dividend  34,456   35   2,067   (2,102)          - 
Purchase of treasury stock (14,858 shares)                      (906)  (906)
Restricted stock, executive and Board of Director awards          (300)          415   115 
Restricted stock vesting          218               218 
Forfeited restricted stock          9           (9)  - 
Cash dividends, $0.436 per share              (1,585)          (1,585)
Balance, June 30, 2019  3,938,668  $3,939  $55,096  $103,733  $(337) $(14,410) $148,021 
                             
Balance, December 31, 2018  3,904,212   3,904   53,099   99,727   (3,921)  (13,580)  139,229 
                             
Comprehensive income:                            
Net income              9,251           9,251 
Net other comprehensive income                  3,584       3,584 
Stock dividend  34,456   35   2,067   (2,102)          - 
Purchase of treasury stock (20,620 shares)                      (1,236)  (1,236)
Restricted stock, executive and Board of Director awards          (300)          415   115 
Restricted stock vesting          221               221 
Forfeited restricted stock          9           (9)  - 
Cash dividends, $0.872 per share              (3,143)          (3,143)
Balance, June 30, 2019  3,938,668  $3,939  $55,096  $103,733  $(337) $(14,410) $148,021 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

4
Index

CITIZENS FINANCIAL SERVICES, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)

 
Six Months Ended
June 30,
 
(in thousands) 2020  2019 
CASH FLOWS FROM OPERATING ACTIVITIES:      
Net income $9,869  $9,251 
Adjustments to reconcile net income to net Cash (used in) provided by operating activities:        
Provision for loan losses  950   750 
Depreciation and amortization  (1,264)  267 
Amortization and accretion of investment securities  277   294 
Deferred income taxes  173   660 
Equity security gains (losses), net  243   (41)
Available for sale security gains, net  (117)  - 
Earnings on bank owned life insurance  (334)  (305)
Originations of loans held for sale  (31,889)  (7,628)
Proceeds from sales of loans held for sale  15,542   8,077 
Realized gains on loans sold  (427)  (163)
Increase in accrued interest receivable  (809)  (160)
Increase (decrease) in accrued interest payable  (364)  (28)
Other, net  2,444   (656)
Net cash (used in) provided by operating activities  (5,706)  10,318 
CASH FLOWS FROM INVESTING ACTIVITIES:        
Available-for-sale securities:        
Proceeds from sales  5,476   - 
Proceeds from maturity and principal repayments  44,204   30,767 
Purchase of securities  (76,877)  (23,907)
Purchase of equity securities  (245)  - 
Purchase of interest bearing time deposits with other banks  (350)  - 
Proceeds from matured interest bearing time deposits with other banks  350   - 
Proceeds from redemption of regulatory stock  6,383   5,215 
Purchase of regulatory stock  (3,923)  (5,472)
Net increase in loans  (22,949)  (21,456)
Purchase of premises and equipment  (561)  (165)
Proceeds from sale of premises and equipment  -   7 
Proceeds from sale of foreclosed assets held for sale  466   452 
Acquisition, net of cash paid  1,023   - 
Net cash used in investing activities  (47,003)  (14,559)
CASH FLOWS FROM FINANCING ACTIVITIES:        
Net increase in deposits  93,339   (1,498)
Proceeds from long-term borrowings  5,000   5,000 
Repayments of long-term borrowings  (3,000)  (3,123)
Net (decrease) increase in short-term borrowed funds  (17,423)  7,913 
Purchase of treasury and restricted stock  (1,502)  (1,236)
Dividends paid  (3,195)  (3,143)
Net cash provided by financing activities  73,219   3,913 
Net increase (decrease) in cash and cash equivalents  20,510   (328)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD  18,520   16,797 
CASH AND CASH EQUIVALENTS AT END OF PERIOD $39,030  $16,469 
         
Supplemental Disclosures of Cash Flow Information:        
Interest paid $4,523  $6,295 
Income taxes paid $-  $1,850 
Loans transferred to foreclosed property $-  $3,747 
Right of use asset and liability $-  $1,454 
Stock Dividend $1,916  $2,102 
         
Acquisition of     
Midcoast
Community
Bancorp Inc
 
Non-cash assets acquired        
Available-for-sale securities     $- 
Loans      223,235 
Premises and equipment      1,787 
Accrued interest receivable      586 
Bank owned life insurance      3,766 
Intangibles      157 
Deferred tax asset      3,402 
Other assets      2,878 
Goodwill      8,080 
       243,891 
         
Liabilities assumed        
Noninterest-bearing deposits      38,694 
Interest-bearing deposits      170,132 
Accrued interest payable      164 
Borrowed funds      15,497 
Other liabilities      1,198 
       225,685 
Net non-cash assets acquired      18,206 
Cash and cash equivalents acquired     $8,637 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

5
Index

CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Note 1 - Basis of Presentation



Citizens Financial Services, Inc. (individually and collectively with its direct and indirect subsidiaries, the “Company”) is a Pennsylvania corporation and the holding company of its wholly owned subsidiary, First Citizens Community Bank (the “Bank”), and of the Bank’s wholly owned subsidiaries, First Citizens Insurance Agency, Inc. (“First Citizens Insurance”) and 1st Realty of PA LLC (“Realty”). The Bank is the wholly owned subsidiary of CZFS Acquisition Company, LLC, which is a wholly owned subsidiary of the Company. Realty was formed in March of 2019 to manage and sell properties acquired by the Bank in the settlement of a bankruptcy filing with a commercial customer.



The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders’ equity.  All material inter‑company balances and transactions have been eliminated in consolidation.



In the opinion of management of the Company, the accompanying interim financial statements at March 31,June 30, 2020 and for the periods ended March 31,June 30, 2020 and 2019 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations at the dates and for the periods presented. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and of revenues and expenses for the period covered by the Consolidated Income Statement. The financial performance reported for the Company for the three and six month period ended March 31,June 30, 2020 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.


Note 2 – Revenue Recognition



In accordance with ASC 606, Management determined that the primary sources of revenue emanating from interest and dividend income on loans and investments along with noninterest revenue resulting from investment security gains, loan servicing, gains on loans sold and earnings on bank owned life insurances are not within the scope of ASC 606. These sources of revenue cumulatively comprise 90.0%92.85% and 89.8%90.02% of the total revenue of the Company for the three months ended March 31,June 30, 2020 and 2019, respectively, and 91.52% and 90.0% of the total revenue of the Company for the six months ended June 30, 2020 and 2019, respectively. The main types of noninterest income within the scope of the standard are as follows:


Service charges on deposit accounts – The Company has contracts with its deposit customers where fees are charged if certain parameters are not met. These agreements can be cancelled at any time by either the Company or the deposit customer. Revenue from these transactions is recognized on a monthly basis as the Company has an unconditional right to the fee consideration. The Company also has transaction fees related to specific transactions or activities resulting from a customer request or activity that include overdraft fees, online banking fees, interchange fees, ATM fees and other transaction fees. All of these fees are attributable to specific performance obligations of the Company where the revenue is recognized at a defined point in time upon the completion of the requested service/transaction.


6

Trust fees – Typical contracts for trust services are based on a fixed percentage of the assets earned ratably over a defined period and billed on a monthly basis. Fees charged to customers’ accounts are recognized as revenue over the period during which the Company fulfills its performance obligation under the contract (i.e., holding client asset in a managed fiduciary trust account). For these accounts, the performance obligation of the Company is typically satisfied by holding and managing the customer’s assets over time. Other fees related to specific customer requests are attributable to specific performance obligations of the Company where the revenue is recognized at a defined point in time, upon completion of the requested service/transaction.


6

Gains and losses on sale of other real estate owned – Gains and losses are recognized at the completion of the property sale when the buyer obtains control of the real estate and all of the performance obligations of the Company have been satisfied. Evidence of the buyer obtaining control of the asset include transfer of the property title, physical possession of the asset, and the buyer obtaining control of the risks and rewards related to the asset. In situations where the Company agrees to provide financing to facilitate the sale, additional analysis is performed to ensure that the contract for sale identifies the buyer and seller, the asset to be transferred, payment terms, and that the contract has a true commercial substance and that collection of amounts due from the buyer are reasonable. In situations where financing terms are not reflective of current market terms, the transaction price is discounted impacting the gain/loss and the carrying value of the asset.


Brokerage and insurance – Fees includes commissions from the sales of investments and insurance products recognized on a trade date basis as the performance obligation is satisfied at the point in time in which the trade is processed. Additional fees are based on a percentage of the market value of customer accounts and billed on a monthly or quarterly basis. The Company’s performance obligation under the contracts with certain customers is generally satisfied through the passage of time as the Company monitors and manages the assets in the customer’s portfolio and is not dependent on certain return or performance level of the customer’s portfolio. Fees for these services are billed monthly and are recorded as revenue at the end of the month for which the wealth management service has been performed. Other performance obligations (such as the delivery of account statements to customers) are generally considered immaterial to the overall transaction price.



The following table depicts the disaggregation of revenue derived from contracts with customers to depict the nature, amount, timing, and uncertainty of revenue and cash flows for the three and six months ended March 31,June 30, 2020 and 2019 (in thousands). All revenue in the table below relates to goods and services transferred at a point in time.


 Three Months Ended  Three Months Ended  Six Months Ended 
 March 31,  June 30,  June 30, 
Revenue stream 2020  2019  2020  2019  2020  2019 
Service charges on deposit accounts                  
Overdraft fees $359  358  $206  $369  $565  $727 
Statement fees 56  51   50   50   106   101 
Interchange revenue 522  540   555   595   1,077   1,135 
ATM income 83  91   59   101   142   192 
Other service charges  61   59   44   59   105   118 
Total Service Charges  1,081   1,099   914   1,174   1,995   2,273 
Trust 198  232   145   209   343   441 
Brokerage and insurance 340  293   249   261   589   554 
Other  107   111   138   76   245   187 
Total $1,726  $1,735  $1,446  $1,720  $3,172  $3,455 



7

Note 3 - Earnings per Share



The following table sets forth the computation of earnings per share.


 Three months ended  Six months ended 
  June 30,  June 30, 
  2020  2019  2020  2019 
Net income applicable to common stock $5,338  $4,846  $9,869  $9,251 
                 
Basic earnings per share computation                
Weighted average common shares outstanding  3,845,175   3,561,453   3,699,200   3,564,106 
Earnings per share – basic $1.39  $1.36  $2.67  $2.60 
                 
Diluted earnings per share computation                
Weighted average common shares outstanding for basic earnings per share  3,845,175   3,561,453   3,699,200   3,564,106 
Add: Dilutive effects of restricted stock  1,029   1,382   514   695 
Weighted average common shares outstanding for dilutive earnings per share  3,846,204   3,562,835   3,699,714   3,564,801 
Earnings per share – diluted $1.39  $1.36  $2.67  $2.60 
7

  Three Months Ended 
  March 31, 
  2020  2019 
Net income applicable to common stock $4,531,000  $4,405,000 
         
Basic earnings per share computation        
Weighted average common shares outstanding  3,515,500   3,528,466 
Earnings per share – basic $1.29  $1.25 
         
Diluted earnings per share computation        
Weighted average common shares outstanding for basic earnings per share  3,515,500   3,528,466 
Add: Dilutive effects of restricted stock  -   - 
Weighted average common shares outstanding for dilutive earnings per share  3,515,500   3,528,466 
Earnings per share – diluted $1.29  $1.25 


For the three months ended March 31,June 30, 2020 and 2019, there were 7,5646,304 and 6,7055,343 shares, respectively, related to the restricted stock plan that were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had per share prices ranging from $52.44-$59.24-$62.93 for the three month period ended March 31,June 30, 2020 and per share prices ranging from $47.81-$50.65-$62.93 for the three month period ended March 31,June 30, 2019. For the six months ended June 30, 2020 and 2019, 6,304 and 5,343 shares, respectively, related to the restricted stock plan were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had prices ranging from $59.24-$62.93 for the six month period ended June 30, 2020 and prices ranging from $50.65-$62.93 for the six month period ended June 30, 2019.


Note 4 – Investments



The amortized cost, gross unrealized gains and losses, and fair value of investment securities at March 31,June 30, 2020 and December 31, 2019 were as follows (in thousands):


    Gross  Gross    
 Amortized  Unrealized  Unrealized  Fair 
March 31, 2020 Cost  Gains  Losses  Value 
June 30, 2020 
Amortized
Cost
  
Gross
Unrealized
Gains
  
Gross
Unrealized
Losses
  
Fair
Value
 
Available-for-sale securities:                        
U.S. agency securities $74,681  $2,869  $(40) $77,510  $75,652  $2,818  $(34) $78,436 
U.S. treasury securities 27,406  907  -  28,313   27,418   839   -   28,257 
Obligations of state and            
political subdivisions 73,276  1,650  (148) 74,778 
Obligations of state and political subdivisions  81,695   1,991   (159)  83,527 
Corporate obligations 3,250  97  -  3,347   4,250   71   -   4,321 
Mortgage-backed securities in            
government sponsored entities  71,942   1,919   (21)  73,840 
Mortgage-backed securities in government sponsored entities  75,828   2,038   (47)  77,819 
Total available-for-sale securities $250,555  $7,442  $(209) $257,788  $264,843  $7,757  $(240) $272,360 
                            
December 31, 2019                                
Available-for-sale securities:                            
U.S. agency securities $83,410  $1,523  $(70) $84,863  $83,410  $1,523  $(70) $84,863 
U.S. treasury securities 27,394  267  -  27,661   27,394   267   -   27,661 
Obligations of state and            
political subdivisions 60,667  865  (77) 61,455 
Obligations of state and political subdivisions  60,667   865   (77)  61,455 
Corporate obligations 3,250  78  -  3,328   3,250   78   -   3,328 
Mortgage-backed securities in            
government sponsored entities  63,086   468   (155)  63,399 
Mortgage-backed securities in government sponsored entities  63,086   468   (155)  63,399 
Total available-for-sale securities $237,807  $3,201  $(302) $240,706  $237,807  $3,201  $(302) $240,706 


8


The following table shows the Company’s gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, which individual securities have been in a continuous unrealized loss position, at March 31,June 30, 2020 and December 31, 2019 (in thousands). As of March 31,June 30, 2020, the Company owned 2921 securities whose fair value was less than their cost basis.


June 30, 2020 Less than Twelve Months  Twelve Months or Greater  Total 
  
Fair
Value
  
Gross
Unrealized
Losses
  
Fair
Value
  
Gross
Unrealized
Losses
  
Fair
Value
  
Gross
Unrealized
Losses
 
U.S. agency securities $4,022  $(34) $-  $-  $4,022  $(34)
Obligations of state and political subdivisions  8,947   (159)  -   -   8,947   (159)
Mortgage-backed securities in government sponsored entities  4,344   (22)  3,580   (25)  7,924   (47)
Total securities $17,313  $(215) $3,580  $(25) $20,893  $(240)
                         
December 31, 2019                        
U.S. agency securities $14,587  $(63) $13,094  $(7) $27,681  $(70)
Obligations of states and political subdivisions  7,508   (75)  1,507   (2)  9,015   (77)
Mortgage-backed securities in government sponsored entities  27,737   (97)  9,559   (58)  37,296   (155)
Total securities $49,832  $(235) $24,160  $(67) $73,992  $(302)

8


  Less than Twelve Months  Twelve Months or Greater  Total 
     Gross     Gross     Gross 
  Fair  Unrealized  Fair  Unrealized  Fair  Unrealized 
 March 31, 2020 Value  Losses  Value  Losses  Value  Losses 
U.S. agency securities $3,765  $(40) $-  $-  $3,765  $(40)
Obligations of state and                        
    political subdivisions  13,631   (148)  -   -   13,631   (148)
Mortgage-backed securities in                        
   government sponsored entities  3,870   (6)  3,886   (15)  7,756   (21)
    Total securities $21,266  $(194) $3,886  $(15) $25,152  $(209)
                         
                         
December 31, 2019                         
U.S. agency securities $14,587  $(63) $13,094  $(7) $27,681  $(70)
Obligations of states and                        
     political subdivisions  7,508   (75)  1,507   (2)  9,015   (77)
Mortgage-backed securities in                        
   government sponsored entities  27,737   (97)  9,559   (58)  37,296   (155)
    Total securities $49,832  $(235) $24,160  $(67) $73,992  $(302)

As of March 31,June 30, 2020 and December 31, 2019, the Company’s investment securities portfolio contained unrealized losses on agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, obligations of states and political subdivisions and mortgage backed securities issued by government sponsored entities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in marketfair value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or issuer-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.


9


Proceeds from sales of securities available-for-sale for the three and six months ended June 30, 2020 were $5,476,000.There were no0 sales of available for sale securities during the three or six months ended March 31, 2020June 30, 2019. The gross gains and 2019.losses were as follows (in thousands):


 Three Months Ended  Six Months Ended 
  June 30  June 30 
  2020  2019  2020  2019 
Gross gains on available for sale securities $117  $-  $117  $- 
Gross losses on available for sale securities  -   -   -   - 
Net gains $117  $-  $117  $- 



The following table presents the net gains (losses) on the Company’s equity investments recognized in earnings during the three and six month periods ended March 31,June 30, 2020 and 2019, and the portion of unrealized gains for the period that relates to equity investments held at March 31,June 30, 2020 and 2019 (in thousands):


  Three Months Ended 
  March 31, 
Equity Securities 2020  2019 
Net (losses) gains recognized in equity securities during the period $(254) $11 
Less: Net gains realized on the sale of equity securities during the period  -   - 
Net unrealized  (losses) gains $(254) $11 
 
Three Months Ended
June 30,
  
Six Months Ended
June 30,
 
Equity securities 2020  2019  2020  2019 
Net gains (losses) recognized in equity securities during the period $11  $30  $(243) $41 
Less: Net gains realized on the sale of equity securities during the period  -   -   -   - 
Net unrealized gains (losses) $11  $30  $(243) $41 




Investment securities with an approximate carrying value of $203.1$221.7 million and $209.1 million at March 31,June 30, 2020 and December 31, 2019, respectively, were pledged to secure public funds, certain other deposits and borrowing lines.


9
ExpectedActual maturities willmay differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities (excludes equity securities) at March 31,June 30, 2020, by contractual maturity, are shown below (in thousands):


 Amortized    
 Cost  Fair Value  
Amortized
Cost
  Fair Value 
Available-for-sale debt securities:            
Due in one year or less $17,816  $17,979  $15,308  $15,477 
Due after one year through five years 71,725  75,025   66,358   69,524 
Due after five years through ten years 49,897  51,081   51,976   53,386 
Due after ten years  111,117   113,703   131,201   133,973 
Total $250,555  $257,788  $264,843  $272,360 


Note 5 – Loans



The Company grants loans primarily to customers throughout north central, central and south central Pennsylvania and the southern tier of New York. The recently completed MidCoast acquisition has expanded our lending market into Wilmington and Dover, Delaware.   Although the Company had a diversified loan portfolio at March 31,June 30, 2020 and December 31, 2019, a substantial portion of its debtors’ ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio and how those segments are analyzed within the allowance for loan losses as of March 31,June 30, 2020 and December 31, 2019 (in thousands):


March 31, 2020 Total Loans  Individually evaluated for impairment  Loans acquired with deteriorated credit quality (PCI)  Collectively evaluated for impairment 
June 30, 2020 Total Loans  
Individually
evaluated for
impairment
  
Loans acquired
with deteriorated
credit quality
  
Collectively
evaluated for
impairment
 
Real estate loans:                        
Residential $216,179  $1,220  $23  $214,936  $210,789  $1,194  $21  $209,574 
Commercial 338,490  11,480  1,195  325,815   513,598   11,829   3,820   497,949 
Agricultural 300,606  3,893  -  296,713   313,136   3,470   1,781   307,885 
Construction 17,926  -  -  17,926   31,744   -   -   31,744 
Consumer 9,533  3  -  9,530   30,973   -   -   30,973 
Other commercial loans 71,038  1,842  30  69,166   132,503   1,741   -   130,762 
Other agricultural loans 46,170  1,293  -  44,877   44,912   1,289   381   43,242 
State and political subdivision loans  93,778   -   -   93,778   85,978   -   -   85,978 
Total 1,093,720  19,731  1,248  1,072,741   1,363,633   19,523   6,003   1,338,107 
Less: allowance for loan losses  14,247   753   -   13,494 
Allowance for loan losses  14,827   888   -   13,939 
Net loans $1,079,473  $18,978  $1,248  $1,059,247  $1,348,806  $18,635  $6,003  $1,324,168 
            
December 31 , 2019                
Real estate loans:            
Residential $217,088  $1,166  $23  $215,899 
Commercial 342,023  11,537  1,210  329,276 
Agricultural 311,464  3,782  -  307,682 
Construction 15,519  -  -  15,519 
Consumer 9,947  4  -  9,943 
Other commercial loans 69,970  1,902  49  68,019 
Other agricultural loans 55,112  1,281  -  53,831 
State and political subdivision loans  94,446   -   -   94,446 
Total 1,115,569  19,672  1,282  1,094,615 
Less: allowance for loan losses  13,845   735   -   13,110 
Net loans $1,101,724  $18,937  $1,282  $1,081,505 


Upon
10

December 31, 2019 Total Loans  
Individually evaluated
for impairment
  
Loans acquired
with deteriorated
credit quality
  
Collectively
evaluated for
impairment
 
Real estate loans:            
Residential $217,088  $1,166  $23  $215,899 
Commercial  342,023   11,537   1,210   329,276 
Agricultural  311,464   3,782   -   307,682 
Construction  15,519   -   -   15,519 
Consumer  9,947   4   -   9,943 
Other commercial loans  69,970   1,902   49   68,019 
Other agricultural loans  55,112   1,281   -   53,831 
State and political subdivision loans  94,446   -   -   94,446 
Total  1,115,569   19,672   1,282   1,094,615 
Allowance for loan losses  13,845   735   -   13,110 
Net loans $1,101,724  $18,937  $1,282  $1,081,505 


The Company evaluated whether loans acquired as part of the MidCoast acquisition the Company evaluates whether an acquired loan iswere within the scope of ASC 310-30, Receivables-Loans and Debt Securities Acquired with Deteriorated Credit Quality. PCI, defined above,Purchased credit-impaired loans (“PCI”) are loans that have evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. There were no material increases or decreases in the expected cash flows of these loans between April 17, 2020 (the “acquisition date”) and June 30, 2020. The fair value of PCIpurchased credit-impaired loans, on the acquisition date, was determined, primarily based on the fair value of the loans’loan collateral. The carrying value of PCIpurchased loans acquired with deteriorated credit quality as a result of the MidCoast acquisition was $1,248,000$4,796,000 at June 30, 2020.


On the acquisition date, the preliminary estimate of the unpaid principal balance for all loans evidencing credit impairment acquired in the MidCoast acquisition was $8,005,000 and $1,282,000 at March 31, 2020 and December 31, 2019, respectively. The carryingthe estimated fair value of the PCI loans was determined by projected discounted contractual$4,869,000. Total contractually required payments on these loans, including interest, at the acquisition date was $8,801,000. However, the Company’s preliminary estimate of expected cash flows.flows was $5,835,000 at the acquisition date. At the acquisition date, the Company established a credit risk related non-accretable discount (a discount representing amounts which are not expected to be collected from the customer nor liquidation of collateral) of $2,966,000 relating to these impaired loans, reflected in the recorded net fair value. Such amount is reflected as a non-accretable fair value adjustment to loans. The Company further estimated the timing and amount of expected cash flows in excess of the estimated fair value and established an accretable discount of $966,000 on the acquisition date relating to these impaired loans.

10
11

The table below presents the components of the purchase accounting adjustments related to the purchased impaired loans acquired in the MidCoast Acquisition as of April 17, 2020 (in thousands):

 April 17, 2020 
Contractually required principal and interest at acquisition $8,801 
Non-accretable  discount  (2,966)
Expected cash flows  5,835 
Accretable discount $(966)
Estimated fair value $4,869 


Changes in the accretable yield for PCI loans were as follows for the three and six months ended March 31,June 30, 2020 and 2019, respectively (in thousands):


 Three months ended 
 March 31  
Three months ended
June 30,
  
Six months ended
June 30,
 
 2020  2019  2020  2019  2020  2019 
Balance at beginning of period $89  $104  $88  $102  $89  $104 
Acquisition of Midcoast  966   -   966   - 
Accretion  (1)  (2)  (67)  (2)  (68)  (4)
Balance at end of period $88  $102  $987  $100  $987  $100 



The following table presents additional information regarding loans acquired with specific evidence of deterioration in credit quality under ASC 310-30 (in thousands):


 March 31, 2020  December 31, 2019  June 30, 2020  December 31, 2019 
Outstanding balance $4,057  $4,072  $10,589  $4,072 
Carrying amount 1,248  1,282   6,003   1,282 



The segments of the Company’s loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consist primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equity loans are consumer purpose installment loans or lines of credit with terms of 15 years or less secured by a mortgage which is often a second lien on residential real estate. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential, commercial or agricultural real estate used during the construction phase of residential, commercial or agricultural projects. Consumer loans are typically unsecured or primarily secured by assets other than real estate and overdraft lines of credit are typically secured by customer deposit accounts. Other commercial loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivision loans are loans to state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.



Management considers other commercial loans, other agricultural loans, state and political subdivision loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer’s results of operations and cash flows or if the loan is modified in a troubled debt restructuring. In addition, certaincertain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships that are determined to be impaired may also be classified as impaired. Impaired loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allocation ofto the allowance for loan losses or a charge-off to the allowance for loan losses.


12


The following table includes the recorded investment and unpaid principal balances for impaired loan receivables by class, excluding PCI loans, with the associated allowance amount, if applicable (in(in thousands):


June 30, 2020 
Unpaid
Principal
Balance
  
Recorded
Investment
With No
Allowance
  
Recorded
Investment
With
Allowance
  
Total
Recorded
Investment
  
Related
Allowance
 
Real estate loans:               
Mortgages $1,272  $756  $297  $1,053  $20 
Home Equity  163   79   62   141   10 
Commercial  12,402   10,613   1,216   11,829   452 
Agricultural  3,628   1,535   1,935   3,470   77 
Other commercial loans  2,360   1,375   366   1,741   175 
Other agricultural loans  1,377   125   1,164   1,289   154 
Total $21,202  $14,483  $5,040  $19,523  $888 

December 31, 2019               
Real estate loans:               
Mortgages $1,212  $794  $223  $1,017  $20 
Home Equity  170   83   66   149   12 
Commercial  12,070   10,723   814   11,537   251 
Agricultural  3,900   1,580   2,202   3,782   151 
Consumer  4   4   -   4   - 
Other commercial loans  2,517   1,555   347   1,902   147 
Other agricultural loans  1,347   126   1,155   1,281   154 
Total $21,220  $14,865  $4,807  $19,672  $735 

11

     Recorded  Recorded       
  Unpaid  Investment  Investment  Total    
  Principal  With No  With  Recorded  Related 
March 31, 2020 Balance  Allowance  Allowance  Investment  Allowance 
Real estate loans:               
     Mortgages $1,282  $776  $300  $1,076  $20 
     Home Equity  166   80   64   144   11 
     Commercial  12,000   10,668   812   11,480   335 
     Agricultural  4,046   1,549   2,344   3,893   86 
Consumer  3   3   -   3   - 
Other commercial loans  2,459   1,499   343   1,842   148 
Other agricultural loans  1,381   129   1,164   1,293   153 
Total $21,337  $14,704  $5,027  $19,731  $753 

     Recorded  Recorded       
  Unpaid  Investment  Investment  Total    
  Principal  With No  With  Recorded  Related 
December 31, 2019 Balance  Allowance  Allowance  Investment  Allowance 
Real estate loans:               
     Mortgages $1,212  $794  $223  $1,017  $20 
     Home Equity  170   83   66   149   12 
     Commercial  12,070   10,723   814   11,537   251 
     Agricultural  3,900   1,580   2,202   3,782   151 
Consumer  4   4   -   4   - 
Other commercial loans  2,517   1,555   347   1,902   147 
Other agricultural loans  1,347   126   1,155   1,281   154 
Total $21,220  $14,865  $4,807  $19,672  $735 


The following tables includes the average balance of impaired loan receivables by class and the income recognized on these receivables for the three and six month periods ended March 31,June 30, 2020 and 2019(in2019 (in thousands):
  For the Three Months Ended 
  March 31, 2020  March 31, 2019 
        Interest        Interest 
  Average  Interest  Income  Average  Interest  Income 
  Recorded  Income  Recognized  Recorded  Income  Recognized 
  Investment  Recognized  Cash Basis  Investment  Recognized  Cash Basis 
Real estate loans:                  
     Mortgages $1,031  $5  $-  $1,103  $4  $- 
     Home Equity  146   2   -   85   1   - 
     Commercial  11,486   104   2   12,548   119   6 
     Agricultural  3,777   21   -   5,575   32   - 
Consumer  3   -   -   -   -   - 
Other commercial loans  1,839   1   -   2,137   1   - 
Other agricultural loans  1,276   2   -   1,431   2   - 
Total $19,558  $135  $2  $22,879  $159  $6 


 For the Six Months Ended 
  June 30, 2020  June 30, 2019 
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Interest
Income
Recognized
Cash Basis
  
Average
Recorded
Investment
  
Interest
Income
Recognized
  
Interest
Income
Recognized
Cash Basis
 
Real estate loans:                  
Mortgages $1,047  $10  $-  $1,088  $9  $- 
Home Equity  144   3   -   90   2   - 
Commercial  11,529   219   2   11,699   230   11 
Agricultural  3,761   40   -   5,205   56   - 
Consumer  3   -   -   1   -   - 
Other commercial loans  1,822   2   -   2,096   1   - 
Other agricultural loans  1,283   4   -   1,424   4   - 
Total $19,589  $278  $2  $21,603  $302  $11 

13

 For the Three Months Ended 
  June 30, 2020  June 30, 2019 
Real estate loans:                  
Mortgages $1,062  $5  $-  $1,073  $5  $- 
Home Equity  142   1   -   95   1   - 
Commercial  11,572   115   -   10,849   111   5 
Agricultural  3,746   19   -   4,835   24   - 
Consumer  2   -   -   2   -   - 
Other commercial loans  1,805   1   -   2,056   -   - 
Other agricultural loans  1,290   2   -   1,416   2   - 
Total $19,619  $143  $-  $20,326  $143  $5 

Credit Quality Information



For commercial real estate, agricultural real estate, construction, other commercial, other agricultural and state and political subdivision loans, management uses a nine grade internal risk rating system to monitor and assess credit quality. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
12
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.

Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.

Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.

Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.



To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay the loan as agreed, the Company’s loan rating process includes several layers of internal and external oversight. The Company’s loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial, agricultural and state and political relationships over $500,000 are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Company engages an external consultant on at least an annual basis to: 1) review a minimum of 50% of the dollar volume of the commercial, agricultural and municipal loan portfolios on an annual basis, 2) review a sample of new loans originated for over $1.0 million in the last year, 3) review a sample of borrowers with commitments greater than or equal to $1.0 million,  4) review selected loan relationships over $750,000 which are over 30 days past due or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.


14

The following tables represent credit exposures by internally assigned grades as of March 31,June 30, 2020 and December 31, 2019 (in(in thousands):


March 31, 2020 Pass  Special Mention  Substandard  Doubtful  Loss  Ending Balance 
June 30, 2020 Pass  
Special
Mention
  Substandard  Doubtful  Loss  Ending Balance 
Real estate loans:                                    
Commercial $326,415  $4,256  $7,780  $39  $-  $338,490  $499,279  $6,022  $8,258  $39  $-  $513,598 
Agricultural 276,091  14,648  9,867  -  -  300,606   282,906   15,843   14,387   -   -   313,136 
Construction 17,926  -  -  -  -  17,926   31,744   -   -   -   -   31,744 
Other commercial loans 68,042  986  1,948  62  -  71,038   126,757   1,626   4,060   60   -   132,503 
Other agricultural loans 42,917  1,030  2,223  -  -  46,170   41,151   1,027   2,734   -   -   44,912 
State and political                  
subdivision loans  93,369   -   409   -   -   93,778 
State and political subdivision loans  85,592   -   386   -   -   85,978 
Total $824,760  $20,920  $22,227  $101  $-  $868,008  $1,067,429  $24,518  $29,825  $99  $-  $1,121,871 


December 31, 2019 Pass  Special Mention  Substandard  Doubtful  Loss  Ending Balance  Pass  
Special
Mention
  Substandard  Doubtful  Loss  Ending Balance 
Real estate loans:                                    
Commercial $329,831  $4,305  $7,848  $39  $-  $342,023  $329,831  $4,305  $7,848  $39  $-  $342,023 
Agricultural 287,044  14,261  10,159  -  -  311,464   287,044   14,261   10,159   -   -   311,464 
Construction 15,519  -  -  -  -  15,519   15,519   -   -   -   -   15,519 
Other commercial loans 66,880  984  2,042  64  -  69,970   66,880   984   2,042   64   -   69,970 
Other agricultural loans 51,711  1,077  2,324  -  -  55,112   51,711   1,077   2,324   -   -   55,112 
State and political                  
subdivision loans  93,993   -   453   -   -   94,446 
State and political subdivision loans  93,993   -   453   -   -   94,446 
Total $844,978  $20,627  $22,826  $103  $-  $888,534  $844,978  $20,627  $22,826  $103  $-  $888,534 



For residential real estate mortgages, home equity and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below, and all loans past due 90 or more days and still accruing. The following table presents the recorded investment in those loan classes based on payment activity as of March 31,June 30, 2020 and December 31, 2019 (in(in thousands):


June 30, 2020 Performing  Non-performing  PCI  Total 
Real estate loans:            
Mortgages $152,008  $1,061  $21  $153,090 
Home Equity  57,644   55   -   57,699 
Consumer  30,950   23   -   30,973 
Total $240,602  $1,139  $21  $241,762 
                 
December 31, 2019 Performing  Non-performing  PCI  Total 
Real estate loans:                
Mortgages $156,151  $904  $23  $157,078 
Home Equity  59,950   60   -   60,010 
Consumer  9,939   8   -   9,947 
Total $226,040  $972  $23  $227,035 


13
15
Index
March 31, 2020 Performing  Non-performing  PCI  Total 
Real estate loans:            
     Mortgages $156,630  $915  $23  $157,568 
     Home Equity  58,555   56   -   58,611 
Consumer  9,514   19   -   9,533 
Total $224,699  $990  $23  $225,712 
                 
December 31, 2019 Performing  Non-performing  PCI  Total 
Real estate loans:                
     Mortgages $156,151  $904  $23  $157,078 
     Home Equity  59,950   60   -   60,010 
Consumer  9,939   8   -   9,947 
Total $226,040  $972  $23  $227,035 

Aging Analysis of Past Due Loan Receivables



Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due loan receivables as of March 31,June 30, 2020 and December 31, 2019 (in(in thousands):


                   Total  90 Days or 
 30-59 Days  60-89 Days  90 Days  Total Past        Loan  Greater and 
March 31, 2020 Past Due  Past Due  Or Greater  Due  Current  PCI  Receivables  Accruing 
June 30, 2020 
30-59 Days
Past Due
  
60-89 Days
Past Due
  
90 Days
Or Greater
  
Total Past
Due
  Current  PCI  
Total
Financing
Receivables
  
90 Days or
Greater and
Accruing
 
Real estate loans:                                                
Mortgages $559  $212  $345  $1,116  $156,429  $23  $157,568  $-  $129  $384  $511  $1,024  $152,045  $21  $153,090  $169 
Home Equity 165  89  53  307  58,304  -  58,611  -   227   47   51   325   57,374   -   57,699   - 
Commercial 2,044  350  3,905  6,299  330,996  1,195  338,490  55   1,210   913   4,942   7,065   502,713   3,820   513,598   416 
Agricultural 201  -  413  614  299,992  -  300,606  98   1,250   1,928   4   3,182   308,173   1,781   313,136   - 
Construction -  -  -  -  17,926  -  17,926  -   -   -   -   -   31,744   -   31,744   - 
Consumer 115  25  19  159  9,374  -  9,533  11   136   33   20   189   30,784   -   30,973   20 
Other commercial loans 63  77  1,715  1,855  69,153  30  71,038  -   78   2   1,642   1,722   130,781   -   132,503   49 
Other agricultural loans 50  -  20  70  46,100  -  46,170  -   60   1,290   20   1,370   43,161   381   44,912   - 
State and political                        
subdivision loans  -   -   -   -   93,778   -   93,778   - 
State and political subdivision loans  -   -   -   -   85,978   -   85,978   - 
Total $3,197  $753  $6,470  $10,420  $1,082,052  $1,248  $1,093,720  $164  $3,090  $4,597  $7,190  $14,877  $1,342,753  $6,003  $1,363,633  $654 
                        
Loans considered non-accrual $786  $5  $6,306  $7,097  $4,205  $-  $11,302    
Loans still accruing  2,411   748   164   3,323   1,077,847   1,248   1,082,418    
Total $3,197  $753  $6,470  $10,420  $1,082,052  $1,248  $1,093,720    


Loans considered non-accrual $2  $2,699  $6,536  $9,237  $1,456  $-  $10,693 
Loans still accruing  3,088   1,898   654   5,640   1,341,297   6,003   1,352,940 
Total $3,090  $4,597  $7,190  $14,877  $1,342,753  $6,003  $1,363,633 

December 31, 2019 
30-59 Days
Past Due
  
60-89 Days
Past Due
  
90 Days
Or Greater
  
Total Past
Due
  Current  PCI  
Total
Loan
Receivables
  
90 Days or
Greater and
Accruing
 
Real estate loans:                        
Mortgages $581  $57  $319  $957  $156,098  $23  $157,078  $1 
Home Equity  334   11   56   401   59,609   -   60,010   1 
Commercial  750   573   3,720   5,043   335,770   1,210   342,023   - 
Agricultural  118   -   785   903   310,561   -   311,464   299 
Construction  -   -   -   -   15,519   -   15,519   - 
Consumer  113   10   8   131   9,816   -   9,947   2 
Other commercial loans  217   71   1,946   2,234   67,687   49   69,970   184 
Other agricultural loans  29   32   -   61   55,051   -   55,112   - 
State and political subdivision loans  -   -   -   -   94,446   -   94,446   - 
Total $2,142  $754  $6,834  $9,730  $1,104,557  $1,282  $1,115,569  $487 

Loans considered non-accrual $90  $95  $6,347  $6,532  $5,004  $-  $11,536 
Loans still accruing  2,052   659   487   3,198   1,099,553   1,282   1,104,033 
Total $2,142  $754  $6,834  $9,730  $1,104,557  $1,282  $1,115,569 

14
16
Index

                    Total  90 Days or 
  30-59 Days  60-89 Days  90 Days  Total Past        Loan  Greater and 
December 31, 2019 Past Due  Past Due  Or Greater  Due  Current  PCI  Receivables  Accruing 
Real estate loans:                        
     Mortgages $581  $57  $319  $957  $156,098  $23  $157,078  $1 
     Home Equity  334   11   56   401   59,609   -   60,010   1 
     Commercial  750   573   3,720   5,043   335,770   1,210   342,023   - 
     Agricultural  118   -   785   903   310,561   -   311,464   299 
     Construction  -   -   -   -   15,519   -   15,519   - 
Consumer  113   10   8   131   9,816   -   9,947   2 
Other commercial loans  217   71   1,946   2,234   67,687   49   69,970   184 
Other agricultural loans  29   32   -   61   55,051   -   55,112   - 
State and political                                
   subdivision loans  -   -   -   -   94,446   -   94,446   - 
Total $2,142  $754  $6,834  $9,730  $1,104,557  $1,282  $1,115,569  $487 
                                 
Loans considered non-accrual $90  $95  $6,347  $6,532  $5,004  $-  $11,536     
Loans still accruing  2,052   659   487   3,198   1,099,553   1,282   1,104,033     
Total $2,142  $754  $6,834  $9,730  $1,104,557  $1,282  $1,115,569     

Nonaccrual Loans



Loans are considered for non-accrual status upon reaching 90 days delinquency, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans, or if full payment of principal and interest is not expected. Additionally, if management is made aware of other information including bankruptcy, repossession, death, or legal proceedings, the loan may be placed on non-accrual status. If a loan is 90 days or more past due and is well secured and in the process of collection, it may still be considered accruing.



The following table reflects the loan receivables, excluding PCI loans, on non-accrual status as of March 31,June 30, 2020 and December 31, 2019, respectively. The balances are presented by class of loan receivable ((in thousands):

 June 30, 2020  December 31, 2019 
Real estate loans:      
Mortgages $892  $903 
Home Equity  55   59 
Commercial  5,005   5,080 
Agricultural  2,046   2,578 
Consumer  3   6 
Other commercial loans  1,657   1,837 
Other agricultural loans  1,035   1,073 
  $10,693  $11,536 

Loan Modifications Related to COVID-19


The Company has elected to follow the loan modification guidance under Section 4013 of the CARES Act with regard to COVID-19 modifications made between March 1, 2020 and the earlier of either December 31, 2020 or the 60th day after the end of the COVID-19 national emergency. Under section 4013 of the CARES Act, loans less than 30 days past due as of December 31, 2019 will be considered current for COVID-19 modifications. A financial institution can then suspend the requirements under GAAP for loan modifications related to COVID-19 that would otherwise be categorized as a TDR, and suspend any determination of a loan modified as a result of COVID-19 as being a TDR, including the requirement to determine impairment for accounting purposes. Similarly, the Financial Accounting Standards Board has confirmed that short-term modifications made on a good-faith basis in thousands):response to COVID-19 to loan customers who were current prior to any relief are not TDRs. A modification of six months or less is considered to be a short-term loan modification. In response to the COVID-19 pandemic, the Company has prudently executed loan modifications for existing loan customers, which includes deferrals of interest and in certain cases deferrals of principal and interest. The following table presents information regarding loans which were subject to a loan modification related to COVID-19, with balances as of the date of modification and June 30, 2020, as well as the balance by modification type as of June 30, 2020.
  March 31, 2020  December 31, 2019 
Real estate loans:      
     Mortgages $915  $903 
     Home Equity  56   59 
     Commercial  5,038   5,080 
     Agricultural  2,464   2,578 
Consumer  8   6 
Other commercial loans  1,786   1,837 
Other agricultural loans  1,035   1,073 
  $11,302  $11,536 


17

June 30 
Number of
loans
  
Balance as of
Modification date
  
Number of
modified loan as
of June 30, 2020
  
Balance as of
June 30, 2020
  
% of loans as of
June 30, 2020
 
Real estate loans:               
Mortgages  46  $9,803   12  $1,962   1.28%
Home Equity  27   1,283   2   80   0.14%
Commercial  246   140,632   67   42,867   8.35%
Agricultural  43   15,833   18   6,658   2.13%
Construction  3   1,178   2   196   0.62%
Consumer  10   68   1   7   0.02%
Other commercial loans  88   24,077   25   1,292   0.98%
Other agricultural loans  46   3,347   7   2,335   5.20%
Total  509  $196,221   134  $55,397   4.06%

Troubled Debt Restructurings



In situations where, for economic or legal reasons related to a borrower'sborrower’s financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a Troubled Debt Restructuring (TDR). Management strives to identify borrowers in financial difficulty early and work with them to structure more affordable terms before their loan reaches nonaccrual status. These restructured terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of interest or principal, or both, management measures any impairment on the restructuring by calculating the present value of the revised loan terms and comparing this balance to the Company’s investment in the loan prior to the restructuring. As these loans are individually evaluated, they are excluded from pooled portfolios when calculating the allowance for loan and lease losses and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered TDRs, including payment history under the modified loan terms, the borrower’s ability to continue to repay the loan based on continued evaluation of their operating results and cash flows from operations.  As of March 31,June 30, 2020 and December 31, 2019, included within the allowance for loan losses are reserves of $273,000$290,000 and $345,000 respectively, that are associated with loans modified as TDRs.


15

Loan modifications that are considered TDRs completed during the three and six months ended March 31,June 30, 2020 and 2019 were as follows (dollars in thousands):


 For the Three Months Ended March 31, 2020  For the Three Months Ended June 30, 2020 
 Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment  Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment 
 Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification 
                                    
Real estate loans:                                    
Agricultural  -   1  $-  $150  $-  $150 
Commercial  -   2  $-  $406  $-  $406 
Total  -   1  $-  $150  $-  $150   -   2  $-  $406  $-  $406 


 For the Six Months Ended June 30, 2020 
 For the Three Months Ended March 31, 2019  Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment 
 Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification 
 Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification                   
Real estate loans:                                    
Commercial -  1  $-  $548  $-  $548   -   2  $-  $406  $-  $406 
Agricultural  -   1   -   150   -   150 
Total  -   1  $-  $548  $-  $548   -   3  $-  $556  $-  $556 


18

 For the Three Months Ended June 30, 2019 
  Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment 
  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification 
Real estate loans:                  
Mortgages  -   1  $-  $4  $-  $4 
Home Equity  -   1   -   40   -   40 
Commercial  -   4   -   222   -   222 
Total  -   6  $-  $266  $-  $266 

 For the Six Months Ended June 30, 2019 
  Number of contracts  Pre-modification Outstanding Recorded Investment  Post-Modification Outstanding Recorded Investment 
  Interest Modification  Term Modification  Interest Modification  Term Modification  Interest Modification  Term Modification 
Real estate loans:                  
Mortgages  -   1  $-  $4  $-  $4 
Home Equity  -   1   -   40   -   40 
Commercial  -   5   -   799   -   799 
Total  -   7  $-  $843  $-  $843 


Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism on modified loans occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. The following table presents the recorded investment in loans that were modified as TDRs during each 12-month period prior to the current reporting periods, which began January 1, 2020 and 2019 (3(6 month periods) and April 1, 2020 and 2019 (3 month periods), respectively, and that subsequently defaulted during these reporting periods (dollars in thousands):


 For the Three Months Ended  For the Three Months Ended  For the Six Months Ended 
 March 31, 2020  March 31, 2019  June 30, 2020  June 30, 2019  June 30, 2020  June 30, 2019 
 Number of contracts  Recorded investment  Number of contracts  Recorded investment  Number of contracts  
Recorded
investment
  Number of contracts  
Recorded
investment
  Number of contracts  
Recorded
investment
  Number of contracts  
Recorded
investment
 
Real estate loans:                        
Commercial  -  $-   1  $542   -  $-   1  $542 
Agricultural  -   -   1   1,439   -   -   1   1,439 
Other agricultural loans  -  $-   1  $124   -   -   3   137   -   -   4   261 
Total recidivism  -  $-   1  $124   -  $-   5  $2,118   -  $-   6  $2,242 


19
Allowance for Loan Losses


The following table segregates the allowance for loan losses (ALLL) into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of March 31,June 30, 2020 and December 31, 2019, respectively (in(in thousands):


 June 30, 2020  December 31, 2019 
  
Individually evaluated for
impairment
  
Collectively evaluated for
impairment
  Total  
Individually evaluated for
impairment
  
Collectively evaluated for
impairment
  Total 
Real estate loans:                  
Residential $30  $1,176  $1,206  $32  $1,082  $1,114 
Commercial  452   4,492   4,944   251   4,298   4,549 
Agricultural  77   4,984   5,061   151   4,871   5,022 
Construction  -   81   81   -   43   43 
Consumer  -   362   362   -   112   112 
Other commercial loans  175   1,026   1,201   147   1,108   1,255 
Other agricultural loans  154   667   821   154   807   961 
State and political subdivision loans  -   547   547   -   536   536 
Unallocated  -   604   604   -   253   253 
Total $888  $13,939  $14,827  $735  $13,110  $13,845 

16


  March 31, 2020  December 31, 2019 
  Individually evaluated for impairment  Collectively evaluated for impairment  Total  Individually evaluated for impairment  Collectively evaluated for impairment  Total 
Real estate loans:                  
     Residential $31  $1,123  $1,154  $32  $1,082  $1,114 
     Commercial  335   4,394   4,729   251   4,298   4,549 
     Agricultural  86   4,792   4,878   151   4,871   5,022 
     Construction  -   56   56   -   43   43 
Consumer  -   117   117   -   112   112 
Other commercial loans  148   1,149   1,297   147   1,108   1,255 
Other agricultural loans  153   682   835   154   807   961 
State and political                        
  subdivision loans  -   558   558   -   536   536 
Unallocated  -   623   623   -   253   253 
Total $753  $13,494  $14,247  $735  $13,110  $13,845 
The following tables roll forward the balance of the ALLL by portfolio segment for the three and six months ended March 31,June 30, 2020 and 2019, respectively (in(in thousands):


 For the three months ended March 31, 2020  For the three months ended June 30, 2020 
 Balance at December 31, 2019  Charge-offs  Recoveries  Provision  
Balance at
March 31, 2020
  
Balance at
March 31, 2020
  Charge-offs  Recoveries  Provision  
Balance at
June 30, 2020
 
Real estate loans:                              
Residential $1,114  $-  $-  $40  $1,154  $1,154  $-  $-  $52  $1,206 
Commercial 4,549  (1) 1  180  4,729   4,729   -   33   182   4,944 
Agricultural 5,022  -  -  (144) 4,878   4,878   -   -   183   5,061 
Construction 43  -  -  13  56   56   -   -   25   81 
Consumer 112  (8) 8  5  117   117   (10)  4   251   362 
Other commercial loans 1,255  -  2  40  1,297   1,297   -   3   (99)  1,201 
Other agricultural loans 961  -  -  (126) 835   835   -   -   (14)  821 
State and political               
subdivision loans 536  -  -  22  558 
State and political subdivision loans  558   -   -   (11)  547 
Unallocated  253   -   -   370   623   623   -   -   (19)  604 
Total $13,845  $(9) $11  $400  $14,247  $14,247  $(10) $40  $550  $14,827 


 For the three months ended March 31, 2019  For the three months ended June 30, 2019 
 
Balance at
December 31, 2018
  Charge-offs  Recoveries  Provision  
Balance at
March 31, 2019
  
Balance at
March 31, 2019
  Charge-offs  Recoveries  Provision  
Balance at
June 30, 2019
 
Real estate loans:                              
Residential $1,105  $-  $-  $(16) $1,089  $1,089  $-  $-  $(23) $1,066 
Commercial 4,115  (200) -  215  4,130   4,130   (93)  -   363   4,400 
Agricultural 4,264  -     128  4,392   4,392   -   -   140   4,532 
Construction 58  -  -  (26) 32   32   -   -   4   36 
Consumer 120  (14) 11  7  124   124   (8)  7   (5)  118 
Other commercial loans 1,354  -  3  (74) 1,283   1,283��  (38)  2   81   1,328 
Other agricultural loans 752  -  -  4  756   756   -   -   (15)  741 
State and political               
subdivision loans 762  -  -  (197) 565 
State and political subdivision loans  565   -   -   (26)  539 
Unallocated  354   -   -   359   713   713   -   -   (169)  544 
Total $12,884  $(214) $14  $400  $13,084  $13,084  $(139) $9  $350  $13,304 


20

 For the six months ended June 30, 2020 
  
Balance at
December 31, 2019
  Charge-offs  Recoveries  Provision  
Balance at
June 30, 2020
 
Real estate loans:               
Residential $1,114  $-  $-  $92  $1,206 
Commercial  4,549   (1)  34   362   4,944 
Agricultural  5,022   -   -   39   5,061 
Construction  43   -   -   38   81 
Consumer  112   (18)  12   256   362 
Other commercial loans  1,255   -   5   (59)  1,201 
Other agricultural loans  961   -   -   (140)  821 
State and political subdivision loans  536   -   -   11   547 
Unallocated  253   -   -   351   604 
Total $13,845  $(19) $51  $950  $14,827 

 For the six months ended June 30, 2019 
  
Balance at
December 31, 2018
  Charge-offs  Recoveries  Provision  
Balance at
June 30, 2019
 
Real estate loans:               
Residential $1,105  $-  $-  $(39) $1,066 
Commercial  4,115   (293)  -   578   4,400 
Agricultural  4,264   -   -   268   4,532 
Construction  58   -   -   (22)  36 
Consumer  120   (22)  18   2   118 
Other commercial loans  1,354   (38)  5   7   1,328 
Other agricultural loans  752   -   -   (11)  741 
State and political subdivision loans  762   -   -   (223)  539 
Unallocated  354   -   -   190   544 
Total $12,884  $(353) $23  $750  $13,304 


The Company allocates the ALLL based on the factors described below, which conform to the Company’s loan classification policy and credit quality measurements. In reviewing risk within the Company’s loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The ALLL consists of amounts applicable to: (i) residential real estate loans; (ii) residential real estate home equity loans; (iii) commercial real estate loans; (iv) agricultural real estate loans; (v) real estate construction loans; (vi) other commercial and agricultural loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non-classified loans. The following qualitative factors are analyzed:


17

Level of and trends in delinquencies and impaired/classified loans
◾Change in volume and severity of past due loans
◾Volume of non-accrual loans
◾Volume and severity of classified, adversely or graded loans;
Level of and trends in charge-offs and recoveries;
Trends in volume, terms and nature of the loan portfolio;
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;
Changes in the quality of the Company’s loan review system;
Experience, ability and depth of lending management and other relevant staff;
National, state, regional and local economic trends and business conditions
◾General economic conditions
◾Unemployment rates
◾Inflation rate/ Consumer Price Index
◾Changes in values of underlying collateral for collateral-dependent loans;

21

Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses;
Existence and effect of any credit concentrations, and changes in the level of such concentrations; and
Any change in the level of board oversight.



The Company analyzes its loan portfolio at least each quarter to determine the adequacy of its ALLL.



Loans determined to be TDRs are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. In calculating the impairment, the Company calculates the present value utilizing an analysis of discounted cash flows. If the present value calculated is below the recorded investment of the loan, impairment is recognized by a charge to the provision for loan and lease losses and a credit to the ALLL.



For the three and six months ended March 31,June 30, 2020, the allowance for all categories was increased due to a general deterioration in economic activity and increase in unemployment as a result of the Covid-19 pandemic. In addition, commercial real estate was increased due to an increase in past due and nonaccrual loans. The decrease in the provision for agricultural real estate loans and other agricultural loans is due to the decrease in outstanding loans in these loan portfolios as of March 31,June 30, 2020 compared to December 31, 2019. The decrease in the provision for other commercial loans is due to the decrease in the unguaranteed balance of other commercial loans from December 31, 2019 to June 30, 2020, excluding loans acquired as part of the MidCoast acquisition.



For the three months ended March 31,June 30, 2019, the allowance for commercial real estate was decreasedincreased in general reserves due to a decreasean increase in the amountsize of non-accrual, classified and past due loans, which was offset bythe portfolio as well as an increase in specific reserves. This was represented as an increase in the provision. The allowance for agricultural real estate loans was increased in general reserves as a result of higher loan balances, an increase in the amount of loans classified as non-accrualspecial mention and past due.an increase in specific reserves. The result of this was represented as an increase in the provision. The allowance for other commercial loans was decreasedincreased as a result of a decreasegeneral increase in specific reservesthe size of the portfolio and a decreasean increase in the volume of classified loans. The result of these changes was represented as an increase in the provision.


For the six months ended June 30, 2019, the allowance for commercial real estate was increased in general reserves due to general increase in the size of the portfolio. There also was an increase in specific reserves for commercial real estate, which was partially offset by the decrease in substandard loans. The total change was represented as an increase in the provision. The allowance for agricultural real estate loans was increased in general reserves as a decreaseresult of higher loan balances and an increase in the amount of loans classified as special mention, substandard nonaccrual. Additionally, there was an increase in specific reserves. These resulted in an increase in the provision. The allowance for state and political subdivision was decreased as a result a decrease in the volume of classified loans. The result of this change was represented as a decrease in the provision.

Foreclosed Assets Held For Sale



Foreclosed assets acquired in settlement of loans are carried at fair value, less estimated costs to sell, and are included in other assets on the Consolidated Balance Sheet. As of March 31,June 30, 2020 and December 31, 2019, included within other assets are $3,056,000$2,853,000 and $3,404,000, respectively, of foreclosed assets. As of March 31,June 30, 2020, included within the foreclosed assets are $167,000 of consumer residential mortgages that were foreclosed on or received via a deed in lieu transaction prior to the period end. As of March 31,June 30, 2020, the Company had initiated formal foreclosure proceedings on $743,000$723,000 of consumer residential mortgages, which had not yet been transferred into foreclosed assets.assets In accordance with various state regulations, foreclosure actions have been suspended into the third quarter.



18
22

Note 6 – Goodwill and Other Intangible Assets



The following table provides the gross carrying value and accumulated amortization of intangible assets as of March 31,June 30, 2020 and December 31, 2019 (in thousands):


 March 31, 2020  December 31, 2019  June 30, 2020  December 31, 2019 
 Gross carrying value  Accumulated amortization  Net carrying value  Gross carrying value  Accumulated amortization  Net carrying value  Gross carrying value  
Accumulated
amortization
  Net carrying value  Gross carrying value  
Accumulated
amortization
  Net carrying value 
Amortized intangible assets (1):                                    
Mortgage servicing rights (MSRs) $1,764  $(1,125) $639  $1,718  $(1,077) $641 
MSRs $1,838  $(1,174) $664  $1,718  $(1,077) $641 
Core deposit intangibles 1,786  (1,131) 655  1,786  (1,081) 705   1,943   (1,186)  757   1,786   (1,081)  705 
Covenant not to compete  125   (125)  -   125   (125)  -   125   (125)  -   125   (125)  - 
Total amortized intangible assets $3,675  $(2,381) $1,294  $3,629  $(2,283) $1,346  $3,906  $(2,485) $1,421  $3,629  $(2,283) $1,346 
Unamortized intangible assets:                                          
Goodwill $23,296          $23,296          $31,376          $23,296         


(1) Excludes fully amortized intangible assets


The following table provides the current year and estimated future amortization expense for amortized intangible assets for the next five years (in thousands). We based our projections of amortization expense shown below on existing asset balances at March 31,June 30, 2020. Future amortization expense may vary from these projections:


 MSRs  Core deposit intangibles  Covenant not to compete  Total  MSRs  Core deposit intangibles  Covenant not to compete  Total 
Three months ended March 31, 2020 (actual) $48  $50  $-  $98 
Three months ended March 31, 2019 (actual)  48   58   8   114 
Three months ended June 30, 2020 (actual) $49  $55  $-  $104 
Six months ended June 30, 2020 (actual)  97   105   -   202 
Three months ended June 30, 2019 (actual)  46   58   8   112 
Six months ended June 30, 2019 (actual)  94   116   16   226 
Estimate for year ending December 31,                            
Remaining 2020 138  147  -  285   98   112   -   210 
2021 141  165  -  306   165   192   -   357 
2022 108  133  -  241   128   156   -   284 
2023 80  100  -  180   97   121   -   218 
2024 57  68  -  125   71   85   -   156 
Thereafter  115   42   -   157   105   91   -   196 
Total $639  $655  $-  $1,294  $664  $757  $-  $1,421 



Note 7 - Employee Benefit Plans



For additional detailed disclosure on the Company'sCompany’s pension and employee benefits plans, please refer to Note 11 of the Company'sCompany’s Consolidated Financial Statements included in the 2019 Annual Report on Form 10-K.



Noncontributory Defined Benefit Pension Plan



The Bank sponsors a trusteed noncontributory defined benefit pension plan (“Pension Plan”) covering substantially all employees and officers hired prior to January 1, 2007. Additionally, the Bank assumed the noncontributory defined benefit pension plan of the First National Bank of Fredericksburg (FNB) when FNB was acquired in December 2015. The FNB plan was closed and all assets were distributed in the fourth quarter of 2019. The Bank’s funding policy is to make annual contributions, if needed, based upon the funding formula developed by the plans’ actuary. Any employee with a hire date of January 1, 2007 or later is not eligible to participate in the Pension Plan.



In lieu of the Pension Plan, employees with a hire date of January 1, 2007 or later are eligible to receive, after meeting certain length of service requirements, an annual discretionary 401(k) plan contribution from the Bank equal to a percentage of an employee’s base compensation.  The contribution amount, if any, is placed in a separate account within the 401(k) plan and is subject to a vesting requirement.


19
23

For employees who are eligible to participate in the Pension Plan, the Pension Plan requires benefits to be paid to eligible employees based primarily upon age and compensation rates during employment.  Upon retirement or other termination of employment, employees can elect either an annuity benefit or a lump sum distribution of vested benefits in the Pension Plan.



The following sets forth the components of net periodic benefit costs of the Pension Plan and the line item on the Consolidated Statement of Income where such amounts are included, for the three and six months ended March 31,June 30, 2020 and 2019, respectively (in thousands):
  Three Months Ended 
  March 31, 
  2020  2019 
Service cost $83  $89 
Interest cost  87   139 
Expected return on plan assets  (225)  (205)
Net amortization and deferral  62   61 
Net periodic benefit cost $7  $84 


 
Three Months Ended
June 30,
  
Six Months Ended
June 30,
  
  2020  2019  2020  2019 
Affected line item on the Consolidated
Statement of Income
Service cost $82  $89  $165  $178 Salary and Employee Benefits
Interest cost  79   139   166   278 Other Expenses
Expected return on plan assets  (206)  (205)  (431)  (410)Other Expenses
Partial Settlement  307   -   307   - Other Expenses
Net amortization and deferral  55   62   117   123 Other Expenses
Net periodic benefit cost $317  $85  $324  $169  


The Bank does not0t expect to contribute to the Pension Plan during 2020.



Restricted Stock Plan



The Company maintains a Restricted Stock Plan (the “Plan”) whereby employees and non-employee corporate directors are eligible to receive awards of restricted stock based upon performance related requirements.  Awards granted under the Plan are in the form of the Company’s common stock and are subject to certain vesting requirements including continuous employment or service with the Company.  In April of 2016, the Company’s shareholdersstockholders authorized a total of 150,000 shares of the Company’s common stock to be made available under the Plan. As of March 31,June 30, 2020, 129,211124,564 shares remain available to be issued under the Plan.  The Plan assists the Company in attracting, retaining and motivating employees to make substantial contributions to the success of the Company and to increase the emphasis on the use of equity as a key component of compensation.



The following table details the vesting, awarding and forfeiting of restricted sharesstock during the three and six months ended March 31,June 30, 2020:


 Three months 
    Weighted 
 Unvested  Average  Three months  Six months 
 Shares  Market Price  
Unvested
Shares
  
Weighted
Average
Market Price
  
Unvested
Shares
  
Weighted
Average
Market Price
 
Outstanding, beginning of period 10,877  $60.11   10,197  $60.12   10,877  $60.11 
Granted -  -   4,647   51.16   4,647   51.23 
Forfeited -  - 
Vested  (680)  (59.85)  (4,058)  (59.23)  (4,738)  (59.32)
Outstanding, end of period  10,197  $60.12   10,786  $56.60   10,786  $56.60 



Compensation expense related to restricted stock is recognized, based on the market price of the stock at the grant date, over the vesting period. Compensation expense related to restricted stock was $82,000$165,000 and $67,000$141,000 for the six months ended June 30, 2020 and 2019, respectively. For the three months ended March 31,June 30, 2020 and 2019, compensation expense totaled $83,000 and $74,000, respectively. At March 31,June 30, 2020, the total compensation cost related to nonvested awards that had not yet been recognized was $613,000,$610,000, which is expected to be recognized over the next three years.years.


24

Note 8 – Accumulated Comprehensive Income Loss(Loss)



The following tables present the changes in accumulated other comprehensive lossincome (loss) by component, net of tax, for the three and six months ended March 31,June 30, 2020 and 2019 (in thousands):


 Six months ended June 30, 2020 
  
Unrealized gain
(loss) on available
for sale securities (a)
  
Defined Benefit
Pension Items (a)
  
Unrealized loss on
interest rate swap (a)
  Total 
Balance as of December 31, 2019 $2,290  $(2,919) $-  $(629)
Other comprehensive income (loss) before reclassifications (net of tax)  3,740   -   (446)  3,294 
Amounts reclassified from accumulated other comprehensive income (loss) (net of tax)  (92)  334   -   242 
Net current period other comprehensive income (loss)  3,648   334   (446)  3,536 
Balance as of June 30, 2020 $5,938  $(2,585) $(446) $2,907 


 Six months ended June 30, 2019 
  
Unrealized gain
(loss) on available
for sale securities (a)
  
Defined Benefit
Pension Items (a)
  
Unrealized loss on
interest rate swap (a)
  Total 
Balance as of December 31, 2018 $(973) $(2,948) $-  $(3,921)
Other comprehensive income (loss) before reclassifications (net of tax)  3,488   -   -   3,488 
Amounts reclassified from accumulated other comprehensive income (loss) (net of tax)  -   96   -   96 
Net current period other comprehensive income (loss)  3,488   96   -   3,584 
Balance as of June 30, 2019 $2,515  $(2,852) $-  $(337)

 Three months ended June 30, 2020 
  
Unrealized gain
(loss) on available
for sale securities (a)
  
Defined Benefit
Pension Items (a)
  
Unrealized loss on
interest rate swap (a)
  Total 
Balance as of March 31, 2020 $5,714  $(2,796) $-  $2,918 
Other comprehensive income (loss) before reclassifications (net of tax)  316   -   (446)  (130)
Amounts reclassified from accumulated other comprehensive income (loss) (net of tax)  (92)  211   -   119 
Net current period other comprehensive income (loss)  224   211   (446)  (11)
Balance as of June 30, 2020 $5,938  $(2,585) $(446) $2,907 
20
 Three months ended June 30, 2019 
  
Unrealized gain
(loss) on available
for sale securities (a)
  
Defined Benefit
Pension Items (a)
  
Unrealized loss on
interest rate swap (a)
  Total 
Balance as of March 31, 2019 $75  $(2,900) $-  $(2,825)
Other comprehensive income (loss) before reclassifications (net of tax)  2,440   -   -   2,440 
Amounts reclassified from accumulated other comprehensive income (loss) (net of tax)  -   48   -   48 
Net current period other comprehensive income (loss)  2,440   48   -   2,488 
Balance as of June 30, 2019 $2,515  $(2,852) $-  $(337)


  Three months ended March 31, 2020 
  Unrealized gain (loss) on available for sale securities (a)  Defined Benefit Pension Items (a)  Total 
Balance as of December 31, 2019 $2,290  $(2,919) $(629)
Other comprehensive income (loss) before reclassifications (net of tax)  3,424   -   3,424 
Amounts reclassified from accumulated other            
     comprehensive income (loss) (net of tax)  -   123   123 
Net current period other comprehensive income (loss)  3,424   123   3,547 
Balance as of March 31, 2020 $5,714  $(2,796) $2,918 


  Three months ended March 31, 2019 
  Unrealized gain (loss) on available for sale securities (a)  Defined Benefit Pension Items (a)  Total 
Balance as of December 31, 2018 $(973) $(2,948) $(3,921)
Other comprehensive income (loss) before reclassifications (net of tax)  1,048   -   1,048 
Amounts reclassified from accumulated other            
     comprehensive income (loss) (net of tax)  -   48   48 
Net current period other comprehensive income (loss)  1,048   48   1,096 
Balance as of March 31, 2019 $75  $(2,900) $(2,825)
(a) Amounts in parentheses indicate debits on the Consolidated Balance Sheet.


25

The following table presents the significant amounts reclassified out of each component of accumulated other comprehensive income (loss) for the three and six months ended March 31,June 30, 2020 and 2019 (in thousands):


Details about accumulated other comprehensive income (loss) Amount reclassified from accumulated comprehensive income (loss) (a) Affected line item in the Consolidated Statement of Income 
Amount reclassified from
accumulated comprehensive
income (loss) (a)
 
Affected line item in the Consolidated Statement of
 Income
 Three Months Ended June 30, 2020  
 2020  2019  
Unrealized gains and losses on available for sale securities           
 $117  $- Available for sale securities gains, net
  (25)  - Provision for income taxes
 Three Months Ended March 31, 2020   $92  $- Net of tax
 2020  2019              
Defined benefit pension items                    
 $(156) $(61)Other expenses $(267) $(62)Other expenses
  33   13 Provision for income taxes  56   14 Provision for income taxes
 $(123) $(48)Net of tax $(211) $(48)Net of tax
            
Total reclassifications $(123) $(48)  $(119) $(48) 

  Six Months Ended June 30,  
  2020  2019  
Unrealized gains and losses on available for sale securities           
  $117  $- Available for sale securities gains, net
   (25)  - Provision for income taxes
  $92  $- Net of tax
             
Defined benefit pension items           
  $(423) $(123)Other expenses
   89   27 Provision for income taxes
  $(334) $(96)Net of tax
             
Total reclassifications $(242) $(96) 

(a) Amounts in parentheses indicate debitsexpenses and other amounts indicate income on the Consolidated Statement of Income


Note 9 – Fair Value Measurements



The Company has established a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by this hierarchy are as follows:follows:

Level I:Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level II:Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but traded less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.

Level III:Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.



26

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.


21

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the Company'sCompany’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Transfers between levels of the fair value hierarchy are recognized on the actual date of the event or circumstances that caused the transfer, which generally coincides with the Company’s monthly and/or quarterly valuation process.


Assets and Liabilities Required to be Measured at Fair Value on a Recurring Basis


The fair values of equity securities and securities available for sale are determined by quoted prices in active markets, when available, and classified as Level I. If quoted market prices are not available, the fair value is determined by a matrix pricing, which is a mathematical technique, widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities and classified as Level II. The fair values consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.


The following tables present the assets and liabilities reported on the Consolidated Balance Sheet at their fair value on a recurring basis as of March 31,June 30, 2020 and December 31, 2019 by level within the fair value hierarchy (in thousands). Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


March 31, 2020 Level I  Level II  Level III  Total 
June 30, 2020 Level I  Level II  Level III  Total 
Fair value measurements on a recurring basis:                        
Assets                        
Equity securities $649  $-  $-  $649  $703  $-  $-  $703 
Available for sale securities:                            
U.S. Agency securities -  77,510  -  77,510   -   78,436   -   78,436 
U.S. Treasury securities 28,313  -  -  28,313   28,257   -   -   28,257 
Obligations of state and            
political subdivisions -  74,778  -  74,778 
Obligations of state and political subdivisions  -   83,527   -   83,527 
Corporate obligations -  3,347  -  3,347   -   4,321   -   4,321 
Mortgage-backed securities in            
government sponsored entities -  73,840  -  73,840 
Mortgage-backed securities in government sponsored entities  -   77,819   -   77,819 
Liabilities                
Interest Rate Swaps  -   566   -   566 
                            
December 31, 2019 Level I  Level II  Level III  Total  Level I  Level II  Level III  Total 
Fair value measurements on a recurring basis:                            
Assets                            
Equity securities $701  $-  $-  $701  $701  $-  $-  $701 
Available for sale securities:                            
U.S. Agency securities -  84,863  -  84,863   -   84,863   -   84,863 
U.S. Treasuries securities 27,661  -  -  27,661   27,661   -   -   27,661 
Obligations of state and            
political subdivisions -  61,455  -  61,455 
Obligations of state and political subdivisions  -   61,455   -   61,455 
Corporate obligations -  3,328  -  3,328   -   3,328   -   3,328 
Mortgage-backed securities in            
government sponsored entities -  63,399  -  63,399 
Mortgage-backed securities in government sponsored entities  -   63,399   -   63,399 


22
27
Assets and Liabilities Required to be Measured and Reported at Fair Value on a Nonrecurring Basis



Assets measured at fair value on a nonrecurring basis as of March 31,June 30, 2020 and December 31, 2019 are included in the table below (in(in thousands):


March 31, 2020 Level I  Level II  Level III  Total 
June 30, 2020 Level I  Level II  Level III  Total 
Impaired Loans $-  $-  $4,178  $4,178  $-  $-  $4,056  $4,056 
Other real estate owned -  -  2,951  2,951   -   -   2,746   2,746 
                            
December 31, 2019 Level I  Level II  Level III  Total  Level I  Level II  Level III  Total 
Impaired Loans $-  $-  $3,860  $3,860  $-  $-  $3,860  $3,860 
Other real estate owned -  -  3,299  3,299   -   -   3,299   3,299 


•
Impaired Loans - The Company has measured impairment on impaired loans generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties. In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed.   Additionally, management makes estimates about expected costs to sell the property which are also included in the net realizable value.  If the fair value of the collateral dependent loan is less than the carrying amount of the loan a specific reserve for the loan is made in the allowance for loan losses or a charge-off is taken to reduce the loan to the fair value of the collateral (less estimated selling costs) and the loan is included in the table above as a Level III measurement.  If the fair value of the collateral exceeds the carrying amount of the loan, then the loan is not included in the table above as it is not currently being carried at its fair value. The fair values above excluded estimated selling costs of $458,000 and $424,000 at June 30, 2020 and December 31, 2019, respectively.

•
Other Real Estate Owned (OREO) – OREO is carried at the lower of cost or fair value, less estimated costs to sell, which is measured at the date of foreclosure.  If the fair value of the collateral exceeds the carrying amount of the loan, no charge-off or adjustment is necessary, the loan is not considered to be carried at fair value, and is therefore not included in the table above. If the fair value of the collateral is less than the carrying amount of the loan, management will charge the loan down to its estimated realizable value. The fair value of OREO is based on the appraised value of the property, which is generally unadjusted by management and is based on comparable sales for similar properties in the same geographic region as the subject property, and is included in the above table as a Level II measurement.  In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed.  In these cases, the loans are categorized in the above table as a Level III measurement since these adjustments are considered to be unobservable inputs. Income and expenses from operations and further declines in the fair value of the collateral subsequent to foreclosure are included in net expenses from OREO.

Impaired Loans - The Company has measured impairment on impaired loans generally based on the fair value of the loan’s collateral.  Fair value is generally determined based upon independent third-party appraisals of the properties. In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed.   Additionally, management makes estimates about expected costs to sell the property which are also included in the net realizable value.  If the fair value of the collateral dependent loan is less than the carrying amount of the loan a specific reserve for the loan is made in the allowance for loan losses or a charge-off is taken to reduce the loan to the fair value of the collateral (less estimated selling costs) and the loan is included in the table above as a Level III measurement.  If the fair value of the collateral exceeds the carrying amount of the loan, then the loan is not included in the table above as it is not currently being carried at its fair value. The fair values above excluded estimated selling costs of $459,000 and $424,000 at March 31, 2020 and December 31, 2019, respectively.
Other Real Estate Owned (OREO) – OREO is carried at the lower of cost or fair value, less estimated costs to sell, which is measured at the date of foreclosure.  If the fair value of the collateral exceeds the carrying amount of the loan, no charge-off or adjustment is necessary, the loan is not considered to be carried at fair value, and is therefore not included in the table above. If the fair value of the collateral is less than the carrying amount of the loan, management will charge the loan down to its estimated realizable value. The fair value of OREO is based on the appraised value of the property, which is generally unadjusted by management and is based on comparable sales for similar properties in the same geographic region as the subject property, and is included in the above table as a Level II measurement.  In some cases, management may adjust the appraised value due to the age of the appraisal, changes in market conditions, or observable deterioration of the property since the appraisal was completed.  In these cases, the loans are categorized in the above table as a Level III measurement since these adjustments are considered to be unobservable inputs. Income and expenses from operations and further declines in the fair value of the collateral subsequent to foreclosure are included in net expenses from OREO.

The following table provides a listing of the significant unobservable inputs used in the fair value measurement process for items valued utilizing Level III techniques (dollars in thousands).


March 31, 2020 Fair Value Valuation Technique(s)Unobservable input Range  Weighted average 
June 30, 2020 Fair Value Valuation Technique(s)Unobservable input Range  
Weighted
average
 
Impaired Loans $4,178 Appraised Collateral ValuesDiscount for time since appraisal 0-100% 15.54% $4,056 Appraised Collateral ValuesDiscount for time since appraisal  0-100%  16.37%
      Selling costs 5%-10% 9.34%         Selling costs  5%-10%  9.29%
      Holding period 0 - 12 months  11.93 months          Holding period 0 - 12 months  11.86 months 
                       
Other real estate owned 2,951 Appraised Collateral ValuesDiscount for time since appraisal 5-33% 16.27%  2,746 Appraised Collateral ValuesDiscount for time since appraisal  5-30%  18.47%
          


December 31, 2019 Fair Value Valuation Technique(s)Unobservable input Range  
Weighted
average
 
Impaired Loans  3,860 Appraised Collateral ValuesDiscount for time since appraisal  0-100%  19.22%
          Selling costs  5%-10%  9.26%
          Holding period 6 - 12 months  11.76 months 
               
Other real estate owned  3,299 Appraised Collateral ValuesDiscount for time since appraisal  5-43%  16.37%

23
28

Deceber 31, 2020 Fair Value Valuation Technique(s)Unobservable input Range  Weighted average 
Impaired Loans $3,860
 Appraised Collateral ValuesDiscount for time since appraisal  0-100%  19.22%
        Selling costs  5%-10%  9.26%
        Holding period 6- 12 months  11.76 months 
               
Other real estate owned  3,299
 Appraised Collateral ValuesDiscount for time since appraisal  5-43%  16.37%
               

Financial Instruments Not Required to be Measured or Reported at Fair Value



The carrying amount and fair value of the Company’s financial instruments that are not required to be measured or reported at fair value on a recurring basis are as follows (in thousands):


 Carrying             
March 31, 2020 Amount  Fair Value  Level I  Level II  Level III 
June 30, 2020
Carrying
Amount
Fair ValueLevel ILevel IILevel III
Financial assets:                  
Interest bearing time deposits with other banks $14,506  $14,962  $-  $-  $14,962 $14,256$14,966$-$-$14,966
Loans held for sale 2,006  2,006  -  -  2,006 17,468--17,468
Net loans 1,079,473  1,073,943  -  -  1,073,943 1,348,8061,356,103--1,356,103
                  
Financial liabilities:                  
Deposits 1,205,150  1,209,221  946,724  -  262,497 1,513,2841,519,3361,134,398-384,938
Borrowed funds 83,563  84,101  -  -  84,101 85,13585,375--85,375
                  
 Carrying             Carrying   
December 31, 2019 Amount  Fair Value  Level I  Level II  Level III AmountFair ValueLevel ILevel IILevel III
Financial assets:                  
Interest bearing time deposits with other banks $14,256  $14,635  $-  $-  $14,635 $14,256$14,635$-$-$14,635
Loans held for sale 815  815  -  -  815 815--815
Net loans 1,101,724  1,091,006  -  -  1,091,006 1,101,7241,091,006--1,091,006
                  
Financial liabilities:                  
Deposits 1,211,118  1,211,200  938,387  -  272,813 1,211,1181,211,200938,387-272,813
Borrowed funds 85,117  84,581  -  -  84,581 85,11784,581--84,581



The carrying amounts for cash and due from banks, bank owned life insurance, regulatory stock, accrued interest receivable and payable approximate fair value and are considered Level I measurements.


Note 10 – Acquisition of MidCoast Community Bancorp, Inc.


On April 17, 2020, Citizens Financial Services, Inc. (Company) and its wholly owned subsidiary, First Citizens Community Bank (Bank), and

In the second quarter of 2019, the Company announced the signing of a definitive merger agreement to acquire 100% of the outstanding equity interest of MidCoast Community Bancorp, Inc. (MidCoast),(“MidCoast”) for $6.50 per share in cash and stock. MidCoast was a Pennsylvania Corporation that conducted its business primarily through, its wholly owned subsidiary MidCoast Community Bank, (“MC Bank”) completed the merger agreed towhich operated from a main office in 2019, pursuant to whichWilmington, Delaware, and 2 branches in Wilmington, Delaware, and 1 branch in Dover, Delaware.


The transaction closed on April 17, 2020, with MidCoast Community Bank having been merged with and into a wholly-owned acquisition subsidiary of the Company, with the acquisition subsidiary as the surviving corporation. Concurrent with the merger, MC Bank merged with and into theFirst Citizens Community Bank, with theFirst Citizens Community Bank as the surviving institution.entity. The acquisition established the Company’s presence in the Wilmington and Dover, Delaware markets.


Each outstanding share of MidCoast common stock was converted into $6.50 in cash or 0.1065 shares
Under the terms of the Company’s common stock.  The merger resulted in 25%agreement, the Company acquired all of the outstanding shares of MidCoast for a total purchase price of approximately $26,843,000.  As a result of the acquisition, the Company issued 373,356 common stock (including for this purpose, dissenters’ shares) paidshares and $7.6 million in cash to the former shareholders of MidCoast. The shares were issued with a value of $51.50 per share, which was based on the close price of the Company’s stock on April 17, 2020.

29

The acquired assets and assumed liabilities were measured at estimated fair values. Management made significant estimates and exercised significant judgment in accounting for the acquisition.  Management measured loan fair values based on loan file reviews, appraised collateral values, expected cash flows, and historical loss factors of MidCoast.  Real estate acquired through foreclosure was primarily valued based on appraised collateral values.  The Company also recorded an identifiable intangible asset representing the core deposit base of MidCoast based on management’s evaluation of the cost of such deposits relative to alternative funding sources.  Management used significant estimates including the average lives of depository accounts, future interest rate levels, and the remainder was paidcost of servicing various depository products.


The business combination resulted in the Company’s common stock.   acquisition of loans with and without evidence of credit quality deterioration. MidCoast’s loans were deemed to have credit impairment at the acquisition date if the Company did not expect to receive all contractually required cash flows due to concerns about credit quality.  Such loans were fair valued and the difference between contractually required payments at the acquisition date and cash flows expected to be collected was recorded as a non-accretable difference. At the acquisition date, the Company recorded $4,869,000 of purchased credit-impaired loans. The method of measuring carrying value of purchased loans differs from loans originated by the Company (originated loans), and as such, the Company identifies purchased loans and purchased loans with a credit quality discount and originated loans at amortized cost.



MidCoast’s loans without evidence of credit deterioration were fair valued by discounting both expected principal and interest cash flows using an observable discount rate for similar instruments that a market participant would consider in determining fair value.  Additionally, consideration was given to management’s best estimates of default rates and pre-payment speeds.


The senior managementfollowing table summarizes the purchase of MidCoast as of April 17, 2020:

(In Thousands, Except Per Share Data)      
Purchase Price Consideration in Common Stock      
Citizens Financial Services, Inc. shares issued  373,356    
Value assigned to Citizens Financial Services, Inc. common share $51.50    
Purchase price assigned to MidCoast common shares exchanged for Citizens Financial Services, Inc.     $19,228 
Purchase Price Consideration - Cash for Common Stock        
Purchase price assigned to The First National Bank of Fredericksburg common shares exchanged for cash      7,615 
Total Purchase Price      26,843 
Net Assets Acquired:        
MidCoast Community Bancorp, Inc shareholders’ equity $24,330     
Adjustments to reflect assets acquired at fair value:        
Investments       
Loans        
Interest rate  1,424     
General credit  (4,375)    
Specific credit - non-amortizing  (2,135)    
Specific credit - amortizing  (966)    
Core deposit intangible  157     
Owned premises  (426)    
Other assets  65     
Deferred tax assets  2,217     
Adjustments to reflect liabilities acquired at fair value:        
Time deposits  (1,018)    
Borrowings  (497)    
Other liabilities  (13)    
       18,763 
Goodwill resulting from merger     $8,080 

30

The following condensed statement reflects the amounts recognized as of the acquisition date for each major class of asset acquired and liability assumed:

(In Thousands)      
Total purchase price    $26,843 
Net assets acquired:       
Cash and cash equivalents $8,637     
Loans  223,235     
Premises and equipment, net  1,787     
Accrued interest receivable  586     
Bank-owned life insurance  3,766     
Intangibles  157     
Deferred tax asset  3,402     
Other assets  2,878     
Time deposits  (123,841)    
Deposits other than time deposits  (84,985)    
Accrued interest payable  (164)    
Borrowings  (15,497)    
Other liabilities  (1,198)    
       18,763 
Goodwill resulting from the MidCoast merger     $8,080 


The Company recorded goodwill and other intangibles associated with the Bank remainedacquisition of MidCoast totaling $8,237,000.  Goodwill is not amortized, but is periodically evaluated for impairment.  The Company did not recognize any impairment from April 17, 2020 to June 30, 2020. None of the samegoodwill acquired is expected to be deductible for tax purposes.


Identifiable intangibles are amortized to their estimated residual values over the expected useful lives. Such lives are also periodically reassessed to determine if any amortization period adjustments are required. For the period from April 17, 2020 to June 30, 2020, no such adjustments were recorded.  The identifiable intangible asset consists of core deposit intangibles which are being amortized on an accelerated basis over the useful life of such assets.  The gross carrying amount of the core deposit intangible at June 30, 2020 was $157,000, with $5,000 accumulated amortization, respectively, as of that date.


As of June 30, 2020, the current year and estimated future amortization expense for the core deposit intangibles was (in thousands):

 Core deposit intangibles 
Three months ended June 30, 2020 (actual) $5 
Six months ended June 30, 2020 (actual)  5 
Estimate for year ending December 31,    
Remaining 2020  14 
2021  27 
2022  24 
2023  21 
2024  18 
Thereafter  48 
Total $152 

31

Amounts recognized separately from the acquisition include primarily legal fees, investment banking fees, system conversion costs, severance costs and contract termination costs. These costs were included in merger and acquisition expenses within non-interest expenses on the Consolidated Statement of Income and amounted to approximately $1,790,000 for the quarter ended June 30, 2020.


Results of operations for MidCoast prior to the acquisition date are not included in the Consolidated Statement of Income for the quarter ended June 30, 2020. 


The following table presents financial information regarding the merger. former MidCoast operations included in our Consolidated Statement of Income from the date of acquisition through June 30, 2020 under the column “Actual from Acquisition Date through June 30, 2020”.  In addition, the following table presents unaudited pro forma information as if the acquisition of MidCoast had occurred on January 1, 2019 under the “Pro Forma” columns.  The table below has been prepared for comparative purposes only and is not necessarily indicative of the actual results that would have been attained had the acquisition occurred as of the beginning of the periods presented, nor is it indicative of future results. Furthermore, the unaudited proforma information does not reflect management’s estimate of any revenue-enhancing opportunities nor anticipated cost savings as a result of the integration and consolidation of the acquisition.  Merger and acquisition integration costs and amortization of fair value adjustments are included in the numbers below.


    Unaudited Pro Forma for 
  Actual from Acquisition  Three Months Ended  Six Months Ended 
  Date Through  June 30,  June 30, 
(In Thousands, Except Per Share Data) June 30, 2020  2020  2019  2020  2019 
Net interest income $2,261  $18,710  $14,955  $37,206  $29,514 
Non-interest income  33   2,326   2,091   4,241   4,177 
Net income  1,092   3,478   5,440   8,628   10,800 
Pro forma earnings per share:                    
Basic     $1.03  $1.38  $2.20  $2.74 
Diluted     $1.02  $1.38  $2.20  $2.74 


Note 11 – Recent Accounting Pronouncements


24
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which changes the impairment model for most financial assets. This Update is intended to improve financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations.  The underlying premise of the Update is that financial assets measured at amortized cost should be presented at the net amount expected to be collected, through an allowance for credit losses that is deducted from the amortized cost basis. The allowance for credit losses should reflect management’s current estimate of credit losses that are expected to occur over the remaining life of a financial asset.  The income statement will be effected for the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the period. ASU 2016-13 is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted for annual and interim periods beginning after December 15, 2018. With certain exceptions, transition to the new requirements will be through a cumulative effect adjustment to opening retained earnings as of the beginning of the first reporting period in which the guidance is adopted.  In November 2019, the FASB issued ASU 2019-10, Financial Instruments ‒ Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842). This Update defers the effective date of ASU 2016-13 for SEC filers that are eligible to be smaller reporting companies, non-SEC filers, and all other companies to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. We expect to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, but cannot yet determine the magnitude of any such one-time adjustment or the overall impact of the new guidance on the consolidated financial statements. In that regard, we have formed a cross-functional working group. The working group is comprised of individuals from various functional areas including credit, loan origination and finance. We are currently working through our implementation plan which includes assessment and documentation of processes, internal controls and data sources; model development and documentation; and system configuration, among other things. We are also in the process of implementing a third-party vendor solution to assist us in the application of the ASU 2016-13. The adoption of the ASU 2016-13 could result in an increase in the allowance for loan losses as a result of changing from an “incurred loss” model, which encompasses allowances for current known and inherent losses within the portfolio, to an “expected loss” model, which encompasses allowances for losses expected to be incurred over the life of the portfolio. While we are currently unable to reasonably estimate the impact of adopting ASU 2016-13, we expect that the impact of adoption will be significantly influenced by the composition, characteristics and quality of our loan portfolio as well as the prevailing economic conditions and forecasts as of the adoption date.


32

In January 2017, the FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment. To simplify the subsequent measurement of goodwill, the FASB eliminated Step 2 from the goodwill impairment test.  In computing the implied fair value of goodwill under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination.  Instead, under the amendments in this Update, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting units fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.  A public business entity that is a U.S. Securities and Exchange Commission (SEC) filer should adopt the amendments in this Update for its annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. In November 2019, the FASB issued ASU 2019-10, Financial Instruments ‒ Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842), which deferred the effective date for ASC 350, Intangibles – Goodwill and Other, for smaller reporting companies to fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. This Update is not expected to have a significant impact on the Company’s consolidated financial statements.



In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes the Disclosure Requirements for Fair Value Measurements.  The Update removes the requirement to disclose the amount of and reasons for transfers between Level I and Level II of the fair value hierarchy; the policy for timing of transfers between levels; and the valuation processes for Level III fair value measurements. The Update requires disclosure of changes in unrealized gains and losses for the period included in other comprehensive income (loss) for recurring Level III fair value measurements held at the end of the reporting period and the range and weighted average of significant unobservable inputs used to develop Level III fair value measurements. This Update is effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019.  This Update is not expected to have a significant impact on the Company’s consolidated financial statements.


25

In August 2018, the FASB issued ASU 2018-14, Compensation – Retirement Benefits (Topic 715-20). This Update amends ASC 715 to add, remove and clarify disclosure requirements related to defined benefit pension and other postretirement plans. The Update eliminates the requirement to disclose the amounts in accumulated other comprehensive income expected to be recognized as part of net periodic benefit cost over the next year. The Update also removes the disclosure requirements for the effects of a one-percentage-point change on the assumed health care costs and the effect of this change in rates on service cost, interest cost and the benefit obligation for postretirement health care benefits. This Update is effective for public business entities for fiscal years ending after December 15, 2020, and must be applied on a retrospective basis.  For all other entities, this Update is effective for fiscal years ending after DecemberDecember 15, 2021.  This Update is not expected to have a significant impact on the Company’s consolidated financial statements.


33

In April 2019, the FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments, which affects a variety of topics in the Codification and applies to all reporting entities within the scope of the affected accounting guidance. Topic 326, Financial Instruments – Credit Losses amendments are effective for SEC registrants for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. For all other public business entities, the effective date is for fiscal years beginning after December 15, 2020, and for all other entities, the effective date is for fiscal years beginning after December 15, 2021.  Topic 815, Derivatives and Hedging amendments are effective for public business entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2019, and interim periods beginning after December 15, 2020. For entities that have adopted the amendments in Update 2017-12, the effective date is as of the beginning of the first annual period beginning after the issuance of this Update. Topic 825, Financial Instruments amendmentsare effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years. In November 2019, the FASB issued ASU 2019-10, Financial Instruments ‒ Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842). This Update defers the effective date of ASU 2016-13 for SEC filers that are eligible to be smaller reporting companies, non-SEC filers and all other companies to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. Furthermore, the ASU provides a one-year deferral of the effective dates of the ASUs on derivatives and hedging for companies that are not public business entities. The Company qualifies as a smaller reporting company and does not expect to early adopt these ASUs.



In May 2019, the FASB issued ASU 2019-05, Financial Instruments – Credit Losses, Topic 326, which allows entities to irrevocably elect the fair value option for certain financial assets previously measured at amortized cost upon adoption of the new credit losses standard. To be eligible for the transition election, the existing financial asset must otherwise be both within the scope of the new credit losses standard and eligible for the applying the fair value option in ASC 825-10.3. The election must be applied on an instrument-by-instrument basis and is not available for either available-for-sale or held-to-maturity debt securities. For entities that elect the fair value option, the difference between the carrying amount and the fair value of the financial asset would be recognized through a cumulative-effect adjustment to opening retained earnings as of the date an entity adopted ASU 2016-13. Changes in fair value of that financial asset would subsequently be reported in current earnings. For entities that have not yet adopted ASU 2016-13, the effective dates and transition requirements are the same as those in ASU 2016-13. For entities that have adopted ASU 2016-13, ASU 2019-05 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted once ASU 2016-13 has been adopted.  In November 2019, the FASB issued ASU 2019-10, Financial Instruments ‒ Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842). The Update defers the effective date of ASU 2016-13 for SEC filers that are eligible to be smaller reporting companies, non-SEC filers and all other companies to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company qualifies as a smaller reporting company and does not expect to early adopt ASU 2016-13.


26

In July 2019, the FASB issued ASU 2019-07, Codification Updates to SEC Sections, Amendments to SEC Paragraphs Pursuant to SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization, and Miscellaneous Updates. This ASU amends various SEC paragraphs pursuant to the issuance of SEC Final Rule Releases No. 33-10532, Disclosure Update and Simplification, and Nos. 33-10231 and 33-10442, Investment Company Reporting Modernization. Other miscellaneous updates to agree to the electronic Code of Federal Regulations also have been incorporated.


34

In November 2019, the FASB issued ASU 2019-10, Financial Instruments ‒ Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842). The Update defers the effective dates of ASU 2016-13 for SEC filers that are eligible to be smaller reporting companies, non-SEC filers, and all other companies to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. This Update also amends the mandatory effective date for the elimination of Step 2 from the goodwill impairment test under ASU No. 2017-04, Intangibles ‒ Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (Goodwill),to align with those used for credit losses. Furthermore, the ASU provides a one-year deferral of the effective dates of the ASUs on derivatives and hedging and leases for companies that are not public business entities. The Company qualifies as a smaller reporting company and does not expect to early adopt these ASUs.



In November 2019, the FASB issued ASU 2019-11, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, to clarify its new credit impairment guidance in ASC 326, based on implementation issues raised by stakeholders. This Update clarified, among other things, that expected recoveries are to be included in the allowance for credit losses for these financial assets; an accounting policy election can be made to adjust the effective interest rate for existing troubled debt restructurings based on the prepayment assumptions instead of the prepayment assumptions applicable immediately prior to the restructuring event; and extends the practical expedient to exclude accrued interest receivable from all additional relevant disclosures involving amortized cost basis. The effective dates in this Update are the same as those applicable for ASU 2019-10. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s consolidated financial position or results of operations.



In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740), to simplify the accounting for income taxes, change the accounting for certain tax transactions, and make minor improvements to the codification. This Update provides a policy election to not allocate consolidated income taxes when a member of a consolidated tax return is not subject to income tax and provides guidance to evaluate whether a step-up in tax basis of goodwill relates to a business combination in which book goodwill was recognized or a separate transaction. The Update also changes current guidance for making an intraperiod allocation, if there is a loss in continuing operations and gains outside of continuing operations; determining when a deferred tax liability is recognized after an investor in a foreign entity transitions to or from the equity method of accounting; accounting for tax law changes and year-to-date losses in interim periods; and determining how to apply the income tax guidance to franchise taxes that are partially based on income. For public business entities, the amendments in this Update are effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2020. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s consolidated financial position or results of operations.



In January 2020, the FASB issued ASU 2020-1, Investments – Equity Securities (Topic 321), Investments – Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815), to clarify that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting for the purposes of applying the measurement alternative in accordance with Topic 321 immediately before applying or upon discontinuing the equity method. The amendments also clarify that, for the purpose of applying paragraph 815-10-15-141(a) an entity should not consider whether, upon the settlement of the forward contract or exercise of the purchased option, individually or with existing investments, the underlying securities would be accounted for under the equity method in Topic 323 or the fair value option, in accordance with the financial instruments guidance in Topic 825. An entity also would evaluate the remaining characteristics in paragraph 815-10-15-141 to determine the accounting for those forward contracts and purchased options. For public business entities, the amendments in this Update are effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s consolidated financial position or results of operations.


27
35

In January 2020, the FASB issued ASU 2020-2, Financial Instruments – Credit Losses (Topic 326) and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 119 and Update to SEC Section on Effective Date Related to Accounting Standards Update No. 2016-02, Leases (Topic 842), February 2020, to add and amend SEC paragraphs in the Accounting Standards Codification to reflect the issuance of SEC Staff Accounting Bulletin No. 119, related to the new credit losses standard, and comments by the SEC staff related to the revised effective date of the new leases standard. This ASU is effective upon issuance. This did not have a significant impact on the Company’s consolidated financial statements.



In March 2020, the FASB issued ASU 2020-3, Codification Improvements to Financial Instruments. This ASU was issued to improve and clarify various financial instruments topics, including the current expected credit losses (CECL) standard issued in 2016. The ASU includes seven issues that describe the areas of improvement and the related amendments to GAAP; they are intended to make the standards easier to understand and apply and to eliminate inconsistencies, and they are narrow in scope and are not expected to significantly change practice for most entities. Among its provisions, the ASU clarifies that all entities, other than public business entities that elected the fair value option, are required to provide certain fair value disclosures under ASC 825, Financial Instruments, in both interim and annual financial statements. It also clarifies that the contractual term of a net investment in a lease under Topic 842 should be the contractual term used to measure expected credit losses under Topic 326. Amendments related to ASU 2019-04 are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is not permitted before an entity’s adoption of ASU 2016-01. Amendments related to ASU 2016-13 for entities that have not yet adopted that guidance are effective upon adoption of the amendments in ASU 2016-13. Early adoption is not permitted before an entity’s adoption of ASU 2016-13. Amendments related to ASU 2016-13 for entities that have adopted that guidance are effective for fiscal years beginning after December 15, 2019, including interim periods within those years. Other amendments are effective upon issuance of this ASU. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s consolidated financial position or results of operations.



In March 2020, the FASB issued ASU 2020-4, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, March 2020, to provide temporary optional expedients and exceptions to the U.S. GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative reference rates, such as Secured Overnight Financing Rate. Entities can elect not to apply certain modification accounting requirements to contracts affected by what the guidance calls reference rate reform, if certain criteria are met. An entity that makes this election would not have to remeasure the contracts at the modification date or reassess a previous accounting determination. Also, entities can elect various optional expedients that would allow them to continue applying hedge accounting for hedging relationships affected by reference rate reform, if certain criteria are met, and can make a one-time election to sell and/or reclassify held-to-maturity debt securities that reference an interest rate affected by reference rate reform. The amendments in this ASU are effective for all entities upon issuance through December 31, 2022. The Company is currently evaluating the impact the adoption of the standard will have on the Company’s consolidated financial position or results of operations.


28
36

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or expected future results of operations of Citizens Financial Services, Inc., First Citizens Community Bank, First Citizens Insurance Agency, Inc., 1st Realty of PA LLC or the combined Company. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements.  The Company cautions readers that the following important factors, among others, could in the future affect the Company’s actual results and could cause the Company’s actual results for subsequent periods to differ materially from those expressed in any forward-looking statement:
The scope, duration and severity of the COVID-19 pandemic and its effects on our business and operations, our customers, including their ability to make timely payments on loans, our service providers, and on the economy and financial markets in general.
Interest rates could change more rapidly or more significantly than we expect.
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
The financial markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
It could take us longer than we anticipate to implement strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
We may not be able to successfully integrate businesses we acquire or be able to fully realize the expected financial and other benefits from acquisitions.
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition or operating results.
We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.
We could experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
The agricultural economy is subject to extreme swings in both the costs of resources and the prices received from the sale of products, which could negatively impact some of our customers.
Agricultural customers could be affected by factors outside of their control including adverse weather conditions, loss of crops or livestock due to diseases or other factors, and government policies, regulations and tariffs.
Loan concentrations in certain industries could negatively impact financial results, if financial results or economic conditions deteriorate.

29

A budget impasse in the Commonwealth of Pennsylvania could impact our asset values, liquidity and profitability as a result of either delayed or reduced funding to school districts and municipalities who are customers of the Bank.

37
Companies providing support services related to the exploration and drilling of the natural gas reserves in our market area may be affected by federal, state and local laws and regulations such as restrictions on production, permitting, changes in taxes and environmental protection, which could negatively impact our customers and, as a result, negatively impact our loan and deposit volume and loan quality. Additionally, the activities the companies providing support services related to the exploration and drilling of the natural gas reserves may be dependent on the market price of natural gas.  As a result, decreases in the market price of natural gas could also negatively impact these companies, our customers.


Additional factors that may affect our results are discussed under “Part II – Item 1A – Risk Factors” in this report and in the Company’s 2019 Annual Report on Form 10-K under “Item 1.A/ Risk Factors.”  Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.


Introduction


The following is management'smanagement’s discussion and analysis of the financial condition and results of operations at the dates and for the periods presented in the accompanying consolidated financial statements for the Company.  Our consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the preceding financial statements presented under Part I.  The results of operations for the three and six months ended March 31,June 30, 2020 are not necessarily indicative of the results you may expect for the full year.


The Company currently engages in the general business of banking throughout our service area of Potter, Tioga, Clinton, Bradford and Centre counties in north central Pennsylvania, Lebanon, Berks, Schuylkill and Lancaster counties in south central Pennsylvania and Allegany County in southern New York and with the recently closed MidCoast acquisition, the Cities of Wilmington and Dover, Delaware. We also have a limited branch office in Union county, Pennsylvania, which primarily serves agricultural and commercial customers in the central Pennsylvania market. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 2831 banking facilities, 2730 of which operate as bank branches.  In Pennsylvania, the Company has full service offices located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, Rome, the Mansfield Wal-Mart Super Center, Mill Hall, Schuylkill Haven, Friedensburg, Mt. Aetna, Fredericksburg, Mount Joy, Fivepointville, State College and two branches near the city of Lebanon, Pennsylvania. The Fivepointville branch was opened in the first quarter of 2019. The limited branch office is located in Winfield, Pennsylvania. In New York, our office is in Wellsville. With the merger MidCoast completed in the second quarter, we added three branches in Delaware with two being in the Wilmington market and one in Dover.


Covid-19 Pandemic Response and Loan Profile


In response to the Covid-19 pandemic, the Company created a payment relief program that includes the following:
Waiver of late fees for March, April and May
Interest only payment options for consumers and businesses for 60-90 days.
Deferral of principal payments for consumers and businesses in certain
industries for 60-120 days
Waiver of Company ATM fees for customers utilizing foreign ATMS through May
Waiver of early withdrawal penalties through May 1, 2020 on CDs


38
Through AprilJune 30, 2020, we have modified 169509 loans totaling $52.0$196.2 million, primarily business related loans. As of June 30, 2020, loans with aggregate balances of $55.4 million were still under a modified agreement. Customers with balances totaling $23.6 million as of June 30, 2020 required a second round of relief, which have primarily been business related. is included in the $55.4 million as of June 30, 2020. Of the $55.4 million modifications outstanding as of June 30, 2020, $48.1 million mature by the end of July 2020, with an additional $5.3 million maturing in August and the remainder maturing in September. Additionally, in accordance with government regulations, we have paused all foreclosure actions during March and April.in accordance with state mandates.

30

We also are participating in the Paycheck Protection Program for loans provided under the auspices of the Small Business Adminstration (SBA). During the first roundAs of the program,June 30, 2020, we received approval for 422had outstanding 570 loans with balances totaling $47.2$53.7 million that will earn interest at 1% per annum and willare expected to generate fee revenue of approximately $2.0$2.1 million over the next 24 months. A portion of these loans may be forgiven by the SBA depending on the customers usage of the proceeds.  We are currently submitting loans as part of the second phase of this program. As of April 30, 2020, 557 loans have been approved totaling $52.3 million.


The Company tracks industry concentrations to identify risks that could lead to additional credit exposure. As a result of the Covid 19 pandemic, the Company has determined that Hotels/Motels and restaurants represent a higher level of credit risk. At March 31,June 30, 2020, the Company has limited loan concentrations to these industries as follows:
Hotels/Motels - $18.9$34.8 million or 1.7%2.6% of outstanding loans and 87.6% pass rated
Restaurants - $13.1$25.5 million or 1.2%1.9% of outstanding loans and 86.8% pass rated


Our agricultural relationships are also being strained by the pandemic as demand for certain products has declined and processing plant issues have resulted in further strains on our customers as a result of the pandemic. Agricultural lending comprises $346.8$360.1 million, or 31.7%26.4% of outstanding balances as of March 31,June 30, 2020.


Risk Management


Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity, reputational and regulatory risk.


Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in market interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policy to control and manage interest rate risk.


Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.


Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.


Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information, including fraudulent activity outside the Company’s control. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.


39
Regulatory and compliance risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company. We cannot predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.


Competition

31

The banking industry in the Bank’s service areas continue to be extremely competitive, both among commercial banks and with other financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions, agricultural cooperatives and internet entities for loans and deposits. Competition in our north central Pennsylvania market has increased as a result of other financial institutions looking to expand into new markets. With larger population centers in our central and south central markets, as well as the new Delaware operations, we experience more competition to gather deposits and to make loans. Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans, deposits and other financial services.  The Bank is generally competitive with all competing financial institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.


Trust and Investment Services; Oil and Gas Services


Our Investment and Trust Services Division offers professional trust administration, investment management services, estate planning and administration, and custody of securities.  In addition to traditional trust and investment services offered, we assist our customers through various oil and gas specific leasing matters from lease negotiations to establishing a successful approach to personal wealth management. Assets held by the Company in a fiduciary or agency capacity for its customers are not included in the Consolidated Balance Sheets since such items are not assets of the Company.  Revenues and fees of the Trust Department are reflected in trust income in the Consolidated Statement of Income. As of March 31,June 30, 2020 and December 31, 2019, the Trust Department had $110.4$129.5 million and $134.3 million of assets under management, respectively.


Our Investment Representatives offer full service brokerage services and financial planning throughout the Bank’s market area. Products such as mutual funds, annuities, health and life insurance are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.  The assets associated with these products are not included in the Consolidated Balance Sheets since such items are not assets of the Company. Assets owned and invested by customers of the Bank through the Bank’s Investment Representatives decreased from $215.4 million at December 31, 2019 to $200.1$212.6 million at March 31,June 30, 2020. Fee income from the sale of these products is reflected in brokerage and insurance income in the Consolidated Statement of Income. Management believes that there are opportunities to increase non-interest income through these products and services, especially in our central and south central Pennsylvania markets.


Results of Operations


Overview of the Income Statement


The Company had net income of $4,531,000$9,869,000 for the first threesix months of 2020 compared to $4,405,000$9,251,000 for last year’s comparable period, an increase of $126,000,$618,000, or 2.9%6.7%. Basic earnings per share for the first threesix months of 2020 were $1.29,$2.67, compared to $1.25$2.60 last year, representing a 3.2%2.7% increase.  Annualized return on assets and return on equity for the threesix months of 2020 were 1.24% and 11.48%11.90%, respectively, compared with 1.22%1.28% and 12.12%12.61% for last year’s comparable period.


Net income for the three months ended June 30, 2020 was $5,338,000 compared to $4,846,000 in the comparable 2019 period, an increase of $492,000 or 10.2%. Basic earnings per share for the three months ended June 30, 2020 were $1.39, compared to $1.36 last year, representing a 2.2% increase. Annualized return on assets and return on equity for the quarter ended June 30, 2020 was 1.25% and 12.28%, respectively, compared with 1.34% and 13.09% for the same 2019 period.

40
Net Interest Income


Net interest income, the most significant component of the Company’s earnings, is the amount by which interest income generated from interest-earning assets exceeds interest expense paid on interest-bearing liabilities.


Net interest income for the first threesix months of 2020 was $12,890,000,$29,176,000, an increase of $975,000,$4,925,000, or 8.2%20.3%, compared to the same period in 2019.  For the first threesix months of 2020 and 2019, the provision for loan losses totaled $400,000.was $950,000, an increase of $200,000 over the comparable period in 2019. Consequently, net interest income after the provision for loan losses was $12,490,000$28,226,000 in the first threesix months of 2020 compared to $11,515,000$23,501,000 during the first threesix months of 2019.


For the three months ended June 30, 2020, net interest income was $16,286,000 compared to $12,336,000, an increase of $3,950,000, or 32.0% over the comparable period in 2019. The provision for loan losses this quarter was $550,000 compared to $350,000 for last year’s second quarter.  Consequently, net interest income after the provision for loan losses was $15,736,000 for the quarter ended June 30, 2020 compared to $11,986,000 in 2019.

The following table sets forth the average balances of, and the interest earned or incurred on, for each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and interest rate spread created for the three and six months ended March 31,June 30, 2020 and 2019 on a tax equivalent basis (dollars in thousands):

  
  
Analysis of Average Balances and Interest Rates
Six Months Ended
 
  June 30, 2020  June 30, 2019 
(dollars in thousands) 
Average
Balance (1)
$
  
Interest
$
  
Average
Rate
%
  
Average
Balance (1)
$
  
Interest
$
  
Average
Rate
%
 
ASSETS                  
Short-term investments:                  
Interest-bearing deposits at banks  19,013   9   0.10   9,165   13   0.29 
Total short-term investments  19,013   9   0.10   9,165   13   0.29 
Interest bearing time deposits at banks  14,329   183   2.57   15,498   195   2.54 
Investment securities:                        
Taxable  181,469   2,410   2.66   192,737   2,490   2.58 
Tax-exempt (3)  69,896   1,079   3.09   57,482   926   3.22 
Total investment securities  251,365   3,489   2.78   250,219   3,416   2.73 
Loans (2)(3)(4):                        
Residential mortgage loans  214,809   5,643   5.28   215,110   5,692   5.34 
Construction  24,011   596   4.99   24,351   620   5.13 
Commercial Loans  507,490   13,809   5.47   410,532   11,201   5.50 
Agricultural Loans  358,173   8,124   4.56   334,895   7,639   4.60 
Loans to state & political subdivisions  92,306   1,837   4.00   99,945   1,951   3.94 
Other loans  11,517   395   6.90   9,737   368   7.62 
Loans, net of discount  1,208,306   30,404   5.06   1,094,570   27,471   5.06 
Total interest-earning assets  1,493,013   34,085   4.59   1,369,452   31,095   4.58 
Cash and due from banks  7,791           6,395         
Bank premises and equipment  16,823           16,198         
Other assets  67,847           56,135         
Total non-interest earning assets  92,461           78,728         
Total assets  1,585,474           1,448,180         
LIABILITIES AND STOCKHOLDERS’ EQUITY                     
Interest-bearing liabilities:                        
NOW accounts  358,026   694   0.39   328,951   1,167   0.72 
Savings accounts  233,050   291   0.25   214,361   390   0.37 
Money market accounts  186,018   595   0.64   161,518   1,014   1.27 
Certificates of deposit  308,019   2,064   1.35   291,074   2,141   1.48 
Total interest-bearing deposits  1,085,113   3,644   0.68   995,904   4,712   0.95 
Other borrowed funds  88,971   679   1.53   112,204   1,556   2.79 
Total interest-bearing liabilities  1,174,084   4,323   0.74   1,108,108   6,268   1.14 
Demand deposits  229,221           179,144         
Other liabilities  16,277           14,164         
Total non-interest-bearing liabilities  245,498           193,308         
Stockholders’ equity  165,892           146,764         
Total liabilities & stockholders’ equity  1,585,474           1,448,180         
Net interest income      29,762           24,827     
Net interest spread (5)          3.85%          3.44%
Net interest income as a percentage of average interest-earning assets          4.01%          3.66%
Ratio of interest-earning assets  to interest-bearing liabilities          127%          124%
32
(1)Averages are based on daily averages.
(2)Includes loan origination and commitment fees.
(3)Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 21%.
(4)Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5)Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.

41


 Analysis of Average Balances and Interest Rates 
 Three Months Ended 
 March 31, 2020  March 31, 2019    
 Average     Average  Average     Average  
Analysis of Average Balances and Interest Rates
Three Months Ended
 
 Balance (1)  Interest  Rate  Balance (1)  Interest  Rate  June 30, 2020  June 30, 2019 
(dollars in thousands) $      $%  $      $%  
Average
Balance (1)
$
  
Interest
$
  
Average
Rate
%
  
Average
Balance (1)
$
  
Interest
$
  
Average
Rate
%
 
ASSETS                                    
Short-term investments:                                    
Interest-bearing deposits at banks  9,538   3   0.17   8,759   7   0.32   28,182   5   0.07   9,316   6   0.26 
Total short-term investments 9,538  3  0.17  8,759  7  0.32   28,182   5   0.07   9,316   6   0.26 
Interest bearing time deposits at banks 14,272  92  2.59  15,498  97  2.54   14,385   92   2.57   15,498   98   2.54 
Investment securities:                                          
Taxable 179,893  1,217  2.71  196,187  1,242  2.53   183,044   1,193   2.61   173,826   1,248   2.87 
Tax-exempt (3) 62,555  493   3.15  55,866  451   3.23   77,237   587   3.04   59,081   474��  3.22 
Total investment securities 242,448  1,710  2.82  252,053  1,693  2.69   260,281   1,780   2.74   232,907   1,722   2.96 
Loans (2)(3)(4):                                          
Residential mortgage loans 215,838  2,843  5.30  215,670  2,825  5.31   213,780   2,800   5.27   214,557   2,867   5.36 
Construction 17,726  223  5.06  28,439  357  5.09   30,296   373   4.95   20,308   262   5.17 
Commercial Loans 415,199  5,534  5.36  401,813  5,423  5.47   599,800   8,276   5.55   419,175   5,805   5.55 
Agricultural Loans 360,179  4,112  4.59  334,520  3,739  4.53   356,166   4,012   4.53   335,266   3,875   4.64 
Loans to state & political subdivisions 94,122  939  0.01  100,922  978  3.93   90,491   898   3.99   98,979   972   3.94 
Other loans  9,461   171   7.27   9,768   184   7.64   13,572   223   6.91   9,705   184   7.60 
Loans, net of discount  1,112,525   13,822   5.00   1,091,132   13,506   5.05   1,304,105   16,582   5.11   1,097,990   13,965   5.10 
Total interest-earning assets 1,378,783  15,627  4.56  1,367,442  15,303  4.54   1,606,953   18,459   4.62   1,355,711   15,791   4.67 
Cash and due from banks 6,263        6,741         9,319           6,052         
Bank premises and equipment 16,062        16,263         17,584           16,133         
Other assets  56,983           54,278           79,001           73,702         
Total non-interest earning assets  79,308           77,282           105,904           95,887         
Total assets  1,458,091           1,444,724           1,712,857           1,451,598         
LIABILITIES AND STOCKHOLDERS' EQUITY                
LIABILITIES AND STOCKHOLDERS’ EQUITYLIABILITIES AND STOCKHOLDERS’ EQUITY                     
Interest-bearing liabilities:                                          
NOW accounts 332,068  437  0.53  328,357  578  0.71   383,985   257   0.27   329,539   589   0.72 
Savings accounts 225,985  184  0.33  211,149  184  0.35   240,116   107   0.18   217,537   206   0.38 
Money market accounts 174,294  393  0.91  161,424  505  1.27   197,742   202   0.41   161,611   509   1.26 
Certificates of deposit  261,278   973   1.50   293,385   1,047   1.45   354,759   1,091   1.24   288,788   1,094   1.52 
Total interest-bearing deposits 993,625  1,987  0.93  994,315  2,314  0.94   1,176,602   1,657   0.57   997,475   2,398   0.96 
Other borrowed funds 93,849  462   1.98  113,829  788   2.81   84,092   217   1.04   110,598   768   2.79 
Total interest-bearing liabilities 1,087,474  2,449  0.91  1,108,144  3,102  1.14   1,260,694   1,874   0.60   1,108,073   3,166   1.15 
Demand deposits 196,604        176,989         261,839           181,277         
Other liabilities 16,082        14,199         16,471           14,127         
Total non-interest-bearing liabilities 212,686        191,188         278,310           195,404         
Stockholders' equity  157,931           145,392         
Total liabilities & stockholders' equity  1,458,091           1,444,724         
Stockholders’ equity  173,853           148,121         
Total liabilities & stockholders’ equity  1,712,857           1,451,598         
Net interest income      13,178           12,201           16,585           12,625     
Net interest spread (5)       3.65%       3.40%          4.02%          3.52%
Net interest income as a percentage                                          
of average interest-earning assets       3.84%       3.62%          4.15%          3.74%
Ratio of interest-earning assets                                          
to interest-bearing liabilities       127%       123%          127%          122%
                  
(1) Averages are based on daily averages.                  
(2) Includes loan origination and commitment fees.                
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using 
a statutory federal income tax rate of 21%.          
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets. 
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets    
and the average rate paid on interest-bearing liabilities.             


(1)Averages are based on daily averages.
(2)Includes loan origination and commitment fees.
(3)Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 21%.
(4)Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
(5)Interest rate spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.

42
Tax exempt revenue is shown on a tax-equivalent basis (non-Gaap) for proper comparison using a federal statutory income tax rate of 21% for the three and six months ended March 31,June 30, 2020 and 2019.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s Federal statutory rate during the corresponding period. The following table represents the adjustment to convert net interest income to net interest income on a fully taxable equivalent basis for the periods ended March 31,June 30, 2020 and 2019 (in thousands):


 For the Three Months  For the Six Months 
  Ended June 30,  Ended June 30, 
  2020  2019  2020  2019 
Interest and dividend income from investment securities and
interest bearing deposits at banks (non-tax adjusted)
 $1,753  $1,726  $3,454  $3,429 
Tax equivalent adjustment  124   100   227   195 
Interest and dividend income from investment securities
and interest bearing deposits at banks (tax equivalent basis)
 $1,877  $1,826  $3,681  $3,624 
                 
Interest and fees on loans (non-tax adjusted) $16,407  $13,776  $30,045  $27,090 
Tax equivalent adjustment  175   189   359   381 
Interest and fees on loans (tax equivalent basis) $16,582  $13,965  $30,404  $27,471 
                 
Total interest income $18,160  $15,502  $33,499  $30,519 
Total interest expense  1,874   3,166   4,323   6,268 
Net interest income  16,286   12,336   29,176   24,251 
Total tax equivalent adjustment  299   289   586   576 
Net interest income (tax equivalent basis) $16,585  $12,625  $29,762  $24,827 
33
  For the Three Months 
  Ended March 31, 
  2020  2019 
Interest and dividend income from investment securities      
   and interest bearing deposits at banks (non-tax adjusted) $1,701  $1,703 
Tax equivalent adjustment  104   94 
Interest and dividend income from investment securities        
   and interest bearing deposits at banks (tax equivalent basis) $1,805  $1,797 
         
         
         
Interest and fees on loans (non-tax adjusted) $13,638  $13,314 
Tax equivalent adjustment  184   192 
Interest and fees on loans (tax equivalent basis) $13,822  $13,506 
         
         
         
Total interest income $15,339  $15,017 
Total interest expense  2,449   3,102 
Net interest income  12,890   11,915 
Total tax equivalent adjustment  288   286 
Net interest income (tax equivalent basis) $13,178  $12,201 


The following table shows the tax-equivalent effect of changes in volume and rate on interest income and expense (in thousands):


 Three months ended March 31, 2020 vs 2019 (1)  Three months ended June 30, 2020 vs 2019 (1)  Six months ended June 30, 2020 vs 2019 (1) 
 Change in  Change  Total  Change in  Change  Total  Change in  Change  Total 
 Volume  in Rate  Change  Volume  in Rate  Change  Volume  in Rate  Change 
Interest Income:                           
Short-term investments:                           
Interest-bearing deposits at banks $1  $(5) $(4) $(1) $-  $(1) $(10) $6  $(4)
Interest bearing time deposits at banks (7) 2  (5)  (7)  1   (6)  (14)  2   (12)
Investment securities:                                 
Taxable (143) 118  (25)  74   (129)  (55)  (153)  73   (80)
Tax-exempt  52   (10) 42   136   (23)  113   189   (36)  153 
Total investments  (91)  108   17   210   (152)  58   36   37   73 
Loans:                                 
Residential mortgage loans 26  (8) 18   (18)  (49)  (67)  8   (57)  (49)
Construction (132) (2) (134)  122   (11)  111   (7)  (17)  (24)
Commercial Loans 218  (107) 111   2,476   (5)  2,471   2,669   (61)  2,608 
Agricultural Loans 323  50  373   222   (85)  137   549   (64)  485 
Loans to state & political subdivisions (60) 21  (39)  (87)  13   (74)  (148)  34   (114)
Other loans  (4)  (9)  (13)  58   (19)  39   55   (28)  27 
Total loans, net of discount  371   (55)  316   2,773   (156)  2,617   3,126   (193)  2,933 
Total Interest Income  274   50   324   2,975   (307)  2,668   3,138   (148)  2,990 
Interest Expense:                                 
Interest-bearing deposits:                                 
NOW accounts 13  (154) (141)  117   (449)  (332)  118   (591)  (473)
Savings accounts 28  (28) -   23   (122)  (99)  39   (138)  (99)
Money Market accounts 51  (163) (112)  150   (457)  (307)  191   (610)  (419)
Certificates of deposit  (109)  35   (74)  7   (10)  (3)  151   (228)  (77)
Total interest-bearing deposits (17) (310) (327)  297   (1,038)  (741)  499   (1,567)  (1,068)
Other borrowed funds (116) (210) (326)  (154)  (397)  (551)  (274)  (603)  (877)
Total interest expense  (133)  (520)  (653)  143   (1,435)  (1,292)  225   (2,170)  (1,945)
Net interest income $407  $570  $977  $2,832  $1,128  $3,960  $2,913  $2,022  $4,935 
(1)The portion of the total change attributable to both volume and rate changes, which
can not be separated, has been allocated proportionally to the change due to volume
and the change due to rate prior to allocation.
 


(1)The portion of the total change attributable to both volume and rate changes, which can not be separated, has been allocated proportionally to the change due to volume and the change due to rate prior to allocation.

43
Tax equivalent net interest income increased from $12,201,000$24,827,000 for the threesix month period ended March 31,June 30, 2019 to $13,178,000$29,762,000 for the threesix month period ended March 31,June 30, 2020, an increase of $977,000.$4,935,000. The tax equivalent net interest margin increased from 3.62%3.66% for the first threesix months of 2019 to 3.84%4.01% for the comparable period in 2020. The increase is primarily caused by the decrease in the cost on interest-bearing liabilities and the increase in average outstanding loans.

34

Total tax equivalent interest income for the 2020 threesix month period increased $324,000$2,990,000 as compared to the 2019 threesix month period. This increase was a result of an increase of $274,000$3,138,000 due to a change in volume as average interest-bearing assets increased $11.3 million and due to an increase in the yield on interest-earning assets of 2 basis points, which corresponds to an increase of $50,000.$123.6 million. As a result of converting investment assets to loans, the yield on average interest earning assets increased 21 basis pointspoint from 4.54%4.58% to 4.56%4.59%.

Tax equivalent investment income for the threesix months ended March 31,June 30, 2020 increased $17,000$73,000 over the same period last year. The primary cause of the increase was an increase in the average yield onbalance of tax-exempt investment securities of 13 basis points.$12.4 million.

The yield on taxable securities increased 188 basis points from 2.53%2.58% to 2.71%2.66% as a result of calls of investments that were purchased at a discount. This resulted in an increase in investment income of $118,000.$73,000. The average balance of taxable securities decreased $16.3$11.3 million, which resulted in a decrease in investment income of $143,000.
$153,000.

The average balance of tax-exempt securities increased by $6.7$12.4 million, which resulted in an increase in investment income of $52,000.$189,000. The yield on tax-exempt securities decreased 813 basis points from 3.23%3.22% to 3.15%3.09%, which corresponds to a decrease in interest income of $10,000.$36,000. The yield decrease was attributable to higher yielding securities being called and maturing. For a discussion of the Company’s current investment strategy, see the “Financial Condition – Investments”.

Total loan interest income increased $316,000$2,933,000 for the threesix months ended March 31,June 30, 2020 compared to the same period last year, as a result of the MidCoast acquisition that closed in the second quarter and loan growth achieved in 2019 that occurred primarily in our central and south central Pennsylvania markets.

The average balance of commercial loans increased $13.4$97.0 million from a year ago. The growth was primarily attributable to organic growth in our central and south central Pennsylvania markets as well as completed construction projects.the MidCoast acquisition. This had a positive impact of $218,000$2,669,000 on total interest income due to volume. The yield decreased 113 basis points to 5.36%5.47%, which decreased loan interest income $107,000.
$61,000.

Interest income on agricultural loans increased $373,000$485,000 from 2019 to 2020. The increase in the average balance of agricultural loans of $25.7$23.3 million is primarily attributable to loan growth in our central and south central Pennsylvania markets.markets and the MidCoast acquisition. The increase in the average balance of these loans resulted in an increase in interest income due to volume of $323,000.$549,000. The yield on agricultural loans increased 6decreased 4 basis points to 4.59%4.56%, which increaseddecreased loan interest income $50,000.$64,000.

44
The average balance of constructionstate and political subdivision loans decreased $10.7$7.6 million from a year ago as a result of several large commercial and agricultural construction projects being completed in 2019.pay-offs during 2020. This resulted in a decrease of $132,000$148,000 on total interest income due to volume.


Total interest expense decreased $653,000$1,945,000 for the threesix months ended March 31,June 30, 2020 compared with the comparative period last year primarily as a result of a decrease in the cost of interest-bearing liabilities. Interest expense decreased $520,000$2,170,000 due to rate as a result of a decrease in the average rate paid on interest-bearing liabilities from 1.14% to 0.91%0.74%. The decrease was driven by the Federal Reserve interest araterate cuts in the second half of 2019 and the first quarter of 2020.

The average balance of interest bearing deposits decreased $690,000increased $89.2 million from March 31,June 30, 2019 to March 31,June 30, 2020. The primary decreasecause of the increase was the MidCoast acquisition completed in the second quarter of 2020. We experienced increases of $29.1 million in NOW accounts, $18.7 million in savings accounts, $24.5 million in money market accounts and $16.9 million in certificates of deposits, which decreased $32.1 million due to a decrease in brokered certificate balances of $14.4 million. We also had a municipal customer utilize maturing funds to complete a construction project. We experienced increases in NOW accounts of $3.7 million, savings accounts of $14.8 million and money market accounts of $12.9 million.deposit. The cumulative effect of these volume changes was a decreasean increase in interest expense of $17,000.$499,000.  (see also “Financial Condition – Deposits”). The average rate paid on interest bearing deposits was 0.93%0.68% for the first threesix months of 2020 and 0.94%0.95% for the comparable period in 2019. This resulted in a decrease in interest expense of $310,000.$1,567,000. The decrease was due to the Federal Reserve cutting interest rates during 2019 and 2020.


35
The average balance of other borrowed funds decreased $20.0$23.2 million from a year ago. This resulted in a decrease in interest expense of $116,000.$274,000. There was a decrease in the average rate paid on other borrowed funds from 2.81%2.79% to 1.98%1.53% due to a decrease in rates as a result of Federal Reserve interest rate decreases in 2019 and 2020 resulting in a decrease in interest expense of $603,000.

Tax equivalent net interest income for the three months ended June 30, 2020 was $16,585,000 which compares to $12,625,000 for the same period last year.  This represents an increase of $3,960,000 or 31.4% and was primarily caused by the MidCoast acquisition completed in the second quarter of 2020.

Total tax equivalent interest income was $18,459,000 for the three month period ended June 30, 2020, compared to $15,791,000 for the comparable period last year, an increase of $2,668,000. As with the six month period, the increase was driven by the MidCoast acquisition and the associated increase in volume of $2,975,000 due to average interest earning assets increasing $251.2 million offset by a decrease of $307,000 as a result of the average yield on interest-earning assets decreasing 5 basis points from 4.67% to 4.62% for the comparable periods.

Total investment income increased by $58,000 compared to same period last year.  The primary cause of the increase was the increase in average investments of $27.4 million, which corresponds to an increase of $210,000 due to volume. The yield on investments decreased 22 basis points to 2.74%, primarily due to taxable securities, which corresponds to a decrease in investment income of $152,000.

Total loan interest income increased $2,617,000 compared to the same period last year, with the change corresponding to the year to date change. As a result of the MidCoast acquisition, which increased the average loan balance by $206.1 million, loan interest income increased $2,773,000.

Total interest expense decreased $1,292,000 for the three months ended June 30, 2020 compared with last year as a result of the average rate on interest-bearing liabilities decreasing 55 basis points from 1.15% to 0.60%, which decreased interest expense $1,453,000.

The average balance of interest bearing deposits increased $179.1 million for the three month period ended June 30, 2020, as a result of the MidCoast acquisition, which corresponds to a change due to volume of $297,000.  The rate paid on interest bearing deposits was 0.57% for the three months ended June 30, 2020 and 0.96% for the comparable period in 2019. This results in an decrease in interest expense of $1,038,000.

45
The average balance of other borrowed funds decreased $26.5 million from a year ago. This resulted in a decrease in interest expense of $154,000. There was a decrease in the overnight borrowingaverage rate on other borrowed funds from 2.79% to 1.04% as a result of the Federal Reserve interest rate decreases in 2019 and 2020 resulting in a decrease in interest expense of $210,000.
$397,000.


Provision for Loan Losses


For the threesix month period ended March 31,June 30, 2020, and 2019, we recorded a provision for loan losses of $400,000.$950,000, which represents an increase of $200,000 from the $750,000 provision recorded in the corresponding six months of last year. The provision remained consistentwas higher in 2020 than 2019 primarily due to the uncertainty in the economic environment due toas a result of the Covid 19COVID-19 pandemic which has resulted in an increase inand the higher levels of unemployment, claims, which offset the fact thatdecrease in loans decreased duringwhen the first quarter of 2020.MidCoast acquired loans and PPP loans guaranteed by the SBA are excluded from 2020 activity. (see “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).


For the three months ended June 30, 2020, we recorded a provision of $550,000 compared to $350,000 in 2019 with the increase being a result of the economic environment due to the Covid 19 pandemic. (see “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).

Non-interest Income


The following table shows the breakdown of non-interest income for the three and six months ended March 31,June 30, 2020 and 2019 (dollars in thousands):


 Three months ended March 31,  Change  Six months ended June 30,  Change 
 2020  2019  Amount  %  2020  2019  Amount  % 
Service charges $1,081  $1,099  $(18) (1.6) $1,995  $2,273  $(278)  (12.2)
Trust 198  232  (34) (14.7)  343   441   (98)  (22.2)
Brokerage and insurance 340  293  47  16.0   589   554   35   6.3 
Gains on loans sold 167  99  68  68.7   427   163   264   162.0 
Equity security (losses) gains, net (254) 11  (265) (2,409.1)  (243)  41   (284)  (692.7)
Available for sale security gains, net  117   -   117  #DIV/0! 
Earnings on bank owned life insurance 156  151  5  3.3   334   305   29   9.5 
Other  163   148   15   10.1   358   283   75   26.5 
Total $1,851  $2,033  $(182)  (9.0) $3,920  $4,060  $(140)  (3.4)


 Three months ended June 30,  Change 
  2020  2019  Amount  % 
Service charges $914  $1,174  $(260)  (22.1)
Trust  145   209   (64)  (30.6)
Brokerage and insurance  249   261   (12)  (4.6)
Gains on loans sold  260   64   196   306.3 
Equity security gains, net  11   30   (19)  (63.3)
Available for sale security gains, net  117   -   117  #DIV/0! 
Earnings on bank owned life insurance  178   154   24   15.6 
Other  195   135   60   44.4 
Total $2,069  $2,027  $42   2.1 

46
Non-interest income for the threesix months ended March 31,June 30, 2020 totaled $1,851,000,$3,920,000, a decrease of $182,000$140,000 when compared to the same period in 2019.  During the first threesix months of 2020, net equity security losses amounted to $254,000$243,000 as a result of market losses associated with the Covid-19 pandemic compared to gains of $11,000$41,000 last year. We did not sell anyDuring the first six months of 2020, there were $117,000 of gains from the sale of available for sale securities or equity securitiessecurities. There were no sales in the first threesix months of 2020 or 2019. We sold $5.5 million of US agency mortgage backed securities for a pre-tax gain of $117,000.


The increase in brokerage and insurance revenues for the first three months of 2020gains on loans sold is attributable to growtha $7.5 million increase in our south central market.loans sold for the six months ended June 30, 2020 as a result of the low rate environment, which has significantly increased residential refinancings. The decrease in service charges of $278,000 for the six months ended June 30, 2020 is attributrable to the Bank’s response to the COVID-19  pandemic and a decrease in customer spending as a result of mandatory stay at home orders. The decrease in Trust revenues is due to lower estate settlement fees and lower asset levels in 2020 compared to 2019. The

For the three month period ended June 30, 2020, the changes experienced from the prior year related available for sale security gains, gains on loans sold, is attributableservice charges and  trust revenues correspond to a $1.1 million increase in loans sold.the changes experienced for the six month period.


Non-interest Expense


The following tables reflect the breakdown of non-interest expense for the three and six months ended March 31,June 30, 2020 and 2019 (dollars in thousands):


 Six months ended June 30,  Change    
  2020  2019  Amount  % 
Salaries and employee benefits $11,309  $10,033  $1,276   12.7 
Occupancy  1,177   1,109   68   6.1 
Furniture and equipment  320   336   (16)  (4.8)
Professional fees  763   758   5   0.7 
FDIC insurance  206   216   (10)  (4.6)
Pennsylvania shares tax  534   550   (16)  (2.9)
Amortization of intangibles  105   132   (27)  (20.5)
Merger and acquisition  2,179   -   2,179  NA 
Software expenses  493   455   38   8.4 
ORE expenses  191   216   (25)  (11.6)
Other  3,057   2,754   303   11.0 
Total $20,334  $16,559  $3,775   22.8 

 Three months ended June 30,  Change    
  2020  2019  Amount  % 
Salaries and employee benefits $5,895  $5,004  $891   17.8 
Occupancy  651   517   134   25.9 
Furniture and equipment  189   181   8   4.4 
Professional fees  438   316   122   38.6 
FDIC insurance  135   105   30   28.6 
Pennsylvania shares tax  259   275   (16)  (5.8)
Amortization of intangibles  55   66   (11)  (16.7)
Merger and acquisition  1,803   -   1,803  NA 
Software expenses  246   208   38   18.3 
ORE expenses (recovery)  159   109   50   45.9 
Other  1,583   1,456   127   8.7 
Total
 
$
11,413
  
$
8,237
  
$
3,176
   
38.6
 

36
47
Index

  Three months ended       
  March 31,  Change    
  2020  2019  Amount  % 
Salaries and employee benefits $5,414  $5,029  $385   7.7 
Occupancy  526   592   (66)  (11.1)
Furniture and equipment  131   155   (24)  (15.5)
Professional fees  325   442   (117)  (26.5)
FDIC insurance  71   111   (40)  (36.0)
Pennsylvania shares tax  275   275   -   - 
Amortization of intangibles  50   66   (16)  (24.2)
Merger and acquisition  376   -   376  NA 
Software expenses  247   227   20   8.8 
ORE expenses  32   107   (75)  (70.1)
Other  1,474   1,318   156   11.8 
Total $8,921  $8,322  $599   7.2 

Non-interest expenses increased $599,000$3,775,000 for the threesix months ended March 31,June 30, 2020 compared to the same period in 2019. Salaries and employee benefits increased $385,000$1,276,000 or 7.7%12.7%. The increase was due to merit increases effective at the beginning of 2020, additional headcount as part of the MidCoast acquisition and increased health care expenses.


The decrease in occupancy expenses is due to the closure of one branch in the first quarter of 2020 and lower snow plowing expenses. The decrease in professional fees was due to fees incurred in the first quarter of 2019 to settle litigation with a customer in bankruptcy. The decrease in furniture and fixture is due to replacing a significant number of computers in 2019. The decrease in OREO expenses is due to improved rental revenues to offset expenses. The increase in merger and acquisition costs was due to costs associated with the MidCoast acquisition that closed in April 2020. The decreaseincrease in FDIC insurance wasother expenses is attributable to the partial settlement of the Company’s pension plan due to credit received fromlump sum distributions taken during the FDICsecond quarter of 2020.

For the three months ended, June 30, 2020, non-interest expenses increased $3,176,000 when compared to the same period in 2019. The changes are driven by the MidCoast acquisition that closed in the April 2020 resulting in additional headcount and branches as the Deposit Insurance Fund reserve ratio exceeded 1.38%.well as merger and acquisition expenses.


Provision for Income Taxes


The provision for income taxes was $889,000$1,943,000 for the threesix month period ended March 31,June 30, 2020 compared to $821,000$1,751,000 for the same period in 2019. The increase is primarily attributable to the increase in income before the provision for income taxes of $194,000$810,000 for the comparable periods.  Through management of our municipal loan and bond portfolios, management is focused on minimizing our effective tax rate.  Our effective tax rate was 16.4%16.5% and 15.7%15.9% for the first threesix months of 2020 and 2019, respectively, compared to the statutory rate of 21%.


For the three months ended June 30, 2020, the provision for income taxes was $1,054,000 compared to $930,000 for the same period in 2019. The increase is attributable to the increase in income before the provision for income taxes of $616,000 for the comparable periods. Our effective tax rate was 16.5% and 16.1% for the three months ended June 30, 2020 and 2019, respectively.

We are invested in four limited partnerships that have established low-income housing projects in our market areas. We anticipate recognizing an aggregate of $388,000$352,000 of tax credits over the next 2.752.50 years, with an additional $106,000$70,000 anticipated to be recognized during 2020.


Financial Condition


Total assets were $1.46$1.80 billion at March 31,June 30, 2020, a decreasean increase of $1.6$333.8 million from $1.47 billion at December 31, 2019.2019, due primarily to the MidCoast acquisition and PPP loans.  Cash and cash equivalents increased $3.0$20.5 million to $21.5$39.0 million. Available for Salesale securities increased $17.1$31.7 million and net loans decreased $22.3increased $247.1 million to $1.08$1.35 billion at March 31,June 30, 2020.  Total deposits decreased $6.0increased $302.2 million to $1.21$1.51 billion since year-end 2019, while borrowed funds decreased $1.6 million to $83.6remained $85.1 million.


Cash and Cash Equivalents
Cash and cash equivalents totaled $21.5$39.0 million at March 31,June 30, 2020 compared to $18.5 million at December 31, 2019, an increase of $3.0$20.5 million. Management actively measures and evaluates its liquidity position through our Asset–Liability Committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources including the Bank’s core deposits, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.


37
48
Investments


The following table shows the composition of the investment portfolio (including debt and equity securities) as of March 31,June 30, 2020 and December 31, 2019 (dollars in thousands):
  March 31, 2020  December 31, 2019 
  Amount  %  Amount  % 
Debt securities:            
  U. S. Agency securities $77,510   30.0  $84,863   35.1 
  U. S. Treasury notes  28,313   11.0   27,661   11.5 
  Obligations of state & political subdivisions  74,778   28.9   61,455   25.5 
  Corporate obligations  3,347   1.3   3,328   1.4 
  Mortgage-backed securities in                
    government sponsored entities  73,840   28.6   63,399   26.2 
Equity securities  649   0.2   701   0.3 
Total $258,437   100.0  $241,407   100.0 


 March 31, 2020/ 
 December 31, 2019 
 Change  June 30, 2020  December 31, 2019 
 Amount  %  Amount  %  Amount  % 
Debt securities:                  
U. S. Agency securities $(7,353) (8.7) $78,436   28.7  $84,863   35.1 
U. S. Treasury notes 652  2.4   28,257   10.3   27,661   11.5 
Obligations of state & political subdivisions 13,323  21.7   83,527   30.6   61,455   25.5 
Corporate obligations 19  0.6   4,321   1.6   3,328   1.4 
Mortgage-backed securities in      
government sponsored entities 10,441  16.5 
Mortgage-backed securities in government sponsored entities  77,819   28.5   63,399   26.2 
Equity securities  (52)  (7.4)  703   0.3   701   0.3 
Total $17,030   7.1  $273,063   100.0  $241,407   100.0 


 June 30, 2020/ 
  December 31, 2019 
  Change 
  Amount  % 
Debt securities:      
U. S. Agency securities $(6,427)  (7.6)
U. S. Treasury notes  596   2.2 
Obligations of state & political subdivisions  22,072   35.9 
Corporate obligations  993   29.8 
Mortgage-backed securities in government sponsored entities  14,420   22.7 
Equity securities  2   0.3 
Total $31,656   13.1 

Our investment portfolio increased by $17.0$31.7 million, or 7.1%13.1%, from December 31, 2019 to March 31,June 30, 2020. During 2020, we purchased $5.8$16.2 million of U.S. agency obligations, $23.4$32.6 million state and political securities, $12.7$27.2 million of mortgage backed securities, a $1.0 million corporate security and $202,000$245,000 of equity securities, which was offset by $3.8$8.9 million of principal repayments and $25.2$35.3 million of calls and maturities that occurred during the first threesix months of 2020. Additionally, with the Federal Reserve purchasing securities in the “To be Announced” mortgage market, we sold $5.5 million with a gain of $117,000. As a result of changes in interest rates, the unrealized gain on available for sale investment portfolio increased $4.3$4.6 million. We did not sell any investments during the first three months of 2020. Excluding our short-term investments consisting of monies held primarily at the Federal Reserve for liquidity purposes, our investment portfolio for the threesix month period ended March 31,June 30, 2020 yielded 2.82%2.78%, compared to 2.69%2.73% in the comparable period in 2019, on a tax equivalent basis.


The investment strategy for 2020 has been to utilize cashflows from the investment portfolio and loan portfoliosdeposit inflows to purchase mortgage backed securities in government sponsored entities and obligations of state and political securities. The increase in the investment portfolio was in response to opportunities provided by the Covid-19 pandemic that allowed the Company to purchase high quality municipal securities and mortgage backed securities with relatively largehigh spreads compared to recent periods. We continually monitor interest rate trading ranges and try to focus purchases to times when rates are in the top third of the trading range. The Bank believes its investment strategy has appropriately mitigated its interest rate risk exposure for various rate environments, while providing sufficient cashflows to meet liquidity needs.


Management continues to monitor the earnings performance and the liquidity of the investment portfolio on a regular basis.  Through active balance sheet management and analysis of the investment portfolio, the Company believes it maintains sufficient liquidity to satisfy depositor withdrawal requirements and various credit needs of its customers.


38
49
Loans Held for Sale

Loans held for sale increased $16.7 million to $17.5 million as of June 30, 2020 from December 31, 2019. The increase in loans held for sale was due to the amount of refinancings occurring due o the low rate environment as well as system and personnel constraints due to the COVID-19 pandemic.

Loans


The following table shows the composition of the loan portfolio as of March 31,June 30, 2020 and December 31, 2019 (dollars in thousands):


 March 31,  December 31,  June 30,  December 31, 
 2020  2019  2020  2019 
 Amount  %  Amount  %  Amount  %  Amount  % 
Real estate:                        
Residential $216,179  19.8  $217,088  19.5  $210,789   15.5  $217,088   19.5 
Commercial 338,490  30.9  342,023  30.7   513,598   37.7   342,023   30.7 
Agricultural 300,606  27.5  311,464  27.9   313,136   23.0   311,464   27.9 
Construction 17,926  1.6  15,519  1.4   31,744   2.3   15,519   1.4 
Consumer 9,533  0.9  9,947  0.8   30,973   2.3   9,947   0.8 
Other commercial loans 71,038  6.5  69,970  6.3   132,503   9.7   69,970   6.3 
Other agricultural loans 46,170  4.2  55,112  4.9   44,912   3.3   55,112   4.9 
State & political subdivision loans  93,778   8.6   94,446   8.5   85,978   6.2   94,446   8.5 
Total loans 1,093,720  100.0  1,115,569  100.0   1,363,633   100.0   1,115,569   100.0 
Less allowance for loan losses  14,247       13,845       14,827       13,845     
Net loans $1,079,473      $1,101,724     $1,348,806      $1,101,724     
            
 March 31, 2020/       
 December 31, 2019       
 Change       
 Amount  %        
Real estate:            
Residential $(909) (0.4)      
Commercial (3,533) (1.0)      
Agricultural (10,858) (3.5)      
Construction 2,407  15.5       
Consumer (414) (4.2)      
Other commercial loans 1,068  1.5       
Other agricultural loans (8,942) (16.2)      
State & political subdivision loans (668) (0.7)       
Total loans $(21,849)  (2.0)       


 June 30, 2020/ 
  December 31, 2019 
  Change 
  Amount  % 
Real estate:      
Residential $(6,299)  (2.9)
Commercial  171,575   50.2 
Agricultural  1,672   0.5 
Construction  16,225   104.5 
Consumer  21,026   211.4 
Other commercial loans  62,533   89.4 
Other agricultural loans  (10,200)  (18.5)
State & political subdivision loans  (8,468)  (9.0)
Total loans $248,064   22.2 

The Bank’s lending efforts have historically been focused in north central Pennsylvania and southern New York. The acquisition of FNB in 2015 expanded the focus into Lebanon, Lancaster and Schuylkill County markets in south central Pennsylvania. The opening of the Winfield office in 2016 and the acquisition of the State College branch in 2017 has increased our presence in the central Pennsylvania market. The recently closed MidCoast acquisition has expanded our lending market into Wilmington and Dover, Delaware. We originate loans primarily through direct loans to our existing customer base, with new customers generated through the strong relationships our lending teams have with their customers and our lenders expertise in certain areas, as well as by referrals from real estate brokers, building contractors, attorneys, accountants, corporate and advisory board members, existing customers and the Bank’s website.  The Bank offers a variety of loans although historically most of our lending has focused on real estate loans including residential, commercial, agricultural, and construction loans.  All lending is governed by a lending policy that is developed and administered by management and approved by the Board of Directors. As of March 31,June 30, 2020, the Company had one industry specific loan concentration to the dairy industry, totaling $149.7$146.9 million or 13.7%10.8% of total loans.

50
During the first threesix months of 2020, the primary driver of growth was the decrease inMidCoast acquisition, which increased loans $223.2 million and the PPP program administered by the SBA, which generated loan portfolio was twogrowth of $53.7 million as of June 30, 2020. Excluding the acquisition and PPP program, loans would have decreased $28.9 million since year-end as a result of three large relationships paying off in the first quarter.half of 2020. Commercial and agricultural loan demand is subject to significant competitive pressures, the yield curve, and overall national, regional and local economic conditions.
While the Bank lends to companies that service the exploration for natural gas in our market area, the Bank has not originated any loans to companies performing the actual drilling and exploration activities. Loans made by the Bank are to service industry customers which include trucking companies, stone quarries and other support businesses, favoring customers that had a relationship with the Bank prior to supporting the exploration for natural gas. We also have originated loans to businesses and individuals for restaurants, hotels and apartment rentals that have been developed and expanded to meet the housing and living needs of the gas industry workers. Due to our understanding of the industry and its cyclical nature, the loans made for natural gas-related activities have been originated in accordance with specific policies and procedures for lending to these entities, which include more stringent loan to value thresholds, shortened amortization periods, and expansion of our monitoring of loan concentrations associated with this activity.

39
Residential real estate loans decreased slightly during the first threesix months of 2020. Loan demand for conforming mortgages, which the Company typically sells on the secondary market, increased slightlysignificantly in 2020 when compared to 2019.2019 as a result of the low rate environment. For loans sold on the secondary market, the Company recognizes fee income for servicing these sold loans, which is included in non-interest income.


In response to the Covid-19 pandemic, the Company has implemented programs to assist our customers. These include allowing customers to make interest only payments for up to 60 days and allowing certain customers in specific industries like hospitality to defer both principal and interest payments for up to 120 days. The Company has also agreed to waive late fees for March, April and May of 2020.


Allowance for Loan Losses


The allowance for loan losses is maintained at a level which in management’s judgment is adequate to absorb probable future loan losses inherent in the loan portfolio at the balance sheet date.  The provision for loan losses is charged against current income.  Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance.  The following table presents an analysis of the allowance for loan losses and non-performing loans and assets as of and for the three months ended March 31,June 30, 2020 and for the years ended December 31, 2019, 2018, 2017 and 2016 (dollars in thousands):


40
51
Index

  March 31  December 31, 
  2020  2019  2018  2017  2016 
Balance               
  at beginning of period $13,845  $12,884  $11,190  $8,886  $7,106 
Charge-offs:                    
  Real estate:                    
     Residential  -   32   118   107   85 
     Commercial  1   578   66   41   100 
     Agricultural  -   -   -   30   - 
  Consumer  8   49   40   130   100 
  Other commercial loans  -   38   91   -   55 
  Other agricultural loans  -   60   50   5   - 
Total loans charged-off  9   757   365   313   340 
Recoveries:                    
  Real estate:                    
     Residential  -   -   69   -   - 
     Commercial  1   -   3   11   479 
     Agricultural  -   -   -   -   - 
  Consumer  8   33   31   49   88 
  Other commercial loans  2   10   30   16   33 
  Other agricultural loans  -   -   1   1   - 
Total loans recovered  11   43   134   77   600 
                     
Net loans (recovered) charged-off  (2)  714   231   236   (260)
Provision charged to expense  400   1,675   1,925   2,540   1,520 
Balance at end of year $14,247  $13,845  $12,884  $11,190  $8,886 
                     
Loans outstanding at end of period $1,093,720  $1,115,569  $1,081,883  $1,000,525  $799,611 
Average loans outstanding, net $1,112,525  $1,102,565  $1,044,250  $883,355  $725,881 
Non-performing assets:                    
    Non-accruing loans $11,302  $11,536  $13,724  $10,171  $11,454 
    Accrual loans - 90 days or more past due  164   487   68   555   405 
      Total non-performing loans $11,466  $12,023  $13,792  $10,726  $11,859 
    Foreclosed assets held for sale  3,056   3,404   601   1,119   1,036 
      Total non-performing assets $14,522  $15,427  $14,393  $11,845  $12,895 
                     
Annualized net charge-offs (recoveries) to average loans  0.00%  0.06%  0.02%  0.03%  (0.04%)
Allowance to total loans  1.30%  1.24%  1.19%  1.12%  1.11%
Allowance to total non-performing loans  124.25%  115.15%  93.42%  104.33%  74.93%
Non-performing loans as a percent of loans                 
   net of unearned income  1.05%  1.08%  1.27%  1.07%  1.48%
Non-performing assets as a percent of loans                 
  net of unearned income  1.33%  1.38%  1.33%  1.18%  1.61%



 
 June 30,  December 31, 
  2020  2019  2018  2017  2016 
Balance at beginning of period $13,845  $12,884  $11,190  $8,886  $7,106 
Charge-offs:                    
Real estate:                    
Residential  -   32   118   107   85 
Commercial  1   578   66   41   100 
Agricultural  -   -   -   30   - 
Consumer  18   49   40   130   100 
Other commercial loans  -   38   91   -   55 
Other agricultural loans  -   60   50   5   - 
Total loans charged-off  19   757   365   313   340 
Recoveries:                    
Real estate:                    
Residential  -   -   69   -   - 
Commercial  34   -   3   11   479 
Agricultural  -   -   -   -   - 
Consumer  12   33   31   49   88 
Other commercial loans  5   10   30   16   33 
Other agricultural loans  -   -   1   1   - 
Total loans recovered  51   43   134   77   600 
                     
Net loans (recovered) charged-off  (32)  714   231   236   (260)
Provision charged to expense  950   1,675   1,925   2,540   1,520 
Balance at end of year $14,827  $13,845  $12,884  $11,190  $8,886 
                     
Loans outstanding at end of period $1,363,633  $1,115,569  $1,081,883  $1,000,525  $799,611 
Average loans outstanding, net $1,208,306  $1,102,565  $1,044,250  $883,355  $725,881 
Non-performing assets:                    
Non-accruing loans $10,693  $11,536  $13,724  $10,171  $11,454 
Accrual loans - 90 days or more past due  654   487   68   555   405 
Total non-performing loans $11,347  $12,023  $13,792  $10,726  $11,859 
Foreclosed assets held for sale  2,853   3,404   601   1,119   1,036 
Total non-performing assets $14,200  $15,427  $14,393  $11,845  $12,895 
                     
Annualized net charge-offs to average loans  0.00%  0.06%  0.02%  0.03%  -0.04%
Allowance to total loans  1.09%  1.24%  1.19%  1.12%  1.11%
Allowance to total non-performing loans  130.67%  115.15%  93.42%  104.33%  74.93%
Non-performing loans as a percent of loans net of unearned income  0.83%  1.08%  1.27%  1.07%  1.48%
Non-performing assets as a percent of loansnet of unearned income  1.04%  1.38%  1.33%  1.18%  1.61%

Management believes that it uses the best information available when establishing the allowance for loan losses and that the allowance for loan losses is adequate as of March 31,June 30, 2020.  However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination.  A prolonged downturn in the economy, high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income. Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.


On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may choose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan.  In certain cases, loans may be placed on non-accrual status or charged-off based upon management’s evaluation of the borrower’s ability to pay.  All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans and other commercial and agricultural loans, on non-accrual are evaluated quarterly for impairment.


41
52
The allowance for loan losses was $14,247,000$14,827,000 or 1.30%1.09% of total loans as of March 31,June 30, 2020, as compared to $13,845,000 or 1.24% of loans as of December 31, 2019. The $402,000$982,000 increase in the allowance during the first threesix months of 2020 is the result of a $400,000$950,000 provision and net recoveries of $2,000.$32,000. The decrease as a percent of loans is attributable to the increase in loans as part of the acquisition of MidCoast and the associated purchase accounting adjustments that were applied to the MidCoast loan portfolio. The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category as of March 31,June 30, 2020 and December 31, 2019, 2018, 2017 and 2016 (dollars in thousands):


 March 31,  December 31  June 30,  December 31 
 2020  2019     2018     2017     2016     2020  2019     2018     2017     2016    
 Amount  %  Amount  %  Amount  %  Amount  %  Amount  %  Amount  %  Amount  %  Amount  %  Amount  %  Amount  % 
Real estate loans:                                                            
Residential $1,154  19.8  $1,114  19.4  $1,105  19.9  $1,049  21.4  $1,064  25.9  $1,206   15.5  $1,114   19.4  $1,105   19.9  $1,049   21.4  $1,064   25.9 
Commercial 4,729  30.9  4,549  30.7  4,115  29.5  3,867  30.8  3,589  31.6   4,944   37.7   4,549   30.7   4,115   29.5   3,867   30.8   3,589   31.6 
Agricultural 4,878  27.5  5,022  27.9  4,264  26.3  3,143  24.0  1,494  15.5   5,061   23.0   5,022   27.9   4,264   26.3   3,143   24.0   1,494   15.5 
Construction 56  1.6  43  1.4  58  3.1  23  1.3  47  3.2   81   2.3   43   1.4   58   3.1   23   1.3   47   3.2 
Consumer 117  0.9  112  0.9  120  0.9  124  1.0  122  1.4   362   2.3   112   0.9   120   0.9   124   1.0   122   1.4 
Other commercial loans 835  6.5  1,255  6.3  1,354  6.9  1,272  7.2  1,327  7.3   1,201   9.7   1,255   6.3   1,354   6.9   1,272   7.2   1,327   7.3 
Other agricultural loans 1,297  4.2  961  4.9  752  3.9  492  3.8  312  2.9   821   3.3   961   4.9   752   3.9   492   3.8   312   2.9 
State & political subdivision loans 558  8.6  536  8.5  762  9.5  816  10.5  833  12.2   547   6.2   536   8.5   762   9.5   816   10.5   833   12.2 
Unallocated  623   N/A   253   N/A   354   N/A   404   N/A   98   N/A   604   N/A   253   N/A   354   N/A   404   N/A   98   N/A 
Total allowance for loan losses $14,247   100.0  $13,845   100.0  $12,884   100.0  $11,190   100.0  $8,886   100.0  $14,827   100.0  $13,845   100.0  $12,884   100.0  $11,190   100.0  $8,886   100.0 


As a result of previous loss experiences and other risk factors utilized in determining the allowance, the Bank’s allocation of the allowance does not directly correspond to the actual balances of the loan portfolio. While commercial and agricultural real estate total 58.4%totaled 60.7% of the loan portfolio, 67.4%67.5% of the allowance isat that date was assigned to this segment of the loan portfolio as these loans have more inherent credit risk than residential real estate or loans to state and political subdivisions.


The following table identifies amounts of loans contractually past due 30 to 89 days and non-performing loans by loan category, as well as the change from December 31, 2019 to March 31,June 30, 2020 in non-performing loans(dollars in thousands). Non-performing loans include accruing loans that are contractually past due 90 days or more and non-accrual loans. Interest does not accrue on non-accrual loans.  Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management'smanagement’s assessment of its ultimate ability to collect principal and interest.


 March 31, 2020  December 31, 2019 
    Non-Performing Loans     Non-Performing Loans 
 30 - 89 Days  90 Days        30 - 89 Days  90 Days        June 30, 2020  December 31, 2019 
 Past Due  Past Due  Non-  Total Non-  Past Due  Past Due  Non-  Total Non-     Non-Performing Loans     Non-Performing Loans 
(in thousands) Accruing  Accruing  accrual  Performing  Accruing  Accruing  accrual  Performing  
30 - 89 Days
Past Due
Accruing
  
90 Days
Past Due
Accruing
  
Non-
accrual
  
Total Non-
Performing
  
30 - 89 Days
Past Due
Accruing
  
90 Days
Past Due
Accruing
  
Non-
accrual
  
Total Non-
Performing
 
Real estate:                                                
Residential $1,025  $-  $971  $971  $933  $2  $962  $964  $788  $169  $947  $1,116  $933  $2  $962  $964 
Commercial 1,609  55  5,038  5,093  1,225  -  5,080  5,080   2,123   416   5,005   5,421   1,225   -   5,080   5,080 
Agricultural 201  98  2,464  2,562  118  299  2,578  2,877   1,494   -   2,046   2,046   118   299   2,578   2,877 
Construction -  -  -  -  -  -  -  -   -   -   -   -   -   -   -   - 
Consumer 140  11  8  19  123  2  6  8   169   20   3   23   123   2   6   8 
Other commercial loans 134  -  1,786  1,786  283  184  1,837  2,021   77   49   1,657   1,706   283   184   1,837   2,021 
Other agricultural loans  50   -   1,035   1,035   29   -   1,073   1,073   335   -   1,035   1,035   29   -   1,073   1,073 
Total nonperforming loans $3,159  $164  $11,302  $11,466  $2,711  $487  $11,536  $12,023  $4,986  $654  $10,693  $11,347  $2,711  $487  $11,536  $12,023 



42
53


      
 Change in Non-Performing Loans  Change in Non-Performing Loans 
 March 31, 2020 /December 31, 2019  June 30, 2020 /December 31, 2019 
(in thousands) Amount  %  Amount  % 
Real estate:            
Residential $7  0.7  $152   15.8 
Commercial 13  0.3   341   6.7 
Agricultural (315) (10.9)  (831)  (28.9)
Construction -  NA   -  #DIV/0! 
Consumer 11  137.5   15   187.5 
Other commercial loans (235) (11.6)  (315)  (15.6)
Other agricultural loans  (38)  (3.5)  (38)  (3.5)
Total nonperforming loans $(557)  (4.6) $(676)  (5.6)


For the threesix months ended March 31,June 30, 2020 and 2019, we recorded a provision for loan losses of $400,000.$950,000. Non-performing loans decreased $557,000$676,000 or 4.6%5.6%, from December 31, 2019 to March 31,June 30, 2020, primarily due to two customer relationships that were 90 days past due and accruing returning to current status in the first quarterhalf of 2020. Approximately 59.1%58.7% of the Bank’s non-performing loans at March 31,June 30, 2020 are associated with the following three customer relationships:


A commercial loan relationship with $2.4 million outstanding, and additional letters of credit of $2.1 million available, secured by undeveloped land, stone quarries and equipment, was on non-accrual status as of March 31,June 30, 2020. The customer is an excavation company and expanded to meet the needs of the natural gas industry for stone for pad and road development. The decreased exploration activities have significantly impacted the cash flows of the customer. During 2019, the Company had the underlying equipment collateral appraised. The 2019 appraisal indicated a decrease in collateral values compared to the appraisal ordered for the loan origination and an appraisal performed in 2017, however, the loan is still considered well secured on a loan to value basis. Management determined that no specific reserve was required as of March 31,June 30, 2020.
An agricultural customer with a total loan relationship of $2.7 million, secured by real estate, equipment and cattle, was on non-accrual status as of March 31,June 30, 2020. The customer declared bankruptcy during the fourth quarter of 2018 and developed a workout plan that was approved in the fourth quarter of 2019 and resulted in monthly payments resuming in late 2019. Included within these loans to this customer are $1,022,000 of loans which are subject to Farm Service Agency guarantees. Depressed milk prices have created cash flow difficulties for this customer.  Absent a sizable and sustained increase in milk prices, which is not assured, we will need to rely upon the collateral for repayment of interest and principal. As of March 31,June 30, 2020, there was a specific reserve of $199,000$218,000 for this relationship.
A commercial customer with a loan relationship of $1.7$1.6 million, secured by commercial real estate, business assets and vehicles, was on non-accrual status as of March 31,June 30, 2020. The business expanded into a new market, which has not grown as originally expected and has created cashflow issues. Management reviewed the collateral and determined that no specific reserve was required as of March 31,June 30, 2020.


Management of the Company believes that the allowance for loan losses as of March 31,June 30, 2020 is adequate, which is based on the following factors:

•
Three loan relationships comprised 58.7% of the non-performing loan balance, which had approximately $218,000 of specific reserves, as of June 30, 2020.
•
The Company has a history of low charge-offs, which have returned to lower levels in the first half of 2020 after being slightly elevated in 2019. Net charge-offs for the first half of 2020 were 0.0% and were 0.06% for all of 2019.
Three loan relationships comprised 59.1% of the non-performing loan balance, which had approximately $199,000 of specific reserves, as of March 31, 2020.
The Company has a history of low charge-offs, which have returned to lower levels in the first quarter of 2020 after being slightly elevated in 2019. Net charge-offs for the first quarter of 2020 were 0.0% and were 0.06% for all of 2019.
54

Bank Owned Life Insurance

43

The Company holds bank owned life insurance policies to offset future employee benefit costs. These policies provide the Bank with an asset that generates earnings to partially offset the current costs of benefits, and eventually (at the death of the insureds) provide partial recovery of cash outflows associated with the benefits.  As of March 31,June 30, 2020 and  December 31, 2019, the cash surrender value of the life insurance was $28.3$32.2 million and $28.1 million, respectively. The change in cash surrender value, net of purchases and amounts acquired through acquisitions, is recognized in the results of operations. As part of the acquisition, the Bank acquired $3.8 million of bank owned life insurance. The amounts recorded as non-interest income totaled $156,000$178,000 and $151,000$154,000 for the three month periods ended March 31,June 30, 2020 and 2019, respectively. For the six months ended June 30, 2020 and 2019, $334,000 and $305,000, respectively, was recorded in non-interest income. The Company evaluates annually the risks associated with the life insurance policies, including limits on the amount of coverage and an evaluation of the various carriers’ credit ratings.


The Company agreements that were purchased directly from insurance companies are structured so that any death benefits received from a policy while the insured person is an active employee of the Bank will be split with the beneficiary of the policy.  Under these agreements, the employee’s beneficiary will be entitled to receive 50% of the net amount at risk from the proceeds.  The net amount at risk is the total death benefit payable less the cash surrender value of the policy as of the date of death. The policies acquired as part of the acquisition of FNB provide a fixed split-dollar benefit for the beneficiaries estate, which is dependent on several factors including whether the covered individual was a former Director of FNBFirst National Bank of Fredericksburg (“FNB”) or ana former employee of FNB and their salary level. As of March 31,June 30, 2020 and December 31, 2019, included in other liabilities on the Consolidated Balance Sheet was a liability of $685,000 and $684,000, respectively, for the obligation under the split-dollar benefit agreements.


Premises and Equipment


Premises and equipment increased $289,000$1.9 million to $16.2$17.8 million as of March 31,June 30, 2020 from December 31, 2019. This occurred primarily asAs a result of purchases made in the first quarteracquisition, $1.8 million was acquired, which is the primary driver of 2020 offset by normal depreciation expense.the increase.


Deposits


The following table shows the composition of deposits as of March 31,June 30, 2020 and December 31, 2019 (dollars in thousands):
  March 31,  December 31, 
  2020  2019 
  Amount  %  Amount  % 
Non-interest-bearing deposits $204,489   17.0  $203,793   16.9 
NOW accounts  342,396   28.4   340,273   28.1 
Savings deposits  226,329   18.8   224,456   18.5 
Money market deposit accounts  173,510   14.4   169,865   14.0 
Certificates of deposit  258,426   21.4   272,731   22.5 
Total $1,205,150   100.0  $1,211,118   100.0 
                 
  March 31, 2020/         
  December 31, 2019         
  Change         
  Amount  %         
Non-interest-bearing deposits $696   0.3         
NOW accounts  2,123   0.6         
Savings deposits  1,873   0.8         
Money market deposit accounts  3,645   2.1         
Certificates of deposit  (14,305)  (5.2)        
Total $(5,968)  (0.5)        


 June 30,  December 31, 
  2020  2019 
  Amount  %  Amount  % 
Non-interest-bearing deposits $278,612   18.4  $203,793   16.9 
NOW accounts  398,460   26.3   340,273   28.1 
Savings deposits  243,508   16.1   224,456   18.5 
Money market deposit accounts  213,818   14.1   169,865   14.0 
Certificates of deposit  378,886   25.1   272,731   22.5 
Total $1,513,284   100.0  $1,211,118   100.0 

 June 30, 2020/ 
  December 31, 2019 
  Change 
  Amount  % 
Non-interest-bearing deposits $74,819   36.7 
NOW accounts  58,187   17.1 
Savings deposits  19,052   8.5 
Money market deposit accounts  43,953   25.9 
Certificates of deposit  106,155   38.9 
Total $302,166   24.9 

55
Deposits decreased $6.0increased $302.2 million since December 31, 2019. The decrease in deposits is driven by a $14.3 million decrease in certificatesAs part of deposit, which is due to a $10.2 million decrease in brokered certificates since December 31, 2019. As of March 31, 2020,the MidCoast acquisition, the Bank had $4.8acquired $208.8 million in deposits. A portion of brokered certificates ofthe remaining increase is related to customers who deposited PPP loan proceeds into a deposit outstanding compared to $15.0 million as of December 31, 2019.account at the Bank. We continue to enhance our cash management services to improve our customer services and to grow deposits through our current customers.

44

Borrowed Funds


Borrowed funds were $85.1 million as of June 30, 2020 and December 31, 2019. As part of the MidCoast acquisition, $15.5 million of borrowings were acquired. Excluding the acquisition, Overnight advances decreased $1.6$24.8 million, during the first three months of 2020. The decrease was the result of repaying a $20.0 millionwhile short term loan through borrowing $12.5advances increased $5.0 million. We borrowed $5.0 million on a long-term basis and subsequent to the acquisition, we repaid $3.0 million of overnight advances froma long term advance acquired as part of the FHLB and $5.0acquisition. There was $2.4 million of long-term advances from the FHLB. We also experienced an increase in repurchase agreements. As of June 30, 2020, long-term advances total $38.5 million, while short-term advances total $25.0 million.

During the second quarter, we implemented several interest rate hedging strategies. In April 2020, the Bank entered into two interest rate swap agreements to convert floating-rate debt to fixed rate debt on notional amounts of $934,000. $15.0 million and $10.0 million. The interest rate swap instruments involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amounts. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreements were entered into on April 1, 2020 and expire on April 1, 2025 and April 1, 2027. In April 2020, the Company entered into an interest rate swap agreement to convert floating-rate debt to fixed rate debt on a notional amounts of $7.5 million. The interest rate swap instrument involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreements were entered into on April 13, 2020 and expire on June 17, 2027. In May, the Bank entered into three two year forward interest rate swaps that will convert floating rate debt to fixed rate debt on notional amounts of $6.0 million each.  The interest rate swap instruments involves an agreement to receive a floating rate and pay a fixed rate, at specified intervals, calculated on the agreed-upon notional amount. The differentials paid or received on interest rate swap agreements are recognized as adjustments to interest expense in the period. The interest rate swap agreements were entered into on May 14, 2020 and expire on May 14, 2027, 2029 and 2032. The fair value of the interest rate swaps at June 30, 2020 was $566,000 and is included within other liabilities on the consolidated balance sheets.

The Company’s current strategy for borrowings is to consider terms and structures to manage interest rate risk and liquidity in a flat to inverted interest rate environment. The Company'sCompany’s daily cash requirements or short-term investments are primarily met by using the financial instruments available through the Federal Home Loan Bank of Pittsburgh.


Stockholders’ Equity


We evaluate stockholders’ equity in relation to total assets and the risks associated with those assets.  The greater the capital resource, the more likely a corporation will meet its cash obligations and absorb unforeseen losses.  For these reasons, capital adequacy has been, and will continue to be, of paramount importance to the Company. As such, the Company has implemented policies and procedures to ensure that it has adequate capital levels. As part of this process, we routinely stress test our capital levels and identify potential risk and alternative sources of additional capital should the need arise.


56
Total stockholders’ equity was $159.9$183.1 million at March 31,June 30, 2020 compared to $154.8 million at December 31, 2019, an increase of $5,149,000,$28,321,000, or 3.3%18.3%.  Excluding accumulated other comprehensive income (loss), stockholders’ equity increased $1.6$24.8 million, or 1.0%16.0%. As part of the MidCoast acquisition, we issued 373,356 shares with a value of $19.2 million based on the Company’s closing stock price of $51.50 per share on April 17, 2020. The Company purchased 23,41227,917 shares of treasury stock at a weighted average cost of $54.64$53.81 per share. The Company reissued 2046,651 shares to employees and Directors as a reward for years of services and performance at a weighted average cost of $61.00$50.85 per share. For the threesix months of 2020, the Company had net income of $4.5$9.9 million and declared cash dividends of $2.0$3.8 million, or $0.55$1.0 per share, representing a cash dividend payout ratio of 43.2%38.0%.


All of the Company’s debt investment securities are classified as available-for-sale, making this portion of the Company’s balance sheet more sensitive to the changing market value of investments. As a result of changes in the interest rate environment, and the defined benefit plan obligations and the interest rate swaps entered into during 2020, accumulated other comprehensive income increased approximately $3.5 million from December 31, 2019.


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


Quantitative measures established by regulatory capital standards to ensure capital adequacy require the Bank to maintain minimum amounts and ratios  of total and Tier 1 capital (as defined) to risk-weighted assets (as defined), common equity Tier 1 capital (as defined) to total risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of March 31,June 30, 2020 and December 31, 2019, that the Bank meets all capital adequacy requirements to which it was subject at such dates.


As permitted by applicable federal regulation, the Bank has opted to use the community bank leverage ratio (the “CBLR”) framework for determining its capital adequacy.  Under the CBLR framework a qualifying community bank is considered well-capitalized if its leverage ratio (Tier 1 capital divided by average total consolidated assets) exceeds 9%.  At March 31, 2020, the Bank was considered well-capitalized” under the CBLR framework, with a leverage ratio of 9.45%. Following the passage of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act in response to the COVID-19 pandemic, the federal banking regulators revised the CBLR framework as follows: (i) beginning in the second quarter of 2020, a qualifying community bank need only have a leverage ratio of at least 8%, subject to the other qualifying requirements, and (ii) if a qualifying community bank’s leverage ratio falls below 8%, then it will have two calendar quarters to maintain a leverage ratio of 7% or greater.  These revisions under the CARES Act are effective April 23, 2020 and will terminate upon the earlier of the termination of the national emergency related to COVID-19 or December 31, 2020.  Following such termination there is a grace period for returning to the 9% CBLR threshold.  The CBLR will be set at 8% for the remainder of 2020, 8.5% for 2021, and 9% thereafter.  The grace period is also adjusted to account for the graduating increase. As a result, in 2020 and 2021, a qualifying community bank utilizing the grace period must maintain a CBLR of at least 7% and 7.5%, respectively. Thereafter, a qualifying community bank utilizing the grace period must maintain a CBLR of at least 8%. If a qualifying community bank fails to maintain the applicable minimum CBLR during the grace period, or if it is unable to restore compliance with the CBLR within the grace period, then it will revert to the Basel III capital framework and the normal Prompt Corrective Action capital categories will applyapply. At June 30, 2020, the Bank was considered “well-capitalized” under the CBLR framework, with a leverage ratio of 8.90%.

45

Off-Balance Sheet Activities


Some financial instruments, such as loan commitments, credit lines, and letters of credit, are issued to meet customer financing needs.  The contractual amount of financial instruments with off-balance sheet risk was as follows at March 31,June 30, 2020 and December 31, 2019 (in thousands):
  March 31, 2020  December 31, 2019 
Commitments to extend credit $215,529  $211,530 
Standby letters of credit  16,717   17,857 
  $232,246  $229,387 


 June 30, 2020  December 31, 2019 
Commitments to extend credit $246,867  $211,530 
Standby letters of credit  17,289   17,857 
  $264,156  $229,387 

57
We also offer limited overdraft protection as a non-contractual courtesy which is available to demand deposit accounts in good standing. Overdraft charges as a result of ATM withdrawals and one time point of sale (non-recurring) transactions require prior approval of the customer. The non-contractual amount of financial instruments with off-balance sheet risk at March 31,June 30, 2020 and December 31, 2019 was $11,864,000$12,169,000 and $11,872,000, respectively. The Company reserves the right to discontinue this service without prior notice.


Liquidity


Liquidity is a measure of the Company'sCompany’s ability to efficiently meet normal cash flow requirements of both borrowers and depositors.  To maintain proper liquidity, we use funds management policies, which include liquidity target ratios, along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders.  Liquidity is needed to meet depositors'depositors’ withdrawal demands, extend credit to meet borrowers'borrowers’ needs, provide funds for normal operating expenses and cash dividends, and to fund other capital expenditures.


Cash generated by operating activities, investing activities and financing activities influences liquidity management. Our Company'sCompany’s historical activity in this area can be seen in the Consolidated Statement of Cash Flows.  The most important source of funds is core deposits.  Repayment of principal on outstanding loans and cash flows created from the investment portfolio are also factors in liquidity management.  Other sources of funding include brokered certificates of deposit and the sale of loans or investments, if needed.


The Company'sCompany’s use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is presented.  Other uses of funds include purchasing stock from the Federal Home Loan Bank (FHLB) of Pittsburgh, as well as capital expenditures.  Capital expenditures (including software purchases), during the first threesix months of 2020 were $507,000$561,000 compared to $105,000$165,000 during the same time period in 2019.


Short-term debt from the FHLB supplements the Bank’s availability of funds.  The Bank achieves liquidity primarily from temporary or short‑term investments in the Federal Reserve and the FHLB.  The Bank had a maximum borrowing capacity at the FHLB of approximately $537.8$672.9 million, of which $114.1$113.9 million was outstanding, at March 31,June 301, 2020. The Bank also had two federal funds lines with third party providers in the total amount of $34.0 million as of March 31,June 30, 2020, which are unsecured and undrawn upon. We also have a borrower in custody line with the Federal Reserve Bank of approximately $9.0$10.4 million, which also is not drawn upon as of March 31,June 30, 2020. The Company continues to evaluate its liquidity needs and as necessary finds additional sources.

46

Citizens Financial Services, Inc. is a separate legal entity from the Bank and must provide for its own liquidity.  In addition to its operating expenses, Citizens Financial Services, Inc. is responsible for paying any dividends declared to its shareholders.  Citizens Financial also has repurchased shares of its common stock.  Citizens Financial Services, Inc.’s primary source of income is dividends received from the Bank.  Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. In particular, the Bank may not, as a state-chartered bank which is a member of the Federal Reserve System, declare a dividend without approval of the Federal Reserve, unless the dividend to be declared by the Bank’s Board of Directors does not exceed the total of:  (i) the Bank’s net profits for the current year to date, plus (ii) its retained net profits for the preceding two current years, less any required transfers to surplus.  The Federal Reserve Board and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends and no dividend may be paid which would make the Bank undercapitalized after the dividend.  At March 31,June 30, 2020, Citizens Financial Services, Inc. (on an unconsolidated basis) had liquid assets of $6.6$5.8 million.


58
Interest Rate and Market Risk Management


The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.


Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, because we have no trading portfolio, we are not subject to trading risk. Currently, the Company has equity securities that represent only 0.04% of its total assets and, therefore, equity risk is not significant.


The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments.  The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings.  Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts, typically help by local governments, which are paid current market interest rates).


Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company'sCompany’s net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures.  In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels.  We have not experienced the kind of earnings volatility that might be indicated from gap analysis.


The Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management and asset liability management processes that we believe will effectively identify, measure, and monitor the Company’s risk exposure.  In this analysis, the Company examines the results of movements in interest rates with additional assumptions made concerning prepayment speeds on mortgage loans and mortgage securities.   Shock scenarios, which assume a parallel shift in interest rates and is instantaneous, typically have the greatest impact on net interest income. The following is a rate shock analysis and the impact on net interest income as of March 31,June 30, 2020 (dollars in thousands):


    Change In  % Change In 
  Prospective One-Year  Prospective  Prospective 
Changes in Rates Net Interest Income  Net Interest Income  Net Interest Income 
-100 Shock  58,787   (733)  (1.23)
Base  59,520   -   - 
+100 Shock  58,524   (996)  (1.67)
+200 Shock  57,748   (1,772)  (2.98)
+300 Shock  56,985   (2,535)  (4.26)
+400 Shock  56,077   (3,443)  (5.78)
47

    Change In % Change In
   Prospective One-Year  Prospective Prospective
Changes in Rates  Net Interest Income Net Interest Income Net Interest Income
      
-100 Shock                           49,991                           (540)                        (1.07)
Base                           50,531                                 -                             -
+100 Shock                           49,115                        (1,416)                        (2.80)
+200 Shock                           47,884                        (2,647)                        (5.24)
+300 Shock                           46,816                        (3,715)                        (7.35)
+400 Shock                           45,618                        (4,913)                        (9.72)


The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage backed securities, call activity of other investment securities, and deposit selection, re-pricing and maturity structure.  Because of these assumptions, actual results could differ significantly from these estimates which would result in significant differences in the calculated projected change on net interest income. Additionally, the changes above do not necessarily represent the level of change under which management would undertake specific measures to realign its portfolio in order to reduce the projected level of change. It should be noted that the changes in net interest income noted above are in line with Company policy for interest rate risk.


59
Item 3-Quantitative3 – Quantitative and Qualitative Disclosure about Market Risk


In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary.  Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments and was discussed previously in this Form 10-Q.  Management and a committee of the Board of Directors manage interest rate risk (see also “Interest Rate and Market Risk Management”).


Item 4 – Control and Procedures

(a) Disclosure Controls and Procedures

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”).  Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the SEC (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes to Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2020 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1 – Legal Proceedings

Management is not aware of any pending or threatened litigation that would have a material adverse effect on the consolidated financial position of the Company.  Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary.  In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.

Item 4-Control and Procedures

(a) Disclosure Controls and Procedures

     The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”).  Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the SEC (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes to Internal Control over Financial Reporting

     There were no changes in the Company’s internal control over financial reporting during the quarter ended March 31, 2020 that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

PART II ‑ OTHER INFORMATION

Item 1 ‑ Legal Proceedings

     Management is not aware of any pending or threatened litigation that would have a material adverse effect on the consolidated financial position of the Company.  Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary.  In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.

48

Item 1A – Risk Factors


In addition to the risk factor discussed below and the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1.A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2019, which could materially affect our business, financial condition or future results. At March 31,June 30, 2020, the risk factors of the Company have not changed materially from those reported in our Annual Report on Form 10-K.  However, the risks described in our Annual Report on Form 10-K are not the only risks that we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.


The COVID-19 pandemic has adversely impacted our business and financial results and that of many of our customers, and the ultimate impact will depend on future developments, which are highly uncertain, cannot be predicted and outside of our control, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.


60
The COVID-19 pandemic has created extensive disruptions to the global economy and to the lives of individuals throughout the world. Governments, businesses, and the public are taking unprecedented actions to contain the spread of COVID-19 and to mitigate its effects, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal and monetary stimulus, and legislation designed to deliver financial aid and other relief. While the scope, duration, and full effects of COVID-19 are rapidly evolving and not fully known, the pandemic and the efforts to contain it have disrupted global economic activity, adversely affected the functioning of financial markets, impacted market interest rates, increased economic and market uncertainty, and disrupted trade and supply chains.  If these effects continue for a prolonged period or result in sustained economic stress or recession, many of the risk factors identified in our Form 10-K could be exacerbated and the effects of COVID-19 could have a material adverse impact on us in a number of ways as described in more detail below.


Credit Risk – Our risks of timely loan repayment and the value of collateral supporting the loans are affected by the strength of our borrowers’ businesses. Concern about the spread of COVID-19 has caused and is likely to continue to cause business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and commercial property vacancy rates, reduced profitability and ability for property owners to make mortgage payments, and overall economic and financial market instability, all of which may cause our customers to be unable to make scheduled loan payments. Hotel and restaurant operators and others in the leisure, hospitality and travel industries and the agricultural industry, among other industries, have been particularly hurt by COVID-19.  If the effects of COVID-19 result in widespread and sustained repayment shortfalls on loans in our portfolio, we could incur significant delinquencies, foreclosures and credit losses, particularly if the available collateral is insufficient to cover our credit exposure. The future effects of COVID-19 on economic activity could negatively affect the collateral values associated with our existing loans, the ability to liquidate the real estate collateral securing our residential and commercial real estate loans, our ability to maintain loan origination volume and to obtain additional financing, the future demand for or profitability of our lending and services, and the financial condition and credit risk of our customers. Further, in the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from making our business decisions or may result in a delay in our taking certain remediation actions, such as foreclosure. In addition, we have unfunded commitments to extend credit to customers. During a challenging economic environment like now, our customers depend more on our credit commitments and increased borrowings under these commitments could adversely impact our liquidity. Furthermore, in an effort to support our communities during the pandemic, we are participating in the Paycheck Protection Program under the CARES Act whereby loans to small businesses are made and those loans are subject to the regulatory requirements that would require forbearance of loan payments for a specified time or that would limit our ability to pursue all available remedies in the event of a loan default. If the borrower under the PPP loan fails to qualify for loan forgiveness, we are at the heightened risk of holding these loans at unfavorable interest rates as compared to the loans to customers that we would have otherwise extended credit.

49

Strategic Risk – Our success may be affected by a variety of external factors that may affect the price or marketability of our products and services, changes in interest rates that may increase our funding costs, reduced demand for our financial products due to economic conditions and the various response of governmental and nongovernmental authorities. The COVID-19 pandemic has significantly increased economic and demand uncertainty and has led to disruption and volatility in the global capital markets. Furthermore, many of the governmental actions have been directed toward curtailing household and business activity to contain COVID-19. These actions have been rapidly expanding in scope and intensity. For example, in many of our markets, local governments have acted to temporarily close or restrict the operations of most businesses. The future effects of COVID-19 on economic activity could negatively affect the future banking products we provide, including a decline in originating loans.


61
Operational Risk – Current and future restrictions on our workforce’s access to our facilities could limit our ability to meet customer servicing expectations and have a material adverse effect on our operations. We rely on business processes and branch activity that largely depend on people and technology, including access to information technology systems as well as information, applications, payment systems and other services provided by third parties. In response to COVID-19, we have modified our business practices with a portion of our employees working remotely from their homes to have our operations uninterrupted as much as possible. Further, technology in employees’ homes may not be as robust as in our offices and could cause the networks, information systems, applications, and other tools available to employees to be more limited or less reliable than in our offices. The continuation of these work-from-home measures also introduces additional operational risk, including increased cybersecurity risk from phishing, malware, and other cybersecurity attacks, all of which could expose us to risks of data or financial loss and could seriously disrupt our operations and the operations of any impacted customers.


Moreover, we rely on many third parties in our business operations, including the appraiser of the real property collateral, vendors that supply essential services such as loan servicers, providers of financial information, systems and analytical tools and providers of electronic payment and settlement systems, and local and federal government agencies, offices, and courthouses. In light of the developing measures responding to the pandemic, many of these entities may limit the availability and access of their services. If the third-party service providers continue to have limited capacities for a prolonged period or if additional limitations or potential disruptions in these services materialize, it may negatively affect our operations.


Interest Rate Risk/Market Value Risk – Our net interest income, lending and investment activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the Federal Reserve lowered the target range for the federal funds rate to a range from 0% to 0.25%, citing concerns about the impact of COVID-19 on financial markets and market stress in the energy sector. A prolonged period of extremely volatile and unstable market conditions would likely increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in prevailing fair market values of our investment securities and other assets. Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.


Because there have been no comparable recent global pandemics that resulted in similar global impact, we do not yet know the full extent of COVID-19’s effects on our business, operations, or the global economy as a whole. Any future development will be highly uncertain and cannot be predicted, including the scope and duration of the pandemic, the effectiveness of our work-from-home arrangements, third party providers’ ability to support our operations, and any actions taken by governmental authorities and other third parties in response to the pandemic. The uncertain future development of this crisis could materially and adversely affect our business, operations, operating results, financial condition, liquidity or capital levels.


50
62
Index
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES 
             
Period 
Total Number
of Shares (or
units Purchased)
  
Average Price
Paid per Share
(or Unit)
  
Total Number of
Shares (or Units)
Purchased as Part of
Publicly Announced
Plans of Programs
  Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) 
             
1/1/20 to 1/31/20  2,100  $64.00   2,100   46,540 
2/1/20 to 2/29/20  1,612  $61.00   1,612   44,928 
3/1/20 to 3/31/20  19,700  $53.12   19,700   25,228 
Total  23,412  $54.64   23,412   25,228 


ISSUER PURCHASES OF EQUITY SECURITIES 
             
Period 
Total Number of
Shares (or units
purchased)
  
Average Price
Paid per Share
(or Unit)
  
Total Number of Shares (or
Units) Purchased as Part of
Publicly Announced Plans of
Programs
  
Maximum Number (or
Approximate Dollar Value) of
Shares (or Units) that May
Yet Be Purchased Under the
Plans or Programs (1)
 
             
4/1/20 to 4/30/20  -  $0.00   -   175,228 
5/1/20 to 5/31/20  -  $0.00   -   175,228 
6/1/20 to 6/30/20  4,505  $49.52   4,505   170,723 
Total  4,505  $49.52   4,505   170,723 

(1)On October 20, 2015, the Company announced that the Board of Directors authorized the Company to repurchase up to an additional 150,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.

(2)On April 21, 2020, the Company announced that the Board of Directors authorized the Company to repurchase up to an additional 150,000 shares at an aggregate purchase price not to exceed $12.0 million over a period of 36 months. The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.


Item 3 ‑– Defaults Upon Senior Securities


Not applicable.



Item 4 – Mine Safety Disclosure


Not applicable.


Item 5 ‑– Other Information


None



Item 6 ‑– Exhibits


(a)  The following documents are filed as a part of this report:

 2.1
Agreement and Plan of Merger by and between Citizens Financial Services, Inc. and MidCoast Community Bancorp, Inc. (1)3.1
3.1
Articles of Incorporation of Citizens Financial Services, Inc., as amended (2)(1)
 3.2 
3.2
Bylaws of Citizens Financial Services, Inc. (3)(2)
 4.1 
4.1
Form of Common Stock Certificate. (4)(3)
 
31.1
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
31.2
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer

51

32.1
Section 1350 Certification of Chief Executive Officer and Chief Financial Officer

 101
The following materials from the Company’s Quarterly Report on Form 10-Q for the period ended  March 31,June 30, 2020, formatted in XBRL (Extensible Business Reporting Language): (i) The Consolidated Balance Sheet (unaudited), (ii) the Consolidated Statement of Income (unaudited), (iii) the Consolidated Statement of Comprehensive Income (unaudited), (iv) the Consolidated Statement of Changes in Stockholders’ Equity, (v) the Consolidated Statement of Cash Flows (unaudited) and (vi) related notes (unaudited).





(1) Incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K, as filed with the Commission on September 18, 2019

(2)Incorporated by reference to Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2018, as filed with the Commission on August 9, 2018.


 (3)(2)Incorporated by reference to Exhibit 9.01 to the Company’s Current Report on Form 8-K, as filed with the Commission on December 24, 2009.


 (4)(3)Incorporated by reference to Exhibit 4 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005, as filed with the Commission on March 14, 2006.



52
63
Index
Signatures



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




Citizens Financial Services, Inc.
(Registrant)
(Registrant)
  
May 7,August 6, 2020
By:/s/ Randall E. Black
By: Randall E. Black
President and Chief Executive Officer
(Principal Executive Officer)
  Randall E. Black
President and Chief Executive Officer
(Principal Executive Officer)


May 7,August 6, 2020
By:/s/ Stephen J. Guillaume
 By: Stephen J. Guillaume
 
Chief Financial Officer
(Principal Financial and Accounting Officer)



53
64



54