SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 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: 0-16084 CITIZENS & NORTHERN CORPORATION (Exact name of Registrant as specified in its charter) Pennsylvania 23-2451943 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 90-92 Main Street Wellsboro, Pa. 16901 (Address of principal executive offices) (Zip code) 570-724-3411 (Registrant's telephone number including area code) Not applicable (Former name, former address, and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X_ No ___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes X No --- --- (APPLICABLE ONLY TO CORPORATE REGISTRANTS) Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. <TABLE> <CAPTION> Title Outstanding <S> <C> Common Stock ($1.00 par value) 8,212,160 Shares Outstanding July 28, 2005 </TABLE> 1
CITIZENS & NORTHERN CORPORATION Index <Table> <S> <C> Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheet - June 30, 2005 and December 31, 2004 Page 3 Consolidated Statement of Income - Three Months and Six Months Ended June 30, 2005 and 2004 Page 4 Consolidated Statement of Cash Flows - Six Months Ended June 30, 2005 and 2004 Page 5 Notes to Consolidated Financial Statements Pages 6 through 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 11 through 24 Item 3. Quantitative and Qualitative Disclosures About Market Risk Pages 24 through 27 Item 4. Controls and Procedures Page 27 Part II. Other Information Pages 27 through 29 Signatures Page 30 Exhibit 31.1. Rule 13a-14(a)/15d-14(a) Certification - Chief Executive Officer Page 31 Exhibit 31.2. Rule 13a-14(a)/15d-14(a) Certification - Chief Financial Officer Page 32 Exhibit 32. Section 1350 Certifications Page 33 </Table> 2
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEET (In Thousands Except Share Data) <TABLE> <CAPTION> JUNE 30, DECEMBER 31, 2005 2004 (UNAUDITED) (NOTE) <S> <C> <C> ASSETS Cash and due from banks: Noninterest-bearing $ 14,710 $ 14,845 Interest-bearing 1,943 4,108 - --------------------------------------------------------------------------------------------------------------------- Total cash and cash equivalents 16,653 18,953 Available-for-sale securities 453,288 475,085 Held-to-maturity securities 427 433 Loans, net 604,514 572,826 Bank-owned life insurance 18,362 18,083 Accrued interest receivable 5,110 5,094 Bank premises and equipment, net 18,459 16,725 Foreclosed assets held for sale 166 497 Other assets 16,722 15,306 - --------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 1,133,701 $ 1,123,002 ===================================================================================================================== LIABILITIES Deposits: Noninterest-bearing $ 84,719 $ 80,378 Interest-bearing 600,386 596,167 - --------------------------------------------------------------------------------------------------------------------- Total deposits 685,105 676,545 Dividends payable 1,889 1,864 Short-term borrowings 50,562 34,178 Long-term borrowings 254,599 270,827 Accrued interest and other liabilities 8,730 8,003 - --------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 1,000,885 991,417 - --------------------------------------------------------------------------------------------------------------------- STOCKHOLDERS' EQUITY Common stock, par value $1.00 per share; authorized 20,000,000 shares, issued 8,389,418 in 2005 and 8,307,305 in 2004 8,389 8,307 Stock dividend distributable - 2,188 Paid-in capital 24,767 22,456 Retained earnings 93,300 90,484 - --------------------------------------------------------------------------------------------------------------------- Total 126,456 123,435 Accumulated other comprehensive income 8,478 10,535 Unamortized stock compensation (99) (46) Treasury stock, at cost: 178,497 shares at June 30, 2005 (2,019) 204,659 shares at December 31, 2004 (2,339) - --------------------------------------------------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 132,816 131,585 - --------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $ 1,133,701 $ 1,123,002 ===================================================================================================================== </Table> The accompanying notes are an integral part of these consolidated financial statements. Note: The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all the information and notes required by U.S. generally accepted accounting principles for complete financial statements. 3
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) <Table> <Caption> 3 MONTHS ENDED FISCAL YEAR TO DATE JUNE 30, JUNE 30, 6 MONTHS ENDED JUNE 30, 2005 2004 2005 2004 INTEREST INCOME (CURRENT) (PRIOR YEAR) (CURRENT) (PRIOR YEAR) <S> <C> <C> <C> <C> Interest and fees on loans $ 9,318 $ 8,326 $ 18,324 $ 16,561 Interest on balances with depository institutions 9 1 13 4 Interest on loans to political subdivisions 268 239 515 453 Interest on federal funds sold 22 3 30 4 Income from available-for-sale and held-to-maturity securities: Taxable 3,618 3,493 7,279 6,757 Tax-exempt 1,415 1,938 2,887 3,873 Dividends 258 343 553 706 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest and dividend income 14,908 14,343 29,601 28,358 - ---------------------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest on deposits 3,628 2,965 7,054 6,308 Interest on short-term borrowings 332 126 557 249 Interest on long-term borrowings 2,195 2,402 4,501 4,639 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest expense 6,155 5,493 12,112 11,196 - ---------------------------------------------------------------------------------------------------------------------------------- Interest margin 8,753 8,850 17,489 17,162 Provision for loan losses 375 350 750 700 - ---------------------------------------------------------------------------------------------------------------------------------- Interest margin after provision for loan losses 8,378 8,500 16,739 16,462 - ---------------------------------------------------------------------------------------------------------------------------------- OTHER INCOME Service charges on deposit accounts 383 453 725 874 Service charges and fees 109 55 196 131 Trust and financial management revenue 571 573 1,050 1,030 Insurance commissions, fees and premiums 86 110 184 219 Increase in cash surrender value of life insurance 140 153 279 312 Fees related to credit card operation 238 225 448 409 Other operating income 362 286 710 505 - ---------------------------------------------------------------------------------------------------------------------------------- Total other income before realized gains on securities, net 1,889 1,855 3,592 3,480 Realized gains on securities, net 929 321 1,995 1,285 - ---------------------------------------------------------------------------------------------------------------------------------- Total other income 2,818 2,176 5,587 4,765 - ---------------------------------------------------------------------------------------------------------------------------------- OTHER EXPENSES Salaries and wages 3,048 2,729 5,923 5,400 Pensions and other employee benefits 953 828 1,985 1,812 Occupancy expense, net 461 360 925 737 Furniture and equipment expense 650 388 1,298 724 Pennsylvania shares tax 197 211 412 423 Other operating expense 1,864 1,773 3,758 3,421 - ---------------------------------------------------------------------------------------------------------------------------------- Total other expenses 7,173 6,289 14,301 12,517 - ---------------------------------------------------------------------------------------------------------------------------------- Income before income tax provision 4,023 4,387 8,025 8,710 Income tax provision 725 698 1,432 1,315 - ---------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 3,298 $ 3,689 $ 6,593 $ 7,395 ================================================================================================================================== PER SHARE DATA: Net income - basic $ 0.40 $ 0.45 $ 0.80 $ 0.90 Net income - diluted $ 0.40 $ 0.45 $ 0.80 $ 0.90 - ---------------------------------------------------------------------------------------------------------------------------------- Dividend per share $ 0.23 $ 0.22 $ 0.46 $ 0.44 - ---------------------------------------------------------------------------------------------------------------------------------- Number of shares used in computation - basic 8,210,469 8,182,034 8,201,902 8,187,606 Number of shares used in computation - diluted 8,274,780 8,229,149 8,269,365 8,239,222 </Table> The accompanying notes are an integral part of these consolidated financial statements. 4
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <Table> <Caption> 6 MONTHS ENDED JUNE 30, 2005 2004 <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 6,593 $ 7,395 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 750 700 Realized gains on securities, net (1,995) (1,285) (Gain) loss on sale of foreclosed assets, net (113) 6 Depreciation expense 1,111 669 Accretion and amortization, net 142 383 Increase in cash surrender value of life insurance (279) (312) Amortization of restricted stock 46 44 Increase in accrued interest receivable and other assets (1,980) (1,283) Increase in accrued interest payable and other liabilities 1,835 1,378 - ---------------------------------------------------------------------------------------------------------- Net Cash Provided by Operating Activities 6,110 7,695 - ---------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturity of held-to-maturity securities 5 113 Proceeds from sales of available-for-sale securities 103,978 28,108 Proceeds from calls and maturities of available-for-sale securities 32,764 54,937 Purchase of available-for-sale securities (116,208) (114,840) Purchase of Federal Home Loan Bank of Pittsburgh stock (3,053) (2,813) Redemption of Federal Home Loan Bank of Pittsburgh stock 3,554 1,779 Net increase in loans (32,637) (27,260) Purchase of premises and equipment (2,845) (3,096) Proceeds from sale of foreclosed assets 643 42 - ---------------------------------------------------------------------------------------------------------- Net Cash Used in Investing Activities (13,800) (63,030) - ---------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 8,560 12,033 Net increase in short-term borrowings 16,384 2,990 Proceeds from long-term borrowings 19,557 63,943 Repayments of long-term borrowings (35,785) (19,780) Purchase of treasury stock - (575) Sale of treasury stock 453 462 Dividends paid (3,779) (3,575) - ---------------------------------------------------------------------------------------------------------- Net Cash Provided by Financing Activities 5,390 55,498 - ---------------------------------------------------------------------------------------------------------- (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (2,300) 163 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 18,953 15,171 - ---------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 16,653 $ 15,334 ========================================================================================================== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Assets acquired through foreclosure of real estate loans $ 199 $ - Interest paid $ 10,503 $ 8,643 Income taxes paid $ 1,325 $ 1,773 </Table> The accompanying notes are an integral part of these consolidated financial statements. 5
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF INTERIM PRESENTATION The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2004, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods. Results reported for the three-month and six-month periods ended June 30, 2005 might not be indicative of the results for the year ending December 31, 2005. This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency. 2. PER SHARE DATA Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflect the retroactive effect of stock splits and dividends for all periods presented. The following data show the amounts used in computing net income per share and the weighted average number of shares of dilutive stock options. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period. <Table> <Caption> WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE <S> <C> <C> <C> SIX MONTHS ENDED JUNE 30, 2005 Earnings per share - basic $ 6,593,000 8,201,902 $0.80 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 231,305 Hypothetical share repurchase at $30.05 (163,842) - ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 6,593,000 8,269,365 $0.80 ==================================================================================================== SIX MONTHS ENDED JUNE 30, 2004 Earnings per share - basic $ 7,395,000 8,187,606 $0.90 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 227,141 Hypothetical share repurchase at $25.65 (175,525) - ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 7,395,000 8,239,222 $0.90 ==================================================================================================== </Table> 6
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q <Table> <Caption> WEIGHTED- AVERAGE EARNINGS NET COMMON PER INCOME SHARES SHARE <S> <C> <C> <C> QUARTER ENDED JUNE 30, 2005 Earnings per share - basic $ 3,298,000 8,210,469 $0.40 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 220,808 Hypothetical share repurchase at $30.11 (156,497) - ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 3,298,000 8,274,780 $0.40 ==================================================================================================== QUARTER ENDED JUNE 30, 2004 Earnings per share - basic $ 3,689,000 8,182,034 $0.45 Dilutive effect of potential common stock arising from stock options: Exercise of outstanding stock options 223,023 Hypothetical share repurchase at $25.06 (175,908) - ---------------------------------------------------------------------------------------------------- Earnings per share - diluted $ 3,689,000 8,229,149 $0.45 ==================================================================================================== </Table> 3. STOCK COMPENSATION PLANS The Corporation uses the intrinsic value method of accounting for stock compensation plans, under Accounting Principles Board Opinion No. 25 (APB Opinion 25), and as permitted by Statement of Financial Accounting Standards (SFAS) No. 123. Utilizing the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock as of the grant date (or other measurement date) over the amount an employee or director must pay to acquire the stock. Stock options issued under the Corporation's stock option plans have no intrinsic value, and accordingly, no compensation cost is recorded for them. The Corporation has also made awards of restricted stock. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock options. <Table> <Caption> (NET INCOME IN THOUSANDS) 3 MONTHS ENDED 6 MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 2005 2004 <S> <C> <C> <C> <C> Net income, as reported $ 3,298 $ 3,689 $ 6,593 $ 7,395 Deduct: Total stock option compensation expense determined under fair value method for all awards, net of tax effects (34) (42) (69) (91) - -------------------------------------------------------------------------------------------------------------- Pro forma net income $ 3,264 $ 3,647 $ 6,524 $ 7,304 ============================================================================================================== </Table> 7
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, which replaces SFAS No. 123 and supersedes APB Opinion 25. SFAS No. 123R will require the Corporation to record stock option expense based on estimated fair value calculated using an option valuation model. As issued, SFAS No. 123R would have applied to new awards granted, and to modifications of existing awards, on or after July 1, 2005. In April 2005, however, the Securities and Exchange Commission extended the date for mandatory implementation of SFAS No. 123R, effectively requiring the Corporation to apply SFAS No. 123R in the first quarter 2006. The Corporation does not plan early implementation of the provisions of SFAS No. 123R. 4. COMPREHENSIVE INCOME U.S. generally accepted accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, changes in unrealized gains and losses on available-for-sale securities, along with net income, are components of comprehensive income (loss). The components of comprehensive income, and the related tax effects, are as follows: <Table> <Caption> (IN THOUSANDS) 3 MONTHS ENDED 6 MONTHS ENDED JUNE 30, JUNE 30, JUNE 30, JUNE 30, 2005 2004 2005 2004 <S> <C> <C> <C> <C> Net income $ 3,298 $ 3,689 $ 6,593 $ 7,395 Unrealized holding gains (losses) on available-for-sale securities 4,759 (15,613) (1,122) (10,748) Reclassification adjustment for gains realized in income (929) (321) (1,995) (1,285) - --------------------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss) before income tax 3,830 (15,934) (3,117) (12,033) Income tax related to other comprehensive income/loss (1,302) 5,419 1,060 4,093 - --------------------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss) 2,528 (10,515) (2,057) (7,940) - --------------------------------------------------------------------------------------------------------------------------------- Comprehensive income (loss) $ 5,826 $ (6,826) $ 4,536 $ (545) ================================================================================================================================= </Table> 8
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q 5. SECURITIES Amortized cost and fair value of securities at June 30, 2005 are summarized as follows: <TABLE> <CAPTION> JUNE 30, 2005 GROSS GROSS UNREALIZED UNREALIZED AMORTIZED HOLDING HOLDING FAIR (IN THOUSANDS) COST GAINS LOSSES VALUE <S> <C> <C> <C> <C> AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - Obligations of other U.S. Government agencies 40,020 32 (100) 39,952 Obligations of states and political subdivisions 119,891 4,300 (384) 123,807 Other securities 99,306 1,945 (612) 100,639 Mortgage-backed securities 159,202 262 (2,012) 157,452 - ---------------------------------------------------------------------------------------------------------------------------------- Total debt securities 418,419 6,539 (3,108) 421,850 Marketable equity securities 22,024 9,727 (313) 31,438 - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 440,443 $ 16,266 $ (3,421) $ 453,288 ================================================================================================================================== HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ 315 $ 20 $ - $ 335 Obligations of other U.S. Government agencies 98 12 - 110 Mortgage-backed securities 14 - - 14 - ---------------------------------------------------------------------------------------------------------------------------------- Total $ 427 $ 32 $ - $ 459 ================================================================================================================================== </Table> The following table presents gross unrealized losses and fair value of investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2005. <TABLE> <CAPTION> (IN THOUSANDS) LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED VALUE LOSSES VALUE LOSSES VALUE LOSSES <S> <C> <C> <C> <C> <C> <C> AVAILABLE-FOR-SALE SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies 19,900 (100) - - 19,900 (100) Obligations of states and political subdivisions 10,568 (140) 7,256 (244) 17,824 (384) Other securities 33,962 (396) 10,996 (216) 44,958 (612) Mortgage-backed securities 60,084 (411) 77,580 (1,601) 137,664 (2,012) - -------------------------------------------------------------------------------------------------------------------------------- Total debt securities 124,514 (1,047) 95,832 (2,061) 220,346 (3,108) Marketable equity securities 4,360 (159) 976 (154) 5,336 (313) - -------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired available-for-sale securities $128,874 $ (1,206) $ 96,808 $ (2,215) $225,682 $ (3,421) ================================================================================================================================ HELD-TO-MATURITY SECURITIES: Obligations of the U.S. Treasury $ - $ - $ - $ - $ - $ - Obligations of other U.S. Government agencies - - - - - - Mortgage-backed securities - - - - - - - -------------------------------------------------------------------------------------------------------------------------------- Total temporarily impaired held-to-maturity securities $ - $ - $ - $ - $ - $ - ================================================================================================================================ </Table> 9
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The unrealized losses on debt securities are primarily the result of volatility in interest rates. Based on the credit worthiness of the issuers, which are almost exclusively U.S. Government agencies or state and political subdivisions, management believes the Corporation's debt securities at June 30, 2005 were not other-than-temporarily impaired. 6. DEFINED BENEFIT PLANS The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years. In addition, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance and will not affect the Corporation's future expenses. Similarly, such feature will minimize the impact, if any, of the Medicare Prescription Drug, Improvement and Modernization Act (the "Act"), signed into law in December 2003. The Corporation has not yet determined whether benefits provided under the postretirement plan are actuarially equivalent to benefits that will be available under Medicare Part D. Accordingly, the financial statement amounts and disclosures related to the postretirement benefits plan do not reflect the effects of the Act. The Corporation uses a December 31 measurement date for its plans. The components of net periodic benefit costs from these defined benefit plans are as follows: <Table> <Caption> (IN THOUSANDS) PENSION POSTRETIREMENT 6 MONTHS ENDED 6 MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 2005 2004 <S> <C> <C> <C> <C> Service cost $ 238 $ 237 $ 24 $ 22 Interest cost 309 310 33 32 Expected return on plan assets (397) (374) - - Amortization of transition (asset) obligation (12) (12) 18 18 Recognized net actuarial loss (gain) 19 33 1 2 - --------------------------------------------------------------------------------------------------- Net periodic benefit cost (benefit) $ 157 $ 194 $ 76 $ 74 =================================================================================================== </TABLE> <TABLE> <CAPTION> (IN THOUSANDS) PENSION POSTRETIREMENT 3 MONTHS ENDED 3 MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 2005 2004 <S> <C> <C> <C> <C> Service cost $ 119 $ 119 $ 12 $ 11 Interest cost 154 155 16 16 Expected return on plan assets (199) (187) - - Amortization of transition (asset) obligation (6) (6) 9 9 Recognized net actuarial loss (gain) 9 16 - 1 - --------------------------------------------------------------------------------------------------- Net periodic benefit cost (benefit) $ 77 $ 97 $ 37 $ 37 =================================================================================================== </Table> 10
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The Corporation funded its total defined benefit pension contribution for 2005 of $178,000 in April 2005. In the first six months of 2005, the Corporation funded postretirement contributions totaling $26,000. The estimated total (annual) amount of 2005 postretirement contributions is $60,000. 7. CONTINGENCIES In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management's opinion, the Corporation's financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings. CITIZENS & NORTHERN CORPORATION - FORM 10 - Q PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Citizens & Northern Corporation ("Corporation") is a one-bank holding company whose principal subsidiary is Citizens & Northern Bank ("Bank"). The Corporation's principal office is located in Wellsboro, Pennsylvania. The Corporation's other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company ("Bucktail"). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of the Bank. FORWARD-LOOKING STATEMENTS Certain statements in this section and elsewhere in this quarterly report on Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", "likely", "expect", "plan", "anticipate", "target", "forecast", and "goal". These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management's control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following: - - changes in monetary and fiscal policies of the Federal Reserve Board and the U. S. Government, particularly related to changes in interest rates - - changes in general economic conditions - - legislative or regulatory changes - - downturn in demand for loan, deposit and other financial services in the Corporation's market area - - increased competition from other banks and non-bank providers of financial services - - technological changes and increased technology-related costs - - changes in accounting principles, or the application of generally accepted accounting principles. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. REFERENCES TO 2005 AND 2004 Unless otherwise noted, all references to "2005" in the following discussion of operating results are intended to mean the six months ended June 30, 2005, and similarly, references to "2004" are intended to mean the six months ended June 30, 2004. EARNINGS OVERVIEW Net income in 2005 was $6,593,000, or $.80 per share - basic and diluted. This represents a decrease of 10.8% in net income compared to 2004. Return on average assets was 1.17% in 2005, as compared to 1.35% in 2004. Return on average equity was 9.96% in 2005, as compared to 11.52% in 2004. 11
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The most significant income statement changes between 2005 and 2004 were as follows: - Despite a flattening yield curve, the interest margin of $17,489,000 in 2005 was $327,000, or 1.9%, higher than in 2004. Net loans increased 10.9% as compared to one year earlier, to $604,514,000 as of June 30, 2005. The increase in loan volume has been the major reason for the slight growth in the interest margin in 2005 over 2004. As described in the Net Interest Margin section of Management's Discussion and Analysis, on a fully taxable equivalent basis, the interest margin is slightly lower in 2005 than in 2004. - Net realized gains from securities amounted to $1,955,000 in 2005, up $710,000 from 2004. The Corporation's volume of investment security sales was high by historical standards during the first six months of 2005, as management identified several bank stocks that were deemed fully valued and also sold selected debt securities in an effort to manage its interest rate risk position. - Other (noninterest) expense increased $1,784,000 (14.3%) in 2005 as compared to 2004. Furniture and equipment expense increased $574,000, or 79.3%, mainly due to depreciation and maintenance costs associated with the new core banking software system, which was implemented in the fourth quarter 2004. Salaries and wages increased $523,000, or 9.7%. The increase in salaries expense is primarily a reflection of a greater number of employees, resulting from expansion into new branches in Williamsport and South Williamsport in 2004, hiring new employees for the Jersey Shore and Old Lycoming Township branches expected to open within the next six months, and the addition of new employees for support functions, such as Risk Management, Finance and Training. Other expenses increased $293,000, or 9.1%, including an increase in attorney fees of $159,000, mainly related to collection activities on a large commercial credit, and an increase of $135,000 in expenses associated with maintaining and preparing other real estate properties for sale. Increases in other expenses are described in more detail in the Noninterest Expense section of Management's Discussion and Analysis. - The income tax provision increased to $1,432,000 in 2005 from $1,315,000 in 2004. The Corporation's effective tax rate rose to 17.8% in 2005 from 15.1% in 2004. This higher effective tax rate resulted mainly from management's decision to decrease the weighting of tax-exempt obligations of states and political subdivisions, as a percentage of total assets, to avoid or reduce what would have otherwise been a substantial alternative minimum tax liability. SECOND QUARTER 2005 Net Income in the second quarter 2005 was $3,298,000, or 10.6%, lower than second quarter 2004 Net Income of $3,689,000. Net Income for the second quarter 2005 was almost identical to first quarter 2005 Net income of $3,295,000. Net Income Per Share (Basic and Diluted) was $0.40 in the second quarter 2005, the same as the first quarter 2005, but down from $0.45 (Basic and Diluted) in the second quarter 2004. <Table> <Caption> TABLE I - QUARTERLY FINANCIAL DATA (IN THOUSANDS) JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2005 2005 2004 2004 2004 2004 <S> <C> <C> <C> <C> <C> <C> Interest income $14,908 $14,693 $14,991 $14,573 $14,343 $14,015 Interest expense 6,155 5,957 5,745 5,665 5,493 5,703 - ----------------------------------------------------------------------------------------------------------------------- Interest margin 8,753 8,736 9,246 8,908 8,850 8,312 Provision for loan losses 375 375 350 350 350 350 - ----------------------------------------------------------------------------------------------------------------------- Interest margin after provision for loan losses 8,378 8,361 8,896 8,558 8,500 7,962 Other income 1,889 1,703 1,815 1,627 1,855 1,625 Securities gains 929 1,066 1,133 459 321 964 Other expenses 7,173 7,128 6,746 6,738 6,289 6,228 - ----------------------------------------------------------------------------------------------------------------------- Income before income tax provision 4,023 4,002 5,098 3,906 4,387 4,323 Income tax provision 725 707 1,035 501 698 617 - ----------------------------------------------------------------------------------------------------------------------- Net income $ 3,298 $ 3,295 $ 4,063 $ 3,405 $ 3,689 $ 3,706 ======================================================================================================================= Net income per share - basic $ 0.40 $ 0.40 $ 0.50 $ 0.42 $ 0.45 $ 0.45 ======================================================================================================================= Net income per share - diluted $ 0.40 $ 0.40 $ 0.49 $ 0.41 $ 0.45 $ 0.45 ======================================================================================================================= </Table> 12
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The number of shares used in calculating net income per share for each quarter presented in Table I reflects the retroactive effect of stock splits and dividends. PROSPECTS FOR THE REMAINDER OF 2005 An update on the Corporation's expansion projects is as follows: - The planned July opening of the Jersey Shore, PA office was temporarily delayed due to failure of a landscaping retaining wall. Further engineering has been completed to ensure the new wall will be sound, and construction of the new wall has resumed. We expect to open in the 3rd quarter 2005. - Also in the 3rd quarter 2005, we expect to close on the acquisition of Canisteo Valley Corporation, the parent company of First State Bank of Canisteo, NY, with total assets of approximately $42 million as of June 30, 2005. - Construction has begun on a new administrative building in Wellsboro, within 2 blocks of the main office. We expect to move approximately 50 employees into this new facility by year-end. - Upon completion of the Jersey Shore office, we anticipate that construction will begin on a branch facility in Old Lycoming Township, PA. We hope to open this office in January 2006. Management expects the investments in new markets to provide future, continuing opportunities for earnings growth. However, as evidenced by our lower earnings performance in the 1st half of 2005, it will be difficult to achieve earnings for the year 2005 comparable to 2004's annual results. Short-term interest rates have been rising faster than long-term rates, and further increases in short-term rates are expected over the remainder of 2005. Management expects rising short-term interest rates to continue to have a negative effect on the Corporation's net interest margin throughout much of 2005. The Corporation's exposure to interest rate risk is discussed in more detail in Item 3. Also, consistent with the first half results discussed above, noninterest expense in 2005 is expected to be up significantly, mainly due to payroll and other start-up costs related to the new branches, as well as costs from the planned administrative facility and a full year of depreciation and maintenance from the core computer system that was placed in service in October 2004. Another major variable that affects the Corporation's earnings is securities gains and losses. Management's decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. It is difficult to predict, with much precision, the amount of net securities gains and losses that will be realized in 2005. CRITICAL ACCOUNTING POLICIES The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates. A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation's methodology for determining the allowance for loan losses is described in a separate section later in Management's Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore, calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination. Another material estimate is the calculation of fair values of the Corporation's investments in debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. The large majority of the Corporation's securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the 13
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders' equity). NET INTEREST MARGIN The Corporation's primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation's net interest margin for 2005 and 2004. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables. The net interest margin, on a tax-equivalent basis, was $19,078,000 in 2005, down $144,000, or 0.8%, from 2004. As reflected in Table IV, interest rate changes had the effect of decreasing net interest income $633,000 in 2005 as compared to 2004, as rising short-term interest rates caused increases in the Corporation's interest expense on money market deposits, certificates of deposits and short-term borrowings. Table IV also shows that increased interest income from higher volumes of earning assets (primarily loans) exceeded increases in interest expense attributable to higher volumes of interest-bearing liabilities by $489,000 in 2005 compared to 2004. As presented in Table III, the "Interest Rate Spread" (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) was 3.28% for the first six months of 2005, compared to 3.43% for the year ended December 31, 2004 and 3.45% for the first six months of 2004. INTEREST INCOME AND EARNING ASSETS Interest income increased 2.5%, to $31,190,000 in 2005 from $30,418,000 in 2004. Interest and fees from loans increased $1,851,000, or 10.7%, while income from available-for-sale securities decreased $1,113,000, or 8.5%. Overall, the majority of the increase in interest income resulted from higher volumes of loans, which more than offset the effect of the lower average volume of available-for-sale securities. As indicated in Table III, average available-for-sale securities in the first half of 2005 amounted to $449,486,000, a decrease of 6.6% from the first half of 2004. Proceeds from sales and maturities of securities have been used, in part, to help fund the substantial growth in loans. Also, because short-term interest rates have been rising faster than long-term rates, there have been few opportunities to purchase mortgage-backed securities or other bonds at spreads sufficient to justify the applicable interest rate risk. The average rate of return on available-for-sale securities was 5.41% for first half of 2005, slightly lower than the 5.50% level in the first half of 2004, and the same as the rate of return for the year ended December 31, 2004. Tax-exempt securities (municipal bonds) were a smaller portion of the Corporation's earning assets in 2005 than in 2004. The average balance of municipal bonds shrunk to $121,179,000 in 2005 from $161,064,000 in the first half of 2004. Management decided to reduce the Corporation's investment in municipal bonds during the fourth quarter 2004, in order to reduce or eliminate the alternative minimum tax liabilities incurred in 2004, and that would otherwise have been expected for 2005. The average balance of gross loans increased 12.1% in the first half of 2005 over the first 6 months of 2004, to $600,163,000 from $535,160,000. The largest growth was in commercial loans, due in part to new personnel and relationships in Williamsport and throughout Lycoming County, as well as from growth in staffing and an increased emphasis on commercial lending throughout the Corporation's market area over the last few years. The average rate of return on loans was 6.41% in the first 6 months of 2005, as compared to 6.47% in the first 6 months of 2004. The decrease in average rate was affected, in part, by substantial competition for commercial loan relationships with high credit quality, particularly in Lycoming County. 14
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES Interest expense rose $916,000, or 8.2%, to $12,112,000 in 2005 from $11,196,000 in 2004. Table III reflects the current trend in interest rates incurred on liabilities, as the overall cost of funds on interest-bearing liabilities rose to 2.69% for the first half of 2005, from 2.55% for the first six months of 2004. In Table III, you can see the impact of rising short-term interest rates on some of the Corporation's largest sources of funds: (1) money market accounts, which increased to an average rate of 1.86% in 2005 from 1.20% in the first half of 2004, (2) certificates of deposit, which increased to an average rate of 3.14% from 2.79%, and (3) short-term borrowings, which rose to an average rate of 2.46% from 1.27%. Helping to offset some of the impact of rising short-term market rates were IRAs, for which the average rate fell to 3.49% from 4.14%, and long-term borrowings, for which the average rate fell to 3.44% from 3.60%. In the first quarter 2004, the average rate paid on the majority of the Corporation's IRAs was 5%, which was the "floor" on 18-month passbook IRAs that existed prior to October 1, 2003. Effective April 1, 2004, the floor on those IRAs fell to 3%, and the Corporation's passbook IRA rate has ranged from 3.25% to 3.50% thereafter. The decrease in average rate incurred on long-term borrowings resulted from repayment of borrowings originated in earlier interest rate cycles at higher rates, with replacements in either short-term instruments or long-term instruments at lower rates, mostly during the second and third quarters of 2004. As you can calculate from Table III, total average deposits (interest-bearing and noninterest-bearing) increased to $678,209,000 in the first half of 2005 from $660,129,000 in the first half of 2004, an increase of 2.7%. Of the increase in average deposits, the largest growth categories were money market deposits of $7,169,000, and IRA's of $5,937,000. Average total short-term and long-term borrowed funds increased $10,863,000 to $309,507,000 in 2005 from $298,644,000 in the first half of 2004. In 2004, the Corporation utilized borrowings to fund security purchases and to help fund loan growth. In 2005, this trend has changed, as management has begun to use proceeds from the securities portfolio to help fund loan growth, has allowed total borrowings to remain approximately stagnant, and in an attempt to contain the amount of growth in interest expense, has rolled over maturing long-term borrowings into overnight or short-term borrowings. This change in trend is reflected in the consolidated balance sheet, as total short-term borrowings increased to $50,562,000 at June 30, 2005 from $34,178,000 at December 31, 2004, and total long-term borrowings decreased to $254,199,000 at June 30, 2005 from $270,827,000 at December 31, 2004. 15
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE <Table> <Caption> SIX MONTHS ENDED JUNE 30, INCREASE/ (IN THOUSANDS) 2005 2004 (DECREASE) <S> <C> <C> <C> INTEREST INCOME Available-for-sale securities: Taxable $ 7,820 $ 7,450 $ 370 Tax-exempt 4,237 5,720 (1,483) - ---------------------------------------------------------------------------------------------------- Total available-for-sale securities 12,057 13,170 (1,113) - ---------------------------------------------------------------------------------------------------- Held-to-maturity securities, Taxable 12 13 (1) Interest-bearing due from banks 13 4 9 Federal funds sold 30 4 26 Loans: Taxable 18,324 16,561 1,763 Tax-exempt 754 666 88 - ---------------------------------------------------------------------------------------------------- Total loans 19,078 17,227 1,851 - ---------------------------------------------------------------------------------------------------- Total Interest Income 31,190 30,418 772 - ---------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest checking 118 114 4 Money market 1,782 1,110 672 Savings 141 139 2 Certificates of deposit 2,906 2,558 348 Individual Retirement Accounts 2,104 2,384 (280) Other time deposits 3 3 - Short-term borrowings 557 249 308 Long-term borrowings 4,501 4,639 (138) - ---------------------------------------------------------------------------------------------------- Total Interest Expense 12,112 11,196 916 - ---------------------------------------------------------------------------------------------------- Net Interest Income $ 19,078 $ 19,222 $ (144) ==================================================================================================== </Table> Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. 16
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IIL - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES (DOLLARS IN THOUSANDS) <Table> <Caption> 6 MONTHS YEAR 6 MONTHS ENDED RATE OF ENDED RATE OF ENDED RATE OF 6/30/2005 RETURN/ 12/31/2004 RETURN/ 6/30/2004 RETURN/ AVERAGE COST OF AVERAGE COST OF AVERAGE COST OF BALANCE FUNDS % BALANCE FUNDS % BALANCE FUNDS % <S> <C> <C> <C> <C> <C> <C> EARNING ASSETS Available-for-sale securities, at amortized cost: Taxable $ 328,307 4.80% $ 331,447 4.65% $ 320,162 4.68% Tax-exempt 121,179 7.05% 151,049 7.09% 161,064 7.14% - -------------------------------------------------------------------------------------------------------------------------------- Total available-for-sale securities 449,486 5.41% 482,496 5.41% 481,226 5.50% - -------------------------------------------------------------------------------------------------------------------------------- Held-to-maturity securities, Taxable 430 5.63% 460 5.87% 479 5.46% Interest-bearing due from banks 1,089 2.41% 1,449 0.76% 1,147 0.70% Federal funds sold 2,242 2.70% 778 1.29% 798 1.01% Loans: Taxable 576,291 6.41% 530,045 6.46% 515,047 6.47% Tax-exempt 23,872 6.37% 21,307 6.58% 20,113 6.66% - -------------------------------------------------------------------------------------------------------------------------------- Total loans 600,163 6.41% 551,352 6.47% 535,160 6.47% - -------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets 1,053,410 5.97% 1,036,535 5.96% 1,018,810 6.00% Cash 8,975 14,273 14,325 Unrealized gain/loss on securities 13,385 16,182 18,619 Allowance for loan losses (6,997) (6,523) (6,336) Bank premises and equipment 17,452 14,953 13,741 Other assets 44,648 38,621 37,810 - ---------------------------------------------------------------------------------------------------------------------- Total Assets $ 1,130,873 $ 1,114,041 $ 1,096,969 ====================================================================================================================== INTEREST-BEARING LIABILITIES Interest checking $ 38,029 0.63% $ 39,188 0.59% $ 39,500 0.58% Money market 193,270 1.86% 192,450 1.31% 186,101 1.20% Savings 57,325 0.50% 57,439 0.49% 56,118 0.50% Certificates of deposit 186,876 3.14% 180,332 2.85% 184,181 2.79% Individual Retirement Accounts 121,643 3.49% 116,622 3.75% 115,706 4.14% Other time deposits 1,101 0.57% 1,275 0.39% 1,232 0.49% Short-term borrowing 45,643 2.46% 39,458 1.37% 39,293 1.27% Long-term borrowing 263,864 3.44% 268,211 3.55% 259,351 3.60% - -------------------------------------------------------------------------------------------------------------------------------- Total Interest-bearing Liabilities 907,751 2.69% 894,975 2.53% 881,482 2.55% Demand deposits 79,965 82,001 77,291 Other liabilities 10,748 8,691 9,856 - -------------------------------------------------------------------------------------------------------------------------------- Total Liabilities 998,464 985,667 968,629 - -------------------------------------------------------------------------------------------------------------------------------- Stockholders' equity, excluding other comprehensive income/loss 123,575 117,695 116,052 Other comprehensive income/loss 8,834 10,679 12,288 - -------------------------------------------------------------------------------------------------------------------------------- Total Stockholders' Equity 132,409 128,374 128,340 - -------------------------------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 1,130,873 $ 1,114,041 $ 1,096,969 ================================================================================================================================ Interest Rate Spread 3.28% 3.43% 3.45% Net Interest Income/Earning Assets 3.65% 3.78% 3.79% </TABLE> (1) Rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis. (2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings. 17
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES (IN THOUSANDS) <TABLE> <CAPTION> YTD ENDED 6/30/05 VS. 6/30/04 CHANGE IN CHANGE IN TOTAL VOLUME RATE CHANGE <S> <C> <C> <C> EARNING ASSETS Available-for-sale securities: Taxable $ 181 $ 189 $ 370 Tax-exempt (1,410) (73) (1,483) - -------------------------------------------------------------------------------------------------- Total available-for-sale securities (1,229) 116 (1,113) - -------------------------------------------------------------------------------------------------- Held-to-maturity securities, Taxable (1) - (1) Interest-bearing due from banks - 9 9 Federal funds sold 13 13 26 Loans: Taxable 1,905 (142) 1,763 Tax-exempt 118 (30) 88 - -------------------------------------------------------------------------------------------------- Total loans 2,023 (172) 1,851 - -------------------------------------------------------------------------------------------------- Total Interest Income 806 (34) 772 - -------------------------------------------------------------------------------------------------- INTEREST-BEARING LIABILITIES Interest checking (4) 8 4 Money market 44 628 672 Savings 3 (1) 2 Certificates of deposit 37 311 348 Individual Retirement Accounts 116 (396) (280) Other time deposits - - - Short-term borrowings 45 263 308 Long-term borrowings 76 (214) (138) - -------------------------------------------------------------------------------------------------- Total Interest Expense 317 599 916 - -------------------------------------------------------------------------------------------------- Net Interest Income $ 489 $ (633) $ (144) ================================================================================================== </Table> (1) Changes in income on tax-exempt securities and loans is presented on a fully taxable-equivalent basis, using the Corporation's marginal federal income tax rate of 34%. (2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. 18
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE V - COMPARISON OF NONINTEREST INCOME (IN THOUSANDS) <TABLE> <CAPTION> 6 MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 <S> <C> <C> Service charges on deposit accounts $ 725 $ 874 Service charges and fees 196 131 Trust and financial management revenue 1,050 1,030 Insurance commissions, fees and premiums 184 219 Increase in cash surrender value of life insurance 279 312 Fees related to credit card operation 448 409 Other operating income 710 505 - ------------------------------------------------------------------------------------ Total other operating income, before realized gains on securities, net 3,592 3,480 Realized gains on securities, net 1,995 1,285 - ------------------------------------------------------------------------------------ Total Other Income $ 5,587 $ 4,765 ==================================================================================== </Table> Total noninterest income increased $822,000, or 17.3%, in 2005 compared to 2004, including an increase in net realized gains on securities of $710,000. Securities gains are discussed in the Earnings Overview section of Management's Discussion and Analysis. Other items of significance are as follows: - - Service charges on deposit accounts fell $149,000, or 17.0%, in 2005 as compared to 2004. Changes in deposit account processing resulting from the new core banking system have resulted in overdraft and other charges no longer being assessed for some transactions that would have generated charges with the former system. Management is working with the core system vendor to reestablish as many of the former overdraft and service charge routines as possible. - - Other operating income increased $205,000, or 40.6%, in 2005 over 2004. Included in this category were increases in 2005 in dividend income on Federal Home Loan Bank of Pittsburgh stock, gains from sales of other real estate properties, and debit card fees. TABLE VI- COMPARISON OF NONINTEREST EXPENSE (IN THOUSANDS) <TABLE> <CAPTION> 6 MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 <S> <C> <C> Salaries and wages $ 5,923 $ 5,400 Pensions and other employee benefits 1,985 1,812 Occupancy expense, net 925 737 Furniture and equipment expense 1,298 724 Pennsylvania shares tax 412 423 Other operating expense 3,758 3,421 - ------------------------------------------------------------------------ Total Other Expense $ 14,301 $ 12,517 ======================================================================== </Table> Salaries and wages increased $523,000, or 9.7%, in 2005 over 2004. The increase in salaries expense is primarily a reflection of a greater number of employees, resulting from expansion into new branches in Williamsport and South Williamsport in 2004, hiring new employees for the Jersey Shore and Old Lycoming Township branches expected to open within the next six months, and the addition of new employees for support functions, such as Risk Management, Finance and Training. The number of full-time equivalent employees was 340 as of June 30, 2005, up 14.1% from one year earlier. 19
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Furniture and equipment expense increased $574,000, or 79.3%, in 2005 over 2004. Depreciation expense within this category increased $383,000, to $784,000 in 2005 from $401,000 in 2004, including approximately $300,000 of depreciation in 2005 from the new core banking software system. Similarly, maintenance and repair expense within this category increased $177,000, to $437,000 in 2005 from $260,000 in 2004, primarily because of maintenance costs associated with the new core banking software system of approximately $180,000 in 2005. Other operating expense increased $337,000, or 9.9%, in 2005 over 2004. The major items that changed within this category were attorney fees, which increased $159,000 in 2005 to $175,000, mainly because of collection activities on a large commercial credit, and expenses associated with maintaining and preparing other real estate properties for sale, which increased $135,000 in 2005 to $150,000. FINANCIAL CONDITION Significant changes in the average balances of the Corporation's earning assets and interest-bearing liabilities are described in the "Net Interest Margin" section of Management's Discussion and Analysis. Also included in the Net Interest Margin section is a discussion of a change in trend regarding short-term and long-term borrowings. The allowance for loan losses and stockholders' equity are discussed in separate sections of Management's Discussion and Analysis. As discussed in the "Prospects for the Remainder of 2005" section of Management's Discussion and Analysis, the Corporation is expected to complete construction of a new branch in Jersey Shore in 2005, as well as a new administrative building in Wellsboro, and begin another branch in Old Lycoming Township. In addition to the building projects, the Corporation will need to purchase furniture, equipment and computer-related items on an ongoing basis for its existing and new operations. In total, management expects 2005 capital purchases to range between $6 and $8.5 million. As discussed in the Earnings Overview section of Management's Discussion and Analysis, management expects the initial depreciation and start-up costs associated with the new locations to have a negative impact on 2005 earnings; however, in light of the Corporation's strong capital position, the overall impact of 2005 capital purchases is not expected to be materially adverse to the Corporation's financial condition. PROVISION AND ALLOWANCE FOR LOAN LOSSES The allowance for loan losses reflects probable losses resulting from the analysis of individual loans and historical loss experience, as modified for identified trends and concerns, for each loan category. The historical loan loss experience element is determined based on the ratio of net charge-offs to average loan balances over a five-year period, for each significant type of loan, modified for qualitative risk adjustment factors identified by management for each type of loan. The charge-off ratio and qualitative factors are then applied to the current outstanding loan balance for each type of loan (net of other loans that are individually evaluated). In the second quarter 2005, management changed its process for determining and disclosing the components of the allowance for loan losses. A management committee evaluated several qualitative factors, including economic conditions, lending policies, changes in the portfolio, risk profile of the portfolio, competition and regulatory requirements, and other factors. This analysis was performed separately for 4 categories of lending activity: commercial, mortgage, consumer and credit card. Based on the results of this evaluation, allocations were made to the components of the allowance shown in Table VIII. In prior periods, the portion of the allowance determined by management's subjective assessment of economic conditions and other factors was reflected completely in the unallocated component of the allowance. As a result of this change in process, Table VIII shows the amounts allocated to the allowance for commercial, consumer mortgage and consumer loans at June 30, 2005 have increased in comparison to the corresponding amounts at March 31, 2005 and December 31, 2004, while the unallocated portion of the allowance decreased to $328,000 at June 30, 2005 from $2,504,000 at March 31, 2005 and $2,578,000 at December 31, 2004. 20
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q As indicated in Table IX, total impaired loans amounted to $8,258,000 at June 30, 2005, as compared to $8,663,000 at March 31, 2005, $8,261,000 at December 31, 2004 and $4,621,000 at December 31, 2003. In total, the valuation allowance related to impaired loans amounted to $1,614,000 at June 30, 2005, up from $1,340,000 at March 31, 2005 and $1,378,000 at December 31, 2004. Table IX also shows that the amount of loans classified as nonaccrual amounted to $7,910,000 at June 30, 2005, as compared to $8,429,000 at March 31, 2005, $7,796,000 at December 31, 2004 and $1,145,000 at December 31, 2003. The growth in 2004 in past due and nonaccrual loans resulted mainly from certain large commercial loan relationships, including one commercial loan relationship with total outstanding loan balances of approximately $3.6 million at June 30, 2005 and $3.7 million as of March 31, 2005 and December 31, 2004. In 2004, management moved most of the loans outstanding related to this large relationship to nonaccrual status. Also, in the first quarter 2005, a large ($600,000) residential mortgage loan to the principal owner of the $3.7 million relationship was moved to nonaccrual. During the second quarter 2005, the Corporation charged off $83,000 related to 2 loans to this borrower, and increased the valuation allowance to $570,000 from $173,000 at March 31, 2005 and December 31, 2004. There is another commercial loan relationship with total outstanding balances of approximately $1.6 million that has been classified as impaired and nonaccrual throughout most of 2004 and all of 2005 to date, and for which the valuation allowance has been estimated at $200,000 throughout the last several quarters. Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss and nonaccrual status. However, the actual losses realized from these relationships could vary materially from the allowances calculated as of June 30, 2005. Management continues to closely monitor these commercial loan relationships, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate. The allowance for loan losses was $7,037,000 at June 30, 2005, an increase of $250,000 from the balance at December 31, 2004. Net charge-offs amounted to $500,000 in the first six months of 2005, while the provision for loan losses was $750,000. In the first six months of 2004, net charge-offs totaled $188,000, and the provision was $700,000. The amount of the provision in each period is determined based on the amount required to maintain an appropriate allowance in light of the factors described above. Tables VII, VIII, IX and X present an analysis of the allowance for loan losses, the allocation of the allowance, information concerning impaired and past due loans and a five-year summary of loans by type. TABLE VII- ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES <Table> <Caption> (IN THOUSANDS) SIX MONTHS SIX MONTHS YEARS ENDED DECEMBER 31, ENDED ENDED JUNE 30, JUNE 30, 2005 2004 2004 2003 2002 2001 2000 <S> <C> <C> <C> <C> <C> <C> <C> Balance, beginning of year $6,787 $6,097 $6,097 $5,789 $5,265 $5,291 $5,131 - -------------------------------------------------------------------------------------------------------------------- Charge-offs: Real estate loans 175 51 375 168 123 144 272 Installment loans 78 90 217 326 116 138 77 Credit cards and related plans 114 91 178 171 190 200 214 Commercial and other loans 202 - 16 303 123 231 53 - -------------------------------------------------------------------------------------------------------------------- Total charge-offs 569 232 786 968 552 713 616 - -------------------------------------------------------------------------------------------------------------------- Recoveries: Real estate loans 12 3 3 75 30 6 26 Installment loans 33 18 32 52 30 27 23 Credit cards and related plans 14 14 23 17 18 20 28 Commercial and other loans 10 9 18 32 58 34 23 - -------------------------------------------------------------------------------------------------------------------- Total recoveries 69 44 76 176 136 87 100 - -------------------------------------------------------------------------------------------------------------------- Net charge-offs 500 188 710 792 416 626 516 Provision for loan losses 750 700 1,400 1,100 940 600 676 - -------------------------------------------------------------------------------------------------------------------- Balance, end of year $7,037 $6,609 $6,787 $6,097 $5,789 $5,265 $5,291 ==================================================================================================================== </Table> 21
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q TABLE VIII - ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES BY TYPE (IN THOUSANDS) <Table> <Caption> AS OF AS OF AS OF DECEMBER 31, JUNE 30, MARCH 31, 2005 2005 2004 2003 2002 2001 2000 <S> <C> <C> <C> <C> <C> <C> <C> Commercial $2,212 $2,165 $1,909 $1,578 $1,315 $1,837 $1,612 Consumer mortgage 2,304 512 513 456 460 674 952 Impaired loans 1,614 1,340 1,378 1,542 1,877 73 273 Consumer 579 404 409 404 378 494 471 Unallocated 328 2,504 2,578 2,117 1,759 2,187 1,983 - ------------------------------------------------------------------------------------------------------------ Total Allowance $7,037 $6,925 $6,787 $6,097 $5,789 $5,265 $5,291 ============================================================================================================ </Table> TABLE IX - PAST DUE AND IMPAIRED LOANS (IN THOUSANDS) <Table> <Caption> JUNE 30, MAR. 31, DEC. 31, DEC. 31, DEC. 31, 2005 2005 2004 2003 2002 <S> <C> <C> <C> <C> <C> Impaired loans without a valuation allowance $ 1,295 $ 3,945 $ 3,552 $ 114 $ 675 Impaired loans with a valuation allowance 6,963 4,718 4,709 4,507 3,039 - ------------------------------------------------------------------------------------------------------------------- Total impaired loans $ 8,258 $ 8,663 $ 8,261 $ 4,621 $ 3,714 =================================================================================================================== Valuation allowance related to impaired loans $ 1,614 $ 1,340 $ 1,378 $ 1,542 $ 1,877 Total nonaccrual loans $ 7,910 $ 8,429 $ 7,796 $ 1,145 $ 1,252 Total loans past due 90 days or more and still accruing $ 1,658 $ 2,021 $ 1,307 $ 2,546 $ 2,318 </Table> TABLE X - SUMMARY OF LOANS BY TYPE (IN THOUSANDS) <Table> <Caption> JUNE 30, AS OF DECEMBER 31, 2005 2004 2003 2002 2001 2000 <S> <C> <C> <C> <C> <C> <C> Real estate - construction $ 4,125 $ 4,178 $ 2,856 $ 103 $ 1,814 $ 452 Real estate - residential mortgage 346,507 347,705 330,807 292,136 245,997 207,100 Real estate - commercial mortgage 136,634 128,073 100,240 78,317 60,267 56,225 Consumer 33,064 31,702 33,977 31,532 29,284 28,141 Agricultural 2,507 2,872 2,948 3,024 2,344 1,983 Commercial 63,672 43,566 34,967 30,874 24,696 20,776 Other 1,923 1,804 1,183 2,001 1,195 948 Political subdivisions 23,119 19,713 17,854 13,062 13,479 12,462 Lease receivables - - 65 96 152 218 - --------------------------------------------------------------------------------------------------------------------------------- Total 611,551 579,613 524,897 451,145 379,228 328,305 Less: allowance for loan losses (7,037) (6,787) (6,097) (5,789) (5,265) (5,291) - --------------------------------------------------------------------------------------------------------------------------------- Loans, net $ 604,514 $ 572,826 $ 518,800 $ 445,356 $ 373,963 $ 323,014 ================================================================================================================================= </Table> DERIVATIVE FINANCIAL INSTRUMENTS The Corporation has utilized derivative financial instruments related to a certificate of deposit product called the "Index Powered Certificate of Deposit" (IPCD). IPCDs have a term of 5 years, with interest paid at maturity based on 90% of the appreciation (as defined) in the S&P 500 index. There is no guaranteed interest payable to a depositor of an IPCD - however, assuming an IPCD is held to maturity, a depositor is guaranteed the return of his or her principal, at a minimum. In 2004, the Corporation stopped originating new IPCDs, but continues to maintain and account for IPCDs and the related derivative contracts entered into between 2001 and 2004. 22
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Statement of Financial Accounting Standards No. 133 requires the Corporation to separate the amount received from each IPCD issued into 2 components: (1) an embedded derivative, and (2) the principal amount of each deposit. Embedded derivatives are derived from the Corporation's obligation to pay each IPCD depositor a return based on appreciation in the S&P 500 index. Embedded derivatives are carried at fair value, and are included in other liabilities in the consolidated balance sheet. Changes in fair value of the embedded derivative are included in other expense in the consolidated income statement. The difference between the contractual amount of each IPCD issued, and the amount of the embedded derivative, is recorded as the initial deposit (included in interest-bearing deposits in the consolidated balance sheet). Interest expense is added to principal ratably over the term of each IPCD at an effective interest rate that will increase the principal balance to equal the contractual IPCD amount at maturity. In connection with IPCD transactions, the Corporation has entered into Equity Indexed Call Option (Swap) contracts with the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh). Under the terms of the Swap contracts, the Corporation must pay FHLB-Pittsburgh quarterly amounts calculated based on the contractual amount of IPCDs issued times a negotiated rate. In return, FHLB-Pittsburgh is obligated to pay the Corporation, at the time of maturity of the IPCDs, an amount equal to 90% of the appreciation (as defined) in the S&P 500 index. If the S&P 500 index does not appreciate over the term of the related IPCDs, the FHLB-Pittsburgh would make no payment to the Corporation. The effect of the Swap contracts is to limit the Corporation's cost of IPCD funds to the market rate of interest paid to FHLB-Pittsburgh. (In addition, the Corporation paid a fee of 0.75% to a consulting firm at inception of each deposit. This fee is amortized to interest expense over the term of the IPCDs.) Swap liabilities are carried at fair value, and included in other liabilities in the consolidated balance sheet. Changes in fair value of swap liabilities are included in other expense in the consolidated income statement. Amounts recorded as of June 30, 2005 and December 31, 2004, and for the first six months of 2005 and 2004, related to IPCDs are as follows (in thousands): <Table> <Caption> JUNE 30, DEC. 31, 2005 2004 <S> <C> <C> Contractual amount of IPCDs (equal to notional amount of Swap contracts) $ 3,959 $ 4,045 Carrying value of IPCDs 3,666 3,695 Carrying value of embedded derivative liabilities 458 297 Carrying value of Swap contract liabilities (185) 42 </TABLE> <TABLE> <CAPTION> 6 MONTHS 6 MONTHS ENDED ENDED JUNE 30, JUNE 30, 2005 2004 <S> <C> <C> Interest expense $ 78 $ 69 Other expense (5) 1 </Table> LIQUIDITY Liquidity is the ability to quickly raise cash at a reasonable cost. An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand. The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity. Also, the Corporation maintains borrowing facilities with FHLB - Pittsburgh, secured by mortgage loans and various investment securities. At June 30, 2005, the Corporation had unused borrowing availability with correspondent banks and the FHLB - Pittsburgh totaling approximately $126,268,000. Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets, and uses "RepoSweep" arrangements to borrow funds from commercial banking customers on an overnight basis. Further, if required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. At June 30, 2005, the carrying value of non-pledged securities was $270,095,000. Management believes the combination of its strong capital position (discussed in the next section), ample available borrowing facilities and substantial non-pledged securities portfolio have placed the Corporation in a position of minimal short-term and long-term liquidity risk. 23
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q STOCKHOLDERS' EQUITY AND CAPITAL ADEQUACY The Corporation and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. For many years, the Corporation and the Bank have maintained strong capital positions. The following table presents consolidated capital ratios at June 30, 2005: <Table> <S> <C> Total capital to risk-weighted assets 18.45% Tier 1 capital to risk-weighted assets 16.91% Tier 1 capital to average total assets 10.99% </Table> Management expects the Corporation and the Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions for the next 12 months and for the foreseeable future. Planned capital expenditures (as discussed in the "Earnings Overview" section of Management's Discussion and Analysis) during the next 12 months are not expected to have a detrimental effect on capital ratios. INFLATION Over the last several years, direct inflationary pressures on the Corporation's payroll-related and other noninterest costs have been modest. The Corporation is significantly affected by the Federal Reserve Board's efforts to control inflation through changes in interest rates. Management monitors the impact of economic trends, including indicators of inflationary pressure, in managing interest rate and other financial risks. PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 3. INTEREST RATE RISK AND MARKET RISK ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The Corporation's two major categories of market risk, interest rate and equity securities risk, are discussed in the following sections. INTEREST RATE RISK Business risk arising from changes in interest rates is a significant factor in operating a bank. The Corporation's assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from short-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation's financial instruments when interest rates change. The Bank uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. Only assets and liabilities of the Bank are included in management's monthly simulation model calculations. Since the Bank makes up more than 90% of the Corporation's total assets and liabilities, and because the Bank is the source of the most volatile interest rate risk, management does not consider it necessary to run the model for the remaining entities within the consolidated group. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates. 24
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q The Bank's Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. The Bank's policy provides limits at +/- 100, 200 and 300 basis points from current rates for fluctuations in net interest income from the baseline (flat rates) one-year scenario. The policy also limits acceptable market value variances from the baseline values based on current rates. The most sensitive scenario presented in Table XI presented below is the "+300 basis points" scenario. As the table shows, as of June 30, 2005, if interest rates were to immediately rise 300 basis points, the Bank's calculations based on the model show that although the change in net interest income is within the policy threshold, the market value of portfolio equity would decrease 47.6%, which exceeds the policy limit of 45%. Similarly, at December 31, 2004, the change in net interest income was within the policy threshold, but the market value of portfolio equity decrease of 49.2% exceeded the policy threshold. Management will continue to evaluate whether to make any changes to asset or liability holdings in an effort to reduce exposure to decline in market value or net interest income in a rising interest rate environment. The table that follows was prepared using the simulation model described above. The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest margin and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates. TABLE XI - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES JUNE 30, 2005 DATA (IN THOUSANDS) <TABLE> <CAPTION> 12 MOS. ENDING JUNE 30, 2006 INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT <S> <C> <C> <C> <C> <C> <C> +300 65,428 37,145 28,283 -16.1% 20.0% +200 63,468 33,214 30,254 -10.3% 15.0% +100 61,426 29,284 32,142 -4.7% 10.0% 0 59,080 25,354 33,726 0.0% 0.0% -100 55,836 21,963 33,873 0.4% 10.0% -200 52,481 19,004 33,477 -0.7% 15.0% -300 49,437 17,140 32,297 -4.2% 20.0% </TABLE> MARKET VALUE OF PORTFOLIO EQUITY AT JUNE 30, 2005 <TABLE> <CAPTION> PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT <S> <C> <C> <C> <C> +300 71,805 -47.6% 45.0% +200 93,596 -31.7% 35.0% +100 116,152 -15.2% 25.0% 0 136,999 0.0% 0.0% -100 146,404 6.9% 25.0% -200 152,461 11.3% 35.0% -300 161,425 17.8% 45.0% </Table> 25
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q DECEMBER 31, 2004 DATA (IN THOUSANDS) <TABLE> <CAPTION> 12 MOS. ENDING DEC. 31, 2005 INTEREST INTEREST NET INTEREST NII NII BASIS POINT CHANGE IN RATES INCOME EXPENSE INCOME (NII) % CHANGE RISK LIMIT <S> <C> <C> <C> <C> <C> +300 62,724 34,583 28,141 -16.8% 20.0% +200 61,066 30,840 30,226 -10.7% 15.0% +100 59,327 27,098 32,229 -4.7% 10.0% 0 57,343 23,510 33,833 0.0% 0.0% -100 54,581 20,676 33,905 0.2% 10.0% -200 51,800 17,924 33,876 0.1% 15.0% -300 49,090 16,850 32,240 -4.7% 20.0% </TABLE> MARKET VALUE OF PORTFOLIO EQUITY AT DECEMBER 31, 2004 <TABLE> <CAPTION> PRESENT PRESENT PRESENT VALUE VALUE VALUE BASIS POINT CHANGE IN RATES EQUITY % CHANGE RISK LIMIT <S> <C> <C> <C> <C> +300 71,244 -49.2% 45.0% +200 94,088 -32.9% 35.0% +100 117,491 -16.2% 25.0% 0 140,168 0.0% 0.0% -100 153,026 9.2% 25.0% -200 162,400 15.9% 35.0% -300 171,463 22.3% 45.0% </Table> EQUITY SECURITIES RISK The Corporation's equity securities portfolio consists primarily of investments in stock of banks and bank holding companies located mainly in Pennsylvania. The Corporation also owns some other stocks and mutual funds. Included in "Other Equity Securities" in the table that follows are preferred stocks issued by U.S. Government agencies with a fair value of $1,980,000 at June 30, 2005 and $6,130,000 at December 31, 2004. Investments in bank stocks are subject to the risk factors that affect the banking industry in general, including competition from nonbank entities, credit risk, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of bank and bank holding companies located in Pennsylvania, these investments could decline in market value if there is a downturn in the state's economy. Equity securities held as of June 30, 2005 and December 31, 2004 are presented in Table XII. 26
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q <Table> <CAPTION> TABLE XII - EQUITY SECURITIES (IN THOUSANDS) HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT MARCH 31, 2005 COST VALUE VALUE VALUE <S> <C> <C> <C> <C> Banks and bank holding companies $ 18,088 $ 27,258 $ (2,726) $ (5,452) Other equity securities 3,936 4,180 (418) (836) - -------------------------------------------------------------------------------------------------------------------------------- Total $ 22,024 $ 31,438 $ (3,144) $ (6,288) ================================================================================================================================ </TABLE> <TABLE> <CAPTION> HYPOTHETICAL HYPOTHETICAL 10% 20% DECLINE IN DECLINE IN FAIR MARKET MARKET AT DECEMBER 31, 2004 COST VALUE VALUE VALUE <S> <C> <C> <C> <C> Banks and bank holding companies $ 17,426 $ 29,880 $ (2,988) $ (5,976) Other equity securities 8,962 8,383 (838) (1,677) - -------------------------------------------------------------------------------------------------------------------------------- Total $ 26,388 $ 38,263 $ (3,826) $ (7,653) ================================================================================================================================ </TABLE> PART I - FINANCIAL INFORMATION (CONTINUED) ITEM 4. CONTROLS AND PROCEDURES The Corporation's management, under the supervision of and with the participation of the Corporation's Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation's disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation's disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There were no significant changes in the Corporation's internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to affect, our internal control over financial reporting. PART II - OTHER INFORMATION Item 1. Legal Proceedings The Corporation and the Bank are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation's financial condition or results of operations. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None 27
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Item 4. Submission of Matters to a Vote of Security Holders The Annual Meeting of Shareholders of Citizens & Northern Corporation was held on Tuesday, April 19, 2005. The Board of Directors fixed the close of business on March 1, 2005 as the record date for the determination of stockholders entitled to notice of and to vote at the Annual Meeting and at any adjournment thereof. On this record date, there were outstanding and entitled to vote 8,190,990 shares of Common Stock. The total number of votes cast was 5,591,779. There were 67 votes cast in person by owners or representatives and 5,591,712 votes by proxy for the election of the following as Class III Directors to serve for a term of three years: <TABLE> <S> <C> <C> Dennis F. Beardslee Total Votes in Favor 5,543,080 Total Votes Withheld/Against 48,699 Jan E. Fisher Total Votes in Favor 5,527,826 Total Votes Withheld/Against 63,953 Karl W. Kroeck Total Votes in Favor 5,488,170 Total Votes Withheld/Against 103,609 Craig G. Litchfield Total Votes in Favor 5,527,892 Total Votes Withheld/Against 63,887 Ann M. Tyler Total Votes in Favor 5,538,218 Total Votes Withheld/Against 53,561 </TABLE> There were 380,105 shares non-voted by brokers related to the election of the Class III Directors noted above. Item 5. Other Information None 28
CITIZENS & NORTHERN CORPORATION - FORM 10 - Q Item 6. Exhibits <Table> <S> <C> 3. (i) Articles of Incorporation Incorporated by reference to the exhibits filed with the Corporation's registration statement on Form S-4 on March 27, 1987. 3. (ii) By-laws Incorporated by reference to Exhibit 3.1 of the Corporation's Form 8-K filed August 25, 2004 11. Statement re: computation of per share earnings Information concerning the computation of earnings per share is provided in Note 2 to the Consolidated Financial Statements, which is included in Part I, Item 1 of Form 10-Q 31. Rule 13a-14(a)/15d-14(a) certifications: 31.1 Certification of Chief Executive Officer Filed herewith 31.2 Certification of Chief Financial Officer Filed herewith 32. Section 1350 certifications Filed herewith </Table> 29
CITIZENS AND NORTHERN CORPORATION - FORM 10 - Q Signature Page 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 & NORTHERN CORPORATION August 5, 2005 By: Craig G. Litchfield /s/ - -------------- ----------------------- Date Chairman, President and Chief Executive Officer August 5, 2005 By: Mark A. Hughes /s/ - -------------- ------------------ Date Treasurer and Chief Financial Officer 30