WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

ý  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

OR

o  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 0-12126

FRANKLIN FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)

20 SOUTH MAIN STREET (P.O. BOX 6010), CHAMBERSBURG,PA 17201-0819

(Address of principal executive offices)

717/264-6116

(Registrant’s telephone number, including area code)

(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 ý   Noo

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes o   Noý

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

There were 2,668,962 outstanding shares of the Registrant’s common stock as of November 4, 2003.

INDEX

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CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except per share data)

The accompanying notes are an integral part of these financial statements

3

CONSOLIDATED STATEMENTS OF INCOME

(amounts in thousands, except per share data)

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

4

Consolidated Statements of Changes in Shareholders’ Equity

for the nine months ended September 30, 2002 and 2003

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

5

CONSOLIDATED STATEMENTS OF CASH FLOWS

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FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

NOTESTO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 - Basis of Presentation

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiary, Farmers and Merchants Trust Company of Chambersburg (the Bank) and the Bank’s wholly-owned subsidiary, Franklin Realty Services Corporation.  All significant intercompany transactions and account balances have been eliminated.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows at September 30, 2003, and for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted.  It is suggested that these condensed consolidated financial statements be read in conjunction with the audited financial statements and notes thereto included in the Corporation’s 2002 Annual Report on Form 10-K.  The results of operations for the period ended September 30, 2003, are not necessarily indicative of the operating results for the full year.

For purposes of reporting cash flows, cash and cash equivalents include Cash and due from banks, Interest-bearing deposits in other banks and Federal funds sold.  Generally, Federal funds are purchased and sold for one-day periods.

Earnings per share is computed based on the weighted average number of shares outstanding during each period.  A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:

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Note 2.  Capital Adequacy

Quantitative measures established by regulation to ensure capital adequacy require financial institutions to maintain minimum amounts and ratios of total and Tier I capital to risk-weighted assets and of Tier I capital to average assets.  The Capital ratios of the Corporation and its bank subsidiary are as follows:

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NOTE 3 – Stock Repurchase Program

On March 6, 2003, the Board of Directors authorized the repurchase of up to 50,000 shares of the Corporation’s $1.00 par value common stock.  The repurchases are authorized to be made from time to time over a twelve-month period ending March 2004, in open market or privately negotiated transactions.  The repurchased shares will be held as treasury shares available for issuance in connection with future stock dividends and stock splits, employee benefit plans, executive compensation plans, and for issuance under the Dividend Reinvestment Plan and other corporate purposes.  During the nine months ended September 30, 2003, no shares of the Corporation’s common stock were repurchased.

NOTE 4 – Comprehensive Income

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

NOTE 5 – Recent Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”  This Interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under certain specified guarantees.  FIN 45 clarifies the requirements of

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FASB Statement No. 5, “Accounting for Contingencies.”  In general FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, liability or equity security of the guaranteed party, which would include financial standby letters of credit.  Certain guarantee contracts are excluded from both the disclosure and recognition requirements of this Interpretation, including, among others, guarantees related to commercial letters of credit and loan commitments.  The disclosure requirements of FIN 45 require disclosure of the nature of the guarantee, the maximum potential amount of future payments that the guarantor could be required to make under the guarantee and the current amount of the liability, if any, for the guarantor’s obligations under the guarantee.  The accounting recognition requirements of FIN 45 are to be applied prospectively to guarantees issued or modified after December 31, 2002.  Adoption of FIN 45 did not have a significant impact on the Corporation’s financial condition or results of operations.

Outstanding letters of credit written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments.  The Bank had $1,658,000 of standby letters of credit as of September 30, 2003.  The Bank uses the same credit policies in making conditional obligations as it does for on-balance sheet instruments.

The majority of these standby letters of credit expire within the next twelve months.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments.  The Company requires collateral and personal guarantees supporting these letters of credit as deemed necessary.  Management believes that the proceeds obtained through the liquidation of such collateral and the enforcement of personal guarantees would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees.  The current amount of the liability as of September 30, 2003 for guarantees under standby letters of credit issued after December 31, 2002 is not material.

In April 2003, the Financial Accounting Standards Board issued Statement No. 149, “Amendment of Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.”  This statement clarifies the definition of a derivative and incorporates certain decisions made by the Board as part of the Derivatives Implementation Group process.  This statement is effective for contracts entered into or modified, and for hedging relationships designated after June 30, 2003 and should be applied prospectively.  The provisions of the Statement that relate to implementation issues addressed by the Derivatives Implementation Group that have been effective should continue to be applied in accordance with their respective effective dates.  Adoption of this standard did not have a significant impact on the Corporation’s financial condition or results of operations.

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.”  This interpretation provides new guidance for the consolidation of variable interest entities (VIEs) and requires such entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among parties involved.  The interpretation also adds disclosure requirements for investors that are involved with unconsolidated VIEs.  The disclosure requirements apply to all financial statements issued after January 31, 2003.  The consolidation requirements apply immediately to VIEs created after January 31, 2003 and are effective December 31, 2003, for VIEs acquired before February 1, 2003.  The adoption of this interpretation is not expected to have an impact on the Corporation’s financial condition or results of operations.

In May 2003, the Financial Standards Accounting Board issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  This Statement requires that an issuer classify a financial instrument that is within its scope as a liability.  Many of these instruments were previously classified as equity.  This Statement was effective for financial instruments entered into or modified after May 31, 2003 and otherwise was effective beginning July 1, 2003.  The adoption of this standard did not have an impact on the Corporation’s financial condition or results of operations.

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Note 6 – Stock Based Compensation

The Corporation has elected to follow the disclosure requirements of FASB Statement No. 123, “Accounting for Stock-Based Compensation.”  Accordingly, no compensation expense for the plans has been recognized in the financial statements of the Corporation.  Had compensation cost for the plans been recognized in accordance with Statement No. 123, the Corporation’s net income and per share amounts would have been reduced to the following pro-forma amounts.

NOTE 7 – Contingencies

In the normal course of business, the Corporation is exposed to lawsuits, contingent liabilities and claims.  At the present time, the Corporation does not have sufficient information to be in a position to determine whether any such contingencies will have a materially adverse effect, in any future reporting periods, on its consolidated financial position or results of operations.

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Management’s Discussion and Analysis of
Results of Operations and Financial Condition
for the Three and Nine Month Periods
Ended September 30, 2003 and 2002

Part 1, Item 2

Forward Looking Statement

Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms.  Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements.  These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors.

Critical Accounting Policies

Management has identified critical accounting policies for the Corporation to include Allowance for Loan Losses, Mortgage Servicing Rights, Financial Derivatives and Stock-based Compensation.  There were no new critical accounting policies disclosed in the 2002 Annual Report on Form 10-K in regards to application or related judgements and estimates used.  Please refer to Item 7 on pages 8, 9 and 10 of the Corporation’s 2002 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

The Corporation reported earnings for the third quarter and nine months ended September 30, 2003, totaling $1,430,000 and $4,509,000, respectively, representing increases of 18.1% and 11.3%, respectively, over the same periods in 2002.  The primary factor contributing to higher earnings in the third quarter of 2003 was related to the absence of a significant impairment charge on mortgage servicing rights like occurred in the third quarter of 2002.  In addition, for the third quarter and nine months, heavy mortgage refinancing volume and the subsequent sales added substantially to net income, as well as, a retail overdraft privilege program implemented at the end of the 2002 third quarter.  Basic earnings per share for the third quarter and nine months ended September 30, 2003 were $.53 and $1.68, respectively, versus $.45 and $1.52, respectively, for the same periods one year earlier.  Diluted earnings per share was unchanged from basic earnings per share for the third quarters ended September 30, 2003 and 2002, and was $1.68 for the nine months ended September 30, 2003 compared to $1.51 for the same period in 2002.  Per share earnings are weighted to reflect the impact of the Corporation’s stock

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repurchase program.  Book value per share at September 30, 2003 equaled $18.75 versus $17.53 at September 30, 2002.  Market value was $32.00 per common share at September 30, 2003 compared to $26.50 at September 30, 2002.

The Corporation’s annualized return on average assets (ROA) and return on average equity (ROE) for the first nine months of 2003 were 1.11% and 12.11%, respectively, compared to 1.02% and 11.53%, respectively, for the first nine months of 2002.

Net Interest Income

Net interest income for the third quarter of 2003 was relatively flat, increasing $33,000, or .84%, to $3.95 million compared to $3.92 million for the third quarter of 2002.  Interest income decreased $762,000 for the third quarter of 2003 versus the third quarter of 2002; at the same time, interest expense decreased $795,000 for the third quarter of 2003 versus the third quarter of 2002.  Lower rates paid on interest-bearing liabilities outpaced the lower yields earned on earning assets and was the driver behind the modest increase in net interest income for the third quarter ended September 30, 2003.

Net interest income for the first nine months of 2003 showed modest improvement over the same period in 2002 with an increase of $276,000, or 2.38%, to $11.860 from $11.58 million.  Average interest-earning assets increased 2.1% during the nine-month period ended September 30, 2003 versus the same period in 2002 and represented 94.3% of total assets.  Despite the net growth in interest earning assets during the nine months, the growth was not enough to offset a significant decrease of $1.85 million in interest income related to lower yields on the total average interest earning assets.  More than offsetting this decrease in interest income for the nine months was a decrease of $2.13 million in interest expense, primarily from lower rates paid for interest-bearing liabilities.

Interest spread for the nine months ended September 30, 2003 improved to 3.12% from 3.08% for the corresponding period ended September 30, 2002.  Net interest margin on a full tax-equivalent basis decreased 2 basis points to 3.43% for the nine months ended September 30, 2003 from 3.45% for the nine months ended September 30, 2002.

Provision for loan losses

For the three and nine-month periods ended September 30, 2003, the Corporation charged $241,000 and $1.17 million, respectively, against earnings for provision for loan losses compared to $195,000 and $895,000, respectively, for the same periods in 2002.  For more information concerning the provision for loan losses and nonperforming loans refer to the Loan Quality discussion later in this MD&A.

Noninterest Income

Total noninterest income for the third quarter ended September 30, 2003, excluding net securities gains, totaled $1.74 million, an increase of $587,000, or 51.1%.  A new overdraft privilege program implemented at the end of the third quarter in 2002 added approximately $135,000 to service charge and fee income.  This increase was partially offset by a decrease in

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loan fees for the quarter.  Mortgage banking income recorded a significant increase for the third quarter of 2003 versus the third quarter of 2002.  This increase was the driven by gains on the sale of mortgages and changes in the valuation of mortgage servicing rights.  Residential mortgages originated and sold in the third quarter of 2003 totaled $10.7 million versus $6.6 million for the third quarter of 2002, an increase in volume of 62.1%.  Accordingly, the Bank recorded an increase in gains from mortgage loans sold of $166,000 to $253,000 for the third quarter ended September 30, 2003.  Additionally, in the third quarter of 2002, a $340,000 impairment charge for mortgage servicing rights was charged against earnings versus a third quarter 2003 credit to earnings of $23,000 that partially reversed impairment charges previously recognized.

Total noninterest income, excluding net securities gains, for the nine months ended September 30, 2003 increased $1.69 million, or 43.6% to $5.57 million versus $3.88 million at September 30, 2002.  Service charges and fees increased $455,000, or 27.0%, to $2.14 million for the nine month period ended September 30, 2003 versus $1.68 million for the nine-month period ended September 30, 2002.  Fees from retail overdrafts and, to a lesser extent, fees earned from retail deposit accounts were primarily responsible for this.  Mortgage banking income increased $869,000 to $837,000 for the nine months ended September 30, 2003 from a loss of $32,000 for the nine-month period ended September 30, 2002.  An $18.5 million volume increase to $38.7 million in residential mortgages sold to the secondary market during the nine-month period ended September 30, 2003 was one contributing factor to the growth in mortgage banking income.  Another factor was a greatly reduced impairment charge against the mortgage servicing rights held on the balance sheet as discussed above for the third quarter.  Other noninterest income for the first nine months of 2003 increased $300,000 and was related to proceeds received from the settlement of two legal claims.

Securities gains for the third quarter ended September 30, 2003 totaled $14,000 versus none for the third quarter ended September 30, 2002.  For the nine months ended September 30, 2003, securities gains totaled $277,000 versus $365,000 for the same period ended September 30, 2002.

Noninterest Expense

Total noninterest expense for the third quarter ended September 30, 2003 recorded a net increase of $250,000, or 7.2%, to $3.70 million from $3.45 million for the third quarter of 2002.  Salaries and benefits expense rose  $77,000 to $1.82 million for the three months ended September 30, 2003 compared with $1.74 million for the third quarter ended September 30, 2002.  Salary expense, adjusted for deferred costs, recorded a decrease of $52,000 to $1.32 million for the third quarter.  Deferred costs, related to originating loans, were almost $107,000 higher for the third quarter of 2003 than the third quarter of 2002.  Salary expense without deferred costs grew by $55,000, or 3.63%, to $1.57 million for the third quarter ended September 30, 2003 compared to $1.52 million for the third quarter ended September 30, 2002.  Benefits expense increased $130,000, or 34.8%, to $502,000 for the third quarter ended September 30, 2003 versus $372,000 for the same period ended September 30, 2002.  For the quarter ended September 30, 2003, increases in benefits were primarily due to growth in health insurance and pension expense.  Legal and professional fees were $44,000, or 34.6%, higher for the third quarter ended September 30, 2003 due largely to costs associated with the retail overdraft

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privilege program.  Increases in other noninterest expense for the third quarter ended September 30, 2003 occurred in several categories, none of which were significant.

Total noninterest expense for the nine months ended September 30, 2003, increased $877,000, or 8.7%, to $10.94 million from $10.06 million for the same period ended September 30, 2002.  Salaries and benefits expense was up $278,000, or 5.27%, to $5.55 million for the nine months ended September 30, 2003.  Salary expense, adjusted for deferred costs, recorded a decrease of $91,000, or 2.27%, to $3.90 million.  Benefits expense increased $369,000, or 28.9% to $1.64 million for the period then ended.  Higher costs related to pay-for-performance, health insurance and pension expense were the primary contributors to the increase in benefits expense.  Occupancy expense increased $112,000, or 17.8%, to $740,000 for the nine-month period ended September 30, 2003 and was primarily related to the opening of two new community offices in 2003.  Advertising costs grew $105,000, or 21.2%, to $600,000 for the nine months ended September 30, 2003 due primarily to the opening of two new community offices and additional advertising to take advantage of recent bank mergers within the Bank’s marketing area.  The $82,000 increase in legal and professional fees for the nine months ended September 30, 2003 was almost entirely related to costs associated with the retail overdraft privilege program.  Costs associated with this program will be incurred in the first three years of the program, be based on a percentage of fee income earned and will end in 2006.  Data processing expense increased $90,000 to $846,000 from $756,000 at September 30, 2002 largely due to higher processing and software costs.  Other noninterest expense increased $178,000, or 10.0%, to $1.95 million at September 30, 2003 from $1.78 million at September 30, 2002.  Numerous expense items impacted this category with the largest increase related to other taxes.  Other tax expense increased $59,000 due to refunds received in 2002 from prior years amended state tax returns.

Federal income tax expense for the third quarter and nine months ended September 30, 2003 totaled $329,000 and $1.09 million, respectively, as compared to $210,000 and $820,000, respectively, for the third quarter and nine months ended September 30, 2002.  The Corporation’s effective tax rate for the nine months ended September 30, 2003, was 19.5% compared to 16.8% for the nine months ended September 30, 2002.  The increase in the effective tax rate was attributable to lower levels of tax-free income relative to higher pretax income for the nine-month period ended September 30, 2003.

Financial Condition

Total assets reached $550.3 million at September 30, 2003 from $532.4 million at December 31, 2002, an increase of $17.9 million, or, 3.4%.  Asset growth came primarily from interest bearing deposits in other banks, fed funds sold and loans and was funded primarily through decreases in investments, increases in deposits and retained earnings.  Interest-bearing deposits in other banks and fed funds sold grew $16.0 million to $17.2 million at September 30, 2003 from $1.2 million at December 31, 2002 and represent overnight lending to these banks.  Investment securities decreased $9.8 million, or 5.9%, to $156.4 million at September 30, 2003, while loans recorded an increase of $12.5 million, or 3.88%, to $334.8 million.  Loan growth for the nine months ended September 30, 2003, came primarily from residential real estate loans which grew 8.2% to $111.7 million.  During the nine months ended September 30, 2003, $81.0

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million in residential real estate loans were closed; $59.2 million of those loans were refinanced mortgage loans.  Almost $39.0 million of the closed loans were sold on the secondary market primarily to FNMA and PHFA (Pennsylvania Housing Finance Agency).  In order to create more efficiency in the Bank’s mortgage-processing area and to satisfy FNMA requirements, management is in the process of implementing an underwriting quality control enhancement for mortgages originated through its mortgage services area.  This enhancement will be through a third-party vendor with implementation expected in the first quarter of 2004.  For the nine months ended September 30, 2003 consumer lending was flat, recording an increase of $128,000 to $55.6 million.  The incentives offered to consumers by automobile manufacturers had a negative impact on the Corporation’s automobile and truck lending.  That coupled with customers refinancing their mortgages at lower rates and rolling consumer debt into the refinancing, were the primary factors contributing to slow activity in consumer lending over the nine months.

Subsequent to the end of the third quarter, F&M Trust (the Bank) announced its partnering with American Home Bank, N.A.  to form Ameribanq Mortgage Group, LLC.  With F&M Trust’s $500,000 investment in Ameribanq, F&M Trust will own 25% of Ameribanq and will account for its ownership under the equity method.  Lindley Mortgage Corporation, owned by R. Daniel Lindley of Oak Hill, Virginia, combined its operations with Ameribanq Mortgage Group in October 2003.  Ameribanq Mortgage Group is headquartered in Fairfax, Virginia with a major operations center in Camp Springs, Maryland.  This new entity commenced operations on November 4, 2003.  Ameribanq Mortgage Group will employ 150 employees among its 22 locations primarily serving Virginia and Maryland.  Ameribanq Mortgage Group will offer a variety of mortgage services including conventional, VA/FHA, Alt-A, and second mortgages.  Both American Home Bank and F&M Trust will continue to offer mortgage services separately through their respective banks.  The Banks will provide funding, servicing, and secondary market management for mortgage loans originated by Ameribanq Mortgage Group.

Total deposits and customer repurchase agreements grew $23.0 million, or 5.6%, to $432.9 million at September 30, 2003, from $409.9 at December 31, 2002.  Deposit growth, primarily from time deposits followed by savings and interest checking, contributed almost $13.9 million; Repos contributed $9.1 million to the growth.  Included in the time deposit total of $127.8 million at September 30, 2003 are two short-term certificates totaling $16.0 million.  Generally, the low interest rate environment has challenged the bank’s ability to attract deposits for its funding source.

Total shareholders’ equity recorded an increase of $3.19 million to $50.4 million at September 30, 2003 from $47.2 million at year-end 2002.  Cash dividends declared in the first nine months of 2003 reduced shareholder’s equity by $2.0 million.  Net income for the nine-month period totaling $4.5 million more than offset the reduction from cash dividends paid to shareholders.

Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios.  At September 30, 2003, the Corporation was well capitalized as defined by the banking regulatory agencies.  The Corporation’s leverage ratio, Tier I and Tier II

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risk-based capital ratios at September 30, 2003 were 8.98 %, 12.75 %, and 13.96%, respectively.  For more information on capital ratios refer to Note 2 of the accompanying financial statements.

Loan Quality

Net charge-offs for the third quarter and nine months ended September 30, 2003, totaled $286,000 and $1.36 million, respectively, compared to $198,000 and $607,000 for the third quarter and nine months, respectively, of 2002.  Commercial loans accounted for 96% of the first nine months 2003 charge-offs compared to 81% for the first nine months of 2002.  While these loans had specific impairment reserves, the provision expense also increased to $1.17 million for the nine months ended September 30, 2003 from $895,000 for the same period in 2002, primarily due to impairment on one specific credit worsening in 2003.  The ratio of annualized net charge-offs to average loans was .42% for the nine months ended September 30, 2003 compared to .36% for the year ended December 31, 2002.

Nonperforming loans increased $1.87 million to $5.32 million at September 30, 2003 compared to $3.45 million at December 31, 2002.  Included in nonperforming loans at September 30, 2003, were nonaccrual loans totaling $4.8 million and loans past due 90 days or more totaling $528,000 compared to $2.8 million and $651,000, respectively at December 31, 2002.  The increase in nonperforming loans for the nine months ended September 30, 2003, is related primarily to one significant commercial credit discussed below.  The Corporation held foreclosed real estate totaling $1.3 million at September 30, 2003 versus $1.5 million at December 31, 2002.  Subsequent to the end of the third quarter ended September 30, 2003, the Bank received settlement proceeds on one significant foreclosed property which reduced total foreclosed real estate to $299,000 at October 31, 2003.  Nonperforming assets represented 1.22% of total assets at September 30, 2003 compared to .94% at December 31, 2002.

Regularly scheduled payments were received during the third quarter of 2003 on a significant commercial loan participation that was moved to nonaccrual at June 30, 2003.  Although profitable through the end of the quarter, the borrower had requested a refinancing in order to enhance its cash flow.  The majority of the participant banks, holding 91% of the outstanding debt,  were unwilling to modify the terms of the credit agreement.  Subsequent to quarter end, the borrower proposed a discounted payoff.  The participant banks approved the discount based on the borrower’s fulfillment of certain conditions.  It is expected that the borrower will satisfy the conditions during the fourth quarter of 2003 and the Corporation will recognize an associated loan loss of approximately $1.3 million prior to year-end 2003.  The Corporation has fully reserved for this loss in the Allowance for Loan Losses.  Under the terms of an agreement, the Corporation may recover up to one third of this loss.

The allowance for loan losses totaled $4.43 million at September 30, 2003, compared to $4.30 million at December 31, 2002.  The allowance represents 1.32% and 1.34%, of total loans at September 30, 2003 and December 31, 2002, respectively.  The allowance provided 84% coverage for nonperforming loans at September 30, 2003.

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Local economy

Unemployment in Franklin County improved to 3.5% in September from 4.5% in June 2003 and continues to be relatively stable.  Franklin County was hit hard by the 1995 BRAC (Base Reduction and Closure) and sees another BRAC looming on the horizon where 1,700 jobs could be in jeopardy.  A group called “Opportunity ‘05” has been formed to support the Letterkenny Army Depot.  The group is working very hard to keep Letterkenny off the BRAC list and is working with Depot management to help the Depot demonstrate and enhance its military value, which is the key to saving it.  Franklin County has attracted logistics businesses with four large companies establishing warehousing operations.  These operations have contributed to the improved unemployment rate the County has recorded in recent years, partially offsetting the loss of manufacturing jobs.  Local economic development groups continue to work to boost the number of high-tech jobs in the County and are evaluating the possibility of a community college in Franklin County.

Cumberland County reported an unemployment rate of 2.8% for September 2003 which was improved from 3.5% for June 2003.  The Corporation currently has six community offices located in Cumberland County and has plans to open two more in 2004.  With the County’s strong job market, strong economic base and its close proximity to Harrisburg, the Corporation believes that it can profitability grow its franchise with its entrance into the Cumberland County market.

The unemployment rates for the State and the Nation were reported to be 4.8% and 5.8%, respectively, for September 2003 versus 5.8% and 6.5%, respectively, for June 2003.

Liquidity

The Corporation’s liquidity ratio (net cash, short-term and marketable assets divided by net deposits and short-term liabilities) was 32.6% at September 30, 2003.  The Corporation has the ability to borrow funds from the Federal Home Loan Bank of Pittsburgh (FHLB), if necessary, to enhance its liquidity position.  At September 30, 2003, the funding available to the Corporation with the FHLB is approximately $113.0 million.  In addition to the funding available through the FHLB, the Corporation also has unpledged and available-for-sale investment securities with a September 30, 2003 market value of approximately $48.0 million.  These securities could be used for liquidity purposes.  Management believes that liquidity is adequate to meet the borrowing and deposit needs of its customers.

Off Balance Sheet Commitments

The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk.  These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments.  Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation.  Unused commitments and standby letters of credit

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totaled $82.8 million and $93.0 million, respectively, at September 30, 2003 and December 31, 2002.

The Corporation has entered into various contractual obligations to make future payments.  These obligations include time deposits, long-term debt and operating leases.  At September 30, 2003, the total of these obligations did not change significantly from what was reported at December 31, 2002.

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PART I, Item 3

Qualitative and Quantitative Disclosures about Market Risk

There were no material changes in the Corporation’s exposure to market risk during the third quarter and nine months ended September 30, 2003.  For more information on market rate risk refer to the Corporation’s 2002 Form10-K.

PART I, Item 4

Controls and Procedures

Franklin Financial Services Corporation maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the company files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Based upon their evaluation of those controls and procedures performed as of September 30, 2003, the chief executive officer and chief financial officer of Franklin Financial Services Corporation concluded that Franklin Financial Services Corporation’s disclosure controls and procedures were adequate.

Franklin Financial Services Corporation made no significant changes in its internal controls or in other factors that could significantly affect these controls during the quarter ended September 30, 2003.

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PART II - OTHER INFORMATION

Item 1.             Legal Proceedings

None

Item 2.             Changes in Securities and Use of Proceeds

None

Item 3.             Defaults by the Company on its Senior Securities

None

Item 4.             Submission of Matters to a Vote of Security Holders

None

Item 5.             Other Information

None

Item 6.             Exhibits and Reports on Form 8-K

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FRANKLIN FINANCIAL SERVICES CORPORATION
and SUBSIDIARY

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.

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