FRANKLIN FINANCIAL SERVICES CORP /PA/ - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2017

☐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)


PENNSYLVANIA	25-1440803
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)


20 South Main Street, Chambersburg	PA 17201-0819
(Address of principal executive offices)	(Zip Code)

(717) 264-6116

(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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

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

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

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

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act) Yes ☐ No ☒

There were 4,347,855 outstanding shares of the Registrant’s common stock as of October 31, 2017.

INDEX


Part I - FINANCIAL INFORMATION

Item 1	Financial Statements
	Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016 (unaudited)	1
	Consolidated Statements of Income for the Three and Nine Months ended September 30, 2017	2
	and 2016 (unaudited)
	Consolidated Statements of Comprehensive Income for the Three and Nine Months ended	3
	September 30, 2017 and 2016 (unaudited)
	Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months	3
	ended September 30, 2017 and 2016 (unaudited)
	Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2017	4
	and 2016 (unaudited)
	Notes to Consolidated Financial Statements (unaudited)	5

Item 2	Management’s Discussion and Analysis of Results of Operations and Financial Condition	28
Item 3	Quantitative and Qualitative Disclosures about Market Risk	48
Item 4	Controls and Procedures	48

Part II - OTHER INFORMATION

Item 1	Legal Proceedings	49
Item 1A	Risk Factors	49
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	49
Item 3	Defaults Upon Senior Securities	49
Item 4	Mine Safety Disclosures	49
Item 5	Other Information	50
Item 6	Exhibits	50
SIGNATURE PAGE		51

Part I FINANCIAL INFORMATION

Item 1 Financial Statements

Consolidated Balance Sheets



(Dollars in thousands, except share and per share data)(unaudited)	September 30,		December 31,
	2017		2016
Assets
Cash and due from banks	$	16,678	$	16,888
Interest-bearing deposits in other banks		54,683		19,777
Total cash and cash equivalents		71,361		36,665
Investment securities available for sale, at fair value		132,322		143,875
Restricted stock		456		1,767
Loans held for sale		452		540
Loans		911,503		893,873
Allowance for loan losses		(11,543)		(11,075)
Net Loans		899,960		882,798
Premises and equipment, net		13,807		14,058
Bank owned life insurance		22,850		22,459
Goodwill		9,016		9,016
Other real estate owned		2,629		4,915
Deferred tax asset, net		6,146		5,844
Other assets		6,550		5,506
Total assets	$	1,165,549	$	1,127,443

Liabilities
Deposits
Non-interest bearing checking	$	183,297	$	170,345
Money management, savings and interest checking		774,513		737,140
Time		75,338		74,635
Total deposits		1,033,148		982,120
Short-term borrowings		—		24,270
Other liabilities		7,821		4,560
Total liabilities		1,040,969		1,010,950

Shareholders' equity
Common stock, $1 par value per share,15,000,000 shares authorized with
4,688,349 shares issued and 4,346,394 shares outstanding at September 30, 2017 and
4,688,349 shares issued and 4,316,836 shares outstanding at December 31, 2016		4,688		4,688
Capital stock without par value, 5,000,000 shares authorized with no
shares issued and outstanding		—		—
Additional paid-in capital		40,238		39,752
Retained earnings		89,532		83,081
Accumulated other comprehensive loss		(3,607)		(4,215)
Treasury stock, 341,955 shares at September 30, 2017 and 371,513 shares at
December 31, 2016, at cost		(6,271)		(6,813)
Total shareholders' equity		124,580		116,493
Total liabilities and shareholders' equity	$	1,165,549	$	1,127,443

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

Consolidated Statements of Income



	For the Three Months Ended				For the Nine Months Ended
(Dollars in thousands, except per share data) (unaudited)	September 30,				September 30,
	2017		2016		2017		2016
Interest income
Loans, including fees	$	9,130	$	8,343	$	26,808	$	24,394
Interest and dividends on investments:
Taxable interest		509		569		1,558		1,729
Tax exempt interest		275		355		861		1,079
Dividend income		2		2		23		12
Deposits and obligations of other banks		147		79		297		220
Total interest income		10,063		9,348		29,547		27,434
Interest expense
Deposits		629		559		1,785		1,650
Short-term borrowings		—		4		15		6
Total interest expense		629		563		1,800		1,656
Net interest income		9,434		8,785		27,747		25,778
Provision for loan losses		250		1,150		420		3,325
Net interest income after provision for loan losses		9,184		7,635		27,327		22,453
Noninterest income
Investment and trust services fees		1,353		1,211		3,991		3,683
Loan service charges		201		102		657		518
Deposit service charges and fees		611		635		1,789		1,815
Other service charges and fees		340		325		996		941
Debit card income		325		373		1,062		1,095
Increase in cash surrender value of life insurance		130		131		391		399
Net loss on sale of other real estate owned		(23)		(20)		(23)		(31)
OTTI losses on debt securities		—		(10)		—		(30)
Securities gains, net		1		—		3		4
Other		33		56		186		219
Total noninterest income		2,971		2,803		9,052		8,613
Noninterest Expense
Salaries and employee benefits		4,694		4,566		14,190		13,282
Occupancy, furniture and equipment, net		809		777		2,386		2,363
Advertising		332		296		873		839
Legal and professional		502		423		1,173		1,114
Data processing		567		539		1,643		1,540
Pennsylvania bank shares tax		243		203		728		699
FDIC Insurance		82		188		281		514
ATM/debit card processing		190		214		630		642
Foreclosed real estate		24		18		95		93
Telecommunications		106		91		308		300
Other		756		665		2,116		2,119
Total noninterest expense		8,305		7,980		24,423		23,505
Income before federal income taxes		3,850		2,458		11,956		7,561
Federal income tax expense		774		383		2,517		1,198
Net income	$	3,076	$	2,075	$	9,439	$	6,363
Per share
Basic earnings per share	$	0.71	$	0.48	$	2.18	$	1.48
Diluted earnings per share	$	0.70	$	0.48	$	2.17	$	1.48
Cash dividends declared	$	0.24	$	0.21	$	0.69	$	0.61

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

Consolidated Statements of Comprehensive Income


	For the Three Months Ended				For the Nine Months Ended
	September 30,				September 30,
(Dollars in thousands) (unaudited)	2017		2016		2017		2016
Net Income	$	3,076	$	2,075	$	9,439	$	6,363

Securities:
Unrealized gains arising during the period		(97)		(524)		924		1,528
Reclassification adjustment for net (gains) losses and OTTI
included in net income (1)		(1)		10		(3)		26
Net unrealized gains		(98)		(514)		921		1,554
Tax effect		33		174		(313)		(528)
Net of tax amount		(65)		(340)		608		1,026

Pension:
Change in plan assets and benefit obligations		—		—		—		—
Reclassification adjustment for losses included in net income (2)		—		225		—		225
Net unrealized losses		—		225		—		225
Tax effect		—		(76)		—		(76)
Net of tax amount		—		149		—		149

Total other comprehensive (loss) income		(65)		(191)		608		1,175

Total Comprehensive Income	$	3,011	$	1,884	$	10,047	$	7,538


Reclassification adjustment / Statement line item	Tax expense (benefit)
(1) Securities / securities (gains) losses and OTTI losses, net	$	—	$	(3)	$	1	$	(9)
(2) Pension / Salary & Benefits		—		(77)		—		(77)

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

Consolidated Statements of Changes in Shareholders' Equity

For the Nine Months ended September 30, 2017 and 2016



							Accumulated
			Additional				Other
	Common		Paid-in		Retained		Comprehensive		Treasury
(Dollars in thousands, except per share data) (unaudited)	Stock		Capital		Earnings		Loss		Stock		Total
Balance at December 31, 2015	$	4,659	$	38,778	$	78,517	$	(3,722)	$	(6,856)	$	111,376
Net income		—		—		6,363		—		—		6,363
Other comprehensive income		—		—		—		1,175		—		1,175
Cash dividends declared, $.61 per share		—		—		(2,618)		—		—		(2,618)
Acquisition of 30,196 shares of treasury stock		—		—		—		—		(700)		(700)
Treasury shares issued under employer stock purchase plan, 539 shares		—		2		—		—		10		12
Treasury shares issued under dividend reinvestment plan, 24,171 shares		—		134		—		—		438		572
Common stock issued under dividend reinvestment plan, 25,230 shares		25		527		—		—		—		552
Common stock issued under incentive stock option plan, 3,600 shares		4		55		—		—		—		59
Stock option compensation expense		—		88		—		—		—		88
Balance at September 30, 2016	$	4,688	$	39,584	$	82,262	$	(2,547)	$	(7,108)	$	116,879

Balance at December 31, 2016	$	4,688	$	39,752	$	83,081	$	(4,215)	$	(6,813)	$	116,493
Net income		—		—		9,439		—		—		9,439
Other comprehensive income		—		—		—		608		—		608
Cash dividends declared, $.69 per share		—		—		(2,988)		—		—		(2,988)
Treasury shares issued under employee stock purchase plan, 6,568 shares		—		29		—		—		120		149
Treasury shares issued under dividend reinvestment plan, 22,990 shares		—		296		—		—		422		718
Stock option compensation expense		—		161		—		—		—		161
Balance at September 30, 2017	$	4,688	$	40,238	$	89,532	$	(3,607)	$	(6,271)	$	124,580

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

Consolidated Statements of Cash Flows



	Nine Months Ended September 30,
	2017		2016
(Dollars in thousands) (unaudited)
Cash flows from operating activities
Net income	$	9,439	$	6,363
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		973		1,002
Net amortization of loans and investment securities		1,269		1,218
Amortization and net change in mortgage servicing rights valuation		41		41
Provision for loan losses		420		3,325
Gain on sales of securities		(3)		(4)
Impairment write-down on securities recognized in earnings		—		30
Loans originated for sale		(6,773)		(6,598)
Proceeds from sale of loans		6,861		6,692
Write-down of other real estate owned		60		46
Write-down on premises and equipment available for sale		45		—
Net loss on sale or disposal of other real estate/other repossessed assets		23		31
Increase in cash surrender value of life insurance		(391)		(399)
Stock option compensation		161		88
Decrease in other assets		(1,242)		154
Increase (decrease) in other liabilities		2,753		(2,247)
Net cash provided by operating activities		13,636		9,742
Cash flows from investing activities
Proceeds from sales and calls of investment securities available for sale		875		1,925
Proceeds from maturities and pay-downs of securities available for sale		16,875		18,984
Purchase of investment securities available for sale		(6,533)		(16,605)
Net decrease in restricted stock		1,311		(336)
Net increase in loans		(17,643)		(79,275)
Capital expenditures		(871)		(515)
Proceeds from surrender of life insurance policy		—		436
Proceeds from sale of other assets		154		—
Proceeds from sale of other real estate		2,255		625
Net cash used in investing activities		(3,577)		(74,761)
Cash flows from financing activities
Net increase in demand deposits, interest-bearing checking, and savings accounts		50,325		68,454
Net increase (decrease) in time deposits		703		(8,414)
Net decrease (increase) in short-term borrowings		(24,270)		8,530
Dividends paid		(2,988)		(2,618)
Treasury shares issued under employee stock purchase plan		149		—
Treasury shares issued under dividend reinvestment plan		718		—
Common stock issued under stock option plans		—		71
Common stock issued under dividend reinvestment plan		—		1,124
Purchase of Treasury shares		—		(700)
Net cash provided by financing activities		24,637		66,447
Increase in cash and cash equivalents		34,696		1,428
Cash and cash equivalents as of January 1		36,665		39,166
Cash and cash equivalents as of September 30	$	71,361	$	40,594
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest on deposits and other borrowed funds	$	1,786	$	1,643
Income taxes	$	3,405	$	2,100
Noncash Activities:
Loans transferred to Other Real Estate	$	52	$	123

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

FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES

UNAUDITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Basis of Presentation

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank) and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly-owned subsidiary, Franklin Financial Properties Corp. Franklin Financial Properties Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company. The activities of non-bank entities are not significant to the consolidated totals. 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 consolidated financial position, results of operations, and cash flows as of September 30, 2017, and for all other periods presented have been made.

Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s 2016 Annual Report on Form 10-K. The consolidated results of operations for the three and nine month periods ended September 30, 2017 are not necessarily indicative of the operating results for the full year. Management has evaluated subsequent events for potential recognition and/or disclosure through the date these consolidated financial statements were issued.

The consolidated balance sheet at December 31, 2016 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete consolidated financial statements.

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


	For the Three Months Ended				For the Nine Months Ended
	September 30,				September 30,
(Dollars and shares in thousands, except per share data)	2017		2016		2017		2016
Weighted average shares outstanding (basic)		4,343		4,307		4,332		4,295
Impact of common stock equivalents		21		7		21		3
Weighted average shares outstanding (diluted)		4,364		4,314		4,353		4,298
Anti-dilutive options excluded from calculation		—		9		—		37
Net income	$	3,076	$	2,075	$	9,439	$	6,363
Basic earnings per share	$	0.71	$	0.48	$	2.18	$	1.48
Diluted earnings per share	$	0.70	$	0.48	$	2.17	$	1.48

Note 2. Recent Accounting Pronouncements


Standard	Description	Effective Date	Effect on the financial statements or other significant matters

ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-based Payment Accounting	The standard requires entities to recognize the income tax effects of share-based awards in the income statement when the awards vest or are settled (i.e. the additional paid-in capital pools will be eliminated). The guidance on employers' accounting for an employee's use of shares to satisfy the employer's statutory income tax withholding obligation and for forfeitures is changing. The standard also provides an entity the option to make an entity-wide accounting policy election to either estimate the number of awards that are expected to vest or account for forfeitures when they occur.	January 1, 2017	We adopted the standard during the first quarter of 2017. Due to the type of stock compensation plans used by the Corporation, there was no effect on the Corporation's consolidated financial statements.

ASU 2017-09, Premium Amortization on Purchased Callable Debt Securities	The standard shortens the amortization period for premiums on purchased callable debt securities to the earliest call date, rather than amortizing over the full contractual term. The standard does change the standard for securities held at a discount. The amendments require companies to reset the effective yield using the payment terms of the debt security if the call option is not exercised on the earliest call date. If the security has additional future called dates, any excess of the amortized cost basis over the amount repayable by the issuer at the next call date should be amortized to the next call date.	January 1, 2017	We adopted the standard during the first quarter of 2017, and there was no effect on the Corporation's consolidated financial statements.

ASU 2016-15, Statements of Cash Flow (Topic 320): Classification of Certain Cash Receipts and Cash Payments	The standard clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are intended to reduce diversity in practice. The standard contains additional guidance clarifying when an entity should separate cash receipts and cash payments and classifies them into more than one class of cash flows (including when reasonable judgement is required to estimate and allocate cash flows) versus when an entity should classify the aggregate amount into one class of cash flows on the basis of predominance.	January 1, 2018	We do not expect this guidance will have an effect on the Corporation's consolidated financial statements.

ASU 2017-07, Employee Benefits Plan (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost	This standard requires an employer to report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations. The amendments in this update also allow only the service cost component to be eligible for capitalization when applicable.	January 1, 2018	We do not expect this standard will have an effect on the Corporation's consolidated financial statements.

ASU 2014-09, Revenue from Contracts with Customers (Topic 606)	The amendments in this Update (ASU 2014-09) establish a comprehensive revenue recognition standard. The revenue standard’s core principle is built on the contract between a vendor and a customer for the provision of goods and services. It attempts to depict the exchange of rights and obligations between the parties in the pattern of revenue recognition based on the consideration to which the vendor is entitled. To accomplish this objective, the standard requires five basic steps: (i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract, and (v) recognize revenue when (or as) the entity satisfies a performance obligation. Three basic transition methods are available – full retrospective, retrospective with certain practical expedients, and a cumulative effect approach.	January 1, 2018	The majority of our revenue comes from net interest income, and is explicitly out of scope of the guidance. The contracts in noninterest income that are in scope of the guidance are primarily related to service charges and fees on deposit accounts, investment and trust income and other service charges and fees. We have completed the analysis of the contracts in scope and have determined only estate settlement fees will require a change in the method of revenue recognition. The effect of this change has not been determined but it is not expected to be material to the Corporation's consolidated financial statements.

ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities	The standard amends the guidance on the classification and measurement of financial instruments. Some of the amendments include the following: 1) requires equity investments to be measured at fair value with changes in fair value recognized in net income; 2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; 3) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; and 4) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value; among others.	January 1, 2018	We do not expect this guidance will have a material effect on the Corporation's consolidated financial statements. We do not have a significant number of AFS equity securities. Additionally we do not have financial liabilities accounted for under the fair value option. The adoption of this guidance is not expected to be material.

ASU 2016-02, Leases (Topic 842)	From the lessee’s perspective, the new standard established a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement for a lessees. From the lessor’s perspective, the new standard requires a lessor to classify leases as either sales-type, finance or operating. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as financing. If the lessor doesn’t convey risks and rewards or control, an operating lease results.	January 1, 2019	The Corporation currently has real estate and equipment leases that it classifies as operating leases that are not recognized on the balance sheet. Under the new standard, these leases will move onto the balance sheet. The Corporation has identified a lease accounting model it expects to use to implement the standard. It is expected the model will be functional during the fourth quarter of 2017, but the Corporation does not plan to early adopt the standard. The Corporation believes the new standard will not have a material effect on its consolidated financial statements.

ASU 2017-04, Goodwill (Topic 350)	This guidance, among other things, removes step 2 of the goodwill impairment test thus eliminating the need to determine the fair value of individual assets and liabilities of the reporting unit. Upon adoption of this standard, goodwill impairment will be the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. This may result in more or less impairment being recognized than under the current guidance.	January 1, 2020	We do not currently expect this guidance to have a material effect on the Corporation's consolidated financial statements based upon the most recent goodwill impairment analysis.

ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments	This standard requires credit losses on most financial assets measured at amortized cost and certain other instruments to be measured using an expected credit loss model (referred to as the current expected credit loss (CECL) model). Under this model, entities will estimate credit losses over the entire contractual term of the instrument (considering estimated prepayments, but not expected extensions or modifications unless reasonable expectation of a troubled debt restructuring exists) from the date of initial recognition of that instrument. The ASU replaces the current accounting model for purchased credit impaired loans and debt securities. The allowance for credit losses for purchased financial assets with a more-than insignificant amount of credit deterioration since origination (“PCD assets”), should be determined in a similar manner to other financial assets measured on an amortized cost basis. However, upon initial recognition, the allowance for credit losses is added to the purchase price (“gross up approach”) to determine the initial amortized cost basis. The subsequent account for PCD financial assets is the same expected loss model described above.	January 1, 2020	We have formed an implementation team led by the Corporation's Risk Management function. The team is reviewing the requirements of the ASU and evaluating methods and models for implementation. The Corporation preliminarily believes the new standard will result in earlier recognition of additions to the allowance for loan losses and possibly a larger allowance for loan loss balance with a corresponding increase in the provision for loan losses in results of operations; however, the Corporation is continuing to evaluate the impact of the pending adoption of the new standard on its consolidated financial statements.

Note 3. Accumulated Other Comprehensive Loss

The components of accumulated other comprehensive losses included in shareholders' equity are as follows:



	September 30,		December 31,
	2017		2016
(Dollars in thousands)
Net unrealized gains (losses) on securities	$	901	$	(20)
Tax effect		(306)		7
Net of tax amount		595		(13)

Accumulated pension adjustment		(6,366)		(6,366)
Tax effect		2,164		2,164
Net of tax amount		(4,202)		(4,202)

Total accumulated other comprehensive loss	$	(3,607)	$	(4,215)

Note 4. Investments

The amortized cost and estimated fair value of investment securities available for sale as of September 30, 2017 and December 31, 2016 are as follows:



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
September 30, 2017	cost		gains		losses		value
Equity securities	$	164	$	183	$	—	$	347
U.S. Government and Agency securities		11,591		123		(32)		11,682
Municipal securities		59,920		971		(193)		60,698
Trust preferred securities		5,994		4		(187)		5,811
Agency mortgage-backed securities		52,818		359		(402)		52,775
Private-label mortgage-backed securities		905		81		(5)		981
Asset-backed securities		29		—		(1)		28
	$	131,421	$	1,721	$	(820)	$	132,322



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
December 31, 2016	cost		gains		losses		value
Equity securities	$	164	$	126	$	—	$	290
U.S. Government and Agency securities		12,598		148		(26)		12,720
Municipal securities		62,763		793		(571)		62,985
Trust preferred securities		5,979		—		(518)		5,461
Agency mortgage-backed securities		61,305		431		(452)		61,284
Private-label mortgage-backed securities		1,053		56		(5)		1,104
Asset-backed securities		33		—		(2)		31
	$	143,895	$	1,554	$	(1,574)	$	143,875

At September 30, 2017 and December 31, 2016, the fair value of investment securities pledged to secure public funds, trust balances, deposit and other obligations totaled $92.5 million and $79.1 million, respectively.

The amortized cost and estimated fair value of debt securities at September 30, 2017, by contractual maturity are shown below. Actual maturities may differ from contractual maturities because of prepayment or call options embedded in the securities.



(Dollars in thousands)	Amortized cost		Fair value
Due in one year or less	$	951	$	953
Due after one year through five years		14,110		14,354
Due after five years through ten years		33,407		33,683
Due after ten years		29,066		29,229
		77,534		78,219
Mortgage-backed securities		53,723		53,756
	$	131,257	$	131,975

The composition of the net realized securities gains for the three and nine months ended are as follows:


	For the Three Months Ended				For the Nine Months Ended
	September 30,				September 30,
(Dollars in thousands)	2017		2016		2017		2016
Gross gains realized	$	1	$	—	$	3	$	4
Gross losses realized		—		—		—		—
Net gains realized	$	1	$	—	$	3	$	4

The following table provides additional detail about trust preferred securities as of September 30, 2017:

Trust Preferred Securities


(Dollars in thousands)
Deal Name	Maturity	Single Issuer or Pooled	Class	Amortized Cost		Fair Value		Gross Unrealized Gain (Loss)		Lowest Credit Rating Assigned

BankAmerica Cap III	1/15/2027	Single	Preferred Stock	$	969	$	945	$	(24)	BB+
Wachovia Cap Trust II	1/15/2027	Single	Preferred Stock		280		282		2	BBB
Huntington Cap Trust	2/1/2027	Single	Preferred Stock		949		903		(46)	BB
Corestates Captl Tr II	2/15/2027	Single	Preferred Stock		946		948		2	BBB
Huntington Cap Trust II	6/15/2028	Single	Preferred Stock		905		852		(53)	BB
Chase Cap VI JPM	8/1/2028	Single	Preferred Stock		967		934		(33)	BBB-
Fleet Cap Tr V	12/18/2028	Single	Preferred Stock		978		947		(31)	BB+
				$	5,994	$	5,811	$	(183)

The following table provides additional detail about private label mortgage-backed securities as of September 30, 2017:

Private Label Mortgage Backed Securities


(Dollars in thousands)						Gross					Cumulative
	Origination	Amortized		Fair		Unrealized		Collateral	Lowest Credit	Credit	OTTI
Description	Date	Cost		Value		Gain (Loss)		Type	Rating Assigned	Support %	Charges
MALT 2004-6 7A1	6/1/2004	$	250	$	245	$	(5)	ALT A	CCC	16.60	$	—
RALI 2005-QS2 A1	2/1/2005		113		127		14	ALT A	CC	0.44		15
RALI 2006-QS4 A2	4/1/2006		343		369		26	ALT A	Caa3	—		323
GSR 2006-5F 2A1	5/1/2006		30		39		9	Prime	D	—		15
RALI 2006-QS8 A1	7/28/2006		169		201		32	ALT A	Ca	—		242
		$	905	$	981	$	76				$	595

Impairment:

The investment portfolio contained ninety-three securities with $51.1 million of temporarily impaired fair value and $820 thousand in unrealized losses at September 30, 2017. The total unrealized loss position has improved from a $1.6 million unrealized loss at year-end 2016.

For securities with an unrealized loss, Management applies a systematic methodology in order to perform an assessment of the potential for other-than-temporary impairment. In the case of debt securities, investments considered for other-than-temporary impairment: (1) had a specified maturity or repricing date; (2) were generally expected to be redeemed at par, and (3) were expected to achieve a recovery in market value within a reasonable period of time. In addition, the Bank considers whether it intends to sell these securities or whether it will be forced to sell these securities before the earlier of amortized cost recovery or maturity. Equity securities are assessed for other-than-temporary impairment based on the length of time of impairment, dollar amount of the impairment and general market and financial conditions relating to specific issues. The impairment identified on debt and equity securities and subject to assessment at September 30, 2017, was deemed to be temporary and required no further adjustments to the financial statements, unless otherwise noted.

The following table reflects temporary impairment in the investment portfolio (excluding restricted stock), aggregated by investment category, length of time that individual securities have been in a continuous unrealized loss position and the number of securities in each category as of September 30, 2017 and December 31, 2016:



	September 30, 2017
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency securities	$	1,690	$	(3)	4	$	3,628	$	(29)	10	$	5,318	$	(32)	14
Municipal securities		4,823		(34)	8		6,561		(159)	12		11,384		(193)	20
Trust preferred securities		—		—	—		4,581		(187)	5		4,581		(187)	5
Agency mortgage-backed securities		14,801		(115)	27		14,760		(287)	25		29,561		(402)	52
Private-label mortgage-backed securities		245		(5)	1		—		—	—		245		(5)	1
Asset-backed securities		—		—	—		4		(1)	1		4		(1)	1
Total temporarily impaired securities	$	21,559	$	(157)	40	$	29,534	$	(663)	53	$	51,093	$	(820)	93



	December 31, 2016
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency securities	$	789	$	(9)	1	$	3,413	$	(17)	10	$	4,202	$	(26)	11
Municipal securities		23,407		(417)	43		1,598		(154)	2		25,005		(571)	45
Trust preferred securities		—		—	—		5,461		(518)	7		5,461		(518)	7
Agency mortgage-backed securities		26,995		(359)	39		4,656		(93)	11		31,651		(452)	50
Private-label mortgage-backed securities		281		(5)	1		—		—	—		281		(5)	1
Asset-backed securities		—		—	—		4		(2)	1		4		(2)	1
Total temporarily impaired securities	$	51,472	$	(790)	84	$	15,132	$	(784)	31	$	66,604	$	(1,574)	115

The unrealized loss in the municipal bond portfolio decreased to $193 thousand from $571 thousand at December 31, 2016 as market prices improved during the quarter. There are twenty securities in this portfolio with an unrealized loss and the loss in this portfolio is deemed to be non-credit related and no other-than-temporary impairment charges have been recorded.

single issue, variable rate notes with long maturities (2027 – 2028). None of these bonds have suspended or missed a dividend payment. At September 30, 2017, the Bank believes it will be able to collect all interest and principal due on these bonds and no other-than-temporary-impairment charges were recorded.

The PLMBS sector is showing an unrealized gain of $76 thousand at quarter end. This is primarily a result of the cumulative OTTI charges recorded on this portfolio. Due to the nature of these bonds, they are evaluated closely. These bonds were all rated AAA at time of purchase, but have since experienced rating declines. Some have experienced increased delinquencies and defaults, while others have seen the credit support increase as the bonds paid-down. The Bank monitors the performance of the PLMBS investments on a regular basis and reviews delinquencies, default rates, credit support levels and various cash flow stress test scenarios. In determining the credit related loss, Management considers all principal past due 60 days or more as a loss. If additional principal moves beyond 60 days past due, it will also be considered a loss. The Bank has recorded $595 thousand of cumulative impairment charges on this portfolio. Management continues to monitor these securities and it is possible that additional write-downs may occur if current loss trends continue.

The following table represents the cumulative credit losses on debt securities recognized in earnings for:



	Nine Months Ended
(Dollars in thousands)	September 30,
	2017		2016
Balance of cumulative credit-related OTTI at January 1	$	595	$	555
Additions for credit-related OTTI not previously recognized		—		30
Additional increases for credit-related OTTI previously recognized when there is
no intent to sell and no requirement to sell before recovery of amortized cost basis		—		—
Decreases for previously recognized credit-related OTTI because there was an intent to sell		—		—
Reduction for increases in cash flows expected to be collected		—		—
Balance of credit-related OTTI at September 30	$	595	$	585

The Bank held $456 thousand of restricted stock at September 30, 2017. Except for $30 thousand, this investment represents stock in FHLB Pittsburgh. The Bank is required to hold this stock to be a member of FHLB and it is carried at cost of $100 per share. The level of FHLB stock held is determined by FHLB and is comprised of a minimum membership amount plus a variable activity amount. FHLB stock is evaluated for impairment primarily based on an assessment of the ultimate recoverability of its cost. As a government sponsored entity, FHLB has the ability to raise funding through the U.S. Treasury that can be used to support its operations. There is not a public market for FHLB stock and the benefits of FHLB membership (e.g., liquidity and low cost funding) add value to the stock beyond purely financial measures. Management intends to remain a member of the FHLB and believes that it will be able to fully recover the cost basis of this investment.

Note 5. Loans

The Bank reports its loan portfolio based on the primary collateral of the loan. It further classifies these loans by the primary purpose, either consumer or commercial. The Bank’s residential real estate loans include long-term loans to individuals and businesses secured by mortgages on the borrower’s real property and include home equity loans. Construction loans are made to finance the purchase of land and the construction of residential and commercial buildings thereon, and are secured by mortgages on real estate. Commercial real estate loans include construction, owner and non-owner occupied properties and farm real estate. Commercial loans are made to businesses of various sizes for a variety of purposes including property, plant and equipment, working capital and loans to government municipalities. Commercial lending is concentrated in the Bank’s primary market, but also includes purchased loan participations. Consumer loans are comprised of installment loans and unsecured personal lines of credit.

A summary of loans outstanding, by class, at the end of the reporting periods is as follows:



	September 30,		December 31,
(Dollars in thousands)	2017		2016
Residential Real Estate 1-4 Family
Consumer first liens	$	98,905	$	103,125
Commercial first lien		62,075		65,445
Total first liens		160,980		168,570

Consumer junior liens and lines of credit		44,789		44,817
Commercial junior liens and lines of credit		5,352		5,396
Total junior liens and lines of credit		50,141		50,213
Total residential real estate 1-4 family		211,121		218,783

Residential real estate - construction
Consumer		1,610		1,350
Commercial		7,966		7,625
Total residential real estate construction		9,576		8,975

Commercial real estate		403,746		390,584
Commercial		282,527		270,826
Total commercial		686,273		661,410

Consumer		4,533		4,705
		911,503		893,873
Less: Allowance for loan losses		(11,543)		(11,075)
Net Loans	$	899,960	$	882,798

Included in the loan balances are the following:
Net unamortized deferred loan costs	$	223	$	242

Loans pledged as collateral for borrowings and commitments from:
FHLB	$	708,950	$	711,682
Federal Reserve Bank		36,288		41,152
	$	745,238	$	752,834

Note 6. Loan Quality and Allowance for Loan Losses

The following table presents, by class, the activity in the Allowance for Loan Losses (ALL) for the periods ended:


	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

ALL at June 30, 2017	$	1,075	$	322	$	281	$	6,052	$	2,023	$	100	$	1,454	$	11,307
Charge-offs		—		—		—		(9)		(6)		(31)		—		(46)
Recoveries		1		5		—		17		5		4		—		32
Provision		(15)		(3)		(42)		198		(19)		19		112		250
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

ALL at December 31, 2016	$	1,105	$	323	$	224	$	6,109	$	1,893	$	100	$	1,321	$	11,075
Charge-offs		(13)		—		—		(14)		(8)		(83)		—		(118)
Recoveries		2		6		—		17		111		30		—		166
Provision		(33)		(5)		15		146		7		45		245		420
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

ALL at June 30, 2016	$	1,023	$	319	$	205	$	5,940	$	1,596	$	97	$	1,138	$	10,318
Charge-offs		—		—		—		(776)		—		(42)		—		(818)
Recoveries		1		—		—		5		7		22		—		35
Provision		(3)		1		8		876		132		21		115		1,150
ALL at September 30, 2016	$	1,021	$	320	$	213	$	6,045	$	1,735	$	98	$	1,253	$	10,685

ALL at December 31, 2015	$	989	$	308	$	194	$	5,649	$	1,519	$	102	$	1,325	$	10,086
Charge-offs		(49)		—		—		(2,730)		(66)		(126)		—		(2,971)
Recoveries		34		—		—		18		129		64		—		245
Provision		47		12		19		3,108		153		58		(72)		3,325
ALL at September 30, 2016	$	1,021	$	320	$	213	$	6,045	$	1,735	$	98	$	1,253	$	10,685

The following table presents, by class, loans that were evaluated for the ALL under the specific reserve (individually) and those that were evaluated under the general reserve (collectively) and the amount of the ALL established in each class as of September 30, 2017 and December 31, 2016:



	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

September 30, 2017
Loans evaluated for ALL:
Individually	$	697	$	53	$	469	$	11,180	$	190	$	—	$	—	$	12,589
Collectively		160,283		50,088		9,107		392,566		282,337		4,533		—		898,914
Total	$	160,980	$	50,141	$	9,576	$	403,746	$	282,527	$	4,533	$	—	$	911,503

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		1,061		324		239		6,258		2,003		92		1,566		11,543
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

December 31, 2016
Loans evaluated for ALL:
Individually	$	628	$	52	$	480	$	13,523	$	—	$	—	$	—	$	14,683
Collectively		167,942		50,161		8,495		377,061		270,826		4,705		—		879,190
Total	$	168,570	$	50,213	$	8,975	$	390,584	$	270,826	$	4,705	$	—	$	893,873

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		1,105		323		224		6,109		1,893		100		1,321		11,075
ALL at December 31, 2016	$	1,105	$	323	$	224	$	6,109	$	1,893	$	100	$	1,321	$	11,075

The following table shows additional information about those loans considered to be impaired at September 30, 2017 and December 31, 2016:



	Impaired Loans
	With No Allowance				With Allowance
(Dollars in thousands)			Unpaid				Unpaid
	Recorded		Principal		Recorded		Principal		Related
September 30, 2017	Investment		Balance		Investment		Balance		Allowance
Residential Real Estate 1-4 Family
First liens	$	1,142	$	1,239	$	—	$	—	$	—
Junior liens and lines of credit		53		54		—		—		—
Total		1,195		1,293		—		—		—
Residential real estate - construction		469		531		—		—		—
Commercial real estate		11,180		11,645		—		—		—
Commercial		291		304		—		—		—
Total	$	13,135	$	13,773	$	—	$	—	$	—



December 31, 2016
Residential Real Estate 1-4 Family
First liens	$	956	$	1,030	$	—	$	—	$	—
Junior liens and lines of credit		85		93		—		—		—
Total		1,041		1,123		—		—		—
Residential real estate - construction		480		535		—		—		—
Commercial real estate		13,523		14,133				—		—
Commercial		23		35		—		—		—
Total	$	15,067	$	15,826	$	—	$	—	$	—

The following table shows the average of impaired loans and related interest income for the three and nine months ended September 30, 2017 and 2016:


	Three Months Ended				Nine Months Ended
	September 30, 2017				September 30, 2017
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	1,157	$	10	$	1,152	$	32
Junior liens and lines of credit		54		—		85		—
Total		1,211		10		1,237		32
Residential real estate - construction		471		—		475		—
Commercial real estate		11,218		109		12,216		328
Commercial		292		—		263		—
Total	$	13,192	$	119	$	14,191	$	360


	Three Months Ended				Nine Months Ended
	September 30, 2016				September 30, 2016
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	1,196	$	10	$	1,262	$	30
Junior liens and lines of credit		96		—		90		—
Total		1,292		10		1,352		30
Residential real estate - construction		548		—		554		—
Commercial real estate		13,889		118		17,871		478
Commercial		25		—		34		—
Total	$	15,754	$	128	$	19,811	$	508

The following table presents the aging of payments of the loan portfolio:



(Dollars in thousands)			Loans Past Due and Still Accruing										Total
	Current		30-59 Days		60-89 Days		90 Days+		Total		Non-Accrual		Loans
September 30, 2017
Residential Real Estate 1-4 Family
First liens	$	160,383	$	69	$	93	$	103	$	265	$	332	$	160,980
Junior liens and lines of credit		49,964		87		37		—		124		53		50,141
Total		210,347		156		130		103		389		385		211,121
Residential real estate - construction		8,951		156		—		—		156		469		9,576
Commercial real estate		399,784		1,994		91		—		2,085		1,877		403,746
Commercial		282,038		198		—		—		198		291		282,527
Consumer		4,515		16		2		—		18		—		4,533
Total	$	905,635	$	2,520	$	223	$	103	$	2,846	$	3,022	$	911,503



December 31, 2016
Residential Real Estate 1-4 Family
First liens	$	166,689	$	1,236	$	414	$	—	$	1,650	$	231	$	168,570
Junior liens and lines of credit		50,031		96		—		—		96		86		50,213
Total		216,720		1,332		414		—		1,746		317		218,783
Residential real estate - construction		8,495		—		—		—		—		480		8,975
Commercial real estate		384,658		858		447		665		1,970		3,956		390,584
Commercial		270,478		250		75		—		325		23		270,826
Consumer		4,672		30		3		—		33		—		4,705
Total	$	885,023	$	2,470	$	939	$	665	$	4,074	$	4,776	$	893,873

The following table reports the internal credit rating for the loan portfolio. Consumer purpose loans are assigned a rating of either pass or substandard based on the performance status of the loans. Substandard consumer loans are comprised of loans 90 days or more past due and still accruing, and nonaccrual loans. Commercial purpose loans may be assigned any rating in accordance with the Bank’s internal risk rating system.



	Pass		Special Mention		Substandard		Doubtful
(Dollars in thousands)	(1-5)		(6)		(7)		(8)		Total

September 30, 2017
Residential Real Estate 1-4 Family
First liens	$	158,175	$	1,486	$	1,319	$	—	$	160,980
Junior liens and lines of credit		50,088		—		53		—		50,141
Total		208,263		1,486		1,372		—		211,121
Residential real estate - construction		8,361		—		1,215		—		9,576
Commercial real estate		392,367		685		10,694		—		403,746
Commercial		280,941		18		1,568		—		282,527
Consumer		4,533		—		—		—		4,533
Total	$	894,465	$	2,189	$	14,849	$	—	$	911,503



December 31, 2016
Residential Real Estate 1-4 Family
First liens	$	167,199	$	227	$	1,144	$	—	$	168,570
Junior liens and lines of credit		50,017		28		168		—		50,213
Total		217,216		255		1,312		—		218,783
Residential real estate - construction		8,220		—		755		—		8,975
Commercial real estate		377,283		—		13,301		—		390,584
Commercial		267,901		957		1,968		—		270,826
Consumer		4,705		—		—		—		4,705
Total	$	875,325	$	1,212	$	17,336	$	—	$	893,873

The following table presents information on the Bank’s Troubled Debt Restructuring (TDR) loans:


								Troubled Debt Restructurings
								That Have Defaulted on
								Modified Terms in the
(Dollars in thousands)	Troubled Debt Restructurings							Last Twelve Months
	Number of	Recorded						Number of	Recorded
	Contracts	Investment		Performing*		Nonperforming*		Contracts	Investment
September 30, 2017
Residential real estate - construction	1	$	469	$	469	$	—	—	$	—
Residential real estate	5		746		707		39	1		39
Commercial real estate	11		11,094		10,499		595	1		595
Total	17	$	12,309	$	11,675	$	634	2	$	634


December 31, 2016
Residential real estate - construction	1	$	480	$	480	$	—	—	$	—
Residential real estate	5		875		724		151	1		151
Commercial real estate	11		12,064		10,814		1,250	1		1,250
Total	17	$	13,419	$	12,018	$	1,401	2	$	1,401

*The performing status is determined by the loan’s compliance with the modified terms.

There were no new TDR loans during 2017.

The following table reports new TDR loans during 2016, concession granted and the recorded investment as of September 30, 2016:


	New During Period
Nine Months Ended	Number of		Pre-TDR		After-TDR		Recorded
September 30, 2016	Contracts		Modification		Modification		Investment	Concession
Commercial real estate	1	$	525	$	525	$	515	multiple
Residential real estate	1		238		238		238	maturity
	2	$	763	$	763	$	753

Note 7. Other Real Estate Owned

Changes in other real estate owned during the nine months ended September 30, 2017 and 2016 were as follows:


	September 30,
(Dollars in thousands)	2017		2016
Balance at beginning of the period	$	4,915	$	6,451
Additions		52		123
Proceeds from dispositions		(2,255)		(625)
(Loss) gain on sales, net		(23)		(31)
Valuation adjustment		(60)		(46)
Balance at the end of the period	$	2,629	$	5,872

Note 8. Pension

The components of pension expense for the periods presented are as follows:


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(Dollars in thousands)	2017		2016		2017		2016
Components of net periodic cost:
Service cost	$	80	$	83	$	237	$	247
Interest cost		167		180		500		540
Expected return on plan assets		(268)		(290)		(804)		(873)
Settlement expense		—		225		—		225
Recognized net actuarial loss		137		120		411		351
Net period cost	$	116	$	318	$	344	$	490

The Bank expects its pension expense to decrease to approximately $459 thousand in 2017 compared to $922 thousand in 2016. This decrease is due to a pension settlement expense of approximately $564 thousand that was recorded in the second half of 2016, as a result of lump sum distributions. No pension contributions were made or are expected to be made in 2017.

Note 9. Fair Value Measurements and Fair Values of Financial Instruments

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

FASB ASC Topic 820, “Financial Instruments”, requires disclosure of the fair value of financial assets and liabilities, including those financial assets and liabilities that are not measured and reported at fair value on a recurring and nonrecurring basis. The Corporation does not report any nonfinancial assets at fair value. FASB ASC Topic 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy under FASB ASC Topic 820 are as follows:

Level 1: Valuation is based on unadjusted, quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. There may be substantial differences in the assumptions used for securities within the same level. For example, prices for U.S. Agency securities have fewer assumptions and are closer to level 1 valuations than the private label mortgage backed securities that require more assumptions and are closer to level 3 valuations.

Level 3: Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Corporation’s assumptions regarding what market participants would assume when pricing a financial instrument.

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

The following methods and assumptions were used to estimate the fair values of the Corporation’s financial instruments at September 30, 2017 and December 31, 2016.

Cash and Cash Equivalents: For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Investment securities: The fair value of investment securities is determined in accordance with the methods described under FASB ASC Topic.

Restricted stock: The carrying value of restricted stock approximates its fair value based on redemption provisions for the restricted stock.

Loans held for sale: The fair value of loans held for sale is determined by the price set between the Bank and the purchaser prior to origination. These loans are usually sold at par.

Net loans (including impaired loans): The fair value of fixed-rate loans is estimated for each major type of loan (e.g. real estate, commercial, industrial and agricultural and consumer) by discounting the future cash flows associated with such loans using rates currently offered for loans with similar terms to borrowers of comparable credit quality. The model considers scheduled principal maturities, repricing characteristics, prepayment assumptions and interest cash flows. The discount rates used are estimated based upon consideration of a number of factors including the treasury yield curve, expense and service charge factors. For variable rate loans that reprice frequently and have no significant change in credit quality, carrying values approximate the fair value.

Accrued Interest Receivable: The carrying amount is a reasonable estimate of fair value.

Deposits and Short-term borrowings: The fair value of demand deposits, savings accounts, and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-rate certificates of deposit is estimated by discounting the future cash flows using rates approximating those currently offered for certificates of deposit with similar remaining maturities. For short-term borrowings, the carrying value approximates a reasonable estimate of the fair value.

Accrued interest payable: The carrying amount is a reasonable estimate of fair value.

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

The fair value of the Corporation's financial instruments are as follows:



	September 30, 2017
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	71,361	$	71,361	$	71,361	$	—	$	—
Investment securities available for sale		132,322		132,322		347		131,975		—
Restricted stock		456		456		—		456		—
Loans held for sale		452		452		—		452		—
Net loans		899,960		900,811		—		—		900,811
Accrued interest receivable		3,360		3,360		—		3,360		—

Financial liabilities:
Deposits	$	1,033,148	$	1,032,522	$	—	$	1,032,522	$	—
Accrued interest payable		130		120		—		120		—

	December 31, 2016
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets:
Cash and cash equivalents	$	36,665	$	36,665	$	36,665	$	—	$	—
Investment securities available for sale		143,875		143,875		290		143,585		—
Restricted stock		1,767		1,767		—		1,767		—
Loans held for sale		540		540		—		540		—
Net loans		882,798		889,910		—		—		889,910
Accrued interest receivable		3,592		3,592		—		3,592		—

Financial liabilities:
Deposits	$	982,120	$	981,949	$	—	$	981,949	$	—
Short-term debt		24,270		24,270		24,270		—		—
Accrued interest payable		116		116		—		116		—

Recurring Fair Value Measurements

For financial assets and liabilities measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2017 and December 31, 2016 are as follows:



(Dollars in Thousands	Fair Value at September 30, 2017
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities	$	347	$	—	$	—	$	347
U.S. Government and Agency securities		—		11,682		—		11,682
Municipal securities		—		60,698		—		60,698
Trust Preferred Securities		—		5,811		—		5,811
Agency mortgage-backed securities		—		52,775		—		52,775
Private-label mortgage-backed securities		—		981		—		981
Asset-backed securities		—		28		—		28
Total assets	$	347	$	131,975	$	—	$	132,322



(Dollars in Thousands)	Fair Value at December 31, 2016
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities	$	290	$	—	$	—	$	290
U.S. Government and Agency securities		—		12,720		—		12,720
Municipal securities		—		62,985		—		62,985
Trust Preferred Securities		—		5,461		—		5,461
Agency mortgage-backed securities		—		61,284		—		61,284
Private-label mortgage-backed securities		—		1,104		—		1,104
Asset-backed securities		—		31		—		31
Total assets	$	290	$	143,585	$	—	$	143,875

The Corporation used the following methods and significant assumptions to estimate the fair values for financial assets measured at fair value on a recurring basis.

Investment securities: Level 1 securities represent equity securities that are valued using quoted market prices from nationally recognized markets. Level 2 securities represent debt securities that are valued using a mathematical model based upon the specific characteristics of a security in relationship to quoted prices for similar securities.

Nonrecurring Fair Value Measurements

For financial assets measured at fair value on a nonrecurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2017 and December 31, 2016 are as follows:



(Dollars in Thousands)
	Fair Value at September 30, 2017
Asset Description	Level 1		Level 2		Level 3		Total
Other real estate owned (1)	$	—	$	—	$	121	$	121
Total assets	$	—	$	—	$	121	$	121



(Dollars in Thousands)	Fair Value at December 31, 2016
Asset Description	Level 1		Level 2		Level 3		Total
Premises held-for-sale (1)	$	—	$	—	$	200	$	200
Other real estate owned (1)		—		—		2,407		2,407
Total assets	$	—	$	—	$	2,607	$	2,607

(1)

Includes assets directly charged-down to fair value during the year-to-date period.

The Corporation used the following methods and significant assumptions to estimate the fair values for financial assets measured at fair value on a nonrecurring basis.

Premises held-for-sale: The fair value of premises held for sale, upon initial recognition, is estimated using Level 3 inputs within the fair value hierarchy.

Other real estate: The fair value of other real estate, upon initial recognition, is estimated using Level 2 inputs within the fair value hierarchy based on observable market data and Level 3 inputs based on customized discounting criteria. In connection with the measurement and initial recognition of the foregoing assets, the Corporation recognizes charge-offs through the allowance for loan losses. Subsequent charge-offs are recognized as an expense.

The Corporation did not record any liabilities at fair value for which measurement of the fair value was made on a nonrecurring basis at September 30, 2017. For financial assets and liabilities measured at fair value on a recurring basis, there were no transfers of financial assets or liabilities between Level 1 and Level 2 during the period ending September 30, 2017.

The following table presents additional quantitative information about Level 3 assets measured at fair value on a nonrecurring basis:



(Dollars in Thousands)		Quantitative Information about Level 3 Fair Value Measurements
September 30, 2017		Fair Value	Valuation Technique	Unobservable Input	(Weighted Average)
Other real estate owned	$	121	Appraisal	N/A	—
				Cost to sell	8% (8%)

					Range
December 31, 2016		Fair Value	Valuation Technique	Unobservable Input	(Weighted Average)
Premises held-for-sale	$	200	Appraisal	Qualitative adjustment	5% (5%)

Other real estate owned		2,407	Appraisal	N/A	—
				Cost to sell	8% (8%)

Note 10. Capital Ratios

Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios. In July 2013, Federal banking regulators approved the final rules from the Basel Committee on Banking Supervision for the regulation of capital requirements for bank holding companies and U.S banks, generally referred to as “Basel III.” The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015 (subject to a phase-in period for certain provisions). Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place. The capital ratios to be considered “well capitalized” under Basel III are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. The CET1 ratio is a new capital ratio under Basel III and the Tier 1 risk-based capital ratio of 8% has been increased from 6%. The rules also include changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer will be phased-in beginning January 1, 2016 at 0.625%, 1.25% for 2017, 1.875% for 2018 and 2.50% for 2019 and thereafter. The capital conservation buffer will be applicable to all of the capital ratios except for the Tier1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum for each respective capital measurement. The Bank’s capital conservation buffer at September 30, 2017 was 8.89% (total risk-based capital 16.89% less 8.00%) compared to the 2017 regulatory buffer of 1.25%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions. As of September 30, 2017, the Bank was “well capitalized’ under the Basel III requirements and believes it would be “well capitalized” on a fully-phased in basis had such a requirement been in effect.

The following table summarizes regulatory capital information as of September 30, 2017 and December 31, 2016 for the Corporation and the Bank.


			Regulatory Ratios
			Adequately	Well
	September 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2017	2016	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	15.62%	14.41%	4.500%	N/A
Farmers & Merchants Trust Company	15.56%	14.29%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	15.62%	14.41%	6.000%	N/A
Farmers & Merchants Trust Company	15.56%	14.29%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	16.89%	15.67%	8.000%	N/A
Farmers & Merchants Trust Company	16.82%	15.55%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	10.39%	10.11%	4.000%	N/A
Farmers & Merchants Trust Company	10.34%	10.02%	4.000%	5.00%

(1) Common equity Tier 1 capital/ total risk-weighted assets (2) Tier 1 capital / total risk-weighted assets
(3) Total risk-based capital / total risk-weighted assets, (4) Tier 1 capital / average quarterly assets

31Note 11. Reclassification

Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect the Corporation’s financial position or results of operations.

1Note 12. Contingencies

The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business, including, without limitation, the Kalan et al. v. Farmers and Merchants Trust Company of Chambersburg, et al. case filed in the United States District Court of the Eastern District of Pennsylvania.

In management’s opinion, we are not able to anticipate, at the present time, whether the ultimate aggregate liability, if any, arising out of such litigation will have a material adverse effect on our financial position. We cannot now determine, whether or not any claims asserted against us, including the disclosed matter, will have a material adverse effect on our results of operations in any future reporting period, which will depend on, among other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. At the date of this filing, we are unable to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss and, accordingly, have not yet established any specific accrual for this matter. In addition, no material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.

Management’s Discussion and Analysis of Results of Operations and Financial Condition

For the Three and Nine Months Ended September 30, 2017 and 2016

Forward Looking Statements

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 such as “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. These policies are particularly sensitive, requiring significant judgements, estimates and assumptions to be made by Management. There were no changes to the critical accounting policies disclosed in the 2016 Annual Report on Form 10-K in regards to application or related judgments and estimates used. Please refer to Item 7 of the Corporation’s 2016 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Year-to-Date Summary

At September 30, 2017, total assets were $1.166 billion. The investment portfolio declined during the year as maturing cash flow was reinvested in the loan portfolio. Growth in the loan portfolio was primarily in commercial loans. However, this growth was tempered by approximately $14 million in loan participations which were paid off during the year. All deposit categories have seen an increase during the year. Net income increased due to the growth in interest income from the loan portfolio as well as a decrease in provision for loan losses. The provision for loan losses decreased due to an improvement in loan quality and higher provision for loan losses in 2016 related to a large commercial loan charge-off. The increase in noninterest income was primarily from assets under management in the Bank’s Investment and Trust Services department and loan service charges from past due fees collected on the pay-off of a large nonaccrual commercial loan. Noninterest expense increased primarily from increases in salaries and benefits.

Key performance ratios as of, or for the three months ended September 30, 2017 and 2016 and the year ended December 31, 2016 are listed below:


	September 30,		December 31,		September 30,
	2017		2016		2016
(Dollars in thousands, except per share)

Balance Sheet Highlights
Total assets	$	1,165,549	$	1,127,443	$	1,107,120
Investment securities		132,322		143,875		155,345
Loans, net		899,960		882,798		847,891
Deposits		1,033,148		982,120		978,552
Shareholders' equity		124,580		116,493		116,879

Summary of Operations
Interest income	$	29,547	$	36,979	$	27,434
Interest expense		1,800		2,245		1,656
Net interest income		27,747		34,734		25,778
Provision for loan losses		420		3,775		3,325
Net interest income after provision for loan losses		27,327		30,959		22,453
Noninterest income		9,052		11,605		8,613
Noninterest expense		24,423		33,175		23,505
Income before income taxes		11,956		9,389		7,561
Federal income tax expense		2,517		1,302		1,198
Net income	$	9,439	$	8,087	$	6,363

Performance Measurements
Return on average assets*		1.11%		0.74%		0.79%
Return on average equity*		10.50%		7.04%		7.42%
Return on average tangible assets (1)*		1.12%		0.75%		0.79%
Return on average tangible equity (1)*		11.35%		7.64%		8.05%
Efficiency ratio (1)		63.00%		68.26%		65.21%
Net interest margin*		3.71%		3.62%		3.61%

Shareholders' Value (per common share)
Diluted earnings per share	$	2.17	$	1.88	$	1.48
Basic earnings per share		2.18		1.88		1.48
Regular cash dividends paid		0.69		0.82		0.61
Book value		28.66		26.99		27.19
Tangible book value (1)		26.59		24.90		25.09
Market value		35.05		28.60		24.31
Market value/book value ratio		122.30%		105.97%		89.41%
Price/earnings multiple*		12.13		15.21		12.34
Current dividend yield*		2.74%		2.94%		3.46%
Dividend payout ratio		31.66%		43.56%		41.14%

Safety and Soundness
Risk-based capital ratio (Total)		16.89%		15.67%		15.86%
Leverage ratio (Tier 1)		10.39%		10.11%		10.07%
Common equity ratio (Tier 1)		15.62%		14.41%		14.60%
Nonperforming loans/gross loans		0.34%		0.61%		0.69%
Nonperforming assets/total assets		0.49%		0.92%		1.07%
Allowance for loan losses as a % of loans		1.27%		1.24%		1.24%
Net (recoveries) loan charge-offs/average loans*		-0.01%		0.33%		0.44%

Trust assets under management (fair value)	$	662,733	$	622,630	$	617,289

*Annualized

(1) See the section titled “GAAP versus Non-GAAP Presentation” that follows.

GAAP versus non-GAAP Presentations – The Corporation supplements its traditional GAAP measurements with certain non-GAAP measurements to evaluate its performance and to eliminate the effect of intangible assets. By eliminating intangible assets, the Corporation believes it presents a measurement that is comparable to companies that have no intangible assets or to companies that have eliminated intangible assets in similar calculations. However, not all companies may use the same calculation method for each measurement. The non-GAAP measurements are not intended to be used as a substitute for the related GAAP measurements. The following table shows the calculation of the non-GAAP measurements.


(Dollars in thousands, except per share)	Nine Months Ended		Twelve Months Ended		Nine Months Ended
	September 30, 2017		December 31, 2016		September 30, 2016
Return on Average Tangible Assets (non-GAAP)
Net income	$	9,439	$	8,087	$	6,363
Plus intangible amortization (net of tax)		—		—		—
Net income (non-GAAP)		9,439		8,087		6,363

Average assets		1,133,791		1,088,047		1,079,250
Less average intangible assets		(9,016)		(9,016)		(9,016)
Average assets (non-GAAP)		1,124,775		1,079,031		1,070,234

Return on average tangible assets (non-GAAP)		1.12%		0.75%		0.79%

Return on Tangible Equity (non-GAAP)
Net income	$	9,439	$	8,087	$	6,363
Plus intangible amortization (net of tax)		—		—		—
Net income (non-GAAP)		9,439		8,087		6,363

Average shareholders' equity		119,886		114,884		114,363
Less average intangible assets		(9,016)		(9,016)		(9,016)
Average shareholders' equity (non-GAAP)		110,870		105,868		105,347

Return on average tangible equity (non-GAAP)		11.35%		7.64%		8.05%

Tangible Book Value (per share) (non-GAAP)
Shareholders' equity	$	124,580	$	116,493	$	116,879
Less intangible assets		(9,016)		(9,016)		(9,016)
Shareholders' equity (non-GAAP)		115,564		107,477		107,863

Shares outstanding (in thousands)		4,346		4,317		4,299

Tangible book value (non-GAAP)		26.59		24.90		25.09

Efficiency Ratio
Noninterest expense	$	24,423	$	33,175	$	23,505

Net interest income		27,747		34,734		25,778
Plus tax equivalent adjustment to net interest income		1,970		2,246		1,626
Plus noninterest income, net of securities gains/losses & OTTI		9,049		11,623		8,639
Total revenue		38,766		48,603		36,043

Efficiency ratio		63.00%		68.26%		65.21%

Net Interest Income

The largest source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. Demand deposits enhance net interest income because they are noninterest-bearing deposits. For the purpose of this discussion, balance sheet items refer to the average balance for the year and net interest income is adjusted to a fully taxable-equivalent basis. This tax-equivalent adjustment facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Corporation’s 34% Federal statutory rate.

Comparison of the three months ended September 30, 2017 to the three months ended September 30, 2016:

Tax equivalent net interest income increased $760 thousand to $10.1 million in the third quarter of 2017 compared to $9.4 million in the same period in 2016. Balance sheet volume contributed $523 thousand to this increase and changes in interest rates added $237 thousand.

The following table presents average balances, tax-equivalent (T/E) interest income, and yields earned or rates paid on the assets or liabilities. All nontaxable interest income has been adjusted to a tax-equivalent basis using a tax rate of 34%.


	For the Three Months Ended September 30,
	2017					2016

	Average		Income or		Average	Average		Income or		Average
(Dollars in thousands)	balance		expense		yield/rate	balance		expense		yield/rate

Interest-earning assets:
Interest-bearing obligations of other
banks and federal funds sold	$	43,692	$	147	1.33%	$	32,055	$	79	0.98%
Investment securities:
Taxable		92,074		511	2.20%		107,998		571	2.10%
Tax Exempt		43,032		412	3.83%		52,444		533	4.07%
Investments		135,106		923	2.71%		160,442		1,104	2.74%
Loans:
Commercial, industrial and agricultural		757,619		8,029	4.15%		691,245		7,135	4.04%
Residential mortgage		74,095		742	4.01%		76,776		763	3.98%
Home equity loans and lines		72,162		843	4.63%		71,990		777	4.29%
Consumer		4,644		64	5.47%		4,785		64	5.32%
Loans		908,520		9,678	4.18%		844,796		8,739	4.06%
Total interest-earning assets		1,087,318	$	10,748	3.92%		1,037,293	$	9,922	3.81%
Other assets		64,536					67,808
Total assets	$	1,151,854				$	1,105,101

Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	280,727	$	91	0.13%	$	259,986	$	87	0.13%
Money Management		412,209		391	0.38%		394,866		341	0.34%
Savings		78,683		36	0.18%		73,814		14	0.08%
Time		72,154		111	0.61%		79,084		117	0.59%
Total interest-bearing deposits		843,773		629	0.30%		807,750		559	0.28%

Other borrowings		—		—	—		3,190		4	0.54%
Total interest-bearing liabilities		843,773		629	0.30%		810,940		563	0.28%
Noninterest-bearing deposits		180,034					174,131
Other liabilities		5,185					3,860
Shareholders' equity		122,862					116,170
Total liabilities and shareholders' equity	$	1,151,854				$	1,105,101
T/E net interest income/Net interest margin				10,119	3.69%				9,359	3.59%
Tax equivalent adjustment				(685)					(574)
Net interest income			$	9,434				$	8,785

Provision for Loan Losses

Provision expense for the third quarter was $250 thousand, compared to $1.2 million in 2016. The decrease in the provision expense was due to slower net growth in the loan portfolio and an improvement in loan quality and higher provision expense in 2016 related to a large commercial loan charge-off. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the third quarter of 2017, noninterest income increased $168 thousand from the same period in 2016. Investment and trust service fees increased due to growth in assets under management and commissions from insurance sales in the third quarter of 2017. Loan service charges increased from higher mortgage production fees and commercial letter of credit fees.

The following table presents a comparison of noninterest income for the three months ended September 30, 2017 and 2016.


	For the Three Months Ended
	September 30,				Change
(Dollars in thousands)	2017		2016		Amount		%
Noninterest Income
Investment and trust services fees	$	1,353	$	1,211	$	142	11.7
Loan service charges		201		102		99	97.1
Deposit service charges and fees		611		635		(24)	(3.8)
Other service charges and fees		340		325		15	4.6
Debit card income		325		373		(48)	(12.9)
Increase in cash surrender value of life insurance		130		131		(1)	(0.8)
Net loss on sale of other real estate owned		(23)		(20)		(3)	(15.0)
OTTI losses on debt securities		—		(10)		10	100.0
Securities gains, net		1		—		1	N/A
Other		33		56		(23)	(41.1)
Total noninterest income	$	2,971	$	2,803	$	168	6.0

Noninterest Expense

Noninterest expense for the third quarter of increased $325 thousand compared to the same period in 2016. The increase in salaries and benefits was primarily due to an increase in salary expense due to merit increases and increased staffing levels ($124 thousand), health insurance costs ($65 thousand), incentive plans ($37 thousand) and stock option compensation ($24 thousand) compared to the same period in 2016. Legal and professional fees increased due to fees associated with a lawsuit brought against the Corporation in 2015. FDIC insurance decreased due to a lower assessment rate as a result of an improvement in the Bank’s credit quality. Other expenses increased due to recruitment fees for increased staffing levels.

The following table presents a comparison of noninterest expense for the three months ended September 30, 2017 and 2016


	For the Three Months Ended
(Dollars in thousands)	September 30,				Change
Noninterest Expense	2017		2016		Amount		%
Salaries and benefits	$	4,694	$	4,566	$	128	2.8
Occupancy, net		596		556		40	7.2
Furniture and equipment		213		221		(8)	(3.6)
Advertising		332		296		36	12.2
Legal and professional		502		423		79	18.7
Data processing		567		539		28	5.2
Pennsylvania bank shares tax		243		203		40	19.7
FDIC insurance		82		188		(106)	(56.4)
ATM/debit card processing		190		214		(24)	(11.2)
Foreclosed real estate		24		18		6	33.3
Telecommunications		106		91		15	16.5
Other		756		665		91	13.7
Total noninterest expense	$	8,305	$	7,980	$	325	4.1

Provision for Income Taxes

For the third quarter of 2017, the Corporation recorded a Federal income tax expense of $774 thousand compared to $383 thousand for the same quarter in 2016. The effective tax rate was 20.1% for the third quarter of 2017 compared to 15.6% for the same period in 2016. The increase in the effective tax rate was due to an increase in pretax income in 2017. Pre-tax income increased $1.4 million in 2017 due to an increase in net interest income and a $900 thousand decrease in the provision for loan losses expense. The variances from the federal statutory rate are generally due to tax-exempt income from investments, loans and bank-owned life insurance. All taxable income for the Corporation is taxed at a rate of 34%.

Comparison of the nine months ended September 30, 2017 to the nine months ended September 30, 2016:

Net Interest Income

Tax equivalent net interest income increased $2.3 million to $29.7 million in the first nine months of 2017 compared to $27.4 million in the same period in 2016. Balance sheet volume contributed $2.1 million to this increase and changes in interest rates added $252 thousand.


	For the Nine Months Ended September 30,
	2017					2016

	Average		Income or		Average	Average		Income or		Average
(Dollars in thousands)	balance		expense		yield/rate	balance		expense		yield/rate

Interest-earning assets:
Interest-bearing obligations of other
banks and federal funds sold	$	31,431	$	297	1.26%	$	34,639	$	220	0.85%
Investment securities:
Taxable		92,660		1,581	2.28%		107,310		1,741	2.17%
Tax Exempt		44,617		1,291	3.86%		51,864		1,618	4.16%
Investments		137,277		2,872	2.80%		159,174		3,359	2.82%
Loans:
Commercial, industrial and agricultural		749,693		23,462	4.13%		665,302		20,683	4.09%
Residential mortgage		75,243		2,241	3.97%		77,467		2,318	3.99%
Home equity loans and lines		71,945		2,457	4.57%		71,443		2,288	4.28%
Consumer		4,672		188	5.38%		4,861		192	5.28%
Loans		901,553		28,348	4.16%		819,073		25,481	4.10%
Total interest-earning assets		1,070,261	$	31,517	3.94%		1,012,886	$	29,060	3.83%
Other assets		63,530					66,364
Total assets	$	1,133,791				$	1,079,250


Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	271,454	$	257	0.13%	$	250,390		239	0.13%
Money Management		414,988		1,119	0.36%		392,050		1,007	0.34%
Savings		78,269		87	0.15%		72,368		41	0.08%
Time		73,106		322	0.59%		81,960		363	0.59%
Total interest-bearing deposits		837,817		1,785	0.28%		796,768		1,650	0.28%

Other borrowings		2,466		15	0.82%		1,597		6	0.56%
Total interest-bearing liabilities		840,283		1,800	0.29%		798,365		1,656	0.28%
Noninterest-bearing deposits		168,453					161,727
Other liabilities		5,169					4,795
Shareholders' equity		119,886					114,363
Total liabilities and shareholders' equity	$	1,133,791				$	1,079,250
T/E net interest income/Net interest margin				29,717	3.71%				27,404	3.61%
Tax equivalent adjustment				(1,970)					(1,626)
Net interest income			$	27,747				$	25,778

Provision for Loan Losses

Provision expense for the first nine months of 2017 was $420 thousand, compared to $3.3 million in 2016. The decrease in the provision for loan losses expense was due to slower net growth in the loan portfolio, as several large participation loans paid-off in 2017, an improvement in loan quality and a higher provision expense in 2016 related to a large commercial loan charge-off. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the first nine months of 2017, noninterest income increased $439 thousand from the same period in 2016. Investment and trust service fees increased primarily due to an increase in assets under management. Loan service charges increased from past due fees ($160 thousand) collected from a pay-off on a large nonaccrual commercial loan. Other service charges and fees increased from the Bank’s Merchant card program. Other income was higher in 2016, due to a $76 thousand gain from the proceeds of a bank owned life insurance policy.

The following table presents a comparison of noninterest income for the nine months ended September 30, 2017 and 2016.


	For the Nine Months Ended
	September 30,				Change
(Dollars in thousands)	2017		2016		Amount		%
Noninterest Income
Investment and trust services fees	$	3,991	$	3,683	$	308	8.4
Loan service charges		657		518		139	26.8
Deposit service charges and fees		1,789		1,815		(26)	(1.4)
Other service charges and fees		996		941		55	5.8
Debit card income		1,062		1,095		(33)	(3.0)
Increase in cash surrender value of life insurance		391		399		(8)	(2.0)
Net loss on sale of other real estate owned		(23)		(31)		8	25.8
OTTI losses on debt securities		—		(30)		30	100.0
Securities gains, net		3		4		(1)	(25.0)
Other		186		219		(33)	(15.1)
Total noninterest income	$	9,052	$	8,613	$	439	5.1

Noninterest Expense

Noninterest expense for the first nine months of 2017 increased $918 thousand compared to the same period in 2016. The increase in salaries and benefits was due primarily to an increase in salary expense due to merit increases and increased staffing levels ($317 thousand), incentive plans ($181 thousand), health insurance costs ($181 thousand), 401K expense ($118 thousand) and stock option compensation ($73 thousand) compared to the same period in 2016. Legal and professional fees increased due to fees associated with a lawsuit brought against the Corporation in 2015. The change in data processing expenses is due to increased utilization of the Bank’s mobile banking platforms. FDIC insurance decreased due to a lower assessment rate as a result of an improvement in the Bank’s credit quality.

The following table presents a comparison of noninterest expense for the nine months ended September 30, 2017 and 2016:


	For the Nine Months Ended
(Dollars in thousands)	September 30,				Change
Noninterest Expense	2017		2016		Amount		%
Salaries and benefits	$	14,190	$	13,282	$	908	6.8
Occupancy, net		1,716		1,708		8	0.5
Furniture and equipment		670		655		15	2.3
Advertising		873		839		34	4.1
Legal and professional		1,173		1,114		59	5.3
Data processing		1,643		1,540		103	6.7
Pennsylvania bank shares tax		728		699		29	4.1
FDIC insurance		281		514		(233)	(45.3)
ATM/debit card processing		630		642		(12)	(1.9)
Foreclosed real estate		95		93		2	2.2
Telecommunications		308		300		8	2.7
Other		2,116		2,119		(3)	(0.1)
Total noninterest expense	$	24,423	$	23,505	$	918	3.9

Provision for Income Taxes

For the first nine months of 2017, the Corporation recorded a Federal income tax expense of $2.5 million compared to $1.2 million for the same period in 2016. The effective tax rate was 21.1% for the first nine months of 2017 compared to 15.8% for the same period in 2016. The increase in the effective tax rate was due primarily to an increase in pretax income in 2017. Pre-tax income increased $4.4 million in 2017 due to an increase in net interest income and a $2.9 million decrease in the provision for loan losses expense. The variances from the federal statutory rate are generally due to tax-exempt income from investments, loans and bank-owned life insurance. All taxable income for the Corporation is taxed at a rate of 34%.

Financial Condition

Summary:

At September 30, 2017, assets totaled $1.166 billion, an increase of $38.1 million from the 2016 year-end balance of $1.127 billion. Investment securities decreased $11.6 million, while net loans increased $17.2 million (1.9%) due to growth in the commercial loan portfolio. Deposits increased $51.0 million (5.2%) during the first nine months of 2017, mainly in interest-bearing deposits. Shareholders’ equity increased $8.1 million during the first nine months as retained earnings increased $6.5 million, accumulated other comprehensive loss decreased $608 thousand and the Corporation’s Dividend Reinvestment Plan (DRIP) added an additional $718 thousand in new capital.

Cash and Cash Equivalents:

Cash and cash equivalents totaled $71.4 million at September 30, 2017, an increase of $34.7 million from the prior year-end balance of $36.7 million. Interest-bearing deposits are held primarily at the Federal Reserve ($48.1 million) and in short-term bank owned certificates of deposit ($6.2 million).

Investment Securities:

The investment portfolio has decreased $12.5 million on a cost basis, since year-end 2016. The composition of the portfolio has remained consistent with municipal securities and U.S. Agency mortgage-backed securities comprising the greatest portion of the portfolio at approximately 46% and 40% of the portfolio fair value, respectively. The average life of the portfolio was 3.61 years.

The investment portfolio had a net unrealized gain of $901 thousand at September 30, 2017 compared to a net unrealized loss of $20 thousand at the prior year-end. The increase in the unrealized gain is due primarily to the change in interest rates. The portfolio averaged $137.3 million with a yield of 2.80% for the first nine months of 2017. This compares to an average of $159.2 million and a yield of 2.82% for the same period in 2016.

The Bank holds only one equity security, a Pennsylvania community bank. The municipal bond portfolio is well diversified geographically (issuers from within 28 states) and is comprised primarily of general obligation bonds (72%). Many municipal bonds have credit enhancements in the form of private bond insurance or other credit support. The largest geographic municipal bond exposure is to 14 issuers in the state of Texas with a fair value of $8.4 million and 9 issuers in the states of Ohio and Pennsylvania each with a fair value of $5.7 million in each state. The average rating of the municipal portfolio from Moody’s is Aa2. It contains $59.3 million of bonds rated A3 or higher and one bond of $600 thousand that is not rated by Moody’s rating agency. No municipal bonds are rated below investment grade.

The holdings of trust preferred investments and private-label mortgage-backed securities (PLMBS) are unchanged since year-end and are detailed in separate tables.

The amortized cost and estimated fair value of investment securities available for sale as of September 30, 2017 and December 31, 2016 is as follows:



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
September 30, 2017	cost		gains		losses		value
Equity securities	$	164	$	183	$	—	$	347
U.S. Government and Agency securities		11,591		123		(32)		11,682
Municipal securities		59,920		971		(193)		60,698
Trust preferred securities		5,994		4		(187)		5,811
Agency mortgage-backed securities		52,818		359		(402)		52,775
Private-label mortgage-backed securities		905		81		(5)		981
Asset-backed securities		29		—		(1)		28
	$	131,421	$	1,721	$	(820)	$	132,322



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
December 31, 2016	cost		gains		losses		value
Equity securities	$	164	$	126	$	—	$	290
U.S. Government and Agency securities		12,598		148		(26)		12,720
Municipal securities		62,763		793		(571)		62,985
Trust preferred securities		5,979		—		(518)		5,461
Agency mortgage-backed securities		61,305		431		(452)		61,284
Private-label mortgage-backed securities		1,053		56		(5)		1,104
Asset-backed securities		33		—		(2)		31
	$	143,895	$	1,554	$	(1,574)	$	143,875



	September 30, 2017
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency securities	$	1,690	$	(3)	4	$	3,628	$	(29)	10	$	5,318	$	(32)	14
Municipal securities		4,823		(34)	8		6,561		(159)	12		11,384		(193)	20
Trust preferred securities		—		—	—		4,581		(187)	5		4,581		(187)	5
Agency mortgage-backed securities		14,801		(115)	27		14,760		(287)	25		29,561		(402)	52
Private-label mortgage-backed securities		245		(5)	1		—		—	—		245		(5)	1
Asset-backed securities		—		—	—		4		(1)	1		4		(1)	1
Total temporarily impaired securities	$	21,559	$	(157)	40	$	29,534	$	(663)	53	$	51,093	$	(820)	93



	December 31, 2016
	Less than 12 months					12 months or more					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(Dollars in thousands)	Value		Losses		Count	Value		Losses		Count	Value		Losses		Count

U.S. Government and Agency securities	$	789	$	(9)	1	$	3,413	$	(17)	10	$	4,202	$	(26)	11
Municipal securities		23,407		(417)	43		1,598		(154)	2		25,005		(571)	45
Trust preferred securities		—		—	—		5,461		(518)	7		5,461		(518)	7
Agency mortgage-backed securities		26,995		(359)	39		4,656		(93)	11		31,651		(452)	50
Private-label mortgage-backed securities		281		(5)	1		—		—	—		281		(5)	1
Asset-backed securities		—		—	—		4		(2)	1		4		(2)	1
Total temporarily impaired securities	$	51,472	$	(790)	84	$	15,132	$	(784)	31	$	66,604	$	(1,574)	115

The trust preferred portfolio contains five securities with a fair value of $4.6 million and an unrealized loss of $187 thousand. The trust-preferred securities held by the Bank are single entity issues, not pooled trust preferred securities. Therefore, the impairment review of these securities is based only on the issuer and the security cannot be impaired by the performance of other issuers as if it was a pooled trust-preferred bond. All of the Bank’s trust preferred securities are single issue, variable rate notes with long maturities (2027 – 2028). None of these bonds have suspended or missed a dividend payment. At September 30, 2017, the Bank believes it will be able to collect all interest and principal due on these bonds and no other-than-temporary-impairment charges were recorded.

Loans:

Residential real estate: This category is comprised of consumer purpose loans secured by residential real estate and to a lesser extent, commercial purpose loans secured by residential real estate. The consumer purpose category represents traditional residential mortgage loans and home equity products (primarily junior liens and lines of credit). Commercial purpose loans in this category represent loans made for various business needs, but are secured with residential real estate. In addition to the real estate collateral, it is possible that additional security is provided by personal guarantees or UCC filings. These loans are underwritten as commercial loans and are not originated to be sold.

Total residential real estate loans decreased $7.7 million over 2016, primarily due to pay downs. For the first nine months of 2017, the Bank originated $12.2 million in mortgages, including approximately $6.8 million for a fee through a third party brokerage agreement. The Bank does not originate or hold any loans that would be considered sub-prime or Alt-A, and does not generally originate mortgages outside of its primary market area.

Residential real estate construction: The largest component of this category represents loans to residential real estate developers ($8.0 million), while loans for individuals to construct personal residences totaled $1.6 million at September 30, 2017. The Bank’s exposure to residential construction loans is concentrated primarily in south central Pennsylvania. Real estate construction loans, including residential real estate and land development loans, occasionally provide an interest reserve in order to assist the developer during the development stage when minimal cash flow is generated. All real estate construction loans are underwritten in the same manner, regardless of the use of an interest reserve.

At September 30, 2017, the Bank had $3.9 million in residential real estate construction loans funded with an interest reserve and capitalized $74 thousand of interest from these reserves on active projects. These loans were comprised of $503 thousand in residential construction and $3.3 million in commercial construction (reported in the commercial real estate category). Real estate construction loans are monitored on a regular basis by either an independent third party inspector or the assigned loan officer depending on loan amount or complexity of the project. This monitoring process includes at a minimum, the submission of invoices and AIA documents (depending on the complexity of the project) detailing costs incurred by the borrower, on-site inspections, and a signature by the assigned loan officer for disbursement of funds.

Commercial real estate (CRE): This category includes commercial, industrial, farm and agricultural loans, where real estate serves as the primary collateral for the loans. Total commercial real estate loans increased to $403.7 million from $390.6 million at the end of 2016, an increase of $13.2 million. The increase was primarily in office buildings and real estate development loans, offset by a decrease in multi-family units, as an $8.9 million participation loan was paid-off in April. The largest sectors (by collateral) in the commercial real estate category are: office buildings ($57.2 million), hotels and motels ($48.5 million), land development ($47.5 million), auto dealerships ($31.7 million) and apartment units ($29.5 million).

Commercial (C&I): This category includes commercial, industrial, farm, agricultural, and municipal loans. C&I loans increased $11.7 million to $282.5 million at September 30, 2017, compared to $270.8 million at the end of 2016, primarily in the municipal loan portfolio. At September 30, 2017, the Bank had $173.3 million in tax-free loans. The largest sectors (by industry) in the commercial loan category are: public administration ($83.6 million), utilities ($36.4 million), educational services ($27.0 million) and retail trade ($25.1 million). The Bank continues to reduce its portfolio of purchased participation commercial loans. At September 30, 2017, the Bank held $114.4 million in purchased loan participations in its portfolio, a decrease of $18.9 million from December 31, 2016. The Bank expects that commercial lending will continue to be the primary area of loan growth in the future, via in-market lending, but it expects new purchase participations to decline.

Consumer loans: This category decreased $172 thousand due primarily to regular payments and maturities. The majority of the Bank’s consumer loans, approximately $3.3 million, are personal lines of credit. The Bank believes the consumer portfolio will continue to decline.

The following table presents a summary of loans outstanding, by class as of:



	September 30,		December 31,			Change
(Dollars in thousands)	2017		2016			Amount	%
Residential Real Estate 1-4 Family
Consumer first liens	$	98,905	$	103,125	$	(4,220)	(4.1)
Commercial first lien		62,075		65,445		(3,370)	(5.1)
Total first liens		160,980		168,570		(7,590)	(4.5)

Consumer junior liens and lines of credit		44,789		44,817		(28)	(0.1)
Commercial junior liens and lines of credit		5,352		5,396		(44)	(0.8)
Total junior liens and lines of credit		50,141		50,213		(72)	(0.1)
Total residential real estate 1-4 family		211,121		218,783		(7,662)	(3.5)

Residential real estate - construction
Consumer		1,610		1,350		260	19.3
Commercial		7,966		7,625		341	4.5
Total residential real estate construction		9,576		8,975		601	6.7

Commercial real estate		403,746		390,584		13,162	3.4
Commercial		282,527		270,826		11,701	4.3
Total commercial		686,273		661,410		24,863	3.8

Consumer		4,533		4,705		(172)	(3.7)
		911,503		893,873		17,630	2.0
Less: Allowance for loan losses		(11,543)		(11,075)		(468)	4.2
Net Loans	$	899,960	$	882,798	$	17,162	1.9

Loan Quality:

Management utilizes a risk rating scale ranging from 1-Prime to 9-Loss to evaluate loan quality. This risk rating scale is used primarily for commercial purpose loans. Consumer purpose loans are identified as either a pass or substandard rating based on the performance status of the loans. Substandard consumer loans are loans that are 90 days or more past due and still accruing. Loans rated 1 – 4 are considered pass credits. Loans that are rated 5 are pass credits, but have been identified as credits that are likely to warrant additional attention and monitoring. Loans rated 6-Special Mention or worse begin to receive enhanced monitoring and reporting by the Bank. Loans rated 7-Substandard or 8-Doubtful exhibit the greatest financial weakness and present the greatest possible risk of loss to the Bank. Nonaccrual loans are rated no better than 7-Substandard. The following factors represent some of the factors used in determining the risk rating of a borrower: cash flow, debt coverage, liquidity, management, and collateral. Risk ratings, for pass credits, are generally reviewed annually for term debt and at renewal for revolving or renewing debt. The Bank monitors loan quality by reviewing four primary measurements: (1) loans rated 6-Special Mention or worse (collectively “watch list”), (2) delinquent loans, (3) net-charge-offs, and (4) other real estate owned (OREO).

Watch list loans exhibit financial weaknesses that increase the potential risk of default or loss to the Bank. However, inclusion on the watch list, does not by itself, mean a loss is certain. The watch list totaled $17.0 million at quarter end and includes both performing and nonperforming loans. It is comprised entirely of loans rate 6-Special Mention and 7- Substandard. The Bank has no loans rated 8-Doubtful or 9-Loss. Included in the substandard total are $3.0 million of nonaccrual loans. The watch list totaled $18.5 million at December 31, 2016. The credit composition of the portfolio, by primary collateral is shown in Note 6 of the accompanying financial statements. The Bank’s Loan Management Committee reviews these loans and risk ratings on a quarterly basis in order to proactively identify and manage problem loans. In addition, a committee meets monthly to discuss possible workout strategies for OREO and all credits rated 7-Substandard or worse. Management also tracks other commercial loan risk measurements including high loan to value loans, concentrations, participations and policy exceptions and reports these to the Credit Risk Oversight Committee of the Board of Directors. The Bank also uses a third-party consultant to assist with internal loan review with a goal of reviewing 60% of commercial loans each year. The FDIC defines certain supervisory loan-to-value lending limits. The Bank’s internal loan–to-value limits are all equal to, or have a lower loan-to-value limit, than the supervisory limits. At September 30, 2017, the Bank had loans of $29.3 million that exceeded the supervisory limit.

Delinquent loans are a result of borrowers’ cash flow and/or alternative sources of cash being insufficient to repay loans. The Bank’s likelihood of collateral liquidation to repay the loans becomes more probable the further behind a

borrower falls, particularly when loans reach 90 days or more past due. Management monitors the performance status of loans by the use of an aging report. The aging report can provide an early indicator of loans that may become severely delinquent and possibly result in a loss to the Bank. See Note 6 in the accompanying financial statements for a table that presents the aging of payments in the loan portfolio.

Nonaccruing loans generally represent Management’s determination that the borrower will be unable to repay the loan in accordance with its contractual terms and that collateral liquidation may or may not fully repay both interest and principal. It is the Bank’s policy to evaluate the probable collectability of principal and interest due under terms of loan contracts for all loans 90-days or more, nonaccrual loans, or impaired loans. Further, it is the Bank’s policy to discontinue accruing interest on loans that are not adequately secured and in the process of collection. Upon determination of nonaccrual status, the Bank subtracts any current year accrued and unpaid interest from its income, and any prior year accrued and unpaid interest from the allowance for loan losses. Management continually monitors the status of nonperforming loans, the value of any collateral and potential of risk of loss. Nonaccrual loans are rated no better than 7-Substandard.

Loan quality, as measured by the balance of nonperforming loans has improved since year-end 2016. Nonaccrual loans have decreased $1.8 million since year-end 2016. This reduction was due to the pay-off of a $1.1 million loan that had been in nonaccrual status since December 2014 and a partial pay-down of $655 thousand on another loan. OREO declined during the year due to the sale in the first quarter of 2017 of a property that was carried at $1.9 million. See Note 7 in the accompanying financial statements for additional information about OREO.

The following table presents a summary of nonperforming assets as of:


	September 30,		December 31,
(Dollars in thousands)	2017		2016

Nonaccrual loans
Residential Real Estate 1-4 Family
First liens	$	332	$	231
Junior liens and lines of credit		53		86
Total		385		317
Residential real estate - construction		469		480
Commercial real estate		1,877		3,956
Commercial		291		23
Total nonaccrual loans		3,022		4,776

Loans past due 90 days or more and not included above
Residential Real Estate 1-4 Family
First liens		103		—
Commercial real estate		—		665
Total loans past due 90 days or more and still accruing		103		665

Total nonperforming loans		3,125		5,441

Other real estate owned		2,629		4,915
Total nonperforming assets	$	5,754	$	10,356


Nonperforming loans to total gross loans		0.34%		0.61%
Nonperforming assets to total assets		0.49%		0.92%
Allowance for loan losses to nonperforming loans		369.38%		203.55%

The following table identifies the most significant loans in nonaccrual status. These two nonaccrual loans account for 75% of the total nonaccrual balance. The table also indicates those significant nonaccrual loans that are classified as troubled debt restructurings (TDR). A TDR loan is maintained on nonaccrual status until a satisfactory repayment history is established. All loans on the watch list that are not on nonaccrual or past due 90 days more are considered potential problem loans. Potential problem loans at September 30, 2017 totaled $13.9 million compared to $17.1 million at year-end 2016. The following table provides information on the most significant nonaccrual loans as of September 30, 2017:

(Dollars in thousands)

ALL

Nonaccrual

TDR

Last

Balance

Reserve

Date

Status

Collateral

Location

Appraisal(1)

Credit 1

1,665

—

Mar-12

1st and 2nd liens on commercial real estate, residential real estate and business assets

Jan-16

3,810

Credit 2

595

—

Sep-16

1st lien on farmland

Jul-14

2,391

2,260

—

(1) Appraisal value, as reported, does not reflect the pay-off of any senior liens or the cost to liquidate the collateral, but does reflect only the Bank’s share of the collateral if it is a participated loan.

Credit 1 is a TDR that is performing in accordance with the modified terms. Credit 2 paid down $655 thousand during the second quarter from the sale of real estate and foreclosure proceedings have begun.

In addition to monitoring nonaccrual loans, the Bank also closely monitors impaired loans and troubled debt restructurings (TDR). A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Nonaccrual loans (excluding consumer purpose loans) and TDR loans are considered impaired.

A loan is considered a troubled debt restructuring if the creditor (the Bank), for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. These concessions may include lowering the rate, extending the maturity, re-amortization of the payment, or a combination of multiple concessions. The Bank reviews all loans rated 6-Special Mention or worse when it is providing a loan restructure, modification or new credit facility to determine if the action is a TDR. If a TDR loan is placed on nonaccrual status, it remains on nonaccrual status for at least six months to ensure performance.

In accordance with financial accounting standards, TDR loans are always considered impaired until they are paid off or in certain circumstances, refinanced. However, an impaired TDR loan can be a performing loan. Impaired loans totaled $13.1 million at quarter-end compared to $15.1 million at year-end 2016.

The following table shows the composition of impaired loans as of:


	September 30, 2017
(Dollars in thousands)	Nonaccrual				Accruing		Accruing		Total
	Non-TDR		TDR		TDR		Other (1)		Impaired
Residential Real Estate 1-4 Family
First liens	$	293	$	39	$	707	$	103	$	1,142
Junior liens and lines of credit		53		—		—		—		53
Total		346		39		707		103		1,195
Residential real estate - construction		—		469		—		—		469
Commercial real estate		86		1,791		9,303		—		11,180
Commercial		291		—		—		—		291
Total	$	723	$	2,299	$	10,010	$	103	$	13,135

(1) impaired consumer purpose loans not yet on nonaccrual

Allowance for Loan Losses:

Management performs a quarterly evaluation of the adequacy of the allowance for loan losses (ALL). The ALL is determined by segmenting the loan portfolio based on the loan’s collateral. The Bank further classifies the portfolio based on the primary purpose of the loan, either consumer or commercial. When calculating the ALL, consideration is given to a variety of factors in establishing this estimate including, but not limited to, current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, historical charge-offs, the adequacy of the underlying collateral (if collateral dependent) and other relevant factors. The Bank begins enhanced monitoring of all loans rated 6 (Special Mention) or worse, and obtains a new appraisal or asset valuation for any loan rated 7 (Substandard) or worse. Management, at its discretion, may determine that additional adjustments to the appraisal or valuation are required. Valuation adjustments will be made as necessary based on factors, including, but not limited to: the economy, deferred maintenance, industry, type of property/equipment, age of the appraisal, etc. and the knowledge Management has

about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. When determining the allowance for loan losses, certain factors involved in the evaluation are inherently subjective and require material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. Management monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy quarterly to the Credit Risk Oversight Committee of the Board of Directors. Management believes that the allowance for loan losses at September 30, 2017 is adequate.

The analysis for determining the ALL is consistent with guidance set forth in generally accepted accounting principles (GAAP) and the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The analysis has two components, specific and general allocations. The specific component addresses specific reserves established for impaired loans. A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all interest and principal payments due according to the originally contracted terms of the loan agreement. Collateral values discounted for market conditions and selling costs are used to establish specific allocations for impaired loans. It is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. For impaired commercial loans with balances less than $250 thousand and all consumer purpose loans, a specific reserve analysis is not performed and these loans are added to the general allocation pool. These loans totaled $545 thousand at September 30, 2017 and are comprised primarily of loans secured by residential real estate. Management does not believe that excluding these loans from the specific reserve analysis presents any additional risk. At September 30, 2017, impaired loans totaled $13.1 million compared to $15.1 million at year-end 2016. The Bank currently has no specific reserve established for any loans. Note 6 in the accompanying financial statements provide additional information about the ALL established for impaired loans.

The general allocation component addresses the reserves established for pools of homogenous loans. The general component includes a quantitative and qualitative analysis. When calculating the general allocation, the Bank segregates its loan portfolio into the following sectors based primarily on the type of supporting collateral: residential real estate, commercial, industrial or agricultural real estate; commercial and industrial (C&I non-real estate), and consumer. The residential real estate sector is further segregated by first lien loans, junior liens and home equity products, and residential real estate construction. The quantitative analysis uses the Bank’s twenty quarter rolling historical loan loss experience adjusted for factors derived from current economic and market conditions that have been determined to have an effect on the probability and magnitude of a loss. The historical loss experience factor for the general allocation was .84% ($7.6 million) of gross loans, unchanged from to .84% ($7.5 million) at December 31, 2016.

The qualitative analysis utilizes a risk matrix that incorporates qualitative and environmental factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. These factors are each risk rated from minimal to high risk and in total can add up to a maximum qualitative factor of 37.5 basis points. At September 30, 2017, these factors totaled 26 basis points ($2.4 million), unchanged from year-end 2016. The risk assessment of factors is determined on the basis of Management’s observation, judgment and experience. In addition to the two factors above, there is an unallocated reserve of $1.6 million at September 30, 2017 compared to $1.3 million at the prior year-end.

Real estate appraisals and collateral valuations are an important part of the Bank’s process for determining potential loss on collateral dependent loans and thereby have a direct effect on the determination of loan reserves, charge-offs and the calculation of the allowance for loan losses. As long as the loan remains a performing loan, no further updates to appraisals are required. If a loan or relationship migrates to risk rating of 7-Substandard or worse, an evaluation for impairment status is made based on the current information available at the time of downgrade and a new appraisal or collateral valuation is obtained.

In determining the allowance for loan losses, Management, at its discretion, may determine that additional adjustments to the fair value obtained from an appraisal or collateral valuation are required. Adjustments will be made as necessary based on factors, including, but not limited to the economy, deferred maintenance, industry, type of property or equipment etc., and the knowledge Management has about a particular situation. In addition, the cost to sell or liquidate the collateral is also estimated and deducted from the valuation in order to determine the net realizable value to the Bank. If an appraisal is not available, Management may make its best estimate of the real value of the collateral or use last known market value and apply appropriate discounts. If an adjustment is made to the collateral valuation, this will be documented with appropriate support and reported to the Loan Management Committee.

The following table shows the loans that were evaluated for the allowance for loan losses under a specific reserve (individually) and those that were evaluated under a general reserve (collectively), and the amount of the allowance established in each loan class as of September 30, 2017 and December 31, 2016:



	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

September 30, 2017
Loans evaluated for ALL:
Individually	$	697	$	53	$	469	$	11,180	$	190	$	—	$	—	$	12,589
Collectively		160,283		50,088		9,107		392,566		282,337		4,533		—		898,914
Total	$	160,980	$	50,141	$	9,576	$	403,746	$	282,527	$	4,533	$	—	$	911,503

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		1,061		324		239		6,258		2,003		92		1,566		11,543
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

December 31, 2016
Loans evaluated for ALL:
Individually	$	628	$	52	$	480	$	13,523	$	—	$	—	$	—	$	14,683
Collectively		167,942		50,161		8,495		377,061		270,826		4,705		—		879,190
Total	$	168,570	$	50,213	$	8,975	$	390,584	$	270,826	$	4,705	$	—	$	893,873

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		1,105		323		224		6,109		1,893		100		1,321		11,075
ALL at December 31, 2016	$	1,105	$	323	$	224	$	6,109	$	1,893	$	100	$	1,321	$	11,075

Charged-off loans usually result from: (1) a borrower being legally relieved of loan repayment responsibility through bankruptcy, (2) insufficient collateral sale proceeds to repay a loan; or (3) the borrower and/or guarantor does not own other assets that, if sold, would generate sufficient sale proceeds to repay a loan. Charged-off loans decrease the Bank’s allowance for loan losses (ALL), while the recovery of previously charge-off loans and the provision for loan loss expense increase the ALL.

Year-to-date, the Bank recorded a net recovery on previously charged-off loans of $48 thousand. For the same period of 2016, the Bank recorded $2.7 million in net charge-offs, primarily the result of a $2.7 million charge-off on a commercial real estate loan.

The Bank recorded $250 thousand for the loan loss provision expense for the third quarter of 2017 and $420 thousand on a year-to-date basis. This compares to $1.2 million for the third quarter of 2016 and $3.3 million for the 2016 year-to-date period. The change in the provision expense year-over-year is due to the following: 1) several large participated loans paid-off during the second quarter of 2017, tempering net loan growth, 2) credit quality has improved during 2017, and 3) the 2016 charge-off of $2.7 million previously mentioned.

For the nine months of 2017, the allowance for loan losses increased $468 thousand to $11.5 million, or 1.27% of gross loans.

The following table presents an analysis of the allowance for loan losses for the periods ended:



	Residential Real Estate 1-4 Family
	First		Junior Liens &				Commercial
(Dollars in thousands)	Liens		Lines of Credit		Construction		Real Estate		Commercial		Consumer		Unallocated		Total

ALL at June 30, 2017	$	1,075	$	322	$	281	$	6,052	$	2,023	$	100	$	1,454	$	11,307
Charge-offs		—		—		—		(9)		(6)		(31)		—		(46)
Recoveries		1		5		—		17		5		4		—		32
Provision		(15)		(3)		(42)		198		(19)		19		112		250
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

ALL at December 31, 2016	$	1,105	$	323	$	224	$	6,109	$	1,893	$	100	$	1,321	$	11,075
Charge-offs		(13)		—		—		(14)		(8)		(83)		—		(118)
Recoveries		2		6		—		17		111		30		—		166
Provision		(33)		(5)		15		146		7		45		245		420
ALL at September 30, 2017	$	1,061	$	324	$	239	$	6,258	$	2,003	$	92	$	1,566	$	11,543

The allocation of the allowance for loan losses is based on estimates and is not intended to imply limitations on the usage of the allowance. The entire allowance is available to absorb any losses without regard to the category in which the loan is classified.


	Nine Months Ended		Year ended		Nine Months Ended
	September 30, 2017		December 31, 2016		September 30, 2016
Net (recoveries) charge-offs/average loans		-0.01%		0.33%		0.48%
Net loan charge-offs as a percentage of the provision for loan losses		-11.43%		73.80%		0.89%
Allowance for loan losses as a % of loans		1.27%		1.24%		1.25%
Net (recoveries) charge-offs	$	(48)	$	2,786	$	1,943

Other Real Estate Owned:

The Bank holds $2.6 million of other real estate owned (OREO), comprised of three properties compared to $4.9 million on five properties at December 31, 2016. The Bank sold $2.3 million of OREO during 2017, including one property carried at $1.9 million. The most significant OREO holding is one property carried at $2.5 million (95% of total OREO) that is secured by 196 acres of land intended for residential real estate development. This property is under contract to be sold; however, the agreement allows for a due diligence period until November 2017. Therefore, the final outcome is not certain. This property was part of a participated loan and the workout is being handled by the lead bank. During 2017, the Bank recorded write downs of $60 thousand and incurred expense of $35 thousand to hold and maintain OREO. Note 7 of the accompanying financial statements provides additional information on activity in OREO.

The Bank had $61 thousand and $123 thousand of residential properties in the process of foreclosure at September 30, 2017 and December 31, 2016, respectively.

Deposits:

Total deposits increased $51.0 million during the first nine months of 2017 to $1.033 billion. Non-interest bearing deposits increased $13.0 million (primarily in municipal accounts), while interest-bearing checking and savings increased $37.4 million and time deposits increased $703 thousand. Interest bearing checking increased by $27.1 million, primarily from nonprofit deposits. The Bank’s Money Management product increased $6.8 million, primarily in municipal accounts. Retail time deposits increased since year-end from short-term municipal deposits.

As of September 30, 2017, the Bank had $157.5 million placed in the ICS program ($88.7 million in interesting-bearing checking and $68.7 million in money management) and $3.3 million in reciprocal time deposits in the CDARS program included in brokered time deposits. These programs allow the Bank to offer full FDIC coverage to large depositors, but with the convenience to the customer of only having to deal with one bank. The Bank solicits these deposits from within its market and it believes they present no greater risk than any other local deposit. However, regulatory guidance requires that these deposits be classified as brokered deposits. The Bank had no wholesale brokered CDs at September 30, 2017.


	September 30,		December 31,			Change
(Dollars in thousands)	2017		2016			Amount	%
Noninterest-bearing checking	$	183,297	$	170,345	$	12,952	7.6

Interest-bearing checking		268,992		241,906		27,086	11.2
Money management		427,151		420,309		6,842	1.6
Savings		78,370		74,925		3,445	4.6
Total interest-bearing checking and savings		774,513		737,140		37,373	5.1

Retail time deposits		72,076		71,264		812	1.1
Brokered time deposits		3,262		3,371		(109)	(3.2)
Total time deposits		75,338		74,635		703	0.9
Total deposits	$	1,033,148	$	982,120	$	51,028	5.2

Overdrawn deposit accounts reclassified as loans	$	106	$	181

Borrowings:

The Corporation had no short-term borrowings at September 30, 2017, compared to $24.3 million at December 31, 2016.

Shareholders’ Equity:

Total shareholders’ equity increased $8.1 million to $124.6 million at September 30, 2017, compared to $116.5 million at the end of 2016. The increase in retained earnings from the Corporation’s net income of $9.4 million was partially offset by the cash dividend of $3.0 million. The Corporation’s dividend payout ratio was 31.7% for the first nine months of 2017 compared to 41.1% in 2016.

As part of its quarterly dividend decision, the Corporation considers current and future income projections, dividend yield, payout ratio, and current and future capital ratios. For the third quarter of 2017, the Corporation paid a $0.24 per share dividend, compared to $0.21 paid in the third quarter of 2016. On October 12, 2017 the Board of Directors declared a $0.24 per share regular quarterly dividend for the fourth quarter of 2017, which will be paid on November 22, 2017.

In addition, the Corporation considers how dividend decisions may affect the Dividend Reinvestment Plan (DRIP), which has raised $718 thousand in new capital this year with 22,990 new shares purchased. No shares were repurchased in the first nine months of 2017. The 2016 stock repurchase plan expired on March 31, 2017. On October 12, 2017, the Board of Directors authorized the repurchase of up to 100,000 shares of the Corporation’s $1.00 par value common stock at market prices in o pen market or privately negotiated transactions beginning October 16, 2017 and continuing through September 30, 2018.

In July 2013, Federal banking regulators approved the final rules from the Basel Committee on Banking Supervision for the regulation of capital requirements for bank holding companies and U.S banks, generally referred to as “Basel III.” The Basel III standards were effective for the Corporation and the Bank, effective January 1, 2015 (subject to a phase-in period for certain provisions). Basel III imposes significantly higher capital requirements and more restrictive leverage and liquidity ratios than those previously in place. The capital ratios to be considered “well capitalized” under Basel III are: (1) Common Equity Tier 1 (CET1) of 6.5%, (2) Tier 1 Leverage of 5%, (3) Tier 1 Risk-Based Capital of 8%, and (4) Total Risk-Based Capital of 10%. The CET1 ratio is a new capital ratio under Basel III and the Tier 1 risk-based capital ratio of 8% has been increased from 6%. The rules also include changes in the risk weights of certain assets to better reflect credit and other risk exposures. In addition, a capital conservation buffer will be phased-in beginning January 1,

2016 at 0.625%, 1.25% for 2017, 1.875% for 2018 and 2.50% for 2019 and thereafter. The capital conservation buffer will be applicable to all of the capital ratios except for the Tier1 Leverage ratio. The capital conservation buffer is equal to the lowest value of the three applicable capital ratios less the regulatory minimum for each respective capital measurement. The Bank’s capital conservation buffer at September 30, 2017 was 8.89% (total risk-based capital 16.89% less 8.00%) compared to the 2017 regulatory buffer of 1.25%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions. As of September 30, 2017, the Bank was “well capitalized’ under the Basel III requirements and believes it would be “well capitalized” on a fully-phased in basis had such a requirement been in effect.

The following table summarizes regulatory capital information as of September 30, 2017 and December 31, 2016 for the Corporation and the Bank.


			Regulatory Ratios
			Adequately	Well
	September 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2017	2016	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	15.62%	14.41%	4.500%	N/A
Farmers & Merchants Trust Company	15.56%	14.29%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	15.62%	14.41%	6.000%	N/A
Farmers & Merchants Trust Company	15.56%	14.29%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	16.89%	15.67%	8.000%	N/A
Farmers & Merchants Trust Company	16.82%	15.55%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	10.39%	10.11%	4.000%	N/A
Farmers & Merchants Trust Company	10.34%	10.02%	4.000%	5.00%

(1) Common equity Tier 1 capital/ total risk-weighted assets (2) Tier 1 capital / total risk-weighted assets
(3) Total risk-based capital / total risk-weighted assets, (4) Tier 1 capital / average quarterly assets

Economy

The Corporation’s primary market area includes Franklin, Fulton, Cumberland and Huntingdon Counties, Pennsylvania. This area is diverse in demographic and economic makeup. County populations range from a low of approximately 15,000 in Fulton County to over 238,000 in Cumberland County. Unemployment in the Bank’s market area has remained virtually unchanged over the past year and ranges from a low of 4.1% in Cumberland County to 5.7% in Huntingdon County. The market area has a diverse economic base and local industries include warehousing, truck & rail shipping centers, light and heavy manufacturers, health-care, higher education institutions, farming and agriculture, and a varied service sector. The Corporation’s primary market area is located in south central Pennsylvania and provides easy access to the major metropolitan markets on the east coast via trucking and rail transportation. Because of this, warehousing and distribution companies continue to find the area attractive. The local economy is not overly dependent on any one industry or business and Management believes that the Bank’s primary market area continues to be well suited for growth.

The following provides selected economic data for the Bank’s primary market:

Economic Data



	September 30,	December 31,
	2017	2016
Unemployment Rate (seasonally adjusted)
Market area range (1)	4.1% - 5.7%	4.2 - 6.6%
Pennsylvania	5.0%	5.7%
United States	4.3%	4.6%

Housing Price Index - year over year change
PA, nonmetropolitan statistical area	0.8%	2.8%
United States	6.4%	5.6%

Building Permits - year over year change -12 moths
Harrisburg-Carlisle, PA MSA & Chambersburg-Waynesboro, PA MSA
Residential, estimated	1.4%	20.9%
Multifamily, estimated	20.4%	-31.7%

(1) Franklin, Cumberland, Fulton and Huntingdon Counties

Unlike many companies, the assets and liabilities of the Corporation are financial in nature. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation’s financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes. In June 2017, the FOMC increased the federal funds rate target range by .25%, its fourth such increase since December 31, 2015. Despite these actions, the yield curve has flattened during the year. The Federal Reserve also announced it would begin to reduce the size of its balance sheet by not reinvesting cash-flow from maturing assets. Looking through the remainder of 2017, the FOMC continues to state that the timing and magnitude of rate increases will be data dependent; therefore, the likelihood of any rate increase or decrease for the rest of 2017 is unknown, despite predictions of another increase.

Liquidity

The Corporation must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders’ investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. The Bank regularly reviews it liquidity position by measuring its projected net cash flows (in and out) at a 30 and 90-day interval. The Bank stresses the measurements by assuming a level of deposit out-flows that have not historically been realized. In addition to this forecast, other funding sources are reviewed as a method to provide emergency funding if necessary. The objective of this measurement is to identify the amount of cash that could be raised quickly without the need to liquidate assets. The Bank also stresses its liquidity position utilizing different longer-term scenarios. The varying degrees of stress create pressure on deposit flows in its local market, reduce access to wholesale funding and limit access of funds available through brokered deposit channels. In addition to stressing cash flow, specific liquidity risk indicators are monitored to help identify risk areas. This analysis helps identify and quantify the potential cash surplus/deficit over a variety of time horizons to ensure the Bank has adequate funding resources. Assumptions used for liquidity stress testing are subjective. Should an evolving liquidity situation or business cycle present new data, potential assumption changes will be considered. The Bank believes it can meet all anticipated liquidity demands.

Historically, the Corporation has satisfied its liquidity needs from earnings, repayment of loans and amortizing investment securities, maturing investment securities, loan` sales, deposit growth and its ability to access existing lines of credit. All investment securities are classified as available for sale; therefore, securities that are not pledged as collateral for borrowings are an additional source of readily available liquidity, either by selling the security or, more preferably, to provide collateral for additional borrowing. At September 30, 2017, the Bank had approximately $73.0 million (fair value) in its investment portfolio pledged as collateral for deposits. The Bank also has access to other wholesale funding via the brokered CD market.

The FHLB system has always been a major funding source for community banks. The Bank’s maximum borrowing capacity with the FHLB at September 30, 2017 was $310 million with $310 million available to borrow. There are no indicators that lead the Bank to believe the FHLB would discontinue its lending function or restrict the Bank’s ability to

borrow. If either of these events would occur, it would have a negative effect on the Bank and it is unlikely that the Bank could replace the level of FHLB funding in a short time.

The Bank has established credit at the Federal Reserve Discount Window and as of quarter-end had the ability to borrow approximately $20 million.

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 totaled $301.3 million and $301.3 million, respectively, at September 30, 2017 and December 31, 2016.

The Corporation has entered into various contractual obligations to make future payments. These obligations include time deposits, long-term debt, operating leases, deferred compensation and pension payments. These amounts have not changed materially from those reported in the Corporation’s 2016 Annual Report on Form 10-K.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There were no material changes in the Corporation’s exposure to market risk during the nine months ended September 30, 2017. For more information on market risk refer to the Corporation’s 2016 Annual Report on Form 10-K.

Item 4. Controls and Procedures

Evaluation of Controls and Procedures

The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2017, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There were no changes in the Corporation’s internal control over financial reporting during the quarterly period ended September 30, 2017, that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.

The management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Part II – OTHER INFORMATION

Item 1. Legal Proceedings

The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business including, without limitation, the Kalan et al. v. Farmers and Merchants Trust Company of Chambersburg, et al. (Case No. 2:15-CV-01435-WB) case filed in the United States District Court for the Eastern District of Pennsylvania and described in our current reports on Form 8-K filed July 29, 2016, July 28, 2017 and November 3, 2017. No material proceedings are pending or are known to be threatened or contemplated against us by governmental authorities.

The impact that any matter may have upon our results of operation or financial condition in any future reporting period will depend upon, among other things, the amount of loss resulting from such matter and the amount of income otherwise reported for the period. We establish accruals for legal proceedings when information related to the loss contingencies represented by those matters indicates both that a loss is probable and that the amount of loss can be reasonably estimated. When we are able to do so, we also determine estimates of possible losses or ranges of possible losses, whether in excess of any related accrued liability or where there is no accrued liability.

We have not yet established any specific accrual for the Kalan matter because we are not yet able to provide an evaluation of the likelihood of an unfavorable outcome or an estimate of the amount or range of potential loss. The damages sought by the Plaintiffs are as yet unspecified and uncertain. It is as yet unclear as to whether the case will be allowed to proceed as a class action and, if so, how the class would be defined. The case presents a number of legal uncertainties yet to be resolved including, whether Plaintiffs’ claims are timely and whether, as a directed trustee, the Bank could be liable for the Plaintiffs’ claims. There are significant facts in dispute and discovery is in early stages.

These assessments are based upon our analysis of currently available information and are subject to significant judgment and a variety of assumptions and uncertainties. As new information is obtained, we may change our assessments and, as a result, take or adjust the amounts of our accruals and change our estimates of possible losses or ranges of possible losses. Due to the inherent subjectivity of the assessments and unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation from the Kalan or any other legal proceeding. Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.

Item 1A. Risk Factors

Except as set forth below, there were no material changes in the Corporation’s risk factors during the nine months ended September 30, 2017. For more information, refer to the Corporation’s 2016 Annual Report on Form 10-K.

Our business and financial results could be impacted materially by adverse results in legal proceedings.

The nature of the Corporation’s business generates a certain amount of litigation involving matters arising in the ordinary course of business (and, in some cases, from the activities of companies we have acquired). These legal proceedings, whether founded or unfounded, could result in reputation damage and have an adverse effect on our financial condition and results of operation if they are not resolved in a manner favorable to the Corporation. Although we establish accruals for legal proceedings when information related to the loss contingencies represented by these matters indicates that both a loss is probable and that the amount of the loss can be reasonably estimated, we do not have accruals for all legal proceedings where we face a risk of loss. In addition, due to the inherent subjectivity of the assessments and unpredictability of outcomes of legal proceedings, any amounts that may be accrued or included in estimates of possible losses or ranges of possible losses may not represent the actual loss to the Corporation. We discuss these matters further in Part II, Item 1 Legal Proceedings and in Note 12 Contingencies in the Notes to Consolidated Financial Statements in Part I, Item 1 of this Report.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults by the Company on its Senior Securities

None

Item 4. Mine Safety Disclosures

Not Applicable

Item 5. Other Information

None

Item 6. Exhibits

Exhibits


3.1	Articles of Incorporation of the Corporation. (Filed as Exhibit 3.1 to Annual Report on Form 10-K for the year ended December 31, 2014 and incorporated herein by reference.)

3.2	Bylaws of the Corporation. (Filed as Exhibit 3.2 to Annual Report on Form 10-K for the year ended December 31, 2016 and incorporated herein by reference.)

31.1	Rule 13a – 14(a)/15d-14(a) Certifications – Principal Executive Officer

31.2	Rule 13a – 14(a)/15d-14(a) Certifications – Principal Financial Officer

32.1	Section 1350 Certifications – Principal Executive Officer

32.2	Section 1350 Certifications – Principal Financial Officer

101	Interactive Data File (XBRL)

FRANKLIN FINANCIAL SERVICES CORPORATION

and SUBSIDIARIES

SIGNATURES

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

Franklin Financial Services Corporation



November 6, 2017		/s/ Timothy G. Henry
		Timothy G. Henry
		Chief Executive Office and President
		(Principal Executive Officer)

November 6, 2017		/s/ Mark R. Hollar
		Mark R. Hollar
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)