FRANKLIN FINANCIAL SERVICES CORP /PA/ - Quarter Report: 2019 June (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 June 30, 2019

☐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 001-38884

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)

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


Title of class	Symbol	Name of exchange on which registered
Common stock	FRAF	Nasdaq Capital Market

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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ 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 4,338,756 outstanding shares of the Registrant’s common stock as of July 31, 2019.

INDEX


Part I - FINANCIAL INFORMATION

Item 1	Financial Statements
	Consolidated Balance Sheets as of June 30, 2019 and December 31, 2018 (unaudited)	1
	Consolidated Statements of Income for the Three and Six Months ended June 30, 2019	2
	and 2018 (unaudited)
	Consolidated Statements of Comprehensive Income for the Three and Six Months ended	3
	June 30, 2019 and 2018 (unaudited)
	Consolidated Statements of Changes in Shareholders’ Equity for the Three and Six Months	3
	ended June 30, 2019 and 2018 (unaudited)
	Consolidated Statements of Cash Flows for the Six Months ended June 30, 2019	5
	and 2018 (unaudited)
	Notes to Consolidated Financial Statements (unaudited)	6

Item 2	Management’s Discussion and Analysis of Results of Operations and Financial Condition	26
Item 3	Quantitative and Qualitative Disclosures about Market Risk	44
Item 4	Controls and Procedures	44

Part II - OTHER INFORMATION

Item 1	Legal Proceedings	45
Item 1A	Risk Factors	45
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	46
Item 3	Defaults Upon Senior Securities	46
Item 4	Mine Safety Disclosures	46
Item 5	Other Information	47
Item 6	Exhibits	47
SIGNATURE PAGE		48

Part I FINANCIAL INFORMATION

Item 1 Financial Statements

Consolidated Balance Sheets



(Dollars in thousands, except share and per share data)(unaudited)	June 30,		December 31,
	2019		2018
Assets
Cash and due from banks	$	19,383	$	16,957
Interest-bearing deposits in other banks		63,064		36,000
Total cash and cash equivalents		82,447		52,957
Debt securities available for sale, at fair value		129,422		131,472
Equity securities		390		374
Restricted stock		465		452
Loans held for sale		692		118
Loans		982,457		973,375
Allowance for loan losses		(12,553)		(12,415)
Net Loans		969,904		960,960
Premises and equipment, net		13,329		13,521
Right of use asset		5,649		—
Bank owned life insurance		23,751		23,496
Goodwill		9,016		9,016
Other real estate owned		2,684		2,684
Deferred tax asset, net		5,491		5,992
Other assets		8,901		8,545
Total assets	$	1,252,141	$	1,209,587

Liabilities
Deposits
Non-interest bearing checking	$	204,386	$	197,417
Money management, savings and interest checking		822,646		823,619
Time		86,017		61,593
Total deposits		1,113,049		1,082,629
Lease liability		5,670		—
Other liabilities		9,508		8,562
Total liabilities		1,128,227		1,091,191

Shareholders' equity
Common stock, $1 par value per share,15,000,000 shares authorized with
4,708,349 shares issued and 4,382,944 shares outstanding at June 30, 2019 and
4,701,367 shares issued and 4,408,761 shares outstanding at December 31, 2018		4,708		4,701
Capital stock without par value, 5,000,000 shares authorized with no
shares issued and outstanding		—		—
Additional paid-in capital		42,040		41,530
Retained earnings		88,658		83,946
Accumulated other comprehensive loss		(4,498)		(6,380)
Treasury stock, 325,405 shares at June 30, 2019 and 292,606 shares at
December 31, 2018, at cost		(6,994)		(5,401)
Total shareholders' equity		123,914		118,396
Total liabilities and shareholders' equity	$	1,252,141	$	1,209,587

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

Consolidated Statements of Income


	For the Three Months Ended				For the Six Months Ended
(Dollars in thousands, except per share data) (unaudited)	June 30,				June 30,
	2019		2018		2019		2018
Interest income
Loans, including fees	$	11,125	$	10,126	$	22,134	$	19,703
Interest and dividends on investments:
Taxable interest		575		528		1,114		1,041
Tax exempt interest		281		295		620		569
Dividend income		12		4		16		10
Deposits and obligations of other banks		403		100		499		218
Total interest income		12,396		11,053		24,383		21,541
Interest expense
Deposits		1,833		952		3,457		1,747
Short-term borrowings		—		2		36		2
Total interest expense		1,833		954		3,493		1,749
Net interest income		10,563		10,099		20,890		19,792
Provision for loan losses		—		9,129		399		9,329
Net interest income after provision for loan losses		10,563		970		20,491		10,463
Noninterest income
Investment and trust services fees		1,647		1,464		3,099		2,861
Loan service charges		228		217		431		449
Deposit service charges and fees		603		574		1,149		1,148
Other service charges and fees		381		353		734		686
Debit card income		464		417		866		802
Increase in cash surrender value of life insurance		128		129		255		257
Net gains on sales of debt securities		229		52		253		52
Change in fair value of equity securities		13		(7)		16		38
Other		3		22		59		76
Total noninterest income		3,696		3,221		6,862		6,369
Noninterest Expense
Salaries and employee benefits		5,355		5,096		10,797		10,082
Net occupancy		858		787		1,715		1,602
Advertising		481		341		883		768
Legal and professional		471		442		901		771
Data processing		738		604		1,443		1,200
Pennsylvania bank shares tax		243		234		486		473
FDIC Insurance		115		164		180		293
ATM/debit card processing		247		237		505		476
Foreclosed real estate		(12)		41		5		55
Telecommunications		107		124		211		232
Provision for credit losses on off-balance sheet exposures		—		2,361		—		2,361
Other		1,003		757		1,891		1,524
Total noninterest expense		9,606		11,188		19,017		19,837
Income (loss) before federal income taxes		4,653		(6,997)		8,336		(3,005)
Federal income tax expense (benefit)		669		(1,816)		1,115		(1,326)
Net income (loss)	$	3,984	$	(5,181)	$	7,221	$	(1,679)
Per share
Basic earnings (loss) per share	$	0.91	$	(1.18)	$	1.64	$	(0.38)
Diluted earnings (loss) per share	$	0.90	$	(1.18)	$	1.63	$	(0.38)
Cash dividends declared	$	0.30	$	0.27	$	0.57	$	0.51

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

Consolidated Statements of Comprehensive Income


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars in thousands) (unaudited)	2019		2018		2019		2018
Net Income	$	3,984	$	(5,181)	$	7,221	$	(1,679)

Debt Securities:
Unrealized gains (losses) arising during the period		1,220		(292)		2,634		(1,335)
Reclassification adjustment included in net income (1)		(229)		(52)		(253)		(52)
Net unrealized gains (losses)		991		(344)		2,381		(1,387)
Tax effect (2)		(208)		72		(499)		334
Net of tax amount		783		(272)		1,882		(1,053)

Total other comprehensive income (loss)		783		(272)		1,882		(1,053)

Total Comprehensive Income (loss)	$	4,767	$	(5,453)	$	9,103	$	(2,732)

(1) Reclassified to net gains on sales of debt securities
(2) Net of the reclassification of $48, $11, $52, and $11 to Federal income tax expense (benefit)

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

Consolidated Statements of Changes in Shareholders’ Equity

For the three and six months ended June 30, 2019 and 2018


							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 April 1, 2019	$	4,708	$	41,841	$	85,991	$	(5,281)	$	(5,768)	$	121,491
Net income		—		—		3,984		—		—		3,984
Other comprehensive income		—		—		—		783		—		783
Cash dividends declared, $.30 per share		—		—		(1,317)		—		—		(1,317)
Acquisition of 39,600 shares of treasury stock		—		—		—		—		(1,467)		(1,467)
Treasury shares issued under employee stock purchase plan, 2,110 shares		—		25		—		—		44		69
Treasury shares issued under dividend reinvestment plan, 9,554 shares		—		174		—		—		197		371
Balance at June 30, 2019	$	4,708	$	42,040	$	88,658	$	(4,498)	$	(6,994)	$	123,914

Balance at January 1, 2019	$	4,701	$	41,530	$	83,946	$	(6,380)	$	(5,401)	$	118,396
Net income		—		—		7,221		—		—		7,221
Other comprehensive income		—		—		—		1,882		—		1,882
Cash dividends declared, $.57 per share		—		—		(2,509)		—		—		(2,509)
Acquisition of 54,763 shares of treasury stock		—		—		—		—		(2,027)		(2,027)
Treasury shares issued under employee stock purchase plan, 2,260 shares		—		27		—		—		47		74
Treasury shares issued under dividend reinvestment plan, 19,704 shares		—		335		—		—		387		722
Incentive stock options exercised, 6,982 shares		7		148		—		—		—		155
Balance at June 30, 2019	$	4,708	$	42,040	$	88,658	$	(4,498)	$	(6,994)	$	123,914


Balance at April 1, 2018	$	4,696	$	40,668	$	84,876	$	(7,010)	$	(6,106)	$	117,124
Net income		—		—		(5,181)		—		—		(5,181)
Other comprehensive (loss)		—		—		—		(272)		—		(272)
Cash dividends declared, $.27 per share		—		—		(1,181)		—		—		(1,181)
Treasury shares issued under employee stock purchase plan, 2,363 shares		—		27		—		—		43		70
Treasury shares issued under dividend reinvestment plan, 12,098 shares		—		207		—		—		224		431
Incentive stock options exercised, 4,150 shares		4		84		—		—		—		88
Stock option compensation expense		—		93		—		—		—		93
Balance at June 30, 2018	$	4,700	$	41,079	$	78,514	$	(7,282)	$	(5,839)	$	111,172

Balance at January 1, 2018	$	4,689	$	40,396	$	82,218	$	(6,028)	$	(6,131)	$	115,144
Cumulative adjustment for fair value of equity securities		—		—		201		(201)		—		—
Net loss		—		—		(1,679)		—		—		(1,679)
Other comprehensive loss		—		—		—		(1,053)		—		(1,053)
Cash dividends declared, $.51 per share		—		—		(2,226)		—		—		(2,226)
Acquisition of 2,605 shares of treasury stock		—		—		—		—		(88)		(88)
Treasury shares issued under employee stock purchase plan, 2,563 shares		—		29		—		—		47		76
Treasury shares issued under dividend reinvestment plan, 18,009 shares		—		303		—		—		333		636
Incentive stock options exercised, 10,668 shares		11		228		—		—		—		239
Stock option compensation expense		—		123		—		—		—		123
Balance at June 30, 2018	$	4,700	$	41,079	$	78,514	$	(7,282)	$	(5,839)	$	111,172

Consolidated Statements of Cash Flows


	Six Months Ended June 30,
	2019		2018
(Dollars in thousands) (unaudited)
Cash flows from operating activities
Net income	$	7,221	$	(1,679)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		681		668
Net amortization of loans and investment securities		733		877
Provision for loan losses		399		9,329
Increase in fair value of equity securities		(16)		(38)
Debt securities gains, net		(253)		(52)
Pay-out of legal settlement		—		(10,000)
Provision for credit losses on off-balance sheet exposures		—		2,361
Loans originated for sale		(16,892)		(9,813)
Proceeds from sale of loans		16,318		9,799
Write-down of other real estate owned		—		6
Loss on sale of premises		—		17
Increase in cash surrender value of life insurance		(255)		(257)
Stock option compensation		—		123
Contribution to pension plan		—		(1,000)
Increase in other assets		(70)		(3,916)
Increase in other liabilities		643		1,331
Net cash provided (used) by operating activities		8,509		(2,244)
Cash flows from investing activities
Proceeds from sales and calls of investment securities available for sale		16,955		3,811
Proceeds from maturities and pay-downs of securities available for sale		13,318		10,173
Purchase of investment securities available for sale		(26,319)		(17,328)
Net increase in restricted stock		(13)		(168)
Net increase in loans		(9,362)		(32,271)
Capital expenditures		(433)		(479)
Proceeds from sale of other assets		—		117
Net proceeds from the sale of other real estate		—		32
Net cash used in investing activities		(5,854)		(36,113)
Cash flows from financing activities
Net increase in demand deposits, interest-bearing checking, and savings accounts		5,996		16,645
Net increase (decrease) in time deposits		24,424		(6,146)
Dividends paid		(2,509)		(2,226)
Purchase of Treasury shares		(2,004)		—
Cash received from option exercises		206		315
Treasury shares issued under dividend reinvestment plan		722		636
Net cash provided by financing activities		26,835		9,224
Increase (decrease) in cash and cash equivalents		29,490		(29,133)
Cash and cash equivalents at the beginning of the period		52,957		58,603
Cash and cash equivalents at the end of the period	$	82,447	$	29,470
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest on deposits and other borrowed funds	$	3,275	$	1,750
Income taxes	$	—	$	250
Noncash Activities
Recognition of Operating Lease Right-of-Use Asset	$	22	$	—
Recognition of Operating Lease Liability	$	22	$	—

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 June 30, 2019, 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 2018 Annual Report on Form 10-K. The consolidated results of operations for the three month period ended June 30, 2019 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, 2018 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 Six Months Ended
	June 30,				June 30,
(Dollars and shares in thousands, except per share data)	2019		2018		2019		2018
Weighted average shares outstanding (basic)		4,396		4,373		4,404		4,366
Impact of common stock equivalents		25		—		23		—
Weighted average shares outstanding (diluted)		4,421		4,373		4,427		4,366
Anti-dilutive options excluded from calculation		—		—		—		—
Net income	$	3,984	$	(5,181)	$	7,221	$	(1,679)
Basic earnings (loss) per share	$	0.91	$	(1.18)	$	1.64	$	(0.38)
Diluted earnings (loss) per share	$	0.90	$	(1.18)	$	1.63	$	(0.38)

Note 2. Recent Accounting Pronouncements

The following accounting pronouncements have recently been adopted or will be adopted in future periods. For information on accounting pronouncements previously adopted, please refer to the Corporation’s report on Form 10-K for the year-ended December 31, 2018.


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

ASU 2016-02, Leases (Topic 842) and all subsequently issued amendments	In February 2016, the FASB issued ASU 2016-02, "Leases (Subtopic 842)." This ASU requires all lessees to recognize a lease liability and a right-of-use asset, measured at the present value of the future minimum lease payments, at the lease commencement date. Lessor accounting remains largely unchanged under the new guidance. FASB subsequently issued various amendments that provided implementation guidance designed to provide entities with relief from the costs of implementing certain aspects of the new standard. From the lessee's perspective, the new standard requires a lessee to record a right-of-use asset and a lease liability on the balance sheet for all leases. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement for lessees. ASU 2016-02 and all subsequent amendments are effective for fiscal years, including interim periods, beginning after December 15, 2018.	January 1, 2019	The Corporation adopted ASU 2016-02, "Leases (Topic 842)" and all subsequent amendments on January 1, 2019 using the modified retrospective approach, and it did not have a material effect on its consolidated results of operations. Adoption of the new standard resulted in the recognition of a lease liability and a right-of-use asset of $6.2 million without a cumulative effect adjustment to retained earnings. The Corporation did not restate any prior period results. The Corporation adopted the package of practical expedients offered in ASU 2016-02 and therefore, existing lease classifications were not reassessed, expired or existing contracts were not reassessed for a lease, and the initial direct costs for any existing leases were not reassessed. In addition to the package of practical expedients, the Corporation also utilized other practical expedients offered: (1) the hindsight expedient which allows entities to use hindsight to determine the lease term was not adopted, (2) leases, for all underlying asset classes, with a term less than 12 months and no purchase option were excluded, (3) the option to not separate lease and non-lease components and account for them as a single component was adopted for real estate leases, and (4) the option to not apply lease accounting to existing land easements was adopted. See Note 7 for additional information on the adoption of the new standard.

ASU 2018-13, Disclosure Framework (Topic 820)	This guidance eliminates, adds and modifies certain disclosure requirements for fair value measurements. Among the changes, entities will no longer be required to disclose the amount of and reason for transfers between Level 1 and Level 2 of the fair value hierarchy, but will be required to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements.	January 1, 2019	The Corporation adopted the standard on January 1, 2019 and it did not have a material effect on its consolidated results of operations.

ASU 2018-15, Accounting for Implementation Costs in a Cloud Computing Arrangement (Topic 350)	This ASU required an entity in a cloud computing arrangement (i.e., hosting arrangement) that is a service contract to follow the internal-use software guidance in ASC 350-40 to determine which implementation costs to capitalize as assets or expense as incurred. Capitalized implementation costs should be presented in the same line item on the balance sheet as amounts prepaid for the hosted service, if any (generally as an "other asset"). The capitalized costs will be amortized over the term of the hosting arrangement, with the amortization expense being presented in the same income statement line item as the fees paid for the hosted service. The ASU is effective January 1, 2020 with early adoption permitted.	January 1, 2020	The Corporation adopted the standard on January 1, 2019 and it did not have a material effect on its consolidated results of operations.

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. Early adoption is permitted for any impairment tests performed after January 1, 2017, applied prospectively.	January 1, 2020	The Corporation early adopted the ASU in the fourth quarter of 2018 with the completion of the 2018 impairment analysis. The ASU did not have a material effect on the consolidated financial statements.

ASU 2018-14, Disclosure Framework (Topic 715): Changes to the Disclosure Requirements for Defined Benefit Plans	This ASU makes minor changes to the disclosure requirements for employers that sponsor defined benefit pension and/or other postretirement benefit plans. ASU 2018-14 is effective for fiscal years ending after December 15, 2020; early adoption is permitted.	January 1, 2020	The Corporation will adopt the provisions of the ASU on January 1, 2020. As the ASU only revises disclosure requirements, it is not expected to have a material effect on the consolidated financial statements.

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 accounting for PCD financial assets is the same expected loss model described above. On July 17, 2019, FASB tentatively decided to delay the effective date of ASU 2016-13 for smaller reporting companies to January 2023. The FASB plans to issue a proposed ASU in the near future to expose the tentative decision for public comment. The comment period is expected to last 30 days.	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 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. A third-party vendor has been selected to assist with the CECL calculations and the implementation process has started. The Corporation began running the CECL model in test mode in the second quarter of 2019.

ASU 2019-05, Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief	This ASU allows entities to irrevocably elect, upon adoption of ASU 2016-13, the fair value option on financial instruments that (1) were previously recorded at amortized cost and (2) are within the scope of ASC 326-20 if the instruments are eligible for the fair value option under ASC 825-10. The fair value option election does not apply to held-to-maturity debt securities. Entities are required to make this election on an instrument-by-instrument basis. ASU 2019-05 has the same effective date as ASU 2016-13.	January 1, 2020	The Corporation will continue to review the ASU as part of its adoption of ASU 2016-13

Note 3. Accumulated Other Comprehensive Loss

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



	June 30,		December 31,
	2019		2018
(Dollars in thousands)
Net unrealized gains (losses) on debt securities	$	1,281	$	(1,100)
Tax effect		(269)		230
Net of tax amount		1,012		(870)

Accumulated pension adjustment		(6,975)		(6,975)
Tax effect		1,465		1,465
Net of tax amount		(5,510)		(5,510)

Total accumulated other comprehensive loss	$	(4,498)	$	(6,380)

Note 4. Investments

Available for Sale (AFS) Securities

The amortized cost and estimated fair value of AFS securities as of June 30, 2019 and December 31, 2018 are as follows:



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
June 30, 2019	cost		gains		losses		value
U.S. Government and Agency securities	$	10,492	$	75	$	(12)	$	10,555
Municipal securities		59,685		1,255		(46)		60,894
Trust preferred securities		4,085		—		(189)		3,896
Agency mortgage-backed securities		46,667		396		(138)		46,925
Private-label mortgage-backed securities		440		36		—		476
Asset-backed securities		6,772		—		(96)		6,676
	$	128,141	$	1,762	$	(481)	$	129,422



(Dollars in thousands)			Gross		Gross
	Amortized		unrealized		unrealized		Fair
December 31, 2018	cost		gains		losses		value
U.S. Government and Agency securities	$	9,120	$	21	$	(65)	$	9,076
Municipal securities		67,811		320		(484)		67,647
Trust preferred securities		4,074		—		(316)		3,758
Agency mortgage-backed securities		45,241		65		(648)		44,658
Private-label mortgage-backed securities		457		31		—		488
Asset-backed securities		5,869		—		(24)		5,845
	$	132,572	$	437	$	(1,537)	$	131,472

At June 30, 2019 and December 31, 2018, the fair value of AFS securities pledged to secure public funds and trust deposits totaled $69.6 million and $84.6 million, respectively.

The amortized cost and estimated fair value of debt securities at June 30, 2019, by contractual maturity are shown below. Actual maturities may differ from contractual maturities because of prepayment or call options embedded in the securities. Securities not due at a single maturity date are presented separately.



(Dollars in thousands)	Amortized cost		Fair value
Due in one year or less	$	19,503	$	19,576
Due after one year through five years		20,565		20,764
Due after five years through ten years		36,647		37,270
Due after ten years		4,319		4,411
		81,034		82,021
Mortgage-backed and asset-backed securities		47,107		47,401
	$	128,141	$	129,422

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


	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2019		2018		2019		2018
Proceeds	$	14,906	$	3,811	$	18,781	$	3,811

Gross gains realized		248		63		281		63
Gross losses realized		(19)		(11)		(28)		(11)
Net gains realized	$	229	$	52	$	253	$	52

Tax expense on net gains realized	$	48	$	11	$	53	$	11

Impairment:

The AFS securities portfolio contained 84 securities with $37.3 million of temporarily impaired fair value and $481 thousand in unrealized losses at June 30, 2019. The total unrealized loss position has decreased $1.1 million since year-end 2018.

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. The impairment identified on debt securities and subject to assessment at June 30, 2019, 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 AFS portfolio, 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 June 30, 2019 and December 31, 2018:



	June 30, 2019
	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	$	1,002	$	(6)	2	$	2,189	$	(6)	9	$	3,191	$	(12)	11
Municipal securities		378		(4)	1		4,167		(42)	7		4,545		(46)	8
Trust preferred securities		885		(32)	1		3,011		(157)	4		3,896		(189)	5
Agency mortgage-backed securities		3,174		(16)	4		15,806		(122)	47		18,980		(138)	51
Asset-backed securities		6,659		(95)	7		17		(1)	2		6,676		(96)	9
Total temporarily impaired securities	$	12,098	$	(153)	15	$	25,190	$	(328)	69	$	37,288	$	(481)	84



	December 31, 2018
	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	$	2,071	$	(6)	2	$	5,175	$	(59)	14	$	7,246	$	(65)	16
Municipal securities		5,832		(12)	10		25,091		(472)	42		30,923		(484)	52
Trust preferred securities		2,008		(159)	3		1,750		(157)	2		3,758		(316)	5
Agency mortgage-backed securities		7,687		(46)	16		30,511		(602)	74		38,198		(648)	90
Asset-backed securities		5,826		(22)	6		19		(2)	2		5,845		(24)	8
Total temporarily impaired securities	$	23,424	$	(245)	37	$	62,546	$	(1,292)	134	$	85,970	$	(1,537)	171

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



	Six Months Ended
(Dollars in thousands)	June 30,
	2019		2018
Balance of cumulative credit-related OTTI at January 1	$	272	$	595
Additions for credit-related OTTI not previously recognized		—		—
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 June 30	$	272	$	595

Equity securities at Fair Value

The Corporation owns one equity investment. At June 30, 2019 and December 31, 2018, this investment was reported at fair value of $390 thousand and $374 thousand, respectively, with changes in value reported through income.

Restricted Stock at Cost

The Bank held $465 thousand of restricted stock at June 30, 2019. 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:



	June 30,		December 31,
(Dollars in thousands)	2019		2018
Residential Real Estate 1-4 Family
Consumer first liens	$	88,069	$	89,673
Commercial first lien		58,202		59,227
Total first liens		146,271		148,900

Consumer junior liens and lines of credit		40,754		42,504
Commercial junior liens and lines of credit		4,878		4,716
Total junior liens and lines of credit		45,632		47,220
Total residential real estate 1-4 family		191,903		196,120

Residential real estate - construction
Consumer		3,487		1,667
Commercial - land development		10,601		8,558
Total residential real estate construction		14,088		10,225

Commercial real estate		505,653		487,980
Commercial		264,862		274,054
Total commercial		770,515		762,034

Consumer		5,951		4,996
		982,457		973,375
Less: Allowance for loan losses		(12,553)		(12,415)
Net Loans	$	969,904	$	960,960

Included in the loan balances are the following:
Net unamortized deferred loan (fees) costs	$	(47)	$	123

Loans pledged as collateral for borrowings and commitments from:
FHLB	$	790,766	$	772,564
Federal Reserve Bank		32,977		34,160
	$	823,743	$	806,724

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 shown:


	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 March 31, 2019	$	487	$	132	$	152	$	5,906	$	4,562	$	72	$	1,370	$	12,681
Charge-offs		(1)		—		—		(123)		(14)		(25)		—		(163)
Recoveries		2		1		—		20		9		3		—		35
Provision		(51)		(20)		10		64		(43)		45		(5)		—
ALL at June 30, 2019	$	437	$	113	$	162	$	5,867	$	4,514	$	95	$	1,365	$	12,553

ALL at December 31, 2018	$	491	$	133	$	108	$	5,698	$	4,511	$	70	$	1,404	$	12,415
Charge-offs		(34)		(1)		(3)		(186)		(75)		(51)		—		(350)
Recoveries		3		1		—		21		51		13		—		89
Provision		(23)		(20)		57		334		27		63		(39)		399
ALL at June 30, 2019	$	437	$	113	$	162	$	5,867	$	4,514	$	95	$	1,365	$	12,553

ALL at March 31, 2018	$	1,043	$	320	$	260	$	6,698	$	2,073	$	104	$	1,491	$	11,989
Charge-offs		-		—		—		—		(8,736)		(29)		—		(8,765)
Recoveries		-		—		—		16		108		5		—		129
Provision		(21)		(2)		22		314		8,788		27		1		9,129
ALL at June 30, 2018	$	1,022	$	318	$	282	$	7,028	$	2,233	$	107	$	1,492	$	12,482

ALL at December 31, 2017	$	1,060	$	330	$	224	$	6,526	$	2,110	$	105	$	1,437	$	11,792
Charge-offs		-		—		—		—		(8,736)		(55)		—		(8,791)
Recoveries		1		—		—		16		116		19		—		152
Provision		(39)		(12)		58		486		8,743		38		55		9,329
ALL at June 30, 2018	$	1,022	$	318	$	282	$	7,028	$	2,233	$	107	$	1,492	$	12,482

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 June 30, 2019 and December 31, 2018:



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

June 30, 2019
Loans evaluated for ALL:
Individually	$	397	$	—	$	647	$	12,566	$	—	$	—	$	—	$	13,610
Collectively		145,874		45,632		13,441		493,087		264,862		5,951		—		968,847
Total	$	146,271	$	45,632	$	14,088	$	505,653	$	264,862	$	5,951	$	—	$	982,457

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		437		113		162		5,867		4,514		95		1,365		12,553
ALL at June 30, 2019	$	437	$	113	$	162	$	5,867	$	4,514	$	95	$	1,365	$	12,553

December 31, 2018
Loans evaluated for ALL:
Individually	$	405	$	—	$	455	$	10,099	$	181	$	—	$	—	$	11,140
Collectively		148,495		47,220		9,770		477,881		273,873		4,996		—		962,235
Total	$	148,900	$	47,220	$	10,225	$	487,980	$	274,054	$	4,996	$	—	$	973,375

ALL established for loans evaluated:
Individually	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Collectively		491		133		108		5,698		4,511		70		1,404		12,415
ALL at December 31, 2018	$	491	$	133	$	108	$	5,698	$	4,511	$	70	$	1,404	$	12,415

The following table shows additional information about those loans considered to be impaired at June 30, 2019 and December 31, 2018:


	Impaired Loans
	With No Allowance				With Allowance
(Dollars in thousands)			Unpaid				Unpaid
	Recorded		Principal		Recorded		Principal		Related
June 30, 2019	Investment		Balance		Investment		Balance		Allowance
Residential Real Estate 1-4 Family
First liens	$	776	$	776	$	—	$	—	$	—
Junior liens and lines of credit		26		26		—		—		—
Total		802		802		—		—		—
Residential real estate - construction		647		729		—		—		—
Commercial real estate		12,765		13,374		—		—		—
Commercial		145		163		—		—		—
Total	$	14,359	$	15,068	$	—	$	—	$	—


December 31, 2018
Residential Real Estate 1-4 Family
First liens	$	871	$	958	$	—	$	—	$	—
Junior liens and lines of credit		49		49		—		—		—
Total		920		1,007		—		—		—
Residential real estate - construction		455		531		—		—		—
Commercial real estate		10,236		10,808		—		—		—
Commercial		315		9,763		—		—		—
Total	$	11,926	$	22,109	$	—	$	—	$	—

The following table shows the average of impaired loans and related interest income for the three and six months ended June 30, 2019 and 2018:


	Three Months Ended				Six Months Ended
	June 30, 2019				June 30, 2019
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	779	$	11	$	813	$	21
Junior liens and lines of credit		26		1		35		1
Total		805		12		848		22
Residential real estate - construction		651		—		652		—
Commercial real estate		13,242		102		13,368		204
Commercial		147		—		138		—
Total	$	14,845	$	114	$	15,006	$	226

	Three Months Ended				Six Months Ended
	June 30, 2018				June 30, 2018
	Average		Interest		Average		Interest
(Dollars in thousands)	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
Residential Real Estate 1-4 Family
First liens	$	831	$	11	$	818	$	22
Junior liens and lines of credit		1,045		4		995		10
Total		1,876		15		1,813		32
Residential real estate - construction		463		—		465		—
Commercial real estate		10,008		100		10,072		199
Commercial		11,835		—		5,927		—
Total	$	24,182	$	115	$	18,277	$	231

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
June 30, 2019
Residential Real Estate 1-4 Family
First liens	$	145,271	$	476	$	416	$	28	$	920	$	80	$	146,271
Junior liens and lines of credit		45,440		121		45		—		166		26		45,632
Total		190,711		597		461		28		1,086		106		191,903
Residential real estate - construction		13,441		—		—		—		—		647		14,088
Commercial real estate		499,291		634		982		332		1,948		4,414		505,653
Commercial		264,409		128		180		—		308		145		264,862
Consumer		5,918		29		4		—		33		—		5,951
Total	$	973,770	$	1,388	$	1,627	$	360	$	3,375	$	5,312	$	982,457



December 31, 2018
Residential Real Estate 1-4 Family
First liens	$	148,183	$	322	$	202	$	113	$	637	$	80	$	148,900
Junior liens and lines of credit		47,040		131		—		26		157		23		47,220
Total		195,223		453		202		139		794		103		196,120
Residential real estate - construction		9,572		—		198		—		198		455		10,225
Commercial real estate		481,774		1,343		3,323		113		4,779		1,427		487,980
Commercial		273,534		65		40		100		205		315		274,054
Consumer		4,933		46		12		5		63		—		4,996
Total	$	965,036	$	1,907	$	3,775	$	357	$	6,039	$	2,300	$	973,375

The following table reports the risk rating for those loans in the portfolio that are assigned an individual risk rating. 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

June 30, 2019
Residential Real Estate 1-4 Family
First liens	$	145,945	$	—	$	326	$	—	$	146,271
Junior liens and lines of credit		45,606		—		26		—		45,632
Total		191,551		—		352		—		191,903
Residential real estate - construction		13,441		—		647		—		14,088
Commercial real estate		497,767		—		7,886		—		505,653
Commercial		263,895		—		967		—		264,862
Consumer		5,951		—		—		—		5,951
Total	$	972,605	$	—	$	9,852	$	—	$	982,457



December 31, 2018
Residential Real Estate 1-4 Family
First liens	$	148,453	$	—	$	447	$	—	$	148,900
Junior liens and lines of credit		47,171		—		49		—		47,220
Total		195,624		—		496		—		196,120
Residential real estate - construction		9,572		—		653		—		10,225
Commercial real estate		479,969		660		7,351		—		487,980
Commercial		272,959		—		1,095		—		274,054
Consumer		4,991		—		5		—		4,996
Total	$	963,115	$	660	$	9,600	$	—	$	973,375

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


								Troubled Debt Restructurings
								Within the Last 12 Months
								That Have Defaulted
(Dollars in thousands)	Troubled Debt Restructurings							On Modified Terms
	Number of	Recorded						Number of	Recorded
	Contracts	Investment		Performing*		Nonperforming*		Contracts	Investment
June 30, 2019
Residential real estate - construction	1	$	449	$	449	$	—	—	$	—
Residential real estate	4		667		667		—	—		—
Commercial real estate	11		9,594		9,594		—	—		—
Total	16	$	10,710	$	10,710	$	—	—	$	—


December 31, 2018
Residential real estate - construction	1	$	455	$	—	$	455	—	$	—
Residential real estate	4		678		678		—	—		—
Commercial real estate	11		10,099		8,809		1,290	—		—
Total	16	$	11,232	$	9,487	$	1,745	—	$	—

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

There were no new TDR loans during 2019 and 2018.

Note 7. Leases

The Corporation adopted ASU 2016-02 “Leases (Topic 842)” and all subsequent amendments on January 1, 2019 using the modified retrospective method. The Corporation has elected the option to apply the new standard as of January 1, 2019 without restatement of any prior period results. Adoption of the new standard resulted in the recognition of a lease liability and a right-of-use asset of $6.2 million without a cumulative effect adjustment to retained earnings.

The Corporation leases various assets in the course of its operations that are subject to recognition under the new standard. The Corporation considers all of its leases to be operating leases and it has no finance leases. The leased assets are comprised of equipment, and buildings and land (collectively real estate). The equipment leases are shorter-term than the real estate leases, and generally have a fixed payment over a defined term without renewal options. Certain equipment leases have purchase options and it was determined the option was not reasonably certain to be exercised. The real estate leases are longer-term and may contain renewal options after the initial term, but none of the real estate leases contain a purchase option. The renewal options on real estate leases were reviewed and if it was determined the option was reasonably certain to be renewed, the option term was considered in the determination of the lease liability. There is only one real estate lease with a variable payment based on an index included in the lease liability. None of the leases contain any restrictive covenants and there are no significant leases that have not yet commenced. The discount rate used to determine the lease liability is based on the Bank’s fully secured borrowing rate from the Federal Home Loan Bank for a term similar to the lease term. Adoption of the new standard did not affect the Corporation’s status as a “well-capitalized” institution. The Corporation has one real estate lease to a related party with a liability value of $1.8 million. Operating lease expense is included in net occupancy expense in the consolidated statements of income. See Note 1 for additional information on the adoption of the new standard.

Lease costs for the three and six months ended June 30, 2019 were as follows:


	Three Months Ended		Six Months Ended
(Dollars in thousands)	June 30, 2019		June 30, 2019
Operating lease cost	$	184	$	372
Short-term lease cost		3		9
Variable lease cost		12		23
Total lease cost	$	199	$	404

Cash paid for amounts included in the measurement of lease liabilities and the weighted-average remaining lease term and discount rate were as follows:


	Six Months Ended
(Dollars in thousands)	June 30, 2019
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases	$	249

Weighted-average remaining lease term (years)		13.0
Weighted-average discount rate		3.51%

As of June 30, 2019, the future minimum payments for operating leases having initial or remaining lease terms in excess of one year were as follows:


(Dollars in thousands)

2019	$	352
2020		674
2021		651
2022		567
2023		527
2024 and beyond		4,380
Total undiscounted cash flows		7,151
Discounted cash flows		(1,481)
Total lease liability	$	5,670

Note 8. Other Real Estate Owned

Changes in other real estate owned were as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2019		2018		2019		2018
Balance at beginning of the period	$	2,684	$	2,592	$	2,684	$	2,598
Additions		—		105		—		105
Proceeds from dispositions		—		(32)		—		(32)
Loss on sales, net		—		—		—		—
Valuation adjustment		—		—		—		(6)
Balance at the end of the period	$	2,684	$	2,665	$	2,684	$	2,665

Note 9. Pension

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


	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2019		2018		2019		2018
Components of net periodic cost:
Service cost	$	81	$	90	$	161	$	180
Interest cost		157		138		315		276
Expected return on plan assets		(272)		(279)		(542)		(558)
Recognized net actuarial loss		134		176		286		352
Net period cost	$	100	$	125	$	220	$	250

The Bank expects its pension expense to decrease to approximately $420 thousand in 2019 compared to $500 thousand in 2018, due primarily to decreases in service costs and recognized net actuarial losses. The service cost component of pension expense is in the salaries and employee benefits line on the income statement. All other cost components are in the other expense line on the income statement.

Note 10. 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. The Corporation uses the exit price notion to measure the fair value of financial instruments.

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 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:



	June 30, 2019
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets, carried at cost:
Cash and cash equivalents	$	82,447	$	82,447	$	82,447	$	—	$	—
Restricted stock		465		465		—		465		—
Loans held for sale		692		692				692
Net loans		969,904		959,048		—		—		959,048
Accrued interest receivable		4,246		4,246		—		4,246		—

Financial assets, available for sale
Debt securities		129,422		129,422		—		129,422		—

Financial assets, fair value
Equity securities		390		390		390		—		—

Financial liabilities:
Deposits	$	1,113,049	$	1,113,351	$	—	$	1,113,351	$	—
Accrued interest payable		411		411		—		411		—

	December 31, 2018
	Carrying		Fair
(Dollars in thousands)	Amount		Value		Level 1		Level 2		Level 3
Financial assets, carried at cost:
Cash and cash equivalents	$	52,957	$	52,957	$	52,957	$	—	$	—
Restricted stock		452		452		—		452		—
Loans held for sale		118		118		—		118		—
Net loans		960,960		941,930		—		—		941,930
Accrued interest receivable		4,103		4,103		—		4,103		—

Financial assets, available for sale
Debt securities		131,472		131,472		—		131,472		—

Financial assets, fair value
Equity securities		374		374		374		—		—

Financial liabilities:
Deposits	$	1,082,629	$	1,082,425	$	—	$	1,082,425	$	—
Accrued interest payable		193		193		—		193		—

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 June 30, 2019 and December 31, 2018 are as follows:



(Dollars in Thousands	Fair Value at June 30, 2019
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities, at fair value	$	390	$	—	$	—	$	390

Available for sale:
U.S. Government and Agency securities		—		10,555		—		10,555
Municipal securities		—		60,894		—		60,894
Trust Preferred Securities		—		3,896		—		3,896
Agency mortgage-backed securities		—		46,925		—		46,925
Private-label mortgage-backed securities		—		476		—		476
Asset-backed securities		—		6,676		—		6,676
Total assets	$	390	$	129,422	$	—	$	129,812



(Dollars in Thousands)	Fair Value at December 31, 2018
Asset Description	Level 1		Level 2		Level 3		Total
Equity securities, at fair value	$	374	$	—	$	—	$	374

Available for sale:
U.S. Government and Agency securities		—		9,076		—		9,076
Municipal securities		—		67,647		—		67,647
Trust Preferred Securities		—		3,758		—		3,758
Agency mortgage-backed securities		—		44,658		—		44,658
Private-label mortgage-backed securities		—		488		—		488
Asset-backed securities		—		5,845		—		5,845
Total assets	$	374	$	131,472	$	—	$	131,846

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 December 31, 2018 was as follows:




(Dollars in Thousands)	Fair Value at June 30, 2019
Asset Description	Level 1		Level 2		Level 3		Total
Impaired loans (1)	$	—	$	—	$	2,971	$	2,971
Total assets	$	—	$	—	$	2,971	$	2,971



(Dollars in Thousands)	Fair Value at December 31, 2018
Asset Description	Level 1		Level 2		Level 3		Total
Other real estate owned (1)	$	—	$	—	$	71	$	71
Total assets	$	—	$	—	$	71	$	71

(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.

Impaired loans: Impaired loans are reported at the fair value of the underlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 3 inputs based on customized discounting criteria.

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 these 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 June 30, 2019 and December 31, 2018. 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 June 30, 2019.

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


(Dollars in Thousands)					Range
June 30, 2019		Fair Value	Valuation Technique	Unobservable Input	(Weighted Average)
Impaired loans (1)	$	2,971	Appraisal	Appraisal Adjustments (2)	11% - 48% (34%)
				Cost to sell	0% - 8% (8%)
(Dollars in Thousands)
December 31, 2018		Fair Value	Valuation Technique	Unobservable Input	Weighted Average
Other real estate owned (1)	$	71	Appraisal	Cost to sell	8% (8%)

(1) Includes assets directly charged-down to fair value during the year-to-date period.
(2) Qualitative adjustments are discounts specific to each asset and are made as needed.

Note 11. 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 was 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 June 30, 2019 was 7.19% (total risk-based capital 15.19% less 8.00%) compared to the 2019 regulatory buffer of 2.50%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions and is in addition to the Basel III capital requirements. As of June 30, 2019, the Bank was “well capitalized’ under the Basel III requirements.

The following table summarizes the Basel III regulatory capital requirements and results as of June 30, 2019 and December 31, 2018 for the Corporation and the Bank:


			Regulatory Ratios
			Adequately	Well
	June 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2019	2018	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	13.93%	13.96%	4.500%	N/A
Farmers & Merchants Trust Company	13.77%	13.80%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	13.93%	13.96%	6.000%	N/A
Farmers & Merchants Trust Company	13.77%	13.80%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	15.19%	15.21%	8.000%	N/A
Farmers & Merchants Trust Company	15.02%	15.06%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	9.63%	9.78%	4.000%	N/A
Farmers & Merchants Trust Company	9.52%	9.68%	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

Note 12. Revenue Recognition

The Corporation adopted ASC 606 on January 1, 2018 using the modified retrospective approach applied to all contracts initiated on or after the effective date, and for contracts which have remaining obligations as of the effective date. Results for the reporting period beginning January 1, 2018 are presented under ASC 606 while the prior period results continue to be reported under legacy GAAP. Adoption of the standard did not have a material effect on any of the reported periods. The Corporation did not record a cumulative effect adjustment to the beginning retained earnings balance as of January 1, 2018 from the adoption of ASC 606 as it was determined the transition adjustment was immaterial to Corporation’s consolidated financial statements.

All of the Corporation’s revenue from contracts with customers within the scope of ASC 606 is recognized in non-interest income as presented in our consolidated statements of income. Revenue generating activities that fall within the scope of ASC 606 are described as follows:

Investment and Trust Service Fees - these represent fees from wealth management (assets under management), fees from the management and settlement of estates and commissions from the sale of investment and insurance products.

Asset management fees are generally assessed based on a tiered fee schedule, based on the value of assets under management, and are recognized monthly when the service obligation is completed. Fees recognized were $1.5 million for the second quarter of 2019 and $1.3 million for the second quarter of 2018. Asset management fees year-to-date as of June 30 were $2.8 million for 2019 and $2.6 million for 2018.

Fees for estate management services are based on the estimated fair value of the estate. These fees are generally recognized monthly over an 18 month period that Management has determined to represent the average time to fulfill the performance obligations of the contract. Management has the discretion to adjust this time period as needed based upon the nature and complexity of an individual estate. Fees recognized were $84 thousand for the second quarter of 2019, compared to $81 thousand for the second quarter of 2018. Estate management fees year-to-date as of June 30 were $154 thousand in 2019 and $142 thousand in 2018.

Commissions from the sale of investment and insurance products are recognized upon the completion of the transaction. Commissions recognized were $67 thousand for the second quarter of 2019 and $76 thousand for 2018. Year-to-date commissions as of June 30 were $135 thousand for 2019 and $144 thousand for 2018

Loan Service Charges – these represent fees on loans for services or charges that occur after the loan has been booked, for example, late payment fees. These also include fees for mortgages settled for a third party mortgage company.

All of these fees are transactional in nature and are recognized upon completion of the transaction which represents the performance obligation.

Deposit Service Charges and Fees – these represent fees from deposit customers for transaction based, account maintenance, and overdraft services. Transaction based fees include, but are not limited to stop payment fees and overdraft fees. These fees are recognized at the time of the transaction when the performance obligation has been fulfilled. Account maintenance fees and account analysis fee are earned over the course of a month, representing the period of the performance obligation, and are recognized monthly.

Debit Card Income – this represents interchange fees from cardholder transactions conducted through the card payment network. Cardholders use the debit card to conduct point-of-sale transactions that produce interchange fees. The fees are transaction based and the fee is recognized with the processing of the transaction. These fees are reported net of cardholder rewards.

Other Service Charges and Fees – these are comprised primarily of merchant card fees, credit card fees, ATM surcharges and interchange fees and wire transfer fees. Merchant card fees represent fees the Bank earns from a third party for enrolling a customer in the processor’s program. Credit card fees represent a fee earned by the Bank for a successful referral to a card-issuing company. ATM surcharges and interchange fees are the result of Bank customers conducting ATM transactions that generate fee income and are processed through multiple card networks. All of these fees are transaction based and are recognized at the time of the transaction.

Gains/Losses on the Sale of Other Real Estate – these are recognized when control of the property transfers to the buyer.

Increases in the cash surrender value of life insurance and security transactions are not within the scope of ASC 606.

Contract Balances

A contract asset balance occurs when an entity performs a service for a customer before the customer pays consideration (resulting in a contract receivable) or before payment is due (resulting in a contract asset). A contract liability balance is an entity’s obligation to transfer a service to a customer for which the entity has already received payment (or payment is due) from the customer. The Company’s noninterest revenue streams are largely based on transactional activity, or standard month-end revenue accruals such as asset management fees based on month-end market values. Consideration is often received immediately or shortly after the Company satisfies its performance obligation and revenue is recognized. The Company does not typically enter into longer-term revenue contracts with customers, and therefore, does not experience significant contract balances.

Contract Acquisition Costs

The Corporation expenses all contract acquisition costs as costs are incurred.

1Note 13. Commitments and Contingencies

In the normal course of business, the Bank is a party to financial instruments that are not reflected in the accompanying financial statements and are commonly referred to as off-balance-sheet instruments. These financial instruments are entered into primarily to meet the financing needs of the Bank’s customers and include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the consolidated balance sheet.

The Corporation’s exposure to credit loss in the event of nonperformance by other parties to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contract or notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments.

The Bank had the following outstanding commitments for the periods presented:


	June 30,		December 31,
(Dollars in thousands)	2019		2018
Financial instruments whose contract amounts represent credit risk
Commercial commitments to extend credit	$	270,082	$	216,913
Consumer commitments to extend credit (secured)		51,252		49,221
Consumer commitments to extend credit (unsecured)		5,392		5,605
	$	326,726	$	271,739
Standby letters of credit	$	27,382	$	25,429

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses with the exception of home equity lines and personal lines of credit and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank, is based on Management’s credit evaluation of the counterparty. Collateral for most commercial commitments varies but may include accounts receivable, inventory, property, plant, and equipment, and income-producing commercial properties. Collateral for secured consumer commitments consists of liens on residential real estate.

Standby letters of credit are instruments issued by the Bank, which guarantee the beneficiary payment by the Bank in the event of default by the Bank’s customer in the nonperformance of an obligation or service. Most standby letters of credit are extended for one-year periods. Generally, the credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds collateral supporting those commitments for which collateral is deemed necessary primarily in the form of certificates of deposit and liens on real estate. Management believes that the proceeds obtained through a liquidation of such collateral would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018 which remains at June 30, 2019. Except for the liability recorded for standby letters of credit, liabilities for credit loss associated with off-balance sheet commitments were not material at June 30, 2019 and December 31, 2018.

Most of the Bank’s business activity is with customers located within its primary market and does not involve any significant concentrations of credit to any one entity or industry.

Legal Proceedings

The nature of the Corporation’s business generates a certain amount of litigation.

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 the amount of the loss can be reasonably estimated. When we are able to do so, we also determine estimates of possible losses, whether in excess of any accrued liability or where there is no accrued liability.

These assessments are based on 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 the 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 any legal proceeding. Our exposure and ultimate losses may be higher, possibly significantly higher, than amounts we may accrue or amounts we may estimate.

In management’s opinion, we do not anticipate, at the present time, that the ultimate aggregate liability, if any, arising out of all litigation to which the Corporation is a party at this time will have a material adverse effect on our financial position. We cannot now determine, however, whether or not any claim asserted against us will have a material adverse effect on our results of operations in any future reporting period, which will depend on, amount other things, the amount of loss resulting from the claim and the amount of income otherwise reported for the reporting period. Thus, at June 30, 2019, 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 with respect to such other matters and, accordingly, have not yet established any specific accrual for such other matters.

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 Six Months Ended June 30, 2019 and 2018

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. We caution readers not to place undue reliance on these forward-looking statements. They only reflect management’s analysis as of this date. The Corporation does not revise or update these forward-looking statements to reflect events or changed circumstances.

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 2018 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 2018 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

Reported net income of $4.0 million for the second quarter and $7.2 million year-to-date

Diluted earnings per share increased to $.90 for the second quarter, from -$1.18 in the second quarter of 2018. Year-to-date diluted earnings per share was $1.63 compared to -$.38 for the same period in 2018.

Net interest income increased $464 thousand quarter over quarter and $1.1 million year over year due to the growth in interest income which outpaced higher interest expense.

A provision for loan loss expense was not recorded during the second quarter of 2019; however, due to slower loan growth, the Bank maintained an allowance coverage ratio of 1.28%, which was unchanged from year-end 2018. For the first six months of 2019, the provision for loan loss expense was $399 thousand. The provision for loan loss expense for the second quarter and year-to-date periods in 2018 was affected by the impairment charges on the loan participation initially reported in our current report on Form 8-K filed May 31, 2018.

Noninterest income increased $475 thousand quarter over quarter and $493 year over year primarily from asset management fees in the Bank’s Investment and Trust Services department ($183 thousand) and gains from the sale of debt securities ($229 thousand).

Noninterest expense decreased $1.6 million quarter over quarter and $820 thousand year over year primarily from the $2.4 million provision expense for credit losses on off-balance sheet exposures in 2018 for the participation, which was offset by increases in salaries and benefits, audit related costs and a building feasibility study.

Total assets were $1.252 billion at June 30, 2019, an increase of $42.6 million from the 2018 year-end balance of $1.210 billion

The loan portfolio increased approximately $9.1 million due to growth in commercial real estate loans for land development.

A lease liability and a right-of-use asset of $6.2 million were initially recognized in 2019.

Deposits increased $30.4 million primarily in interest-bearing commercial deposits.

Shareholders’ equity increased $5.5 million due to net income of $7.2 million and a $1.9 million increase in other comprehensive income for the year, partially offset by year-to-date dividends of $2.5 million.

Key performance ratios as of, or for the six months ended June 30, 2019 and 2018 and the year ended December 31, 2018 are listed below:


	June 30,		December 31,		June 30,
	2019		2018		2018
(Dollars in thousands, except per share)

Balance Sheet Highlights
Total assets	$	1,252,141	$	1,209,587	$	1,177,541
Investment and equity securities		129,812		131,846		128,302
Loans, net		969,904		960,960		954,814
Deposits		1,113,049		1,082,629		1,057,680
Shareholders' equity		123,914		118,396		111,172

Summary of Operations
Interest income	$	24,383	$	44,868	$	21,541
Interest expense		3,493		4,214		1,749
Net interest income		20,890		40,654		19,792
Provision for loan losses		399		9,954		9,329
Net interest income after provision for loan losses		20,491		30,700		10,463
Noninterest income		6,862		12,629		6,369
Noninterest expense		19,017		37,369		19,837
Income before income taxes		8,336		5,960		(3,005)
Federal income tax (benefit) expense		1,115		(165)		(1,326)
Net income	$	7,221	$	6,125	$	(1,679)

Performance Measurements
Return on average assets*		1.18%		0.52%		-0.29%
Return on average equity*		12.02%		5.34%		-2.89%
Return on average tangible equity (1)*		13.00%		5.80%		-3.13%
Efficiency ratio (1)		67.34%		68.27%		73.96%
Net interest margin*		3.80%		3.78%		3.75%

Shareholders' Value (per common share)
Diluted earnings per share	$	1.63	$	1.39	$	(0.38)
Basic earnings per share		1.64		1.40		(0.38)
Regular cash dividends declared		0.57		1.05		0.51
Book value		28.21		26.85		25.36
Tangible book value (1)		26.21		24.81		23.31
Market value (2)		38.24		31.50		34.25
Market value/book value ratio		135.55%		117.32%		135.06%
Price/earnings multiple*		11.73		22.66		N/A
Current quarter dividend yield		3.14%		3.43%		3.15%
Dividend payout ratio year-to-date		34.75%		75.07%		-132.58%

Safety and Soundness
Risk-based capital ratio (Total)		15.19%		15.21%		14.51%
Leverage ratio (Tier 1)		9.63%		9.78%		9.32%
Common equity ratio (Tier 1)		13.93%		13.96%		13.25%
Nonperforming loans/gross loans		0.59%		0.27%		0.59%
Nonperforming assets/total assets		0.68%		0.44%		0.71%
Allowance for loan losses as a % of loans		1.28%		1.28%		1.29%
Net loans charged-off/average loans*		0.05%		0.97%		1.82%

Assets under Management
Trust assets under management (fair value)	$	763,237	$	684,825	$	695,860
Held at third-party brokers (fair value)		125,448		122,213		134,366

*Year-to-date annualized

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

(2) Based on the closing price of FRAF as quoted on the Nasdaq Capital Market for June 30, 2019, and the OTCQX for all prior periods.

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 (Goodwill), 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)	Six Months Ended		Twelve Months Ended		Six Months Ended
	June 30, 2019		December 31, 2018		June 30, 2018
Return on Tangible Equity (non-GAAP)
Net income	$	7,221	$	6,125	$	(1,679)

Average shareholders' equity		120,128		114,625		116,194
Less average intangible assets		(9,016)		(9,016)		(9,016)
Average shareholders' equity (non-GAAP)		111,112		105,609		107,178

Return on average tangible equity (non-GAAP)*		13.00%		5.80%		-3.13%

Tangible Book Value (per share) (non-GAAP)
Shareholders' equity	$	123,914	$	118,396	$	111,172
Less intangible assets		(9,016)		(9,016)		(9,016)
Shareholders' equity (non-GAAP)		114,898		109,380		102,156

Shares outstanding (in thousands)		4,383		4,409		4,383

Tangible book value (non-GAAP)		26.21		24.81		23.31

Efficiency Ratio
Noninterest expense	$	19,017	$	37,369	$	19,837

Net interest income		20,890		40,654		19,792
Plus tax equivalent adjustment to net interest income		756		1,522		751
Plus noninterest income, net of securities transactions		6,593		12,564		6,279
Total revenue		28,239		54,740		26,822

Efficiency ratio (Noninterest expense/total revenue)		67.34%		68.27%		73.96%

* Year-to-date annualized

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 21% Federal statutory rate.

Comparison of the three months ended June 30, 2019 to the three months ended June 30, 2018:

Tax equivalent net interest income increased $449 thousand to $10.9 million in the second quarter of 2019 compared to $10.5 million in the same period in 2018. Balance sheet volume contributed $346 thousand to this increase and $103 thousand was the result of changes in rates.

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 21%.


	For the Three Months Ended June 30,
	2019					2018

	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	$	66,267	$	403	2.44%	$	21,719	$	100	1.85%
Investment securities:
Taxable		85,825		587	2.74%		84,945		532	2.51%
Tax Exempt		41,913		353	3.38%		47,438		372	3.13%
Investments		127,738		940	2.95%		132,383		904	2.74%
Loans:
Commercial, industrial and agricultural		836,751		9,754	4.63%		814,206		8,817	4.30%
Residential mortgage		69,806		741	4.25%		70,404		720	4.09%
Home equity loans and lines		64,808		839	5.19%		68,963		818	4.76%
Consumer		5,771		87	6.05%		5,062		77	6.10%
Loans		977,136		11,421	4.65%		958,635		10,432	4.33%
Total interest-earning assets		1,171,141	$	12,764	4.37%		1,112,737	$	11,436	4.12%
Other assets		71,890					63,883
Total assets	$	1,243,031				$	1,176,620

Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	318,412	$	302	0.38%	$	298,987	$	220	0.30%
Money Management		414,949		1,066	1.03%		405,167		529	0.52%
Savings		82,977		106	0.51%		83,171		76	0.37%
Time		93,927		359	1.53%		68,105		127	0.75%
Total interest-bearing deposits		910,265		1,833	0.81%		855,430		952	0.45%

Other borrowings		—		—	—		392		2	2.14%
Total interest-bearing liabilities		910,265		1,833	0.81%		855,822		954	0.45%
Noninterest-bearing deposits		196,355					192,403
Other liabilities		14,960					11,151
Shareholders' equity		121,451					117,244
Total liabilities and shareholders' equity	$	1,243,031				$	1,176,620
T/E net interest income/Net interest margin				10,931	3.74%				10,482	3.78%
Tax equivalent adjustment				(368)					(383)
Net interest income			$	10,563				$	10,099

Net Interest Spread					3.56%					3.67%
Cost of Funds					0.66%					0.37%

Provision for Loan Losses

Following its second quarter assessment and analysis, the Bank took no provision for loan loss expense for the second quarter due to slower loan growth, compared to $9.1 million in 2018. During the second quarter of 2018, $8.7 million of a loan participation was charged-off resulting in an increase in the provision for loan loss expense to replenish the allowance for loan losses. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the second quarter of 2019, noninterest income increased $475 thousand from the same period in 2018. Investment and trust service fees increased due to growth in assets under management. Deposit service charges increased due to a higher volume of account analysis fees and retail checking fees, partially offset by lower fees from the Bank’s overdraft protection program. Other service charges and fees were higher from increased income from the Bank’s merchant card and credit card programs, as well as ATM fees. Debit card income was higher due to an increase in transaction volume. Gains on the sale of debt securities increased $177 thousand, as the Bank sold municipal bonds due to improved market conditions and in part to offset the expense of a building feasibility study and certain audit related costs in the second quarter of 2019. The change in the fair value of equity investments recorded through income was a gain of $13 thousand compared to a loss of $7 thousand in the same period in 2018.

The following table presents a comparison of noninterest income for the three months ended June 30, 2019 and 2018


	For the Three Months Ended
	June 30,				Change
(Dollars in thousands)	2019		2018		Amount		%
Noninterest Income
Investment and trust services fees	$	1,647	$	1,464	$	183	12.5
Loan service charges		228		217		11	5.1
Deposit service charges and fees		603		574		29	5.1
Other service charges and fees		381		353		28	7.9
Debit card income		464		417		47	11.3
Increase in cash surrender value of life insurance		128		129		(1)	(0.8)
Debt securities gains, net		229		52		177	340.4
Change in fair value of equity securities		13		(7)		20	(285.7)
Other		3		22		(19)	(86.4)
Total noninterest income	$	3,696	$	3,221	$	475	14.7

Noninterest Expense

Noninterest expense for the second quarter of 2019 decreased $1.6 million compared to the same period in 2018. The increase in salaries and benefits was primarily due to an increase in salary expense ($351 thousand) from merit increases and incentive plans ($32 thousand), offset by a decrease in health insurance expense ($160 thousand) compared to the same period in 2018. Marketing increased due to digital and social marketing initiatives. Data processing increased due to increased mobile banking offerings and software purchased to improve processes and create efficiencies. FDIC insurance expense decreased due to a reduction in the Bank’s base assessment rate. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018 which remains at June 30, 2019. Other expenses increased related to the expense of a building feasibility study.

The following table presents a comparison of noninterest expense for the three months ended June 30, 2019 and 2018


	For the Three Months Ended
(Dollars in thousands)	June 30,				Change
Noninterest Expense	2019		2018		Amount		%
Salaries and benefits	$	5,355	$	5,096	$	259	5.1
Net occupancy		858		787		71	9.0
Advertising		481		341		140	41.1
Legal and professional		471		442		29	6.6
Data processing		738		604		134	22.2
Pennsylvania bank shares tax		243		234		9	3.8
FDIC insurance		115		164		(49)	(29.9)
ATM/debit card processing		247		237		10	4.2
Foreclosed real estate		(12)		41		(53)	(129.3)
Telecommunications		107		124		(17)	(13.7)
Provision for credit losses on off-balance sheet exposures		—		2,361		(2,361)	(100.0)
Other		1,003		757		246	32.5
Total noninterest expense	$	9,606	$	11,188	$	(1,582)	(14.1)

Provision for Income Taxes

For the second quarter, the Corporation recorded a Federal income tax expense of $669 thousand compared to a tax benefit of $1.8 million for the same quarter in 2018. The tax benefit was the result of a pre-tax loss due to the large provision for loan loss expense to replenish the allowance for loan losses from the $8.7 million loan participation charge-off in the second quarter of 2018. The effective tax rate for the second quarter of 2019 was 14.4%. The federal statutory tax rate is 21% for 2019 and 2018.

Comparison of the six months ended June 30, 2019 to the six months ended June 30, 2018:

Tax equivalent net interest income increased $1.1 million to $21.6 million in the first half of 2019 compared to $20.5 million in the same period in 2018. Balance sheet volume contributed $676 thousand to this increase and $427 thousand was the result of changes in rates.


	For the Six Months Ended June 30,
	2019					2018

	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	$	40,831	$	499	2.46%	$	25,577	$	218	1.72%
Investment securities:
Taxable		84,071		1,130	2.71%		85,859		1,051	2.47%
Tax Exempt		46,514		780	3.35%		45,854		716	3.12%
Investments		130,585		1,910	2.95%		131,713		1,767	2.71%
Loans:
Commercial, industrial and agricultural		837,326		19,398	4.62%		800,984		17,078	4.25%
Residential mortgage		69,637		1,492	4.28%		71,162		1,453	4.08%
Home equity loans and lines		65,391		1,671	5.15%		70,186		1,626	4.67%
Consumer		5,449		169	6.25%		5,069		150	5.97%
Loans		977,803		22,730	4.64%		947,401		20,307	4.28%
Total interest-earning assets		1,149,219	$	25,139	4.41%		1,104,691	$	22,292	4.07%
Other assets		69,815					63,366
Total assets	$	1,219,034				$	1,168,057

Interest-bearing liabilities:
Deposits:
Interest-bearing checking	$	307,161	$	565	0.37%	$	290,252	$	397	0.28%
Money Management		419,932		2,112	1.01%		410,830		972	0.48%
Savings		82,072		213	0.52%		81,720		132	0.33%
Time		83,263		567	1.37%		69,769		246	0.71%
Total interest-bearing deposits		892,428		3,457	0.78%		852,571		1,747	0.41%

Other borrowings		2,678		36	2.61%		208		2	2.13%
Total interest-bearing liabilities		895,106		3,493	0.79%		852,779		1,749	0.41%
Noninterest-bearing deposits		190,117					184,794
Other liabilities		13,683					14,290
Shareholders' equity		120,128					116,194
Total liabilities and shareholders' equity	$	1,219,034				$	1,168,057
T/E net interest income/Net interest margin				21,646	3.80%				20,543	3.75%
Tax equivalent adjustment				(756)					(751)
Net interest income			$	20,890				$	19,792

Net Interest Spread					3.62%					3.66%
Cost of Funds					0.65%					0.34%

Provision for Loan Losses

Provision for loan loss expense for the first half was $399 thousand compared to $9.3 million in 2018. During the second quarter of 2018, $8.7 million of a loan participation was charged-off resulting in an increase in the provision for loan loss expense to replenish the allowance for loan losses. For more information refer to the Loan Quality and Allowance for Loan Losses discussion in the Financial Condition section.

Noninterest Income

For the first half of 2019, noninterest income increased $493 thousand from the same period in 2018. Investment and trust service fees increased due to growth in assets under management. Loan service charges were less than the same period in 2018 due to a lower volume of commercial loan originations. Other service charges and fees were higher from increased income from the Bank’s merchant card and credit card programs as well as ATM fees. Debit card income was

higher due to an increase in transaction volume. Gains on the sale of debt securities increased $201 thousand, as the Bank sold municipal bonds due to improved market conditions and in part to offset the expense of a building feasibility and certain audit related costs. The change in the fair value of equity investments recorded through income was a gain of $16 thousand compared to a gain of $38 thousand in the same period in 2018.

The following table presents a comparison of noninterest income for the six months ended June 30, 2019 and 2018.


	For the Six Months Ended
	June 30,				Change
(Dollars in thousands)	2019		2018		Amount		%
Noninterest Income
Investment and trust services fees	$	3,099	$	2,861	$	238	8.3
Loan service charges		431		449		(18)	(4.0)
Deposit service charges and fees		1,149		1,148		1	0.1
Other service charges and fees		734		686		48	7.0
Debit card income		866		802		64	8.0
Increase in cash surrender value of life insurance		255		257		(2)	(0.8)
Debt securities gains, net		253		52		201	386.5
Change in fair value of equity securities		16		38		(22)	(57.9)
Other		59		76		(17)	(22.4)
Total noninterest income	$	6,862	$	6,369	$	493	7.7

Noninterest Expense

Noninterest expense for the first half of 2019 decreased $820 thousand compared to the same period in 2018. The increase in salaries and benefits was primarily due to an increase in salary expense ($740 thousand) from merit increases and incentive plans ($122 thousand), offset by a decrease in health insurance ($147 thousand) compared to the same period in 2018. The increase in legal and professional fees was due to increased audit related costs for additional regulatory filings and the change to a new external audit firm during the second half of 2019. Data processing increased due to increased mobile banking offerings and software purchased to improve processes and create efficiencies. FDIC insurance expense decreased due to a reduction in the Bank’s base assessment rate. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower that declared bankruptcy in the second quarter of 2018 which remains at June 30, 2019. Other expenses increased related to the expense of a building feasibility study, Nasdaq listing fee, increased director’s fees and recruiting fees.

The following table presents a comparison of noninterest expense for the six months ended June 30, 2019 and 2018.


	For the Six Months Ended
(Dollars in thousands)	June 30,				Change
Noninterest Expense	2019		2018		Amount		%
Salaries and employee benefits	$	10,797	$	10,082	$	715	7.1
Net occupancy		1,715		1,602		113	7.1
Advertising		883		768		115	15.0
Legal and professional		901		771		130	16.9
Data processing		1,443		1,200		243	20.3
Pennsylvania bank shares tax		486		473		13	2.7
FDIC insurance		180		293		(113)	(38.6)
ATM/debit card processing		505		476		29	6.1
Foreclosed real estate		5		55		(50)	(90.9)
Telecommunications		211		232		(21)	(9.1)
Provision for credit losses on off-balance sheet exposures		—		2,361		(2,361)	(100.0)
Other		1,891		1,524		367	24.1
Total noninterest expense	$	19,017	$	19,837	$	(820)	(4.1)

Provision for Income Taxes

For the first half of 2019, the Corporation recorded a Federal income tax expense of $1.1 million compared to a tax benefit of $1.3 million for the same period in 2018. The tax benefit was the result of a pre-tax loss due to the large provision for loan loss expense to replenish the allowance for loan losses from the $8.7 million loan participation charge-off in 2018. The effective tax rate for 2019 was 13.4%. The federal statutory tax rate is 21% for 2019 and 2018.

Financial Condition

Cash and Cash Equivalents:

Cash and cash equivalents totaled $82.4 million at June 30, 2019, an increase of $29.4 million from the prior year-end balance of $53.0 million. The increase was mainly due to higher interest bearing balances at the Federal Reserve. Interest-bearing deposits are held primarily at the Federal Reserve ($54.4 million) and in short-term bank owned certificates of deposit ($9.2 million).

Investment Securities:

AFS Securities: The AFS securities portfolio has decreased $4.4 million on a cost basis, since year-end 2018. 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 47% and 36% of the portfolio fair value, respectively. The average life of the portfolio was 4.28 years.

The AFS securities portfolio had a net unrealized gain of $1.3 million at June 30, 2019 compared to a net unrealized loss of $1.1 million at the prior year-end. The portfolio averaged $130.6 million with a yield of 2.95% for the first six months of 2019. This compares to an average of $131.7 million and a yield of 2.71% for the same period in 2018.

The municipal bond portfolio is well diversified geographically (issuers from within 27 states) and is comprised primarily of general obligation bonds (62.3%). Many municipal bonds have credit enhancements in the form of private bond insurance or other credit support. The largest geographic municipal bond exposure is in the states of Texas (14.3%), New York (8.8%), and Indiana (7.4%). The average rating of the municipal portfolio from Moody’s is AA. No municipal bonds are rated below investment grade.

The unrealized loss in the municipal bond portfolio decreased to $46 thousand from $484 thousand at December 31, 2018 as interest rates rose during the year. There are eight 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.

The trust preferred portfolio contains five securities with a fair value of $3.9 million and an unrealized loss of $189 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 June 30, 2019, 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.

Equity securities at Fair Value: The Corporation owns one equity investment. At June 30, 2019 and December 31, 2018, this investment was reported at fair value of $390 thousand and $374 thousand, respectively, with changes in value reported through income.

Restricted Stock at Cost: The Bank held $465 thousand of restricted stock at June 30, 2019. 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.

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 $4.2 million over year-end 2018, as the Bank retained a lower percentage of its originations. For the first six months of 2019, the Bank originated $16.8 million and sold $16.3 million in mortgages 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 ($10.6 million), while loans for individuals to construct personal residences totaled $3.5 million at June 30,

2019. 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 June 30, 2019, the Bank had $20.0 million in real estate construction loans funded with an interest reserve and capitalized $130 thousand of interest in 2019 from these reserves on active projects. These loans were comprised of $2.5 million in residential construction and $17.5 million in commercial construction. 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 $505.7 million from $488.0 million at the end of 2018, an increase of $17.7 million. The increase was primarily in land development loans. The largest sectors (by collateral) in the commercial real estate category are: hotels and motels ($74.1 million), office buildings ($62.4 million), land development ($52.7 million), manufacturing facilities ($41.4 million) and warehouse facilities ($31.6 million).

Commercial (C&I): This category includes commercial, industrial, farm, agricultural, and municipal loans. C&I loans decreased $9.2 million to $264.9 million at June 30, 2019, compared to $274.1 million at the end of 2018, primarily due to a $3.9 million tax free loan pay-off in the first quarter of 2019 and a $4.1 million pay-off in the second quarter. At June 30, 2019, the Bank had approximately $160 million in tax-free loans in the C&I portfolio. The largest sectors (by industry) in the commercial C&I category are: public administration ($83.1 million), utilities ($34.5 million), educational services ($25.2 million) and real estate rental and leasing ($16.4 million). The Bank expects that commercial lending will continue to be the primary area of loan growth in the future via in-market lending.

Participations: The Bank may supplement its own commercial loan production by purchasing loan participations. These participations are primarily located in south-central Pennsylvania. At June 30, 2019, the outstanding commercial participations accounted for 8.8%, or $86.1 million, of total gross loans compared to 9.6% and $93.4 million at December 31, 2018. The Bank’s total exposure (including outstanding balances and unfunded commitments) to purchased participations is $108.9 million, compared to $120.4 million at December 31, 2018. The commercial loan participations are comprised of $19.2 million of C&I loans and $66.9 million of CRE loans, reported in the respective loan class. The above results indicate that Management has been executing its strategy to emphasize loan originations over purchasing participations.

Consumer loans: This category remained unchanged over year-end and is mainly comprised of unsecured personal lines of credit.

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



	June 30,		December 31,			Change
(Dollars in thousands)	2019		2018			Amount	%
Residential Real Estate 1-4 Family
Consumer first liens	$	88,069	$	89,673	$	(1,604)	(1.8)
Commercial first lien		58,202		59,227		(1,025)	(1.7)
Total first liens		146,271		148,900		(2,629)	(1.8)

Consumer junior liens and lines of credit		40,754		42,504		(1,750)	(4.1)
Commercial junior liens and lines of credit		4,878		4,716		162	3.4
Total junior liens and lines of credit		45,632		47,220		(1,588)	(3.4)
Total residential real estate 1-4 family		191,903		196,120		(4,217)	(2.2)

Residential real estate - construction
Consumer		3,487		1,667		1,820	109.2
Commercial - land development		10,601		8,558		2,043	23.9
Total residential real estate construction		14,088		10,225		3,863	37.8

Commercial real estate		505,653		487,980		17,673	3.6
Commercial		264,862		274,054		(9,192)	(3.4)
Total commercial		770,515		762,034		8,481	1.1

Consumer		5,951		4,996		955	19.1
		982,457		973,375		9,082	0.9
Less: Allowance for loan losses		(12,553)		(12,415)		(138)	1.1
Net Loans	$	969,904	$	960,960	$	8,944	0.9

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 three primary measurements: (1) loans rated 6-Special Mention or worse (collectively “watch list”), (2) delinquent loans, and (3) net-charge-offs.,

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 $9.9 million at quarter end, compared to $10.3 million at December 31, 2018. The watch list includes both performing and nonperforming loans. It is comprised entirely of loans rated 7-Substandard. Included in the substandard total are $5.3 million of nonaccrual loans. The credit composition of the watch list (loans rated 6, 7, or 8), by primary collateral is shown in Note 6 of the accompanying financial statements.

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.

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 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. However, in certain instances, the Bank may make a loan that exceeds the supervisory loan-to-value limit. At June 30, 2019 the Bank had loans of $18.3 million (1.9% of gross loans) that exceeded the supervisory limit, the same percentage as at year-end 2018.

Loan quality has declined slightly since year-end 2018, as measured by the balance of nonaccrual loans. Nonaccrual loans increased $3.0 million from year-end 2018 as one commercial real estate credit (current balance of $3.2 million) moved from 60-89 days past due to nonaccrual during the first quarter of 2019. Potential problem loans, defined as watch list loans less loans on nonaccrual or past due more than 90 days declined to $4.2 million at June 30, 2019 compared to $7.6 million at December 31, 2018 as a result of the commercial real estate loan moving to nonaccrual. The following table presents a summary of nonperforming assets as of:


	June 30,		December 31,
(Dollars in thousands)	2019		2018

Nonaccrual loans
Residential Real Estate 1-4 Family
First liens	$	80	$	80
Junior liens and lines of credit		26		23
Total		106		103
Residential real estate - construction		647		455
Commercial real estate		4,414		1,427
Commercial		145		315
Total nonaccrual loans		5,312		2,300

Loans past due 90 days or more and still accruing
Residential Real Estate 1-4 Family
First liens		28		113
Junior liens and lines of credit		—		26
Total		28		139
Commercial real estate		332		113
Commercial		—		100
Consumer		—		5
Total loans past due 90 days or more and still accruing		360		357

Total nonperforming loans		5,672		2,657

Other real estate owned		2,684		2,684
Total nonperforming assets	$	8,356	$	5,341

Nonperforming loans to total gross loans		0.58%		0.27%
Nonperforming assets to total assets		0.67%		0.44%
Allowance for loan losses to nonperforming loans		221.32%		467.26%

The following table identifies the most significant loans in nonaccrual status. These two nonaccrual loans account for 85% of the total nonaccrual balance.

(Dollars in thousands)

ALL

Nonaccrual

TDR

Collateral

Balance

Reserve

Date

Status

Collateral

Location

Value (1)

Credit 1

1,370

—

Mar-12

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

2,995

Credit 2

3,169

—

Mar-19

land for residential development, residential and commercial real estate

3,574

4,539

—

(1) Includes any estimated discount on appraised value and cost to sell.

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 increased to $14.4 million at quarter-end compared to $11.9 million at year-end 2018, primarily from the new nonaccrual loan previously discussed.

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


	June 30, 2019
(Dollars in thousands)	Nonaccrual				Accruing			Accruing	Total
	Non-TDR		TDR		TDR			Other (1)	Impaired
Residential Real Estate 1-4 Family
First liens	$	80	$	—	$	667	$	29	$	776
Junior liens and lines of credit		26		—		—		—		26
Total		106		—		667		29		802
Residential real estate - construction		198		449		—		—		647
Commercial real estate		3,171		1,243		8,351		—		12,765
Commercial		145		—		—		—		145
Total	$	3,620	$	1,692	$	9,018	$	29	$	14,359

(1) impaired consumer purpose loans not on nonaccrual

Allowance for Loan Losses:

Management monitors loan performance on a monthly basis and 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. 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 placed on nonaccrual and 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 June 30, 2019 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 three components; specific, general and unallocated. 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. However, it is possible that as a result of the credit analysis, a specific reserve is not required for an impaired loan. For impaired 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 $749 thousand at June 30, 2019 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. There was no specific reserve established for any of the impaired loans. Note 6 of the accompanying financial statements provides 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 segments 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. Each segment may be further segregated by type of collateral, lien position, or owner/nonowner occupied properties. The quantitative analysis uses the Bank’s twenty quarter rolling historical loan loss experience as determined for each loan segment to determine a loss factor applicable to each loan segment. The qualitative analysis utilizes a risk matrix that incorporates four primary risk factors: economic conditions, delinquency, classified loans, and level of risk, and assigns a risk level (as measured in basis points) to each factor. In determining the risk level for these primary factors, consideration is given to operational factors such as: loan volume, management, loan review process, credit concentrations, competition, and legal and regulatory issues. The level of risk (as measured in basis points) for each primary factor is set for five risk levels ranging from minimal risk to very high risk and is determined independently for commercial loans, residential mortgage loans and consumer loans.

The unallocated component is maintained to cover uncertainties that could affect Management’s estimate of probable loss. The unallocated component of the ALL reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

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 nonaccrual and a 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. We believe this practice complies with the regulatory guidance.

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 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.

The following table shows the ALL and charge-off ratios for the periods ended:


	Six Months Ended		Year ended			Six Months Ended
	June 30, 2019			December 31, 2018		June 30, 2018
Net charge-offs (recoveries)/average loans*		0.05%			0.97%		1.82%
Net loan charge-offs (recoveries) as a percentage of the provision for loan losses		65.41%			93.74%		92.60%
Allowance for loan losses as a % of loans		1.28%			1.28%		1.29%
Net charge-offs (recoveries)	$	261		$	9,331	$	8,639
* Annualized

Other Real Estate Owned:

The Bank holds $2.7 million of other real estate owned (OREO), comprised of two properties. The most significant OREO holding is one property carried at $2.6 million (97% of total OREO) that is secured by 196 acres of land intended for residential real estate development. The Bank has a contract on the property that is expected to settle in 2019 with no loss to the Bank. During 2019, the expense to hold and maintain OREO was $5 thousand. Note 8 of the accompanying financial statements provides additional information on activity in OREO.

Deposits:

Total deposits increased $30.4 million during the first six months of 2019 to $1.113 billion. Non-interest bearing deposits decreased $7.0 million (primarily in commercial checking deposits) and interest-bearing checking deposits remained flat, while time deposits increased $24.4 million. Interest bearing checking increased by $25.7 million, primarily in commercial deposits while the Bank’s Money Management product decreased $30.3 million, primarily in retail accounts as customers moved funds to higher rate time deposits. Time deposits increased since year-end from CD promotions.

As of June 30, 2019, the Bank had $183.4 million placed in the ICS program ($141.1 million in interesting-bearing checking and $42.3 million in money management) and $3.2 million in reciprocal time deposits in the CDARS program included in 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.


	June 30,		December 31,			Change
(Dollars in thousands)	2019		2018			Amount	%
Noninterest-bearing checking	$	204,386	$	197,417	$	6,969	3.5

Interest-bearing checking		331,364		305,661		25,703	8.4
Money management		406,473		436,752		(30,279)	(6.9)
Savings		84,809		81,206		3,603	4.4
Total interest-bearing checking and savings		822,646		823,619		(973)	(0.1)

Time deposits		86,017		61,593		24,424	39.7

Total deposits	$	1,113,049	$	1,082,629	$	30,420	2.8

Overdrawn deposit accounts reclassified as loans	$	168	$	120

Borrowings:

The Corporation had no short-term borrowings at June 30, 2019 and December 31, 2018.

Shareholders’ Equity:

Total shareholders’ equity increased $5.5 million to $123.9 million at June 30, 2019, from $118.4 million at the end of 2018. The Corporation’s net earnings of $7.2 million were partially offset by the cash dividend of $2.5 million. The Corporation’s Dividend Reinvestment Plan (DRIP) added $322 thousand in new capital from optional cash contributions and $400 thousand from the reinvestment of quarterly dividends. The Corporation’s dividend payout ratio was 34.75% for the first six months of 2019.

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 first half of 2019, the Corporation paid a $0.57 per share

dividend, compared to $0.51 paid in the first half of 2018. On July 11, 2019 the Board of Directors declared a $0.30 per share regular quarterly dividend for the third quarter of 2019, which will be paid on August 28, 2019.

On December 20, 2018, the Board of Directors authorized the 2018 Repurchase Plan for the repurchase of up to 100,000 shares of the Corporation’s $1.00 par value common stock at market prices in open market or privately negotiated transactions beginning December 21, 2018 and continuing through December 21, 2019. During the first half months of 2019, 54,153 shares were repurchased. No shares were repurchased in the first half of 2018. The 2017 Repurchase Plan expired on 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 was 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 June 30, 2019 was 7.19% (total risk-based capital 15.19% less 8.00%) compared to the 2018 regulatory buffer of 2.50%. Compliance with the capital conservation buffer is required in order to avoid limitations to certain capital distributions and is in addition to the Basel III capital requirements. As of June 30, 2019, 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 the Basel III regulatory capital requirements and results as of June 30, 2019 and December 31, 2018 for the Corporation and the Bank:


			Regulatory Ratios
			Adequately	Well
	June 30,	December 31,	Capitalized	Capitalized
(Dollars in thousands)	2019	2018	Minimum	Minimum

Common Equity Tier 1 Risk-based Capital Ratio (1)
Franklin Financial Services Corporation	13.93%	13.96%	4.500%	N/A
Farmers & Merchants Trust Company	13.77%	13.80%	4.500%	6.50%

Tier 1 Risk-based Capital Ratio (2)
Franklin Financial Services Corporation	13.93%	13.96%	6.000%	N/A
Farmers & Merchants Trust Company	13.77%	13.80%	6.000%	8.00%

Total Risk-based Capital Ratio (3)
Franklin Financial Services Corporation	15.19%	15.21%	8.000%	N/A
Farmers & Merchants Trust Company	15.02%	15.06%	8.000%	10.00%

Tier 1 Leverage Ratio (4)
Franklin Financial Services Corporation	9.63%	9.78%	4.000%	N/A
Farmers & Merchants Trust Company	9.52%	9.68%	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 249,000 in Cumberland County. Unemployment in the Bank’s market area has remained virtually unchanged over the past year and ranges from a low of 2.4% in Cumberland County to 4.0% 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 PA 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



	June 30,	December 31,
	2019	2018
Unemployment Rate (seasonally adjusted)
Market area range (1)	2.4% - 4.0%	3.0 - 4.5%
Pennsylvania	3.8%	4.0%
United States	3.4%	3.7%

Housing Price Index - year over year change
PA, nonmetropolitan statistical area	2.4%	3.6%
United States	5.5%	6.6%

Building Permits - year over year change -12 months
Harrisburg-Carlisle, PA MSA & Chambersburg-Waynesboro, PA MSA
Residential, estimated	-4.1%	15.9%
Multifamily, estimated	-20.9%	136.0%

(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. At its July 31, 2019 meeting, the FOMC lowered the Fed Funds rate by .25%. There were two dissenting votes against the rate cut. The FOMC statement regarding future rate adjustments will take into account a wide range of information, including labor market conditions, inflation expectations and international developments. With this cut by the FOMC, the prime lending rate charged by banks is expected to be lowered.

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 unencumbered (approximately $69.5 million fair value) 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. 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 June 30, 2019 was $371.9 million with $371.9 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 $17.1 million. The Bank also has a $6.0 million unsecured line of credit at a correspondent bank.

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 $354.1 million and $271.7 million, respectively, at June 30, 2019 and December 31, 2018. As of June 30, 2018, the Bank established a $2.4 million allowance against letters of credit issued in connection with a commercial borrower (related to the loan participation that was initially reported in our current report on Form 8-K filed May 31, 2018) that declared bankruptcy, as the result of internal fraud, in the second quarter of 2018 which remains at June 30, 2019.

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 2018 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 six months ended June 30, 2019. For more information on market risk refer to the Corporation’s 2018 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 June 30, 2019, 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 June 30, 2019, 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. In management’s opinion, there are no proceedings pending to which the Corporation is a party or to which its property is subject which, if determined adversely to the Corporation, would be material. No material proceedings are pending or are known to be threatened or contemplated against us by any governmental authorities.

As described in our current report on Form 8-K filed on August 3, 2018, the court entered an order on July 31, 2018 granting final approval of the settlement agreements in the Kalan et al. v. Farmers and Merchants Trust Company of Chambersburg, et al. (Case No. 2:15-CV-01435-WB) case filed against F&M Trust in the United States District Court for the Eastern District of Pennsylvania in March, 2015 and described in our current reports on Form 8-K filed July 29, 2016, July 28, 2017, November 3, 2017, January 2, 2018, April 13, 2018, May 7, 2018 and August 3, 2018. Among other things, the order also dismissed the case against F&M Trust with prejudice; certified the settlement class; and, permanently enjoined the named plaintiffs and the members of the settlement class from asserting any further claims arising out of or related to the claims alleged or that could have been alleged in the case against F&M Trust. The settlement agreements provide for the Bank to make a settlement payment of $10.0 million in full and final settlement of all such claims. The settlement agreements further provide for general releases by all parties. F&M Trust made the settlement payment in May, 2018, in accordance with the court’s earlier order preliminarily approving the settlement agreements. The Corporation previously accrued the $10.0 million settlement payment as an expense for the year ended December 31, 2017.

Item 1A. Risk Factors

There were no material changes in the Corporation’s risk factors during the six months ended June 30, 2019. For more information, refer to the Corporation’s 2018 Annual Report on Form 10-K.

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


(Dollars in thousands, except per share)
Period	Number of Shares Purchased as Part of Publically Announced Program	Weighted Average Price Paid per Share		Dollar Amount of Shares Purchased as Part of Publically Announced Program	Shares Yet To Be Purchased Under Program
April 2019	21,940	36.83		808	63,507
May 2019	300	38.08		11	63,207
June 2019	17,360	37.32		648	45,847
	39,600		$	1,467

On December 20, 2018, the Board of Directors authorized the 2018 Repurchase Plan for the repurchase of up to 100,000 shares of the Corporation’s $1.00 par value common stock at market prices in open market or privately negotiated transactions beginning December 21, 2018 and continuing through December 21, 2019. The 2018 Repurchase plan was completed in the third quarter of 2019.

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 Current Report on Form 8-K, as filed with the commission on December 21, 2018 and incorporated herein by reference.)

10.1	Franklin Financial Services Corporation 2019 Omnibus Stock Incentive Plan (Incorporated by reference to the Registrant’s Definitive Proxy Statement on Schedule 14A, as filed with the Commission on March 18, 2019.

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



August 2, 2019		/s/ Timothy G. Henry
		Timothy G. Henry
		Chief Executive Office and President
		(Principal Executive Officer)

August 2, 2019		/s/ Mark R. Hollar
		Mark R. Hollar
		Treasurer and Chief Financial Officer
		(Principal Financial and Accounting Officer)