Edgar Filing: CODORUS VALLEY BANCORP INC

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2018

☐ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from____________to______________

Commission file number: 0-15536

CODORUS VALLEY BANCORP, INC.

(Exact name of registrant as specified in its charter)

Pennsylvania	23-2428543
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

105 Leader Heights Road, P.O. Box 2887, York, Pennsylvania 17405

(Address of principal executive offices) (Zip code)

717-747-1519

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year,

if changed since the last report.)

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

Indicate by check mark whether the registrant has submitted electronically 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 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 Exchange Act). Yes ☐ No ☒

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. On October 26, 2018, 8,956,679 shares of common stock, par value $2.50, were outstanding.

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Codorus Valley Bancorp, Inc.

Form 10-Q Index


PART I – FINANCIAL INFORMATION		Page #

Item 1.	Financial statements (unaudited):
	Consolidated balance sheets	3
	Consolidated statements of income	4
	Consolidated statements of comprehensive income	5
	Consolidated statements of cash flows	6
	Consolidated statements of changes in shareholders’ equity	7
	Notes to consolidated financial statements	8

Item 2.	Management’s discussion and analysis of financial condition and results of operations	40

Item 3.	Quantitative and qualitative disclosures about market risk	65

Item 4.	Controls and procedures	66

PART II – OTHER INFORMATION

Item 1.	Legal proceedings	66

Item 1A.	Risk factors	66

Item 2.	Unregistered sales of equity securities and use of proceeds	66

Item 3.	Defaults upon senior securities	66

Item 4.	Mine safety disclosures	66

Item 5.	Other information	67

Item 6.	Exhibits	68

SIGNATURES		69

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Codorus Valley Bancorp, Inc.

Consolidated Balance Sheets


	(Unaudited)
	September 30,			December 31,
(dollars in thousands, except per share data)	2018			2017
Assets
Interest bearing deposits with banks	$	60,421		$	55,566
Cash and due from banks		24,927			23,958
Total cash and cash equivalents		85,348			79,524
Securities, available-for-sale		146,089			158,591
Restricted investment in bank stocks, at cost		6,122			6,311
Loans held for sale		3,795			1,715
Loans (net of deferred fees of $3,866 - 2018 and $4,039 - 2017)		1,494,027			1,399,764
Less-allowance for loan losses		(18,234	)		(16,689	)
Net loans		1,475,793			1,383,075
Premises and equipment, net		24,844			24,382
Goodwill		2,301			2,301
Other assets		56,479			53,306
Total assets	$	1,800,771		$	1,709,205

Liabilities
Deposits
Noninterest bearing	$	258,816		$	246,866
Interest bearing		1,211,443			1,137,641
Total deposits		1,470,259			1,384,507
Short-term borrowings		8,624			20,495
Long-term debt		135,310			130,310
Other liabilities		12,981			9,674
Total liabilities		1,627,174			1,544,986

Shareholders’ equity
Preferred stock, par value $2.50 per share;
1,000,000 shares authorized; 0 shares issued and outstanding		0			0
Common stock, par value $2.50 per share; 30,000,000 shares authorized at
September 30, 2018 and 15,000,000 at December 31, 2017; shares issued:		23,504			22,265
8,954,157 at September 30, 2018 and 8,906,052 at December 31, 2017; and shares outstanding: 8,953,998 at September 30, 2018 and 8,906,052 at December 31, 2017
Additional paid-in capital		134,143			120,052
Retained earnings		19,880			22,860
Accumulated other comprehensive loss		(3,925	)		(958	)
Treasury stock, at cost; 159 shares at September 30, 2018		(5	)		0
Total shareholders’ equity		173,597			164,219
Total liabilities and shareholders’ equity	$	1,800,771		$	1,709,205

See accompanying notes.

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Codorus Valley Bancorp, Inc.

Consolidated Statements of Income

Unaudited


	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands, except per share data)	2018		2017		2018		2017
Interest income
Loans, including fees	$	19,580	$	16,997	$	55,723	$	48,493
Investment securities:
Taxable		568		620		1,702		1,922
Tax-exempt		261		297		817		946
Dividends		100		78		318		236
Other		287		71		663		266
Total interest income		20,796		18,063		59,223		51,863

Interest expense
Deposits		3,581		2,071		9,283		5,826
Federal funds purchased and other short-term borrowings		15		71		48		263
Long-term debt		768		629		2,036		1,794
Total interest expense		4,364		2,771		11,367		7,883
Net interest income		16,432		15,292		47,856		43,980
Provision for loan losses		1,300		2,100		1,800		3,575
Net interest income after provision for loan losses		15,132		13,192		46,056		40,405

Noninterest income
Trust and investment services fees		818		738		2,389		2,138
Income from mutual fund, annuity and insurance sales		255		214		806		620
Service charges on deposit accounts		1,187		1,057		3,485		3,078
Income from bank owned life insurance		248		257		730		779
Other income		364		276		1,221		817
Gain on sales of loans held for sale		435		252		1,436		823
Gain on sales of securities		0		16		0		79
Total noninterest income		3,307		2,810		10,067		8,334

Noninterest expense
Personnel		7,159		6,366		21,855		19,501
Occupancy of premises, net		860		793		2,556		2,471
Furniture and equipment		701		724		2,262		2,115
Postage, stationery and supplies		196		181		560		572
Professional and legal		286		294		609		616
Marketing		373		459		1,200		1,156
FDIC insurance		189		163		493		537
Debit card processing		318		294		902		780
Charitable donations		119		148		1,792		982
Telecommunications		119		204		500		608
External data processing		579		405		1,563		1,252
Foreclosed real estate including provision for (recovery of) losses		13		10		33		(18	)
Other		1,090		945		2,557		2,644
Total noninterest expense		12,002		10,986		36,882		33,216
Income before income taxes		6,437		5,016		19,241		15,523
Provision for income taxes		1,377		1,606		4,044		5,009
Net income	$	5,060	$	3,410	$	15,197	$	10,514
Net income per share, basic	$	0.53	$	0.37	$	1.62	$	1.13
Net income per share, diluted	$	0.53	$	0.36	$	1.60	$	1.11

See accompanying notes.

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Codorus Valley Bancorp, Inc.

Consolidated Statements of Comprehensive Income

Unaudited


	Three months ended
	September 30,
(dollars in thousands)	2018			2017
Net income	$	5,060		$	3,410
Other comprehensive income (loss):
Securities available for sale:
Net unrealized holding (losses) gains arising during the period (net of tax (benefit) expense of ($203) and $16, respectively)		(767	)		30
Reclassification adjustment for (gains) included in net income (net of tax expense of $0 and $6, respectively) (a) (b)		0			(10	)
Net unrealized (losses) gains		(767	)		20
Comprehensive income	$	4,293		$	3,430

	Nine months ended
	September 30,
(dollars in thousands)	2018			2017
Net income	$	15,197		$	10,514
Other comprehensive income (loss):
Securities available for sale:
Net unrealized holding (losses) gains arising during the period (net of tax (benefit) expense of ($788) and $484, respectively)		(2,967	)		899
Reclassification adjustment for (gains) included in net income (net of tax expense of $0 and $28, respectively) (a) (b)		0			(51	)
Net unrealized (losses) gains		(2,967	)		848
Comprehensive income	$	12,230		$	11,362

(a)

Amounts are included in net gain on sales of securities on the Consolidated Statements of Income within noninterest income.

(b)

Income tax amounts are included in the provision for income taxes on the Consolidated Statements of Income.

See accompanying notes.

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Codorus Valley Bancorp, Inc.

Consolidated Statements of Cash Flows

Unaudited


	Nine months ended
	September 30,
(dollars in thousands)	2018			2017
Cash flows from operating activities
Net income	$	15,197		$	10,514
Adjustments to reconcile net income to net cash provided by operations:
Depreciation/amortization		1,780			1,755
Net amortization of premiums on securities		335			535
Amortization of deferred loan origination fees and costs		(1,264	)		(1,128	)
Provision for loan losses		1,800			3,575
Recovery of foreclosed real estate		0			(47	)
Increase in bank owned life insurance		(730	)		(779	)
Originations of mortgage loans held for sale		(28,746	)		(28,467	)
Originations of SBA loans held for sale		(12,292	)		(3,186	)
Proceeds from sales of mortgage loans held for sale		29,744			27,682
Proceeds from sales of SBA loans held for sale		10,352			2,148
Gain on sales of mortgage loans held for sale		(718	)		(694	)
Gain on sales of SBA loans held for sale		(718	)		(129	)
Gain on disposal of premises and equipment		(11	)		(8	)
Gain on sales of securities, available-for-sale		0			(79	)
Loss (gain) on sales of foreclosed real estate		3			(11	)
Stock-based compensation		457			509
(Increase) decrease in interest receivable		(174	)		173
Decrease (increase) in other assets		355			(1,640	)
Increase in interest payable		239			127
Increase (decrease) in other liabilities		1,830			(63	)
Net cash provided by operating activities		17,439			10,787
Cash flows from investing activities
Purchases of securities, available-for-sale		(10,946	)		(10,669	)
Maturities, repayments and calls of securities, available-for-sale		20,616			33,233
Sales of securities, available-for-sale		0			5,692
Net decrease (increase) in restricted investment in bank stock		189			(98	)
Net increase in loans made to customers		(94,963	)		(129,600	)
Purchases of premises and equipment		(2,231	)		(1,275	)
Investment in bank owned life insurance		(7	)		(4,007	)
Proceeds from sales of foreclosed real estate		155			452
Net cash used in investing activities		(87,187	)		(106,272	)
Cash flows from financing activities
Net increase in demand and savings deposits		69,510			60,564
Net increase (decrease) in time deposits		16,242			(1,969	)
Net decrease in short-term borrowings		(11,871	)		(24,713	)
Proceeds from issuance of long-term debt		30,000			10,000
Repayment of long-term debt		(25,000	)		0
Cash dividends paid to shareholders		(4,151	)		(3,418	)
Issuance of stock		842			644
Net cash provided by financing activities		75,572			41,108
Net increase (decrease) in cash and cash equivalents		5,824			(54,377	)
Cash and cash equivalents at beginning of year		79,524			74,032
Cash and cash equivalents at end of period	$	85,348		$	19,655

See accompanying notes.

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Codorus Valley Bancorp, Inc.

Consolidated Statements of Changes in Shareholders’ Equity

Unaudited


									Accumulated
					Additional				Other
	Preferred		Common		Paid-in		Retained		Comprehensive		Treasury
*(dollars in thousands, except per share data)*	Stock		Stock		Capital		Earnings		Loss		Stock		Total

Balance, January 1, 2018	$	0	$	22,265	$	120,052	$	22,860	$	(958)	$	0	$	164,219
Net income								15,197						15,197
Other comprehensive loss, net of tax										(2,967)				(2,967)
Cash dividends ($0.443 per share, adjusted)								(4,151)						(4,151)
5% stock dividend, 447,700 shares at fair value				1,119		12,907		(14,026)						0
Stock-based compensation						457								457
Forfeiture of restricted stock and withheld shares						5						(75)		(70)
Issuance and reissuance of stock:
12,718 shares under the dividend reinvestment and stock purchase plan				31		322						57		410
30,535 shares under the stock option plan				70		305						9		384
4,217 shares of stock-based compensation awards				10		(10)								0
5,125 shares under employee stock purchase plan				9		105						4		118

Balance, September 30, 2018	$	0	$	23,504	$	134,143	$	19,880	$	(3,925)	$	(5)	$	173,597

Balance, January 1, 2017	$	0	$	21,067	$	106,102	$	28,909	$	(1,121)	$	0	$	154,957
Net income								10,514						10,514
Other comprehensive income, net of tax										848				848
Cash dividends ($0.368 per share, adjusted)								(3,418)						(3,418)
5% stock dividend, 423,053 shares at fair value				1,058		12,607		(13,665)						0
Stock-based compensation						509								509
Forfeiture of restricted stock						4						(9)		(5)
Issuance and reissuance of stock:
12,655 shares under the dividend reinvestment and stock purchase plan				32		317								349
11,397 shares under the stock option plan				28		157								185
7,037 shares of stock-based compensation awards				18		(18)								0
4,844 shares under employee stock purchase plan				8		103						4		115

Balance, September 30, 2017	$	0	$	22,211	$	119,781	$	22,340	$	(273)	$	(5)	$	164,054

See accompanying notes.

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Note 1—Summary of Significant Accounting Policies

Nature of Operations and Basis of Presentation

The accompanying consolidated balance sheet at December 31, 2017 has been derived from audited financial statements, and the unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q, and FASB Accounting Standards Codification (ASC) 270. Accordingly, the interim financial statements do not include all of the financial information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the interim consolidated financial statements include all adjustments necessary to present fairly the financial condition and results of operations for the reported periods, and all such adjustments are of a normal and recurring nature.

Codorus Valley Bancorp, Inc. (“Corporation” or “Codorus Valley”) is a one-bank holding company headquartered in York, Pennsylvania that provides a full range of banking services through its subsidiary, PeoplesBank, A Codorus Valley Company (“PeoplesBank” or “Bank”). PeoplesBank operates three wholly-owned subsidiaries as of September 30, 2018. Codorus Valley Financial Advisors, Inc. d/b/a PeoplesWealth Advisors, which sells nondeposit investment products in Pennsylvania; SYC Settlement Services, Inc., which provides real estate settlement services and Codorus Valley Financial Advisors, Inc. d/b/a PeoplesWealth Advisors, which sells nondeposit investment products in Maryland. In addition, PeoplesBank may periodically create nonbank subsidiaries for the purpose of temporarily holding foreclosed properties pending the liquidation of these properties. PeoplesBank operates under a state charter and is subject to regulation by the Pennsylvania Department of Banking and Securities, and the Federal Deposit Insurance Corporation. The Corporation is subject to regulation by the Federal Reserve Board and the Pennsylvania Department of Banking and Securities.

The consolidated financial statements include the accounts of Codorus Valley and its wholly-owned bank subsidiary, PeoplesBank, and a wholly-owned nonbank subsidiary, SYC Realty Company, Inc. SYC Realty was inactive during the period ended September 30, 2018. The accounts of CVB Statutory Trust No. 1 and No. 2 are not included in the consolidated financial statements as discussed in Note 7—Short-Term Borrowings and Long-Term Debt. All significant intercompany account balances and transactions have been eliminated in consolidation. The accounting and reporting policies of Codorus Valley and subsidiaries conform to accounting principles generally accepted in the United States of America and have been followed on a consistent basis.

These consolidated statements should be read in conjunction with the notes to the audited consolidated financial statements contained in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2017.

The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the results to be expected for the full year.

In accordance with FASB ASC 855, the Corporation evaluated the events and transactions that occurred after the balance sheet date of September 30, 2018 and through the date these consolidated financial statements were issued, for items of potential recognition or disclosure.

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Loans

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at their outstanding unpaid principal balances less amounts charged off, net of an allowance for loan losses and any deferred fees or costs. Interest income is accrued on the unpaid principal balance. Generally, loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the yield (interest income) over the contractual life of the loan. The loans receivable portfolio is segmented into commercial and consumer loans. Commercial loans consist of the following industry classes: builder & developer, commercial real estate investor, residential real estate investor, hotel/motel, wholesale & retail, agriculture, manufacturing and all other. Consumer loans consist of the following classes: residential mortgage, home equity and all other.

Generally, for all classes of loans receivable, the accrual of interest is discontinued when the contractual payment of principal or interest has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though the loan may be currently performing. A past due loan may remain on accrual status if it is in the process of collection and well secured. When a loan is placed on nonaccrual status, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against the allowance for loan losses. Interest received on nonaccrual loans, including impaired loans, generally is either applied against principal or reported as interest income, according to the Corporation’s judgment as to the collectability of principal. Generally, nonaccrual loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is no longer in doubt. The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments.

Acquired Loans

Acquired loans are initially recorded at their acquisition date fair values. The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing principal losses expected over the life of the loan are a component of the initial fair value and amortized over the life of the asset. Subsequent to the acquisition date, the methods used to estimate the required allowance for loan losses on these loans is similar to originated loans. However, the Corporation records a provision for loan losses only when the required allowance for loan losses exceeds any remaining credit discount. The remaining differences between the acquisition date fair value and the unpaid principal balance at the date of acquisition are recorded in interest income over the life of the loan.

Acquired loans that have evidence of deterioration in credit quality since origination and for which it is probable, at acquisition, that the Corporation will be unable to collect all contractually required payments are accounted for as impaired loans under FASB ASC 310-30. The excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loans. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable discount. The non-accretable discount represents estimated future credit losses expected to be incurred over the life of the loan. Subsequent decreases to the expected cash flows require the Corporation to evaluate the need for an allowance for loan losses on these loans. Subsequent improvements in expected cash flows result in the reversal of a corresponding amount of the non-accretable discount which the Corporation then reclassifies as an accretable discount that is recognized into interest income over the remaining life of the loans using the interest method.

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Allowance for Loan Losses

The allowance for loan losses represents the Corporation’s estimate of losses inherent in the loan portfolio as of the balance sheet date and is recorded as a reduction to loans. The allowance for loan losses is increased by the provision for loan losses, and decreased by charge-offs, net of recoveries. Loans deemed to be uncollectable are charged against the allowance for loan losses, and subsequent recoveries, if any, are credited to the allowance. All, or part, of the principal balance of loans receivable are charged off to the allowance as soon as it is determined that the repayment of all, or part, of the principal balance is highly unlikely. While the Corporation attributes a portion of the allowance to individual loans and groups of loans that it evaluates and determines to be impaired, the allowance is available to cover all charge-offs that arise from the loan portfolio.

The allowance for loan losses is maintained at a level considered by management to be adequate to provide for losses that can be reasonably anticipated. The Corporation performs a quarterly evaluation of the adequacy of the allowance. The allowance is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired, generally substandard and nonaccrual loans. For loans that are classified as impaired, an allowance is established when the collateral value (or discounted cash flows or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers pools of loans by loan class, including commercial loans not considered impaired, as well as smaller balance homogeneous loans such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates for each of these classes of loans, adjusted for qualitative (environmental) risk factors. Historical loss rates are based on a two year rolling average of net charge-offs. Qualitative risk factors that supplement historical losses in the evaluation of loan pools are shown below. Each factor is assigned a value to reflect improving, stable or declining conditions based on the Corporation’s best judgment using relevant information available at the time of the evaluation.

●

Changes in national and local economies and business conditions

●

Changes in the value of collateral for collateral dependent loans

●

Changes in the level of concentrations of credit

●

Changes in the volume and severity of classified and past due loans

●

Changes in the nature and volume of the portfolio

●

Changes in collection, charge-off, and recovery procedures

●

Changes in underwriting standards and loan terms

●

Changes in the quality of the loan review system

●

Changes in the experience/ability of lending management and key lending staff

●

Regulatory and legal regulations that could affect the level of credit losses

●

Other pertinent environmental factors

●

Impact of imposed and proposed tariffs

The unallocated component is maintained to cover uncertainties that could affect the Corporation’s estimate of probable losses. For example, increasing credit risks and uncertainties, not yet reflected in current leading indicators, associated with prolonged low economic growth, or recessionary business conditions for certain industries or the broad economy, or the erosion of real estate values, represent risk factors, the occurrence of any or all of which can adversely affect a borrowers’ ability to service their loans. The unallocated component of the allowance also reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan portfolio, including the unpredictable timing and amounts of charge-offs and related historical loss averages, and specific-credit or broader portfolio future cash flow value and collateral valuation uncertainties which could negatively impact unimpaired portfolio loss factors.

- 10 -

As disclosed in Note 4—Loans, the Corporation engages in commercial and consumer lending. Loans are made within the Corporation’s primary market area and surrounding areas, and include the purchase of whole loan or participation interests in loans from other financial institutions or private equity companies. Commercial loans, which pose the greatest risk of loss to the Corporation, whether originated or purchased, are generally secured by real estate. Within the broad commercial loan segment, the builder & developer and commercial real estate investor loan classes generally present a higher level of risk than other commercial loan classifications. This greater risk is due to several factors, including the concentration of principal in a limited number of loans and borrowers, the effect of general economic conditions on income producing properties, unstable real estate prices and the dependency upon successful construction and sale or operation of the real estate project. Within the consumer loan segment, junior (i.e., second) liens present a higher risk to the Corporation because economic and housing market conditions can adversely affect the underlying value of the collateral, which could render the Corporation under-secured or unsecured. In addition, economic and housing market conditions can adversely affect the ability of some borrowers to service their debt.

A loan is considered impaired when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered in determining impairment include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. The Corporation determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Loans that are deemed impaired are evaluated for impairment loss based on the net realizable value of the collateral, as applicable. Loans that are not collateral dependent will rely on the present value of expected future cash flows discounted at the loan’s effective interest rate to determine impairment loss. Large groups of smaller balance homogeneous loans such as residential mortgage loans, home equity loans and other consumer loans are collectively evaluated for impairment, unless they are classified as impaired.

An allowance for loan losses is established for an impaired commercial loan if its carrying value exceeds its estimated fair value. For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals of the underlying collateral. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the most recent appraisal and the condition of the property. Appraisals are generally discounted to provide for selling costs and other factors to determine an estimate of the net realizable value of the property. For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable aging or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets. In instances when specific consumer related loans become impaired, they may be partially or fully charged off, which obviates the need for a specific allowance.

Loans whose terms are modified are classified as troubled debt restructurings if the Corporation grants borrowers experiencing financial difficulties concessions that it would not otherwise consider. Concessions granted under a troubled debt restructuring may involve an interest rate that is below the market rate given the associated credit risk of the loan or an extension of a loan’s stated maturity date. Loans classified as troubled debt restructurings are designated as impaired. Non-accrual troubled debt restructurings are restored to accrual status if principal and interest payments, under the modified terms, are current for a reasonable period of time, generally six consecutive months after modification and future payments are reasonably assured.

- 11 -

Banking regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses and may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination, which may not be currently available to the Corporation. Based on an analysis of the loan portfolio, the Corporation believes that the level of the allowance for loan losses at September 30, 2018 is adequate.

Foreclosed Real Estate

Foreclosed real estate, included in other assets, is comprised of property acquired through a foreclosure proceeding or property that is acquired through in-substance foreclosure. Foreclosed real estate is initially recorded at fair value minus estimated costs to sell at the date of foreclosure, establishing a new cost basis. Any difference between the carrying value and the new cost basis is charged against the allowance for loan losses. Appraisals, obtained from an independent third party, are generally used to determine fair value. After foreclosure, management reviews valuations at least quarterly and adjusts the asset to the lower of cost or fair value minus estimated costs to sell through a valuation allowance or a write-down. Costs related to the improvement of foreclosed real estate are generally capitalized until the real estate reaches a saleable condition subject to fair value limitations. Revenue and expense from operations and changes in the valuation allowance are included in noninterest expense. When a foreclosed real estate asset is ultimately sold, any gain or loss on the sale is included in the income statement as a component of noninterest expense. At September 30, 2018, there was $1,767,000 of foreclosed real estate, which included $32,000 of residential real estate, compared to $216,000, which included $96,000 of residential real estate, at December 31, 2017. Included within loans receivable as of September 30, 2018 was a recorded investment of $18,000 of consumer mortgage loans secured by residential real estate properties, for which formal foreclosure proceedings were in process according to local requirements of the applicable jurisdiction.

Mortgage Servicing Rights

The mortgage servicing rights (MSRs) associated with the sold loans are included in other assets on the consolidated balance sheets at an amount equal to the estimated fair value of the contractual rights to service the mortgage loans. The MSR asset is amortized as a reduction to servicing income. The MSR asset is evaluated periodically for impairment and carried at the lower of amortized cost or fair value. A third party calculates fair value by discounting the estimated cash flows from servicing income using a rate consistent with the risk associated with these assets and an expected life commensurate with the expected life of the underlying loans. In the event that the amortized cost of the MSR asset exceeds the fair value of the asset, a valuation allowance would be established through a charge against servicing income. Subsequent fair value evaluations may determine that impairment has been reduced or eliminated, in which case the valuation allowance would be reduced through a credit to earnings. At September 30, 2018, the balance of residential mortgage loans serviced for third parties was $94,004,000 compared to $70,780,000 at December 31, 2017.

	Three months ended						Nine months ended
	September 30,						September 30,
(dollars in thousands)	2018			2017			2018			2017
Amortized cost:
Balance at beginning of period	$	808		$	492		$	672		$	324
Originations of mortgage servicing rights		104			77			297			277
Amortization expense		(36	)		(20	)		(93	)		(52	)
Balance at end of period	$	876		$	549		$	876		$	549

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Goodwill and Core Deposit Intangible Assets

Goodwill arising from acquisitions is not amortized, but is subject to an annual impairment test. This test consists of a qualitative analysis. If the Corporation determines events or circumstances indicate that it is more likely than not that goodwill is impaired, a quantitative analysis must be completed. Analyses may also be performed between annual tests. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions, and selecting an appropriate control premium. The Corporation completes its annual goodwill impairment test on October 1^st of each year. Based upon a qualitative analysis of goodwill, the Corporation concluded that the amount of recorded goodwill was not impaired as of October 1, 2018.

Core deposit intangibles represent the value assigned to demand, interest checking, money market, and savings accounts acquired as part of an acquisition. The core deposit intangible value represents the future economic benefit of potential cost savings from acquiring core deposits as part of an acquisition compared to the cost of alternative funding sources and the alternative cost to grow a similar core deposit base. The core deposit intangible asset resulting from the merger with Madison Bancorp, Inc. was determined to have a definite life and is being amortized using the sum of the years’ digits method over ten years. All intangible assets must be evaluated for impairment if certain events or changes in circumstances occur. Any impairment write-downs would be recognized as expense on the consolidated statements of income.

At September 30, 2018, the Corporation does not have any indicators of potential impairment of either goodwill or core deposit intangibles.

Revenue from Contracts with Customers

Revenue from contracts with customers that are required to be recognized under FASB ASC Topic 606 - Revenue from Contracts with Customers (ASC 606) is measured based on consideration specified in a contract with a customer, and excludes any sales incentives and amounts collected on behalf of third parties. The Corporation recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer.

The majority of the Corporation’s revenue-generating transactions are not within the scope of ASC 606, including revenue generated from financial instruments, such as our loans, letters of credit, derivatives and investment securities, as well as revenue related to our mortgage servicing activities, as these activities are subject to other U.S. Generally Accepted Accounting Principles (GAAP) discussed elsewhere within our disclosures. Descriptions of our revenue-generating activities that are within the scope of ASC 606, which are presented in our consolidated statements of income as components of non-interest income are as follows:

Trust and investment service fees - The Corporation provides trust, investment management custody and irrevocable life insurance trust services to customers. Such services are rendered in accordance with the underlying contracts for which fees are earned. Performance obligations are typically fulfilled on a monthly basis which is when revenue is recognized.

Income from mutual fund, annuity and insurance sales – The Corporation sells mutual funds, annuity and insurance products to its customers. The Corporation’s performance obligation is met upon the signing of the product agreement and, in certain cases, a time component may exist when the customer has the right to rescind the agreement with or without penalty. The Corporation recognizes revenues upon delivery of the product or service unless there is a time component and revenues are recognized utilizing the expected value method.

Service charges on deposits accounts - These represent general service fees for monthly account maintenance and activity- or transaction based fees and consist of transaction-based revenue, time-based revenue (service period), item-based revenue or some other individual attribute-based revenue. Revenue is recognized when the performance obligation is completed which is generally monthly for account maintenance services or when a transaction has been completed.

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Per Share Data

All per share computations include the effect of stock dividends declared, including the 5 percent stock dividend declared on October 9, 2018. The computation of net income per share is provided in the table below.

	Three months ended				Nine months ended
	September 30,				September 30,
(in thousands, except per share data)	2018		2017		2018		2017
Net income	$	5,060	$	3,410	$	15,197	$	10,514

Weighted average shares outstanding (basic)		9,398		9,325		9,379		9,308
Effect of dilutive stock options		107		103		96		105
Weighted average shares outstanding (diluted)		9,505		9,428		9,475		9,413

Basic earnings per share	$	0.53	$	0.37	$	1.62	$	1.13
Diluted earnings per share	$	0.53	$	0.36	$	1.60	$	1.11

Anti-dilutive stock options excluded from the
computation of earnings per share		1		0		2		0

Comprehensive Income

Accounting principles generally accepted in the United States require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the shareholders’ equity section of the balance sheet, such items, along with net income, are components of comprehensive income.

Cash Flow Information

For purposes of the statements of cash flows, the Corporation considers interest bearing deposits with banks, cash and due from banks, and federal funds sold to be cash and cash equivalents.

Supplemental cash flow information is provided in the table below.

	Nine months ended
	September 30,
(dollars in thousands)	2018		2017
Cash paid during the period for:
Income taxes	$	3,115	$	6,425
Interest	$	11,128	$	7,756

Noncash investing activities:
Transfer of loans to foreclosed real estate	$	1,709	$	0
Transfer of loans held for sale to the held-to-maturity portfolio	$	0	$	228
Sale of foreclosed real estate through loans	$	0	$	2,310
Increase in other liabilities for purchase of securities settling after quarter end	$	1,258	$	0

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Recent Accounting Pronouncements

Pronouncements Adopted in 2018

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. This standard clarifies how certain cash receipts and cash payments are presented and classified in the statement of cash flows to reduce diversity in practice. This standard contains guidance clarifying when an entity should separate cash receipts and cash payments and classify them into more than one class of cash flows (including when reasonable judgment is required to estimate and allocate cash flows) versus when an entity should classify the aggregate amount into one class of cash flows on the basis of predominance. The new standard is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Corporation adopted this standard effective with its March 31, 2018 quarterly report on Form 10-Q. The adoption of the new standard did not have a material impact on its consolidated financial statements.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).

This standards update provides a framework that replaces most existing revenue recognition guidance. The guidance requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers. This ASU amends the new revenue standard to make minor technical corrections that affect narrow aspects of the guidance, including contract cost accounting, disclosures, and other matters. ASU 2014-09 and ASU 2016-20 are effective for interim and annual reporting periods beginning after December 15, 2017. The Corporation has determined that certain noninterest income financial statement line items, including trust and investment services fees, income from mutual fund, annuity and insurance sales, service charges on deposit accounts, and other noninterest income, contain revenue streams that are in scope of these updates. The Corporation adopted this standard on January 1, 2018 utilizing the modified retrospective method and the adoption of the new standard did not have a material impact on the recognition of revenue.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 is intended to improve the recognition and measurement of financial instruments by requiring equity investments to be measured at fair value with changes in fair value recognized in net income; requiring public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; eliminating the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured and amortized at cost on the balance sheet; and requiring a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. ASU 2016-01 is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2017. The amendments should be applied by means of a cumulative effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values (including disclosure requirements) should be applied prospectively to equity investments that exist as of the date of adoption. In February 2018, the FASB issued ASU No. 2018-03 which includes technical corrections and improvements to clarify the guidance in ASU No. 2016-01. The Corporation adopted ASU 2016-01 on January 1, 2018 and it did not have a material effect on its accounting for fair value disclosures and other disclosure requirements.

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Pronouncements Not Yet Effective

In January 2017, the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350). This standard simplifies the test for goodwill impairment by eliminating the requirement to calculate the implied fair value of goodwill, which currently is Step 2 of the goodwill impairment test. Instead, the goodwill impairment test will consist of a single quantitative step comparing the fair value of the reporting unit with its carrying amount. An entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The new standard is effective for annual and any interim goodwill impairment tests in reporting periods beginning after December 15, 2019. Early adoption is permitted. The Corporation intends to adopt this standard effective with its October 1, 2020 goodwill impairment test and the adoption of this standard is not expected to have a material impact on its consolidated financial statements based on current circumstances.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326). This standard adds a new Topic 326 which requires companies to measure and record impairment on financial instruments at the time of origination using the expected credit loss (CECL) model. The CECL model calculates impairment based on historical experience, current conditions, and reasonable and supportable forecasts, and reflects the organization’s current estimate of all expected credit losses over the contractual term of its financial assets. The new standard is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018. The Corporation is currently evaluating the impact of the adoption of this guidance on its consolidated financial statements and is in the initial stages of assessing and gathering the necessary data to implement the new standard.

In February 2016, the FASB issued ASU 2016-02, Leases and in July 2018 issued ASU 2018-10 and ASU 2018-11, Codification Improvements to Topic 842, Leases. From the lessee’s perspective, the new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement for a lessees. From the lessor’s perspective, the new standard requires a lessor to classify leases as either sales-type, finance or operating. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing lease. If the lessor doesn’t convey risks and rewards or control, an operating lease results. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. A modified retrospective transition approach is required for lessors for sales-type, direct financing, and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Corporation is currently evaluating the impact of the adoption of this guidance on its consolidated financial statements. The Corporation has determined that the provisions of ASU 2016-02 will result in an increase in assets to recognize the present value of the lease obligations (right-of-use assets) with a corresponding increase in liabilities. The initial measurement of the right-of-use asset and the corresponding liability will be affected by certain key assumptions such as expectations of renewals or extensions and the interest rate to be used to discount the future lease obligations. The Corporation is currently assessing its lease portfolio to determine the key assumptions and financial statement impact; however, the total impact of the new standard will be affected by any new leases that are executed, leases that are terminated prior to the effective date, and any leases with changes to key assumptions or expectations such as renewals and extensions, and discount rates. The adoption is not expected to have an overall material impact on the Corporation’s consolidated financial statements of income.

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In July 2018, the FASB issued ASU 2018-07, Improvements to Nonemployee Share-Based Payment Accounting. This standard expands the scope of Topic 718, Compensation – Stock Compensation to include share-based payment transactions for acquiring goods and services from nonemployees. This standard requires application of Topic 718 to nonemployee awards for specific guidance on inputs to an option pricing model and the attribution of costs (that is, the period of time over which share-based payment awards vest and the pattern of cost recognition over that period). The amendments in the Update are effective for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The adoption of this standard is not expected to have a material impact on the Corporation’s consolidated financial statements based on current circumstances.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement. The amendments in this update modify the disclosure requirements in Topic 820, Fair Value Measurement. The following disclosure requirements were removed: the amount of and reasons for transfers between Level 1 and Level 2, the policy for timing of transfers between levels, and the valuation processes for Level 3 fair value measurements. The following disclosure requirements were modified: for investments in certain entities that calculate net asset value, and entity is required to disclose the timing of liquidation of investee’s assets and the amendments clarify that the measurement uncertainty disclosure is to communicate information about the uncertainty in measurement as of the reporting date. The following disclosure requirements were added: the changes in unrealized gains and losses for the period included in other comprehensive income for recurring Level 3 fair value measurements and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The update is effective for fiscal years beginning after December 15, 2019. The Corporation is currently evaluating the impact of the adoption of this update on its disclosures.

In August 2018, the FASB issued ASU 2018-14, Compensation-Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20). The amendments in this update remove disclosures that are no longer considered cost beneficial, clarify the specific requirements of disclosures, and add disclosure requirements identified as relevant. The update is effective for fiscal years ending after December 15, 2020. Early adoption is permitted. The Corporation is currently evaluating the impact of the adoption of this update on its disclosures.

In August 2018, the FASB issued ASU 2018-15, Intangibles-Goodwill and Other-Internal-Use Software. This standard aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with those incurred to develop or obtain internal-use software. This standard requires application of Subtopic 350-40 to determine which costs to implement the service contract would be capitalized as an asset and which costs would be expensed. The amendments in the Update are effective for the years beginning after December 15, 2019. The Corporation is currently evaluating the impact of the adoption of this guidance on its consolidated financial statements.

Note 2-Securities

A summary of securities available-for-sale at September 30, 2018 and December 31, 2017 is provided below. The securities available-for-sale portfolio is generally comprised of high quality debt instruments, principally obligations of the United States government or agencies thereof and investments in the obligations of states and municipalities. The majority of municipal bonds in the portfolio are general obligation bonds, which can draw upon multiple sources of revenue, including taxes, for payment. Only a few bonds are revenue bonds, which are dependent upon a single revenue stream for payment, but they are for critical services such as water and sewer. In many cases, municipal debt issues are insured or, in the case of school districts of selected states, backed by specific loss reserves. At September 30, 2018, 86 percent of the fair value of the municipal bond portfolio was concentrated in the Commonwealth of Pennsylvania.

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	Amortized		Gross Unrealized					Fair
(dollars in thousands)	Cost		Gains		Losses			Value
September 30, 2018
Debt securities:
U.S. Treasury notes	$	14,779	$	0	$	(1,207	)	$	13,572
U.S. agency		16,000		0		(1,258	)		14,742
U.S. agency mortgage-backed, residential		73,794		37		(1,765	)		72,066
State and municipal		46,484		42		(817	)		45,709
Total debt securities	$	151,057	$	79	$	(5,047	)	$	146,089
December 31, 2017
Debt securities:
U.S. Treasury notes	$	14,758	$	0	$	(687	)	$	14,071
U.S. agency		18,015		0		(712	)		17,303
U.S. agency mortgage-backed, residential		75,204		327		(356	)		75,175
State and municipal		51,827		304		(89	)		52,042
Total debt securities	$	159,804	$	631	$	(1,844	)	$	158,591

The amortized cost and estimated fair value of debt securities at September 30, 2018 by contractual maturity are shown below. Actual maturities may differ from contractual maturities if call options on select debt issues are exercised in the future. Mortgage-backed securities are included in the maturity categories based on average expected life.

	Available-for-sale
	Amortized		Fair
(dollars in thousands)	Cost		Value
Due in one year or less	$	9,013	$	9,026
Due after one year through five years		88,647		86,107
Due after five years through ten years		44,759		42,323
Due after ten years		8,638		8,633
Total debt securities	$	151,057	$	146,089

Gross realized gains and losses on sales of securities available-for-sale are shown below. Realized gains and losses are computed on the basis of specific identification of the adjusted cost of each security and are shown net as a separate line item in the income statement.

	Three months ended				Nine months ended
	September 30,				September 30,
(dollars in thousands)	2018		2017		2018		2017
Realized gains	$	0	$	16	$	0	$	79
Realized losses		0		0		0		0
Net gains	$	0	$	16	$	0	$	79

Investment securities having a carrying value of $135,246,000 and $105,603,000 on September 30, 2018 and December 31, 2017, respectively, were pledged to secure public and trust deposits, repurchase agreements and other short-term borrowings.

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The table below shows gross unrealized losses and fair value, aggregated by investment category and length of time, for securities that have been in a continuous unrealized loss position, at September 30, 2018 and December 31, 2017.

	Less than 12 months							12 months or more							Total
	Number of		Fair		Unrealized			Number of		Fair		Unrealized			Number of		Fair		Unrealized
(dollars in thousands)	Securities		Value		Losses			Securities		Value		Losses			Securities		Value		Losses
September 30, 2018
Debt securities:
U.S. Treasury notes		0	$	0	$	0			3	$	13,572	$	(1,207	)		3	$	13,572	$	(1,207	)
U.S. agency		0		0		0			4		14,742		(1,258	)		4		14,742		(1,258	)
U.S. agency mortgage-backed, residential		36		46,566		(1,107	)		11		16,963		(658	)		47		63,529		(1,765	)
State and municipal		58		28,641		(517	)		12		7,083		(300	)		70		35,724		(817	)
Total temporarily impaired debt securities, available-for-sale		94	$	75,207	$	(1,624	)		30	$	52,360	$	(3,423	)		124	$	127,567	$	(5,047	)
December 31, 2017
Debt securities:
U.S. Treasury notes		0	$	0	$	0			3	$	14,071	$	(687	)		3	$	14,071	$	(687	)
U.S. agency		1		989		(12	)		4		16,314		(700	)		5		17,303		(712	)
U.S. agency mortgage-backed, residential		25		43,329		(261	)		2		5,051		(95	)		27		48,380		(356	)
State and municipal		27		12,171		(60	)		5		3,277		(29	)		32		15,448		(89	)
Total temporarily impaired debt securities, available-for-sale		53	$	56,489	$	(333	)		14	$	38,713	$	(1,511	)		67	$	95,202	$	(1,844	)

Securities available-for-sale are analyzed quarterly for possible other-than-temporary impairment. The analysis considers, among other factors: 1) whether the Corporation has the intent to sell its securities prior to market recovery or maturity; 2) whether it is more likely than not that the Corporation will be required to sell its securities prior to market recovery or maturity; 3) default rates/history by security type; 4) third-party securities ratings; 5) third-party guarantees; 6) subordination; 7) payment delinquencies; 8) nature of the issuer; and 9) current financial news.

The Corporation believes that unrealized losses at September 30, 2018 were primarily the result of changes in market interest rates and that the Corporation has the ability to hold these investments for a time necessary to recover the amortized cost. Through September 30, 2018 the Corporation has collected all interest and principal on its investment securities as scheduled. The Corporation believes that collection of the contractual principal and interest is probable and, therefore, all impairment is considered to be temporary.

Note 3—Restricted Investment in Bank Stocks

Restricted stock, which represents required investments in the common stock of correspondent banks, is carried at cost and, as of September 30, 2018 and December 31, 2017, consisted primarily of the common stock of the Federal Home Loan Bank of Pittsburgh (“FHLBP”) and, to a lesser degree, Atlantic Community Bancshares, Inc. (“ACBI”), the parent company of Atlantic Community Bankers Bank (“ACBB”). Under the FHLBP’s Capital Plan member banks, including PeoplesBank, are required to maintain a minimum stock investment. The FHLBP uses a formula to determine the minimum stock investment, which is based on the volume of loans outstanding, unused borrowing capacity and other factors.

The FHLBP paid dividends during the periods ended September 30, 2018 and 2017. The FHLBP restricts the repurchase of the excess capital stock of member banks. The amount of excess capital stock that can be repurchased from any member is currently the lesser of five percent of the member’s total capital stock outstanding or its excess capital stock outstanding.

- 19 -

Management evaluates the restricted stock for impairment in accordance with FASB ASC Topic 942. Management’s determination of whether these investments are impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value. Using the FHLBP as an example, the determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as: (1) the significance of the decline in net assets of the FHLBP as compared to the capital stock amount for the FHLBP and the length of time this situation has persisted; (2) commitments by the FHLBP to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLBP; and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLBP. Management believes no impairment charge was necessary related to the restricted stock during the periods ended September 30, 2018 and 2017.

Note 4—Loans

Loan Portfolio Composition

The table below provides the composition of the loan portfolio at September 30, 2018 and December 31, 2017. The portfolio is comprised of two segments, commercial and consumer loans. The commercial loan segment is disaggregated by industry class which allows the Corporation to monitor risk and performance. Those industries representing the largest dollar investment and most risk are listed separately. The “Other” commercial loans category is comprised of various industries. The consumer related segment is comprised of residential mortgages, home equity and other consumer loans. The Corporation has not engaged in sub-prime residential mortgage originations.

	September 30,		% Total		December 31,		% Total
(dollars in thousands)	2018		Loans		2017		Loans
Builder & developer	$	162,602		10.9	$	184,402		13.2
Commercial real estate investor		219,424		14.7		230,827		16.5
Residential real estate investor		235,126		15.7		209,414		15.0
Hotel/Motel		86,815		5.8		63,195		4.5
Wholesale & retail		105,949		7.1		103,040		7.3
Manufacturing		84,441		5.7		62,510		4.5
Agriculture		65,520		4.4		59,931		4.3
Other		330,643		22.1		284,511		20.3
Total commercial related loans		1,290,520		86.4		1,197,830		85.6
Residential mortgages		82,763		5.5		79,325		5.6
Home equity		97,301		6.5		97,950		7.0
Other		23,443		1.6		24,659		1.8
Total consumer related loans		203,507		13.6		201,934		14.4
Total loans	$	1,494,027		100.0	$	1,399,764		100.0

Loan Risk Ratings

The Corporation’s internal risk rating system follows regulatory guidance as to risk classifications and definitions. Every approved loan is assigned a risk rating. Generally, risk ratings for commercial related loans and residential mortgages held for investment are determined by a formal evaluation of risk factors performed by the Corporation’s underwriting staff. For consumer loans, and commercial loans up to $500,000, the Corporation uses third-party credit scoring software models for risk rating purposes. The loan portfolio is monitored on a continuous basis by loan officers, loan review personnel and senior management. Adjustments of loan risk ratings are generally performed by the Special Asset Committee, which includes senior management. The Committee, which meets at a minimum quarterly, makes changes, as appropriate, to risk ratings when it becomes aware of credit events such as payment delinquency, cessation of a business or project, bankruptcy or death of the borrower, or changes in collateral value.

- 20 -

The Corporation uses ten risk ratings to grade loans. The first seven ratings, representing the lowest risk, are combined and given a “pass” rating. A pass rating is a satisfactory credit rating, which applies to a loan that is expected to perform in accordance with the loan agreement and has a low probability of loss. A loan rated “special mention” has a potential weakness which may, if not corrected, weaken the loan or inadequately protect the Corporation’s position at some future date. A loan rated “substandard” is inadequately protected by the current net worth or paying capacity of the borrower or of the collateral pledged. A substandard loan has a well-defined weakness or weaknesses that could jeopardize liquidation of the loan, which exposes the Corporation to loss if the deficiencies are not corrected. A loan classified “doubtful” has all the weaknesses inherent in one classified substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and value highly improbable and the possibility of loss extremely high. When circumstances indicate that collection of the loan is doubtful, the loan is risk rated “nonaccrual,” the accrual of interest income is discontinued, and any unpaid interest previously credited to income is reversed. The table below does not include the regulatory classification of “doubtful,” which is subsumed within the nonaccrual risk rating category, nor does it include the regulatory classification of “loss” because the Corporation promptly charges off known loan losses.

The table below presents a summary of loan risk ratings by loan class at September 30, 2018 and December 31, 2017.

			Special
(dollars in thousands)	Pass		Mention		Substandard		Nonaccrual		Total
September 30, 2018
Builder & developer	$	161,351	$	836	$	415	$	0	$	162,602
Commercial real estate investor		214,458		0		4,365		601		219,424
Residential real estate investor		225,570		7,380		1,171		1,005		235,126
Hotel/Motel		86,815		0		0		0		86,815
Wholesale & retail		92,858		5,177		97		7,817		105,949
Manufacturing		80,629		568		1,375		1,869		84,441
Agriculture		61,656		3,203		374		287		65,520
Other		327,020		2,506		955		162		330,643
Total commercial related loans		1,250,357		19,670		8,752		11,741		1,290,520
Residential mortgage		82,206		7		83		467		82,763
Home equity		96,808		0		0		493		97,301
Other		23,198		3		9		233		23,443
Total consumer related loans		202,212		10		92		1,193		203,507
Total loans	$	1,452,569	$	19,680	$	8,844	$	12,934	$	1,494,027

December 31, 2017
Builder & developer	$	179,897	$	1,832	$	581	$	2,092	$	184,402
Commercial real estate investor		224,822		360		4,339		1,306		230,827
Residential real estate investor		204,139		4,065		711		499		209,414
Hotel/Motel		63,195		0		0		0		63,195
Wholesale & retail		95,128		254		7,658		0		103,040
Manufacturing		58,082		588		3,840		0		62,510
Agriculture		57,140		2,476		0		315		59,931
Other		283,086		507		918		0		284,511
Total commercial related loans		1,165,489		10,082		18,047		4,212		1,197,830
Residential mortgage		79,068		10		85		162		79,325
Home equity		97,498		0		0		452		97,950
Other		24,394		30		9		226		24,659
Total consumer related loans		200,960		40		94		840		201,934
Total loans	$	1,366,449	$	10,122	$	18,141	$	5,052	$	1,399,764

- 21 -

Impaired Loans

The table below presents a summary of impaired loans at September 30, 2018 and December 31, 2017. Generally, impaired loans are certain loan risk rated substandard and all loans risk rated nonaccrual or classified as troubled debt restructuring. An allowance is established for individual loans that are commercial related where the Corporation has doubt as to full recovery of the outstanding principal balance. Typically, impaired consumer related loans are partially or fully charged-off eliminating the need for a specific allowance. The recorded investment represents outstanding unpaid principal loan balances adjusted for charge-offs.


	With No Allowance				With A Related Allowance						Total
	Recorded		Unpaid		Recorded		Unpaid		Related		Recorded		Unpaid
(dollars in thousands)	Investment		Principal		Investment		Principal		Allowance		Investment		Principal
September 30, 2018
Builder & developer	$	277	$	571	$	138	$	138	$	51	$	415	$	709
Commercial real estate investor		4,966		4,966		0		0		0		4,966		4,966
Residential real estate investor		2,176		2,176		0		0		0		2,176		2,176
Hotel/Motel		0		0		0		0		0		0		0
Wholesale & retail		347		347		7,817		7,817		757		8,164		8,164
Manufacturing		1,393		1,393		1,851		1,851		539		3,244		3,244
Agriculture		661		661		0		0		0		661		661
Other commercial		1,117		1,117		0		0		0		1,117		1,117
Total impaired commercial related loans		10,937		11,231		9,806		9,806		1,347		20,743		21,037
Residential mortgage		550		574		0		0		0		550		574
Home equity		493		493		0		0		0		493		493
Other consumer		242		242		0		0		0		242		242
Total impaired consumer related loans		1,285		1,309		0		0		0		1,285		1,309
Total impaired loans	$	12,222	$	12,540	$	9,806	$	9,806	$	1,347	$	22,028	$	22,346


December 31, 2017
Builder & developer	$	2,673	$	3,008	$	0	$	0	$	0	$	2,673	$	3,008
Commercial real estate investor		4,585		4,601		1,060		1,060		243		5,645		5,661
Residential real estate investor		1,210		1,510		0		0		0		1,210		1,510
Hotel/Motel		0		0		0		0		0		0		0
Wholesale & retail		7,912		7,912		0		0		0		7,912		7,912
Manufacturing		3,840		3,840		0		0		0		3,840		3,840
Agriculture		315		315		0		0		0		315		315
Other commercial		918		918		0		0		0		918		918
Total impaired commercial related loans		21,453		22,104		1,060		1,060		243		22,513		23,164
Residential mortgage		247		276		0		0		0		247		276
Home equity		452		452		0		0		0		452		452
Other consumer		235		235		0		0		0		235		235
Total impaired consumer related loans		934		963		0		0		0		934		963
Total impaired loans	$	22,387	$	23,067	$	1,060	$	1,060	$	243	$	23,447	$	24,127

- 22 -

The table below presents a summary of average impaired loans and related interest income that was included in net income for the three and nine months ended September 30, 2018 and 2017.


	With No Related Allowance						With A Related Allowance						Total
	Average		Total		Cash Basis		Average		Total		Cash Basis		Average		Total		Cash Basis
	Recorded		Interest		Interest		Recorded		Interest		Interest		Recorded		Interest		Interest
(dollars in thousands)	Investment		Income		Income		Investment		Income		Income		Investment		Income		Income
Three months ended September 30, 2018
Builder & developer	$	1,280	$	4	$	0	$	69	$	2	$	0	$	1,349	$	6	$	0
Commercial real estate investor		6,040		75		7		0		0		0		6,040		75		7
Residential real estate investor		1,909		13		4		0		0		0		1,909		13		4
Hotel/Motel		0		0		0		0		0		0		0		0		0
Wholesale & retail		3,538		3		0		3,909		116		0		7,447		119		0
Manufacturing		2,422		23		0		925		69		0		3,347		92		0
Agriculture		477		3		0		0		0		0		477		3		0
Other commercial		1,039		17		1		0		0		0		1,039		17		1
Total impaired commercial related loans		16,705		138		12		4,903		187		0		21,608		325		12
Residential mortgage		394		16		15		0		0		0		394		16		15
Home equity		529		3		3		0		0		0		529		3		3
Other consumer		248		4		4		0		0		0		248		4		4
Total impaired consumer related loans		1,171		23		22		0		0		0		1,171		23		22
Total impaired loans	$	17,876	$	161	$	34	$	4,903	$	187	$	0	$	22,779	$	348	$	34

Three months ended September 30, 2017
Builder & developer	$	4,199	$	48	$	0	$	2,336	$	0	$	0	$	6,535	$	48	$	0
Commercial real estate investor		5,233		62		4		550		0		0		5,783		62		4
Residential real estate investor		1,420		12		2		299		0		0		1,719		12		2
Hotel/Motel		0		0		0		0		0		0		0		0		0
Wholesale & retail		6,628		90		0		0		0		0		6,628		90		0
Manufacturing		3,581		82		0		1,188		17		0		4,769		99		0
Agriculture		165		0		0		168		0		0		333		0		0
Other commercial		1,146		14		0		92		0		0		1,238		14		0
Total impaired commercial related loans		22,372		308		6		4,633		17		0		27,005		325		6
Residential mortgage		93		0		0		0		0		0		93		0		0
Home equity		375		3		3		0		0		0		375		3		3
Other consumer		293		0		0		0		0		0		293		0		0
Total impaired consumer related loans		761		3		3		0		0		0		761		3		3
Total impaired loans	$	23,133	$	311	$	9	$	4,633	$	17	$	0	$	27,766	$	328	$	9

- 23 -

	With No Related Allowance						With A Related Allowance						Total
	Average		Total		Cash Basis		Average		Total		Cash Basis		Average		Total		Cash Basis
	Recorded		Interest		Interest		Recorded		Interest		Interest		Recorded		Interest		Interest
(dollars in thousands)	Investment		Income		Income		Investment		Income		Income		Investment		Income		Income
Nine months ended September 30, 2018
Builder & developer	$	1,883	$	10	$	0	$	35	$	7	$	0	$	1,918	$	17	$	0
Commercial real estate investor		5,296		210		14		265		0		0		5,561		210		14
Residential real estate investor		1,637		33		9		0		0		0		1,637		33		9
Hotel/Motel		0		0		0		0		0		0		0		0		0
Wholesale & retail		5,316		8		0		1,954		301		0		7,270		309		0
Manufacturing		3,087		68		0		463		206		0		3,550		274		0
Agriculture		427		4		0		0		0		0		427		4		0
Other commercial		1,031		47		1		0		0		0		1,031		47		1
Total impaired commercial related loans		18,677		380		24		2,717		514		0		21,394		894		24
Residential mortgage		327		17		15		0		0		0		327		17		15
Home equity		492		15		14		0		0		0		492		15		14
Other consumer		242		13		13		0		0		0		242		13		13
Total impaired consumer related loans		1,061		45		42		0		0		0		1,061		45		42
Total impaired loans	$	19,738	$	425	$	66	$	2,717	$	514	$	0	$	22,455	$	939	$	66

Nine months ended September 30, 2017
Builder & developer	$	3,741	$	149	$	0	$	1,360	$	0	$	0	$	5,101	$	149	$	0
Commercial real estate investor		5,281		185		15		275		0		0		5,556		185		15
Residential real estate investor		1,411		38		9		379		0		0		1,790		38		9
Hotel/Motel		90		0		0		9		0		0		99		0		0
Wholesale & retail		5,198		174		0		0		0		0		5,198		174		0
Manufacturing		2,431		168		0		913		35		0		3,344		203		0
Agriculture		224		0		0		262		0		0		486		0		0
Other commercial		1,086		41		0		137		0		0		1,223		41		0
Total impaired commercial related loans		19,462		755		24		3,335		35		0		22,797		790		24
Residential mortgage		105		1		0		0		0		0		105		1		0
Home equity		348		7		7		0		0		0		348		7		7
Other consumer		264		6		5		0		0		0		264		6		5
Total impaired consumer related loans		717		14		12		0		0		0		717		14		12
Total impaired loans	$	20,179	$	769	$	36	$	3,335	$	35	$	0	$	23,514	$	804	$	36

- 24 -

Past Due and Nonaccrual

The performance and credit quality of the loan portfolio is also monitored by using an aging schedule that shows the length of time a loan is past due. The table below presents a summary of past due loans, nonaccrual loans and current loans by loan segment and class at September 30, 2018 and December 31, 2017.


					≥ 90 Days
	30-59		60-89		Past Due				Total Past
	Days		Days		and				Due and				Total
(dollars in thousands)	Past Due		Past Due		Accruing		Nonaccrual		Nonaccrual		Current		Loans
September 30, 2018
Builder & developer	$	550	$	223	$	118	$	0	$	891	$	161,711	$	162,602
Commercial real estate investor		1,828		0		0		601		2,429		216,995		219,424
Residential real estate investor		1,910		930		0		1,005		3,845		231,281		235,126
Hotel/Motel		0		0		0		0		0		86,815		86,815
Wholesale & retail		0		0		0		7,817		7,817		98,132		105,949
Manufacturing		0		0		0		1,869		1,869		82,572		84,441
Agriculture		0		17		0		287		304		65,216		65,520
Other		461		63		100		162		786		329,857		330,643
Total commercial related loans		4,749		1,233		218		11,741		17,941		1,272,579		1,290,520
Residential mortgage		364		11		67		467		909		81,854		82,763
Home equity		207		112		0		493		812		96,489		97,301
Other		116		78		8		233		435		23,008		23,443
Total consumer related loans		687		201		75		1,193		2,156		201,351		203,507
Total loans	$	5,436	$	1,434	$	293	$	12,934	$	20,097	$	1,473,930	$	1,494,027

December 31, 2017
Builder & developer	$	615	$	26	$	0	$	2,092	$	2,733	$	181,669	$	184,402
Commercial real estate investor		0		0		0		1,306		1,306		229,521		230,827
Residential real estate investor		347		0		0		499		846		208,568		209,414
Hotel/Motel		0		0		0		0		0		63,195		63,195
Wholesale & retail		0		0		0		0		0		103,040		103,040
Manufacturing		0		0		0		0		0		62,510		62,510
Agriculture		0		137		0		315		452		59,479		59,931
Other		203		117		0		0		320		284,191		284,511
Total commercial related loans		1,165		280		0		4,212		5,657		1,192,173		1,197,830
Residential mortgage		392		72		67		162		693		78,632		79,325
Home equity		264		5		0		452		721		97,229		97,950
Other		123		5		9		226		363		24,296		24,659
Total consumer related loans		779		82		76		840		1,777		200,157		201,934
Total loans	$	1,944	$	362	$	76	$	5,052	$	7,434	$	1,392,330	$	1,399,764

- 25 -

Troubled Debt Restructurings

Loans classified as troubled debt restructurings (TDRs) are designated impaired and arise when the Corporation grants borrowers experiencing financial difficulties concessions that it would not otherwise consider. Concessions granted with respect to these loans generally involve an extension of the maturity date or a below market interest rate relative to new debt with similar credit risk. Generally, these loans are secured by real estate. If repayment of the loan is determined to be collateral dependent, the loan is evaluated for impairment loss based on the fair value of the collateral. For loans that are not collateral dependent, the present value of expected future cash flows, discounted at the loan’s original effective interest rate, is used to determine any impairment loss. A nonaccrual TDR represents a nonaccrual loan, as previously defined, which includes an economic concession. Nonaccrual TDRs are restored to accrual status if principal and interest payments, under the modified terms, are current for six consecutive payments after the modification and future principal and interest payments are reasonably assured. In contrast, an accruing TDR represents a loan that, at the time of the modification, has a demonstrated history of payments and management believes that future loan payments are reasonably assured under the modified terms.

The table below shows loans whose terms have been modified under TDRs during the three and nine months ended September 30, 2018 and 2017. There were no impairment losses recognized on any of these TDRs, and one of the loans modified in the third quarter of 2018 is not performing under their modified terms. There were no defaults during the three and nine months ended September 30, 2018 for TDRs entered into during the previous 12 month period.

Modifications

Pre-Modification

Post-Modification

Number

Outstanding

Recorded

Investment

(dollars in thousands)

Contracts

Investments

at Period End

Three months ended:

September 30, 2018

Commercial related loans accruing

1,114

1,155

1,154

September 30, 2017

None

Nine months ended:

September 30, 2018

Commercial related loans accruing

1,264

1,305

1,293

September 30, 2017

None

- 26 -

NOTE 5 – Allowance for Loan Losses

The table below shows the activity in and the composition of the allowance for loan losses by loan segment and class detail as of and for the three and nine months ended September 30, 2018 and 2017.


		Allowance for Loan Losses
		July 1, 2018										September 30, 2018
(dollars in thousands)		Balance		Charge-offs			Recoveries		Provision			Balance
Builder & developer	$	2,899	$	(144	)	$	41	$	218		$	3,014
Commercial real estate investor		2,695		0			0		49			2,744
Residential real estate investor		2,424		(1	)		3		68			2,494
Hotel/Motel		764		0			0		46			810
Wholesale & retail		938		0			1		775			1,714
Manufacturing		645		0			0		681			1,326
Agriculture		471		0			0		76			547
Other commercial		2,955		0			18		(63	)		2,910
Total commercial related loans		13,791		(145	)		63		1,850			15,559
Residential mortgage		114		0			9		(1	)		122
Home equity		203		(123	)		0		203			283
Other consumer		192		(30	)		13		(17	)		158
Total consumer related loans		509		(153	)		22		185			563
Unallocated		2,847		0			0		(735	)		2,112
Total	$	17,147	$	(298	)	$	85	$	1,300		$	18,234


		Allowance for Loan Losses
		July 1, 2017										September 30, 2017
(dollars in thousands)		Balance		Charge-offs			Recoveries		Provision			Balance
Builder & developer	$	3,511	$	(1,474	)	$	0	$	1,913		$	3,950
Commercial real estate investor		3,073		0			0		128			3,201
Residential real estate investor		2,458		0			3		71			2,532
Hotel/Motel		662		0			0		7			669
Wholesale & retail		845		0			0		34			879
Manufacturing		906		0			0		55			961
Agriculture		673		0			0		(257	)		416
Other commercial		2,434		(68	)		0		113			2,479
Total commercial related loans		14,562		(1,542	)		3		2,064			15,087
Residential mortgage		94		0			0		11			105
Home equity		182		(137	)		0		153			198
Other consumer		73		(51	)		4		47			73
Total consumer related loans		349		(188	)		4		211			376
Unallocated		1,504		0			0		(175	)		1,329
Total	$	16,415	$	(1,730	)	$	7	$	2,100		$	16,792

- 27 -

		Allowance for Loan Losses
		January 1, 2018										September 30, 2018
(dollars in thousands)		Balance		Charge-offs			Recoveries		Provision			Balance
Builder & developer	$	3,388	$	(144	)	$	59	$	(289	)	$	3,014
Commercial real estate investor		3,013		0			0		(269	)		2,744
Residential real estate investor		2,505		(2	)		77		(86	)		2,494
Hotel/Motel		637		0			0		173			810
Wholesale & retail		909		0			3		802			1,714
Manufacturing		592		0			0		734			1,326
Agriculture		431		0			0		116			547
Other commercial		2,643		0			18		249			2,910
Total commercial related loans		14,118		(146	)		157		1,430			15,559
Residential mortgage		108		(10	)		10		14			122
Home equity		217		(123	)		0		189			283
Other consumer		66		(166	)		23		235			158
Total consumer related loans		391		(299	)		33		438			563
Unallocated		2,180		0			0		(68	)		2,112
Total	$	16,689	$	(445	)	$	190	$	1,800		$	18,234


		Allowance for Loan Losses
		January 1, 2017										September 30, 2017
(dollars in thousands)		Balance		Charge-offs			Recoveries		Provision			Balance
Builder & developer	$	2,384	$	(1,474	)	$	2	$	3,038		$	3,950
Commercial real estate investor		2,870		0			0		331			3,201
Residential real estate investor		2,517		(110	)		59		66			2,532
Hotel/Motel		807		(36	)		36		(138	)		669
Wholesale & retail		803		0			0		76			879
Manufacturing		307		0			0		654			961
Agriculture		619		0			0		(203	)		416
Other commercial		2,467		(68	)		0		80			2,479
Total commercial related loans		12,774		(1,688	)		97		3,904			15,087
Residential mortgage		85		0			5		15			105
Home equity		179		(137	)		0		156			198
Other consumer		193		(61	)		9		(68	)		73
Total consumer related loans		457		(198	)		14		103			376
Unallocated		1,761		0			0		(432	)		1,329
Total	$	14,992	$	(1,886	)	$	111	$	3,575		$	16,792

- 28 -

The table below shows the allowance amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment at September 30, 2018, December 31, 2017, and September 30, 2017.


	Allowance for Loan Losses						Loans
	Individually		Collectively				Individually		Collectively
	Evaluated For		Evaluated For				Evaluated For		Evaluated For
(dollars in thousands)	Impairment		Impairment		Balance		Impairment		Impairment			Balance
September 30, 2018
Builder & developer	$	51	$	2,963	$	3,014	$	415	$	162,187	$	162,602
Commercial real estate investor		0		2,744		2,744		4,966		214,458		219,424
Residential real estate investor		0		2,494		2,494		2,176		232,950		235,126
Hotel/Motel		0		810		810		0		86,815		86,815
Wholesale & retail		757		957		1,714		8,164		97,785		105,949
Manufacturing		539		787		1,326		3,244		81,197		84,441
Agriculture		0		547		547		661		64,859		65,520
Other commercial		0		2,910		2,910		1,117		329,526		330,643
Total commercial related		1,347		14,212		15,559		20,743		1,269,777		1,290,520
Residential mortgage		0		122		122		550		82,213		82,763
Home equity		0		283		283		493		96,808		97,301
Other consumer		0		158		158		242		23,201		23,443
Total consumer related		0		563		563		1,285		202,222		203,507
Unallocated		0		2,112		2,112		—		—		—
Total	$	1,347	$	16,887	$	18,234	$	22,028	$	1,471,999	$	1,494,027


December 31, 2017
Builder & developer	$	0	$	3,388	$	3,388	$	2,673	$	181,729	$	184,402
Commercial real estate investor		243		2,770		3,013		5,645		225,182		230,827
Residential real estate investor		0		2,505		2,505		1,210		208,204		209,414
Hotel/Motel		0		637		637		0		63,195		63,195
Wholesale & retail		0		909		909		7,912		95,128		103,040
Manufacturing		0		592		592		3,840		58,670		62,510
Agriculture		0		431		431		315		59,616		59,931
Other commercial		0		2,643		2,643		918		283,593		284,511
Total commercial related		243		13,875		14,118		22,513		1,175,317		1,197,830
Residential mortgage		0		108		108		247		79,078		79,325
Home equity		0		217		217		452		97,498		97,950
Other consumer		0		66		66		235		24,424		24,659
Total consumer related		0		391		391		934		201,000		201,934
Unallocated		0		2,180		2,180		—		—		—
Total	$	243	$	16,446	$	16,689	$	23,447	$	1,376,317	$	1,399,764


September 30, 2017
Builder & developer	$	200	$	3,750	$	3,950	$	5,783	$	190,828	$	196,611
Commercial real estate investor		243		2,958		3,201		5,747		240,250		245,997
Residential real estate investor		154		2,378		2,532		1,716		209,732		211,448
Hotel/Motel		0		669		669		0		66,291		66,291
Wholesale & retail		0		879		879		7,046		91,327		98,373
Manufacturing		400		561		961		4,522		54,439		58,961
Agriculture		0		416		416		329		57,598		57,927
Other commercial		0		2,479		2,479		1,063		264,535		265,598
Total commercial related		997		14,090		15,087		26,206		1,175,000		1,201,206
Residential mortgage		0		105		105		93		79,895		79,988
Home equity		0		198		198		360		95,123		95,483
Other consumer		0		73		73		304		25,281		25,585
Total consumer related		0		376		376		757		200,299		201,056
Unallocated		0		1,329		1,329		—		—		—
Total	$	997	$	15,795	$	16,792	$	26,963	$	1,375,299	$	1,402,262

- 29 -

Note 6—Deposits

The composition of deposits as of September 30, 2018 and December 31, 2017 is shown below. The aggregate amount of demand deposit overdrafts that were reclassified as loans were $190,000 at September 30, 2018, compared to $199,000 at December 31, 2017.


	September 30,		December 31,
(dollars in thousands)	2018		2017
Noninterest bearing demand	$	258,816	$	246,866
Interest Bearing Demand		160,100		157,903
Money market		503,017		447,425
Savings		86,063		86,292
Time deposits less than $100,000		268,486		260,482
Time deposits $100,000 to $250,000		142,950		135,242
Time deposits $250,000 or more		50,827		50,297
Total deposits	$	1,470,259	$	1,384,507

Note 7—Short-Term Borrowings and Long-Term Debt

Short-term borrowings consist of securities sold under agreements to repurchase, federal funds purchased and other borrowings. At September 30, 2018, the balance of securities sold under agreements to repurchase was $8,624,000 compared to $10,295,000 at December 31, 2017. At September 30, 2018, there were no other short-term borrowings compared to $10,200,000 at December 31, 2017.

The following table presents a summary of long-term debt as of September 30, 2018 and December 31, 2017. PeoplesBank’s long-term debt obligations to the FHLBP are fixed rate instruments. Under terms of a blanket collateral agreement with the FHLBP, the obligations are secured by FHLBP stock and PeoplesBank qualifying loan receivables, principally real estate secured loans.


	September 30,		December 31,
(dollars in thousands)	2018		2017
PeoplesBank’s obligations:
Federal Home Loan Bank of Pittsburgh (FHLBP)
Due March 2018, 1.17%	$	0	$	10,000
Due June 2018, 1.87%		0		5,000
Due June 2018, 1.41%		0		10,000
Due November 2018, 1.62%		5,000		5,000
Due December 2018, 1.60%		15,000		15,000
Due April 2019, 1.64%		10,000		10,000
Due June 2019, 1.64%		5,000		5,000
Due June 2019, 2.10%		5,000		5,000
Due December 2019, 1.89%		15,000		15,000
Due March 2020, 1.86%		10,000		10,000
Due June 2020, 1.87%		15,000		15,000
Due June 2020, 2.70%		10,000		0
Due June 2021, 2.14%		15,000		15,000
Due June 2021, 2.81%		10,000		0
Due May 2022, 2.98%		10,000		0
Total FHLBP		125,000		120,000
Codorus Valley Bancorp, Inc. obligations:
Junior subordinated debt
Due 2034, 4.35%, floating rate based on 3 month
LIBOR plus 2.02%, callable quarterly		3,093		3,093
Due 2036, 3.88% floating rate based on 3 month
LIBOR plus 1.54%, callable quarterly		7,217		7,217
Total long-term debt	$	135,310	$	130,310

- 30 -

At September 30, 2018 and December 31, 2017, municipal deposit letters of credit issued by the FHLBP on behalf of PeoplesBank naming applicable municipalities as beneficiaries were $42,000,000. The letters of credit took the place of securities pledged to the municipalities for their deposits maintained at PeoplesBank.

In June 2006, Codorus Valley formed CVB Statutory Trust No. 2, a wholly-owned special purpose subsidiary whose sole purpose was to facilitate a pooled trust preferred debt issuance of $7,217,000. In November 2004, Codorus Valley formed CVB Statutory Trust No. 1 to facilitate a pooled trust preferred debt issuance of $3,093,000. The Corporation owns all of the common stock of these nonbank subsidiaries, and the debentures are the sole assets of the Trusts. The accounts of both Trusts are not consolidated for financial reporting purposes in accordance with FASB ASC 810. For regulatory capital purposes, all of the Corporation’s trust preferred securities qualified as Tier 1 capital for all reported periods. Trust preferred securities are subject to capital limitations under the FDIC’s risk-based capital guidelines. The Corporation used the net proceeds from these offerings to fund its operations.

Note 8—Regulatory Matters

The Corporation and PeoplesBank are subject to various regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if imposed, could have a material adverse effect on the Corporation’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and PeoplesBank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators.

On July 2, 2013, the Board of Governors of the Federal Reserve System finalized its rule implementing the Basel III regulatory capital framework, which the FDIC adopted on July 9, 2013. Under the rule, minimum requirements increased both the quantity and quality of capital held by banking organizations. Consistent with the Basel III framework, the rule included a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5 percent, and a common equity Tier 1 conservation buffer of 2.5 percent of risk-weighted assets, that applies to all supervised financial institutions, which is to be phased in over a four year period beginning January 1, 2016, with the full 2.5 percent required as of January 1, 2019. The rule also raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4 percent to 6 percent, and includes a minimum leverage ratio of 4 percent for all banking organizations. The new rule also increased the risk weights for past-due loans, certain commercial real estate loans, and some equity exposures, and makes selected other changes in risk weights and credit conversion factors. The rule for smaller, less complex institutions, including the Corporation, took effect January 1, 2015.

- 31 -

As of September 30, 2018, the Corporation and PeoplesBank met the minimum requirements of the Basel III framework, and PeoplesBank’s capital ratios exceeded the amount to be considered “well capitalized” as defined in the regulations. The table below provides a comparison of the Corporation’s and PeoplesBank’s risk-based capital ratios and leverage ratios to the minimum regulatory requirement for the periods indicated.

						Minimum for					Well Capitalized
	Actual					Capital Adequacy (1)					Minimum (2)
(dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
*Codorus Valley Bancorp, Inc. (consolidated)*
at September 30, 2018
Capital ratios:
Common equity Tier 1	$	175,204		11.82	%	$	94,493		6.375	%		n/a		n/a
Tier 1 risk based		185,204		12.49			116,726		7.875			n/a		n/a
Total risk based		203,438		13.73			146,371		9.875			n/a		n/a
Leverage		185,204		10.39			71,335		4.00			n/a		n/a

at December 31, 2017
Capital ratios:
Common equity Tier 1	$	162,860		11.58	%	$	80,842		5.750	%		n/a		n/a
Tier 1 risk based		172,860		12.29			101,932		7.250			n/a		n/a
Total risk based		189,549		13.48			130,051		9.250			n/a		n/a
Leverage		172,860		10.26			67,382		4.00			n/a		n/a

PeoplesBank, A Codorus Valley Company
at September 30, 2018
Capital ratios:
Common equity Tier 1	$	181,193		12.25	%	$	94,260		6.375	%	$	96,108		6.50	%
Tier 1 risk based		181,193		12.25			116,439		7.875			118,287		8.00
Total risk based		199,427		13.49			146,011		9.875			147,859		10.00
Leverage		181,193		10.18			71,188		4.00			88,986		5.00

at December 31, 2017
Capital ratios:
Common equity Tier 1	$	168,879		12.04	%	$	80,630		5.750	%	$	91,147		6.50	%
Tier 1 risk based		168,879		12.04			101,664		7.250			112,181		8.00
Total risk based		185,568		13.23			129,709		9.250			140,226		10.00
Leverage		168,879		10.05			67,234		4.00			84,043		5.00

(1) Minimum amounts and ratios as of September 30, 2018 include the third year phase in of the capital conservation buffer of 1.875 percent required by the Basel III framework. At December 31, 2017, the minimum amounts and ratios included the second year phase in of the capital conservation buffer of 1.25 percent required by the Basel III framework. The conservation buffer is to be phased in over a four year period beginning January 1, 2016, with the full 2.5 percent required as of January 1, 2019.

(2) To be “well capitalized” under the prompt corrective action provisions in the Basel III framework. “Well capitalized” applies to PeoplesBank only.

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Note 9—Shareholders’ Equity

Authorized Shares

At the May 15, 2018 annual shareholder meeting, the shareholders of the Corporation approved a change in the Articles of Incorporation to increase the number of authorized shares of common stock from 15,000,000 to 30,000,000.

Stock Dividend

Periodically, the Corporation distributes stock dividends on its stock. On October 9, 2018, the Corporation declared a 5 percent stock dividend payable on December 11, 2018, to shareholders of record at close of business on October 23, 2018. Distribution of this stock dividend will result in the issuance of approximately 447,700 additional shares. The Corporation distributed a 5 percent stock dividend on December 12, 2017 which resulted in the issuance of 422,439 additional shares.

Note 10—Contingent Liabilities

There are no legal proceedings pending against Codorus Valley Bancorp, Inc. or any of its subsidiaries which are expected to have a material impact upon the consolidated financial position and/or operating results of the Corporation, other than routine litigation incidental to the business. Management is not aware of any proceedings known or contemplated by government authorities.

Note 11—Guarantees

Codorus Valley does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are written conditional commitments issued by PeoplesBank to guarantee the performance of a client to a third party. Generally, all letters of credit, when issued, have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to clients. The Corporation generally holds collateral and/or personal guarantees supporting these commitments. The Corporation had $27,564,000 of standby letters of credit outstanding on September 30, 2018, compared to $23,603,000 on December 31, 2017. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding letters of credit. The amount of the liability as of September 30, 2018 and December 31, 2017, for guarantees under standby letters of credit issued, was not material. Many of the commitments are expected to expire without being drawn upon and, therefore, generally do not present significant liquidity risk to the Corporation or PeoplesBank.

- 33 -

Note 12—Fair Value of Assets and Liabilities

The Corporation uses its best judgment in estimating the fair value of the Corporation’s assets and liabilities; however, there are inherent weaknesses in any estimation technique. Therefore, the fair value estimates herein are not necessarily indicative of the amounts that could be realized in sales transactions 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 subsequent to the respective reporting dates may be different than the amounts reported at each period end.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for an asset or liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date. GAAP establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: Inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

Level 2: Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets; inputs to the valuation methodology include quoted prices for identical or similar assets or liabilities in markets that are not active; or inputs to the valuation methodology that utilize model-based techniques for which all significant assumptions are observable in the market.

Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement; inputs to the valuation methodology that utilize model-based techniques for which significant assumptions are not observable in the market; or inputs to the valuation methodology that require significant management judgment or estimation, some of which may be internally developed.

Since management maximizes the use of observable inputs and minimizes the use of unobservable inputs when determining fair value, 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. Management reviews and updates the fair value hierarchy classifications on a quarterly basis.

- 34 -

Assets Measured at Fair Value on a Recurring Basis

Securities available-for-sale

The fair values of investment securities were measured using information from a third-party pricing service. The pricing service uses quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique, used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities, but rather, by relying on the securities’ relationship to other benchmark quoted prices. At least annually, the Corporation reviews a random sample of the pricing information received from the third-party pricing service by comparing it to price quotes from third-party brokers. Historically, price deviations have been immaterial.

			Fair Value Measurements
(dollars in thousands)	Total		(Level 1) Quoted Prices in Active Markets for Identical Assets		(Level 2) Significant Other Observable Inputs		(Level 3) Significant Other Unobservable Inputs
September 30, 2018
Securities available-for-sale:
U.S. Treasury notes	$	13,572	$	13,572	$	0	$	0
U.S. agency		14,742		0		14,742		0
U.S. agency mortgage-backed, residential		72,066		0		72,066		0
State and municipal		45,709		0		45,709		0

December 31, 2017
Securities available-for-sale:
U.S. Treasury notes	$	14,071	$	14,071	$	0	$	0
U.S. agency		17,303		0		17,303		0
U.S. agency mortgage-backed, residential		75,175		0		75,175		0
State and municipal		52,042		0		52,042		0

Assets Measured at Fair Value on a Nonrecurring Basis

Impaired loans

Impaired loans are those that are accounted for under FASB ASC Topic 310, in which the Corporation has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These loans are included as Level 3 fair values, based on the lowest level of input that is significant to the fair value measurements. At September 30, 2018, the fair value of impaired loans with a valuation allowance or charge-off was $8,683,000, net of valuation allowances of $1,347,000 and charge-offs of $159,000. At December 31, 2017 the fair value of impaired loans with a valuation allowance or charge-off was $1,331,000, net of valuation allowances of $243,000 and charge-offs of $506,000.

Foreclosed Real Estate

Other real estate property acquired through foreclosure is initially recorded at fair value of the property at the transfer date less estimated selling cost. Subsequently, other real estate owned is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based on an independent third-party appraisal of the property or occasionally on a recent sales offer. At September 30, 2018 and December 31, 2017, there were no foreclosed real estate assets with a valuation allowance or write-down.

- 35 -

Mortgage Servicing Rights

Mortgage servicing rights are initially recorded at fair value upon the sale of residential mortgage loans to secondary market investors. The fair value of servicing rights is based on the present value of estimated future cash flows on pools of mortgages stratified by rate and original time to maturity. Mortgage servicing rights are subsequently evaluated for impairment on a quarterly basis. Significant inputs to the valuation include expected cash flow, expected net servicing income, a cash flow discount rate and the expected life of the underlying loans. At September 30, 2018, the fair value of the mortgage servicing rights asset was $1,081,000. At December 31, 2017, the fair value of the mortgage servicing rights asset was $769,000.

			Fair Value Measurements
(dollars in thousands)	Total		(Level 1) Quoted Prices in Active Markets for Identical Assets		(Level 2) Significant Other Observable Inputs		(Level 3) Significant Other Unobservable Inputs
September 30, 2018
Impaired loans	$	8,683	$	0	$	0	$	8,683
Mortgage servicing rights		1,081		0		0		1,081

December 31, 2017
Impaired loans	$	1,331	$	0	$	0	$	1,331
Mortgage servicing rights		769		0		0		769

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which the Corporation has utilized Level 3 inputs to determine fair value:

	Quantitative Information about Level 3 Fair Value Measurements
(dollars in thousands)	Fair Value Estimate		Valuation Techniques	Unobservable Input	Range		Weighted Average
September 30, 2018
Impaired loans	$	311	Appraisal ⁽¹⁾	Appraisal adjustments ⁽²⁾		15% - 25%		23	%
Impaired loans		8,372	Financial statements ⁽³⁾	Valuation adjustments ⁽²⁾		0% - 52%		50	%
Mortgage servicing rights		1,081	Multiple of annual	Estimated prepayment speed		7.2% - 8.3%		7.4	%
			service fee	based on rate and term
December 31, 2017
Impaired loans	$	1,331	Appraisal ⁽¹⁾	Appraisal adjustments ⁽²⁾		24% - 52%		38	%
Mortgage servicing rights		769	Multiple of annual	Estimated prepayment speed		6.9% - 8.5%		7.6	%
			service fee	based on rate and term

(1)

Fair value is generally determined through independent appraisals, which generally include various level 3 inputs that are not identifiable.

(2)

Appraisals and financial statement amounts may be adjusted downward by the Corporation’s management for qualitative factors such as economic conditions and estimated liquidation expenses. The range of liquidation expenses and other adjustments are a percent of the appraisal or financial statement book value.

(3)

Internal financial statements provided by customers.

- 36 -

Disclosures about Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of the Corporation’s financial instruments as of September 30, 2018 and December 31, 2017:

Cash and cash equivalents

The carrying amount is a reasonable estimate of fair value.

Securities available for sale

The fair value of securities available for sale is determined in accordance with the methods described under FASB ASC Topic 820 as described above.

Restricted investment in bank stocks

The carrying amount of restricted investment in bank stocks is a reasonable estimate of fair value. The Corporation is required to maintain minimum investment balances in these stocks. These stocks are not actively traded and, therefore, have no readily determinable market value.

Loans held for sale

The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted prices exist, the fair value of a loan is determined using quoted prices for a similar loan or loans, adjusted for the specific attributes of that loan.

Loans, net

The fair value of loans, for September 30, 2018, are estimated on an exit price basis incorporating adjustments for such factors as credit, liquidity and marketability factors. This is not comparable with the fair values disclosed for December 31, 2017, which were based on an entrance price basis. For that date, fair values of variable rate loans that reprice frequently and with no significant change in credit risk were based on carrying values. The fair values of other loans as of that date were estimated using discounted cash flow analyses which used interest rates then being offered for loans with similar terms to borrowers of similar credit quality.

Interest receivable

The carrying value of interest receivable is a reasonable estimate of fair value.

Deposits

The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair values of time deposits are estimated using a discounted cash flow analyses. The discount rates used are based on rates currently offered for deposits with similar remaining maturities. The fair values of variable rate time deposits that reprice frequently are based on carrying value. The fair values of time deposit liabilities do not take into consideration the value of the Corporation’s long-term relationships with depositors, which may have significant value.

Short-term borrowings

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

Long-term debt

Long-term debt includes FHLBP advances (Level 2) and junior subordinated debt (Level 3). The fair value of FHLBP advances is estimated using discounted cash flow analysis, based on quoted prices for new FHLBP advances with similar credit risk characteristics, terms and remaining maturity. These prices are obtained from this active market and represent a market value that is deemed to represent the transfer price if the liability were assumed by a third party. The fair value of junior subordinated debt is estimated using discounted cash flow analysis, based on market rates and spread characteristics of similar debt with similar credit risk characteristics, terms and remaining maturity.

- 37 -

Interest payable

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

Off-balance sheet instruments

Off-balance sheet instruments consist of lending commitments and letters of credit and are based on fees currently charged in the market to enter into similar arrangements, taking into account the remaining terms of the agreements and counterparties’ credit standing. These amounts were not considered material.

The following presents the carrying amounts and estimated fair values of the Corporation’s financial instruments as of September 30, 2018 and December 31, 2017.

					Fair Value Estimates
(dollars in thousands)	Carrying Amount		Estimated Fair Value		(Level 1) Quoted Prices in Active Markets for Identical Assets		(Level 2) Significant Other Observable Inputs		(Level 3) Significant Other Unobservable Inputs
September 30, 2018
Financial assets
Cash and cash equivalents	$	85,348	$	85,348	$	85,348	$	0	$	0
Securities available-for-sale		146,089		146,089		13,572		132,517		0
Restricted investment in bank stocks		6,122		6,122		0		6,122		0
Loans held for sale		3,795		3,928		0		3,928		0
Loans, net		1,475,793		1,452,672		0		0		1,452,672
Interest receivable		5,142		5,142		0		5,142		0
Mortgage servicing rights		876		1,081		0		0		1,081

Financial liabilities
Deposits	$	1,470,259	$	1,452,587	$	0	$	1,452,587	$	0
Short-term borrowings		8,624		8,624		0		8,624		0
Long-term debt		135,310		132,178		0		123,740		8,438
Interest payable		865		865		0		865		0

Off-balance sheet instruments		0		0		0		0		0

December 31, 2017
Financial assets
Cash and cash equivalents	$	79,524	$	79,524	$	79,524	$	0	$	0
Securities available-for-sale		158,591		158,591		14,071		144,520		0
Restricted investment in bank stocks		6,311		6,311		0		6,311		0
Loans held for sale		1,715		1,798		0		1,798		0
Loans, net		1,383,075		1,368,753		0		0		1,368,753
Interest receivable		4,968		4,968		0		4,968		0
Mortgage servicing rights		672		769		0		0		769

Financial liabilities
Deposits	$	1,384,507	$	1,369,008	$	0	$	1,369,008	$	0
Short-term borrowings		20,495		20,495		0		20,495		0
Long-term debt		130,310		127,586		0		119,474		8,112
Interest payable		626		626		0		626		0

Off-balance sheet instruments		0		0		0		0		0

- 38 -

Note 13—Assets and Liabilities Subject to Offsetting

Securities Sold Under Agreements to Repurchase

PeoplesBank enters into agreements with clients in which it sells securities subject to an obligation to repurchase the same securities (“repurchase agreements”). The contractual maturity of the repurchase agreement is overnight and continues until either party terminates the agreement. These repurchase agreements are accounted for as a collateralized financing arrangement (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability (short-term borrowings) in the Corporation’s consolidated financial statements of condition, while the securities underlying the repurchase agreements are appropriately segregated for safekeeping purposes and remain in the respective securities asset accounts. Thus, there is no offsetting or netting of the securities with the repurchase agreement liabilities.

							Gross amounts Not Offset in
			Gross		Net Amounts		the Statements of Condition
	Gross		Amounts		of Liabilities		Financial Instruments
	Amounts of		Offset in the		Presented in		U.S. agency				Cash
	Recognized		Statements		the Statements		mortgage-backed,				Collateral		Net
(dollars in thousands)	Liabilities		of Condition		of Condition		residential		U.S. agency		Pledged		Amount
September 30, 2018
Repurchase Agreements	$	8,624	$	0	$	8,624	$	(8,624)	$	0	$	0	$	0

December 31, 2017
Repurchase Agreements	$	10,295	$	0	$	10,295	$	(10,295)	$	0	$	0	$	0

As of September 30, 2018 and December 31, 2017, the carrying value of securities pledged in connection with repurchase agreements was $9,406,000 and $15,545,000, respectively.

- 39 -

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

Management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for Codorus Valley Bancorp, Inc. (“Codorus Valley” or “the Corporation”), a bank holding company, and its wholly-owned subsidiary, PeoplesBank, A Codorus Valley Company (“PeoplesBank”), are provided below. Codorus Valley’s consolidated financial condition and results of operations consist almost entirely of PeoplesBank’s financial condition and results of operations. Current performance does not guarantee, and may not be indicative of, similar performance in the future.

Forward-looking Statements

Management of the Corporation has made forward-looking statements in this Form 10-Q. These forward-looking statements may be subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When words such as “believes,” “expects,” “anticipates” or similar expressions occur in the Form 10-Q, management is making forward-looking statements.

Note that many factors, some of which are discussed elsewhere in this report and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this Form 10-Q. These factors include, but are not limited to, the following:

●

Operating, legal and regulatory risks;

●

Credit risk, including an increase in nonperforming assets requiring loss provisions and the incurrence of carrying costs related to nonperforming assets;

●

Interest rate fluctuations which could increase our cost of funds or decrease our yield on earning assets and therefore reduce our net interest income;

●

Declines in the market value of investment securities considered to be other-than-temporary;

●

Unavailability of capital when needed, or availability at less than favorable terms;

●

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer systems or otherwise, which may adversely affect the Corporation’s operations, net income or reputation;

●

Inability to achieve merger-related synergies, and difficulties in integrating the business and operations of acquired institutions;

●

A prolonged economic downturn;

●

Political and competitive forces affecting banking, securities, asset management and credit services businesses;

●

The effects of and changes in the rate of FDIC premiums, including special assessments;

●

Future legislative or administrative changes to U.S. governmental capital programs;

●

Future changes in federal or state tax laws or tax rates;

●

Enacted financial reform legislation, e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act, may have a significant impact on the Corporation’s business and results of operations; and

●

The risk that management’s analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report.

- 40 -

Critical Accounting Policies

The Corporation’s critical accounting policies, as summarized in Note 1—Summary of Significant Accounting Policies, include those related to the allowance for loan losses, valuation of foreclosed real estate, evaluation of other-than-temporary impairment of securities, and determination of acquisition-related goodwill and fair value adjustments, which require management to make significant judgments, estimates and assumptions that have a material impact on the carrying value of the respective assets and liabilities. For this Form 10-Q, there were no material changes made to the Corporation’s critical accounting policies, which are more fully disclosed in Item 7 of the Corporation’s previously filed Annual Report on Form 10-K for the year ended December 31, 2017.

Three Months Ended September 30, 2018 vs. Three Months Ended September 30, 2017

Financial Highlights

The Corporation’s net income (earnings) was $5,060,000 for the quarter ended September 30, 2018, as compared to $3,410,000 for the quarter ended September 30, 2017, an increase of $1,650,000 or 48 percent.

●

Net interest income for the third quarter of 2018 increased $1,140,000 or 7 percent above the same period in 2017, primarily due to increased interest income from a higher volume of commercial loans in the third quarter of 2018 as compared to the third quarter of 2017.

●

The Corporation’s net interest margin (tax-equivalent basis) for the third quarter of 2018 was 3.86 percent, compared to 3.88 percent for the third quarter of 2017. The net interest margin contraction was a result of an increase in the volume and cost of interest-bearing liabilities, partially offset by an increase in the volume of interest earning assets.

●

The provision for loan losses was $1,300,000 for the third quarter of 2018, an $800,000 decrease as compared to a provision of $2,100,000 for the third quarter of 2017. The change in the provision for the third quarter of 2018 was primarily due to specific loan loss reserves assigned during the third quarter of 2018 as compared to a larger aggregate amount of net charge-offs and specific reserves taken during the third quarter of 2017. The allowance as a percentage of total loans was 1.22 percent at September 30, 2018 as compared to 1.19 percent at December 31, 2017 and 1.20 percent at September 30, 2017.

●

Noninterest income for the third quarter of 2018 increased $497,000 or 18 percent compared to the third quarter of 2017. Several sources contributed to the rise in noninterest income, including increased gains on sales of loans held for sale, service charges on deposit accounts, trust and investment services fees, income from mutual fund, annuity and insurance sales and other income.

●

Noninterest expenses in the third quarter of 2018 were $1,016,000 or 9 percent higher than the third quarter of 2017. Higher personnel costs, which include compensation and benefit expenses, external data processing and other expenses accounted for a majority of the increase. The increase was partially offset by decreases in marketing and telecommunications.

●

The provision for income taxes for the third quarter of 2018 decreased by $229,000 or 14 percent as compared to the third quarter of 2017 as a result of the new corporate tax rate of 21 percent enacted as part of the Tax Cuts and Jobs Act that became effective January 1, 2018.

- 41 -

The schedule below presents selected performance metrics for the third quarter of both 2018 and 2017. Per share computations include the effect of stock dividends, including the 5 percent stock dividend declared on October 9, 2018.

	Three months ended
	September 30,
	2018			2017
Basic earnings per common share	$	0.53		$	0.37
Diluted earnings per common share	$	0.53		$	0.36
Cash dividend payout ratio		27.40	%		33.46	%
Return on average assets		1.14	%		0.82	%
Return on average equity		11.66	%		8.30	%
Net interest margin (tax equivalent basis)		3.86	%		3.88	%
Net overhead ratio		1.95	%		1.96	%
Efficiency ratio		60.30	%		59.54	%
Average equity to average assets		9.74	%		9.84	%

A more detailed analysis of the factors and trends affecting the Corporation’s earnings and financial position follows.

Income Statement Analysis

Net Interest Income

Unless otherwise noted, this section discusses interest income and interest expense amounts as reported in the Consolidated Statements of Income, which are not presented on a tax equivalent basis.

Net interest income for the quarter ended September 30, 2018 was $16,432,000, an increase of $1,140,000 or 7 percent compared to net interest income of $15,292,000 for the third quarter of 2017. The increase was primarily attributable to higher loan interest income. The Corporation’s net interest margin, computed as interest income (tax-equivalent basis) annualized as a percentage of average interest earning assets, was 3.86 percent for the third quarter of 2018 compared to the 3.88 percent for the third quarter of 2017.

Total interest income for the third quarter of 2018 totaled $20,796,000, an increase of $2,733,000 or 15 percent above the amount of total interest income for the third quarter of 2017. The change was primarily a result of a significant increase in loan income, partially offset by a decline in investment income.

Interest and dividend income on investments decreased $66,000 or 7 percent in the third quarter of 2018 compared to the same period in 2017. The average balance of the investment securities portfolio decreased $26,918,000 or 15 percent when comparing the third quarter of 2018 to the same period in 2017. The tax-equivalent yield on investments for the third quarter of 2018 was 2.49 percent or 3 basis points higher than the 2.46 percent experienced in the third quarter of 2017.

Interest income on loans increased $2,583,000 or 15 percent in the third quarter of 2018 compared to the same period in 2017. The average balance of outstanding loans, primarily commercial loans, increased approximately $105,090,000 or 8 percent comparing the third quarter of 2018 to the same period in 2017 which was the primary driver to the increase in interest income on loans. The tax-equivalent yield on loans for the third quarter 2018 was 5.24 percent or 33 basis points more than the 4.91 percent experienced in the third quarter of 2017.

- 42 -

Total interest expense for the third quarter of 2018 was $4,364,000, an increase of $1,593,000 or 57 percent as compared to total interest expense of $2,771,000 for the third quarter of 2017. The change was primarily the result of an increase in the cost of deposits.

Interest expense on deposits increased $1,510,000 or 73 percent in the third quarter of 2018 compared to the same period in 2017. The average rate paid on interest-bearing deposits was 1.19 percent in the third quarter of 2018 or 44 basis points higher than the average rate paid of 0.75 percent in the third quarter of 2017. The average balance of interest-bearing deposits for the third quarter of 2018 increased by $91,947,000 or 8 percent compared to the third quarter of 2017. Also, the Corporation experienced favorable growth in noninterest-bearing deposits, with the average volume for the third quarter of 2018 increasing 16 percent to $257,749,000 as compared to $221,474,000 for the third quarter of 2017.

For the third quarter of 2018 interest expense on borrowings increased $83,000 or 12 percent compared to the third quarter of 2017. Short-term borrowings consisting of repurchase agreements and other short-term borrowings averaged $10,430,000 for the third quarter of 2018, compared to an average balance of $37,307,000 for the third quarter of 2017. The rate on average short-term borrowings for the third quarter of 2018 was 0.57 percent, a decrease as compared to a rate of 0.76 percent for the third quarter of 2017. Long-term debt, primarily from the Federal Home Loan Bank of Pittsburgh (FHLBP), averaged $135,310,000 for both the third quarter of 2018 and the third quarter of 2017. For the third quarter of 2018, the rate on average long-term borrowings was 2.25 percent, an increase as compared to a rate of 1.84 percent for the third quarter of 2017.

- 43 -

Table 1-Average Balances and Interest Rates (tax equivalent basis)

	Three months ended September 30,
	2018								2017
	Average					Yield/			Average					Yield/
(dollars in thousands)	Balance		Interest			Rate			Balance		Interest			Rate

Assets
Interest bearing deposits with banks	$	57,361	$	287			1.99	%	$	22,629	$	71			1.24	%
Investment securities:
Taxable		111,601		668			2.37			130,756		698			2.12
Tax-exempt		46,254		324			2.78			54,017		447			3.28
Total investment securities		157,855		992			2.49			184,773		1,145			2.46

Loans:
Taxable (1)		1,468,188		19,465			5.26			1,361,637		16,875			4.92
Tax-exempt		15,923		144			3.59			17,384		185			4.22
Total loans		1,484,111		19,609			5.24			1,379,021		17,060			4.91
Total earning assets		1,699,327		20,888			4.88			1,586,423		18,276			4.57
Other assets (2)		83,115								82,580
Total assets	$	1,782,442							$	1,669,003
Liabilities and Shareholders’ Equity
Deposits:
Interest bearing demand	$	648,634	$	1,702			1.04	%	$	585,856	$	716			0.48	%
Savings		87,465		21			0.10			87,474		22			0.10
Time		456,246		1,858			1.62			427,068		1,333			1.24
Total interest bearing deposits		1,192,345		3,581			1.19			1,100,398		2,071			0.75
Short-term borrowings		10,430		15			0.57			37,307		71			0.76
Long-term debt		135,310		768			2.25			135,310		629			1.84
Total interest bearing liabilities		1,338,085		4,364			1.29			1,273,015		2,771			0.86

Noninterest bearing deposits		257,749								221,474
Other liabilities		13,018								10,252
Shareholders’ equity		173,590								164,262

Total liabilities and shareholders’ equity	$	1,782,442							$	1,669,003
Net interest income (tax equivalent basis)			$	16,524							$	15,505
Net interest margin (3)							3.86	%							3.88	%
Tax equivalent adjustment				(92	)							(213	)
Net interest income			$	16,432							$	15,292

(1)

Average balance includes average nonaccrual loans of $4,232,000 for 2018 and $7,095,000 for 2017.

Interest includes net loan fees of $868,000 for 2018 and $680,000 for 2017.

(2)

Average balance includes average bank owned life insurance, foreclosed real estate and unrealized holding gains (losses) on investment securities.

(3)

Net interest income (tax equivalent basis) annualized as a percentage of average earning assets.

- 44 -

Table 2-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis)

	Three months ended
	September 30,
	2018 vs. 2017
	Increase (decrease) due to change in*
(dollars in thousands)		Volume			Rate			Net

Interest Income
Interest bearing deposits with banks	$	110		$	106		$	216
Investment securities:
Taxable		(99	)		69			(30	)
Tax-exempt		(64	)		(59	)		(123	)
Loans:
Taxable		1,548			1,042			2,590
Tax-exempt		(16	)		(25	)		(41	)
Total interest income		1,479			1,133			2,612
Interest Expense
Deposits:
Interest bearing demand		78			908			986
Savings		(1	)		0			(1	)
Time		91			434			525
Short-term borrowings		(56	)		0			(56	)
Long-term debt		0			139			139
Total interest expense		112			1,481			1,593
Net interest income (tax equivalent basis)	$	1,367		$	(348	)	$	1,019

*Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate.

Provision for Loan Losses

The provision for loan losses is an expense charged to earnings to cover the estimated losses attributable to uncollected loans. The provision reflects management’s judgment of an appropriate level for the allowance for loan losses. The provision for loan losses was $1,300,000 for the third quarter of 2018, an $800,000 decrease as compared to a provision of $2,100,000 for the third quarter of 2017. The provision in the third quarter of 2018 was primarily due to approximately $1,347,000 of specific loan loss reserves assigned during the quarter, provision related to net loan growth during the quarter, net charge-offs of $213,000 and the net impact of adjustments made to certain qualitative factors and the unallocated reserve. The provision of $2,100,000 in the third quarter of 2017 related primarily to individual net loan charge-off of $1,730,000 and provision related to net loan growth during the quarter. The provision for both periods supported adequate allowance for loan loss coverage considering several factors, including the Corporation’s continued commercial loan growth. The allowance as a percentage of total loans was 1.22 percent at September 30, 2018, as compared to 1.19 percent at December 31, 2017 and 1.20 percent at September 30, 2017.

More information about the allowance for loan losses can be found in this report under the caption Allowance for Loan Losses on page 63.

- 45 -

Noninterest Income

The following table presents the components of total noninterest income for the third quarter of 2018, compared to the third quarter of 2017.

Table 3 - Noninterest income

	Three months ended				Change
	September 30,				Increase (Decrease)
(dollars in thousands)	2018		2017		$			%

Trust and investment services fees	$	818	$	738	$	80			11	%
Income from mutual fund, annuity and insurance sales		255		214		41			19
Service charges on deposit accounts		1,187		1,057		130			12
Income from bank owned life insurance		248		257		(9	)		(4	)
Other income		364		276		88			32
Gain on sales of loans held for sale		435		252		183			73
Gain on sales of securities		0		16		(16	)		(100	)
Total noninterest income	$	3,307	$	2,810	$	497			18	%

The discussion that follows addresses changes in selected categories of noninterest income.

Service charges on deposits accounts—The $130,000 or 12 percent increase in service charges on deposit accounts was due to the higher volume of demand deposit accounts subject to fees and debit card transactions.

Other income—The $88,000 or 32 percent increase in other income was due to higher loan related income such as mortgage and SBA loan servicing income, letter of credit fees and miscellaneous client based service charges such as gift card and credit card merchant fees.

Gain on sales of loans held for sale—The $183,000 or 73 percent increase in gain on sales of loans was due to the sale of a higher volume of the guaranteed portion of SBA loans to the secondary market.

- 46 -

Noninterest Expense

The following table presents the components of total noninterest expense for the third quarter of 2018, compared to the third quarter of 2017.

Table 4 - Noninterest expense

	Three months ended				Change
	September 30,				Increase (Decrease)
(dollars in thousands)	2018		2017		$			%

Personnel	$	7,159	$	6,366	$	793			12	%
Occupancy of premises, net		860		793		67			8
Furniture and equipment		701		724		(23	)		(3	)
Postage, stationery and supplies		196		181		15			8
Professional and legal		286		294		(8	)		(3	)
Marketing		373		459		(86	)		(19	)
FDIC insurance		189		163		26			16
Debit card processing		318		294		24			8
Charitable donations		119		148		(29	)		(20	)
Telecommunications		119		204		(85	)		(42	)
External data processing		579		405		174			43
Foreclosed real estate including provision for losses		13		10		3			30
Other		1,090		945		145			15
Total noninterest expense	$	12,002	$	10,986	$	1,016			9	%

The discussion that follows addresses changes in selected categories of noninterest expense.

Personnel—The $793,000 or 12 percent increase in personnel expense was largely due to the addition of new employees to support the Corporation’s business and consumer banking services in our Maryland and Pennsylvania markets and higher health insurance costs.

Marketing—The $86,000 or 19 percent decrease in marketing expenses is attributed to a decrease in advertising costs during the quarter as compared to the prior year.

Telecommunications—The $85,000 or 42 percent decrease was due to a change in network providers which provide a higher level of service for a lower cost.

External data processing—The $174,000 or 43 percent increase in external data processing expenses reflects increased reliance on outsourcing transaction processing to specialized vendors, which is typically performed on such vendors’ hosted and secure websites. Transaction volumes in both accounts and transactions year over year due to business expansion resulted in higher costs. The Corporation continues to expand and enhance electronic banking services provided to our clients which contributed to the increase in the expense.

Other—The $145,000 or 15 percent increase in other expenses, which is comprised of many underlying expenses, is primarily due to liability insurance, PA shares tax and other miscellaneous loan expense.

- 47 -

Provision for Income Taxes

The provision for income taxes for the third quarter of 2018 was $1,377,000, a decrease of $229,000 or

14 percent as compared to the third quarter of 2017. For the third quarter of 2018 the Corporation’s statutory federal income tax rate was 21 percent compared to 35 percent for the third quarter of 2017. The effective income tax rate was 21 percent and 32 percent for the quarters ended September 30, 2018 and 2017, respectively. The effective tax rate differs from the statutory tax rate due to the impact of certain elements with specific tax benefits, including tax-exempt income, such as income from tax-exempt investments, tax-exempt loans, and bank-owned life insurance. Decreases in the provision for income taxes and effective tax rate were due to the new 21 percent corporate tax rate enacted as part of the Tax Cuts and Jobs Act that became effective January 1, 2018.

- 48 -

Nine Months Ended September 30, 2018 vs. Nine Months Ended September 30, 2017

Financial Highlights

The Corporation’s net income (earnings) was $15,197,000 for the first nine months of 2018 compared to $10,514,000 for the first nine months of 2017, an increase of $4,683,000 or 45 percent.

●

Net interest income for the first nine months of 2018 increased $3,876,000 or 9 percent above the first nine months of 2017, primarily due to increased interest income from a higher volume of commercial loan growth over the previous twelve months.

●

The Corporation’s net interest margin (tax-equivalent basis) for the nine months ended September 30, 2018 was 3.88 percent, compared to 3.82 percent for the first nine months of 2017. The net interest margin expansion was a result of a change in the mix of interest earning assets and an increase in noninterest bearing demand deposits, which more than offset the increase in the volume and cost of interest bearing liabilities.

●

The provision for loan losses for the first nine months of 2018 was $1,800,000 or a $1,775,000 decrease as compared to a provision of $3,575,000 for the first nine months of 2017. The change in provision for 2018 was primarily due to specific loan loss reserves assigned during 2018 as compared to a larger amount of aggregate net charge-offs and specific reserves taken during 2017. The provision for both periods supported adequate allowance for loan loss coverage considering several factors, including the Corporation’s substantial growth in commercial loans. The allowance as a percentage of total loans was 1.22 percent at September 30, 2018, as compared to 1.19 percent at December 31, 2017, and 1.20 percent at September 30, 2017.

●

Noninterest income for the first nine months of 2018 increased $1,733,000 or 21 percent ($1,812,000 or 22 percent excluding gain on sales of securities) compared to the first nine months of 2017. Contributing to the rise in noninterest income were income from mutual fund, annuity and insurance sales, gain on sales of loans and other income. Offsetting some of the increase was a decline in gain on sales of securities.

●

Noninterest expenses for the first nine months of 2018 were $36,882,000 or 11 percent higher than the first nine months of 2017. The increase was primarily attributable to higher personnel costs, debit card processing, charitable donations and external data processing costs. Offsetting some of the increase were declines in FDIC insurance fees and other expenses.

●

The provision for income taxes for the first nine months of 2018 decreased $965,000 or 19 percent as compared to the first nine months of 2017 as a result of the new corporate tax rate of 21 percent enacted as part of the Tax Cuts and Jobs Act that became effective January 1, 2018.

On September 30, 2018, the Corporation’s total assets were over $1.80 billion, an increase of 5 percent since December 31, 2017. The increase was attributed to loan growth, primarily in commercial loans.

The Corporation’s capital level remained sound as evidenced by regulatory capital ratios that exceed current regulatory requirements for well capitalized institutions. As of September 30, 2018, the Corporation’s capital calculations and ratios reflect full compliance with the Basel III regulatory capital framework, which became effective on January 1, 2015.

- 49 -

The schedule below presents selected performance metrics for the first nine months of both 2018 and 2017. Per share computations include the effect of stock dividends, including the 5 percent stock dividend declared October 9, 2018.

	Nine months ended
	September 30,
	2018			2017
Basic earnings per common share	$	1.62		$	1.13
Diluted earnings per common share	$	1.60		$	1.11
Cash dividend payout ratio		27.31	%		32.50	%
Return on average assets		1.16	%		0.85	%
Return on average equity		11.97	%		8.72	%
Net interest margin (tax equivalent basis)		3.88	%		3.82	%
Net overhead ratio		2.06	%		2.02	%
Efficiency ratio		63.12	%		62.24	%
Average equity to average assets		9.73	%		9.77	%

A more detailed analysis of the factors and trends affecting the Corporation’s earnings and financial position follows.

Income Statement Analysis

Net Interest Income

Net interest income for the nine months ending September 30, 2018 was $47,856,000, an increase of $3,876,000 or 9 percent compared to net interest income of $43,980,000 for the first nine months of 2017. The increase was primarily attributable to higher loan interest income. The Corporation’s net interest margin, computed as interest income (tax-equivalent basis) annualized as a percentage of average interest earning assets, was 3.88 percent for the first nine months of 2018, representing an increase compared to the 3.82 percent net interest margin for the first nine months of 2017.

Total interest income for the first nine months of 2018 totaled $59,223,000, an increase of $7,360,000 or 14 percent above the amount of total interest income for the first nine months of 2017. The change was primarily a result of a significant increase in loan income, partially offset by a decline in investment income.

Interest income on loans increased $7,230,000 or 15 percent in the first nine months of 2018 compared to the same period in 2017. The average balance of outstanding loans increased approximately $112,743,000 or 8 percent in the first nine months of 2018 compared to the first nine months of 2017, reflecting commercial loan growth over the past year.

Investment income for the first nine months of 2018 decreased $267,000 or 9 percent compared to the first nine months of 2017. The tax-equivalent yield on investments for the first nine months of 2018 was 2.52 percent or 5 basis points higher than the 2.47 percent experienced during the first nine months of 2017, as the yields on maturing investments were generally higher than those on investments purchased in the current lower interest rate environment.

- 50 -

Total interest expense for the first nine months of 2018 was $11,367,000, an increase of $3,484,000 or 44 percent as compared to total interest expense of $7,883,000 for the first nine months of 2017. The change in interest expense was primarily a result of an increase in the cost of deposits and long-term borrowings.

Interest expense on deposits increased $3,457,000 or 59 percent in the first nine months of 2018 compared to the same period in 2017. The change was due to both an increase in the costs of and growth in deposits. The average balance of interest-bearing deposits for the first nine months of 2018, primarily in lower cost core deposits, increased by $84,331,000 or 8 percent compared to the average for the first nine months of 2017. The average rate paid on interest-bearing deposits in the first nine months of 2018 was 1.06 percent, an increase from the average rate of 0.72 percent paid on interest-bearing deposits during the first nine months of 2017. Also, the Corporation experienced favorable growth in noninterest-bearing deposits, with the average volume for the first nine months of 2018 increasing to $247,484,000, as compared to $211,582,000 for the first nine months of 2017.

Interest expense on borrowings for the first nine months of 2018 increased $27,000 or 1 percent compared to the first nine months of 2017, due to a higher cost of long-term debt, which was partially offset by a decrease in volume of short-term borrowings and long-term debt. Outstanding long-term debt, consisting primarily of Federal Home Loan Bank of Pittsburgh (FHLBP) advances, averaged $130,347,000 for the first nine months of 2018, compared to an average balance of approximately $132,233,000 for the same period of 2017. The rate on average long-term debt for the first nine months of 2018 was 2.09 percent, an increase as compared to the rate of 1.81 percent for the same period of 2017.

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Table 5-Average Balances and Interest Rates (tax equivalent basis)

	Nine months ended September 30,
			2018								2017
	Average					Yield/			Average					Yield/
(dollars in thousands)	Balance		Interest			Rate			Balance		Interest			Rate

Assets
Interest bearing deposits with banks	$	48,520	$	663			1.83	%	$	34,218	$	266			1.04	%
Investment securities:
Taxable		113,256		2,020			2.38			136,642		2,158			2.11
Tax-exempt		47,916		1,018			2.84			57,169		1,427			3.34
Total investment securities		161,172		3,038			2.52			193,811		3,585			2.47

Loans:
Taxable (1)		1,432,389		55,364			5.17			1,318,529		48,117			4.88
Tax-exempt		16,676		449			3.60			17,793		569			4.28
Total loans		1,449,065		55,813			5.15			1,336,322		48,686			4.87
Total earning assets		1,658,757		59,514			4.80			1,564,351		52,537			4.49
Other assets (2)		80,911								81,445
Total assets	$	1,739,668							$	1,645,796
Liabilities and Shareholders’ Equity
Deposits:
Interest bearing demand	$	630,302	$	4,147			0.88	%	$	574,941	$	1,950			0.45	%
Savings		88,090		66			0.10			86,288		64			0.10
Time		451,666		5,070			1.50			424,498		3,812			1.20
Total interest bearing deposits		1,170,058		9,283			1.06			1,085,727		5,826			0.72
Short-term borrowings		10,812		48			0.59			44,353		263			0.79
Long-term debt		130,347		2,036			2.09			132,233		1,794			1.81
Total interest bearing liabilities		1,311,217		11,367			1.16			1,262,313		7,883			0.83

Noninterest bearing deposits		247,484								211,582
Other liabilities		11,675								11,156
Shareholders’ equity		169,292								160,745

Total liabilities and shareholders’ equity	$	1,739,668							$	1,645,796
Net interest income (tax equivalent basis)			$	48,147							$	44,654
Net interest margin (3)							3.88	%							3.82	%
Tax equivalent adjustment				(291	)							(674	)
Net interest income			$	47,856							$	43,980

(1)

Average balance includes average nonaccrual loans of $4,389,000 for 2018 and $4,712,000 for 2017.

Interest includes net loan fees of $2,555,000 for 2018 and $2,057,000 for 2017.

(2)

Average balance includes average bank owned life insurance, foreclosed real estate and unrealized holding gains (losses) on investment securities.

(3)

Net interest income (tax equivalent basis) annualized as a percentage of average interest earning assets.

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Table 6-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis)

	Nine months ended
	September 30,
	2018 vs. 2017
	Increase (decrease) due to change in*
(dollars in thousands)		Volume			Rate			Net

Interest Income
Interest bearing deposits with banks	$	111		$	286		$	397
Investment securities:
Taxable		(360	)		222			(138	)
Tax-exempt		(231	)		(178	)		(409	)
Loans:
Taxable		4,549			2,698			7,247
Tax-exempt		(36	)		(84	)		(120	)
Total interest income		4,033			2,944			6,977
Interest Expense
Deposits:
Interest bearing demand		178			2,019			2,197
Savings		2			0			2
Time		244			1,014			1,258
Short-term borrowings		(217	)		2			(215	)
Long-term debt		(24	)		266			242
Total interest expense		183			3,301			3,484
Net interest income (tax equivalent basis)	$	3,850		$	(357	)	$	3,493

*Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate.

Provision for Loan Losses

For the first nine months of 2018, the provision for loan losses was $1,800,000, as compared to a provision of $3,575,000 for the first nine months of 2017. The provision in 2018 was due to approximately $1,347,000 of specific loan loss reserves assigned during 2018, provision related to net loan growth during 2018, net charge-offs of $255,000 and the net impact of adjustments made to certain qualitative factors and the unallocated reserve. The provision of $3,575,000 in 2017 was related primarily to net loan charge-offs of $1,775,000 and provision related to net loan growth during 2017. The provision for both periods supported adequate allowance for loan loss coverage, including the Corporation’s substantial growth in commercial loans. The allowance as a percentage of total loans was 1.22 percent at September 30, 2018, as compared to 1.19 percent at December 31, 2017, and 1.20 percent at September 30, 2017.

More information about the allowance for loan losses can be found in this report under the caption Allowance for Loan Losses on page 63.

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Noninterest Income

The following table presents the components of total noninterest income for the first nine months of 2018, compared to the first nine months of 2017.

Table 7 - Noninterest income

	Nine months ended				Change
	September 30,				Increase (Decrease)
(dollars in thousands)	2018		2017		$			%

Trust and investment services fees	$	2,389	$	2,138	$	251			12	%
Income from mutual fund, annuity and insurance sales		806		620		186			30
Service charges on deposit accounts		3,485		3,078		407			13
Income from bank owned life insurance		730		779		(49	)		(6	)
Other income		1,221		817		404			49
Gain on sales of loans held for sale		1,436		823		613			74
Gain on sales of securities		0		79		(79	)		(100	)
Total noninterest income	$	10,067	$	8,334	$	1,733			21	%

The discussion that follows addresses changes in selected categories of noninterest income.

Income from mutual fund, annuity and insurance sales—The $186,000 or 30 percent increase in income from the sale of mutual fund, annuity and insurance products by CVFA d/b/a PeoplesWealth Advisors was due to the higher volume of assets under management during the first nine months of 2018 and a $74,000 fee received during the first quarter of 2018 associated with a one-time transaction associated with an Internal Revenue Code Section 1031 exchange.

Service charges on deposit accounts—The $407,000 or 13 percent increase in service charge income on deposit accounts was due to a growth in the volume of deposit accounts subject to fees.

Other income—The $404,000 or 49 percent increase in other income was due to higher loan related income such as mortgage and SBA loan servicing income, letter of credit and referral fees and miscellaneous client based service charges such as gift card and credit card merchant and ATM fees.

Gain on sales of loans held for sale—The $613,000 or 74 percent increase in gain on sales of loans was due to the sale of a higher volume of the guaranteed portion of SBA loans to the secondary market.

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Noninterest Expense

The following table presents the components of total noninterest expense for the first nine months of 2018, compared to the first nine months of 2017.

Table 8 - Noninterest expense

	Nine months ended					Change
	September 30,					Increase (Decrease)
(dollars in thousands)	2018		2017			$			%

Personnel	$	21,855	$	19,501		$	2,354			12	%
Occupancy of premises, net		2,556		2,471			85			3
Furniture and equipment		2,262		2,115			147			7
Postage, stationery and supplies		560		572			(12	)		(2	)
Professional and legal		609		616			(7	)		(1	)
Marketing		1,200		1,156			44			4
FDIC insurance		493		537			(44	)		(8	)
Debit card processing		902		780			122			16
Charitable donations		1,792		982			810			82
Telecommunications		500		608			(108	)		(18	)
External data processing		1,563		1,252			311			25
Foreclosed real estate including provision for (recovery of) losses		33		(18	)		51			*nm
Other		2,557		2,644			(87	)		(3	)
Total noninterest expense	$	36,882	$	33,216		$	3,666			11	%

*nm – not meaningful

The discussion that follows addresses changes in selected categories of noninterest expense.

Personnel—The $2,354,000 or 12 percent increase in personnel expense was due largely to the addition of new employees to support the Corporation’s business growth, severance costs incurred on the termination of an executive officer of PeoplesBank, one-time bonuses to non-executive officers and higher health insurance costs.

FDIC insurance—The $44,000 or 8 percent decrease was a result of a lower assessment rate used to calculate the quarterly premiums.

Debit card processing—The $122,000 or 16 percent increase in debit card processing was a result of a higher assessment base and rate for card processing and a decrease in incentive credits received as compared to the prior year.

Charitable donations—The $810,000 or 82 percent increase in charitable contributions was primarily due to a donation to the recently formed PeoplesBank Charitable Foundation and an increase in donations that qualify for educational improvement tax credits which reduces Pennsylvania bank shares tax.

External data processing—The $311,000 or 25 percent increase in external data processing expenses reflects increased reliance on outsourcing transaction processing to specialized vendors, which is typically performed on such vendors’ hosted and secure websites. In addition, increased volumes in both accounts and transactions year over year due to business expansion resulted in higher costs. The Corporation continues to expand and enhance electronic banking services provided to our clients which contributed to the increase in the expense.

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Provision for Income Taxes

The provision for income taxes for the first nine months of 2018 was $4,044,000, a decrease of $965,000 or 19 percent as compared to the first nine months of 2017. For the first nine months of 2018, the Corporation’s statutory federal income tax rate was 21 percent compared to 35 percent for the first nine months of 2017. The effective income tax rate was 21 percent and 32 percent for the first nine months ended September 30, 2018 and 2017, respectively. The effective tax rate differs from the statutory tax rate due to the impact of certain elements with specific tax benefits, including tax-exempt income, such as income from tax-exempt investments, tax-exempt loans, and bank-owned life insurance. Decreases in the provision for income taxes and effective tax rate were due to the new 21 percent corporate tax rate enacted as part of the Tax Cuts and Jobs Act that became effective January 1, 2018.

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Balance Sheet Review

Interest Bearing Deposits with Banks

On September 30, 2018, interest bearing deposits with banks totaled $60,421,000, an increase of $4,855,000 or 9 percent, compared to the level at year-end 2017. The increase was primarily the result of the growth in client deposits.

Investment Securities (Available-for-Sale)

The Corporation’s entire investment securities portfolio is classified available-for-sale, and is comprised primarily of interest-earning debt securities. The overall composition of the Corporation’s investment securities portfolio is provided in Note 2—Securities. On September 30, 2018, the fair value of investment securities available-for-sale totaled $146,089,000, which represented a decrease of $12,502,000 as compared to the fair value of investment securities at year-end 2017. Principal reductions from investment maturities and mortgage-backed security payments exceeded new investments during the first nine months of 2018 and were redeployed in higher yielding loans.

Loans

On September 30, 2018, total loans, net of deferred fees, were $1.49 billion, which was $94,263,000 or 7 percent higher than the level at year-end 2017. This change in volume was due primarily to an increase in commercial loans, particularly within the residential real estate investor sector and the other sector, which reflected continued commercial loan demand in our markets. Commercial loans within the commercial real estate investor, residential real estate investor and builder & developer sectors each represented more than 10 percent of the total portfolio. The composition of the Corporation’s loan portfolio is provided in Note 4—Loans.

Deposits

Deposits are the Corporation’s principal source of funding for earning assets. On September 30, 2018, deposits totaled $1.47 billion, which reflected an $85,752,000 or 6 percent increase compared to the level at year-end 2017. Of the increase in total deposits, $11,950,000 was attributable to noninterest bearing deposits and $57,560,000 related to growth in interest bearing demand, money market and savings deposits. Time deposits increased $16,242,000 compared to the level at year-end 2017. The composition of the Corporation’s total deposit portfolio is provided in Note 6—Deposits.

Short-term Borrowings

Short-term borrowings, which consist of securities sold under agreements to repurchase (repurchase agreements), federal funds purchased, and other short-term borrowings, totaled $8,624,000 at September 30, 2018, which reflected an $11,871,000 or 58 percent decrease compared to the level at year-end 2017. The decrease was primarily attributed to a reduction of $10,200,000 in other short-term borrowings.

Long-term Debt

The Corporation uses long-term borrowings as a secondary funding source for asset growth and to manage interest rate risk. On September 30, 2018, long-term debt totaled $135,310,000 compared to $130,310,000 at year-end 2017. The $5,000,000 increase was due to $30,000,000 in new advances and $25,000,000 of maturities during the first nine months of 2018. A listing of outstanding long-term debt obligations is provided in Note 7—Short-Term Borrowings and Long-Term Debt.

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Shareholders’ Equity and Capital Adequacy

Shareholders’ equity, or capital, enables Codorus Valley to maintain asset growth and absorb losses. Capital adequacy can be affected by a multitude of factors, including profitability, new stock issuances, corporate expansion and acquisitions, dividend policy and distributions, and regulatory mandates. The Corporation’s total shareholders’ equity was approximately $173,597,000 on September 30, 2018, an increase of approximately $9,378,000 or 6 percent, compared to the level at year-end 2017.

Cash Dividends on Stock

The Corporation has historically paid cash dividends on its stock on a quarterly basis. The Board of Directors determines the dividend rate after considering the Corporation’s capital requirements, current and projected net income, and other relevant factors. As recently announced, the Board of Directors declared a quarterly cash dividend of $0.155 per share on October 9, 2018, payable on November 13, 2018, to shareholders of record at the close of business on October 23, 2018. This cash dividend follows the $0.155 cash dividend distributed in August 2018.

Capital Adequacy

The Corporation and PeoplesBank are subject to various regulatory capital requirements administered by banking regulators that involve quantitative guidelines and qualitative judgments. The regulatory capital measures for the Corporation and PeoplesBank as of September 30, 2018 and the minimum capital ratios established by regulators are set forth in Note 8—Regulatory Matters to the financial statements. We believe that both Codorus Valley and PeoplesBank were well capitalized on September 30, 2018.

Our capital adequacy as of September 30, 2018, reflects updated regulatory capital guidelines from the Board of Governors of the Federal Reserve System finalized rule which implemented the Basel III regulatory capital framework, and which became effective for the Corporation and PeoplesBank on January 1, 2015. Under the revised regulatory capital framework, minimum requirements increased both the quantity and quality of capital held by banking organizations. Additionally, a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5 percent and a common equity Tier 1 conservation buffer of risk-weighted assets applies to all supervised financial institutions. The rule also raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4 percent to 6 percent and includes a minimum leverage ratio of 4 percent for all banks. The new rule also increases the risk weights for past-due loans, certain commercial real estate loans and some equity exposures, and makes selected other changes in risk weights and credit conversion factors.

The new rule further provides that, in order to avoid restrictions on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold the 2.5 percent capital conservation buffer, which is to be phased in over a four year period beginning January 1, 2016, with the full 2.5 percent required as of January 1, 2019.

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The transition schedule for new ratios, including the capital conservation buffer, is as follows:

	As of January 1:
	2015			2016			2017			2018			2019
Minimum common equity Tier 1 capital ratio		4.5	%		4.5	%		4.5	%		4.5	%		4.5	%
Common equity Tier 1 capital conservation buffer		N/A			0.625	%		1.25	%		1.875	%		2.5	%
Minimum common equity Tier 1 capital ratio plus capital conservation buffer		4.5	%		5.125	%		5.75	%		6.375	%		7.0	%
Phase-in of most deductions from common equity Tier 1 capital		40	%		60	%		80	%		100	%		100	%
Minimum Tier 1 capital ratio		6.0	%		6.0	%		6.0	%		6.0	%		6.0	%
Minimum Tier 1 capital ratio plus capital conservation buffer		N/A			6.625	%		7.25	%		7.875	%		8.5	%
Minimum total capital ratio		8.0	%		8.0	%		8.0	%		8.0	%		8.0	%
Minimum total capital ratio plus capital conservation buffer		N/A			8.625	%		9.25	%		9.875	%		10.5	%

As fully phased in, a banking organization with a buffer greater than 2.5 percent would not be subject to limits on dividend payments or discretionary bonus payments; however, a banking organization with a buffer less than 2.5 percent would be subject to increasingly stringent limitations as the buffer approaches zero. The new rule also prohibits a banking organization from paying dividends or discretionary bonuses if its eligible net income is negative in that quarter and its capital conservation buffer ratio was less than 2.5 percent as of the beginning of that quarter. Eligible net income is defined as net income for the four calendar quarters preceding the current calendar quarter, net of any distributions and associated tax effects not already reflected in net income.

A summary of payout restrictions based on the capital conservation buffer is as follows:

Capital Conservation Buffer (as a % of risk-weighted assets)		Maximum Payout (as a % of eligible net income)
Greater than 2.5%		No payout limitation applies
≤2.5% and >1.875%		60%
≤1.875% and >1.25%		40%
≤1.25% and >0.625%		20%
≤0.625%		0%

Under the new rule as effective through the nine months ending September 30, 2018, the Corporation and PeoplesBank had no regulatory dividend restrictions and remained well capitalized by all regulatory capital measures (see Note 8—Regulatory Matters to the financial statements). The Corporation plans to manage its capital adequacy to ensure continued compliance with the new capital rules.

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Risk Management

Credit Risk Management

Credit risk represents the possibility that a loan client, counterparty or issuer may not perform in accordance with contractual terms, posing one of the most significant risks of loss to the Corporation. Accordingly, the Corporation emphasizes the management of credit risk, and has established a lending policy which management believes is sound given the nature and scope of our operations. The Credit Risk Management section included in Item 7 of the Corporation’s previously filed Annual Report on Form 10-K for the year ended December 31, 2017, provides a more detailed overview of the Corporation’s credit risk management process.

Nonperforming Assets

Nonperforming assets, as shown in the table below, are asset categories that pose the greatest risk of loss. The level of nonperforming assets at September 30, 2018 has increased by approximately $9,650,000 or 181 percent when compared to year-end 2017. The increase was the result of increases in both nonaccrual loans and foreclosed real estate, net of allowance.

The Corporation regularly monitors large and criticized assets in its commercial loan portfolio recognizing that prolonged low economic growth, or a weakening economy, could have negative effects on these commercial borrowers. Nonperforming assets are monitored and managed for collection of these accounts. Collection efforts, including modification of contractual terms for individual accounts based on prevailing market conditions and liquidation of collateral assets, are employed to maximize recovery. A special assets committee meets regularly, at a minimum quarterly, to review nonperforming assets. We generally rely on appraisals performed by independent licensed appraisers to determine the value of real estate collateral for impaired collateral-dependent loans. Generally, an appraisal is performed when: an account reaches 90 days past due, unless a certified appraisal was completed within the past twelve months; market values have changed significantly; the condition of the property has changed significantly; or the existing appraisal is outdated based upon regulatory or policy requirements. In instances where the value of the collateral, net of costs to sell, is less than the net carrying amount for impaired commercial related loans, a specific loss allowance is established for the difference. Further provisions for loan losses may be required for nonaccrual loans as additional information becomes available or conditions change. When it is probable that some portion or an entire loan balance will not be collected, that amount is charged off as loss against the allowance.

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The paragraphs and table below address significant changes in the nonperforming asset categories as of September 30, 2018 compared to December 31, 2017.

Table 9 - Nonperforming Assets

	September 30,			December 31,
(dollars in thousands)	2018			2017

Nonaccrual loans	$	12,934		$	5,052
Accruing loans 90 days or more past due		293			76
Total nonperforming loans		13,227			5,128
Foreclosed real estate, net of allowance		1,767			216
Total nonperforming assets	$	14,994		$	5,344
Accruing troubled debt restructurings	$	4,079		$	3,344

Total period-end loans, net of deferred fees	$	1,494,027		$	1,399,764
Allowance for loan losses (ALL)	$	18,234		$	16,689
ALL as a % of total period-end loans		1.22	%		1.19	%
Net charge-offs year-to-date, annualized as a % of average total loans		0.02	%		0.18	%
ALL as a % of nonperforming loans		137.86	%		325.48	%
Nonperforming loans as a % of total period-end loans		0.89	%		0.37	%
Nonperforming assets as a % of total period-end loans and net foreclosed real estate		1.00	%		0.38	%
Nonperforming assets as a % of total period-end assets		0.83	%		0.31	%
Nonperforming assets as a % of total period-end shareholders’ equity		8.64	%		3.25	%

Nonperforming loans

Nonperforming loans consist of nonaccrual loans and accruing loans 90 days or more past due. We generally place a loan on nonaccrual status and cease accruing interest income (i.e., recognize interest income on a cash basis, as long as the loan is sufficiently collateralized) when loan payment performance is unsatisfactory and the loan is past due 90 days or more. A loan is returned to interest accruing status when we determine that circumstances have improved to the extent that all of the principal and interest amounts contractually due are current for at least six consecutive payments and future payments are reasonably assured. Loans past due 90 days or more and still accruing interest represent loans that are contractually past due, but are well collateralized and in the process of collection. As of September 30, 2018, the nonperforming loan portfolio balance totaled $13,227,000, compared to $5,128,000 at year-end 2017. The increase of $8,099,000 was primarily the result of the transfer of four loans to nonaccrual status totaling approximately $9,686,000 offset by the transfer of a loan to foreclosed real estate totaling $1,618,000. For both periods, the nonperforming portfolio balance was comprised primarily of collateralized commercial loans.

Foreclosed Real Estate

Foreclosed real estate represents real estate acquired to satisfy debts owed to PeoplesBank and is included in the Other Assets category on the Corporation’s balance sheet. The carrying amount of foreclosed real estate as of September 30, 2018, net of allowance, totaled $1,767,000 compared to $216,000 at year-end 2017. The increase is attributable to the acquisition of a commercial property during the third quarter of 2018.

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Troubled Debt Restructurings

Troubled debt restructurings pertain to loans whose terms have been modified to include a concession that we would not ordinarily consider due to the debtor’s financial difficulties. Concessions granted under a troubled debt restructuring typically involve a reduction of interest rate lower than the current market rate for new debt with similar risk, the deferral of payments or extension of the stated maturity date. Troubled debt restructurings are evaluated for impairment if they have been restructured during the most recent calendar year, or if they cease to perform in accordance with the modified terms. As of September 30, 2018, the accruing troubled debt restructuring portfolio balance totaled $4,079,000, compared to $3,344,000 at year-end 2017. The $735,000 increase was the result of a modification to three loans with combined principal balances of $1,305,000 during the second and third quarters of 2018 which was offset by principal repayments of $337,000 and a payoff of $221,000.

Allowance for Loan Losses

Although the Corporation believes that it maintains sound credit policies, certain loans deteriorate and must be charged off as losses. The allowance for loan losses is maintained to absorb losses inherent in the portfolio. The allowance is increased by provisions charged to expense and is reduced by loan charge-offs, net of recoveries. The allowance is based upon management’s continuous evaluation of the loan portfolio coupled with a formal review of adequacy on a quarterly basis, which is subject to review and approval by the Board.

The allowance for loan losses consists primarily of three components: specific allowances for individually impaired commercial loans; allowances calculated for pools of loans; and an unallocated component, which reflects the margin of imprecision inherent in the assumptions that underlie the evaluation of the adequacy of the allowance. The Corporation uses an internal risk rating system to evaluate individual loans. Loans are segmented into industry groups or pools with similar characteristics, and an allowance for loan losses is allocated to each segment based on quantitative factors such as recent loss history (two-year rolling average of net charge-offs) and qualitative factors, such as the results of internal and external credit reviews, changes in the size and composition of the loan portfolio, adequacy of collateral, and general economic conditions. Determining the level of the allowance for probable loan losses at any given period is subjective, particularly during deteriorating or uncertain economic periods, and requires that we make estimates using assumptions. There is also the potential for adjustment to the allowance as a result of regulatory examinations.

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The following table presents an analysis of the activity in the allowance for loan losses for nine months ended September 30, 2018 and 2017:

Table 10 - Analysis of Allowance for Loan Losses

(dollars in thousands)	2018			2017
Balance-January 1,	$	16,689		$	14,992

Provision charged to operating expense		1,800			3,575

Loans charged off:
Commercial, financial and agricultural		146			214
Real estate - construction and land development		0			1,474
Real estate - residential mortgages		10			0
Consumer and home equity		289			198
Total loans charged off		445			1,886
Recoveries:
Commercial, financial and agricultural		139			97
Real estate - construction and land development		18			0
Real estate - residential mortgages		10			5
Consumer and home equity		23			9
Total recoveries		190			111
Net charge-offs		255			1,775
Balance-September 30,	$	18,234		$	16,792

Ratios:
Allowance for loan losses as a % of total period-end loans		1.22	%		1.20	%
Net charge-offs year-to-date, annualized as a % of average total loans		0.02	%		0.17	%
Allowance for loan losses as a % of nonperforming loans		137.86	%		262.72	%

The provision for loan losses decreased $1,775,000 or 50 percent from September 30, 2017 to September 30, 2018. The change in provision for 2018 was primarily due to specific loan loss reserves assigned during 2018 as compared to a larger amount of net charge-offs taken during 2017. The provision for both periods supported adequate allowance for loan loss coverage considering several factors, including the Corporation’s substantial growth in commercial loans.

Net charge-offs for the first nine months of 2018 were $255,000 compared to $1,775,000 for the same period of 2017. During the first nine months of 2018, there were $445,000 of charge-offs as compared to $1,886,000 during the same period in 2017. The risks and uncertainties associated with weak economic and business conditions, or the erosion of real estate values may adversely affect our borrowers’ ability to service their loans, causing significant fluctuations in the level of charge-offs and provision expense from one period to another. The provision for loan losses for the first nine months of 2018 was $1,800,000, compared to $3,575,000 for the same period of 2017. The allowance as a percentage of total loans was 1.22 percent at September 30, 2018, as compared to 1.19 percent at December 31, 2017 and 1.20 percent at September 30, 2017. The unallocated portion of the allowance was $2,112,000 or 12 percent of the total allowance as of September 30, 2018, as compared to $2,180,000 or 13 percent of the total allowance as of December 31, 2017.

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Liquidity Risk Management

Maintaining adequate liquidity provides the Corporation with the ability to meet financial obligations to depositors, loan clients, employees, and shareholders on a timely and cost effective basis in the normal course of business. Additionally, adequate liquidity provides funds for growth and business opportunities as they arise. Liquidity is generated from transactions relating to both the Corporation’s assets and liabilities. The primary sources of asset liquidity are funds received from client loan payments, investment maturities and cash inflows from mortgage-backed securities, and the net proceeds of asset sales. The primary sources of liability liquidity are deposit growth, and funds obtained from short-term borrowings and long-term debt. The Consolidated Statements of Cash Flows, included in this report, present the changes in cash from operating, investing and financing activities. At September 30, 2018, we believe that liquidity was adequate based upon the potential liquidation of unpledged available-for-sale securities with a fair value totaling approximately $9,585,000 and available credit from the Federal Home Loan Bank of Pittsburgh totaling approximately $381,144,000. The Corporation’s loan-to-deposit ratio was approximately 102 percent as of September 30, 2018, 106 percent as of September 30, 2017 and 101 percent as of December 31, 2017.

Off-Balance Sheet Arrangements

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 primarily of commitments to grant new loans, unfunded commitments under existing loan facilities, and letters of credit issued under the same standards as on-balance sheet instruments. Unused commitments on September 30, 2018, totaled $488,031,000 and consisted of $389,572,000 in unfunded commitments under existing loan facilities, $70,895,000 to grant new loans and $27,564,000 in letters of credit. Generally these commitments have fixed expiration dates or termination clauses and are for specific purposes. Accordingly, many of the commitments are expected to expire without being drawn upon and, therefore, generally do not present significant liquidity risk to the Corporation or PeoplesBank.

Recent Legislative Developments

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Act”), which was designed to ease certain restrictions imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Most of the changes made by the new Act can be grouped into five general areas: mortgage lending; certain regulatory relief for “community” banks; enhanced consumer protections in specific areas, including subjecting credit reporting agencies to additional requirements; certain regulatory relief for large financial institutions, including increasing the threshold at which institutions are classified a systemically important financial institutions (from $50 billion to $250 billion) and therefore subject to stricter oversight, and revising the rules for larger institution stress testing; and certain changes to federal securities regulations designed to promote capital formation. Some of the key provisions of the Act as it relates to community banks and bank holding companies include, but are not limited to: (i) designating mortgages held in portfolio as “qualified mortgages” for banks with less than $10 billion in assets, subject to certain documentation and product limitations; (ii) exempting banks with less than $10 billion in assets from Volcker Rule requirements relating to proprietary trading; (iii) simplifying capital calculations for banks with less than $10 billion in assets by requiring federal banking agencies to establish a community bank leverage ratio of tangible equity to average consolidated assets of not less than 8% or more than 10%, and provide that banks that maintain tangible equity in excess of such ratio will be deemed to be in compliance with risk-based capital and leverage requirements; (iv) assisting smaller banks with obtaining stable funding by providing an exception for reciprocal deposits from FDIC restrictions on acceptance of brokered deposits; (v) raising the eligibility for use of short-form Call Reports from $1 billion to $5 billion in assets; and (vi) clarifying definitions pertaining to high volatility commercial real estate loans (HVCRE), which require higher capital allocations, so that only loans with increased risk are subject to higher risk weightings. As required by the Act, the Federal Reserve Board issued an interim final rule that expanded applicability of the Board’s small bank holding company policy statement, raising the policy statement’s asset threshold from $1 billion to $3 billion in total consolidated assets for a bank holding company or savings and loan holding company, subject to other conditions. Management believes the Corporation meets the conditions of the Federal Reserve’s small bank holding company policy statement and is therefore excluded from consolidated capital requirements as of September 30, 2018. Further, qualification as a small bank holding company allows the Corporation to file more abbreviated, and less frequent, consolidated and holding company reports with the Federal Reserve. The Corporation continues to analyze the changes implemented by the Act, but does not believe that such changes will materially impact the Corporation’s business, operations, or financial results.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

The most significant market risk to which the Corporation is exposed is interest rate risk. The primary business of the Corporation and the composition of its balance sheet consist of investments in interest earning assets (primarily loans and securities), which are funded by interest bearing liabilities (deposits and borrowings), all of which have varying levels of sensitivity to changes in market interest rates. Changes in rates also have an impact on the Corporation’s liquidity position and could affect its ability to meet obligations and continue to grow.

The Corporation employs various management techniques to minimize its exposure to interest rate risk. An Asset Liability Management Committee, consisting of key financial and senior management personnel, meets on a regular basis. The Committee is responsible for reviewing the interest rate sensitivity and liquidity positions of the Corporation, reviewing projected sources and uses of funds, approving asset and liability management policies, monitoring economic conditions, and overseeing the formulation and implementation of strategies regarding balance sheet positions.

Simulation of net interest income is performed for the next twelve-month period. A variety of interest rate scenarios are used to measure the effects of sudden and gradual movements upward and downward in the yield curve. These results are compared to the results obtained in a flat or unchanged interest rate scenario. Simulation of net interest income is used primarily to measure the Corporation’s short-term earnings exposure to rate movements. A “shock” is an immediate upward or downward movement of interest rates. The shocks do not take into account changes in client behavior that could result in changes to mix and/or volumes in the balance sheet, nor do they account for competitive pricing over the forward 12-month period. The Corporation applies these interest rate “shocks” to its financial instruments up and down 100, 200, 300, and 400 basis points. A 300 and 400 basis point decrease in interest rates cannot be simulated at this time due to the historically low interest rate environment.

The following table summarizes the expected impact of interest rate shocks on net interest income as well as the Corporation’s policy limits at each level. All scenarios were within policy limits at September 30, 2018.

Change in Interest Rates	Annual Change in Net		% Change in Net		% Change
(basis points)	Interest Income (in thousands)		Interest Income		Policy Limit
+100	$	2,625	3.86	%	(5.00)	%
-100	$	(2,656)	(3.91)	%	(5.00)	%

+200	$	5,106	7.51	%	(15.00)	%
-200	$	(4,327)	(6.36)	%	(15.00)	%

+300	$	7,728	11.36	%	(25.00)	%

+400	$	10,374	15.25	%	(35.00)	%

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Item 4. 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 Treasurer, 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 Treasurer concluded that, as of September 30, 2018, the Corporation’s disclosure controls and procedures were effective. The Corporation’s disclosure controls and procedures are designed to provide reasonable, not absolute, assurance 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. A control system, no matter how well conceived and operated, must reflect the fact that there are resource constraints and that the benefits of controls must be considered relative to their costs, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

There has been no change in the Corporation’s internal control over financial reporting that occurred during the three and nine months ended September 30, 2018, that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

Part II—OTHER INFORMATION

Item 1. Legal Proceedings

The Corporation and PeoplesBank are involved in routine litigation incidental to their business. In the opinion of management, there are no legal proceedings pending against the Corporation or any of its subsidiaries which are expected to have a material impact upon the consolidated financial position and/or operating results of the Corporation. Management is not aware of any adverse proceedings known or contemplated by government authorities.

Item 1A. Risk Factors

There have been no material changes to the risk factors as previously disclosed in Item 1A – Risk Factors – in our Annual Report on Form 10-K for the year ended December 31, 2017.

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

The Corporation relies on its subsidiary PeoplesBank, A Codorus Valley Company, for dividend distributions, which are subject to restrictions as reported in Note 9—Regulatory Matters of the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2017.

The Corporation has a Share Repurchase Program (Program), which was authorized in 1995, and has been periodically amended, to permit the purchase of up to a maximum of 4.9 percent of the outstanding shares of the Corporation’s common stock at a price per share no greater than 200 percent of the latest quarterly published book value. No shares were repurchased in 2017 under the 1995 Program. On February 13, 2018, the Corporation cancelled the prior Program and authorized a new Share Repurchase Program (2018 Program), to permit the purchase of up to a maximum of 4.9 percent of the outstanding shares of the Corporation’s common stock at a price per share no greater than 150 percent of the latest quarterly published book value. For the nine month period ended September 30, 2018 the Corporation had not acquired any of its common stock under the 2018 Program.

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

This Item 4 is not applicable to the Corporation.

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Item 5. Other Information

None

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Item 6. Exhibits

Exhibit
Number

Description of Exhibit

3.1

Amended Articles of Incorporation (Incorporated by reference to Exhibit 3.1 to the Quarterly Report on Form 10-Q for June 30, 2018, filed with the Commission on August 6, 2018)

3.2

Amended By-laws (Incorporated by reference to Exhibit 3.1 to the Registrant’s Current Report on Form 8-K, filed with the Commission on January 12, 2016)

10.1

Change of Control Agreement by and among Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Larry D. Pickett, dated August 9, 2018 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on August 9, 2018)*

10.2

Employment Agreement by and among Codorus Valley Bancorp, Inc., PeoplesBank, A Codorus Valley Company and Craig L. Kauffman, dated August 6, 2018 (incorporated by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the Commission on August 16, 2018)*

31.1

Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 – filed herewith.

31.2

Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 – filed herewith.

Certification of Principal Executive Officer and Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 – filed herewith.

101

Financial statements from the Quarterly Report on Form 10-Q of Codorus Valley Bancorp, Inc. for the quarter ended September 30, 2018, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income (iii) the Consolidated Statements of Comprehensive Income (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Changes in Shareholder’s Equity, and (vi) the Notes to Consolidated Financial Statements – filed herewith.

*Management contract or compensation plan or arrangement required to be filed or incorporated as an exhibit.

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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.

	Codorus Valley Bancorp, Inc.
	(Registrant)

November 8, 2018	/s/ Larry J. Miller
Date	Larry J. Miller
	Chairman, President and Chief Executive Officer
	(Principal Executive Officer)

November 8, 2018	/s/ Larry D. Pickett
Date	Larry D. Pickett, CPA
	Treasurer
	(Principal Financial and Accounting Officer)

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