2. Merger accounting:

On June 28, 2013, the Company and Penseco announced the execution of an agreement of merger, providing for the merger of Penseco with and into the Company. This merger became effective prior to the start of business on December 1, 2013. Pursuant to the terms of the merger agreement, the merger was effected by the issuance of shares of Peoples stock to Penseco shareholders. Each share of Penseco common stock was converted into the right to receive 1.3636 shares of Peoples common stock, with cash in lieu of fractional shares. The Merger provided an expanded geographic footprint for the Company and increased the size of the balance sheet wherein the combined companies can realize economies of scale and other operating efficiencies.

The Merger has been accounted for as a reverse merger using the acquisition method of accounting. For accounting purposes, Penseco is considered to have acquired Peoples in this transaction with the surviving legal entity operating under Peoples articles of incorporation. Immediately following the holding company merger, Penn Security Bank and Trust Company, merged with and into Peoples Neighborhood Bank, the wholly-owned subsidiary of Peoples, under the name Peoples Security Bank and Trust Company. Peoples Bank is, therefore, the wholly owned subsidiary of Peoples and operates under the prior Peoples Neighborhood Bank charter. To determine the accounting treatment of the Merger, management utilized the following facts in concluding that the transaction would be treated as a reverse merger, with Penseco as the accounting acquirer:

•

The role of Chief Executive Officer of the post-combination entity has been assumed by the executive officer of Penseco;

•

Upon the effective date of the Merger, the Peoples Board of Directors consists of fourteen members, of which six of the members have been appointed from the historical Peoples Board of Directors with the remaining eight directors having been appointed from the Penseco Board of Directors;

•

After the closing of the Merger and as a result of the fixed share exchange ratio of 1.3636 shares of Peoples common stock for each Penseco common share, the former Penseco shareholders, as a group, held approximately 59.1 percent of the outstanding shares of Peoples stock;

•

Penseco contributed greater than fifty percent of the total assets and tangible equity to the combined entity.

As a result of accounting for the Merger as a reverse acquisition, People’s assets and liabilities have been incorporated into Penseco’s historical balance sheet based on the fair values of the net assets acquired as of the closing date, November 30, 2013. Prior to the Merger the balance sheets, statements of income and comprehensive income, and statements of cash flows reflect only the operations of Penseco. Following the Merger, the statements of operations reflect the operations of both Penseco and Peoples. The number of shares issued and outstanding, additional paid-in capital and all references to share quantities of the Company in these notes have been retroactively adjusted to reflect the equivalent number of shares issued by the Company in the Merger.

In a reverse acquisition, the accounting acquirer usually issues no consideration for the acquired entity. Rather, the accounting acquiree issues its equity shares to the owners of the accounting acquirer. Accordingly, the acquisition-date fair value of the consideration transferred by Penseco for its interest in Peoples is based on the number of equity interests Penseco would have to issue, measured on the transaction closing date, to give the owners of Peoples the same percentage equity interest in the combined Peoples entity that results from the reverse acquisition. The Company has utilized the closing price of Peoples’s common stock on November 29, 2013, the last trading day prior to the merger, of $34.50 per share to determine the acquisition date fair value of the consideration transferred. Immediately prior to the merger, Peoples owned 9,928 shares of Penseco which were retired on the acquisition date. The table below illustrates the calculation of the consideration effectively transferred.


Penseco shares outstanding at November 30, 2013(A)		3,275,217
Exchange ratio		1.3636
Peoples shares issued to Penseco shareholders(B)		4,465,538
Peoples shares outstanding at November 30, 2013		3,087,406
Total Peoples shares outstanding at November 30, 2013		7,552,944
Penseco % ownership		59.12	%
Peoples % ownership		40.88	%

Theoretical Penseco share to be issued as consideration
Penseco shares outstanding at November 30, 2013(A)		3,275,217
Ownership % held by Penseco shareholders		59.12	%
Theoretical Penseco shares after consideration paid		5,539,653
Ownership % by legacy Peoples shareholders		40.88	%
Theoretical Penseco shares issued as consideration		2,264,436
Fair value of Penseco shares at November 30, 2013 ($34.50 multiplied by 1.3636)	$	47.04
Fair value of theoretical Penseco shares offered				$	106,519
Cash paid for fractional shares					17

				$	106,536

(A)	Excludes 9,928 shares of Penseco common shares owned by Peoples which were retired.

(B)	Excludes payment for fractional shares.

The acquired assets and assumed liabilities were measured at fair value as of the acquisition date. In many cases, determining the fair value of the acquired assets and assumed liabilities required the Company to estimate cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest, which required the utilization of significant estimates and judgment in accounting for the acquisition. As of November 30, 2013, goodwill totaled $36,972, which is equal to the excess of the consideration transferred over the fair value of the identifiable net assets acquired in connection with the Merger. Goodwill recorded in the Merger resulted from the expected synergies of the combined operations of the newly merged entities as well as intangibles that do not qualify for separate recognition such as the acquired workforce. There is no tax deductible goodwill in the transaction. While the Company believes that the accounting for the merger is complete, FASB ASC 805 does allow for adjustments to goodwill for a period of up to one year following the acquisition date should new information come to light that reflects circumstances that existed at the acquisition date.


Total Purchase Price				$	106,536
Net Assets Acquired:
Cash and due from banks	$	6,982
Federal funds sold		15,410
Investment securities available-for-sale		156,435
Restricted equity securities		997
Loans, net		504,002
Accrued interest receivable		3,625
Premises and equipment		11,737
Core deposit and other intangible assets		6,323
Other assets		18,647
Deposits		(628,304	)
Short-term borrowings		(17,737	)
Long-term debt		(2,516	)
Accrued interest payable		(473	)
Other liabilities		(5,976	)

Net assets acquired					69,152

Treasury stock acquired					412

Goodwill resulting from merger				$	36,972

The estimated fair values of cash and due from banks, federal funds sold, other assets and other liabilities approximate their stated value.

The estimated fair values of the investment securities available for sale were calculated primarily using level 2 inputs. The prices for these instruments are obtained through an independent pricing service and are derived from market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. Management reviewed the data and assumptions used in pricing the securities to ensure the highest level of significant inputs are derived from market observable data.

Land and buildings, included in premises and equipment, net, and real estate acquired through foreclosure, included in other assets, were primarily valued based on appraised collateral values.

The most significant fair value determination related to the valuation of acquired loans. Management measured loan fair values based on loan file reviews including borrower financial statements or tax returns, appraised collateral values, expected cash flows and historical loss factors. The business combination resulted in the acquisition of loans with and without evidence of credit quality deterioration.

Peoples Bank’s loans without evidence of credit deterioration were assembled into groupings by characteristics such as loan type, term, collateral and rate and fair valued by discounting both expected principal and interest cash flows using an observable discount rate for similar instruments that a market participant would consider in determining fair value. The discount rate utilized was the average of market rates for similar loans obtained from various external data sources. Additionally, consideration was given to management’s best estimates of default rates and payment speeds in projecting the expected cash flows. A general credit risk fair value adjustment was calculated using a two part general credit fair value analysis: (1) expected lifetime losses, using an average of historical losses of the Company, Penseco and peer banks; and (2) an estimated fair value adjustment for qualitative factors related to general economic conditions and the risk related to lack of familiarity with the originator’s underwriting process. At acquisition, Peoples Bank’s loan portfolio without evidence of credit deterioration was recorded at a current fair value of $496,650.

Peoples’ loans were deemed impaired at the acquisition date if the Company did not expect to receive all contractually required cash flows due to concerns about credit quality. Such loans were fair valued by discounting the expected cash flows at acquisition by an observable discount rate for similar instruments that a market participant would consider in determining fair value. The difference between contractually required payments at the acquisition date and cash flows expected to be collected was recorded as a nonaccretable difference.

The following is a summary of the acquired nonimpaired and impaired loans from the merger with Peoples:


	Acquired Nonimpaired Loans			Acquired Impaired Loans
Contractually required principal and interest at acquisition	$	501,423		$	19,353
Contractual cash flows not expected to be collected (nonaccretable discount)					(10,873	)

Expected cash flows at acquisition		501,423			8,480
Interest component of expected cash flows (accretable discount)		(4,773	)		(1,128	)

Fair value of acquired loans	$	496,650		$	7,352

The Company recorded a core deposit intangible asset related to a value ascribed to demand, interest checking, money market and savings account, referred to as core deposits, acquired as part of the acquisition. The value assigned to the acquired core deposits represents the future economic benefit of the potential cost savings from acquiring the core deposits, net of operating expenses and including ancillary fee income, compared to the cost of obtaining alternative funds from available market sources. Management used estimates including the expected attrition rates of depository accounts, future interest rate levels, and the cost of servicing various depository products. The Company also recorded a trade name intangible asset using relief from royalty method. The value assigned to the trade name represents the present value of the potential cost savings of paying a royalty for the use of a trade name. Both the core deposit intangible and trade name intangible are being amortized over an estimated useful life of 10 years.

Time deposits are not considered to be core deposits as they are assumed to have a low expected average life upon acquisition. The fair value of time deposits was calculated as the present value of the certificates’ expected contractual payments discounted by market rates for similar time deposits.

The Company recorded the fair value of borrowings based on prepayment amounts obtained from the Federal Home Loan Bank.

In connection with the acquisition, Peoples incurred merger-related expenses in regards to personnel, professional fees, occupancy and equipment and other costs of integrating and conforming acquired operations. Those expenses consisted largely of costs related to professional and consulting services, employment severance and early retirement charges, termination of Penseco’s core system contractual agreement and conversion of systems and/or integration of operations, initial communication expenses, printing and filing costs of completing the transaction and investment banking charges.

A summary of merger related costs included in the consolidated statements of income for the year ended December 31, 2013 is summarized as follows:


December 31,	2013
Accounting	$	65
Legal and consulting		1,011
Salaries and benefits		1,851
Equipment disposition and contract termination		709
System conversion/deconversion costs		956
Other		17

Total	$	4,609

There were no merger related costs incurred for the years ended December 31, 2012 and 2011.

Pro Forma Condensed Combined Financial Information:

The following table presents unaudited pro forma information as if the merger between Peoples and Penseco had been completed on January 1, 2011. The pro forma information does not necessarily reflect the results of operations that would have occurred had the Company merged with Penseco at the beginning of 2011. Supplemental pro forma earnings for 2013 were adjusted to exclude $4,609 of merger related costs incurred for the year ended December 31 2013. The results for 2011 were adjusted to include these charges. The expected future amortizations of the various fair value adjustments were included beginning in 2011. Cost savings are not reflected in the unaudited pro forma amounts for the periods presented. The pro forma financial information does not include the impact of possible business model changes, nor does it consider any potential impacts of current market conditions on revenues, expense efficiencies, or other factors.


Years ended December 31,	2013		2012		2011
Net interest income after loan loss provision	$	52,734	$	52,917	$	51,312
Noninterest income		16,080		16,287		18,186
Noninterest expense		52,295		49,827		56,319

Net income	$	16,519	$	19,377	$	13,179

Net income per share	$	2.19	$	2.55	$	1.73

The amounts of net interest income after loan loss provision, noninterest income, noninterest expense and net income attributable to Peoples since the acquisition date included in the consolidated statement of income for the year ended December 31, 2013 were $2,248, $363, $3,115, and $(261), respectively.