UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

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

For the transition period from                      to                     

FRANKLIN FINANCIAL SERVICES CORPORATION

(Exact name of registrant as specified in its charter)

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

20 SOUTH MAIN STREET (P.O. BOX 6010), CHAMBERSBURG, PA 17201-0819
(Address of principal executive offices)

717/264-6116

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 þ No o

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

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller reporting company o

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

There were 3,815,417 outstanding shares of the Registrant’s common stock as of October 31, 2008.

 

 

INDEX

Part I — FINANCIAL INFORMATION
Item 1 — Financial Statements			3
Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007			3
Consolidated Statements of Income for the Three and Nine Months ended September 30, 2008 and 2007			4
Consolidated Statements of Changes in Shareholders’ Equity for the Nine Months ended September 30, 2008 and 2007			5
Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2008 and 2007			6
Notes to Consolidated Financial Statements			7
Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations			13
Item 3 — Quantitative and Qualitative Disclosures about Market Risk			26
Item 4 — Controls and Procedures			26
Part II — OTHER INFORMATION
Item 1 — Legal Proceedings			27
Item 1A — Risk Factors			27
Item 2 — Unregistered Sales of Equity Securities and Use of Proceeds			27
Item 3 — Defaults by the Company on its Senior Securities			27
Item 4 — Submission of Matters to a Vote of Security Holders			27
Item 5 — Other Information			27
Item 6 — Exhibits			27
SIGNATURE PAGE			28
EXHIBITS			29
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

Part I — FINANCIAL INFORMATION

Item 1 — Financial Statements

Consolidated Balance Sheets

		September 30				December 31
		2008				2007
Assets
Cash and due from banks		$	16,770			$	17,871
Fed funds sold			—				7,400
Interest bearing deposits in other banks			179				220
Total cash and cash equivalents			16,949				25,491
Investment securities available for sale			150,000				164,990
Restricted stock			6,487				3,916
Loans held for sale			262				476
Loans			655,219				571,617
Allowance for loan losses			(7,706	)			(7,361	)
Net Loans			647,513				564,256
Premises and equipment, net			14,679				13,862
Bank owned life insurance			18,710				18,215
Goodwill			8,520				8,520
Other intangible assets			2,440				2,710
Equity method investment			3,950				4,077
Other assets			15,075				13,858
Total Assets		$	884,585			$	820,371
Liabilities
Deposits
Demand (non-interest bearing)		$	91,075			$	84,920
Savings and Interest checking			334,797				361,243
Time			179,956				160,114
Total Deposits			605,828				606,277
Securities sold under agreements to repurchase			70,990				68,157
Fed funds purchased and short-term borrowings			23,150				—
Long-term debt			99,283				59,714
Other liabilities			7,307				8,581
Total Liabilities			806,558				742,729
Shareholders’ equity
Common stock $1 par value per share, 15,000 shares authorized with 4,299 shares issued, and 3,826 shares and 3,845 shares outstanding at September 30, 2008 and December 31, 2007, respectively			4,299				4,299
Capital stock without par value, 5,000 shares authorized with no shares issued or outstanding			—				—
Additional paid in capital			32,868				32,620
Retained earnings			52,054				47,946
Accumulated other comprehensive (loss) income			(2,742	)			664
Treasury stock, 473 shares and 454 shares at cost at September 30, 2008 and December 31, 2007, respectively			(8,452	)			(7,887	)
Total Shareholders’ Equity			78,027				77,642
Total Liabilities and Shareholders’ Equity		$	884,585			$	820,371

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

Consolidated Statements of Income

		For the Three Months Ended								For the Nine Months Ended
		September 30								September 30
		2008				2007				2008				2007
Interest Income
Loans, including fees		$	9,756			$	10,194			$	28,792			$	29,698
Interest and dividends on investments:
Taxable interest			1,263				1,714				3,881				4,943
Tax exempt interest			495				545				1,582				1,684
Dividend income			75				73				219				240
Federal funds sold			—				50				36				307
Deposits and obligations of other banks			1				6				6				26
Total interest income			11,590				12,582				34,516				36,898
Interest Expense
Deposits			2,698				4,637				8,150				13,901
Securities sold under agreements to repurchase			337				1,026				1,295				3,042
Short-term borrowings			102				36				165				69
Long-term debt			843				426				2,320				1,346
Total interest expense			3,980				6,125				11,930				18,358
Net interest income			7,610				6,457				22,586				18,540
Provision for loan losses			273				340				778				790
Net interest income after provision for loan losses			7,337				6,117				21,808				17,750
Noninterest Income
Investment and trust services fees			891				1,390				2,651				3,253
Loan service charges			227				223				628				535
Mortgage banking activities			(36	)			71				100				399
Deposit service charges and fees			674				637				1,900				1,782
Other service charges and fees			308				398				921				987
Increase in cash surrender value of life insurance			164				164				495				487
Equity method investments			(5	)			13				(127	)			(12	)
Other			31				(17	)			35				106
Impairment writedown on equity securities			(199	)			—				(631	)			(32	)
Gains (losses) on sale of securities, net			(144	)			—				185				284
Total noninterest income			1,911				2,879				6,157				7,789
Noninterest Expense
Salaries and benefits			2,940				2,922				9,024				8,472
Net occupancy expense			426				433				1,335				1,253
Furniture and equipment expense			206				242				632				744
Advertising			556				293				1,325				1,040
Legal and professional fees			348				291				872				813
Data processing			350				334				1,120				1,035
Pennsylvania bank shares tax			1				170				338				511
Intangible amortization			90				90				271				271
Other			690				834				2,573				2,784
Total noninterest expense			5,607				5,609				17,490				16,923
Income before Federal income taxes			3,641				3,387				10,475				8,616
Federal income tax expense			1,029				830				2,881				1,936
Net income		$	2,612			$	2,557			$	7,594			$	6,680
Per share data
Basic earnings per share		$	0.68			$	0.66			$	1.98			$	1.74
Diluted earnings per share		$	0.68			$	0.66			$	1.98			$	1.73
Regular cash dividends declared		$	0.27			$	0.26			$	0.80			$	0.77

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

Consolidated Statements of Changes in Shareholders’ Equity

														Accumulated
						Additional								Other
		Common				Paid-in				Retained				Comprehensive				Treasury
(Dollars in thousands, except per share data)		Stock				Capital				Earnings				Income (Loss)				Stock				Total
Balance at December 31, 2006		$	4,299			$	32,251			$	42,649			$	236			$	(7,821	)		$	71,614
Comprehensive income:
Net income			—				—				6,680				—				—				6,680
Unrealized loss on securities, net of reclassification adjustments and taxes			—				—				—				(1,038	)			—				(1,038	)
Unrealized loss on hedging activities, net of reclassification adjustments and taxes			—				—				—				(5	)			—				(5	)
Total Comprehensive income																							5,637
Cash dividends declared, $.77 per share			—				—				(2,959	)			—				—				(2,959	)
Common stock issued under stock option plans			—				25				—				—				69				94
Acquisition of 16,770 shares of treasury stock			—				—				—				—				(434	)			(434	)
Treasury shares issued to dividend reinvestment plan			—				188				—				—				332				520
Stock option compensation			—				105				—				—				—				105
Balance at September 30, 2007		$	4,299			$	32,569			$	46,370			$	(807	)		$	(7,854	)		$	74,577
Balance at December 31, 2007		$	4,299			$	32,620			$	47,946			$	664			$	(7,887	)		$	77,642
Comprehensive income:
Net income			—				—				7,594				—				—				7,594
Unrealized loss on securities, net of reclassification adjustments and taxes			—				—				—				(3,193	)			—				(3,193	)
Unrealized loss on hedging activities, net of reclassification adjustments and taxes			—				—				—				(213	)			—				(213	)
Total Comprehensive income															—								4,188
Cash dividends declared, $.80 per share			—				—				(3,064	)			—				—				(3,064	)
Cumulative adjustment for change in accounting principle											(422	)											(422	)
Acquisition of 43,083 shares of treasury stock			—				—				—				—				(995	)			(995	)
Treasury shares issued to dividend reinvestment plan			—				131				—				—				406				537
Common stock issued under stock option plans			—				1				—				—				6				7
Common stock issued from Treasury stock			—				4												18				22
Stock option compensation			—				112				—				—				—				112
Balance at September 30, 2008		$	4,299			$	32,868			$	52,054			$	(2,742	)		$	(8,452	)		$	78,027

The accompanying notes are an integral part of these statements.

Consolidated Statements of Cash Flows
(unaudited)

		For the Nine Months Ended September 30
(Amounts in thousands)		2008				2007
Cash flows from operating activities
Net income		$	7,594			$	6,680
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			971				958
Net accretion of loans and investment securities			(156	)			(795	)
Stock option compensation expense			112				105
Amortization and net change in mortgage servicing rights valuation			241				50
Amortization of intangibles			271				271
Provision for loan losses			778				790
Net realized losses (gains) on sales of securities and impairment writedowns			446				(284	)
Loans originated for sale			(3,702	)			(17,312	)
Proceeds from sales of loans			3,989				16,493
Gain on sales of loans			(73	)			(181	)
Loss on sales or disposal of premises and equipment			—				17
Increase in cash surrender value of life insurance			(495	)			(487	)
Loss on equity method investments			127				12
Contribution to pension plan			(333	)			32
Decrease (increase) in interest receivable and other assets			205				(942	)
(Decrease) increase in interest payable and other liabilities			(1,672	)			257
Other, net			(71	)			189
Net cash provided by operating activities			8,232				5,853
Cash flows from investing activities
Proceeds from sales of investment securities available for sale			10,023				10,425
Proceeds from maturities of investment securities available for sale			36,249				76,378
Purchase of investment securities available for sale			(36,202	)			(76,956	)
Net increase in restricted stock			(2,571	)			221
Net increase in loans			(84,364	)			(35,684	)
Proceeds from sale of other real estate owned			208				—
Capital expenditures			(1,727	)			(1,690	)
Net cash used in investing activities			(78,384	)			(27,306	)
Cash flows from financing activities
Net (decrease) increase in demand deposits, NOW accounts and savings accounts			(20,291	)			30,230
Net increase (decrease) in certificates of deposit			19,842				(8,838	)
Net increase in short-term borrowings			25,983				3,109
Long-term debt payments			(3,488	)			(6,082	)
Long-term debt advances			43,057				—
Dividends paid			(3,064	)			(2,959	)
Common stock issued to dividend reinvestment plan			537				520
Common stock issued under stock option plans			7				94
Common stock issued from treasury shares			22				—
Purchase of treasury shares			(995	)			(434	)
Net cash provided by financing activities			61,610				15,640
Decrease in cash and cash equivalents			(8,542	)			(5,813	)
Cash and cash equivalents as of January 1			25,491				22,148
Cash and cash equivalents as of September 30		$	16,949			$	16,335
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest on deposits and other borrowed funds		$	11,908			$	18,189
Income taxes		$	3,358			$	1,352

The accompanying notes are an integral part of these statements.

FRANKLIN FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
UNAUDITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Basis of Presentation

The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank), Franklin Financial Properties Corp., and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly-owned subsidiary, Franklin Realty Services Corporation. Franklin Realty Services Corporation is an inactive real-estate brokerage company. Franklin Financial Properties Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company. The activities of nonbank entities are not significant to the consolidated totals. All significant intercompany transactions and account balances have been eliminated.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows as of September 30, 2008, and for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s 2007 Annual Report on Form 10-K. The results of operations for the period ended September 30, 2008 are not necessarily indicative of the operating results for the full year.

The balance sheet at December 31, 2007 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

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

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

		For the Three Months Ended								For the Nine Months Ended
		September 30								September 30
(Amounts in thousands)		2008				2007				2008				2007
Weighted average shares outstanding (basic)			3,824				3,847				3,831				3,844
Impact of common stock equivalents			1				6				3				8
Weighted average shares outstanding (diluted)			3,825				3,853				3,834				3,852

Note 2 — Comprehensive Income

Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on available-for-sale securities and derivatives and the change in plan assets and benefit obligations on the Bank’s pension plan, net of tax, that are recognized as separate components of shareholders’ equity.

The components of other comprehensive income (loss) and related tax effects are as follows:

		For the Three Months Ended								For the Nine Months Ended
		September 30								September 30
(Amounts in thousands)		2008				2007				2008				2007
Net Income		$	2,612			$	2,557			$	7,594			$	6,680
Securities:
Unrealized (losses) gains arising during the period			(2,176	)			502				(5,285	)			(1,320	)
Reclassification adjustment for losses (gains) included in net income			343				—				446				(252	)
Net unrealized (losses) gains			(1,833	)			502				(4,839	)			(1,572	)
Tax effect			623				(171	)			1,646				534
Net of tax amount			(1,210	)			331				(3,193	)			(1,038	)
Derivatives:
Unrealized losses arising during the period			(317	)			(32	)			(548	)			(25	)
Reclassification adjustment for losses included in net income			108				8				225				18
Net unrealized losses			(209	)			(24	)			(323	)			(7	)
Tax effect			72				8				110				2
Net of tax amount			(137	)			(16	)			(213	)			(5	)
Total other comprehensive (loss) income			(1,347	)			315				(3,406	)			(1,043	)
Total Comprehensive Income		$	1,265			$	2,872			$	4,188			$	5,637

The components of accumulated other comprehensive income (loss) included in shareholders’ equity are as follows:

		September 30
(Amounts in thousands)		2008				2007
Net unrealized gains (losses) on securities		$	(3,695	)		$	835
Tax effect			1,256				(284	)
Net of tax amount			(2,439	)			551
Net unrealized losses on derivatives			(371	)			(44	)
Tax effect			126				15
Net of tax amount			(245	)			(29	)
Accumulated pension adjustment			(87	)			(2,014	)
Tax effect			29				685
Net of tax amount			(58	)			(1,329	)
Total accumulated other comprehensive loss		$	(2,742	)		$	(807	)

Note 3 — Guarantees

The Corporation does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer 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 customers. The Bank generally holds collateral and/or personal guarantees supporting these commitments. The Bank had $31.6 million standby letters of credit as of September 30, 2008 and $24.6 million as of December 31, 2007. 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 guarantees. The amount of the liability as of September 30, 2008 and December 31, 2007 for guarantees under standby letters of credit issued was not material.

Note 4 — Pensions

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

		Three Months Ended								Nine Months Ended
		September 30								September 30
(Amounts in thousands)		2008				2007				2008				2007
Components of net periodic benefit cost:
Service cost		$	90			$	91			$	270			$	274
Interest cost			200				182				540				544
Expected return on plan assets			(232	)			(230	)			(696	)			(690	)
Amortization of prior service cost			(58	)			24				(135	)			71
Net periodic benefit cost		$	—			$	67			$	(21	)		$	199

The Bank closed its pension plan to new employees as of April 1, 2007. In addition, effective January 1, 2008, the Bank changed its existing pension plan to a career average formula from a final average formula. The Bank contributed $333 thousand to its pension plan during the second quarter of 2008. This amount represents the minimum required contribution as defined in the Pension Protection Act. The Bank does not expect to make any additional contributions in 2008.

Note 5 — Fair Value Measurements

The Corporation reports the fair value of certain assets and liabilities in its balance sheet on a recurring basis. The valuation techniques and inputs used to measure fair value are defined as follows:

	•		Level 1, quoted prices in active markets for identical assets or liabilities,
	•		Level 2, quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in inactive markets; or other observable inputs, and
	•		Level 3, unobservable inputs using the reporting entity’s own assumptions about what market participants would use in pricing the asset or liability.

The assets and liabilities reported at fair value as of September 30, 2008 and the corresponding valuation technique are shown below:

						Fair Value Measurements at Reporting
						Date Using the Following Valuation Inputs
		Fair Value at
(Dollars in Thousands)		September 30, 2008				Level 1				Level 2				Level 3
Asset Description
Investment securities available for sale		$	156,487			$	3,585			$	152,902			$	—
Liability Description
Interest rate swaps		$	372							$	372

Level 1 inputs use observable prices in markets for indentical assets.

Level 2 imputs use significant other observable inputs.

Level 3 inputs use significant unobservable imputs.

The Corporation used the following methods and significant assumptions to estimate the fair value.

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

Interest rate swaps: The interest rate swaps are valued using a discounted cash flow model that uses verifiable market environment inputs to calculate the fair value. This method is not dependant on the input of any significant judgments or assumptions by Management.

Note 6 — Recent Accounting Pronouncements

SFAS No. 141 (R) “Business Combinations”

FASB Statement No. 141 (R) “Business Combinations” was issued in December of 2007. This Statement establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The Statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective as of the beginning of a company’s fiscal year beginning after December 15, 2008. This new pronouncement will impact the Corporation’s accounting for business combinations completed beginning January 1, 2009.

SFAS No. 161 “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133”

In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (Statement 161). Statement 161 requires entities that utilize derivative instruments to provide qualitative disclosures about their objectives and strategies for using such instruments, as well as any details of credit-risk-related contingent features contained within derivatives. Statement 161 also requires entities to disclose additional information about the amounts and location of derivatives located within the financial statements, how the provisions of SFAS 133 has been applied, and the impact that hedges have on an entity’s financial position, financial performance, and cash flows. Statement 161 is effective for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Corporation is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

FSP FAS 142-3 “Determination of the Useful Life of Intangible Assets”

In April 2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The intent of this FSP is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R, and other GAAP. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Corporation is currently evaluating the potential impact the new pronouncement will have on its consolidated financial statements.

FASB Staff Position (FSP) 157-3“Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”

In October 2008, the FASB issued FSP SFAS No. 157-3, "Determining the Fair Value of a Financial Asset When The Market for That Asset Is Not Active” (FSP 157-3), to clarify the application of the provisions of SFAS 157 in an inactive market and how an entity would determine fair value in an inactive market. FSP 157-3 is effective immediately and applies to our September 30, 2008 financial statements. The application of the provisions of FSP 157-3 did not materially affect our results of operations or financial condition as of and for the periods ended September 30, 2008.

FSP 133-1 and FIN 45-4“Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161”

In September 2008, the FASB issued FSP 133-1 and FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161” (FSP 133-1 and FIN 45-4). FSP 133-1 and FIN 45-4 amends and enhances disclosure requirements for sellers of credit derivatives and financial guarantees. It also clarifies that the disclosure requirements of SFAS No. 161 are effective for quarterly periods beginning after November 15, 2008, and fiscal years that include those periods. FSP 133-1 and FIN 45-4 is effective for reporting periods (annual or interim) ending after November 15, 2008. The implementation of this standard will not have a material impact on our consolidated financial position and results of operations.

Note 7 — Reclassifications

Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect reported net income.

Note 8 — Acquisition

On July 26, 2008, Franklin Financial Services Corporation, holding company of Farmers & Merchants Trust Company of Chambersburg, and Community Financial, Inc. (Community) have announced the execution of an agreement and plan of merger under which Community will merge with and into Franklin. Community is the holding company of Community Trust Company, a Pennsylvania trust company headquartered in Camp Hill, Pennsylvania. In connection with the holding company merger, Community Trust Company will merge with and into Farmers and Merchants Trust Company. The acquisition is expected to be completed in 2008, pending regulatory approval.

Note 9 — Equity Method Investment

The Corporation has an investment in American Home Bank, N.A. The Corporation owns approximately 21% of the voting stock of this bank and accounts for this investment using the equity method of accounting. On September 19, 2008, First Chester County Corporation announced that it signed an agreement to acquire American Home Bank. The acquisition is expected to be completed in 2008, pending shareholder and regulatory approval. The Corporation is reviewing the details of the transaction and its potential affect on the Corporation’s consolidated financial statements.

Part I, Item 2

Management’s Discussion and Analysis of Results of Operations and Financial Condition
For the Three and Nine Month Periods Ended September 30, 2008 and 2007

Forward Looking Statements

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

Critical Accounting Policies

Management has identified critical accounting policies for the Corporation to include Allowance for Loan Losses, Mortgage Servicing Rights, Financial Derivatives, Other Than Temporary Investment Impairment, Stock-based Compensation and Goodwill. There were no changes to the critical accounting policies disclosed in the 2007 Annual Report on Form 10-K in regards to application or related judgements and estimates used. Please refer to Item 7 of the Corporation’s 2007 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.

Results of Operations

Summary

The financial markets, which had been strained for much of 2008 due to concerns about liquidity and sub-prime lending, finally cracked during the third quarter. The quarter ended with a bust as the market witnessed a government takeover of Fannie Mae and Freddie Mac, the failure of Lehman Brothers and Washington Mutual and the forced acquisition of Wachovia by Wells Fargo. These events have led to unprecedented intervention into the banking system by the Treasury Department, Federal Reserve and FDIC (see Economy section for additional discussion). Despite these events, the core banking operation of the Corporation performed well.

The Corporation reported net income for the nine months ended September 30, 2008 of $7.6 million. This is a 13.7% increase versus net income of $6.7 million for the same period in 2007. Total revenue (interest income and noninterest income) decreased $4.0 million year-over-year, due primarily to lower interest income and less noninterest income due to other than temporary impairment write-downs on investment securities. The provision for loan losses was $778 thousand for the period, $12 thousand less than in 2007. Diluted earnings per share increased from $1.73 in 2007 to $1.98 in 2008. Total assets were $884.6 million at September 30, 2008, up 7.8% from year-end 2007. During 2008, net loans grew to $647.5 million, while total deposits and securities sold under agreements to repurchase grew slightly to $676.8 million.

Other key performance ratios for the nine months ended September 30, 2008, (on an annualized basis) are listed below:

		2008				2007
Net interest margin			4.04	%			3.51	%
Return on average equity (ROE)			12.62	%			11.99	%
Return on average assets (ROA)			1.18	%			1.07	%
Return on average tangible equity(1)			15.43	%			15.04	%
Return on average tangible assets(1)			1.25	%			1.14	%

GAAP Measurement		Calculation
Return on Average Assets		Net Income / Average Assets
Return on Average Equity		Net Income / Average Equity

Non-GAAP Measurement		Calculation
Return on Average Tangible Assets		Net Income plus Intangible Amortization /Average Assets less Average Intangible Assets
Return on Average Tangible Equity		Net Income plus Intangible Amortization /Average Equity less Average Intangible Assets

A more detailed discussion of the operating results for the three and nine months ended September 30, 2008 follows:

Comparison of the three months ended September 30, 2008 to the three months ended September 30, 2007:

Net Interest Income

The most important source of the Corporation’s earnings is net interest income, which is defined as the difference between income on interest-earning assets and the expense of interest-bearing liabilities supporting those assets. Principal categories of interest-earning assets are loans and securities, while deposits, securities sold under agreements to repurchase (Repos), short-term borrowings and long-term debt are the principal categories of interest-bearing liabilities. Demand deposits enhance net interest income because they are noninterest-bearing deposits. All balance sheet amounts in the discussion of net interest income refer to either year-to-date or quarterly average balances.

Net interest income for the quarter was $7.6 million and represents an increase of $1.1 million over net interest income of $6.5 million in the third quarter of 2007. Interest income decreased $992 thousand (7.9%) during the quarter, to $11.6 million as compared to $12.6 million in the prior year quarter. Even though the average outstanding balance of the loan portfolio reported an increase of $69.5 million quarter over quarter, interest income from the loan portfolio decreased during the quarter compared to the prior year, caused by a reduction in rates. The increase in the average balance in the loan portfolio was primarily from growth in the commercial loan portfolio. The decrease in interest income from investments was primarily due to lower average balances during the quarter caused by maturities in the investment portfolio, which were reinvested in the loan portfolio.

Interest expense was $4.0 million for the quarter, a decrease of $2.1 million from the prior year quarter. The largest contributor to the decrease in interest expense was the expense of interest-bearing deposits. Interest expense on interest-bearing deposits decreased $1.9 million quarter over quarter as average balances decreased $17.1 million. The largest decrease in interest expense on interest-bearing deposits came from the Money Management product, which decreased $1.5 million, as the average balance decreased $34.7 million quarter over quarter. The average balance of the Repo product for the third quarter of 2008 decreased $5.8 million as compared to the same quarter in 2007. The increase of $417 thousand in interest expense for long-term debt was due to an increase of $44.7 million in the average balance quarter over quarter, as the Bank took additional advances from the FHLB during the last twelve months to lock in lower rates and to fund loan growth.

The following table shows a comparative analysis of average balances, asset yields and funding costs for the three months ended September 30, 2008 and 2007. All income and expense amounts have been adjusted to a tax-equivalent basis using a tax rate of 34%. These components drive changes in net interest income.

		For the Three Months Ended September 30
		2008												2007
						Tax												Tax
		Average				Equivalent				Average				Average				Equivalent				Average
(Dollars in thousands)		balance				Interest				yield/rate				balance				Interest				yield/rate
Interest-earning assets
Federal funds sold and interest bearing balances		$	316			$	1				1.81	%		$	4,332			$	56				5.15	%
Investment securities			160,677				2,058				5.12	%			184,708				2,598				5.58	%
Loans			634,683				9,827				6.12	%			565,134				10,341				7.26	%
Total interest-earning assets		$	795,676				11,886				5.92	%		$	754,174				12,995				6.84	%
Interest-bearing liabilities
Interest-bearing deposits		$	519,886				2,698				2.06	%		$	537,028				4,637				3.43	%
Securities sold under agreements to repurchase			76,514				337				1.75	%			82,286				1,026				4.95	%
Short-term borrowings			17,995				102				2.25	%			2,681				36				5.33	%
Long-term debt			77,350				843				4.32	%			32,642				426				5.18	%
Total interest-bearing liabilities		$	691,745				3,980				2.29	%		$	654,637				6,125				3.71	%
Interest spread											3.63	%											3.13	%
Net interest income/Net interest margin							7,906				3.93	%							6,870				3.61	%
Tax equivalent adjustment							(296	)											(413	)
Net interest income						$	7,610											$	6,457

Provision for Loan Losses

For the third quarter of 2008, provision expense was $273 thousand versus $340 thousand for the same period in 2007. For more information concerning loan quality and the allowance for loan losses, refer to the Asset Quality discussion.

Noninterest Income

Noninterest income, excluding impairment write-downs on equity securities and net gains on sales of securities, was $2.3 million in the third quarter, a decrease of $625 thousand from the third quarter of 2007 total of $2.9 million. Investment and trust service fees decreased $499 thousand in the third quarter of 2008 versus the prior year period, because of higher than normal estate fees recognized in 2007. Loan service charges and fees remained flat year over year. Mortgage banking activities decreased from 2007 as the result of an impairment charge on mortgage servicing rights of $69 thousand in 2008 versus an impairment charge of $36 thousand in 2007 and due to less gains on the sale of mortgage loans. Deposit service charges and fees increased $37 thousand primarily due to an increase in account analysis fees, as lower rates produced lower earnings credits, and thus higher account analysis fees. The Corporation has an investment in American Home Bank, N.A. and accounts for this investment using the equity method of accounting. This investment produced a loss of $5 thousand in the third quarter of 2008, compared to income of $13 thousand in the third quarter of 2007. On September 19, 2008, First Chester County Corporation announced that it signed an agreement to acquire American Home Bank. The acquisition is expected to be completed in 2008, pending shareholder and regulatory approval. The Corporation is reviewing the details of the transaction and its potential affect on the Corporation’s consolidated financial statements. Net securities losses of $144 thousand were recognized in the third quarter of 2008 compared to $0 in the third quarter of 2007. The Bank sold a Washington Mutual corporate bond that generated a $707 thousand loss. Washington Mutual declared bankruptcy during the quarter and eventually, certain assets and liabilities were assumed by J.P. Morgan. However, J.P. Morgan did not assume the corporate debt of Washington Mutual and the price of its bonds collapsed. The Corporation also took impairment charges of $199 thousand on three bank stocks in its equity portfolio in the third quarter of 2008.

Noninterest Expense

During the third quarter of 2008, noninterest expense remained flat at $5.6 million. Salaries and benefits increased slightly, by $18 thousand in 2008. Within this category, employee salaries increased $193 thousand due to annual performance increases and the 401(k) match increased $23 thousand, while the Bank’s health insurance decreased $42 thousand. Pension expense decreased $66 thousand in the third quarter, due to changes to the pension plan. In 2008, the Corporation began recognizing a liability related to the postretirement benefits covered by split-dollar life insurance arrangements. For the third quarter, this net expense totaled $7 thousand. Stock option expense increased slightly, up $7 thousand from the prior year period. Occupancy and furniture and equipment expense decreased $43 thousand, due to less depreciation expense. Advertising expense increased $263 thousand from a new customer incentive program, advertising for promotions and the opening of a new office. Data processing expense increased slightly, while Pennsylvania bank shares tax decreased $169 thousand from the resolution of prior years’ shares tax returns resulting from the 2006 Fulton Bancshares acquisition. Other noninterest expense decreased $144 thousand due to decreases in loan collection expense.

Income taxes

Federal income tax expense was $1.0 million in 2008 and $830 thousand for 2007. The increase is primarily caused by a decrease in the Corporation’s ratio of tax-free income to taxable income. All taxable income for the Corporation is taxed at a rate of 34%.

Comparison of the nine months ended September 30, 2008 to the nine months ended September 30, 2007:

Net Interest Income

Net interest income increased by $4.1 million during the period to $22.6 million. Interest income totaled $34.5 million at September 30, 2008, a decrease of $2.4 million from the prior year. Average interest-earning assets increased by $26.4 million (3.5%) over the first nine months of 2007. The yield on these assets decreased by 70 basis points and was the primary cause for the decrease in interest income, despite the increase in average interest-earning assets. The decrease in interest income was spread evenly between the loan and investment portfolios. Total average loans increased by $54.8 million from the prior year period while the average yield fell from 7.27% to 6.35%, which caused the decrease in interest income on loans. The majority of the loan growth occurred in the commercial loan portfolio, which increased $42.8 million on average from 2007 to 2008. The average outstanding balance of the consumer loan portfolio reported an increase of $4.7 million year over year. The increase was caused by the Bank’s home equity promotions, but was somewhat offset by a decrease in the average mortgage portfolio balance, which decreased by $8.9 million during the same period as run-off continued. Maturities in the investment portfolio led to a decrease in the average outstanding balance of $21.8 million and consequently a decrease in interest income.

Interest expense was $11.9 million year-to-date, a decrease of $6.4 million from the prior year. Interest-bearing liabilities averaged $667.7 million for the first nine months of 2008, an increase of $21.7 million over the 2007 average. The cost of these liabilities decreased from 3.80% in 2007 to 2.39% for 2008. Average interest-bearing deposits decreased $17.5 million and the cost decreased from 3.52% to 2.12%. The decrease in interest-bearing deposits occurred mainly in the Money Management product, as the average balance decreased $17.6 million year over year. As the rate on this product is tied to short-term market rates, the decrease in the average balance along with the decrease in rates caused a $4.5 million decrease in interest expense for the Money Management product. Securities sold under agreements to repurchase (Repos) have decreased $4.5 million on average over the prior year and the average rate decreased from 5.00% to 2.25%, as this product is also tied to short-term market rates. The average balance of long-term debt increased approximately $36.0 million due to the Bank taking additional advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and was the primary reason for the increase in interest expense for this liability.

The changes in the balance sheet and interest rates resulted in an increase in net interest income of $4.1 million to $22.6 million for the first nine months of 2008 compared to $18.5 million for the first nine months of 2007, an increase of 21.8%. While many financial institutions have experienced margin compression, the Bank has seen its net interest margin improve from 3.51% for the first nine months of 2007 to 4.04% in the first nine months of 2008. The improvement in the net interest margin is due to the cost of interest-bearing liabilities decreasing more rapidly than the yield on interest-earning assets. However, as assets continue to reprice downward, the Bank expects its net interest margin to tighten.

The following table shows a comparative analysis of average balances, asset yields and funding costs for the nine months ended September 30, 2008 and 2007. All income and expense amounts have been adjusted to a tax-equivalent basis using a tax rate of 34%. These components drive changes in net interest income.

		For the Nine Months Ended September 30
		2008												2007
						Tax												Tax
		Average				Equivalent				Average				Average				Equivalent				Average
(Dollars in thousands)		balance				Interest				yield/rate				balance				Interest				yield/rate
Interest-earning assets
Federal funds sold and interest bearing balances		$	1,686			$	42				3.27	%		$	8,293			$	333				5.30	%
Investment securities			162,974				6,402				5.24	%			184,801				7,616				5.51	%
Loans			605,315				29,004				6.35	%			550,498				29,934				7.27	%
Total interest- earning assets		$	769,975				35,448				6.11	%		$	743,592				37,883				6.81	%
Interest-bearing liabilities
Interest-bearing deposits		$	511,103				8,150				2.12	%		$	528,631				13,901				3.52	%
Securities sold under agreements to repurchase			76,749				1,295				2.25	%			81,270				3,042				5.00	%
Short-term borrowings			9,414				165				2.33	%			1,689				69				5.46	%
Long-term debt			70,445				2,320				4.39	%			34,413				1,346				5.23	%
Total interest-bearing liabilities		$	667,710				11,930				2.39	%		$	646,003				18,358				3.80	%
Interest spread											3.72	%											3.01	%
Net interest income/Net interest margin							23,518				4.04	%							19,525				3.51	%
Tax equivalent adjustment							(932	)											(985	)
Net interest income						$	22,586											$	18,540

Provision for Loan Losses

The Corporation recorded $778 thousand in provision expense during the first nine months of 2008 versus $790 thousand for the same period in 2007. For more information concerning loan quality and the allowance for loan losses, refer to the Asset Quality discussion.

Noninterest Income

For the first nine months of 2008, noninterest income, excluding impairment writedowns on equity securities and gains on sales of securities, totaled $6.6 million. This represents a decrease of $902 thousand from the 2007 total of $7.5 million. Investment and trust services income decreased due to higher than normal estate fees recognized in 2007 as compared to 2008. The increase in loan service charges and fees was primarily due to commercial loan fees (up $142 thousand). Mortgage banking fees decreased as a result of net impairment and amortization charges on mortgage servicing rights in 2008 ($242 thousand) compared to 2007 ($50 thousand). Deposit service charges and fees increased due to account analysis fees (up $90 thousand). The Corporation has an investment in American Home Bank, N.A. and is accounted for using the equity method of accounting. This investment produced a loss of $127 thousand year-to-date. Net gains on sales of securities (including the Washington Mutual loss) totaled $185 thousand in 2008 versus $284 thousand the prior year. The Corporation took impairment charges of $631 thousand on eight bank stocks in its equity portfolio in the first nine months of 2008 that offset the gains. The price of bank stocks and the value of bonds continue to be very volatile and Management is closely monitoring the value of its equity and debt investment portfolio. It is possible that additional write-downs may be required during the remainder of 2008.

Noninterest Expense

Year-to-date noninterest expense for 2008 was $17.5 million. This was $567 thousand more than the 2007 expense of $16.9 million. Most categories of noninterest expense increased from 2007. The largest dollar increase occurred in the salary and benefit category that reported an increase of $552 thousand during 2008. Of this increase, approximately $640 thousand is the result of annual performance increases, the staffing of a new office, and the addition of new positions. Health insurance (up $13 thousand) and the 401(k) match (up $73 thousand) contributed to the increase in employee benefits. Pension expense decreased in 2008 ($199 thousand) compared to 2007, as a result of changes made to the plan. The Bank’s pension plan was closed to new participants as of April 1, 2007 and effective January 1, 2008 the pension plan was changed to a career average formula for all participants. In 2008, the Corporation began recognizing a liability related to the postretirement benefits covered by split-dollar life insurance arrangements. For the first nine months of 2008, this net expense totaled $20 thousand. Stock option expense for the first nine months of 2008 totaled $112 thousand. These stock options were awarded in the first quarter of 2008 under the Corporation’s Incentive Stock Option Plan, have a 6-month vesting period and have been fully expensed. Occupancy and equipment costs remained flat year over year, while advertising costs are up $285 thousand over 2007 due to a new customer incentive program ($118 thousand) and the creation of a consumer education website ($132 thousand). Data processing expenses are up $85 thousand and relate to the installation of a new check processing system that is expected to increase efficiencies within the item processing area. Other operating expenses decreased $211 thousand during the first nine months of 2008 compared to 2007, as the prior year expense included a prepayment penalty of $277 thousand on an FHLB term debt payoff.

Income taxes

Federal income tax expense was $2.9 million in 2008 and $1.9 million for 2007. This expense resulted in an effective tax rate for 2008 of 27.5% and 22.5% for 2007. The increase is primarily caused by a decrease in the Corporation’s ratio of tax-free income to taxable income. All taxable income for the Corporation is taxed at a rate of 34%.

Financial Condition

At September 30, 2008, assets totaled $884.6 million, an increase of $64.2 million from the 2007 year-end balance of $820.4 million. The composition of the balance sheet has changed since year-end as loan growth outpaced deposit growth. Fed funds sold have decreased from the year-end balance of $7.4 million to $0, due to the reinvestment of the funds into the loan portfolio. Likewise, maturities and cash-flows from the investment portfolio have been used to fund loan growth, resulting in a decrease in the investment portfolio of $15.0 million. Net loans have increased $83.3 million since year-end. Commercial lending activity continues to be good and these balances have increased more than $86.9 million. This growth has occurred primarily from purchased loan participations in South Central Pennsylvania. However, the growth in commercial loans was partially offset by a decrease of approximately $9.0 million in the residential mortgage loan portfolio. The mortgage portfolio is expected to continue to run-off as the Bank began a new mortgage program at the beginning of 2008 that will allow it to originate mortgages on behalf of many large mortgage companies. The Bank will originate the loan for a fee, but will not fund the loan nor will it service the loan. The consumer loan portfolio increased $5.5 million due to the success of the Bank’s semi-annual home equity loan promotions. The core deposit intangible continues to be amortized over the estimated useful life of the acquired core deposits and has an estimated remaining life of approximately 7 years.

Total deposits decreased $449 thousand during the first nine months of 2008 to $605.8 million from year-end 2007. Non-interest bearing deposits increased $6.2 million and time deposits increased $19.8 million, but were offset by decreases in interest-bearing checking accounts, NOW accounts, Money Management accounts and savings accounts. Savings and interest-bearing checking deposits increased by $2.5 million, while the Money Management product decreased by $28.6 million. The decrease in the Money Management product was due to a decrease in rates as well as current economic conditions, as depositors withdrew funds. The Repo balance increased to $71.0 million from year-end. As of September 30, 2008, the Bank had $23.2 million borrowed overnight with the FHLB. Long-term debt from the FHLB increased $39.6 million as the Bank chose to lock in funding costs to take advantage of low interest rates and to provide funding for growth in the loan portfolio.

Total shareholders’ equity increased $385 thousand to $78.0 million at September 30, 2008, compared to $77.6 million at the end of 2007. The increase in retained earnings from the Corporation’s net income of $7.6 million was partially offset by the cash dividend of $3.1 million and the cumulative-effect adjustment of $422 thousand for the adoption of EITF 06-04. Accumulated Other Comprehensive Income decreased $3.4 million to a loss of $2.7 million at September 30, 2008 due primarily to a decline in the market value of investment securities available for sale. The Corporation repurchased 43,083 shares of its common stock for $995 thousand during the first nine months of 2008.

Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios. At September 30, 2008, the Corporation was well capitalized as defined by the banking regulatory agencies. Regulatory capital ratios for the Corporation and the Bank are shown below:

										Regulatory Ratios
														Well Capitalized
		September 30, 2008				December 31, 2007				Minimum				Minimum
Total Risk Based Capital Ratio (1)
Franklin Financial Services Corporation			11.52	%			12.28	%			8.00	%			n/a
Farmers & Merchants Trust Company			10.18	%			10.63	%			8.00	%			10.00	%
Tier 1 Capital Ratio (2)
Franklin Financial Services Corporation			10.39	%			11.05	%			4.00	%			n/a
Farmers & Merchants Trust Company			9.03	%			9.39	%			4.00	%			6.00	%
Leverage Ratio (3)
Franklin Financial Services Corporation			8.24	%			8.18	%			4.00	%			n/a
Farmers & Merchants Trust Company			7.14	%			6.91	%			4.00	%			5.00	%