ORRF US Equity☆

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of Orrstown and should be read in conjunction with our Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K. Certain prior period amounts presented in this discussion and analysis have been reclassified to conform to current period classifications.

Overview

The results of our operations are highly dependent on economic conditions and market interest rates. Our profitability for the years ended December 31, 2020, 2019 and 2018 was influenced by our continued organic growth and ongoing expansion into targeted markets, the acquisitions of Mercersburg and Hamilton, and a continued focus on maintaining strong asset quality. These and other matters are discussed more fully below.

During the year ended December 31, 2020, the Company recognized charges associated with the consolidation of six branch locations, the discontinuance of three loan production offices, a reduction in back-office real estate and staffing reductions. These actions were initiated due to evolving client preferences for the digital delivery of products and services. In addition, the anticipated future cost reductions resulting from these actions will prepare the Company for a challenging operating environment in 2021. A charge of $1.6 million was recorded in the year ended December 31, 2020, which included $1.3 million related to branch consolidations.

Critical Accounting Estimates

The Company's consolidated financial statements are prepared in accordance with GAAP, and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." In applying those accounting policies, the Company's management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. Certain of the critical accounting estimates are more dependent on such judgment and, in some cases, may contribute to volatility in our reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. Some of the more significant areas in which the Company's management applies critical assumptions and estimates include the following.

Accounting for loan losses — The loan portfolio is the largest asset on the Company's consolidated balance sheets. The allowance for loan losses represents the amount that, in management’s judgment, appropriately reflects credit losses inherent in the loan portfolio at the balance sheet date. A provision for credit losses is recorded to adjust the level of the ALL as deemed necessary by management. In estimating losses inherent in the loan portfolio, assumptions and judgment are applied to measure amounts and timing of expected future cash flows, collateral values and other factors used to determine the borrowers’ abilities to repay obligations. Historical loss trends are also considered, as are economic conditions, industry trends, portfolio trends and borrower-specific financial data. Loans acquired at a discount, that is, in part, attributable to credit quality, are initially recorded at fair value with no carry-over of an acquired entity’s previously established ALL. Cash flows expected at acquisition, in excess of estimated fair value, are recognized as interest income over the remaining lives of the loans. Subsequent decreases in the expected principal cash flows require the Company to evaluate the need for additions to the ALL. Subsequent improvements in expected cash flows result, first, in the recovery of any applicable ALL and, then, in the recognition of additional interest income over the remaining lives of the loans. Changes in the circumstances considered when determining management’s estimates and assumptions, could result in changes to those estimates and assumptions, and also in adjustment of the ALL, or, in the case of loans acquired at a discount, increases in interest income in future periods. The Company has delayed the implementation of ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The implementation deadline of ASU 2016-13 was extended for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022.

Valuation methodologies — Management applies various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include derivatives and mortgage servicing assets. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, costs of servicing and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on our results of operations, financial condition or disclosures of fair value information. In addition to valuation, the Company must assess whether there are any declines in value

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below the carrying value of certain assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statements of income. Examples include investment securities, mortgage servicing rights, goodwill and core deposit intangible assets, among others.

Readers of the Company's consolidated financial statements should be aware that the estimates and assumptions used may need to be updated in future financial presentations for changes in circumstances, business or economic conditions, in order to fairly represent the condition of the Company at that time.

Economic Climate, Inflation and Interest Rates

Preliminary real GDP for the fourth quarter of 2020 resulted in an annualized increase of 4.0%. This is a substantial decrease from an increase of 38.3% for the third quarter of 2020, which reflected the impact of government stimulus and the gradual re-opening of the economy from COVID-19 related shutdowns as multiple vaccines have been approved. Overall, real GDP decreased by 3.5 % for 2020 as compared to an increase of 2.2% in 2019.The increase in fourth quarter of 2020 reflected both the continued economic recovery from the sharp declines earlier in the year and the ongoing impact of the COVID-19 pandemic, including new restrictions and closures that took effect in some parts of the country. The full economic effects of the COVID-19 pandemic cannot be quantified in the GDP estimate for the fourth quarter of 2020 because the impacts are generally embedded in source data and cannot be separately identified. As restrictions continue to be lifted and the world population gets vaccinated, there is hope that the leisure, travel and entertainment industries will recover. Weekly jobless claims remain high but the Labor Department announced a decline to 730,000 on February 25, 2021, a decline of 110,000 claims from the previous report. Also, the prospects for a new government stimulus packages have recently been renewed, but remain uncertain.

The pace of U.S. economic growth weakened substantially late in the first quarter of 2020 and into the second quarter of 2020 as over 30 million people in the U.S filed for unemployment since mid-March 2020. Early in 2020, a novel coronavirus (“COVID-19”) emerged and spread, first in China and then around the globe. The fast spread of the virus and the fear that resulted combined to create a high level of uncertainty about the near and intermediate future economic outlook. Because of this uncertainty, markets were pricing in a wide range of potential outcomes by buying sovereign government bonds, especially U.S. Treasuries, and selling stocks and bonds not issued by sovereign governments. The COVID-19 pandemic has adversely affected, and is likely to continue to adversely affect, economic activity globally, nationally and locally. Actions taken around the world to help mitigate the spread of COVID-19 include restrictions on travel, quarantines in certain areas, and forced closures for certain types of public places and businesses, as well as shelter-in-place orders by many states. These restrictions have slowly been lifted as multiple vaccines have been rolled out late in the fourth quarter of 2020.

The decline in second quarter GDP reflected the response to COVID-19, as shelter-in-place orders issued in March and April were partially lifted in some areas of the country in May and June, and government pandemic assistance payments were distributed to households and businesses. This led to shifts in economic activity, as businesses remained closed or operated remotely and consumers and businesses significantly reduced or redirected their spending. Actions taken to mitigate the spread of COVID-19 have had, and are expected to continue to have, an adverse impact on the economies and financial markets of many countries, including the geographical area in which the Company operates.

Due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling for the first time below 1.00% on March 3, 2020; it was at 0.69% on September 30, 2020. On March 3, 2020, in reaction to the increase in uncertainty, the Federal Reserve cut the Fed Funds rates by 50 basis points between regularly scheduled meetings to a target range of 1.00% to 1.25%. On March 11, 2020, the World Health Organization declared COVID-19 a global pandemic. On March 13, 2020, a national emergency was declared by President Trump under the National Emergencies Act. On March 15, 2020, the Federal Reserve responded by again reducing the Fed Funds rate, this time by 100 basis points, to 0% to 0.25%. The Fed Funds rate was left unchanged in future meetings with rates expected to remain at this level for an extended period of time. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company's financial condition and results of operations in future periods. It is unknown how long the adverse conditions associated with the COVID-19 pandemic will last and what the complete financial effect will be to the Company. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.

The majority of the assets and liabilities of a financial institution are monetary in nature, and therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. Inflationary pressures remain modest and there is great uncertainty about when, or if, inflation will increase and pressure interest rates to move higher.

As the Company’s balance sheet consists primarily of financial instruments, interest income and interest expense are greatly influenced by the level of interest rates and the slope of the yield curve as well as the mix of assets and funding. The Company has been able to grow its net interest income by $14.3 million from 2019 to 2020, through a combination of organic

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commercial loan growth and the recognition of SBA PPP processing fee income. Competition for quality lending opportunities and deposits remains intense, which, together with a flattening yield curve, will continue to challenge our ability to grow our net interest margin and to leverage our overhead expenses.

Results of Operations

Summary

Earnings in 2020 reflected continuing increased interest income from expanding loan and investment portfolios, partially offset by the impact of decreasing interest rates and an overall increase in interest expense. In addition, the comparability of operating results for 2020 with 2019 has been impacted by the Hamilton acquisition, which was completed on May 1, 2019. Hamilton added loans and deposits totaling $347.1 million and $388.2 million, respectively.

The Company recorded net income of $26.5 million, $16.9 million and $12.8 million for 2020, 2019 and 2018, respectively. Diluted earnings per share totaled $2.40, $1.61 and $1.50 for 2020, 2019 and 2018, respectively.

Net interest income totaled $83.6 million, $69.3 million and $52.2 million for 2020, 2019 and 2018, respectively, principally reflecting our expanded geographic footprint, organic growth in commercial loans from an expanded sales force as we continued to take advantage of market opportunities, and SBA PPP processing fee income. As previously noted, interest rates increased throughout 2018 and 2019 and decreased throughout 2020, contributing to fluctuations in yields on loans and investments, and, to a lesser extent, costs of interest-bearing liabilities.

Asset quality trends continue to exhibit low levels of charge-offs and non-performing loans. The provision for loan losses totaled $5.3 million, $900 thousand and $800 thousand in 2020, 2019 and 2018, respectively. The increase in provision for loan losses in 2020 was primarily a result of increased uncertainty related to the COVID-19 pandemic.

Noninterest expenses totaled $74.1 million, $77.3 million and $57.9 million for 2020, 2019 and 2018, respectively. The changes in certain components of noninterest expenses between years reflect the Hamilton acquisition, and the Company's continued focus on aligning its talent and locations with its business model. Salaries and employee benefits expense increased $7.0 million from 2018 to 2019 and by $3.9 million from 2019 to 2020. Occupancy and furniture and fixture costs increased $1.9 million from 2018 to 2019 and $0.5 million from 2019 to 2020 as new and acquired branch locations were brought on line. In 2020, the Company incurred $1.3 million in pretax branch consolidation expenses, with $9.0 million incurred in 2019 for pretax merger related and branch consolidation expenses. During 2020, the Company recorded a loss of $736 thousand associated with the sale of an operations facility.

Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, or an effective tax rate of 18.6%, 13.8% and 11.4% respectively. The Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes.

Net Interest Income

Net interest income is the primary component of Orrstown's revenue. Interest-earning assets include loans, securities and federal funds sold. Interest-bearing liabilities include deposits and borrowed funds.

Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities, and the composition of those assets and liabilities. “Net interest spread” and “net interest margin” are two common statistics related to changes in net interest income. Net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. Net interest margin is the ratio of net interest income to average earning asset balances. Through the use of noninterest-bearing demand deposits and shareholders' equity, the net interest margin exceeds the net interest spread, as these funding sources are noninterest-bearing.

The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the prime interest rate. In 2018, the prime rate rose with 25 basis point increases in each of March, June, September and December, ending the year at 5.50%. In 2019, 25 basis point reductions occurred in August, September and October and the prime rate ended the year at 4.75%. In March 2020, the prime rate was reduced by 150 basis points and ended the year at 3.25%.

Core deposits are deposits that are stable, lower cost and generally reprice more slowly than other deposits when interest rates change. Core deposits, which exclude certificates of deposit, are typically funds of local clients who also have a borrowing or other relationship with the Bank. We are primarily funded by core deposits, with noninterest-bearing demand deposits

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historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on our net interest income and net interest margin in a rising interest rate environment.

Net interest income totaled $83.6 million, $69.3 million and $52.2 million in 2020, 2019 and 2018, respectively. The following table presents net interest income, net interest spread and net interest margin on a taxable-equivalent basis for 2020, 2019 and 2018. Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 21% federal corporate tax rate for 2020, 2019 and 2018, reflecting our statutory tax rates for those years.

Assets

Liabilities and Shareholders’ Equity

Taxable-equivalent net interest margin 3.44 % 3.43 % 3.36 %

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NOTES TO ANALYSIS OF NET INTEREST INCOME:

(2) Average balances include nonaccrual loans.

(3) Interest income on loans includes prepayment and late fees.

The following table presents changes in net interest income on a taxable-equivalent basis for 2020, 2019 and 2018 by rate and volume components.

AverageVolume AverageRate Total AverageVolume AverageRate Total

Interest Income

Interest Expense

Securities sold under agreements to repurchase 118 (145) (27) (7) 41 33

average rate and the remainder is attributable to rate.

2020 versus 2019

In 2020, net interest income increased $14.3 million, or 20.7%, compared with 2019. Net interest income for 2020 on a taxable-equivalent basis increased $14.1 million, or 20.0%, compared with 2019. The Company’s net interest spread increased five basis points to 3.29% for 2020 compared with 2019. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2019 to 2020, reflecting increased average balances from SBA PPP loans, organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2019 and 2020 include the effect of purchase accounting related to the Hamilton acquisition and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.

Interest income on a taxable-equivalent basis on loans increased $12.3 million, or 16.3%, from 2019 to 2020. The increase resulted from SBA PPP loans originated in 2020, which drove an increase in average loan volume and a decrease in yield, with average loans increasing $435.7 million, or 29.2%, and yield decreasing 50 basis points from 5.06% in 2019 to 4.56% in 2020. For the year ended December 31, 2020, SBA PPP loans had an average balance of $318.4 million and an average yield of 3.5%. Accretion of purchase accounting adjustments in connection with acquisitions increased interest income by $2.3 million, $3.8 million and $335 thousand in 2020, 2019 and 2018, respectively.

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Interest income earned on a taxable-equivalent basis on securities decreased by $4.7 million, or 27.4%, from 2019 to 2020, with both average volume and yield decreasing. Average securities decreased by $5.2 million, or 1.0%, and the taxable-equivalent yield decreased from 3.43% in 2019 to 2.52% in 2020. Contributing to the overall decrease in interest income on securities was a decrease in average securities balances of $5.2 million from 2019 to 2020. This was partially offset by declines in the yield on floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019 and an additional 150 basis points in the first half of 2020.

Interest expense on deposits and borrowings decreased by $7.7 million from 2019 to 2020, despite an increase in the average balance of interest-bearing liabilities of $247.9 million, or 14.1%. The cost of interest-bearing liabilities declined by 55 basis points from 1.35% in 2019 to 0.80% in 2020 due to a decline in market interest rates. In addition, there was an increase in non-interest bearing liabilities of $147.5 million, or 62.9% from 2019 to 2020 due primarily to the funding of SBA PPP loans in 2020.

The Company's ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $236.3 million, or 25.7%, in 2020. Interest expense for these deposits decreased by $3.5 million, with the cost of funds decreasing from 0.90% in 2019 to 0.41% in 2020. The decrease was driven by the decreasing market rates from 2019 through 2020 due to the rate decreases commenced by the FRB.

The Company also increased its average FHLB advances in 2020. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings decreased $374 thousand in 2020, with average balances decreasing $9.2 million for short-term borrowings while FHLB advances increased $75.7 million. The average rate paid on short-term borrowings decreased from 1.28% in 2019 to 0.48% in 2020 and the average rate paid on FHLB advances decreased from 2.21% in 2019 to 1.07% in 2020.

2019 versus 2018

In 2019, net interest income increased $17.1 million, or 32.9%, compared with 2018. Net interest income for 2019 on a taxable-equivalent basis increased $16.8 million, or 31.3%, compared with 2018. The Company’s net interest spread increased three basis points to 3.24% for 2019 compared with 2018. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2018 to 2019, reflecting increased average balances from organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2018 and 2019 include the effect of purchase accounting related to the Mercersburg and Hamilton acquisitions and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.

Interest income on a taxable-equivalent basis on loans increased $24.5 million, or 48.1%, from 2018 to 2019. The increase resulted from an increase in both average loan volume and yield, with average loans increasing $392.2 million, or 35.6%, and interest income on loans increasing 42 basis points from 4.64% in 2018 to 5.06% in 2019. The Company's geographic expansion and sales efforts with additional loan officers continued to drive loan growth in 2019 across most loan classes. Increases in prime lending rates in 2018 contributed to an increased yield in the first half of 2019, but were partially offset by rate decreases in the second half. In addition, the middle of the yield curve inverted for much of 2019, which lowered the rate on new loans more than the rate on new deposits, which pressured net interest margin. Accretion of purchase accounting adjustments in connection with the acquisitions increased 2019 interest income by $3.8 million compared with $335 thousand in 2018.

Interest income earned on a taxable-equivalent basis on securities increased $1.4 million, or 8.9%, from 2018 to 2019, with both average volume and yield increasing. Average securities increased $19.8 million, or 4.1%, and the taxable-equivalent yield increased from 3.28% in 2018 to 3.43% in 2019. Contributing to the overall increase in interest income on securities was the purchase of higher yielding, longer maturity, tax-free state and political subdivisions investments in the third quarter of 2018, that were subsequently sold in the third quarter of 2019. This was partially offset by declines in the yield of floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019.

Interest expense on deposits and borrowings increased $10.2 million from 2018 to 2019, as the average balance of interest-bearing liabilities increased $393.1 million, or 28.9%. Interest expense on interest-bearing deposits declined less than the decline in market rates due to competitive factors in the marketplace.

Our ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $152.2 million, or 19.8% in 2019, of which approximately $51.0 million was acquired in the Hamilton acquisition. Interest expense for these deposits increased $3.3 million, with the cost of funds increasing from 0.65% in 2018 to 0.90% in 2019. The increase was driven by increasing market rates throughout 2018, followed by falling short-term rates once the FRB began to decrease rates in the second half of 2019. As noted, yields on

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interest-bearing deposits did not fall as much as market rates due to competitive factors. As a result, interest was paid at higher rates on interest-bearing deposits in 2019 than in 2018.

We also decreased our average short-term borrowings in 2019 in favor of brokered deposits at more attractive rates in early 2019. In late 2018, we issued $32.5 million in aggregate principal amount of subordinated notes, the proceeds of which were designated for the cash portion of merger and acquisition activity and for general corporate purposes. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings increased $1.1 million in 2019, with average balances decreasing $49.2 million for short-term borrowings while long-term borrowings also decreased $3.0 million. The average rate paid on short-term borrowings increased from 1.94% in 2018 to 1.95% in 2019 and the average rate paid on long-term borrowings increased from 1.95% in 2018 to 2.21% in 2019.

Provision for Loan Losses

The Company recorded a provision for loan losses of $5.3 million, $900 thousand and $800 thousand in 2020, 2019, and 2018, respectively. In calculating the provision for loan losses, both quantitative and qualitative factors, including the Company's favorable historical charge-off data and stable economic and market conditions, were considered in the determination of the adequacy of the ALL. Net charge-offs and loan growth resulted in the determination that a provision expense was required in 2020, 2019 and 2018. The increase in provision from 2019 to 2020 was due primarily to the impact of COVID-19 on the Company's loan portfolio as a new qualitative factor was created to address the associated risk.

See further discussion in the “Asset Quality” and “Credit Risk Management” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Noninterest Income

The following table compares noninterest income for 2020, 2019 and 2018.

Gain on sale of commercial loans 2,803 — — 2,803 — — % — %

2020 versus 2019

Noninterest income decreased by $230 thousand from 2019 to 2020. The Company continues to focus on growth in relationship fee-based revenue for commercial and retail clients. The following were significant factors in that net decrease.

•A decline of $530 thousand in service charges on deposit accounts reflects the impact of COVID-19, as the Company waived certain fees for a period of time and experienced an overall decline in account usage.

•Interchange income reflected an overall increase in our clients' activity and card usage due to COVID-19.

•Mortgage banking income increased by $2.7 million due to an increase in loans sold to $205.2 million in 2020 from $106.7 million in 2019 as interest rate declines led to significant refinancing activity.

•Swap fee income declined by $350 thousand from 2019 to 2020. In 2020, Orrstown began entering into interest rate swap agreements directly with its commercial customers. This offering replaced the third party swap transactions

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initiated in the prior year. This fee revenue will fluctuate from quarter to quarter, but client demand to fix loan interest rates declined slightly in the current rate environment.

•Trust and brokerage income reflected increased revenue from strong stock market performance.

•Income from life insurance included death benefit proceeds of $58 thousand in 2020 and $255 thousand in 2019.

•There was a decline of $4.8 million in investment gains from 2019 to 2020 due to prior year asset/liability management strategies which resulted in net gains of $4.8 million on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions.

2019 versus 2018

Noninterest income increased $7.5 million from 2018 to 2019. We continue to focus on growth in relationship fee-based revenue for commercial and retail clients. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.

•Service charges on deposit accounts and interchange on debit card income reflected an overall increase in the Company's clients' activity and card usage from our organic growth as well as the expanded client base from the acquisitions. These stable sources of fee revenue should grow over time as we add retail and commercial clients.

•Gains on SBA loan sales, which are included in other service charges, commissions and fees, decreased approximately $300 thousand from 2018 to 2019.

•The Company began offering interest rate hedging products through a third party in the second half of 2019, whereby its receives a fee at loan closing.

•Trust and brokerage income reflected increased revenue from generally improved market conditions, additional advisors and increased estate fees in 2019. We continue to look to build this business over the coming years and have recently begun efforts to offer wealth management products in our acquired Baltimore market area.

•The increase in mortgage banking activities reflects the increase in loans sold from $93.1 million in 2018 to $106.7 million in 2019. With interest rates currently at low levels and recent market expansion efforts, we see opportunities to increase our market share with existing clients by increasing our focus on branch referrals and local market outreach efforts.

•Income from life insurance included death benefit proceeds in both 2019 and 2018, with the increase between years principally attributable to life insurance assets obtained through acquisitions.

•In both 2019 and 2018, asset/liability management strategies resulted in net gains on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions, while also considering funding requirements of anticipated lending activity.

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Noninterest Expenses

The following table compares noninterest expenses for 2020, 2019 and 2018.

$ Change % Change

2020 versus 2019

Noninterest expenses decreased by $3.2 million from 2019 to 2020. The following were significant factors in that net decrease.

•The salaries and employee benefit increase includes the impact in 2020 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2019, as well as additional new relationship managers. Higher costs in 2020 also include annual merit and incentive compensation increases in 2020, increased stock compensation expense from additional share-based awards granted in 2020, and higher medical costs for claims activity and the expanded workforce.

•Occupancy expense in 2020 reflects a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the first quarter of 2019. In addition, lease termination costs of $588 thousand were recognized in 2020 as a part of the Company's restructuring plan.

•Advertising and bank promotions expense declined from 2019 to 2020 due to additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.

•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion. FDIC insurance expense increased in 2020 after the remaining credits were used to partially offset first quarter 2020 expense.

•In 2020, branch consolidation costs totaled $1.3 million and there were no merger related costs. These costs primarily represented lease termination costs. Merger related costs incurred in 2019 totaled $8.0 million. In the fourth quarter of 2019, the Company recorded $1.0 million in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.

•The insurance claim receivable (recovery) write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.

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•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.

2019 versus 2018

Noninterest expenses increased $19.4 million from 2018 to 2019. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.

•The salaries and employee benefits increase includes the impact in 2019 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2018 and 2019, as well as additional new relationship managers. Higher costs in 2019 also include annual merit and incentive compensation increases in 2019, increased stock compensation expense from additional share-based awards granted in 2019, and higher medical costs for claims activity and the expanded workforce.

•Occupancy and furniture and equipment expenses in 2019 reflect a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the third and fourth quarters of 2018 and two in the first quarter of 2019.

•Increases in data processing reflect volume increases and physical growth and costs associated with more sophisticated product and service offerings.

•Advertising and bank promotions expense includes additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.

•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion.

•Intangible asset amortization increased due to the core deposit intangibles recorded in the Mercersburg and Hamilton acquisitions.

•Merger related costs incurred in 2019 totaled $8.0 million and represented principally data processing contract termination costs, employee contract termination costs and legal and consulting fees for the Hamilton acquisition and system conversion expenses for both the Mercersburg and Hamilton acquisitions. In the fourth quarter of 2019, the Company recorded $988 thousand in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.

•The insurance claim receivable write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.

•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.

Income Taxes

Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, respectively. The effective tax rate for 2020 was 18.6% compared with 13.8% for 2019 and 11.4% for 2018. Generally, the Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes. In 2019, the Company's effective tax rate increased principally due to increased profitability, offset partially by benefits realized from a $185 thousand expense reduction related to a favorable tax law clarification on the treatment of life insurance assets of an acquired entity, as well as a $334 thousand expense reduction related to an increase in deferred state income taxes due to a state tax rate change resulting from the Hamilton acquisition.

Note 8, Income Taxes, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," includes a reconciliation of our federal statutory tax rate to the Company's effective tax rate, which is a meaningful comparison between years and measures income tax expense as a percentage of pretax income.

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Financial Condition

Management devotes substantial time to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and management of the risks associated with these investments.

Securities Available for Sale

The Company utilizes securities available for sale to manage interest rate risk, to enhance income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings.

The Company has established investment policies and an asset management policy to assist in administering our investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, pledges to secure deposits and repurchase agreements and other factors while trying to maximize return on the investments. We may segregate our investment portfolio into three categories: “securities held to maturity,” “trading securities” and “securities available for sale.” At December 31, 2020, management has classified the entire securities portfolio as available for sale, which is accounted for at current market value with unrealized gains and losses excluded from earnings and reported in OCI, net of income taxes.

Our securities available for sale portfolio includes debt investments that are subject to varying degrees of credit and market risks, which arise from general market conditions, and factors impacting specific industries, as well as news that may impact specific issues. Management monitors its debt securities, using various indicators in determining whether a debt security is other-than-temporarily impaired, including the amount of time the security has been in an unrealized loss position, and the extent of the unrealized loss. In addition, management assesses whether it is likely we will have to sell the security prior to recovery, or if we are able to hold the security until the price recovers. For those debt securities in which management concludes the security is other-than-temporarily impaired, it recognizes the credit component of an OTTI impairment in earnings and the remaining portion in OCI. Management considers the asset quality of our debt security portfolio to be strong; therefore, the Company did not record any OTTI expense in 2020, 2019 or 2018.

The following table summarizes the fair value of securities available for sale at December 31, 2020, 2019 and 2018.

GSE residential mortgage-backed securities 4,293 — —

Private label residential CMOs — — 143

The Company decreased its investment portfolio in 2020, with the average balance of securities decreasing from $499.6 million for the year ended December 31, 2019 to $494.4 million for the year ended December 31, 2020.

In late 2018, the Company increased its holdings of longer maturity state and political subdivisions in anticipation of falling interest rates. In 2019, interest rates fell and the attractiveness of tax-free state and political subdivisions declined. In response, we reduced our holdings of longer maturity tax-free state and political subdivisions at a gain. These securities were replaced with additional asset-backed and private label commercial CMOs that were either floating rate or had shorter average lives than the state and political subdivision investments.

Asset-backed securities and CMOs provide monthly cash flows that may be used, in part, to meet anticipated loan demand in 2020, as management anticipates the loan portfolio will continue to grow.

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The following table shows the maturities of investment securities at book value at December 31, 2020, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 21% federal income tax rate.

States and political subdivisions

Average maturity (years) — — 7.6 16.9 14.4

GSE residential mortgage-backed securities

Yield — % — % — % 1.84 % 1.84 %

Average maturity (years) — — — 0.3 0.3

GSE residential CMOs

Yield — % — % — % 2.16 % 2.16 %

Average maturity (years) — — — 23.1 23.1

Non-agency CMOs

Yield — % — % — % 1.09 % 1.09 %

Average maturity (years) — — — 4.5 4.5

Private label commercial CMOs

Asset-backed

Other

Yield — % 2.45 % — % — % 1.64 %

Average maturity (years) — 2.4 — — 1.6

Total

The average maturity is based on the contractual terms of the debt or mortgage-backed securities, and does not factor in required repayments or anticipated prepayments. At December 31, 2020, the weighted average estimated life is 20 years for mortgage-backed and CMO securities, and 21 years for asset-backed securities, based on current interest rates and anticipated prepayment speeds.

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The following table summarizes the credit ratings and collateral associated with the Company's investment portfolio, excluding equity securities, at December 31, 2020:

PACE Loan ABS 1 % $ 5,147 $ 5,243 5 % 100 % — % — % — % — % PACE Loans

Bank CDs — % $ 249 $ 249 — % — % — % — % 100 % FDIC Insured CD

(1) Minimum of 97% guaranteed by U.S. government

(3) 100% guaranteed by U.S. government agencies

Loan Portfolio

The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.

Generally, we are permitted under applicable law to make loans to single borrowers (including certain related persons and entities) in aggregate amounts of up to 15% of the sum of total capital and the ALL. The Company’s legal lending limit to one borrower was $34.7 million at December 31, 2020. No borrower had an outstanding exposure exceeding the limit at year-end.

The risks associated with lending activities differ among loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. A further discussion on the classes of loans the Company makes and related risks is included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

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The following table presents the loan portfolio, excluding residential LHFS, by segments and classes at December 31.

Commercial real estate:

Acquisition and development:

Residential mortgage:

(1) Includes $403.3 million and $0 of SBA PPP loans, net of deferred fees and costs, as of December 31, 2020 and 2019, respectively.

The loan portfolio at December 31, 2020 increased by $335.4 million, or 20.4%, from December 31, 2019 due primarily to the origination of SBA PPP loans in 2020, which was partially offset by a reduction in mortgage loans resulting from significant refinancing activity in the low interest rate environment. The increase in the loan portfolio from 2018 to 2019 was approximately 75% attributable to loans acquired in the Hamilton transaction. The Mercersburg acquisition in 2018 and Hamilton acquisition in 2019 increased the loan portfolio, principally in the residential mortgage - first lien and commercial real estate - owner and non-owner occupied classes. The Company's organic growth has occurred in both core and newer markets, such as Lancaster County, Pennsylvania, principally in commercial real estate, and in commercial and industrial loans and installment and other loans as we focused on increasing diversification in the portfolio. The growth in installment and other loans in 2018 through 2020 was principally attributable to purchased automobile financing loans at higher returns than comparable cash flows in the investment portfolio.

Competition for new business opportunities remains strong, which may temper loan growth in future quarters.

In addition to monitoring our loan portfolio by loan class as noted above, we also monitor concentrations by segment. The Bank’s lending policy reports segment concentrations that exceeds 20% of the Bank’s total risk-based capital ("RBC"). The following segments met this criterion at December 31, 2020.

Balance % of Total Loans % of Total RBC

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The following table presents expected maturities of certain loan classes by fixed rate or adjustable rate categories at December 31, 2020.

Due In

One Yearor Less OneYear ThroughFive Years After FiveYears Total

Acquisition and development:

1-4 family residential construction

Commercial and land development

Commercial and industrial

The final maturity is used in the determination of maturity of acquisition and development loans that convert from construction to permanent status. Variable rate loans shown above include semi-fixed loans that contractually will adjust with prime or LIBOR after the interest lock period, which may be up to 10 years. At December 31, 2020, these semi-fixed loans totaled $29.8 million.

Asset Quality

Risk Elements

The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through our underwriting standards, on-going credit reviews, and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate our risk of credit loss.

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The following table presents the Company’s risk elements and relevant asset quality ratios at December 31.

Loans past due 90 days or more and still accruing (1) 554 2,232 57 — —

Asset quality ratios:

Total nonperforming assets to total assets 0.37 % 0.46 % 0.27 % 0.69 % 0.52 %

Total risk assets to total loans and OREO 0.60 % 0.86 % 0.52 % 1.19 % 0.94 %

(1) Includes $456 thousand and $2.0 million, respectively, of purchased credit impaired loans at December 31, 2020 and 2019.

The following table provides detail of impaired loans at December 31, 2020 and 2019.

Commercial real estate:

Acquisition and development

Commercial and land development 814 — 814 — — —

Residential mortgage:

Installment and other loans 17 — 17 85 — 85

Nonperforming assets include nonaccrual loans and foreclosed real estate. Risk assets, which include nonperforming assets and restructured and loans past due 90 days or more and still accruing, totaled $11.8 million at December 31, 2020, an increase of $2.3 million or 16.1%, from $14.1 million at December 31, 2019. Nonaccrual loans totaled $10.3 million at December 31, 2020, a decrease of $347 thousand from December 31, 2019. The change in nonaccrual loan amounts also impacted other asset quality ratios detailed above.

The ALL totaled $20.2 million at December 31, 2020, a $5.5 million increase from $14.7 million at December 31, 2019, resulting from net recoveries of $171 thousand and a provision for loan losses of $5.3 million for 2020. The ALL is higher as a percentage of the total loan portfolio at December 31, 2020 than in prior years, reflecting the increased ALL balance. An

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increase in special mention loans and loan modifications due to COVID-19 led to the inclusion of $2.8 million in qualitative reserves associated with COVID-19 in the ALL at December 31, 2020. Management believes its coverage ratios are adequate for the risk profile of the loan portfolio given ongoing monitoring of the portfolio and its quantitative and qualitative analysis performed at December 31, 2020. As new information is learned about borrowers or updated appraisals on real estate with lower fair values are obtained, the Company may experience an increase in impaired loans.

For the years ended December 31, 2020, 2019, and 2018, recoveries of $1.2 million, $606 thousand and $882 thousand, respectively, were credited to the ALL. These recoveries on previously charged-off relationships are the result of successful loan monitoring and workout solutions. Recoveries are difficult to predict, and any additional recoveries that the Company receives will be used to replenish the ALL. Recoveries favorably impact historical charge-off factors, and contribute to changes in the quantitative and qualitative factors used in our allowance adequacy analysis. However, as the loan portfolio continues to grow, future provisions for loan losses may result.

The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Impairment reserves remain in place if updated appraisals are pending, and represent management’s estimate of potential loss.

The following table presents exposure to relationships with an impaired loan balance, partial charge-offs taken to date and specific reserves established on the relationships at December 31, 2020 and 2019.

# ofRelationships RecordedInvestment PartialCharge-offsto Date SpecificReserves

Relationships greater than $1 million 2 $ 5,639 $ — $ —

Relationships greater than $500 thousand but less than $1 million 2 1,211 17 —

Relationships greater than $250 thousand but less than $500 thousand 2 637 — —

Relationships greater than $1 million 2 $ 5,218 $ — $ —

Relationships greater than $250 thousand but less than $500 thousand 3 980 — —

Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.

In its individual loan impairment analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or impairment reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at December 31, 2020. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.

The Company’s foreclosed real estate balance at December 31, 2020 was zero for both residential and commercial properties. During 2020, no expense was recorded for the write-down of other real estate owned properties.

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In an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. As of December 31, 2020, the Company had loan deferrals under this program for commercial and consumer clients with a total loan balance of $15.7 million and $2.5 million, respectively. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements. Below is a summary of select loan concentrations and the deferrals within those categories at December 31, 2020.

The following table summarizes COVID-19 related modifications, including deferrals and forbearances:

Loan Type Amount of Loans Percent of Non-PPP Loans

The following table summarizes COVID-19 related deferral balances within certain industry segments at December 31, 2020:

Strip Center/Retail — — 61,268 —

Senior Housing — — 43,814 —

Credit Risk Management

Allowance for Loan Losses

The Company maintains the ALL at a level deemed adequate by management for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses which is charged to earnings. On a quarterly basis, management assesses the adequacy of the ALL utilizing a defined methodology which considers specific credit evaluation of impaired loans, historical loss experience and qualitative factors. Management addresses the requirements for loans individually identified as impaired, loans collectively evaluated for impairment, and other bank regulatory guidance in its assessment.

The ALL is evaluated based on review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for loan losses and related procedures in establishing the appropriate level of reserve is included in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

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The following table summarizes the Company’s internal risk ratings at December 31, 2020 and 2019.

Commercial real estate:

Acquisition and development:

Residential mortgage:

Commercial real estate:

Acquisition and development:

Residential mortgage:

Non-Impaired Substandard loans are performing loans which have characteristics that cause management concern over the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as

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nonperforming, or impaired, loans in the future. Generally, management feels that substandard loans that are currently performing and not considered impaired result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan, and represent potential problem loans. Non-impaired Substandard loans totaled $16.7 million at December 31, 2020.

Additionally, the Special Mention classification is intended to be a temporary classification reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Company’s position at some future date. Special mention loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified, rating. These loans require inquiry by lenders on the cause of the potential weakness and, once analyzed, the loan classification may be downgraded to Substandard or, alternatively, could be upgraded to Pass. Special mention loans increased by $74.8 million from December 31, 2019 to December 31, 2020 due primarily to the economic weakness created by COVID-19 as well as related loan modifications completed in 2020. Any loans with second modifications that are COVID-19 related are classified as special mention.

The following tables summarize the average recorded investment in impaired loans and interest income recognized, on a cash basis, and interest income earned but not recognized for years ended December 31, 2020, 2019, 2018, 2017 and 2016.

AverageImpairedBalance InterestIncomeRecognized InterestEarnedBut NotRecognized

Commercial real estate:

Non-owner occupied 83 — —

Multi-family 205 — —

Non-owner occupied residential 388 — 21

Acquisition and development:

Commercial and land development 641 — 23

Commercial and industrial 1,196 — 20

Residential mortgage:

Home equity – term 11 — 1

Home equity – lines of credit 692 1 36

Installment and other loans 25 — 1

Commercial real estate:

Non-owner occupied 46 — —

Non-owner occupied residential 217 — 21

Acquisition and development:

1-4 family residential construction — — —

Commercial and land development 21 — —

Commercial and industrial 683 — 130

Residential mortgage:

Home equity – term 13 — 1

Home equity – lines of credit 750 2 64

Installment and other loans 13 — 2

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AverageImpairedBalance InterestIncomeRecognized InterestEarnedBut NotRecognized

Commercial real estate:

Non-owner occupied residential 346 — 36

Acquisition and development:

1-4 family residential construction 181 — —

Commercial and land development 1 — 1

Commercial and industrial 322 — 29

Residential mortgage:

Home equity – term 19 — 2

Home equity – lines of credit 657 2 52

Installment and other loans 4 — 5

Commercial real estate:

Non-owner occupied 392 — 10

Non-owner occupied residential 418 — 35

Acquisition and development:

1-4 family residential construction 154 — 7

Commercial and industrial 413 — 25

Residential mortgage:

Home equity – term 61 — 1

Home equity – lines of credit 488 2 26

Installment and other loans 10 — 3

Commercial real estate:

Non-owner occupied residential 645 — 35

Acquisition and development:

Commercial and land development 3 — 1

Commercial and industrial 575 — 25

Residential mortgage:

Home equity – term 98 — 6

Home equity – lines of credit 455 — 19

Installment and other loans 12 — 3

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The following table summarizes activity in the ALL for years ended December 31, 2020, 2019, 2018, 2017 and 2016.

Commercial Consumer

The following table summarizes asset quality ratios for years ended December 31, 2020, 2019, 2018, 2017 and 2016.

The Company recorded a provision for loan losses expense of $5.3 million, $900 thousand, $800 thousand, $1.0 million and $250 thousand for 2020, 2019, 2018, 2017 and 2016, respectively. In addition, in certain cases, loans were successfully

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worked out with smaller charge-offs than the reserve established on them. From 2016 to 2019, the Company has benefited from organic loan portfolio growth and favorable historical charge-off data combined with relatively stable economic conditions over the periods presented above. This was a principal factor in management's determination that a negative or modest provision could be recorded despite net charge-offs recorded in 2016. In 2017, management determined that a provision expense that offset net charge-offs for the year would maintain an adequate ALL, principally due to a charge-off in connection with one commercial credit downgraded to nonaccrual status during the year. In 2018 and 2019, our continued organic loan portfolio growth was a key factor in the quantitative and qualitative considerations used by management in the determination of the provision expense required to maintain an adequate allowance for loan losses. In 2020, the severe economic impact of COVID-19 on the loan portfolio drove an increase in qualitative assumptions. These variations in net charge-offs (recoveries) and provision expense (recovery) resulted in the fluctuations in the ratios presented in the tables above.

See further discussion in the “Provision for Loan Losses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Also, see Note 4, Loans and Allowance for Loan Losses, in the Notes to Consolidated Financial Statements for additional information on the COVID-19 qualitative assumptions.

The following table shows the allocation of the ALL by loan class, as well as the percent of each loan class in relation to the total loan balance at December 31, 2020, 2019, 2018, 2017 and 2016.

Commercial real estate:

Acquisition and development:

Residential mortgage:

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The following table summarizes the ending loan balance individually or collectively evaluated for impairment by loan class and the ALL allocation for each at December 31, 2020 and 2019.

Commercial Consumer

Loans allocated by:

Allowance for loan losses allocated by:

Individually evaluated for impairment $ — $ — $ 1 $ — $ 1 $ 33 $ — $ 33 $ — $ 34

Loans allocated by:

Allowance for loan losses allocated by:

Individually evaluated for impairment $ — $ — $ — $ — $ — $ 36 $ — $ 36 $ — $ 36

In addition to the reserve allocations on impaired loans noted above, 11 loans, with aggregate outstanding principal balances of $1.2 million, have had cumulative partial charge-offs to the ALL totaling $562 thousand at December 31, 2020. As updated appraisals were received on collateral-dependent loans, partial charge-offs were taken to the extent the loans’ principal balance exceeded their fair value.

Management believes the allocation of the ALL between the various loan classes adequately reflects the probable incurred credit losses in each portfolio and is based on the methodology outlined in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." Management re-evaluates and makes certain enhancements to its methodology used to establish a reserve to better reflect the risks inherent in the different segments of the portfolio, particularly in light of increased charge-offs, with noticeable differences between the different loan classes. Management believes these enhancements to the ALL methodology improve the accuracy of quantifying probable incurred credit losses inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for loan losses on its overall analysis.

The largest component of the ALL for the years presented has been allocated to the commercial real estate segment, particularly the non-owner occupied loan classes. The higher allocations in these classes as compared with the other classes is consistent with the inherent risk associated with these loans, as well as generally higher levels of impaired and criticized loans for the periods presented. There has generally been a decrease in the ALL allocated to the commercial real estate portfolio, as the level of classified assets has declined, and historical loss rates have improved as a result of improving economic and market conditions.

The unallocated portion of the ALL reflects estimated inherent losses within the portfolio that have not been detected, as well as the risk of error in the specific and general reserve allocation, other potential exposure in the loan portfolio, variances in management’s assessment of national and local economic conditions and other factors management believes appropriate at the time. The unallocated portion of the allowance increased from $140 thousand at December 31, 2019 to $218 thousand at December 31, 2020 and represents 1.1% of the ALL at December 31, 2020, compared with 1.0% at December 31, 2019. Changes in qualitative factors of certain loan categories were made during 2019 to reflect limited credit losses in recent history.

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The Company monitors the unallocated portion of the ALL, and by policy, has determined it should not exceed 3% of the total reserve. Future negative provisions for loan losses may result if the unallocated portion was to increase, and management determined the reserves were not required for the anticipated risk in the portfolio.

Management believes the Company’s ALL is adequate based on information currently available. Future adjustments to the ALL and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management’s assumptions as to future delinquencies or loss rates.

Deposits

Total deposits grew $481.4 million, or 25.7%, from $1.9 billion at December 31, 2019 to $2.4 billion at December 31, 2020. This increase was primarily due to deposits generated through the SBA PPP during 2020. In 2019, the Company acquired $388.2 million in deposits from Hamilton. At December 31, 2019, those acquired accounts totaled approximately $332.0 million. During 2019, brokered deposits were reduced by $110.6 million and subscription service CDs declined by $21.9 million. Organic growth totaled approximately $147.7 million in 2019.

The following table presents average deposits for years ended December 31, 2020, 2019, and 2018.

Average total deposits increased $310.5 million, or 16.8%, from 2019 to 2020. SBA PPP loan funding was the principal driver of this increase. Average time deposits less than $250 thousand grew from $287.9 million in 2018 to $483.9 million in 2019 and average time deposits in excess of $250 thousand increased from $36.3 million in 2018 to $66.0 million in 2019.

In addition to deposits from acquisitions, the Bank has been able to garner organic growth in both interest-bearing and noninterest-bearing deposit relationships from enhanced cash management offerings as we continued to develop commercial relationships. We also continued to grow core funding deposits through marketing campaigns and improvement in our product delivery with investments in technology and increased sales efforts. We have also been able to increase interest-free funds as we expanded our commercial and industrial loan portfolio.

In 2020, the Bank reduced its brokered deposit balances to zero at December 31, 2020 compared with $16.1 million at December 31, 2019, and averaged $3.2 million for 2020 compared with $100.8 million for 2019. Given interest rate conditions and asset/liability strategies, the Bank borrowed additional funds from FHLB of Pittsburgh to replace called brokered deposits from the second half of 2019 through 2020.

Management evaluates its utilization of brokered deposits, taking into consideration the interest rate curve and regulatory views on non-core funding sources, and balances this funding source with its funding needs based on growth initiatives. The Company anticipates that as loan growth increases, it will be able to generate core deposit funding by offering competitive rates.

The following table presents maturities of time deposits of $250,000 or more at December 31, 2020.

Total

Three months or less $ 25,828

Over three months through six months 15,734

Over six months through one year 12,057

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Borrowings

In addition to deposit products, the Company uses short-term borrowing sources to meet liquidity needs and for temporary funding. Sources of short-term borrowings include the FHLB of Pittsburgh, federal funds purchased, and to a lesser extent, the FRB discount window. Short-term borrowings also include securities sold under agreements to repurchase with deposit clients, in which a client sweeps a portion of a deposit balance into a repurchase agreement, which is a secured borrowing with a pool of securities pledged against the balance.

The Company also utilizes long-term debt, consisting principally of FHLB fixed and amortizing advances to fund its balance sheet with original maturities greater than one year. The Company evaluates its funding needs, interest rate movements, the cost of options, and the availability of attractive structures when considering the timing and extent of when it enters into long-term borrowings.

In December 2018, we issued unsecured subordinated notes payable totaling $32.5 million, the proceeds of which were designated for general corporate use, including funding of cash consideration for mergers and acquisitions.

For additional information about borrowings, refer to Note 13, Short-Term Borrowings, Note 14, Long-Term Debt, and Note 15, Subordinated Notes, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."

Shareholders' Equity

In 2020, total shareholders’ equity increased $23.0 million, or 10.3%. Net income increased equity by $26.5 million. AOCI increased by $3.8 million due to an increase of $4.8 million in unrealized gains on securities partially offset by $1.0 million in unrealized losses on derivatives during 2020. Dividends paid to shareholders decreased equity by $7.6 million.

In September, 2015, the Board of Directors authorized a stock repurchase program which is more fully described in Item 5 under Issuer Purchases of Equity Securities. The maximum number of shares that may yet be purchased under the plan is 261,320 shares at December 31, 2020.

The following table includes additional information for shareholders’ equity for years ended December 31, 2020, 2019, and 2018.

Average equity to average assets ratio 8.58 % 9.26 % 8.75 %

Capital Adequacy and Regulatory Matters

Capital management in a regulated financial services industry must properly balance return on equity to its shareholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company’s capital management strategies have been developed to provide attractive rates of returns to its shareholders, while maintaining a “well capitalized” position of regulatory strength.

Effective with the third quarter of 2018, the FRB raised the consolidated asset limit on small bank holding companies from $1 billion to $3 billion, and a company with assets under the revised limits is not subject to the FRB consolidated capital rules. A company with consolidated assets under the revised limit may continue to file reports that include capital amounts and ratios. The Company has elected to continue to file those reports.

Management believes the Company and the Bank met all capital adequacy requirements to which they are subject at December 31, 2020 and December 31, 2019. At December 31, 2020, the Bank was considered well capitalized under applicable banking regulations.

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Tables presenting the Company’s and the Bank’s capital amounts and ratios at December 31, 2020 and 2019 are included in Note 17 Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."

The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. In addition to the minimum capital ratio requirement and minimum capital ratio to be well capitalized presented in the tables in Note 17, we must maintain a capital conservation buffer as noted in Item 1 - Business under the topic Basel III Capital Rules. At December 31, 2020, the Company's and the Bank's capital conservation buffer, based on the most restrictive capital ratio, was 6.5% and 6.7%, which is above the regulatory requirement of 2.50% at December 31, 2020.

Liquidity and Rate Sensitivity

Liquidity. The primary function of asset/liability management is to ensure adequate liquidity and manage the Company’s sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Company's primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities, the sale of mortgage loans and borrowings from the FHLB of Pittsburgh. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company's maximum borrowing capacity from the FHLB is $830.3 million at December 31, 2020.

The Company regularly adjusts its investments in liquid assets based upon its assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities and the objectives of its asset/liability management policy.

At December 31, 2020, outstanding loan commitments totaled $596.2 million, which included $89.5 million in undisbursed loans, $223.2 million in unused home equity lines of credit, $268.9 million in commercial lines of credit, and $14.5 million in standby letters of credit. Time deposits due within one year after December 31, 2020 totaled $310.3 million, or 78% of time deposits. The large percentage of time deposits that mature within one year reflects clients’ preference not to invest funds for long periods in the current interest rate environment. If these maturing deposits do not remain with us, we will be required to seek other sources of funds, including other time deposits and lines of credit. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on time deposits outstanding at December 31, 2020. We believe, however, based on past experience that a significant portion of our time deposits will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates we offer.

Our most liquid assets are cash and cash equivalents. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At December 31, 2020, cash and cash equivalents totaled $125.3 million, compared with $56.5 million at December 31, 2019. Securities classified as available for sale, net of pledging requirements, provide additional sources of liquidity, and totaled $67.8 million at December 31, 2020. Also at December 31, 2020, the Company had the ability to borrow up to a total of $830.3 million from the FHLB of Pittsburgh, of which $151.4 million in advances and letters of credit were outstanding. The Company’s ability to borrow from the FHLB is dependent on having sufficient qualifying collateral, which generally consists of mortgage loans. In addition, the Company had $30.0 million in available unsecured lines of credit with other banks at December 31, 2020.

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders and interest on its borrowings. The Company also has repurchased shares of its common stock. The Company’s primary source of income is dividends received from the Bank. Restrictions on the Bank’s ability to dividend funds to the Company are included in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

Interest Rate Sensitivity. Interest rate sensitivity management requires the maintenance of an appropriate balance between interest sensitive assets and liabilities. Management, through its asset/liability management process, attempts to manage the level of repricing and maturity mismatch so that fluctuations in net interest income are maintained within policy limits in current and expected market conditions. For further discussion, see Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk."

Contractual Obligations

The Company enters into contractual obligations in the normal course of business to fund loan growth, for asset/liability management purposes, to meet required capital needs and for other corporate purposes. The following table presents significant fixed and determinable contractual obligations of principal by payment date at December 31, 2020. Further discussion of the

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nature of each obligation is included in the referenced Note to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data" referenced in the following table.

Payments Due

NoteReference Less than 1year 2-3 years 4-5 years More than5 years Total

The contractual obligations table above does not include off-balance sheet commitments to extend credit that are detailed in the following section. These commitments generally have fixed expiration dates and many will expire without being drawn upon, therefore the total commitment does not necessarily represent future cash requirements and is excluded from the contractual obligations table.

Off-Balance Sheet Arrangements

The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit.

The following table details significant commitments at December 31, 2020.

Contract or NotionalAmount

Commitments to fund:

Home equity lines of credit $ 223,216

1-4 family residential construction loans 28,928

Commercial real estate, construction and land development loans 60,606

Commercial, industrial and other loans 268,931

Standby letters of credit 14,491

A discussion of the nature, business purpose, and guarantees that result from the Company’s off-balance sheet arrangements is included in Note 19, Financial Instruments with Off-Balance Sheet Risk, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

Recently Adopted and Recently Issued Accounting Standards

Recently adopted and recently issued accounting standards are included in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."

Supplemental Reporting of Non-GAAP Measures

As a result of prior acquisitions, the Company had intangible assets consisting of goodwill and core deposit and other intangible assets totaling $26.9 million and $27.1 million at December 31, 2020 and 2019, respectively.

Management believes providing certain “non-GAAP” information will assist investors in their understanding of the effect of acquisition activity on reported results, particularly to overcome comparability issues related to the influence of intangibles (principally goodwill) created in acquisitions.

Tangible book value per share and net interest margin excluding the impact of purchase accounting, as used by the Company in this supplemental reporting, are not GAAP measures. While we believe this information is a useful supplement to the GAAP based measures presented in Item 6, Selected Financial Data and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, readers are cautioned that this non-GAAP disclosure has limitations as an

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analytical tool, should not be viewed as a substitute for financial measures determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of our results and financial condition as reported under GAAP, nor are such measures necessarily comparable to non-GAAP performance measures that may be presented by other companies. This supplemental presentation should not be construed as an inference that our future results will be unaffected by similar adjustments to be determined in accordance with GAAP.

The following table presents the computation of each non-GAAP based measure shown together with its most directly comparable GAAP based measure.

Tangible book value per common share

Tangible book value per share (non-GAAP) $ 19.93 $ 17.65 $ 16.73

Effect of purchase accounting:

Allowance to unguaranteed loans

Allowance for loan losses $ 20,151

less: SBA guaranteed loans (404,205)

Allowance to unguaranteed loans 1.3 %

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Allowance plus purchase accounting marks to unguaranteed loans:

Allowance plus purchase accounting marks 27,935 32,815

Allowance plus purchase accounting marks to unguaranteed loans: 1.8 % 2.0 %

ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk comprises exposure to interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks. In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring our interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. FRB monetary control efforts, the effects of deregulation, economic uncertainty and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.

Interest Rate Risk

Interest rate risk is the exposure to fluctuations in the Company’s future earnings (earnings at risk) and value (value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest-earning assets and interest-bearing liabilities that reprice within a specified time period as a result of scheduled maturities, scheduled and unscheduled repayments, the propensity of borrowers and depositors to react to changes in their economic interests, and loan contractual interest rate changes.

We attempt to manage the level of repricing and maturity mismatch through our asset/liability management process so that fluctuations in net interest income are maintained within policy limits across a range of market conditions, while satisfying liquidity and capital requirements. Management recognizes that a certain amount of interest rate risk is inherent, appropriate and necessary to ensure the Company’s profitability. Thus, the goal of interest rate risk management is to evaluate the amount of reward for taking risk and adjusting both the size and composition of the balance sheet relative to the level of reward available for taking risk.

Management endeavors to control the exposure to changes in interest rates by understanding, reviewing and making decisions based on its risk position. The Company primarily uses its securities portfolio, FHLB advances, interest rate swaps and brokered deposits to manage its interest rate risk position. Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives.

We use simulation analysis to assess earnings at risk and net present value analysis to assess value at risk. These methods allow management to regularly monitor both the direction and magnitude of our interest rate risk exposure. These analyses require numerous assumptions including, but not limited to, changes in balance sheet mix, prepayment rates on loans and securities, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rate due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and providing a relative gauge of our interest rate risk position over time.

Our asset/liability committee operates under management policies, approved by the Board of Directors, which define guidelines and limits on the level of risk. The committee meets regularly and reviews our interest rate risk position and monitors various liquidity ratios to ensure a satisfactory liquidity position. By utilizing our analyses, we can determine changes that may need to be made to the asset and liability mixes to mitigate the change in net interest income under various interest rate scenarios. Management continually evaluates the condition of the economy, the pattern of market interest rates and other

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economic data to inform the committee on the selection of investment securities. Regulatory authorities also monitor our interest rate risk position along with other liquidity ratios.

Net Interest Income Sensitivity

Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income. The analysis involves changing the interest rates used in determining net interest income over the next twelve months. The resulting percentage change in net interest income in various rate scenarios is an indication of our short-term interest rate risk. The analysis assumes recent pricing trends in new loan and deposit volumes will continue while balances remain constant. Additional assumptions are applied to modify pricing under the various rate scenarios.

The simulation analysis results are presented in the Net Interest Income table below. At December 31, 2020, these results indicate the Company would be better positioned, over the next 12 months, in a moderately declining rate environment than it would be if interest rates increased. At December 31, 2019, the results indicated we would be better positioned in a moderately increasing rate environment than if rates decreased moderately or increased more substantially.

Economic Value

Net present value analysis provides information on the risk inherent in the balance sheet that might not be considered in the simulation analysis due to the short time horizon used in that analysis. The net present value of the balance sheet incorporates the discounted present value of expected asset cash flows minus the discounted present value of expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The resulting percentage change in net present value in various rate scenarios is an indication of the longer term repricing risk and options embedded in the balance sheet.

At December 31, 2020, similar to at December 31, 2019, these results indicate the Company would be better positioned in a rising interest rate environment than it would be if interest rates decreased.

Earnings at Risk Value at Risk

% Change in Net Interest Income % Change in Market Value

Further discussion related to the quantitative and qualitative disclosures about market risk is included under the heading of Liquidity and Rate Sensitivity in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

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ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

SUMMARY OF QUARTERLY FINANCIAL DATA

The following table presents unaudited quarterly results of operations for years ended December 31.

December September June March December September June March

Per share information:

(a) Sum of the quarters may not equal the total year due to rounding.

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Index to Financial Statements and Supplementary Data

Page

Management’s Report on Internal Control over Financial Reporting 62

Report of Crowe LLP, Independent Registered Public Accounting Firm 63

Consolidated Balance Sheets 66

Consolidated Statements of Income 67

Consolidated Statements of Comprehensive Income 68

Consolidated Statements of Changes in Shareholders’ Equity 69

Consolidated Statements of Cash Flows 70

Notes to Consolidated Financial Statements 72

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Management’s Report on Internal Control Over Financial Reporting

The management of Orrstown Financial Services, Inc., together with its consolidated subsidiaries (the "Company"), has the responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. Management maintains a comprehensive system of internal control to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. The Company maintains an internal auditing program, under the supervision of the Audit Committee of the Board of Directors, which independently assesses the effectiveness of the system of internal control and recommends possible improvements.

Under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its internal control over financial reporting at December 31, 2020, using the Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this evaluation, management has concluded that, at December 31, 2020, the Company’s internal control over financial reporting is effective based on the criteria established in Internal Control-Integrated Framework (2013).

Crowe LLP has audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020, as stated in their report dated March 15, 2021.

/s/ Thomas R. Quinn, Jr. /s/ Thomas R. Brugger

Thomas R. Quinn, Jr. Thomas R. Brugger

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Report of Independent Registered Public Accounting Firm

Shareholders and Board of Directors of Orrstown Financial Services, Inc.

Shippensburg, Pennsylvania

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying consolidated balance sheets of Orrstown Financial Services, Inc. (the "Company") as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in shareholders’, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.

Basis for Opinions

The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

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Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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

Critical Audit Matter

The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.

Allowance for Loan Losses – Adjustments for qualitative factors

As more fully described in Note 1 and Note 4 to the consolidated financial statements, the Company estimates and records an allowance for loan losses for loans collectively evaluated for impairment by developing a loss rate based on historical losses and qualitative factors. Qualitative factors are used to adjust historical loss rates considering relevant factors such as nature and volume of loans; national and local economic conditions; concentrations of credit and changes within credit concentrations; quality of loan review; delinquency trends; classified loan trends; underwriting standards and recovery practices; and experience, ability and depth of management and lending staff. The application of the adjustments for qualitative factors to the historical loss rate calculation is subjective.

The principal considerations for our determination that auditing the adjustments to the historical loss rates is a critical audit matter is the high degree of judgment involved in the assessment of the risk of loss associated with each risk factor. Our audit procedures included both control and substantive testing related to the adjustments for qualitative factors. Procedures included, among others:

•Testing the following controls:

◦Management’s review of the accuracy of data inputs used to adjust historical loss rates.

◦Management’s review of the appropriateness and adequacy of the adjustments to the historical loss rates

◦Management’s approval of the conclusions reached over the allowance for loan losses for loans collectively evaluated for impairment.

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•Substantive tests included:

◦Data inputs used to adjust historical loss rates were agreed to source documentation.

◦The adjustments to historical loss rates were evaluated for reasonableness and appropriateness including both directional consistency and the magnitude of the adjustments.

◦Analytical procedures were performed to evaluate changes that occurred in the allowance for loan losses for loans collectively evaluated for impairment.

Crowe LLP

We have served as the Company's auditor since 2014.

Washington, D.C.

March 15, 2021

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Consolidated Balance Sheets

ORRSTOWN FINANCIAL SERVICES, INC.

December 31,

(Dollars in thousands, except per share amounts) 2020 2019

Assets

Restricted investments in bank stocks 10,563 16,184

Loans held for sale, at fair value 11,734 9,364

Cash surrender value of life insurance 68,554 63,613

Liabilities

Deposits:

Securities sold under agreements to repurchase 19,466 8,269

Commitments and contingencies

Shareholders’ Equity

Accumulated other comprehensive income (loss) 3,346 (480)

The Notes to Consolidated Financial Statements are an integral part of these statements.

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Consolidated Statements of Income

ORRSTOWN FINANCIAL SERVICES, INC.

Years Ended December 31,

(Dollars in thousands, except per share amounts) 2020 2019 2018

Interest income

Interest expense

Securities sold under agreements to repurchase 85 623 81

Noninterest income

Other service charges, commissions and fees 683 805 907

Gain on sale of portfolio loans 2,803 — —

Investment securities (losses) gains (16) 4,749 1,006

Noninterest expenses

Merger related and branch consolidation expenses 1,310 8,964 3,197

Insurance claim (recovery) receivable write-off (486) 615 —

Per share information:

The Notes to Consolidated Financial Statements are an integral part of these statements.

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Consolidated Statements of Comprehensive Income

ORRSTOWN FINANCIAL SERVICES, INC.

Years Ended December 31,

Other comprehensive income, net of tax:

Unrealized losses on interest rate swaps used in cash flow hedges (1,347) — —

Reclassification adjustment for losses realized in net income 117 — —

Tax effect 258 — —

The Notes to Consolidated Financial Statements are an integral part of these statements.

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Consolidated Statements of Changes in Shareholders’ Equity

ORRSTOWN FINANCIAL SERVICES, INC.

Total other comprehensive loss, net of taxes — — — (5,817) — (5,817)

Cash dividends ($0.51 per share) — — (4,375) — — (4,375)

Share-based compensation plans:

Total other comprehensive income, net of taxes — — — 2,492 — 2,492

Cash dividends ($0.60 per share) — — (6,150) — — (6,150)

Share-based compensation plans:

Total other comprehensive income, net of taxes — — — 3,826 — 3,826

Cash dividends ($0.68 per share) — — (7,610) — — (7,610)

Share-based compensation plans:

The Notes to Consolidated Financial Statements are an integral part of these statements.

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Consolidated Statements of Cash Flows

ORRSTOWN FINANCIAL SERVICES, INC.

Years Ended December 31,

Cash flows from operating activities

Net discount (accretion) premium amortization (4,481) (2,547) 1,406

Impairment of intangibles 153 — —

Gain on sales of loans originated for sale (6,067) (2,613) (2,144)

Gain on sale of portfolio loans (2,803) — (291)

Net loss (gain) on disposal of OREO 152 (156) (108)

Writedown of OREO 544 — 24

Net loss on disposal of premises and equipment 2 139 12

Investment securities losses (gains) 16 (4,749) (1,006)

Gains on termination of rate swap (226) — —

(Increase) decrease in accrued interest receivable (2,887) 1,248 (879)

Cash flows from investing activities

Net cash and cash equivalents received from acquisitions — 29,442 12,407

Net purchases of restricted investments in bank stocks 5,621 (2,684) (592)

Proceeds from sales of portfolio loans 22,665 — 3,589

Purchases of bank premises and equipment (1,303) (2,911) (4,791)

Proceeds from sale of rate swap 218 — —

Purchases of bank owned life insurance (3,636) (3,280) (900)

Death benefit proceeds from life insurance contracts 391 571 576

Other — — 7

Cash flows from financing activities

Proceeds from subordinated notes, net of issuance costs — — 31,857

Payment of subordinated notes issuance costs — (59) —

Acquisition of treasury stock (1,170) — —

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Years Ended December 31,