FIRST NATIONAL CORP /VA/ - Quarter Report: 2019 June (Form 10-Q)

fxnc20190603_10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2019

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

For the transition period from to

Commission File Number: 0-23976

(Exact name of registrant as specified in its charter)

Virginia	54-1232965
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

112 West King Street, Strasburg, Virginia	22657
(Address of principal executive offices)	(Zip Code)

(540) 465-9121

(Registrant’s telephone number, including area code)

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

Title of each class	Trading symbol(s)	Name of each exchange on which registered
Common stock, par value $1.25 per share	FXNC	The Nasdaq Stock Market LLC

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

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

Large accelerated filer	☐	Accelerated filer	☒
Non-accelerated filer	☐	Smaller reporting company	☒
		Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of August 8, 2019, 4,964,824 shares of common stock, par value $1.25 per share, of the registrant were outstanding.

Table of Contents

TABLE OF CONTENTS

		Page
PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets as of June 30, 2019 (unaudited) and December 31, 2018	3

	Consolidated Statements of Income for the three and six months ended June 30, 2019 and 2018 (unaudited)	4

	Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2019 and 2018 (unaudited)	6

	Consolidated Statements of Cash Flows for the six months ended June 30, 2019 and 2018 (unaudited)	7

	Consolidated Statements of Changes in Shareholders’ Equity for the three and six months ended June 30, 2019 and 2018 (unaudited)	9

	Notes to Consolidated Financial Statements (unaudited)	10

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	49

Item 4.	Controls and Procedures	49

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	50

Item 1A.	Risk Factors	50

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	50

Item 3.	Defaults Upon Senior Securities	50

Item 4.	Mine Safety Disclosures	50

Item 5.	Other Information	50

Item 6.	Exhibits	51

Table of Contents

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

FIRST NATIONAL CORPORATION

Consolidated Balance Sheets

(in thousands, except share and per share data)

	(unaudited)
	June 30,		December 31,
	2019		2018*
Assets
Cash and due from banks	$	12,354	$	13,378
Interest-bearing deposits in banks		10,716		15,240
Securities available for sale, at fair value		119,510		99,857
Securities held to maturity, at amortized cost (fair value, 2019, $18,796; 2018, $42,394)		18,828		43,408
Restricted securities, at cost		1,701		1,688
Loans held for sale		675		419
Loans, net of allowance for loan losses, 2019, $4,995; 2018, $5,009		569,959		537,847
Premises and equipment, net		20,182		20,066
Accrued interest receivable		2,163		2,113
Bank owned life insurance		17,193		13,991
Core deposit intangibles, net		302		472
Other assets		4,801		4,490
Total assets	$	778,384	$	752,969

Liabilities and Shareholders’ Equity

Liabilities
Deposits:
Noninterest-bearing demand deposits	$	186,553	$	181,964
Savings and interest-bearing demand deposits		385,399		369,383
Time deposits		117,863		119,219
Total deposits	$	689,815	$	670,566
Subordinated debt		4,974		4,965
Junior subordinated debt		9,279		9,279
Accrued interest payable and other liabilities		1,507		1,485
Total liabilities	$	705,575	$	686,295
Shareholders’ Equity
Preferred stock, par value $1.25 per share; authorized 1,000,000 shares; none issued and outstanding	$	—	$	—
Common stock, par value $1.25 per share; authorized 8,000,000 shares; issued and outstanding, 2019, 4,964,824 shares; 2018, 4,957,694 shares		6,206		6,197
Surplus		7,566		7,471
Retained earnings		58,268		54,814
Accumulated other comprehensive income (loss), net		769		(1,808	)
Total shareholders’ equity	$	72,809	$	66,674
Total liabilities and shareholders’ equity	$	778,384	$	752,969

*Derived from audited consolidated financial statements.

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income (Unaudited)

(in thousands, except per share data)

	Three Months Ended				Six Months Ended
	June 30,		June 30,		June 30,		June 30,
	2019		2018		2019		2018
Interest and Dividend Income
Interest and fees on loans	$	7,200	$	6,546	$	14,196	$	12,851
Interest on deposits in banks		133		186		243		346
Interest and dividends on securities:
Taxable interest		696		776		1,433		1,456
Tax-exempt interest		159		156		315		301
Dividends		26		22		50		44
Total interest and dividend income	$	8,214	$	7,686	$	16,237	$	14,998
Interest Expense
Interest on deposits	$	1,051	$	665	$	1,973	$	1,255
Interest on subordinated debt		90		89		179		178
Interest on junior subordinated debt		108		101		219		187
Interest on other borrowings		—		—		2		—
Total interest expense	$	1,249	$	855	$	2,373	$	1,620
Net interest income	$	6,965	$	6,831	$	13,864	$	13,378
Provision for loan losses		200		—		200		100
Net interest income after provision for loan losses	$	6,765	$	6,831	$	13,664	$	13,278
Noninterest Income
Service charges on deposit accounts	$	715	$	784	$	1,416	$	1,546
ATM and check card fees		573		555		1,090		1,074
Wealth management fees		458		409		895		816
Fees for other customer services		153		151		328		304
Income from bank owned life insurance		99		77		202		636
Net gains on sale of loans		25		15		47		24
Other operating income		12		76		42		300
Total noninterest income	$	2,035	$	2,067	$	4,020	$	4,700
Noninterest Expense
Salaries and employee benefits	$	3,375	$	3,227	$	6,818	$	6,610
Occupancy		401		387		839		787
Equipment		409		420		829		843
Marketing		239		161		380		270
Supplies		91		88		164		168
Legal and professional fees		303		223		544		414
ATM and check card expense		225		211		441		414
FDIC assessment		35		66		104		148
Bank franchise tax		136		118		266		233
Telecommunications expense		79		98		162		134
Data processing expense		179		170		352		332
Postage expense		44		42		92		103
Amortization expense		80		120		170		251
Other real estate owned expense (income), net		—		1		—		(22	)
Other operating expense		634		532		1,167		1,045
Total noninterest expense	$	6,230	$	5,864	$	12,328	$	11,730

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income (Unaudited)

(Continued)

(in thousands, except per share data)

	Three Months Ended				Six Months Ended
	June 30,		June 30,		June 30,		June 30,
	2019		2018		2019		2018
Income before income taxes	$	2,570	$	3,034	$	5,356	$	6,248
Income tax expense		484		583		1,009		1,110
Net income	$	2,086	$	2,451	$	4,347	$	5,138
Earnings per common share
Basic	$	0.42	$	0.49	$	0.88	$	1.04
Diluted	$	0.42	$	0.49	$	0.88	$	1.04

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Comprehensive Income (Unaudited)

(in thousands)

	Three Months Ended					Six Months Ended
	June 30,		June 30,			June 30,			June 30,
	2019		2018			2019			2018
Net income	$	2,086	$	2,451		$	4,347		$	5,138
Other comprehensive income (loss), net of tax,
Unrealized holding gains (losses) on available for sale securities, net of tax $369 and ($75) for the three months and $776 and ($304) for the six months ended June 30, 2019 and 2018, respectively		1,389		(284	)		2,917			(1,146	)
Unrealized holding losses on securities transferred from held to maturity to available for sale, net of tax $0 and $0 for the three months and ($91) and $0 for the six months ended June 30, 2019 and 2018, respectively		—		—			(340	)		—
Pension liability adjustment, net of tax $0 and $0 for the three months and $0 and ($27) for the six months ended June 30, 2019 and 2018, respectively		—		—			—			(99	)
Total other comprehensive income (loss)		1,389		(284	)		2,577			(1,245	)
Total comprehensive income	$	3,475	$	2,167		$	6,924		$	3,893

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows (Unaudited)

(in thousands)

	Six Months Ended
	June 30,			June 30,
	2019			2018
Cash Flows from Operating Activities
Net income	$	4,347		$	5,138
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of premises and equipment		669			681
Amortization of core deposit intangibles		170			251
Amortization of debt issuance costs		9			8
Origination of loans held for sale		(4,017	)		(2,057	)
Proceeds from sale of loans held for sale		3,808			1,324
Net gains on sales of loans held for sale		(47	)		(24	)
Provision for loan losses		200			100
Net gains on sale of other real estate owned		—			(24	)
Increase in cash value of bank owned life insurance		(202	)		(167	)
Accretion of discounts and amortization of premiums on securities, net		285			274
Accretion of premium on time deposits		(32	)		(43	)
Stock-based compensation		68			89
Excess tax benefits on stock-based compensation		(2	)		(7	)
Deferred income tax (benefit) expense		(78	)		51
Changes in assets and liabilities:
Increase in interest receivable		(50	)		(157	)
(Increase) decrease in other assets		(711	)		1,234
Decrease in accrued expenses and other liabilities		(183	)		(896	)
Net cash provided by operating activities	$	4,234		$	5,775
Cash Flows from Investing Activities
Proceeds from maturities, calls, and principal payments of securities available for sale	$	8,209		$	8,064
Proceeds from maturities, calls, and principal payments of securities held to maturity		1,089			2,413
Purchases of securities available for sale		(1,394	)		(27,146	)
Net purchase of restricted securities		(13	)		(20	)
Purchase of premises and equipment		(785	)		(423	)
Proceeds from sale of other real estate owned		—			350
Purchase of bank owned life insurance		(3,000	)		—
Proceeds from cash value of bank owned life insurance		—			347
Net increase in loans		(32,312	)		(9,187	)
Net cash used in investing activities	$	(28,206	)	$	(25,602	)

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows (Unaudited)

(Continued)

(in thousands)

	Six Months Ended
	June 30,			June 30,
	2019			2018
Cash Flows from Financing Activities
Net increase in demand deposits and savings accounts	$	20,605		$	21,909
Net decrease in time deposits		(1,324	)		(317	)
Cash dividends paid on common stock, net of reinvestment		(837	)		(464	)
Repurchase of common stock		(20	)		(24	)
Net cash provided by financing activities	$	18,424		$	21,104
(Decrease) increase in cash and cash equivalents	$	(5,548	)	$	1,277
Cash and Cash Equivalents
Beginning	$	28,618		$	39,986
Ending	$	23,070		$	41,263
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	2,371		$	1,656
Income taxes	$	1,027		$	96
Supplemental Disclosures of Noncash Investing and Financing Activities
Unrealized gains (losses) on securities available for sale	$	3,693		$	(1,450	)
Unrealized losses on securities transferred from held to maturity to available for sale	$	(431	)	$	—
Fair value of securities transferred from held to maturity to available for sale	$	23,036		$	—
Change in pension liability	$	—		$	(126	)
Transfer from loans to other real estate owned	$	—		$	68
Issuance of common stock, dividend reinvestment plan	$	56		$	31

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

(in thousands, except share and per share data)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Loss			Total
Balance, March 31, 2018	$	6,191	$	7,312	$	48,109		$	(1,919	)	$	59,693
Net income		—		—		2,451			—			2,451
Other comprehensive loss		—		—		—			(284	)		(284	)
Cash dividends on common stock ($0.05 per share)		—		—		(247	)		—			(247	)
Stock-based compensation		—		19		—			—			19
Issuance of 781 shares common stock, dividend reinvestment plan		1		15		—			—			16
Balance, June 30, 2018	$	6,192	$	7,346	$	50,313		$	(2,203	)	$	61,648

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance, March 31, 2019	$	6,204	$	7,515	$	56,629		$	(620	)	$	69,728
Net income		—		—		2,086			—			2,086
Other comprehensive income		—		—		—			1,389			1,389
Cash dividends on common stock ($0.09 per share)		—		—		(447	)		—			(447	)
Stock-based compensation		—		25		—			—			25
Issuance of 1,337 shares common stock, dividend reinvestment plan		2		26		—			—			28
Balance, June 30, 2019	$	6,206	$	7,566	$	58,268		$	769		$	72,809

	Common Stock			Surplus			Retained Earnings			Accumulated Other Comprehensive Loss			Total
Balance, December 31, 2017	$	6,182		$	7,260		$	45,670		$	(958	)	$	58,154
Net income		—			—			5,138			—			5,138
Other comprehensive loss		—			—			—			(1,245	)		(1,245	)
Cash dividends on common stock ($0.10 per share)		—			—			(495	)		—			(495	)
Stock-based compensation		—			89			—			—			89
Issuance of 1,632 shares common stock, dividend reinvestment plan		2			29			—			—			31
Issuance of 7,339 shares common stock, stock incentive plan		9			(9	)		—			—			—
Repurchase of 1,317 shares of common stock, stock incentive plan		(1	)		(23	)		—			—			(24	)
Balance, June 30, 2018	$	6,192		$	7,346		$	50,313		$	(2,203	)	$	61,648

	Common Stock			Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance, December 31, 2018	$	6,197		$	7,471		$	54,814		$	(1,808	)	$	66,674
Net income		—			—			4,347			—			4,347
Other comprehensive income		—			—			—			2,577			2,577
Cash dividends on common stock ($0.18 per share)		—			—			(893	)		—			(893	)
Stock-based compensation		—			68			—			—			68
Issuance of 2,734 shares common stock, dividend reinvestment plan		4			52			—			—			56
Issuance of 5,402 shares common stock, stock incentive plan		7			(7	)		—			—			—
Repurchase of 1,006 shares of common stock, stock incentive plan		(2	)		(18	)		—			—			(20	)
Balance, June 30, 2019	$	6,206		$	7,566		$	58,268		$	769		$	72,809

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Notes to Consolidated Financial Statements (Unaudited)

Note 1. General

The accompanying unaudited consolidated financial statements of First National Corporation (the Company) and its subsidiary, First Bank (the Bank), have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications of a normal and recurring nature considered necessary to present fairly the financial positions at June 30, 2019 and December 31, 2018, the statements of income and comprehensive income for the three and six months ended June 30, 2019 and 2018, the cash flows for the six months ended June 30, 2019 and 2018, and the changes in shareholders’ equity for the three and six months ended June 30, 2019 and 2018. The statements should be read in conjunction with the consolidated financial statements and related notes included in the Annual Report on Form 10-K for the year ended December 31, 2018. Operating results for the three and six months ended June 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.

Adoption of New Accounting Standards

On January 1, 2019, the Company adopted ASU No. 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees are required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee‘s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach does not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The FASB made subsequent amendments to Topic 842 through ASU 2018-10 (“Codification Improvements to Topic 842, Leases.”) and ASU 2018-11 (“Leases (Topic 842): Targeted Improvements.”) Among these amendments is the provision in ASU 2018-11 that provides entities with an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new leases standard will continue to be in accordance with current GAAP (Topic 840, Leases). The adoption of this standard did not have a material effect on the Company's consolidated financial statements. For further information about the Company's leases, see Note 16.

On January 1, 2019, the Company adopted ASU No. 2017-08, "Receivables—Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” The amendments in ASU 2017-08 shorten the amortization period for certain callable debt securities purchased at a premium. Under the new guidance, premiums on these qualifying callable debt securities are amortized to the earliest call date. Discounts on purchased debt securities continue to be accreted to maturity. The adoption of this standard did not have a material effect on the Company's consolidated financial statements and no cumulative effect adjustment was recorded.

On January 1, 2019, the Company adopted ASU No. 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." The amendments in ASU 2017-12 modify the designation and measurement guidance for hedge accounting as well as provide for increased transparency regarding the presentation of economic results on both the financial statements and related footnotes. Certain aspects of hedge effectiveness assessments were simplified upon implementation of this updated. The new guidance also provides for a reclassification of certain debt securities from held to maturity to available for sale if the security is eligible to be hedged using the last-of-layer method. Any unrealized gain or loss existing at the time of transfer is recorded in accumulated comprehensive income or loss. As a permitted activity, the reclassification of securities will not taint future held to maturity classification so long as the securities transferred are eligible to be hedged under the last-of-layer method. Accordingly, on January 1, 2019, the Company reclassified eligible held to maturity securities with amortized costs totaling $23.4 million as available for sale. The unrealized loss associated with the reclassified securities totaled $431 thousand and was included in the Company's accumulated other comprehensive income (loss) on the date of reclassification.

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Notes to Consolidated Financial Statements (Unaudited)

Recent Accounting Pronouncements

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Based on FASB's July 17, 2019 meeting, an exposure draft is expected that, once finalized, could change implementation dates for many companies. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements. The Company has formed a committee to address the compliance requirements of this ASU, which has analyzed gathered data, defined loan pools and segments, and selected methods for applying the concepts included in this ASU. The Company is in the process of testing selected models, building policy and processing documentation, modeling the impact of the ASU on the capital and strategic plans, performing model validation, and finalizing policies and procedures. This guidance may result in material changes in the Company's accounting for credit losses of financial instruments.

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Notes to Consolidated Financial Statements (Unaudited)

Note 2. Securities

The Company invests in U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, and corporate debt securities. Amortized costs and fair values of securities at June 30, 2019 and December 31, 2018 were as follows (in thousands):

	June 30, 2019
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Securities available for sale:
U.S. agency and mortgage-backed securities	$	92,052	$	935	$	(304	)	$	92,683
Obligations of states and political subdivisions		26,486		356		(15	)		26,827
Total securities available for sale	$	118,538	$	1,291	$	(319	)	$	119,510
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	13,721	$	10	$	(121	)	$	13,610
Obligations of states and political subdivisions		3,607		57		—			3,664
Corporate debt securities		1,500		22		—			1,522
Total securities held to maturity	$	18,828	$	89	$	(121	)	$	18,796
Total securities	$	137,366	$	1,380	$	(440	)	$	138,306

	December 31, 2018
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Securities available for sale:
U.S. agency and mortgage-backed securities	$	86,944	$	44	$	(2,066	)	$	84,922
Obligations of states and political subdivisions		15,203		31		(299	)		14,935
Total securities available for sale	$	102,147	$	75	$	(2,365	)	$	99,857
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	27,420	$	—	$	(869	)	$	26,551
Obligations of states and political subdivisions		14,488		20		(174	)		14,334
Corporate debt securities		1,500		9		—			1,509
Total securities held to maturity	$	43,408	$	29	$	(1,043	)	$	42,394
Total securities	$	145,555	$	104	$	(3,408	)	$	142,251

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Notes to Consolidated Financial Statements (Unaudited)

At June 30, 2019 and December 31, 2018, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):

	June 30, 2019
	Less than 12 months				12 months or more					Total
	Fair Value		Unrealized (Loss)		Fair Value		Unrealized (Loss)			Fair Value		Unrealized (Loss)
Securities available for sale:
U.S. agency and mortgage-backed securities	$	—	$	—	$	34,035	$	(304	)	$	34,035	$	(304	)
Obligations of states and political subdivisions		—		—		1,350		(15	)		1,350		(15	)
Total securities available for sale	$	—	$	—	$	35,385	$	(319	)	$	35,385	$	(319	)
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	—	$	—	$	9,761	$	(121	)	$	9,761	$	(121	)
Total securities held to maturity	$	—	$	—	$	9,761	$	(121	)	$	9,761	$	(121	)
Total securities	$	—	$	—	$	45,146	$	(440	)	$	45,146	$	(440	)

	December 31, 2018
	Less than 12 months					12 months or more					Total
	Fair Value		Unrealized (Loss)			Fair Value		Unrealized (Loss)			Fair Value		Unrealized (Loss)
Securities available for sale:
U.S. agency and mortgage-backed securities	$	26,350	$	(215	)	$	49,652	$	(1,851	)	$	76,002	$	(2,066	)
Obligations of states and political subdivisions		3,761		(25	)		5,127		(274	)		8,888		(299	)
Total securities available for sale	$	30,111	$	(240	)	$	54,779	$	(2,125	)	$	84,890	$	(2,365	)
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	—	$	—		$	26,551	$	(869	)	$	26,551	$	(869	)
Obligations of states and political subdivisions		5,326		(37	)		6,115		(137	)		11,441		(174	)
Total securities held to maturity	$	5,326	$	(37	)	$	32,666	$	(1,006	)	$	37,992	$	(1,043	)
Total securities	$	35,437	$	(277	)	$	87,445	$	(3,131	)	$	122,882	$	(3,408	)

The tables above provide information about securities that have been in an unrealized loss position for less than twelve consecutive months and securities that have been in an unrealized loss position for twelve consecutive months or more. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Impairment is considered to be other-than-temporary if the Company (1) intends to sell the security, (2) more likely than not will be required to sell the security before recovering its cost, or (3) does not expect to recover the security’s entire amortized cost basis. Presently, the Company does not intend to sell any of these securities, does not expect to be required to sell these securities, and expects to recover the entire amortized cost of all the securities.

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Notes to Consolidated Financial Statements (Unaudited)

At June 30, 2019, there were thirty-nine out of ninety U.S. agency and mortgage-backed securities and four out of eighty-three obligations of states and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio is considered investment grade. The weighted-average re-pricing term of the portfolio was 3.7 years at June 30, 2019. At December 31, 2018, there were eighty-three out of ninety U.S. agency and mortgage-backed securities and fifty-six out of eighty-two obligations of states and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio was considered investment grade at December 31, 2018. The weighted-average re-pricing term of the portfolio was 4.6 years at December 31, 2018. The unrealized losses at June 30, 2019 in the U.S. agency and mortgage-backed securities portfolio and the obligations of states and political subdivisions portfolio were related to changes in market interest rates and not credit concerns of the issuers.

The amortized cost and fair value of securities at June 30, 2019 by contractual maturity are shown below (in thousands). Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.

	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due within one year	$	2,544	$	2,554	$	186	$	186
Due after one year through five years		8,276		8,307		4,345		4,380
Due after five years through ten years		28,325		28,805		4,145		4,180
Due after ten years		79,393		79,844		10,152		10,050
	$	118,538	$	119,510	$	18,828	$	18,796

On January 1, 2019, the Company adopted ASU No. 2017-12 and reclassified eligible securities with a fair value of $23.0 million from the held to maturity portfolio to the available for sale portfolio. The unrealized loss associated with the reclassified securities totaled $431 thousand on the date of reclassification. The securities were reclassified to provide the Company with opportunities to maximize asset utilization.

Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock are generally viewed as long-term investments and as restricted securities, which are carried at cost, because there is a minimal market for the stock. Therefore, when evaluating restricted securities for impairment, their value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider these investments to be other-than-temporarily impaired at June 30, 2019, and no impairment has been recognized.

The composition of restricted securities at June 30, 2019 and December 31, 2018 was as follows (in thousands):

	June 30, 2019		December 31, 2018
Federal Home Loan Bank stock	$	776	$	763
Federal Reserve Bank stock		875		875
Community Bankers’ Bank stock		50		50
	$	1,701	$	1,688

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Notes to Consolidated Financial Statements (Unaudited)

Note 3. Loans

Loans at June 30, 2019 and December 31, 2018 are summarized as follows (in thousands):

	June 30, 2019			December 31, 2018
Real estate loans:
Construction and land development	$	46,281		$	45,867
Secured by 1-4 family residential		225,820			215,945
Other real estate loans		237,370			219,553
Commercial and industrial loans		49,353			44,605
Consumer and other loans		16,130			16,886
Total loans	$	574,954		$	542,856
Allowance for loan losses		(4,995	)		(5,009	)
Loans, net	$	569,959		$	537,847

Net deferred loan fees included in the above loan categories were $318 thousand and $274 thousand at June 30, 2019 and December 31, 2018, respectively. Consumer and other loans included $208 thousand and $275 thousand of demand deposit overdrafts at June 30, 2019 and December 31, 2018, respectively.

Risk characteristics of each loan portfolio class that are considered by the Company include:

•

1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral.

•

Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget, and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project.

•

Other real estate loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project.

•

Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability.

•

Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. These loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. They are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Consumer and other loans also include purchased consumer loans which could have been originated outside of the Company's market area.

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Notes to Consolidated Financial Statements (Unaudited)

The following tables provide a summary of loan classes and an aging of past due loans as of June 30, 2019 and December 31, 2018 (in thousands):

	June 30, 2019
	30-59 Days Past Due		60-89 Days Past Due		> 90 Days Past Due		Total Past Due		Current		Total Loans		Non-accrual Loans		90 Days or More Past Due and Accruing
Real estate loans:
Construction and land development	$	—	$	—	$	80	$	80	$	46,201	$	46,281	$	391	$	—
Secured by 1-4 family residential		580		140		308		1,028		224,792		225,820		866		—
Other real estate loans		192		—		468		660		236,710		237,370		518		—
Commercial and industrial		35		—		—		35		49,318		49,353		—		—
Consumer and other loans		76		15		19		110		16,020		16,130		—		19
Total	$	883	$	155	$	875	$	1,913	$	573,041	$	574,954	$	1,775	$	19

	December 31, 2018
	30-59 Days Past Due		60-89 Days Past Due		> 90 Days Past Due		Total Past Due		Current		Total Loans		Non-accrual Loans		90 Days or More Past Due and Accruing
Real estate loans:
Construction and land development	$	88	$	80	$	—	$	168	$	45,699	$	45,867	$	327	$	—
Secured by 1-4 family residential		747		393		423		1,563		214,382		215,945		663		—
Other real estate loans		145		36		2,207		2,388		217,165		219,553		1,985		222
Commercial and industrial		—		25		210		235		44,370		44,605		197		13
Consumer and other loans		90		—		—		90		16,796		16,886		—		—
Total	$	1,070	$	534	$	2,840	$	4,444	$	538,412	$	542,856	$	3,172	$	235

Credit Quality Indicators

As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to the risk grading of specified classes of loans. The Company utilizes a risk grading matrix to assign a rating to each of its loans. The loan ratings are summarized into the following categories: pass, special mention, substandard, doubtful and loss. Pass rated loans include all risk rated credits other than those included in special mention, substandard or doubtful. Loans classified as loss are charged-off. Loan officers assign risk grades to loans at origination and as renewals arise. The Bank’s Credit Administration department reviews risk grades for accuracy on a quarterly basis and as credit issues arise. In addition, a certain amount of loans are reviewed each year through the Company’s internal and external loan review process. A description of the general characteristics of the loan grading categories is as follows:

Pass – Loans classified as pass exhibit acceptable operating trends, balance sheet trends, and liquidity. Sufficient cash flow exists to service the loan. All obligations have been paid by the borrower as agreed.

Special Mention – Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the Bank’s credit position at some future date.

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Notes to Consolidated Financial Statements (Unaudited)

Substandard – Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful – Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The Company considers all doubtful loans to be impaired and places the loan on non-accrual status.

Loss – Loans classified as loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.

The following tables provide an analysis of the credit risk profile of each loan class as of June 30, 2019 and December 31, 2018 (in thousands):

	June 30, 2019
	Pass		Special Mention		Substandard		Doubtful		Total
Real estate loans:
Construction and land development	$	45,497	$	228	$	556	$	—	$	46,281
Secured by 1-4 family residential		224,160		533		1,127		—		225,820
Other real estate loans		233,602		858		2,910		—		237,370
Commercial and industrial		48,355		991		7		—		49,353
Consumer and other loans		16,130		—		—		—		16,130
Total	$	567,744	$	2,610	$	4,600	$	—	$	574,954

	December 31, 2018
	Pass		Special Mention		Substandard		Doubtful		Total
Real estate loans:
Construction and land development	$	45,054	$	235	$	578	$	—	$	45,867
Secured by 1-4 family residential		214,089		924		932		—		215,945
Other real estate loans		213,681		900		4,972		—		219,553
Commercial and industrial		44,373		19		213		—		44,605
Consumer and other loans		16,886		—		—		—		16,886
Total	$	534,083	$	2,078	$	6,695	$	—	$	542,856

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Notes to Consolidated Financial Statements (Unaudited)

Note 4. Allowance for Loan Losses

The following tables present, as of June 30, 2019, December 31, 2018 and June 30, 2018, the total allowance for loan losses, the allowance by impairment methodology, and loans by impairment methodology (in thousands):

	June 30, 2019
	Construction and Land Development			Secured by 1-4 Family Residential			Other Real Estate		Commercial and Industrial			Consumer and Other Loans			Total
Allowance for loan losses:
Beginning Balance, December 31, 2018	$	561		$	895		$	2,160	$	464		$	929		$	5,009
Charge-offs		—			(58	)		—		(2	)		(387	)		(447	)
Recoveries		50			5			—		4			174			233
Provision for (recovery of) loan losses		(71	)		(64	)		233		50			52			200
Ending Balance, June 30, 2019	$	540		$	778		$	2,393	$	516		$	768		$	4,995
Ending Balance:
Individually evaluated for impairment		46			20			35		—			—			101
Collectively evaluated for impairment		494			758			2,358		516			768			4,894
Loans:
Ending Balance	$	46,281		$	225,820		$	237,370	$	49,353		$	16,130		$	574,954
Individually evaluated for impairment		391			866			518		—			—			1,775
Collectively evaluated for impairment		45,890			224,954			236,852		49,353			16,130			573,179

	December 31, 2018
	Construction and Land Development		Secured by 1-4 Family Residential			Other Real Estate			Commercial and Industrial			Consumer and Other Loans			Total
Allowance for loan losses:
Beginning Balance, At December 31, 2017	$	414	$	775		$	2,948		$	418		$	771		$	5,326
Charge-offs		—		(55	)		—			(10	)		(1,104	)		(1,169	)
Recoveries		—		13			5			8			226			252
Provision for (recovery of) loan losses		147		162			(793	)		48			1,036			600
Ending Balance, December 31, 2018	$	561	$	895		$	2,160		$	464		$	929		$	5,009
Ending Balance:
Individually evaluated for impairment		71		172			—			—			—			243
Collectively evaluated for impairment		490		723			2,160			464			929			4,766
Loans:
Ending Balance	$	45,867	$	215,945		$	219,553		$	44,605		$	16,886		$	542,856
Individually evaluated for impairment		327		663			2,249			197			—			3,436
Collectively evaluated for impairment		45,540		215,282			217,304			44,408			16,886			539,420

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Notes to Consolidated Financial Statements (Unaudited)

	June 30, 2018
	Construction and Land Development			Secured by 1-4 Family Residential			Other Real Estate			Commercial and Industrial			Consumer and Other Loans			Total
Allowance for loan losses:
Beginning Balance, At December 31, 2017	$	414		$	775		$	2,948		$	418		$	771		$	5,326
Charge-offs		—			(24	)		—			(8	)		(468	)		(500	)
Recoveries		—			8			1			5			99			113
Provision for (recovery of) loan losses		(8	)		32			(285	)		10			351			100
Ending Balance, June 30, 2018	$	406		$	791		$	2,664		$	425		$	753		$	5,039
Ending Balance:
Individually evaluated for impairment		—			—			—			—			—			—
Collectively evaluated for impairment		406			791			2,664			425			753			5,039
Loans:
Ending Balance	$	37,350		$	211,101		$	224,362		$	40,943		$	17,177		$	530,933
Individually evaluated for impairment		865			1,330			2,029			257			—			4,481
Collectively evaluated for impairment		36,485			209,771			222,333			40,686			17,177			526,452

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Notes to Consolidated Financial Statements (Unaudited)

Impaired loans and the related allowance at June 30, 2019, December 31, 2018 and June 30, 2018, were as follows (in thousands):

	June 30, 2019
	Unpaid Principal Balance		Recorded Investment with No Allowance		Recorded Investment with Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
Real estate loans:
Construction and land development	$	410	$	—	$	391	$	391	$	46	$	360	$	1
Secured by 1-4 family		941		715		151		866		20		802		2
Other real estate loans		528		483		35		518		35		1,035		3
Commercial and industrial		—		—		—		—		—		45		—
Total	$	1,879	$	1,198	$	577	$	1,775	$	101	$	2,242	$	6

	December 31, 2018
	Unpaid Principal Balance		Recorded Investment with No Allowance		Recorded Investment with Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
Real estate loans:
Construction and land development	$	336	$	—	$	327	$	327	$	71	$	758	$	12
Secured by 1-4 family		720		356		307		663		172		966		22
Other real estate loans		2,290		2,249		—		2,249		—		1,585		51
Commercial and industrial		200		197		—		197		—		146		—
Total	$	3,546	$	2,802	$	634	$	3,436	$	243	$	3,455	$	85

	June 30, 2018
	Unpaid Principal Balance		Recorded Investment with No Allowance		Recorded Investment with Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment		Interest Income Recognized
Real estate loans:
Construction and land development	$	984	$	865	$	—	$	865	$	—	$	1,063	$	27
Secured by 1-4 family		1,415		1,330		—		1,330		—		1,300		28
Other real estate loans		2,029		2,029		—		2,029		—		1,140		30
Commercial and industrial		270		257		—		257		—		65		2
Total	$	4,698	$	4,481	$	—	$	4,481	$	—	$	3,568	$	87

The “Recorded Investment” amounts in the table above represent the outstanding principal balance on each loan represented in the table. The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged off on each loan and/or payments that have been applied towards principal on non-accrual loans. Only loan classes with balances are included in the tables above.

As of June 30, 2019, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $381 thousand. At June 30, 2019, none of the loans classified as TDRs were performing under the restructured terms and all were considered non-performing assets. There were $467 thousand in TDRs at December 31, 2018, $264 thousand of which were performing under the restructured terms. Modified terms under TDRs may include rate reductions, extension of terms that are considered to be below market, conversion to interest only, and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. There were no loans modified under TDRs during the three months ended June 30, 2019. There was one loan secured by 1-4 family residential real estate modified as a TDR during the six months ended June 30, 2019 because the loan was extended with terms considered to be below market. The TDR described above did not have an impact on the allowance for loan losses at June 30, 2019. There were no loans modified under TDRs during the three and six months ended June 30, 2018.

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Notes to Consolidated Financial Statements (Unaudited)

For the three and six months ended June 30, 2019 and 2018, there were no troubled debt restructurings that subsequently defaulted within twelve months of the loan modification. Management defines default as over ninety days past due or the foreclosure and repossession of the collateral or charge-off of the loan during the twelve month period subsequent to the modification.

Note 5. Other Real Estate Owned (OREO)

Changes in the balance for OREO are as follows (in thousands):

	Six Months Ended		Year Ended
	June 30, 2019		December 31, 2018
Balance at the beginning of year, gross	$	—	$	326
Transfers in		—		68
Sales proceeds		—		(416	)
Gain on disposition		—		22
Balance at the end of period, gross	$	—	$	—
Less: valuation allowance		—		—
Balance at the end of period, net	$	—	$	—

There were no residential real estate properties included in the ending OREO balances above at June 30, 2019 and December 31, 2018. The recorded investment of consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process was $149 thousand as of June 30, 2019.

The Bank did not have any expenses applicable to OREO for the six months ended June 30, 2019. Net expenses applicable to OREO, other than the provision for losses, were $2 thousand for the six months ended June 30, 2018 and the year ended December 31, 2018.

Note 6. Other Borrowings

The Company had an unsecured line of credit totaling $5.0 million with a non-affiliated bank at June 30, 2019. There were no borrowings outstanding on the line of credit at June 30, 2019. The interest rate on the line of credit floats at Wall Street Journal Prime Rate plus 0.25% and matures on March 28, 2025.

The Bank had unused lines of credit totaling $164.7 million and $128.5 million available with non-affiliated banks at June 30, 2019 and December 31, 2018, respectively. These amounts primarily consist of a blanket floating lien agreement with the Federal Home Loan Bank of Atlanta (FHLB) in which the Bank can borrow up to 19% of its total assets. The unused line of credit with FHLB totaled $99.1 million at June 30, 2019. The Bank had collateral pledged on the borrowing line at June 30, 2019 and December 31, 2018 including real estate loans totaling $140.6 million and $110.8 million, respectively, and Federal Home Loan Bank stock with a book value of $776 thousand and $763 thousand, respectively. The Bank did not have borrowings from the FHLB at June 30, 2019 and December 31, 2018.

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Notes to Consolidated Financial Statements (Unaudited)

Note 7. Capital Requirements

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective January 1, 2015, with full compliance of all the requirements phased in over a multi-year schedule, and became fully phased in January 1, 2019. As part of the new requirements, the common equity Tier 1 capital ratio is calculated and utilized in the assessment of capital for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer has been phased-in over four years, which began on January 1, 2016 and was fully implemented on January 1, 2019.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total (as defined in the regulations), Tier 1 (as defined), and common equity Tier 1 capital (as defined) to risk-weighted assets (as defined), and of Tier 1 capital to average assets. Management believes, as of June 30, 2019 and December 31, 2018, that the Bank met all capital adequacy requirements to which it is subject.

As of June 30, 2019, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum risk-based capital and leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the Bank’s category.

A comparison of the capital of the Bank at June 30, 2019 and December 31, 2018 with the minimum regulatory guidelines were as follows (dollars in thousands):

	Actual					Minimum Capital Requirement					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
June 30, 2019
Total Capital (to Risk-Weighted Assets)	$	82,078		14.24	%	$	46,127		8.00	%	$	57,658		10.00	%
Tier 1 Capital (to Risk-Weighted Assets)	$	77,083		13.37	%	$	34,595		6.00	%	$	46,127		8.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	77,083		13.37	%	$	25,946		4.50	%	$	37,478		6.50	%
Tier 1 Capital (to Average Assets)	$	77,083		9.96	%	$	30,970		4.00	%	$	38,712		5.00	%
December 31, 2018
Total Capital (to Risk-Weighted Assets)	$	74,697		13.62	%	$	43,859		8.00	%	$	54,824		10.00	%
Tier 1 Capital (to Risk-Weighted Assets)	$	69,688		12.71	%	$	32,894		6.00	%	$	43,859		8.00	%
Common Equity Tier 1 Capital (to Risk-Weighted Assets)	$	69,688		12.71	%	$	24,671		4.50	%	$	35,635		6.50	%
Tier 1 Capital (to Average Assets)	$	69,688		9.26	%	$	30,100		4.00	%	$	37,625		5.00	%

In addition to the regulatory minimum risk-based capital amounts presented above, the Bank must maintain a capital conservation buffer as required by the Basel III final rules. The buffer began applying to the Bank on January 1, 2016, and is subject to phase-in from 2016 to 2019 in equal annual installments of 0.625%. Accordingly, the Bank was required to maintain a capital conservation buffer of 2.50% and 1.875% at June 30, 2019 and December 31, 2018, respectively. Under the final rules, an institution is subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. As of June 30, 2019 and December 31, 2018, the capital conservation buffer of the Bank was 6.24% and 5.62%, respectively.

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Notes to Consolidated Financial Statements (Unaudited)

Note 8. Subordinated Debt

On October 30, 2015, the Company entered into a Subordinated Loan Agreement (the Agreement) pursuant to which the Company issued an interest only subordinated term note due 2025 in the aggregate principal amount of $5.0 million (the Note). The Note bears interest at a fixed rate of 6.75% per annum. The Note qualifies as Tier 2 capital for regulatory capital purposes and at June 30, 2019, the total amount of subordinated debt issued was included in the Company’s Tier 2 capital. Unamortized debt issuance costs related to the Note were $26 thousand and $35 thousand at June 30, 2019 and December 31, 2018, respectively.

The Note has a maturity date of October 1, 2025. Subject to regulatory approval, the Company may prepay the Note, in part or in full, beginning on October 30, 2020. The Note is an unsecured, subordinated obligation of the Company and ranks junior in right of payment to the Company’s senior indebtedness and to the Company’s obligations to its general creditors. The Note ranks equally with all other unsecured subordinated debt, except any which by its terms is expressly stated to be subordinated to the Note. The Note ranks senior to all current and future junior subordinated debt obligations, preferred stock, and common stock of the Company.

The Note is not convertible into common stock or preferred stock. The Agreement contains customary events of default such as the bankruptcy of the Company and the non-payment of principal or interest when due. The holder of the Note may accelerate the repayment of the Note only in the event of bankruptcy or similar proceedings and not for any other event of default.

Note 9. Junior Subordinated Debt

On June 8, 2004, First National (VA) Statutory Trust II (Trust II), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities. On June 17, 2004, $5.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at June 30, 2019 and December 31, 2018 was 5.01% and 5.39%, respectively. The securities have a mandatory redemption date of June 17, 2034, and were subject to varying call provisions that began September 17, 2009. The principal asset of Trust II is $5.2 million of the Company’s junior subordinated debt with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company. The Company is current on its interest payments on the junior subordinated debt.

On July 24, 2006, First National (VA) Statutory Trust III (Trust III), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities. On July 31, 2006, $4.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at June 30, 2019 and December 31, 2018 was 3.91% and 4.00%, respectively. The securities have a mandatory redemption date of October 1, 2036, and were subject to varying call provisions that began October 1, 2011. The principal asset of Trust III is $4.1 million of the Company’s junior subordinated debt with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company. The Company is current on its interest payments on the junior subordinated debt.

While these securities are debt obligations of the Company, they are included in capital for regulatory capital ratio calculations. Under present regulations, the junior subordinated debt may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total junior subordinated debt. The portion of the junior subordinated debt not considered as Tier 1 capital, if any, may be included in Tier 2 capital. At June 30, 2019 and December 31, 2018, the total amount of junior subordinated debt issued by the Trusts was included in the Company’s Tier 1 capital.

Note 10. Benefit Plans

The Company maintains a 401(k) plan for all eligible employees. Participating employees may elect to contribute up to the maximum percentage allowed by the Internal Revenue Service, as defined in the plan. The Company makes matching contributions, on a dollar-for dollar basis, for the first one percent of an employee’s compensation contributed to the Plan and fifty cents for each dollar of the employee’s contribution between two percent and six percent. The Company also makes an additional contribution based on years of service to participants who have completed at least one thousand hours of service during the year and who are employed on the last day of the Plan Year. All employees who are age nineteen or older are eligible. Employee contributions vest immediately. Employer matching contributions vest after two plan service years with the Company. The Company has the discretion to make a profit sharing contribution to the plan each year based on overall performance, profitability, and other economic factors. For the six months ended June 30, 2019 and 2018, expense attributable to the Plan amounted to $436 thousand and $415 thousand, respectively.

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Notes to Consolidated Financial Statements (Unaudited)

On March 15, 2019, the Company entered into supplemental executive retirement plans and participation agreements with three of its employees. The retirement benefits are fixed and provide for retirement benefits payable in 180 monthly installments. The contribution expense is solely funded by the Company and totaled $88 thousand for the six months ended June 30, 2019.

See Note 13 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 for additional information about the Company’s benefit plans.

Note 11. Earnings per Common Share

Basic earnings per common share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.

The following table presents the computation of basic and diluted earnings per share for the three and six months ended June 30, 2019 and 2018 (dollars in thousands, except per share data):

	Three Months Ended				Six Months Ended
	June 30, 2019		June 30, 2018		June 30, 2019		June 30, 2018
(Numerator):
Net income	$	2,086	$	2,451	$	4,347	$	5,138
(Denominator):
Weighted average shares outstanding – basic		4,963,737		4,952,712		4,962,010		4,950,922
Potentially dilutive common shares – restricted stock units		2,085		1,553		2,978		2,406
Weighted average shares outstanding – diluted		4,965,822		4,954,265		4,964,988		4,953,328
Income per common share
Basic	$	0.42	$	0.49	$	0.88	$	1.04
Diluted	$	0.42	$	0.49	$	0.88	$	1.04

Note 12. Fair Value Measurements

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurement and Disclosures” topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

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Notes to Consolidated Financial Statements (Unaudited)

Fair Value Hierarchy

In accordance with this guidance, the Company groups its assets and liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1 -

Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

Level 2 -

Valuation is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.

Level 3 -

Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires a significant management judgment or estimation.

An instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a recurring basis in the financial statements:

Securities available for sale

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).

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Notes to Consolidated Financial Statements (Unaudited)

The following tables present the balances of assets measured at fair value on a recurring basis as of June 30, 2019 and December 31, 2018 (in thousands).

			Fair Value Measurements at June 30, 2019
Description	Balance as of June 30, 2019		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Securities available for sale
U.S. agency and mortgage-backed securities	$	92,683	$	—	$	92,683	$	—
Obligations of states and political subdivisions		26,827		—		26,827		—
	$	119,510	$	—	$	119,510	$	—

			Fair Value Measurements at December 31, 2018
Description	Balance as of December 31, 2018		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Securities available for sale
U.S. agency and mortgage-backed securities	$	84,922	$	—	$	84,922	$	—
Obligations of states and political subdivisions		14,935		—		14,935		—
	$	99,857	$	—	$	99,857	$	—

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Loans held for sale

Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the six months ended June 30, 2019 and the year ended December 31, 2018.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price of the loan, or the fair value of the collateral less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2) within the last twelve months. However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

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Notes to Consolidated Financial Statements (Unaudited)

Other real estate owned

Loans are transferred to other real estate owned when the collateral securing them is foreclosed on or acquired through a deed in lieu of foreclosure. The measurement of loss associated with other real estate owned is based on the appraisal documents and assessed the same way as impaired loans described above. Any fair value adjustments are recorded in the period incurred as other real estate owned income on the Consolidated Statements of Income.

The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis during the periods (dollars in thousands):

Fair Value Measurements at June 30, 2019

Description

Balance as of

June 30, 2019

Quoted

Prices in

Active

Markets for Identical

Assets

(Level 1)

Significant

Other

Observable

Inputs

(Level 2)

Significant Unobservable

Inputs

(Level 3)

Impaired loans, net

476

—

476

Fair Value Measurements at December 31, 2018

Description

Balance as of

December 31, 2018

Quoted

Prices in

Active

Markets for

Identical

Assets

(Level 1)

Significant

Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Impaired loans, net

391

—

391

Quantitative information about Level 3 Fair Value Measurements for June 30, 2019

Fair Value

Valuation Technique

Unobservable Input

Range
(Weighted Average)

Impaired loans, net

476

Property appraisals

Selling cost

Quantitative information about Level 3 Fair Value Measurements for December 31, 2018

Fair Value

Valuation Technique

Unobservable Input

Range
(Weighted Average)

Impaired loans, net

391

Property appraisals

Selling cost

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Notes to Consolidated Financial Statements (Unaudited)

Accounting guidance requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The carrying values and estimated fair values of the Company’s financial instruments at June 30, 2019 and December 31, 2018 are as follows (in thousands):

			Fair Value Measurements at June 30, 2019 Using
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Fair Value
Financial Assets
Cash and short-term investments	$	23,070	$	23,070	$	—	$	—	$	23,070
Securities available for sale		119,510		—		119,510		—		119,510
Securities held to maturity		18,828		—		17,274		1,522		18,796
Restricted securities		1,701		—		1,701		—		1,701
Loans held for sale		675		—		675		—		675
Loans, net		569,959		—		—		572,508		572,508
Bank owned life insurance		17,193		—		17,193		—		17,193
Accrued interest receivable		2,163		—		2,163		—		2,163
Financial Liabilities
Deposits	$	689,815	$	—	$	571,952	$	117,064	$	689,016
Subordinated debt		4,974		—		—		5,238		5,238
Junior subordinated debt		9,279		—		—		9,460		9,460
Accrued interest payable		173		—		173		—		173

			Fair Value Measurements at December 31, 2018 Using
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets Level 1		Significant Other Observable Inputs Level 2		Significant Unobservable Inputs Level 3		Fair Value
Financial Assets
Cash and short-term investments	$	28,618	$	28,618	$	—	$	—	$	28,618
Securities available for sale		99,857		—		99,857		—		99,857
Securities held to maturity		43,408		—		40,885		1,509		42,394
Restricted securities		1,688		—		1,688		—		1,688
Loans held for sale		419		—		419		—		419
Loans, net		537,847		—		—		528,643		528,643
Bank owned life insurance		13,991		—		13,991		—		13,991
Accrued interest receivable		2,113		—		2,113		—		2,113
Financial Liabilities
Deposits	$	670,566	$	—	$	551,347	$	117,220	$	668,567
Subordinated debt		4,965		—		—		5,035		5,035
Junior subordinated debt		9,279		—		—		7,952		7,952
Accrued interest payable		139		—		139		—		139

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Notes to Consolidated Financial Statements (Unaudited)

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 13. Stock Compensation Plans

On May 13, 2014, the Company’s shareholders approved the First National Corporation 2014 Stock Incentive Plan, which makes available up to 240,000 shares of common stock for the granting of stock options, restricted stock awards, stock appreciation rights, and other stock-based awards. Awards are made at the discretion of the Board of Directors and compensation cost equal to the fair value of the award is recognized over the vesting period.

Stock Awards

Whenever the Company deems it appropriate to grant a stock award, the recipient receives a specified number of unrestricted shares of employer stock. Stock awards may be made by the Company at its discretion without cash consideration and may be granted as settlement of a performance-based compensation award. The Company did not have compensation expense related to stock awards for the six months ended June 30, 2019 and 2018.

Restricted Stock Units

Restricted stock units are an award of units that correspond in number and value to a specified number of shares of employer stock which the recipient receives according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. Each restricted stock unit that vests entitles the recipient to receive one share of common stock on a specified issuance date.

In the first quarter of 2019, 8,692 restricted stock units were granted to employees, with 1,235 units vesting immediately, 2,457 units subject to a two year vesting schedule with one half of the units vesting each year on the grant date anniversary, and 5,000 units subject to a five year vesting schedule will all of the units vesting on the fifth anniversary of the grant date. The recipient does not have any stockholder rights, including voting, dividend, or liquidation rights, with respect to the shares underlying awarded restricted stock units until vesting has occurred and the recipient becomes the record holder of those shares. The unvested restricted stock units will vest on the established schedule if the employees remain employed by the Company on future vesting dates.

A summary of the activity for the Company’s restricted stock units for the period indicated is presented in the following table:

	Six Months Ended
	June 30, 2019
	Shares			Weighted Average Grant Date Fair Value
Unvested, beginning of year		7,103		$	17.93
Granted		8,692			19.56
Vested		(5,402	)		17.99
Forfeited		—			—
Unvested, end of period		10,393		$	19.26

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Notes to Consolidated Financial Statements (Unaudited)

At June 30, 2019, based on restricted stock unit awards outstanding at that time, the total unrecognized pre-tax compensation expense related to unvested restricted stock unit awards was $163 thousand. This expense is expected to be recognized through 2024. Compensation expense related to restricted stock unit awards recognized for the six months ended June 30, 2019 and 2018 totaled $68 thousand and $89 thousand, respectively.

Note 14. Accumulated Other Comprehensive Income (Loss)

Changes in each component of accumulated other comprehensive income (loss) were as follows (in thousands):

	Net Unrealized Gains (Losses) on Securities			Adjustments Related to Pension Benefits			Accumulated Other Comprehensive Income (Loss)
Balance at December 31, 2017	$	(1,057	)	$	99		$	(958	)
Unrealized holding losses (net of tax, ($304))		(1,146	)		—			(1,146	)
Pension liability adjustment (net of tax, ($27))		—			(99	)		(99	)
Change during period		(1,146	)		(99	)		(1,245	)
Balance at June 30, 2018	$	(2,203	)	$	—		$	(2,203	)
Balance at December 31, 2018	$	(1,808	)	$	—		$	(1,808	)
Unrealized holding gains (net of tax, $776)		2,917			—			2,917
Unrealized holding losses transferred from held to maturity to available for sale (net of tax, ($91))		(340	)		—			(340	)
Change during period		2,577			—			2,577
Balance at June 30, 2019	$	769		$	—		$	769

The Company did not have any reclassifications from accumulated other comprehensive income (loss) for the three and six months ended June 30, 2019 and 2018.

Note 15. Revenue Recognition

On January 1, 2018, the Company adopted ASU No. 2014-09, "Revenue from Contracts with Customers: Topic 606" and all subsequent ASUs that modified Topic 606. Most revenue associated with financial instruments, including interest income, loan origination fees, and credit card fees, is outside the scope of the guidance. Gains and losses on investment securities, derivatives, financial guarantees, and sales of financial instruments are similarly excluded from the scope. The guidance is applicable to noninterest revenue streams such as service charges on deposit accounts, ATM and check card fees, wealth management fees, and fees for other customer services. Noninterest revenue streams within the scope of Topic 606 are discussed below.

Service charges on deposit accounts

Service charges on deposit accounts consist of monthly service fees, overdraft and nonsufficient funds fees, and other deposit account related fees. The Company's performance obligation for monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers' accounts. Overdraft and nonsufficient funds fees and other deposit account related fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time.

ATM and check card fees

ATM fees are primarily generated when a Company cardholder uses a non-Company ATM or a non-Company cardholder uses a Company ATM. ATM fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Check card fees are primarily comprised of interchange fee income. Interchange fees are earned whenever the Company's debit cards are processed through card payment networks, such as Visa. The Company's performance obligation for interchange fee income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. In compliance with Topic 606, debit card fee income is presented net of associated expense.

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Notes to Consolidated Financial Statements (Unaudited)

Wealth management fees

Wealth management fees are primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company's performance obligation is generally satisfied over time and the resulting fees are primarily recognized monthly, based upon the month-end market value of the assets under management and the applicable fee rate. Payment is generally received a few days after month-end through a direct charge to customers' accounts. Estate management fees are based upon the size of the estate. Revenue for estate management fees are recorded periodically, according to a fee schedule, and are based on the services that have been provided.

Fees for other customer services

Fees for other customer services include check ordering charges, merchant services income, safe deposit box rental fees, and other service charges. Check ordering charges are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Merchant services income mainly represent fees charged to merchants to process their debit and credit card transactions. The Company's performance obligation for merchant services income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. Safe deposit box rental fees are charged to the customer on an annual basis and recognized upon receipt of payment. The Company determined that since rentals and renewals occur fairly consistently over time, revenue is recognized on a basis consistent with the duration of the performance obligation.

The following table presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the three and six months ended June 30, 2019 and 2018 (in thousands):

	Three Months Ended				Six Months Ended
	June 30, 2019		June 30, 2018		June 30, 2019		June 30, 2018
Noninterest Income
Service charges on deposit accounts	$	715	$	784	$	1,416	$	1,546
ATM and check card fees		573		555		1,090		1,074
Wealth management fees		458		409		895		816
Fees for other customer services		153		151		328		304
Noninterest income (in-scope of Topic 606)	$	1,899	$	1,899	$	3,729	$	3,740
Noninterest income (out-of-scope of Topic 606)		136		168		291		960
Total noninterest income	$	2,035	$	2,067	$	4,020	$	4,700

Note 16. Leases

On January 1, 2019, the Company adopted ASU No. 2016-02, "Leases (Topic 842)" and all subsequent ASUs that modified Topic 842. The Company elected the prospective application approach provided by ASU No. 2018-11 and did not adjust prior periods for ASC 842. There was no cumulative effect adjustment at adoption. The Company also elected certain practical expedients within the standard and did not reassess whether any expired or existing contracts are or contain leases, did not reassess the lease classification for any expired or existing leases, and did not reassess any initial direct costs for existing leases. Prior to adoption, all of the Company's leases were classified as operating leases and remained operating leases at adoption. The implementation of the new standard resulted in recognition of a right-of-use asset and lease liability of $390 thousand for leases existing at the date of adoption.

Contracts that commence subsequent to adoption are evaluated to determine whether they are or contain a lease in accordance with Topic 842. The Company has elected the practical expedient provided by Topic 842 not to allocate consideration in a contract between lease and non-lease components. The Company also elected, as provided by the standard, not to recognize right-of-use assets and lease liabilities for short-term leases, defined by the standard as leases with terms of 12 months or less. The Company has not entered into any new operating leases since adoption.

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Notes to Consolidated Financial Statements (Unaudited)

Lease liabilities represent the Company's obligation to make lease payments and are presented at each reporting date as the net present value of the remaining contractual cash flows. Cash flows are discounted at the Company's incremental borrowing rate in effect at the commencement date of the lease. Right-of-use assets represent the Company's right to use the underlying asset for the lease term and are calculated as the sum of the lease liability and, if applicable, prepaid rent, initial direct costs, and any incentives received from the lessor.

Lease payments

Lease payments for short-term leases are recognized as lease expense on a straight-line basis over the lease term, or for variable lease payments, in the period in which the obligation was incurred. Payments for leases with terms longer than twelve months are included in the determination of the lease liability. Payments may be fixed for the term of the lease or variable. If the lease agreement provides a known escalator, such as a specified percentage increase per year or a stated increase at a specified time, the variable payment is included in the cash flows used to determine the lease liability. If the variable payment is based upon an unknown escalator, such as the consumer price index at a future date, the increase is not included in the cash flows used to determine the lease liability. Three of the Company's leases provide known escalators that are included in the determination of the lease liability. The remaining leases do not have variable payments during the term of the lease.

Options to extend, residual value guarantees, and restrictions and covenants

Of the Company's six leases, five leases offer the option to extend the lease. The calculation of the lease liability includes the additional time and lease payments for options which the Company is reasonably certain it will exercise. None of the Company's leases provide for residual value guarantees and none provide restrictions or covenants that would impact dividends or require incurring additional financial obligations.

The following table presents the operating lease right-of-use asset and operating lease liability as of June 30, 2019 (in thousands):

	Classification in the Consolidated Balance Sheet	June 30, 2019
Operating lease right-of-use asset	Other assets	$	329
Operating lease liability	Accrued interest payable and other liabilities		328

The following table presents the weighted average remaining operating lease term and the weighted average discount rate for operating leases as of June 30, 2019 (dollars in thousands):

	June 30, 2019
Weighted average remaining lease term, in years		3.1
Weighted average discount rate		2.79	%

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Notes to Consolidated Financial Statements (Unaudited)

The following table presents the components of operating lease expense and supplemental cash flow information for the three and six months ended June 30, 2019 (in thousands):

	Three Months Ended				Six Months Ended
	June 30, 2019		June 30, 2018		June 30, 2019		June 30, 2018
Lease Expense
Operating lease expense	$	33	$	N/A	$	66	$	N/A
Short-term lease expense		1		N/A		3		N/A
Total lease expense (1)	$	34	$	39	$	69	$	78

Cash paid for amounts included in lease liability	$	34	$	N/A	$	68	$	N/A

(1)	Included in occupancy expense in the Company's consolidated statements of income.

The following table presents a maturity schedule of undiscounted cash flows that contribute to the operating lease liability as of June 30, 2019 (in thousands):

	June 30, 2019
Six months ending December 31, 2019	$	68
Twelve months ending December 31, 2020		112
Twelve months ending December 31, 2021		89
Twelve months ending December 31, 2022		65
Twelve months ending December 31, 2023		8
Total undiscounted cash flows	$	342
Less: discount		(14	)
Operating lease liability	$	328

The contracts in which the Company is lessee are with parties external to the Company and not related parties.

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

Cautionary Statement Regarding Forward-Looking Statements

The Company makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

•

conditions in the financial markets and economic conditions may adversely affect the Company’s business;

•

the inability of the Company to successfully manage its growth or implement its growth strategy;

•

the Company’s inability to successfully obtain the expected benefits of new or acquired bank branches or entities;

•

intense competition from other businesses both in making loans and attracting deposits;

•

the composition of the loan and deposit portfolio, including the types of accounts and customers, may change, which could impact the amount of net interest income and noninterest income in future periods, including revenue from service charges on deposits;

•

consumers may increasingly decide not to use the Company to complete their financial transactions;

•

limited availability of financing or inability to raise capital;

•

exposure to operational, technological, and organizational risk;

•

reliance on other companies to provide key components of the Company's business infrastructure;

•

the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses;

•

operational functions of business counterparties over which the Company may have limited or no control may experience disruptions;

•

nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition;

•

the level of net charge-offs on loans and the adequacy of the allowance for loan losses;

•

the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets;

•

the value of securities held in the Company's investment portfolio;

•

legislative or regulatory changes or actions;

•

significant litigation;

•

accounting principles, policies and guidelines and elections made by the Company thereunder;

•

unexpected loss of management personnel;

•

losses that could arise from breaches in cyber-security and theft of customer account information;

•

increases in FDIC insurance premiums could adversely affect the Company’s profitability;

•

the ability to retain customers and secondary funding sources if the Company’s reputation would become damaged;

•

the effects of changes in tax laws, including the Tax Cuts and Jobs Act, on the Company's business, some of which is uncertain and subject to interpretation, guidance, and regulations that may be promulgated;

•

changes in interest rates could have a negative impact on the Company’s net interest income and an unfavorable impact on the Company’s customers’ ability to repay loans; and

•

other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2018.

Because of these and other uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at June 30, 2019 and statements of income of the Company for the three and six months ended June 30, 2019 and 2018 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2018. The statements of income for the three and six months ended June 30, 2019 may not be indicative of the results to be achieved for the year.

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Executive Overview

The Company

First National Corporation (the Company) is the bank holding company of:

•

First Bank (the Bank). The Bank owns:

•

First Bank Financial Services, Inc.

•

Shen-Valley Land Holdings, LLC

•

First National (VA) Statutory Trust II (Trust II)

•

First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts)

First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities.

Products, Services, Customers and Locations

The Bank offers loan, deposit, and wealth management products and services. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. Customers include small and medium-sized businesses, individuals, estates, local governmental entities, and non-profit organizations. The Bank’s office locations are well-positioned in attractive markets along the Interstate 81, Interstate 66, and Interstate 64 corridors in the Shenandoah Valley and central regions of Virginia. Within this market area, there are various types of industry including medical and professional services, manufacturing, retail, warehousing, Federal government, hospitality, and higher education.

The Bank’s products and services are delivered through 14 bank branch offices located throughout the Shenandoah Valley and central regions of Virginia, a loan production office, and a customer service center in a retirement village. The branch offices are comprised of 13 full service retail banking offices and one drive-thru express banking office. The location and general character of these properties is further described in Part I, Item 2 of Form 10-K for the year ended December 31, 2018. Many of the Bank’s services are also delivered through the Bank’s mobile banking platform, its website, www.fbvirginia.com, and a network of ATMs located throughout its market area.

Revenue Sources and Expense Factors

The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services, and ATM and check card fees.

Primary expense categories are salaries and employee benefits, which comprised 55% of noninterest expenses for the six months ended June 30, 2019, followed by occupancy and equipment expense, which comprised 14% of noninterest expenses. Historically, the provision for loan losses has also been a primary expense of the Bank. The provision is determined by factors that include net charge-offs, asset quality, economic conditions, and loan growth. Changing economic conditions caused by inflation, recession, unemployment, or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs, and ultimately the required provision for loan losses.

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Quarterly Financial Performance

Net income decreased by $365 thousand to $2.1 million, or $0.42 per basic and diluted share, for the three months ended June 30, 2019, compared to $2.5 million, or $0.49 per basic and diluted share, for the same period in 2018. Return on average assets was 1.08% and return on average equity was 11.76% for the second quarter of 2019, compared to 1.29% and 16.23%, respectively, for the same period in 2018.

The $365 thousand decrease in net income for the three months ended June 30, 2019 resulted primarily from a $200 thousand increase in provision for loan losses, a $32 thousand, or 2%, decrease in noninterest income, and a $366 thousand, or 6%, increase in noninterest expenses, compared to the same period of 2018. These unfavorable variances were partially offset by a $134 thousand, or 2%, increase in net interest income and a $99 thousand decrease in income tax expense.

Net interest income increased from a higher net interest margin and from higher average earning asset balances. Average earning asset balances increased 1%, and the net interest margin increased 2 basis points to 3.88% for the second quarter of 2019, compared to 3.86% for the same period in 2018. Noninterest income decreased primarily from lower service charges on deposit accounts and other operating income. Noninterest expense increased primarily from higher salaries and employee benefits expense, marketing expense, legal and professional fees, and other operating expense. For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income," "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.

Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses of $200 thousand was recorded during the second quarter of 2019. A provision for loan losses was not required during the second quarter of 2018. For a more detailed discussion of the provision for loan losses, see “Provision for Loan Losses” below.

Year-to-Date Financial Performance

Net income decreased by $791 thousand to $4.3 million, or $0.88 per basic and diluted share, for the six months ended June 30, 2019, compared to $5.1 million, or $1.04 per basic and diluted share, for the same period in 2018. Return on average assets was 1.14% and return on average equity was 12.60% for the six months ended June 30, 2019, compared to 1.37% and 17.33%, respectively, for the same period in 2018.

The $791 thousand decrease in net income for the six months ended June 30, 2019 resulted primarily from a $100 thousand increase in provision for loan losses, a $680 thousand, or 14%, decrease in noninterest income, and a $598 thousand, or 5%, increase in noninterest expenses, compared to the same period of 2018. These unfavorable variances were partially offset by a $486 thousand, or 4%, increase in net interest income and a $101 thousand decrease in income tax expense.

Net interest income increased from a higher net interest margin and from higher average earning asset balances. Average earning asset balances increased 1%, and the net interest margin increased 10 basis points to 3.93% for the six months ended June 30, 2019, compared to 3.83% for the same period in 2018. Noninterest income decreased primarily from lower service charges on deposit accounts, income from bank owned life insurance, and other operating income. Noninterest expense increased primarily from higher salaries and employee benefits expense, occupancy expense, marketing expense, legal and professional fees, and other operating expense. For a more detailed discussion of the Company's year-to-date performance, see "Net Interest Income," "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.

Based on management's analysis and the supporting allowance for loan loss calculation, a provision for loan losses of $200 thousand was recorded during the six months ended June 30, 2019, compared to a provision for loan losses of $100 thousand during the six months ended June 30, 2018. For a more detailed discussion of the provision for loan losses, see “Provision for Loan Losses” below.

Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding OREO (expense)/income and amortization of intangibles, by the sum of net interest income on a tax-equivalent basis and noninterest income. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).

	Efficiency Ratio
	Three Months Ended						Six Months Ended
	June 30, 2019			June 30, 2018			June 30, 2019			June 30, 2018
Noninterest expense	$	6,230		$	5,864		$	12,328		$	11,730
Add/(Subtract): other real estate owned (expense)/income, net		—			(1	)		—			22
Subtract: amortization of intangibles		(80	)		(120	)		(170	)		(251	)
	$	6,150		$	5,743		$	12,158		$	11,501
Tax-equivalent net interest income	$	7,017		$	6,883		$	13,968		$	13,479
Noninterest income		2,035			2,067			4,020			4,700
	$	9,052		$	8,950		$	17,988		$	18,179
Efficiency ratio		67.94	%		64.17	%		67.59	%		63.27	%

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This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for both 2019 and 2018 is 21%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).

	Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
	Three Months Ended						Six Months Ended
	June 30, 2019			June 30, 2018			June 30, 2019			June 30, 2018
GAAP measures:
Interest income – loans	$	7,200		$	6,546		$	14,196		$	12,851
Interest income – investments and other		1,014			1,140			2,041			2,147
Interest expense – deposits		(1,051	)		(665	)		(1,973	)		(1,255	)
Interest expense – subordinated debt		(90	)		(89	)		(179	)		(178	)
Interest expense – junior subordinated debt		(108	)		(101	)		(219	)		(187	)
Interest expense – other borrowings		—			—			(2	)		—
Total net interest income	$	6,965		$	6,831		$	13,864		$	13,378
Non-GAAP measures:
Tax benefit realized on non-taxable interest income – loans	$	10		$	11		$	21		$	21
Tax benefit realized on non-taxable interest income – municipal securities		42			41			83			80
Total tax benefit realized on non-taxable interest income	$	52		$	52		$	104		$	101
Total tax-equivalent net interest income	$	7,017		$	6,883		$	13,968		$	13,479

Critical Accounting Policies

General

The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or relieving a liability. The Bank uses historical losses as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.

Presented below is a discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective, and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4 to the Consolidated Financial Statements included in this Form 10-Q.

The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the 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.

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The Company performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is the Company's primary credit quality indicator. The Company has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.

The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality, and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:

•

1-4 family residential mortgage loans carry risks associated with the continued creditworthiness of the borrower and changes in the value of the collateral.

•

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, fair value of collateral less estimated costs to sell, or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are typically performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.

The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system, and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses, see Note 4 to the Consolidated Financial Statements included in this Form 10-Q.

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Lending Policies

General

In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve new loans up to their authority. The Board Loan Committee approves all loans which exceed the authority of the Management Loan Committee. The full Board of Directors must approve loans which exceed the authority of the Board Loan Committee, up to the Bank’s legal lending limit. The Board Loan Committee currently consists of five directors, four of which are non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews risk management reports, including watch list reports and concentrations of credit. The Board Loan Committee meets on a monthly basis and the Chairman of the Committee then reports to the Board of Directors.

Residential loan originations are primarily generated by mortgage loan officer solicitations and referrals by employees, real estate professionals, and customers. Commercial real estate loan originations and commercial and industrial loan originations are primarily obtained through direct solicitation and additional business from existing customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment, and credit history of the applicant. The Bank also participates in commercial real estate loans and commercial and industrial loans originated by other financial institutions that are typically outside its market area. In addition, the Bank purchases consumer loans originated by other financial institutions that are typically outside its market area. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines depending on the type of loan involved. Except for loan participations with other financial institutions, real estate collateral is valued by independent appraisers who have been pre-approved by the Board Loan Committee.

As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year in order to ensure standards of quality are met. The Company also obtains an independent review of loans within the portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.

In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At June 30, 2019, commitments to extend credit, stand-by letters of credit, and rate lock commitments totaled $111.4 million.

Construction and Land Development Lending

The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. The majority of these loans mature in one year. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction and land development loans sometimes involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction and land development lending is the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated based on the completion of construction. Thus, there is risk associated with failure to complete construction and potential cost overruns. To mitigate the risks associated with this type of lending, the Bank generally limits loan amounts relative to the appraised value and/or cost of the collateral, analyzes the cost of the project and the creditworthiness of its borrowers, and monitors construction progress. The Bank typically obtains a first lien on the property as security for its construction loans, typically requires personal guarantees from the borrower’s principal owners, and typically monitors the progress of the construction project during the draw period.

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1-4 Family Residential Real Estate Lending

1-4 family residential lending activity may be generated by Bank loan officer solicitations and referrals by real estate professionals and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment, and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make payments from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. The valuation of residential collateral is generally provided by independent fee appraisers who have been approved by the Board Loan Committee. In addition to originating mortgage loans with the intent to sell to correspondent lenders or broker to wholesale lenders, the Bank also originates and retains certain mortgage loans in its loan portfolio.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, hotels, industrial buildings, and religious facilities. Commercial real estate loan originations are primarily obtained through direct solicitation of customers and potential customers. The valuation of commercial real estate collateral is provided by independent appraisers who have been approved by the Board Loan Committee. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history, and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and considers the valuation of the real estate collateral.

Commercial and Industrial Lending

Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial and industrial loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business. The loans may be unsecured or secured by business assets, such as accounts receivable, equipment, and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, any collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much reliability as real estate.

Consumer Lending

Loans to individual borrowers may be secured or unsecured, and include unsecured consumer loans and lines of credit, automobile loans, deposit account loans, and installment and demand loans. These consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss, or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness, or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income.

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Also included in this category are loans purchased through a third-party lending program. These portfolios include consumer loans and carry risks associated with the borrower, changes in the economic environment, and the vendor itself. The Company manages these risks through policies that require minimum credit scores and other underwriting requirements, robust analysis of actual performance versus expected performance, as well as ensuring compliance with the Company's vendor management program.

Results of Operations

General

Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings, subordinated debt, and junior subordinated debt. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, and noninterest expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts, revenue from wealth management services, ATM and check card income, revenue from other customer services, income from bank owned life insurance, general and administrative expenses, amortization expense, and other real estate owned (expense) income.

Net Interest Income

For the three months ended June 30, 2019, net interest income increased $134 thousand, or 2%, to $7.0 million, compared to $6.8 million for the second quarter of 2018. The increase resulted from a higher net interest margin and higher average earning asset balances. Average earning asset balances increased 1%, and the net interest margin increased 2 basis points to 3.88% for the quarter ended June 30, 2019, compared to 3.86% for the same period in 2018. The increase in the net interest margin resulted from a 23 basis point increase in the yield on total earning assets, which was partially offset by a 21 basis point increase in interest expense as a percent of average earning assets.

The higher yield on earning assets was attributable to an increase in yields on loans and interest-bearing deposits in banks, which benefited from increases in market rates. The 11 basis point increase in the yield on loans had the largest impact on the increase in the yield on earning assets, when comparing the periods.

The increase in interest expense as a percent of average earning assets was primarily attributable to higher interest rates paid on deposits, which was impacted by higher short-term market rates and competition. The cost of interest-bearing checking accounts and money market accounts had the largest impact as their costs increased by 28 basis points and 53 basis points, respectively, when comparing the periods.

For the six months ended June 30, 2019, net interest income increased $486 thousand, or 4%, to $13.9 million, compared to $13.4 million for the same period in 2018. The increase resulted from a higher net interest margin and higher average earning asset balances. Average earning asset balances increased 1%, and the net interest margin increased 10 basis points to 3.93% for the six months ended June 30, 2019, compared to 3.83% for the same period in 2018. The increase in the net interest margin resulted from a 30 basis point increase in the yield on total earning assets, which was partially offset by a 21 basis point increase in interest expense as a percent of average earning assets.

The higher yield on earning assets was attributable to an increase in yields on loans, securities, and interest-bearing deposits in banks, which all benefited from increases in market rates. The 20 basis point increase in the yield on loans had the largest impact on the increase in the yield on earning assets, when comparing the periods.

The increase in interest expense as a percent of average earning assets was primarily attributable to higher interest rates paid on deposits, which was impacted by higher short-term market rates and competition. The cost of interest-bearing checking accounts and money market accounts had the largest impact as their costs increased by 32 basis points and 51 basis points, respectively, when comparing the periods.

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The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):

Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis)

	Three Months Ended
	June 30, 2019								June 30, 2018
	Average Balance			Interest Income/ Expense		Yield/ Rate			Average Balance			Interest Income/ Expense		Yield/ Rate
Assets
Securities:
Taxable	$	111,582		$	696		2.50	%	$	121,004		$	776		2.57	%
Tax-exempt ⁽¹⁾		27,208			201		2.96	%		26,237			197		3.00	%
Restricted		1,701			26		6.00	%		1,590			22		5.63	%
Total securities	$	140,491		$	923		2.63	%	$	148,831		$	995		2.68	%
Loans: ⁽²⁾
Taxable	$	556,699		$	7,162		5.16	%	$	517,508		$	6,504		5.04	%
Tax-exempt ⁽¹⁾		4,302			48		4.48	%		4,785			53		4.49	%
Total loans	$	561,001		$	7,210		5.15	%	$	522,293		$	6,557		5.04	%
Federal funds sold		1			—		2.26	%		—			—		—	%
Interest-bearing deposits with other institutions		23,416			133		2.28	%		44,039			186		1.69	%
Total earning assets	$	724,909		$	8,266		4.57	%	$	715,163		$	7,738		4.34	%
Less: allowance for loan losses		(4,894	)							(5,225	)
Total non-earning assets		53,559								52,688
Total assets	$	773,574							$	762,626
Liabilities and Shareholders’ Equity
Interest bearing deposits:
Checking	$	165,704		$	378		0.92	%	$	161,741		$	260		0.64	%
Regular savings		107,603			17		0.06	%		124,851			24		0.08	%
Money market accounts		109,739			350		1.28	%		87,837			165		0.75	%
Time deposits:
$100,000 and over		49,853			183		1.47	%		49,060			120		0.98	%
Under $100,000		66,778			122		0.73	%		73,912			96		0.52	%
Brokered		609			1		0.49	%		550			—		0.11	%
Total interest-bearing deposits	$	500,286		$	1,051		0.84	%	$	497,951		$	665		0.54	%
Federal funds purchased		2			—		2.88	%		3			—		2.20	%
Subordinated debt		4,972			90		7.23	%		4,954			89		7.26	%
Junior subordinated debt		9,279			108		4.66	%		9,279			101		4.33	%
Total interest-bearing liabilities	$	514,539		$	1,249		0.97	%	$	512,187		$	855		0.67	%
Non-interest bearing liabilities
Demand deposits		186,336								188,666
Other liabilities		1,575								1,181
Total liabilities	$	702,450							$	702,034
Shareholders’ equity		71,124								60,592
Total liabilities and Shareholders’ equity	$	773,574							$	762,626
Net interest income				$	7,017							$	6,883
Interest rate spread							3.60	%							3.67	%
Cost of funds							0.71	%							0.49	%
Interest expense as a percent of average earning assets							0.69	%							0.48	%
Net interest margin							3.88	%							3.86	%

(1)	Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $52 thousand for the three months ended June 30, 2019 and 2018.

(2)	Loans placed on a non-accrual status are reflected in the balances.

	Six Months Ended
	June 30, 2019								June 30, 2018
	Average Balance			Interest Income/ Expense		Yield/ Rate			Average Balance			Interest Income/ Expense		Yield/ Rate
Assets
Securities:
Taxable	$	113,331		$	1,433		2.55	%	$	116,816		$	1,456		2.51	%
Tax-exempt ⁽¹⁾		26,889			398		2.99	%		25,812			381		2.97	%
Restricted		1,695			50		5.92	%		1,581			44		5.59	%
Total securities	$	141,915		$	1,881		2.67	%	$	144,209		$	1,881		2.63	%
Loans: ⁽²⁾
Taxable	$	548,941		$	14,117		5.19	%	$	516,796		$	12,770		4.98	%
Tax-exempt ⁽¹⁾		4,479			100		4.50	%		4,808			102		4.29	%
Total loans	$	553,420		$	14,217		5.18	%	$	521,604		$	12,872		4.98	%
Federal funds sold		1			—		2.26	%		—			—		—	%
Interest-bearing deposits with other institutions		22,005			243		2.23	%		44,270			346		1.58	%
Total earning assets	$	717,341		$	16,341		4.59	%	$	710,083		$	15,099		4.29	%
Less: allowance for loan losses		(4,944	)							(5,246	)
Total non-earning assets		53,657								52,122
Total assets	$	766,054							$	756,959
Liabilities and Shareholders’ Equity
Interest bearing deposits:
Checking	$	162,648		$	730		0.91	%	$	160,179		$	472		0.59	%
Regular savings		110,086			36		0.07	%		124,847			47		0.08	%
Money market accounts		105,691			643		1.23	%		87,063			312		0.72	%
Time deposits:
$100,000 and over		49,860			346		1.40	%		48,644			230		0.95	%
Under $100,000		67,772			216		0.64	%		75,076			193		0.52	%
Brokered		450			2		0.83	%		556			1		0.40	%
Total interest-bearing deposits	$	496,507		$	1,973		0.80	%	$	496,365		$	1,255		0.51	%
Federal funds purchased		1			—		2.88	%		3			—		2.14	%
Subordinated debt		4,969			179		7.24	%		4,952			178		7.26	%
Junior subordinated debt		9,279			219		4.76	%		9,279			187		4.05	%
Other borrowings		83			2		6.21	%		—			—		—	%
Total interest-bearing liabilities	$	510,839		$	2,373		0.94	%	$	510,599		$	1,620		0.64	%
Non-interest bearing liabilities
Demand deposits		183,900								185,160
Other liabilities		1,726								1,401
Total liabilities	$	696,465							$	697,160
Shareholders’ equity		69,589								59,799
Total liabilities and Shareholders’ equity	$	766,054							$	756,959
Net interest income				$	13,968							$	13,479
Interest rate spread							3.65	%							3.65	%
Cost of funds							0.69	%							0.47	%
Interest expense as a percent of average earning assets							0.67	%							0.46	%
Net interest margin							3.93	%							3.83	%

(1)	Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $104 thousand and $101 thousand for the six months ended June 30, 2019 and 2018, respectively.

(2)	Loans placed on a non-accrual status are reflected in the balances.

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Provision for Loan Losses

The Bank recorded a provision for loan losses of $200 thousand during the second quarter of 2019, which resulted in a total allowance for loan losses of $5.0 million, or 0.87% of total loans, at June 30, 2019. The Bank did not record a provision for loan losses during the second quarter of 2018, which resulted in an allowance for loan losses of $5.0 million, or 0.95% of total loans, at June 30, 2018. The allowance for loan losses was $5.0 million, or 0.92% of total loans, at December 31, 2018.

The provision for loan losses for the quarter ended June 30, 2019 resulted from net charge-offs on loans and an increase in the general reserve component of the allowance for loan losses that were partially offset by a decrease in the specific reserve component. Net charge-offs totaled $151 thousand for the second quarter of 2019, compared to $233 thousand of net charge-offs for the same period of 2018. The increase in the general reserve resulted primarily from the impact of $24.5 million of loan growth and increases in the historical loss rate of the loan portfolio. There were no changes to qualitative adjustment factors during the quarter. The specific reserve decreased $28 thousand during the second quarter, primarily from improvements in collateral positions on impaired loans and principal payments received.

A provision for loan losses was not recorded during the second quarter of 2018 as net charge-offs on loans were offset by a decrease in the general reserve component of the allowance for loan losses. The general reserve decreased primarily from improvements in both the historical loss rate of the loan portfolio and the qualitative adjustment factors. Improvements in qualitative adjustment factors resulted from improved asset quality in the construction and land development loan class, as evidenced by lower substandard and past due loan amounts in this respective class, and improved economic conditions. Although impaired loans increased during the quarter, there was no increase to the specific reserve component of the allowance for loan losses.

For the six months ended June 30, 2019, the Bank recorded a provision for loan losses of $200 thousand as net charge-offs on loans and an increase in the general component of the allowance for loan losses were only partially offset by a decrease in the specific reserve component. Net charge-offs totaled $214 thousand for the first six months of 2019, compared to $387 thousand of net charge-offs for the same period of 2018. The increase in the general reserve resulted primarily from the impact of $32.1 million of loan growth during the first six months of 2019. The impact of loan growth on the general reserve was partially offset by improvements in the historical loss rate of the loan portfolio. There were no changes to qualitative adjustment factors during the first six months of 2019. The specific reserve decreased $142 thousand, primarily from improvements in collateral positions on impaired loans, principal payments received, and the resolution of certain impaired loans.

The Bank recorded a provision for loan losses of $100 thousand for the six months ended June 30, 2018 as net charge-offs on loans were only partially offset by a decrease in the general reserve component of the allowance for loan losses. The general reserve decreased primarily from improvements in both the historical loss rate of the loan portfolio and the qualitative adjustment factors. Improvements in qualitative adjustment factors resulted from improved asset quality in the construction and land development loan class, as evidenced by lower substandard and past due loan amounts in this respective class, and improved economic conditions. There was no change to the specific reserve component of the allowance for loan losses during the six months ended June 30, 2018.

Noninterest Income

Noninterest income decreased $32 thousand, or 2%, to $2.0 million for the three months ended June 30, 2019, compared to $2.1 million for the same period in 2018. The decrease in noninterest income was primarily attributable to a $69 thousand, or 9%, decrease in service charges on deposit accounts and a $64 thousand decrease in other operating income. The decrease in service charges on deposit accounts was a result of lower overdraft revenue. The decrease in other operating income was primarily attributable to revenue earned during the prior year from a settlement and release agreement related to brokerage services, which is no longer being earned in the current year. These decreases were partially offset by a $49 thousand, or 12%, increase in wealth management fees and a $22 thousand, or 29%, increase in income from bank owned life insurance, when comparing the periods. The increase in wealth management fees resulted primarily from higher balances of assets under management during the second quarter of 2019 compared to the same period one year ago. The increase in income from bank owned life insurance was primarily attributable to the purchase of additional policies in 2019.

For the six months ended June 30, 2019, noninterest income decreased $680 thousand, or 14%, to $4.0 million, compared to $4.7 million for the same period in 2018. The decrease in noninterest income was primarily attributable to a $130 thousand, or 8%, decrease in service charges on deposit accounts, a $434 thousand decrease in income from bank owned life insurance, and a $258 thousand decrease in other operating income. The decrease in service charges on deposit accounts was a result of lower overdraft revenue. The decrease in income from bank owned life insurance resulted primarily from $469 thousand of life insurance benefits recorded during the first quarter of 2018 due to the death of an employee. The decrease in other operating income was primarily attributable to the termination of the pension plan and the subsequent distribution of plan assets in the prior year, which resulted in a one-time increase in other operating income of $126 thousand during the first quarter of 2018. Other operating income also decreased as a result of revenue earned during the prior year from a settlement and release agreement related to brokerage services. These decreases were partially offset by a $79 thousand, or 10%, increase in wealth management fees, when comparing the periods. The increase in wealth management fees resulted primarily from higher balances of assets under management during the first six months of 2019 compared to the same period one year ago.

Noninterest Expense

Noninterest expense increased $366 thousand, or 6%, to $6.2 million for the quarter ended June 30, 2019, compared to $5.9 million for the same period in 2018. The increase in noninterest expense was primarily attributable to a $148 thousand, or 5%, increase in salaries and employee benefits, a $78 thousand, or 48%, increase in marketing expense, an $80 thousand, or 36%, increase in legal and professional fees, and a $102 thousand, or 19%, increase in other operating expense. The increase in salaries and employee benefits resulted primarily from annual increases to employee salaries and expense associated with the supplemental executive retirement plans entered into during 2019. Marketing expense increased primarily from advertising expenses related to strategic initiatives. The increase in legal and professional fees resulted primarily from legal costs related to certain corporate initiatives and consulting expenses for bank compliance testing and the implementation of new accounting standards. The increase in other operating expense was primarily attributable to additional costs of listing the Company's common stock on the Nasdaq Capital Market stock exchange during the quarter and higher education and training expenses. These increases were partially offset by a $31 thousand, or 47%, decrease in FDIC assessment and a $40 thousand, or 33%, decrease in amortization expense. Amortization expense continued to decrease as a result of the accelerated amortization method of core deposit intangibles.

For the six months ended June 30, 2019, noninterest expense increased $598 thousand, or 5%, to $12.3 million, compared to $11.7 million for the same period in 2018. The increase in noninterest expense was primarily attributable to a $208 thousand, or 3%, increase in salaries and employee benefits, a $52 thousand, or 7%, increase in occupancy expense, a $110 thousand, or 41%, increase in marketing expense, a $130 thousand, or 31%, increase in legal and professional fees, and a $122 thousand, or 12%, increase in other operating expense. The increase in salaries and employee benefits resulted primarily from annual increases to employee salaries and expense associated with the supplemental executive retirement plans entered into during 2019. Occupancy expense increased primarily from expenses associated with the consolidation of two branch offices, which included costs of closing one branch office and improvements to an existing branch office. Marketing expense increased primarily from advertising expenses related to strategic initiatives. The increase in legal and professional fees resulted primarily from legal costs related to certain corporate initiatives, an increase in investment advisory expense of the wealth management department, and consulting expenses for bank compliance testing and the implementation of new accounting standards. The increase in investment advisory expense correlated with the increase in wealth management revenue when comparing the periods. The increase in other operating expense was primarily attributable to additional costs of listing the Company's common stock on the Nasdaq Capital Market stock exchange and higher education and training expenses. These increases were partially offset by a $44 thousand, or 30%, decrease in FDIC assessment and an $81 thousand, or 32%, decrease in amortization expense. Amortization expense continued to decrease as a result of the accelerated amortization method of core deposit intangibles.

Income Taxes

Income tax expense decreased by $99 thousand for the second quarter of 2019 and decreased by $101 thousand for the six months ended June 30, 2019, compared to the same periods one year ago. The Company’s income tax expense differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three and six months ended June 30, 2019 and 2018. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income and income from bank owned life insurance. A more detailed discussion of the Company’s tax calculation is contained in Note 11 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

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Financial Condition

General

Total assets increased by $25.4 million to $778.4 million at June 30, 2019, compared to $753.0 million at December 31, 2018. The increase was primarily attributable to a $32.1 million increase in net loans, which was partially offset by a $4.5 million decrease in interest-bearing deposits in banks and a $4.9 million decrease in securities.

At June 30, 2019, total liabilities increased by $19.3 million to $705.6 million, compared to $686.3 million at December 31, 2018. The increase was primarily attributable to a $19.2 million increase in total deposits. The increase in total deposits resulted from a $4.6 million increase in noninterest-bearing demand deposits and a $16.0 million increase in savings and interest-bearing deposits, which was partially offset by a $1.4 million decrease in time deposits.

Total shareholders' equity increased by $6.1 million to $72.8 million at June 30, 2019, compared to $66.7 million at December 31, 2018. The Company's capital ratios continue to exceed the minimum capital requirements for regulatory purposes.

Loans

Loans, net of the allowance for loan losses, increased $32.1 million to $570.0 million at June 30, 2019, compared to $537.8 million at December 31, 2018. Commercial real estate loans increased by $17.8 million during the first six months of 2019, followed by residential real estate loans, commercial and industrial loans, and construction loans that increased by $9.9 million, $4.7 million, and $414 thousand, respectively. These increases were partially offset by a $756 thousand decrease in consumer loans.

The Company, through its banking subsidiary, grants mortgage, commercial, and consumer loans to customers. The Bank segments its loan portfolio into real estate loans, commercial and industrial loans, and consumer and other loans. Real estate loans are further divided into the following classes: Construction and Land Development; 1-4 Family Residential; and Other Real Estate Loans. Descriptions of the Company’s loan classes are as follows:

Real Estate Loans – Construction and Land Development: The Company originates construction loans for the acquisition and development of land and construction of commercial buildings, condominiums, townhomes, and one-to-four family residences.

Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one-to-four family homes. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, office and retail buildings, industrial and warehouse buildings, hotels, and religious facilities.

Commercial and Industrial Loans: Commercial loans may be unsecured or secured with non-real estate commercial property. The Company's banking subsidiary makes commercial loans to businesses located within its market area and also to businesses outside of its market area through loan participations with other financial institutions.

Consumer and Other Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans, and lines of credit. The Company's banking subsidiary makes consumer loans to individuals located within its market area and also to individuals outside of its market through the purchase of loans from another financial institution.

A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the Bank's market area. The ability of the Bank’s debtors to honor their contracts may be impacted by the real estate and general economic conditions in this area.

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Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing totaled $19 thousand at June 30, 2019, compared to $235 thousand at December 31, 2018. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.

Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.

Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than $250 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential, and certain small commercial loans that are less than $250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled $1.8 million and $3.4 million at June 30, 2019 and December 31, 2018, respectively.

Troubled Debt Restructurings (TDR)

In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status, and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $381 thousand and $467 thousand in loans classified as TDRs as of June 30, 2019 and December 31, 2018, respectively.

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Asset Quality

Management classifies non-performing assets as non-accrual loans and OREO. OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch operations or expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank did not have any assets classified as OREO at June 30, 2019 or December 31, 2018.

Non-performing assets totaled $1.8 million at June 30, 2019 and $3.2 million at December 31, 2018, representing 0.23% and 0.42% of total assets, respectively. Non-performing assets consisted only of non-accrual loans at June 30, 2019 and December 31, 2018.

At June 30, 2019, 49% of non-performing assets were residential real estate loans, 29% were commercial real estate loans, and 22% were construction and land development loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $2.8 million and $3.5 million at June 30, 2019 and December 31, 2018, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing a customers’ ability to meet their debt requirements.

Loans greater than 90 days past due and still accruing totaled $19 thousand at June 30, 2019, which was comprised of four purchased consumer loans. Consumer loans purchased at origination are charged-off when they are greater than 120 days past due. Loans that were greater than 90 days past due and still accruing totaled $235 thousand at December 31, 2018.

The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $5.0 million at June 30, 2019 and December 31, 2018, representing 0.87% and 0.92% of total loans, respectively. For further discussion regarding the allowance for loan losses, see “Provision for Loan Losses” above.

Recoveries of loan losses of $71 thousand and $64 thousand were recorded in the construction and land development and 1-4 family residential loan classes, respectively, during the six months ended June 30, 2019. The recovery of loan losses in the construction and land development loan class resulted primarily from net recoveries of loans charged off in prior periods and a decrease in the specific reserve. The decrease in the specific reserve for the construction and land development loan class resulted from improvements in collateral positions on impaired loans and principal payments received. The recovery of loan losses in the 1-4 family residential loan class resulted primarily from a decrease in the specific reserve. The decrease in the specific reserve for the 1-4 family residential loan class resulted from principal payments received and the resolution of certain impaired loans. These recoveries were offset by provision for loan losses totaling $335 thousand in the other real estate, commercial and industrial, and consumer and other loan classes. For more detailed information regarding the provision for loan losses, see Note 4 to the Consolidated Financial Statements.

Impaired loans totaled $1.8 million and $3.4 million at June 30, 2019 and December 31, 2018, respectively. The related allowance for loan losses provided for these loans totaled $101 thousand and $243 thousand at June 30, 2019 and December 31, 2018, respectively. The average recorded investment in impaired loans during the six months ended June 30, 2019 and the year ended December 31, 2018 was $2.2 million and $3.5 million, respectively. Included in the impaired loans total are loans classified as TDRs totaling $381 thousand and $467 thousand at June 30, 2019 and December 31, 2018, respectively. Loans classified as TDRs represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of June 30, 2019, none of these TDRs were performing under the restructured terms and all were considered non-performing assets.

Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports, and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the qualitative factors underlying management’s estimates and judgments, changes in accounting standards, adverse developments in the economy, on a national basis or in the Company’s market area, loan growth, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies” above.

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Securities

The securities portfolio plays a primary role in the management of the Company’s interest rate sensitivity and serves as a source of liquidity. The portfolio is used as needed to meet collateral requirements, such as those related to secure public deposits and balances with the Reserve Bank. The investment portfolio consists of held to maturity, available for sale, and restricted securities. Securities are classified as available for sale or held to maturity based on the Company’s investment strategy and management’s assessment of the intent and ability to hold the securities until maturity. Management determines the appropriate classification of securities at the time of purchase. If management has the intent and the Company has the ability at the time of purchase to hold the investment securities to maturity, they are classified as investment securities held to maturity and are stated at amortized cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Investment securities which the Company may not hold to maturity are classified as investment securities available for sale, as management has the intent and ability to hold such investment securities for an indefinite period of time, but not necessarily to maturity. Securities available for sale may be sold in response to changes in market interest rates, changes in prepayment risk, increases in loan demand, general liquidity needs and other similar factors and are carried at estimated fair value. Restricted securities, including Federal Home Loan Bank, Federal Reserve Bank, and Community Bankers’ Bank stock, are generally viewed as long-term investments because there is minimal market for the stock and are carried at cost.

Securities at June 30, 2019 totaled $140.0 million, a decrease of $4.9 million, or 3%, from $145.0 million at December 31, 2018. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of June 30, 2019, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the available for sale portfolio totaled $1.3 million and $75 thousand at June 30, 2019 and December 31, 2018, respectively. Gross unrealized losses in the available for sale portfolio totaled $319 thousand and $2.4 million at June 30, 2019 and December 31, 2018, respectively. Gross unrealized gains in the held to maturity portfolio totaled $89 thousand and $29 thousand at June 30, 2019 and December 31, 2018, respectively. Gross unrealized losses in the held to maturity portfolio totaled $121 thousand and $1.0 million at June 30, 2019 and December 31, 2018, respectively. Investments in an unrealized loss position were considered temporarily impaired at June 30, 2019 and December 31, 2018. The change in the unrealized gains and losses of investment securities from December 31, 2018 to June 30, 2019 was related to changes in market interest rates and was not related to credit concerns of the issuers.

Deposits

At June 30, 2019, deposits totaled $689.8 million, an increase of $19.2 million, from $670.6 million at December 31, 2018. There was a slight change in the deposit mix when comparing the periods. At June 30, 2019, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 27%, 56%, and 17% of total deposits, respectively, compared to 27%, 55%, and 18% at December 31, 2018.

Liquidity

Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities, and loans maturing within one year as liquid assets. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.

As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.

At June 30, 2019, cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled $106.0 million. At June 30, 2019, 14% or $80.2 million of the loan portfolio matures within one year. Non-deposit sources of available funds totaled $164.7 million at June 30, 2019, which included $99.1 million available from Federal Home Loan Bank of Atlanta (FHLB), $53.0 million of unsecured federal funds lines of credit with other correspondent banks, and $12.6 million available through the Federal Reserve Discount Window.

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Capital Resources

The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses. The Company meets eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board’s Small Bank Holding Company Policy Statement, and is not obligated to report consolidated regulatory capital.

Effective January 1, 2015, the Bank became subject to new capital rules adopted by federal bank regulators implementing the Basel III regulatory capital reforms adopted by the Basel Committee on Banking Supervision (the Basel Committee), and certain changes required by the Dodd-Frank Act.

The minimum capital level requirements applicable to the Bank under the final rules are as follows: a new common equity Tier 1 capital ratio of 4.5%; a Tier 1 capital ratio of 6%; a total capital ratio of 8%; and a Tier 1 leverage ratio of 4% for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years and, as fully implemented on January 1, 2019, requires a buffer of 2.5% of risk-weighted assets. This results in the following minimum capital ratios beginning in 2019: a common equity Tier 1 capital ratio of 7.0%, a Tier 1 capital ratio of 8.5%, and a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions. Management believes, as of June 30, 2019 and December 31, 2018, that the Bank met all capital adequacy requirements to which it is subject, including the capital conservation buffer.

The following table shows the Bank’s regulatory capital ratios at June 30, 2019:

	First Bank
Total capital to risk-weighted assets		14.24	%
Tier 1 capital to risk-weighted assets		13.37	%
Common equity Tier 1 capital to risk-weighted assets		13.37	%
Tier 1 capital to average assets		9.96	%
Capital conservation buffer ratio⁽¹⁾		6.24	%

(1)	Calculated by subtracting the regulatory minimum capital ratio requirements from the Company’s actual ratio for Common equity Tier 1, Tier 1, and Total risk based capital. The lowest of the three measures represents the Bank’s capital conservation buffer ratio.

The prompt corrective action framework is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized:” a common equity Tier 1 capital ratio of 6.5%; a Tier 1 capital ratio of 8%; a total capital ratio of 10%; and a Tier 1 leverage ratio of 5%. The Bank met the requirements to qualify as "well capitalized" as of June 30, 2019 and December 31, 2018.

Contractual Obligations

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

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Off-Balance Sheet Arrangements

The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.

Commitments to extend credit, which amounted to $94.7 million at June 30, 2019, and $91.1 million at December 31, 2018, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines, and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and may or may not be drawn upon to the total extent to which the Bank is committed.

Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At June 30, 2019 and December 31, 2018, the Bank had $10.4 million and $9.9 million in outstanding standby letters of credit, respectively.

At June 30, 2019, the Bank had $6.3 million in locked-rate commitments to originate mortgage loans. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Not required.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2019 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1. Legal Proceedings

There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which the Company is a party or to which the property of the Company is subject.

Item 1A. Risk Factors

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2018.

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

None

Item 3. Defaults upon Senior Securities

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

None

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Item 6. Exhibits

The following documents are attached hereto as Exhibits:

31.1	Certification of Chief Executive Officer, Section 302 Certification.

31.2	Certification of Chief Financial Officer, Section 302 Certification.

32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350.

32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.

101	The following materials from First National Corporation’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2019 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


FIRST NATIONAL CORPORATION
(Registrant)

/s/ Scott C. Harvard				August 8, 2019
Scott C. Harvard				Date
President and Chief Executive Officer

/s/ M. Shane Bell				August 8, 2019
M. Shane Bell				Date
Executive Vice President and Chief Financial Officer