FIRST NATIONAL CORP /VA/ - Quarter Report: 2021 March (Form 10-Q)

 

 

Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549 

 

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FORM 10-Q

 

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

 

For the quarterly period ended March 31, 2021

 

or

 

☐	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: 1-38874

 

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 (Exact name of registrant as specified in its charter)

 

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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)

 

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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 May 17, 2021, 4,868,462 shares of common stock, par value $1.25 per share, of the registrant were outstanding.

 

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		(unaudited)
		March 31,				December 31,
		2021				2020*
Assets
Cash and due from banks		$	11,940			$	13,115
Interest-bearing deposits in banks			164,322				114,182
Securities available for sale, at fair value			159,742				140,225
Securities held to maturity, at amortized cost (fair value, 2021, $13,843; 2020, $14,743)			13,424				14,234
Restricted securities, at cost			1,631				1,875
Loans held for sale			—				245
Loans, net of allowance for loan losses, 2021, $7,486; 2020, $7,485			630,716				622,429
Premises and equipment, net			19,087				19,319
Accrued interest receivable			2,609				2,717
Bank owned life insurance			18,029				17,916
Core deposit intangibles, net			5				19
Other assets			6,625				4,656
Total assets		$	1,028,130			$	950,932
Liabilities and Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing demand deposits		$	292,280			$	263,229
Savings and interest-bearing demand deposits			526,012				479,035
Time deposits			97,765				100,197
Total deposits		$	916,057			$	842,461
Subordinated debt			9,992				9,991
Junior subordinated debt			9,279				9,279
Accrued interest payable and other liabilities			6,876				4,285
Total liabilities		$	942,204			$	866,016
Commitments and contingencies
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, 2021, 4,868,462 shares; 2020, 4,860,399 shares			6,086				6,075
Surplus			6,214				6,151
Retained earnings			71,144				69,292
Accumulated other comprehensive income, net			2,482				3,398
Total shareholders’ equity		$	85,926			$	84,916
Total liabilities and shareholders’ equity		$	1,028,130			$	950,932

		Three Months Ended
		March 31,				March 31,
		2021				2020
Interest and Dividend Income
Interest and fees on loans		$	7,143			$	7,203
Interest on deposits in banks			33				118
Interest and dividends on securities:
Taxable interest			717				670
Tax-exempt interest			180				151
Dividends			22				26
Total interest and dividend income		$	8,095			$	8,168
Interest Expense
Interest on deposits		$	363			$	962
Interest on subordinated debt			154				90
Interest on junior subordinated debt			66				90
Total interest expense		$	583			$	1,142
Net interest income		$	7,512			$	7,026
Provision for loan losses			—				900
Net interest income after provision for loan losses		$	7,512			$	6,126
Noninterest Income
Service charges on deposit accounts		$	442			$	681
ATM and check card fees			601				519
Wealth management fees			643				525
Fees for other customer services			286				207
Income from bank owned life insurance			113				115
Net gains on securities available for sale			37				—
Net gains on sale of loans			7				31
Other operating income			14				21
Total noninterest income		$	2,143			$	2,099
Noninterest Expense
Salaries and employee benefits		$	3,555			$	3,589
Occupancy			447				402
Equipment			431				410
Marketing			106				106
Supplies			88				89
Legal and professional fees			737				279
ATM and check card expense			231				245
FDIC assessment			69				30
Bank franchise tax			168				153
Data processing expense			204				184
Amortization expense			14				52
Other operating expense			600				605
Total noninterest expense		$	6,650			$	6,144

		Three Months Ended
		March 31,				March 31,
		2021				2020
Income before income taxes		$	3,005			$	2,081
Income tax expense			569				376
Net income		$	2,436			$	1,705
Earnings per common share
Basic		$	0.50			$	0.34
Diluted		$	0.50			$	0.34

		Three Months Ended
		March 31,				March 31,
		2021				2020
Net income		$	2,436			$	1,705
Other comprehensive (loss) income, net of tax,
Unrealized holding (losses) gains on available for sale securities, net of tax ($432) and $556 for the three months ended March 31, 2021 and 2020, respectively			(1,625	)			2,092
Reclassification adjustment for gains included in net income, net of tax ($8) and $0 for the three months ended March 31, 2021 and 2020, respectively			(29	)			—
Change in fair value of cash flow hedges, net of tax $196 and $0 for the three months ended March 31, 2021 and 2020, respectively			738				—
Total other comprehensive (loss) income			(916	)			2,092
Total comprehensive income		$	1,520			$	3,797

		Three Months Ended
		March 31,				March 31,
		2021				2020
Cash Flows from Operating Activities
Net income		$	2,436			$	1,705
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of premises and equipment			323				327
Amortization of core deposit intangibles			14				52
Amortization of debt issuance costs			1				4
Origination of loans held for sale			(318	)			(2,133	)
Proceeds from sale of loans held for sale			570				1,710
Net gains on sales of loans held for sale			(7	)			(31	)
Provision for loan losses			—				900
Net gains on securities available for sale			(37	)			—
Increase in cash value of bank owned life insurance			(113	)			(115	)
Accretion of discounts and amortization of premiums on securities, net			214				157
Accretion of premium on time deposits			(3	)			(12	)
Stock-based compensation			74				132
Excess tax deficiency (benefit) on stock-based compensation			3				(2	)
Gains on disposal of premises and equipment			(12	)			(9	)
Deferred income tax benefit			(95	)			(170	)
Changes in assets and liabilities:
Decrease (increase) in interest receivable			108				(59	)
(Increase) decrease in other assets			(700	)			610
Increase in accrued interest payable and other liabilities			2,592				320
Net cash provided by operating activities		$	5,050			$	3,386
Cash Flows from Investing Activities
Proceeds from maturities, calls, principal payments, and sales of securities available for sale		$	13,425			$	5,318
Proceeds from maturities, calls, and principal payments of securities held to maturity			786				516
Purchase of securities available for sale			(35,189	)			(10,479	)
Net redemption (purchase) of restricted securities			244				(42	)
Purchase of premises and equipment			(91	)			(199	)
Proceeds from sale of premises and equipment			12				9
Net increase in loans			(8,287	)			(7,771	)
Net cash used in investing activities		$	(29,100	)		$	(12,648	)

		Three Months Ended
		March 31,				March 31,
		2021				2020
Cash Flows from Financing Activities
Net increase in demand deposits and savings accounts		$	76,028			$	16,339
Net decrease in time deposits			(2,429	)			(2,142	)
Cash dividends paid on common stock, net of reinvestment			(545	)			(512	)
Repurchase of common stock, stock incentive plan			(39	)			(47	)
Repurchase of common stock, stock repurchase plan			—				(2,071	)
Net cash provided by financing activities		$	73,015			$	11,567
Increase in cash and cash equivalents		$	48,965			$	2,305
Cash and Cash Equivalents
Beginning		$	127,297			$	45,785
Ending		$	176,262			$	48,090
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest		$	543			$	1,169
Supplemental Disclosures of Noncash Investing and Financing Activities
Unrealized (losses) gains on securities available for sale		$	(2,094	)		$	2,648
Change in fair value of cash flow hedges		$	934			$	—
Issuance of common stock, dividend reinvestment plan		$	39			$	35

 

		Common Stock				Surplus				Retained Earnings				Accumulated Other Comprehensive Income				Total
Balance, December 31, 2019		$	6,212			$	7,700			$	62,583			$	724			$	77,219
Net income			—				—				1,705				—				1,705
Other comprehensive income			—				—				—				2,092				2,092
Cash dividends on common stock ($0.11 per share)			—				—				(547	)			—				(547	)
Stock-based compensation			—				132				—				—				132
Issuance of 2,242 shares of common stock, dividend reinvestment plan			3				32				—				—				35
Issuance of 8,992 shares of common stock, stock incentive plan			11				(11	)			—				—				—
Repurchase of 2,223 shares of common stock, stock incentive plan			(3	)			(44	)			—				—				(47	)
Repurchase of 129,035 shares of common stock, stock repurchase plan			(161	)			(1,910	)			—				—				(2,071	)
Balance, March 31, 2020		$	6,062			$	5,899			$	63,741			$	2,816			$	78,518

		Common Stock				Surplus				Retained Earnings				Accumulated Other Comprehensive Income				Total
Balance, December 31, 2020		$	6,075			$	6,151			$	69,292			$	3,398			$	84,916
Net income			—				—				2,436				—				2,436
Other comprehensive loss			—				—				—				(916	)			(916	)
Cash dividends on common stock ($0.12 per share)			—				—				(584	)			—				(584	)
Stock-based compensation			—				74				—				—				74
Issuance of 2,211 shares of common stock, dividend reinvestment plan			3				36				—				—				39
Issuance of 8,073 shares of common stock, stock incentive plan			10				(10	)			—				—				—
Repurchase of 2,221 shares of common stock, stock incentive plan			(2	)			(37	)			—				—				(39	)
Balance, March 31, 2021		$	6,086			$	6,214			$	71,144			$	2,482			$	85,926

 

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 March 31, 2021 and December 31, 2020, the statements of income and comprehensive income for the three months ended March 31, 2021 and 2020, the cash flows for the three months ended March 31, 2021 and 2020, and the changes in shareholders’ equity for the three months ended March 31, 2021 and 2020. 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, 2020. Operating results for the three months ended March 31, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.

 

Risks and Uncertainties

 

The outbreak of COVID-19 has adversely impacted a broad range of industries in which the Company’s customers operate and could impair their ability to fulfill their financial obligations to the Company. The World Health Organization has declared COVID-19 to be a global pandemic indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections. The spread of the outbreak has caused disruptions in the U.S. economy and has disrupted banking and other financial activity in the areas in which the Company operates. While there has been no material impact to the Company’s employees to date, COVID-19 could also potentially create widespread business continuity issues for the Company.

 

Congress, the President, and the Federal Reserve have taken several actions designed to cushion the economic fallout. Most notably, the Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law in March 2020 as a $2 trillion legislative package and the American Rescue Plan Act of 2021 was signed into law in March 2021 and provides an additional $1.9 trillion in spending to address the continued impact of COVID-19. The goal of these legislative measures is to prevent a severe economic downturn through various measures, including direct financial aid to American families and economic stimulus to significantly impacted industry sectors. The package also includes extensive emergency funding for hospitals and providers. In addition to the general impact of COVID-19, certain provisions of the CARES Act as well as other recent legislative and regulatory relief efforts may have a material impact on the Company’s operations.

 

The Company’s business is dependent upon the willingness and ability of its employees and customers to conduct banking and other financial transactions.  If the global response to contain COVID-19 escalates further or is unsuccessful, the Company could experience a material adverse effect on its business, financial condition, results of operations and cash flows. While it is not possible to know the full universe or extent that the impact of COVID-19, and resulting measures to curtail its spread, will have on the Company’s operations, the Company is disclosing potentially material items of which it is aware.

 

Results of Operations

 

The Company’s net interest income could decrease due to COVID-19. In keeping with guidance from regulators, the Company worked with certain COVID-19 affected borrowers to reduce their loan payments by modifying the loan agreements to allow for interest only payments. The loan modification periods ranged from 6 months to 24 months and were intended to provide payment relief to borrowers over the period of time that COVID-19 is expected to continue to negatively affect the profitability of the borrowers’ businesses. Although the modified loan payments have been made as agreed and interest income has been recognized by the Company, should the borrowers be negatively affected by COVID-19 for a period of time that extends beyond the loan modification periods, it’s possible the borrowers may not be able to resume regular principal and interest payments in future periods and the Company may no longer be able to accrue interest income on the loans.  At this time, the Company is unable to project the materiality of such an impact but recognizes the breadth of the economic impact may affect its borrowers' ability to repay in future periods.

 

The Company’s net interest income could also decrease due to adverse economic conditions that may result from COVID-19 and a related decrease in loan demand, causing a shift in earning asset balances from loans into lower yielding interest-bearing deposits in banks and securities.  The decrease in loan demand could also increase the competition for loans and result in a reduction of loan rates offered by other financial institutions. 

 

The Company's noninterest income could decrease due to COVID-19. Service charges on deposits decreased during 2020 and the first quarter of 2021 and may continue to decrease in future periods from less customer spending and/or higher balances of customer deposits. Wealth management revenue may decrease in future periods if the market values of investments decline and mortgage fee income may decrease from less home buying activity in the Company's market area. At this time, the Company is unable to project the materiality of such an impact but recognizes it may unfavorably affect its noninterest income in future periods.

 

The Company’s noninterest expense could increase due to COVID-19. If the Bank's asset quality worsens, it may incur additional loan expenses in future periods from obtaining updated appraisals on loan collateral, additional legal and professional expenses related to the resolution of problem loans, an increase in other real estate owned expense, and potential losses on the sale of other real estate owned.

 

At this time, the Company is unable to project the full extent or materiality of the foregoing impacts but recognizes the breadth of the economic impacts of COVID-19 may have an unfavorable impact on net interest income, noninterest income, noninterest expense, and loan customers' ability to repay loans, in future periods.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Capital and Liquidity

 

While the Company believes it has sufficient capital to withstand an extended economic recession brought about by COVID-19, its reported and regulatory capital ratios could be adversely impacted by provision for loan losses in future periods. Larger amounts of provision for loan losses may result from factors including higher specific reserves on newly identified and existing impaired loans, higher levels of net charge-offs, and additional adjustments to qualitative factors in the general reserve component of the Bank’s allowance for loan losses. In March 2020, the Company suspended future stock repurchases under its stock repurchase program due to the economic uncertainty caused by the pandemic, and the program remained suspended for the remainder of 2020. The Company has not authorized another stock repurchase program due to the continued uncertainty and potential impact of the pandemic on the economy and the Bank’s customers. In June 2020, the Company issued $5.0 million of subordinated debt to strengthen holding company liquidity and to remain a source of strength to the Bank in the event of a severe economic downturn resulting from the pandemic. The Company will continue to update its enterprise risk assessment and capital plans as the operating environment develops.

 

The Company maintains access to multiple sources of liquidity. While wholesale funding markets have remained open, interest rates for short term funding could become volatile. If funding costs would become elevated for an extended period of time, it may have an adverse effect on the Company’s net interest margin. If an extended recession causes large numbers of the Company’s deposit customers to withdraw their funds, the Company could become more reliant on volatile or more expensive sources of funding.

 

Processes, Controls and Business Continuity Plan 

 

The Company continues to operate under its Pandemic Continuity of Operations Plan that includes a remote working strategy. The Company has not incurred additional material costs related to employees working remotely. No material operational or internal control challenges or risks have been identified to date. The Company does not anticipate significant challenges to its ability to maintain its systems and controls in light of the measures the Company has taken to prevent the spread of COVID-19. The Company does not currently face any material resource constraint through the implementation of its business continuity plan.

 

Lending Operations and Accommodations to Borrowers 

 

In keeping with regulatory guidance to work with borrowers during this unprecedented situation, the Company offered a payment deferral program, primarily during the second and third quarters of 2020, for its individual and business customers adversely affected by the pandemic that deferred loan payments for up to 90 days. There were no loans remaining in the program at March 31, 2021. In accordance with the CARES Act and interagency guidance issued in August 2020, these short-term loan payment deferrals were not considered troubled debt restructurings. 

 

During the fourth quarter of 2020, the Bank modified terms of certain loans for customers that continued to be negatively impacted by the pandemic. The loan modifications lowered borrower loan payments by allowing interest only payments for periods ranging between 6 and 24 months. All loans modified were in the Bank’s commercial real estate loan portfolio and totaled $14.3 million at March 31, 2021. The loans were comprised of $12.8 million in the lodging sector and $1.5 million in the leisure sector.

 

With the passage of the Paycheck Protection Program (PPP), administered by the Small Business Administration (SBA), the Company actively participated in assisting its customers with applications for resources through the program. During the second and third quarters of 2020, the Bank originated $76.6 million of PPP loans, received $2.5 million of loan fees, and incurred $535 thousand of loan origination costs. The loan fees are being accreted into earnings evenly over the life of the loans, net of the loan costs, through interest and fees on loans. Approximately 99% of the PPP loan balances will mature in the second quarter of 2022. The Company believes the majority of these loans will ultimately be forgiven and repaid by the SBA in accordance with the terms of the program. As of March 31, 2021, PPP loan balances originated in 2020 totaled $46.5 million. It is the Company’s understanding that loans funded through the PPP program are fully guaranteed by the U.S. government. Should those circumstances change, the Company could be required to establish additional allowance for loan losses through additional provision for loan losses charged to earnings.

 

Congress revived the PPP (new PPP) as part of the COVID-19 relief bill that was signed into law on December 27, 2020. The Bank began participating as a lender in the new PPP in January of 2021. As of March 31, 2021, the Bank originated $19.8 million of new PPP loans and incurred $51 thousand of loan origination costs. The Bank expects to receive $1.1 million of loan fees from the SBA as a result of the loan originations. Loan fees received on new PPP loans will also be accreted into earnings evenly over the life of the loans, net of the loan costs, through interest and fees on loans. These new PPP loans will mature in the first quarter of 2026.

 

Asset Quality 

 

The economic impact of the pandemic had an unfavorable impact on the financial condition of certain Bank customers. The Bank entered into loan modification agreements in the fourth quarter of 2020 to provide relief to certain customers that were continuing to experience temporary business interruptions from the pandemic. The modifications were designed to help borrowers continue their business operations while minimizing potential loan charge-offs. The Bank expects significant pressure on several sectors of the loan portfolio to continue, including retail shopping, and lodging and leisure, among others.

 

The magnitude of the potential decline in the Bank’s loan quality will likely depend on the length and extent that the Bank’s customers experience business interruptions from the pandemic.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Business Combination

 

On February 18, 2021, the Company entered into an agreement to acquire The Bank of Fincastle (Fincastle) for an aggregate purchase price of $31.6 million of cash and stock. Additional information about the acquisition is presented in Note 17.

 

Adoption of New Accounting Pronouncements

 

In December 2019, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2019-12, “Income Taxes (Topic 740) – Simplifying the Accounting for Income Taxes” (ASU 2019-12).  The ASU is expected to reduce cost and complexity related to the accounting for income taxes by removing specific exceptions to general principles in Topic 740 (eliminating the need for an organization to analyze whether certain exceptions apply in a given period) and improving financial statement preparers’ application of certain income tax-related guidance. This ASU is part of the FASB’s simplification initiative to make narrow-scope simplifications and improvements to accounting standards through a series of short-term projects.  ASU 2019-12 was effective for the Company on January 1, 2021. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.

 

In January 2020, the FASB issued ASU No. 2020-01, “Investments – Equity Securities (Topic 321), Investments – Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815) – Clarifying the Interactions between Topic 321, Topic 323, and Topic 815” (ASU 2020-01).  The ASU is based on a consensus of the Emerging Issues Task Force and is expected to increase comparability in accounting for these transactions.  ASU 2016-01 made targeted improvements to accounting for financial instruments, including providing an entity the ability to measure certain equity securities without a readily determinable fair value at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.  Among other topics, the amendments clarify that an entity should consider observable transactions that require it to either apply or discontinue the equity method of accounting.  ASU 2020-01 was effective for the Company on January 1, 2021. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.

 

In October 2020, the FASB issued ASU No. 2020-08, “Codification Improvements to Subtopic 310-20, Receivables – Nonrefundable fees and Other Costs” (ASU 2020-08). This ASU clarifies that an entity should reevaluate whether a callable debt security is within the scope of ASC paragraph 310-20-35-33 for each reporting period. ASU 2020-08 was effective for the Company on January 1, 2021. The adoption of this standard did not have a material effect on the Company's consolidated financial statements.

 

In December 2020, the Consolidated Appropriations Act of 2021 (CAA) was passed.  Under Section 541 of the CAA, Congress extended or modified many of the relief programs first created by the CARES Act, including the PPP loan program and treatment of certain loan modifications related to the COVID-19 pandemic. For information about the impact of the COVID-19 pandemic on the Company, see "Risks and Uncertainties" above. 

 

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” (ASU 2016-13).  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 FASB has issued multiple updates to ASU 2016-13 as codified in Topic 326, including ASU’s 2019-04, 2019-05, 2019-10, 2019-11, 2020-02, and 2020-03.  These ASU’s have provided for various minor technical corrections and improvements to the codification as well as other transition matters.  Smaller reporting companies who file with the U.S. Securities and Exchange Commission (SEC) and all other entities who do not file with the SEC are required to apply the guidance for fiscal years, and interim periods within those years, beginning after December 15, 2022. 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.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Effective November 25, 2019, the SEC adopted Staff Accounting Bulletin (SAB) 119.  SAB 119 updated portions of SEC interpretative guidance to align with FASB ASC 326, “Financial Instruments – Credit Losses.”  It covers topics including (1) measuring current expected credit losses; (2) development, governance, and documentation of a systematic methodology; (3) documenting the results of a systematic methodology; and (4) validating a systematic methodology.

 

In March 2020, the FASB issued ASU No. 2020-04, “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (ASU 2020-04). These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022. Subsequently, in January 2021, the FASB issued ASU No. 2021-01 “Reference Rate Reform (Topic 848): Scope” (ASU 2021-01). This ASU clarifies that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in Topic 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply ASU 2021-01 on contract modifications that change the interest rate used for margining, discounting, or contract price alignment retrospectively as of any date from the beginning of the interim period that includes March 12, 2020, or prospectively to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued. An entity may elect to apply ASU 2021-01 to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020. The Company is currently in the process of identifying loans and other financial instruments that are directly or indirectly influenced by LIBOR. The Company is assessing ASU 2020-04 and its impact on the Company's transition away from LIBOR for its loan and other financial instruments.

 

In August 2020, the FASB issued ASU No. 2020-06, "Debt – Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity" (ASU 2020-06). The ASU simplifies accounting for convertible instruments by removing major separation models required under current U.S. GAAP. Consequently, more convertible debt instruments will be reported as a single liability instrument and more convertible preferred stock as a single equity instrument with no separate accounting for embedded conversion features. The ASU removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, which will permit more equity contracts to qualify for it. The ASU also simplifies the diluted earnings per share (EPS) calculation in certain areas. In addition, the amendment updates the disclosure requirements for convertible instruments to increase the information transparency. For public business entities, excluding smaller reporting companies, the amendments in the ASU are effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. For all other entities, the standard will be effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2020-06 to have a material impact on its consolidated financial statements.

 

Notes to Consolidated Financial Statements (Unaudited)

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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 March 31, 2021 and December 31, 2020 were as follows (in thousands):

 

 

 

 

Notes to Consolidated Financial Statements (Unaudited)

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At March 31, 2021 and December 31, 2020, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):

 

 

 

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.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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At March 31, 2021, there were twenty out of one hundred and one U.S. agency and mortgage-backed securities and twenty-three out of ninety-six 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 4.5 years at March 31, 2021. At December 31, 2020, there were seven out of one hundred and one U.S. agency and mortgage-backed securities and one out of eighty-four 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, 2020. The weighted-average re-pricing term of the portfolio was 3.5 years at December 31, 2020. The unrealized losses at March 31, 2021 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 March 31, 2021 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.

 

 

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 March 31, 2021, and no impairment has been recognized.

 

The composition of restricted securities at March 31, 2021 and December 31, 2020 was as follows (in thousands):

 

 

The Company also holds limited partnership investments in Small Business Investment Companies (SBICs), which are included in other assets in the Consolidated Balance Sheets. The limited partnership investments are measured as equity investments without readily determinable fair values at their cost, less any impairment. The amounts included in other assets for the limited partnership investments were $454 thousand and $529 thousand at March 31, 2021 and December 31, 2020, respectively.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Note 3. Loans

 

Loans at March 31, 2021 and December 31, 2020 are summarized as follows (in thousands):

 

 

Net deferred loan fees included in the above loan categories were $2.0 million and $1.6 million at March 31, 2021 and December 31, 2020, respectively. Consumer and other loans included $112 thousand and $143 thousand of demand deposit overdrafts at March 31, 2021 and December 31, 2020, 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. Consumer 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. Other loans included in this category include loans to states and political subdivisions.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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The following tables provide a summary of loan classes and an aging of past due loans as of March 31, 2021 and December 31, 2020 (in thousands):

 

 

 

 

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.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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 March 31, 2021 and December 31, 2020 (in thousands):

 

 

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Note 4. Allowance for Loan Losses

 

The following tables present, as of March 31, 2021, December 31, 2020 and March 31, 2020, the total allowance for loan losses, the allowance by impairment methodology, and loans by impairment methodology (in thousands):

 

 

 

 

Notes to Consolidated Financial Statements (Unaudited)

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Notes to Consolidated Financial Statements (Unaudited)

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Impaired loans and the related allowance at March 31, 2021, December 31, 2020 and March 31, 2020, were as follows (in thousands):

 

 

 

 

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 March 31, 2021, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $6.0 million. At March 31, 2021, none of the loans classified as TDRs were performing under the restructured terms and all were considered non-performing assets. There were $6.0 million in TDRs at December 31, 2020, none 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 March 31, 2021 and 2020.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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In response to the COVID-19 pandemic, the Company created and implemented a loan payment deferral program for individual and business customers beginning in the first quarter of 2020, which provided them the opportunity to defer monthly payments for 90 days. As of March 31, 2021, there were no loans remaining in the program. These loans were not considered TDRs because they were modified in accordance with relief provisions of the CARES Act and recent interagency regulatory guidance.

 

During the fourth quarter of 2020, the Company modified terms of certain loans for customers that continued to be negatively impacted by the COVID-19 pandemic. The loan modifications lowered borrower loan payments by allowing interest only payments for periods ranging between 6 and 24 months. As of March 31, 2021, loans that were modified totaled $14.3 million. These loans were not considered TDRs because they were modified in accordance with relief provisions of the CARES Act.

 

For the three months ended March 31, 2021 and 2020, there were no TDRs 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)

 

The Bank did not have any OREO activity during the three months ended March 31, 2021 and the year ended December 31, 2020. Accordingly, there were no residential real estate properties included in the ending OREO balances at March 31, 2021 and December 31, 2020. The Bank did not have any consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process as of March 31, 2021.

 

The Bank did not have any expenses applicable to OREO for the three months ended March 31, 2021 and the year ended December 31, 2020.

 

Note 6. Other Borrowings

 

The Company had an unsecured line of credit totaling $5.0 million with a non-affiliated bank at March 31, 2021. There were no borrowings outstanding on the line of credit at March 31, 2021. The interest rate on the line of credit floats at Wall Street Journal Prime Rate plus 0.25%, with a floor of 3.50%, and matures on March 28, 2026.

 

The Bank had unused lines of credit totaling $239.0 million and $237.7 million available with non-affiliated banks at March 31, 2021 and December 31, 2020, 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 $162.5 million at March 31, 2021. The Bank had collateral pledged on the borrowing line at March 31, 2021 and December 31, 2020 including real estate loans totaling $222.1 million and $221.1 million, respectively, and Federal Home Loan Bank stock with a book value of $573 thousand and $818 thousand, respectively. The Bank did not have borrowings from the FHLB at March 31, 2021 and December 31, 2020.

 

 

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 was 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 March 31, 2021 and December 31, 2020, that the Bank met all capital adequacy requirements to which it is subject.

 

As of March 31, 2021, 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 March 31, 2021 and December 31, 2020 with the minimum regulatory guidelines were as follows (dollars in thousands):

 

 

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. Accordingly, the Bank was required to maintain a capital conservation buffer of 2.50% at March 31, 2021 and December 31, 2020. 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 March 31, 2021 and December 31, 2020, the capital conservation buffer of the Bank was 8.05% and 7.82%, respectively.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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 bears interest at a fixed rate of 6.75% per annum. Debt issuance costs related to the note were fully amortized at March 31, 2021 and December 31, 2020. 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 January 1, 2021 through maturity, at the Company's option, on any scheduled interest payment date. 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.

 

On June 29, 2020, the Company issued an interest only subordinated term note due 2030 in the aggregate principal amount of $5.0 million. The note initially bears interest at a fixed rate of 5.50% per annum. Beginning July 1, 2025, the interest rate shall reset quarterly to an interest rate per annum equal to the current three-month Secured Overnight Financing Rate (SOFR), plus 510 basis points. Unamortized debt issuance costs related to the note were $8 thousand and $9 thousand at March 31, 2021 and December 31, 2020, respectively. The note has a maturity date of July 1, 2030. Subject to regulatory approval, the Company may prepay the note, in part or in full, beginning on July 1, 2025 through maturity, at the Company's option, on any scheduled interest payment date. The note 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.

 

Both of the notes are unsecured, subordinated obligations of the Company and they rank junior in right of payment to the Company’s existing and future senior indebtedness and to the Company’s obligations to its general creditors. The notes rank equally with all other unsecured subordinated debt, except any which by its terms is expressly stated to be subordinated to the notes. The notes rank senior to all current and future junior subordinated debt obligations, preferred stock, and common stock of the Company. The notes are not convertible into common stock or preferred stock, and are not callable by the holders.

 

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 March 31, 2021 and December 31, 2020 was 2.78% and 2.83%, 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 March 31, 2021 and December 31, 2020 was 1.84% and 1.83%, 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.

 

Note 10. Benefit Plans

 

The Company maintains a 401(k) plan (the 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 three months ended March 31, 2021 and 2020, expense attributable to the Plan amounted to $253 thousand and $249 thousand, respectively.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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 totaled $66 thousand for the three months ended March 31, 2021 and 2020 and was solely funded by the Company.

 

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, 2020 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 months ended March 31, 2021 and 2020 (dollars in thousands, except per share data):

 

 

Restricted stock units for 4,811 and 59 shares of common stock were not considered in computing diluted earnings per share for the three months ended March 31, 2021 and 2020 because they were antidilutive.

 

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.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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).

 

Derivative asset/liability - cash flow hedges

 

Cash flow hedges are recorded at fair value on a recurring basis. The fair value of the Company's cash flow hedges is determined by a third party vendor using the discounted cash flow method (Level 2).

 

 

Notes to Consolidated Financial Statements (Unaudited)

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The following tables present the balances of assets and liabilities measured at fair value on a recurring basis as of March 31, 2021 and December 31, 2020 (in thousands).

 

 

 

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 three months ended March 31, 2021 and the year ended December 31, 2020.

 

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.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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

 

 

 

 

 

 

(1)	Unobservable inputs were weighted by the relative fair value of the instruments.

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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 March 31, 2021 and December 31, 2020 are as follows (in thousands):

 

 

 

 

Notes to Consolidated Financial Statements (Unaudited)

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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.