FIRST NATIONAL CORP /VA/ - Quarter Report: 2022 June (Form 10-Q)

fxnc20220630_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, 2022

☐	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

(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 11, 2022, 6,252,147 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, 2022 (unaudited) and December 31, 2021	3

	Consolidated Statements of Income for the three and six months ended June 30, 2022 and 2021 (unaudited)	4

	Consolidated Statements of Comprehensive (Loss) Income for the three and six months ended June 30, 2022 and 2021 (unaudited)	6

	Consolidated Statements of Cash Flows for the six months ended June 30, 2022 and 2021 (unaudited)	7

	Consolidated Statements of Changes in Shareholders’ Equity for the three and six months ended June, 2022 and 2021 (unaudited)	9

	Notes to Consolidated Financial Statements (unaudited)	10

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	46

Item 4.	Controls and Procedures	46

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	47

Item 1A.	Risk Factors	47

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	47

Item 3.	Defaults Upon Senior Securities	47

Item 4.	Mine Safety Disclosures	47

Item 5.	Other Information	47

Item 6.	Exhibits	48

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,
	2022			2021*
Assets
Cash and due from banks	$	19,886		$	18,725
Interest-bearing deposits in banks		104,529			157,281
Securities available for sale, at fair value		264,750			289,495
Securities held to maturity, at amortized cost (fair value, 2022, $70,492; 2021, $33,617)		77,151			33,441
Restricted securities, at cost		1,908			1,813
Loans, net of allowance for loan losses, 2022, $6,202; 2021, $5,710		873,887			819,408
Other real estate owned, net of valuation allowance		1,665			1,848
Premises and equipment, net		22,118			22,403
Accrued interest receivable		4,154			3,903
Bank owned life insurance		24,569			24,294
Goodwill		3,030			3,030
Core deposit intangibles, net		145			154
Other assets		16,898			13,642
Total assets	$	1,414,690		$	1,389,437

Liabilities and Shareholders’ Equity

Liabilities
Deposits:
Noninterest-bearing demand deposits	$	431,292		$	413,188
Savings and interest-bearing demand deposits		731,125			689,998
Time deposits		133,733			145,566
Total deposits	$	1,296,150		$	1,248,752
Subordinated debt, net of issuance cost		4,994			9,993
Junior subordinated debt		9,279			9,279
Accrued interest payable and other liabilities		3,952			4,374
Total liabilities	$	1,314,375		$	1,272,398

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, 2022, 6,252,147 shares; 2021, 6,228,176 shares		7,815			7,785
Surplus		32,398			31,966
Retained earnings		82,804			76,990
Accumulated other comprehensive (loss) income, net		(22,702	)		298
Total shareholders’ equity	$	100,315		$	117,039
Total liabilities and shareholders’ equity	$	1,414,690		$	1,389,437

*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,
	2022		2021			2022		2021
Interest and Dividend Income
Interest and fees on loans	$	9,963	$	7,074		$	19,459	$	14,217
Interest on deposits in banks		251		37			321		70
Interest and dividends on securities:
Taxable interest		1,295		697			2,427		1,414
Tax-exempt interest		309		215			614		395
Dividends		21		22			42		44
Total interest and dividend income	$	11,839	$	8,045		$	22,863	$	16,140
Interest Expense
Interest on deposits	$	413	$	328		$	753	$	691
Interest on subordinated debt		69		154			138		308
Interest on junior subordinated debt		67		68			134		134
Total interest expense	$	549	$	550		$	1,025	$	1,133
Net interest income	$	11,290	$	7,495		$	21,838	$	15,007
Provision for (recovery of) loan losses		400		(1,000	)		400		(1,000	)
Net interest income after provision for (recovery of) loan losses	$	10,890	$	8,495		$	21,438	$	16,007
Noninterest Income
Service charges on deposit accounts	$	698	$	447		$	1,307	$	889
ATM and check card fees		797		682			1,547		1,283
Wealth management fees		760		657			1,563		1,300
Fees for other customer services		188		150			421		331
Brokered mortgage fees		58		157			152		262
Income from bank owned life insurance		131		99			275		212
Net gains on securities available for sale		—		—			—		37
Net gains on sale of mortgage loans held for sale		—		18			—		25
Other operating income		148		225			226		239
Total noninterest income	$	2,780	$	2,435		$	5,491	$	4,578
Noninterest Expense
Salaries and employee benefits	$	5,086	$	3,693		$	10,210	$	7,248
Occupancy		545		399			1,117		846
Equipment		620		433			1,179		864
Marketing		223		138			374		244
Supplies		131		77			267		165
Legal and professional fees		381		483			714		1,220
ATM and check card expense		347		268			650		499
FDIC assessment		132		78			284		147
Bank franchise tax		238		172			454		340
Data processing expense		221		216			457		420
Amortization expense		5		5			9		19
Other real estate owned expense, net		41		—			69		—
Other operating expense		948		668			1,778		1,268
Total noninterest expense	$	8,918	$	6,630		$	17,562	$	13,280

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,
	2022		2021		2022		2021
Income before income taxes	$	4,752	$	4,300	$	9,367	$	7,305
Income tax expense		917		958		1,803		1,527
Net income	$	3,835	$	3,342	$	7,564	$	5,778
Earnings per common share
Basic	$	0.61	$	0.69	$	1.21	$	1.19
Diluted	$	0.61	$	0.69	$	1.21	$	1.19

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Consolidated Statements of Comprehensive (Loss) Income (Unaudited)

(in thousands)

	Three Months Ended						Six Months Ended
	June 30,			June 30,			June 30,			June 30,
	2022			2021			2022			2021
Net income	$	3,835		$	3,342		$	7,564		$	5,778
Other comprehensive (loss), net of tax,
Unrealized holding gains (losses) on available for sale securities, net of tax ($2,595) and $78 for the three months and ($6,381) and ($354) for the six months ended June 30, 2022 and 2021, respectively		(9,762	)		292			(24,005	)		(1,333	)
Reclassification adjustment for gains included in net income, net of tax $0 and ($8) for the six months ended June 30, 2022 and 2021. There were no reclassification adjustments for the three month periods.		—			—			—			(29	)
Change in fair value of cash flow hedges, net of tax $120 and ($101) for the three months and $267 and $95 for the six months ended June 30, 2022 and 2021, respectively		452			(376	)		1,005			362
Total other comprehensive (loss)		(9,310	)		(84	)		(23,000	)		(1,000	)
Total comprehensive (loss) income	$	(5,475	)	$	3,258		$	(15,436	)	$	4,778

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,
	2022			2021
Cash Flows from Operating Activities
Net income	$	7,564		$	5,778
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization of premises and equipment		747			642
Amortization of core deposit intangibles		9			19
Amortization of debt issuance costs		1			1
Origination of mortgage loans held for sale		—			(1,586	)
Proceeds from sale of mortgage loans held for sale		—			1,856
Net gains on sales of mortgage loans held for sale		—			(25	)
Provision for (recovery of) loan losses		400			(1,000	)
Net gains on securities available for sale		—			(37	)
Net losses (gains) on sale of other real estate owned		39			(9	)
Increase in cash value of bank owned life insurance		(275	)		(212	)
Accretion of discounts and amortization of premiums on securities, net		629			448
Accretion of premium on time deposits		(122	)		(6	)
Accretion of certain acquisition-related loan discounts, net		(718	)		—
Stock-based compensation		541			119
Excess tax benefits on stock-based compensation		3			3
Losses (gains) on disposal of premises and equipment, net		2			(26	)
Deferred income tax benefit		73			337
Changes in assets and liabilities:
(Increase) decrease in interest receivable		(251	)		55
Decrease (increase) in other assets		4,054			(4,992	)
(Decrease) in accrued interest payable and other liabilities		(422	)		(1,950	)
Net cash provided by (used in ) operating activities	$	12,274		$	(585	)
Cash Flows from Investing Activities
Proceeds from maturities, calls, principal payments, and sales of securities available for sale	$	14,929		$	21,962
Proceeds from maturities, calls, and principal payments of securities held to maturity		5,271			3,288
Purchases of securities available for sale		(21,147	)		(106,060	)
Purchases of securities held to maturity		(49,033	)		—
Net (purchase) redemption of restricted securities		(95	)		244
Purchase of premises and equipment		(404	)		(205	)
Proceeds from sale of premises and equipment		—			32
Proceeds from sale of other real estate owned		84			139
Net (decrease) increase in loans		(54,161	)		11,416
Net cash used in investing activities	$	(104,556	)	$	(69,184	)

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,
	2022			2021
Cash Flows from Financing Activities
Net increase in demand deposits and savings accounts	$	59,231		$	76,309
Net decrease in time deposits		(11,711	)		(4,459	)
Repayment of subordinated debt		(5,000	)		—
Cash dividends paid on common stock, net of reinvestment		(1,646	)		(1,092	)
Repurchase of common stock, stock incentive plan		(183	)		(39	)
Net cash provided by financing activities	$	40,691		$	70,719
(Decrease) increase in cash and cash equivalents	$	(51,591	)	$	950
Cash and Cash Equivalents
Beginning	$	176,006		$	127,297
Ending	$	124,415		$	128,247
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest	$	1,184		$	1,168
Income taxes	$	1,040		$	1,205
Supplemental Disclosures of Noncash Investing and Financing Activities
Unrealized (losses) on securities available for sale	$	(30,386	)	$	(1,724	)
Change in fair value of cash flow hedges	$	1,272		$	457
Transfer from other real estate owned to premises and equipment	$	60		$	—
Transfer from loans to other real estate owned	$	—		$	130
Issuance of common stock, dividend reinvestment plan	$	104		$	77

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 Income			Total
Balance, March 31, 2021	$	6,086	$	6,214	$	71,144		$	2,482		$	85,926
Net income		—		—		3,342			—			3,342
Other comprehensive loss		—		—		—			(84	)		(84	)
Cash dividends on common stock ($0.12 per share)		—		—		(585	)		—			(585	)
Stock-based compensation		—		45		—			—			45
Issuance of 1,997 shares common stock, dividend reinvestment plan		2		36		—			—			38
Balance, June 30, 2021	$	6,088	$	6,295	$	73,901		$	2,398		$	88,682

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive (Loss)			Total
Balance, March 31, 2022	$	7,812	$	32,298	$	79,845		$	(13,392	)	$	106,563
Net income		—		—		3,835			—			3,835
Other comprehensive loss		—		—		—			(9,310	)		(9,310	)
Cash dividends on common stock ($0.14 per share)		—		—		(876	)		—			(876	)
Stock-based compensation		—		56		—			—			56
Issuance of 2,363 shares common stock, dividend reinvestment plan		3		44		—			—			47
Balance, June 30, 2022	$	7,815	$	32,398	$	82,804		$	(22,702	)	$	100,315

	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		—			—			5,778			—			5,778
Other comprehensive loss		—			—			—			(1,000	)		(1,000	)
Cash dividends on common stock ($0.24 per share)		—			—			(1,169	)		—			(1,169	)
Stock-based compensation		—			119			—			—			119
Issuance of 4,208 shares common stock, dividend reinvestment plan		5			72			—			—			77
Issuance of 8,073 shares common stock, stock incentive plan		10			(10	)		—			—			—
Repurchase of 2,221 shares common stock, stock incentive plan		(2	)		(37	)		—			—			(39	)
Balance, June 30, 2021	$	6,088		$	6,295		$	73,901		$	2,398		$	88,682

	Common Stock			Surplus			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance, December 31, 2021	$	7,785		$	31,966		$	76,990		$	298		$	117,039
Net income		—			—			7,564			—			7,564
Other comprehensive loss		—			—			—			(23,000	)		(23,000	)
Cash dividends on common stock ($0.28 per share)		—			—			(1,750	)		—			(1,750	)
Stock-based compensation		—			541			—			—			541
Issuance of 5,120 shares common stock, dividend reinvestment plan		6			98			—			—			104
Issuance of 27,134 shares common stock, stock incentive plan		34			(34	)		—			—			—
Repurchase of 8,283 shares common stock, stock incentive plan		(10	)		(173	)		—			—			(183	)
Balance, June 30, 2022	$	7,815		$	32,398		$	82,804		$	(22,702	)	$	100,315

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 and in accordance with guidance provided by the SEC. Accordingly, they do not include all of the information and footnotes required by GAAP for annual year-end financial statements. 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, 2022 and December 31, 2021, the statements of income and comprehensive (loss) income for the three and six months ended June 30, 2022 and 2021, the cash flows for the six months ended June 30, 2022 and 2021, and the changes in shareholders’ equity for the three and six months ended June 30, 2022 and 2021. 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, 2021. Operating results for the three and six months ended June 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022.

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), such as the Company, 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 process 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.

In March 2022, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2022-01, “Derivatives and Hedging (Topic 815), Fair Value Hedging—Portfolio Layer Method.” ASU 2022-01 clarifies the guidance in ASC 815 on fair value hedge accounting of interest rate risk for portfolios of financial assets and is intended to better align hedge accounting with an organization’s risk management strategies. In 2017, FASB issued ASU 2017-12 to better align the economic results of risk management activities with hedge accounting. One of the major provisions of that standard was the addition of the last-of-layer hedging method. For a closed portfolio of fixed-rate prepayable financial assets or one or more beneficial interests secured by a portfolio of prepayable financial instruments, such as mortgages or mortgage-backed securities, the last-of-layer method allows an entity to hedge its exposure to fair value changes due to changes in interest rates for a portion of the portfolio that is not expected to be affected by prepayments, defaults, and other events affecting the timing and amount of cash flows. ASU 2022-01 renames that method the portfolio layer method. For public business entities, ASU 2022-01 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years. The Company does not expect the adoption of ASU 2022-01 to have a material impact on its consolidated financial statements.

In March 2022, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2022-02, “Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures.” ASU 2022-02 addresses areas identified by the FASB as part of its post-implementation review of the credit losses standard (ASU 2016-13) that introduced the CECL model. The amendments eliminate the accounting guidance for troubled debt restructurings by creditors that have adopted the CECL model and enhance the disclosure requirements for loan refinancings and restructurings made with borrowers experiencing financial difficulty. In addition, the amendments require a public business entity to disclose current-period gross write-offs for financing receivables and net investment in leases by year of origination in the vintage disclosures. For entities that have adopted ASU 2016-13, ASU 2022-02 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. For entities that have not yet adopted ASU 2016-13, the effective dates for ASU 2022-02 are the same as the effective dates in ASU 2016-13. Early adoption is permitted if an entity has adopted ASU 2016-13. The Company is currently assessing the impact that ASU 2022-02 will have on its consolidated financial statements.

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Notes to Consolidated Financial Statements (Unaudited)

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 has identified 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 June 2022, the FASB issued ASU 2022-03, “Fair Value Measurement (Topic 820): Fair Value Measurement of Equity Securities Subject to Contractual Sale Restrictions.” ASU 2022-03 clarifies that a contractual restriction on the sale of an equity security is not considered part of the unit of account of the equity security and, therefore, is not considered in measuring fair value. The ASU is effective for fiscal years, including interim periods within those fiscal years, beginning after December 15, 2023. Early adoption is permitted. The Company does not expect the adoption of ASU 2022-03 to have a material impact on its consolidated financial statements.

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Notes to Consolidated Financial Statements (Unaudited)

Note 2. Securities

The Company invests in U.S. Treasury securities, 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, 2022 and December 31, 2021 were as follows (in thousands):

	June 30, 2022
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Securities available for sale:
U.S. Treasury securities	$	59,815	$	—	$	(3,559	)	$	56,256
U.S. agency and mortgage-backed securities		164,623		120		(16,929	)		147,814
Obligations of states and political subdivisions		69,258		27		(10,604	)		58,681
Corporate debt securities		2,003		—		(4	)		1,999
Total securities available for sale	$	295,699	$	147	$	(31,096	)	$	264,750
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	65,302	$	—	$	(5,400	)	$	59,902
Obligations of states and political subdivisions		8,849		2		(1,174	)		7,677
Corporate debt securities		3,000		—		(87	)		2,913
Total securities held to maturity	$	77,151	$	2	$	(6,661	)	$	70,492
Total securities	$	372,850	$	149	$	(37,757	)	$	335,242

	December 31, 2021
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized (Losses)			Fair Value
Securities available for sale:
U.S. Treasury securities	$	39,871	$	37	$	(250	)	$	39,658
U.S. agency and mortgage-backed securities		177,131		1,085		(1,837	)		176,379
Obligations of states and political subdivisions		71,037		910		(509	)		71,438
Corporate debt securities		2,019		1		—			2,020
Total securities available for sale	$	290,058	$	2,033	$	(2,596	)	$	289,495
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	26,392	$	124	$	(53	)	$	26,463
Obligations of states and political subdivisions		7,049		118		(13	)		7,154
Total securities held to maturity	$	33,441	$	242	$	(66	)	$	33,617
Total securities	$	323,499	$	2,275	$	(2,662	)	$	323,112

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Notes to Consolidated Financial Statements (Unaudited)

At June 30, 2022 and December 31, 2021, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):

	June 30, 2022
	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. Treasury securities	$	56,256	$	(3,559	)	$	—	$	—		$	56,256	$	(3,559	)
U.S. agency and mortgage-backed securities		114,629		(12,586	)		24,426		(4,343	)		139,055		(16,929	)
Obligations of states and political subdivisions		48,145		(8,873	)		6,296		(1,731	)		54,441		(10,604	)
Corporate debt securities		1,999		(4	)		—		—			1,999		(4	)
Total securities available for sale	$	221,029	$	(25,022	)	$	30,722	$	(6,074	)	$	251,751	$	(31,096	)
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	59,902	$	(5,400	)	$	—	$	—		$	59,902	$	(5,400	)
Obligations of states and political subdivisions		6,767		(1,174	)		—		—			6,767		(1,174	)
Corporate debt securities		2,913		(87	)		—		—			2,913		(87	)
Total securities held to maturity	$	69,582	$	(6,661	)	$	—	$	—		$	69,582	$	(6,661	)
Total securities	$	290,611	$	(31,683	)	$	30,722	$	(6,074	)	$	321,333	$	(37,757	)

	December 31, 2021
	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. Treasury securities	$	29,656	$	(250	)	$	—	$	—		$	29,656	$	(250	)
U.S. agency and mortgage-backed securities		109,950		(1,335	)		14,749		(502	)		124,699		(1,837	)
Obligations of states and political subdivisions		34,611		(500	)		1,009		(9	)		35,620		(509	)
Total securities available for sale	$	174,217	$	(2,085	)	$	15,758	$	(511	)	$	189,975	$	(2,596	)
Securities held to maturity:
U.S. agency and mortgage-backed securities	$	5,411	$	(53	)	$	—	$	—		$	5,411	$	(53	)
Obligations of states and political subdivisions		999		(13	)		—		—			999		(13	)
Total securities held to maturity	$	6,410	$	(66	)	$	—	$	—		$	6,410	$	(66	)
Total securities	$	180,627	$	(2,151	)	$	15,758	$	(511	)	$	196,385	$	(2,662	)

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, 2022, there were 11 out of 12 U.S. Treasury securities, 124 out of 145 U.S. agency and mortgage-backed securities, 102 out of 116 obligations of states and political subdivisions, and two out of two corporate debt securities 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 6.1 years at June 30, 2022. At December 31, 2021, there were six out of eight U.S. Treasury securities, 58 out of 135 U.S. agency and mortgage-backed securities and 37 out of 118 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, 2021. The weighted-average re-pricing term of the portfolio was 5.2 years at December 31, 2021. The unrealized losses at June 30, 2022 in the U.S. Treasury securities portfolio, U.S. agency and mortgage-backed securities portfolio, obligations of states and political subdivisions portfolio, and the corporate debt securities 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, 2022 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	$	2,003	$	1,999	$	607	$	610
Due after one year through five years		57,501		54,848		6,511		6,308
Due after five years through ten years		62,062		57,133		19,173		17,970
Due after ten years		174,133		150,770		50,860		45,604
	$	295,699	$	264,750	$	77,151	$	70,492

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, 2022, and no impairment has been recognized.

The composition of restricted securities at June 30, 2022 and December 31, 2021 was as follows (in thousands):

	June 30, 2022		December 31, 2021
Federal Home Loan Bank stock	$	796	$	701
Federal Reserve Bank stock		980		980
Community Bankers’ Bank stock		132		132
	$	1,908	$	1,813

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 $566 thousand and $504 thousand at June 30, 2022 and December 31, 2021, respectively.

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Notes to Consolidated Financial Statements (Unaudited)

Note 3. Loans

Loans at June 30, 2022 and December 31, 2021 are summarized as follows (in thousands):

	June 30, 2022			December 31, 2021
Real estate loans:
Construction and land development	$	49,118		$	55,721
Secured by 1-4 family residential		312,083			291,990
Other real estate loans		401,037			364,921
Commercial and industrial loans		109,548			99,805
Consumer and other loans		8,303			12,681
Total loans	$	880,089		$	825,118
Allowance for loan losses		(6,202	)		(5,710	)
Loans, net	$	873,887		$	819,408

Net deferred loan fees included in the above loan categories were $873 thousand and $871 thousand at June 30, 2022 and December 31, 2021, respectively. Consumer and other loans included $292 thousand and $175 thousand of demand deposit overdrafts at June 30, 2022 and December 31, 2021, 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.

Loans acquired in business combinations are recorded in the Consolidated Balance Sheets at fair value at the acquisition date under the acquisition method of accounting. The outstanding principal balance and the carrying amount at June 30, 2022 of loans acquired in business combinations were as follows:

	Acquired Loans-
	Purchased
(Dollars in thousands)	Performing
Outstanding principal balance	$	188,626

Carrying amount
Real estate loans:
Construction and land development	$	14,611
Secured by 1-4 family residential		47,340
Other real estate loans		93,864
Commercial and industrial loans		25,566
Consumer and other loans		4,296
Total acquired loans	$	185,677

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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, 2022 and December 31, 2021 (in thousands):

	June 30, 2022
	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	$	—	$	43	$	47	$	90	$	49,028	$	49,118	$	—	$	47
Secured by 1-4 family residential		272		185		68		525		311,558		312,083		420		19
Other real estate loans		9		—		—		9		401,028		401,037		22		—
Commercial and industrial		764		258		23		1,045		108,503		109,548		—		23
Consumer and other loans		6		35		3		44		8,259		8,303		—		3
Total	$	1,051	$	521	$	141	$	1,713	$	878,376	$	880,089	$	442	$	92

	December 31, 2021
	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	$	—	$	115	$	—	$	115	$	55,606	$	55,721	$	—	$	—
Secured by 1-4 family residential		1,293		100		372		1,765		290,225		291,990		766		—
Other real estate loans		186		—		—		186		364,735		364,921		29		—
Commercial and industrial		1,474		—		—		1,474		98,331		99,805		1,509		—
Consumer and other loans		56		11		—		67		12,614		12,681		—		—
Total	$	3,009	$	226	$	372	$	3,607	$	821,511	$	825,118	$	2,304	$	—

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, 2022 and December 31, 2021 (in thousands):

	June 30, 2022
	Pass		Special Mention		Substandard		Doubtful		Total
Real estate loans:
Construction and land development	$	49,118	$	—	$	—	$	—	$	49,118
Secured by 1-4 family residential		311,355		—		728		—		312,083
Other real estate loans		401,015		—		22		—		401,037
Commercial and industrial		109,548		—		—		—		109,548
Consumer and other loans		8,303		—		—		—		8,303
Total	$	879,339	$	—	$	750	$	—	$	880,089

	December 31, 2021
	Pass		Special Mention		Substandard		Doubtful		Total
Real estate loans:
Construction and land development	$	55,721	$	—	$	—	$	—	$	55,721
Secured by 1-4 family residential		290,909		—		1,081		—		291,990
Other real estate loans		364,892		—		29		—		364,921
Commercial and industrial		97,215		1,081		1,509		—		99,805
Consumer and other loans		12,681		—		—		—		12,681
Total	$	821,418	$	1,081	$	2,619	$	—	$	825,118

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Notes to Consolidated Financial Statements (Unaudited)

Note 4. Allowance for Loan Losses

The following tables present, as of and during the periods ended June 30, 2022, December 31, 2021 and June 30, 2021, the total allowance for loan losses, the allowance by impairment methodology, and loans by impairment methodology (in thousands):

	June 30, 2022
	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, 2021	$	345		$	1,077		$	3,230	$	718		$	340		$	5,710
Charge-offs		—			(5	)		—		(8	)		(200	)		(213	)
Recoveries		7			10			4		146			138			305
Provision for (recovery of) loan losses		(9	)		(40	)		334		20			95			400
Ending Balance, June 30, 2022	$	343		$	1,042		$	3,568	$	876		$	373		$	6,202
Ending Balance:
Individually evaluated for impairment		—			—			—		—			—			—
Collectively evaluated for impairment		343			1,042			3,568		876			373			6,202
Loans:
Ending Balance	$	49,118		$	312,083		$	401,037	$	109,548		$	8,303		$	880,089
Individually evaluated for impairment		—			420			22		—			—			442
Collectively evaluated for impairment		49,118			311,663			401,015		109,548			8,303			879,647

	December 31, 2021
	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, 2020	$	306	$	1,022		$	4,956		$	784		$	417		$	7,485
Charge-offs		—		(15	)		(992	)		(6	)		(434	)		(1,447	)
Recoveries		6		65			3			7			241			322
Provision for (recovery of) loan losses		33		5			(737	)		(67	)		116			(650	)
Ending Balance, December 31, 2021	$	345	$	1,077		$	3,230		$	718		$	340		$	5,710
Ending Balance:
Individually evaluated for impairment		—		—			—			55			—			55
Collectively evaluated for impairment		345		1,077			3,230			663			340			5,655
Loans:
Ending Balance	$	55,721	$	291,990		$	364,921		$	99,805		$	12,681		$	825,118
Individually evaluated for impairment		—		765			30			1,509			—			2,304
Collectively evaluated for impairment		55,721		291,225			364,891			98,296			12,681			822,814

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Notes to Consolidated Financial Statements (Unaudited)

	June 30, 2021
	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, 2020	$	306		$	1,022		$	4,956		$	784		$	417		$	7,485
Charge-offs		—			—			(992	)		—			(159	)		(1,151	)
Recoveries		—			4			1			4			122			131
Provision for (recovery of) loan losses		(32	)		(11	)		(893	)		(30	)		(34	)		(1,000	)
Ending Balance, June 30, 2021	$	274		$	1,015		$	3,072		$	758		$	346		$	5,465
Ending Balance:
Individually evaluated for impairment		—			—			—			78			—			78
Collectively evaluated for impairment		273			1,015			3,072			680			347			5,387
Loans:
Ending Balance	$	25,035		$	235,158		$	245,455		$	102,966		$	8,734		$	617,348
Individually evaluated for impairment		—			410			158			1,534			—			2,102
Collectively evaluated for impairment		25,035			234,748			245,297			101,432			8,734			615,246

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Notes to Consolidated Financial Statements (Unaudited)

Impaired loans and the related allowance as of and for the periods ended June 30, 2022, December 31, 2021 and June 30, 2021, were as follows (in thousands):

	June 30, 2022
	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:
Secured by 1-4 family residential	$	552	$	420	$	—	$	420	$	—	$	650	$	—
Other real estate loans		34		22		—		22		—		26		—
Commercial and industrial		—		—		—		—		—		1,241		—
Total	$	586	$	442	$	—	$	442	$	—	$	1,917	$	—

	December 31, 2021
	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	$	—	$	—	$	—	$	—	$	—	$	91	$	—
Secured by 1-4 family residential		889		766		—		766		—		429		9
Other real estate loans		40		29		—		29		—		2,384		—
Commercial and industrial		1,673		—		1,509		1,509		55		1,613		—
Total	$	2,602	$	795	$	1,509	$	2,304	$	55	$	4,517	$	9

	June 30, 2021
	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	$	—	$	—	$	—	$	—	$	—	$	273	$	—
Secured by 1-4 family residential		544		410		—		410		—		429		—
Other real estate loans		169		158		—		158		—		4,447		1
Commercial and industrial		1,653		—		1,534		1,534		78		1,548		—
Total	$	2,366	$	568	$	1,534	$	2,102	$	78	$	6,697	$	1

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, 2022, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $116 thousand. At June 30, 2022, none of the loans classified as TDRs were performing under the restructured terms and all were considered non-performing assets. There were $1.6 million in TDRs at December 31, 2021, $7 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 and six months ended June 30, 2022 and 2021.

For the three and six months ended June 30, 2022 and 2021, 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.

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 June 30, 2022, loans that were modified totaled $4.7 million. All modified loans were performing and were not considered TDRs because they were modified in accordance with relief provisions of the CARES Act.

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Note 5. 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, 2022 and 2021 (dollars in thousands, except per share data):

	Three Months Ended				Six Months Ended
	June 30, 2022		June 30, 2021		June 30, 2022		June 30, 2021
(Numerator):
Net income	$	3,835	$	3,342	$	7,564	$	5,778
(Denominator):
Weighted average shares outstanding – basic		6,250,329		4,868,901		6,244,682		4,866,376
Potentially dilutive common shares – restricted stock units		7,149		4,385		5,991		6,330
Weighted average shares outstanding – diluted		6,257,478		4,873,286		6,250,673		4,872,706
Income per common share
Basic	$	0.61	$	0.69	$	1.21	$	1.19
Diluted	$	0.61	$	0.69	$	1.21	$	1.19

There were no antidilutive shares of common stock for the three months and six months ended June 30, 2022 and 2021.

Note 6. Fair Value Measurements

Determination of Fair Value

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).

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).

Table of Contents

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, 2022 and December 31, 2021 (in thousands).

			Fair Value Measurements at June 30, 2022
Description	Balance as of June 30, 2022		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale
U.S. Treasury securities	$	56,256	$	—	$	56,256	$	—
U.S. agency and mortgage-backed securities		147,814		—		147,814		—
Obligations of states and political subdivisions		58,681		—		58,681		—
Corporate debt securities		1,999		—		1,999		—
Total securities available for sale	$	264,750	$	—	$	264,750	$	—
Derivatives - cash flow hedges		2,213		—		2,213		—
Total assets	$	266,963	$	—	$	266,963	$	—

			Fair Value Measurements at December 31, 2021
Description	Balance as of December 31, 2021		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Securities available for sale
U.S. Treasury securities	$	39,658	$	—	$	39,658	$	—
U.S. agency and mortgage-backed securities		176,379		—		176,379		—
Obligations of states and political subdivisions		71,438		—		71,438		—
Corporate debt securities		2,020		—		2,020		—
Total securities available for sale	$	289,495	$	—	$	289,495	$	—
Derivatives - cash flow hedges		941		—		941		—
Total assets	$	290,436	$	—	$	290,436	$	—

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:

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.

Other Real Estate Owned

Certain assets such as OREO are measured at fair value less cost to sell. Valuation of OREO is determined using current appraisals from independent parties, a Level 2 input. If current appraisals cannot be obtained prior to reporting dates, or if declines in value are identified after a recent appraisal is received, appraisal values are discounted, resulting in Level 3 estimates. If the Company markets the property with a realtor, estimated selling costs reduce the fair value, resulting in a valuation based on Level 3 inputs.

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Notes to Consolidated Financial Statements (Unaudited)

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, 2022
Description	Balance as of June 30, 2022		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Other real estate owned, net	$	1,665	$	—	$	—	$	1,665

			Fair Value Measurements at December 31, 2021
Description	Balance as of December 31, 2021		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Other real estate owned, net	$	1,848	$	—	$	—	$	1,848
Impaired loans, net		1,454		—		—		1,454

Quantitative information about Level 3 Fair Value Measurements for June 30, 2022

Fair Value

Valuation Technique

Unobservable Input

Range (Weighted Average) (1)

Other real estate owned, net

1,665

Property appraisals

Selling cost

10.00

Quantitative information about Level 3 Fair Value Measurements for December 31, 2021

Fair Value

Valuation Technique

Unobservable Input

Range (Weighted Average) (1)

Other real estate owned, net

1,848

Property appraisals

Selling cost

10.00

Impaired loans, net

1,454

Present value of cash flows

Discount rate

6.50

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

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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, 2022 and December 31, 2021 are as follows (in thousands):

			Fair Value Measurements at June 30, 2022 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 interest-bearing deposits in banks	$	124,415	$	124,415	$	—	$	—	$	124,415
Securities available for sale		264,750		—		264,750		—		264,750
Securities held to maturity		77,151		—		70,492		—		70,492
Restricted securities		1,908		—		1,908		—		1,908
Loans, net		873,887		—		—		871,253		871,253
Bank owned life insurance		24,569		—		24,569		—		24,569
Accrued interest receivable		4,154		—		4,154		—		4,154
Derivatives - cash flow hedges		2,213		—		2,213		—		2,213
Financial Liabilities
Deposits	$	1,296,150	$	—	$	1,162,417	$	129,645	$	1,292,062
Subordinated debt		4,994		—		—		5,483		5,483
Junior subordinated debt		9,279		—		—		7,547		7,547
Accrued interest payable		115		—		115		—		115

			Fair Value Measurements at December 31, 2021 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 interest-bearing deposits in banks	$	176,006	$	176,006	$	—	$	—	$	176,006
Securities available for sale		289,495		—		289,495		—		289,495
Securities held to maturity		33,441		—		33,617		—		33,617
Restricted securities		1,813		—		1,813		—		1,813
Loans held for sale		—		—		—		—		—
Loans, net		819,408		—		—		827,248		827,248
Bank owned life insurance		24,294		—		24,294		—		24,294
Accrued interest receivable		3,903		—		3,903		—		3,903
Derivatives - cash flow hedges		941		—		941		—		941
Financial Liabilities
Deposits	$	1,248,752	$	—	$	1,103,186	$	145,101	$	1,248,287
Subordinated debt		9,993		—		—		8,932		8,932
Junior subordinated debt		9,279		—		—		8,145		8,145
Accrued interest payable		152		—		152		—		152

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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 7. 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.

Compensation expense related to stock awards totaled $0 and $351 thousand for the three months and six months ended June 30, 2022, respectively. The Company did not have compensation expense related to stock awards for the three months and six months ended June 30, 2022 and 2021.

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.

During the first quarter of 2022, 10,110 restricted stock units were granted to employees, with 3,375 units vesting immediately, and 6,735 units subject to a two year vesting schedule with one half of the units vesting each year. 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, 2022
	Shares			Weighted Average Grant Date Fair Value
Unvested, beginning of year		30,781		$	19.79
Granted		10,110			22.19
Vested		(11,643	)		20.58
Forfeited		—			—
Unvested, end of period		29,248		$	20.31

At June 30, 2022, 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 $423 thousand. This expense is expected to be recognized through 2026. Compensation expense related to restricted stock unit awards recognized for the three and six months ended June 30, 2022 and 2021 totaled $56 thousand and $190 thousand, respectively. Compensation expense related to restricted stock unit awards recognized for the three and six months ended June 30, 2022 and 2021 totaled $45 thousand and $119 thousand, respectively.

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Notes to Consolidated Financial Statements (Unaudited)

Note 8. 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			Change in Fair Value of Cash Flow Hedges			Accumulated Other Comprehensive Income (Loss)
Balance at March 31, 2021	$	1,404		$	1,078		$	2,482
Unrealized holding gains (net of tax, $78)		292			—			292
Change in fair value of cash flow hedge (net of tax, ($100))		—			(376	)		(376	)
Change during period		292			(376	)		(84	)
Balance at June 30, 2021	$	1,696		$	702		$	2,398
Balance at March 31, 2022	$	(14,688	)	$	1,296		$	(13,392	)
Unrealized holding losses (net of tax, ($2,595))		(9,762	)		—			(9,762	)
Change in fair value of cash flow hedge (net of tax, $120)		—			452			452
Change during period		(9,762	)		452			(9,310	)
Balance at June 30, 2022	$	(24,450	)	$	1,748		$	(22,702	)

	Net Unrealized (Losses) on Securities			Change in Fair Value of Cash Flow Hedges		Accumulated Other Comprehensive Income (Loss)
Balance at December 31, 2020	$	3,058		$	340	$	3,398
Unrealized holding losses (net of tax, ($354))		(1,333	)		—		(1,333	)
Reclassification adjustment (net of tax, ($8))		(29	)		—		(29	)
Change in fair value of cash flow hedges (net of tax, $95)		—			362		362
Change during period		(1,362	)		362		(1,000	)
Balance at June 30, 2021	$	1,696		$	702	$	2,398
Balance at December 31, 2021	$	(445	)	$	743	$	298
Unrealized holding losses (net of tax, ($6,381))		(24,005	)		—		(24,005	)
Change in fair value of cash flow hedge (net of tax, $267)		—			1,005		1,005
Change during period		(24,005	)		1,005		(23,000	)
Balance at June 30, 2022	$	(24,450	)	$	1,748	$	(22,702	)

The following table presents information related to reclassifications from accumulated other comprehensive (loss) income for the three and six months ended June 30, 2022 and 2021 (in thousands):

Details About Accumulated Other Comprehensive Income (Loss)	Amount Reclassified from Accumulated Other Comprehensive Income (Loss)				Affected Line Item in the Consolidated Statements of Income
	Three Months Ended
	June 30, 2022		June 30, 2021
Securities available for sale:
Net securities gains reclassified into earnings	$	—	$	—	Net gains on securities available for sale
Related income tax expense		—		—	Income tax expense
Total reclassifications	$	—	$	—	Net of tax

Details About Accumulated Other Comprehensive (Loss) Income	Amount Reclassified from Accumulated Other Comprehensive (Loss) Income					Affected Line Item in the Consolidated Statements of Income
	Six Months Ended
	June 30, 2022		June 30, 2021
Securities available for sale:
Net securities gains reclassified into earnings	$	—	$	(37	)	Net gains on securities available for sale
Related income tax expense		—		8		Income tax expense
Total reclassifications	$	—	$	(29	)	Net of tax

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Notes to Consolidated Financial Statements (Unaudited)

Note 9. Revenue Recognition

Most revenue associated with financial instruments, including interest income, loan origination fees, and credit card fees, is outside the scope of ASC topic 606. 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.

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.

Brokered mortgage fees

Brokered mortgage fees are comprised of loan fee income earned from generating loans in the secondary market. Brokered mortgage fee income is recognized at loan closing.

Fees for other customer services

Fees for other customer services include fees for brokered loans, 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, 2022 and 2021 (in thousands):

	Three Months Ended				Six Months Ended
	June 30, 2022		June 30, 2021		June 30, 2022		June 30, 2021
Noninterest Income
Service charges on deposit accounts	$	698	$	447	$	1,307	$	889
ATM and check card fees		797		682		1,547		1,283
Wealth management fees		760		657		1,563		1,300
Brokered mortgage fees		58		157		152		262
Fees for other customer services		188		150		421		331
Noninterest income (in-scope of Topic 606)	$	2,501	$	2,093	$	4,990	$	4,065
Noninterest income (out-of-scope of Topic 606)		279		342		501		513
Total noninterest income	$	2,780	$	2,435	$	5,491	$	4,578

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Notes to Consolidated Financial Statements (Unaudited)

Note 10. Derivative Financial Instruments

On April 21, 2020, the Company entered into two interest rate swap agreements related to its outstanding junior subordinated debt. One swap agreement was related to the Company’s junior subordinated debt with a redemption date of June 17, 2034, which became effective on March 17, 2020. The notional amount of the interest rate swap was $5.0 million and terminates on June 17, 2034. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.79% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date. The other swap agreement was related to the Company’s junior subordinated debt with a redemption date of October 1, 2036, which became effective on April 1, 2020. The notional amount of the interest rate swap was $4.0 million and terminates on October 1, 2036. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.82% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date. The Company expects the junior subordinated debt instruments to transition from a LIBOR-indexed floating rate of interest to a SOFR-indexed floating rate by June 30, 2023.

The Company entered into interest rate swaps to reduce interest rate risk and to manage interest expense. By entering into these agreements, the Company converted variable rate debt into fixed rate debt. Alternatively, the Company may enter into interest rate swap agreements to convert fixed rate debt into variable rate debt. Interest differentials paid or received under interest rate swap agreements are reflected as adjustments to interest expense. The Company designated the interest rate swaps as hedging instruments in qualifying cash flow hedges. Changes in fair value of these designated hedging instruments is reported as a component of other comprehensive (loss) income. Interest rate swaps designated as cash flow hedges are expected to be highly effective in offsetting the effect of changes in interest rates on the amount of variable rate interest payments, and the Company assesses the effectiveness of each hedging relationship quarterly. If the Company determines that a cash flow hedge is no longer highly effective, future changes in the fair value of the hedging instrument would be reported as earnings. As of June 30, 2022, the Company has designated cash flow hedges to manage its exposure to variability in cash flows on certain variable rate borrowings for periods that end between June 2034 and October 2036. The notional amounts of the interest rate swaps were not exchanged and do not represent exposure to credit loss. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the agreements at current market rates.

All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.

Unrealized gains or losses recorded in other comprehensive (loss) income related to cash flow hedges are reclassified into earnings in the same period(s) during which the hedged interest payments affect earnings. When a designated hedging instrument is terminated and the hedged interest payments remain probable of occurring, any remaining unrecognized gain or loss in other comprehensive (loss) income is reclassified into earnings in the period(s) during which the forecasted interest payments affect earnings. Amounts reclassified into earnings and interest receivable or payable under designated interest rate swaps are reported in interest expense. The Company does not expect any unrealized losses related to cash flow hedges to be reclassified into earnings in the next twelve months.

The following table summarizes key elements of the Company's derivative instruments at June 30, 2022 and December 31, 2021 (in thousands):

	June 30, 2022
	Notional Amount		Assets		Liabilities		Collateral Pledged(1)
Cash Flow Hedges
Interest rate swap contracts	$	9,000	$	2,213	$	—	$	—

	December 31, 2021
	Notional Amount		Assets		Liabilities		Collateral Pledged(1)
Cash Flow Hedges
Interest rate swap contracts	$	9,000	$	941	$	—	$	—

(1)	Collateral pledged may be comprised of cash or securities.

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

Cautionary Statement Regarding Forward-Looking Statements

First National Corporation (the Company) makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include, but are not limited to, statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and the impact of the Company’s acquisitions of The Bank of Fincastle (Fincastle) and the SmartBank loan portfolio, including the expected benefits of the acquisition of Fincastle (Merger) and the potential impact of the acquisitions on the Company’s and First Bank’s (the Bank) 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:

•

the effects of the COVID-19 pandemic, including its potential adverse effect on economic conditions and the Company's employees, customers, credit quality, and financial performance;

•

general business conditions, as well as conditions within the financial markets;

•

general economic conditions, including unemployment levels, inflation and slowdowns in economic growth;

•

the Company’s branch and market expansions, technology initiatives and other strategic initiatives;

•

the impact of competition from banks and non-banks, including financial technology companies (Fintech);

•

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;

•

limited availability of financing or inability to raise capital;

•

reliance on third parties for key services;

•

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

	•	the quality of the loan portfolio and the value of the collateral securing those loans;
	•	demand for loan products;
	•	deposit flows;

•

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, including the effects of changes in tax laws;

•

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

•

cyber threats, attacks or events;

•

the ability to maintain adequate liquidity by retaining deposit customers and secondary funding sources, especially if the Company’s reputation would become damaged;

•

monetary and fiscal policies of the U.S. Government, including policies of the U.S. Department of the Treasury and the Federal Reserve Board, and the effect of those policies on interest rates and business in the Company's markets;

	•	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;
	•	geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad; and

•

other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2021.

Because of these and other uncertainties, actual 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, 2022 and statements of income of the Company for the three andsix months ended June 30, 2022 and 2021 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, 2021. The statements of income for the three andsix months ended June 30, 2022 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.

	•	Bank of Fincastle Services, Inc.
	•	ESF, LLC
	•	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. Bank of Fincastle Services, Inc. owns an entity that provides mortgage services. Shen-Valley Land Holdings, LLC and ESF, LLC were 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, the Roanoke Valley, central regions of Virginia, and the city of Richmond. Within these markets, there are diverse types of industry including medical and professional services, manufacturing, retail, warehousing, Federal and local government, hospitality, and higher education. The Bank’s products and services are delivered through 20 bank branch offices, a loan production office and customer service centers in two retirement villages. For the location and general character of each of these offices, see Item 2 of the Company's Form 10-K for the year ended December 31, 2021. 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 58% of noninterest expenses for the six months ended June 30, 2022, followed by occupancy and equipment expense, which comprised 13% of noninterest expenses. The provision for loan losses is also typically 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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Overview of Quarterly Financial Performance

The following items had the most significant impact on financial performance, when comparing the second quarter of 2022 to the same period in 2021.

●

The acquisition of The Bank of Fincastle (Fincastle) had a significant impact on balance sheet growth. On July 1, 2021, the acquisition date, Fincastle had total assets of $267.9 million, interest-bearing deposits in banks of $43.5 million, total securities of $12.0 million, loans, net of the allowance for loan losses, of $191.5 million, and total deposits of $236.3 million.

●

The acquisition of the SmartBank loan portfolio from its Richmond-area branch impacted the composition of the Bank’s earning assets. On September 30, 2021, the acquisition date, the loan portfolio totaled $82.6 million. The Bank funded the acquisition of the loan portfolio with cash, which decreased interest-bearing deposits in banks in the third quarter of 2021.

●

The provision for loan losses totaled $400 thousand for the second quarter of 2022, which was a $1.4 million increase compared to the recovery of loan losses of $1.0 million in the second quarter of 2021.

●

Total loans increased $43.7 million, during the three-month period ending June 30, 2022.

●

Accretion of PPP income, net of costs decreased to $35 thousand for the second quarter of 2022, compared to $509 thousand for the same period in the prior year.

●

Accretion of purchased loan discounts, net of premium amortization, totaled $351 thousand for the second quarter of 2022, compared to no purchased loan accretion for the same period in the prior year

Net income increased by $493 thousand, or 15%, to $3.8 million, or $0.61 per diluted share, for the three months ended June 30, 2022, compared to $3.3 million, or $0.69 per diluted share, for the same period in 2021. Return on average assets was 1.08% and return on average equity was 15.04% for the second quarter of 2022, compared to 1.31% and 15.33%, respectively, for the same period in 2021.

The increase in net income resulted primarily from a $3.8 million, or 51%, increase in net interest income and a $345 thousand, or 14%, increase in total noninterest income, which were partially offset by a $2.3 million, or 35%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled $400 thousand for the second quarter of 2022, compared to a recovery of loan losses of $1.0 million for the same period of 2021.

The $3.8 million, or 51%, increase in net interest income resulted from an increase in total interest income and no change in total interest expense. Net interest income increased as the net interest margin expanded by 32 basis points and average earning assets increased by 37%. The margin expansion resulted from an increase in earning asset yields, a change in the earning asset composition, and a decrease in the cost of funds. Earning asset yields increased by 25 basis points from a higher interest rate environment during the second quarter of 2022, while the cost of funds decreased by 7 basis points, primarily from lower interest rates paid on deposits and subordinated debt. The change in the earning asset composition favorably impacted the net interest margin as average total securities increased and average interest-bearing deposits in banks decreased. The growth in earning assets resulted from both the acquisition of Fincastle and from deposit growth.

The provision for loan losses totaled $400 thousand for the second quarter of 2022 in contrast to the second quarter of 2021 when the Bank recorded a $1.0 million recovery of loan losses. The allowance for loan losses totaled $6.2 million, or 0.70% of total loans on June 30, 2022, 0.69% of total loans on December 31, 2021, and 0.89% of total loans on June 30, 2021.

The $345 thousand, or 14%, year-over-year quarterly increase in noninterest income was primarily a result of a $251 thousand increase in service charges on deposits, followed by increases in ATM and check card fees, wealth management fees, and an increase in fees for other customer services. The merger with Fincastle contributed to all increased income categories, except for wealth management fees. The increases were partially offset by decreases in brokered mortgage fees and other operating income.

Noninterest expense increased $2.3 million, or 35%, and was primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the SmartBank loan portfolio. Salaries and employee benefits increased by $1.4 million, followed by increases in occupancy, equipment, and other operating expense.

For a more detailed discussion of the Company's quarterly performance, see "Net Interest Income,” “Provision for Loan Losses,” "Noninterest Income," "Noninterest Expense" and "Income Taxes" below.

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Acquisition of The Bank of Fincastle

On July 1, 2021, the Company completed the acquisition of The Bank of Fincastle for an aggregate purchase price of $33.8 million of cash and stock. The Company paid cash consideration of $6.8 million and issued 1,348,065 shares of its common stock to the shareholders of Fincastle. Upon completion of the transaction, Fincastle was merged with and into First Bank. At the time of closing of the acquisition, The Bank of Fincastle had six bank branch offices operating in the Roanoke Valley region of Virginia and reported total assets of $267.9 million, total loans of $194.5 million and total deposits of $236.3 million. After the merger, the former Fincastle branches continued to operate as The Bank of Fincastle, a division of First Bank, until the systems were converted on October 16, 2021. All branch offices have been operating as First Bank since the system conversion. For the three and six months ended June 30, 2022, the Company recorded merger related expenses of $20 thousand in connection with the acquisition of Fincastle.

Purchased performing loans were recorded at fair value, including a credit discount. The fair value discount will be accreted as an adjustment to yield over the estimated lives of the loans. A provision for loan losses on the purchased loans is expected in future periods as the accretion decreases the fair value discount amount. A provision may also be required for any deterioration in these loans in future periods.

The Company expected to benefit from cost savings after the acquisition of Fincastle. As of June 30, 2022, the Company had substantially achieved all expected cost savings related to the merger of Fincastle with and into First Bank.

Acquisition of SmartBank Loan Portfolio

On September 30, 2021, the Bank acquired $82.6 million of loans and certain fixed assets from SmartBank related to its Richmond area branch, located in Glen Allen, Virginia. First Bank paid cash consideration of $83.7 million for the loans and fixed assets. Additionally, an experienced team of bankers based out of the SmartBank location have transitioned to become employees of First Bank. First Bank did not assume any deposit liabilities from SmartBank in connection with the transaction, and SmartBank closed their branch operation on December 31, 2021. First Bank assumed the facility lease and acquired the remaining assets at the branch on December 31, 2021 and now operates a loan production office in the location of the former SmartBank branch. The Company incurred expenses totaling $101 thousand related to the acquisition of loans and fixed assets of SmartBank in the fourth quarter of 2021. There were no additional expenses related to the acquisition for the three and six months ended June 30, 2022.

Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding amortization of intangibles, net gains on disposal of premises and equipment, and merger related expenses, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding securities gains. 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, 2022			June 30, 2021			June 30, 2022			June 30, 2021
Noninterest expense	$	8,918		$	6,630		$	17,562		$	13,280
Add/(Subtract): other real estate owned (expense), net		(41	)		—			(69	)		—
Subtract: amortization of intangibles		(5	)		(5	)		(9	)		(19	)
Add: gains on disposal of premises and equipment, net		—			14			—			26
Subtract: loss on disposal of premises and equipment, net		—			—			(2	)		—
Subtract: merger related expenses		—			(277	)		(20	)		(682	)
	$	8,872		$	6,362		$	17,462		$	12,605
Tax-equivalent net interest income	$	11,372		$	7,560		$	22,008		$	15,128
Noninterest income		2,780			2,435			5,491			4,578
Subtract: securities gains, net		—			—			—			(37	)
	$	14,152		$	9,995		$	27,499		$	19,669
Efficiency ratio		62.69	%		63.65	%		63.50	%		64.09	%

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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 2022 and 2021 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, 2022			June 30, 2021			June 30, 2022			June 30, 2021
GAAP measures:
Interest income – loans	$	9,963		$	7,074		$	19,459		$	14,217
Interest income – investments and other		1,876			971			3,404			1,923
Interest expense – deposits		(413	)		(328	)		(753	)		(691	)
Interest expense – subordinated debt		(69	)		(154	)		(138	)		(308	)
Interest expense – junior subordinated debt		(67	)		(68	)		(134	)		(134	)
Total net interest income	$	11,290		$	7,495		$	21,838		$	15,007
Non-GAAP measures:
Tax benefit realized on non-taxable interest income – loans	$	-		$	8		$	7		$	16
Tax benefit realized on non-taxable interest income – municipal securities		82			57			163			105
Total tax benefit realized on non-taxable interest income	$	82		$	65		$	170		$	121
Total tax-equivalent net interest income	$	11,372		$	7,560		$	22,008		$	15,128

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.

•

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. These loans are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Other loans included in this category include loans to states and political subdivisions.

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.

Loans acquired from Fincastle and SmartBank were recorded at fair value. There was $254 thousand of allowance for loan losses attributable to purchased loans at June 30, 2022.

Loans Acquired in a Business Combination

Acquired loans are classified as either (i) purchased credit-impaired (PCI) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition.

PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Corporation will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows. There were no acquired loans classified as PCI in the acquisition of the Fincastle and the SmartBank loan portfolios.

Goodwill and Other Intangible Assets

Goodwill arises from business combinations and is determined as the excess fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. The Company has selected June 30 as the date to perform the annual impairment test. Intangible assets with finite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the balance sheet.

Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions and are amortized on an accelerated method over their estimated useful lives, which range from 6 to 10 years.

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Lending Policies

There have been no material changes in the Company’s lending policies disclosed in the Annual Report on Form 10-K for the year ended December 31, 2021.

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.

Net Income

Three Month Period Ended June 30, 2022

Six Month Period Ended June 30, 2022

Net income increased by $1.8 million, or 31%, to $7.6 million, or $1.21 per diluted share, for the six months ended June 30, 2022, compared to $5.8 million, or $1.19 per diluted share, for the same period in 2021. Return on average assets was 1.07% and return on average equity was 14.16% for the six months ended June 30, 2022, compared to 1.15% and 13.44%, respectively, for the same period in 2021.

The increase in net income resulted primarily from a $6.8 million, or 46%, increase in net interest income and a $913 thousand, or 20%, increase in total noninterest income, which were partially offset by a $4.3 million, or 32%, increase in total noninterest expense and an increase in the provision for loan losses. The provision for loan losses totaled $400 thousand for the six months ended June 30, 2022, compared to a recovery of loan losses of $1.0 million for the same period of 2021.

Net Interest Income

Three Month Period Ended June 30, 2022

Net interest income increased $3.8 million, or 51%, comparing the second quarter of 2022 to the same period of 2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, and a change in the Company’s earning asset composition. During the second quarter of 2022, the high-end of the Federal funds target increased from 0.50% to 1.75%, compared to a Federal funds rate that remained at 0.25% throughout the second quarter of 2021. The higher rate environment resulted in a 14-basis point increase in the yield on loans and a 72-basis point increase in the yield on interest-bearing deposits in other banks, while the total cost of interest-bearing deposits decreased two basis points. The cost of subordinated debt decreased by 64-basis points from the redemption of $5.0 million of higher rate subordinated debt on January 1, 2022. Although the Federal funds rate increased by 150 basis points, the Company’s total cost of funds decreased seven basis points, when comparing the periods. Average earning assets increased $358.0 million, or 37%, as a result of the acquisition of Fincastle in the third quarter of 2021 and growth of the Bank’s deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to the increase in total interest and dividend income as total average securities increased from 20% to 27% of average earning assets, while average interest-bearing deposits in other banks decreased from 16% to 9%. Average loans were unchanged at 64% of average earning assets when comparing the same periods.

The $3.8 million increase in net interest income resulted from a $3.8 million, or 47%, increase in total interest and dividend income, while total interest expense was unchanged. The increase in total interest and dividend income was attributable to a $2.9 million increase in interest income and fees on loans, a $214 thousand increase in interest on deposits in banks, and a $691 thousand increase in interest income and dividends on securities. There was no change in total interest expense as an increase in interest expense on deposits was offset by a decrease in interest expense on subordinated debt. The net interest margin increased to 3.42%, a 32-basis point increase from 3.10% in the same period one year ago.

Accretion of PPP income, net of costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loans. Net accretion of PPP income totaled $35 thousand in the second quarter of 2022, compared to $509 thousand for the same period of 2021. Net accretion of discounts on purchased loans totaled $351 thousand in the second quarter of 2022. There were no purchased loans in the second quarter of 2021, and as a result, there was no net accretion of discounts on purchased loans during the period.

Six Month Period Ended June 30, 2022

Net interest income increased $6.8 million, or 46%, comparing the six months ended June 30, 2022, to the same period of 2021, and was positively impacted by a higher interest rate environment, a significant increase in average earning assets, and a change in the Company’s earning asset composition. During the six months ended June 30, 2022, the high-end of the Federal funds target increased from 0.25% to 1.75%, compared to a Federal funds rate that remained at 0.25% throughout the same period of 2021. The higher rate environment resulted in a 11-basis point increase in the yield on loans and a 34-basis point increase in the yield on interest-bearing deposits in other banks, while the cost of interest-bearing deposits decreased six basis points. The cost of subordinated debt decreased by 133-basis points from the redemption of $5.0 million of higher rate subordinated debt on January 1, 2022. Although the Federal funds rate increased by 150 basis points, the Company’s total cost of funds decreased nine basis points, when comparing the periods. Average earning assets increased $353.8 million, or 37%, as a result of the acquisition of Fincastle in the third quarter of 2021 and growth of the Bank’s deposit portfolio over the last twelve months. Additionally, the composition of earning assets contributed to the increase in total interest and dividend income as total average securities increased from 18% to 24% of average earning assets, while average interest-bearing deposits in other banks decreased from 16% to 12% and average loans decreased from 66% to 64%.

The $6.8 million increase in net interest income resulted from a $6.7 million, or 42%, increase in total interest and dividend income, while total interest expense decreased by $108 thousand. The increase in total interest and dividend income was attributable to a $5.2 million increase in interest income and fees on loans, a $251 thousand increase in interest on deposits in banks, and a $1.2 million increase in interest income and dividends on securities. The decrease in total interest expense resulted from a $170 thousand decrease in interest expense on subordinated debt, which was partially offset by a $62 thousand increase in interest expense on deposits. The net interest margin increased to 3.39%, a 30-basis point increase from 3.19% in the same period one year ago.

Accretion of PPP income, net of costs, and accretion of discounts on purchased loans, net of premiums, were included in interest and fees on loans. Net accretion of PPP income totaled $358 thousand for the six months ended June 30, 2022, compared to $1.1 million for the same period of 2021. Net accretion of discounts on purchased loans totaled $718 thousand for the six months ended June 30, 2022. There were no purchased loans in the six months ended June 30, 2021, and as a result, there was no net accretion of discounts on purchased loans during the period.

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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, 2022								June 30, 2021
	Average Balance			Interest Income/Expense		Yield/Rate			Average Balance			Interest Income/Expense		Yield/Rate
Assets
Securities:
Taxable	$	296,318		$	1,295		1.75	%	$	147,285		$	697		1.90	%
Tax-exempt ⁽¹⁾		55,908			391		2.81	%		42,712			271		2.54	%
Restricted		1,908			21		4.48	%		1,631			22		5.37	%
Total securities	$	354,134		$	1,707		1.93	%	$	191,628		$	990		2.07	%
Loans: ⁽²⁾
Taxable	$	858,045		$	9,963		4.66	%	$	625,587		$	7,044		4.52	%
Tax-exempt ⁽¹⁾		—			—		—			3,400			38		4.49	%
Total loans	$	858,045		$	9,963		4.66	%	$	628,987		$	7,082		4.52	%
Federal funds sold		—			—		—			—			—		—
Interest-bearing deposits with other institutions		122,797			251		0.82	%		156,317			38		0.10	%
Total earning assets	$	1,334,976		$	11,921		3.58	%	$	976,932		$	8,110		3.33	%
Less: allowance for loan losses		(5,845	)							(7,466	)
Total non-earning assets		90,747								57,117
Total assets	$	1,419,878							$	1,026,583
Liabilities and Shareholders’ Equity
Interest bearing deposits:
Checking	$	300,473		$	157		0.21	%	$	233,720		$	100		0.17	%
Regular savings		209,513			26		0.05	%		134,266			20		0.06	%
Money market accounts		220,182			75		0.14	%		160,462			45		0.11	%
Time deposits:
$100,000 and over		62,346			80		0.51	%		40,212			83		0.83	%
Under $100,000		75,025			75		0.40	%		55,485			80		0.57	%
Brokered		553			—		0.12	%		578			—		0.20	%
Total interest-bearing deposits	$	868,092		$	413		0.19	%	$	624,723		$	328		0.21	%
Federal funds purchased		2			—		—	%		—			—		0.00	%
Subordinated debt		4,994			69		5.56	%		9,992			155		6.20	%
Junior subordinated debt		9,279			67		2.91	%		9,279			67		2.91	%
Total interest-bearing liabilities	$	882,367		$	549		0.25	%	$	643,994		$	550		0.34	%
Non-interest bearing liabilities
Demand deposits		431,995								292,960
Other liabilities		3,247								2,187
Total liabilities	$	1,317,609							$	939,141
Shareholders’ equity		102,269								87,442
Total liabilities and Shareholders’ equity	$	1,419,878							$	1,026,583
Net interest income				$	11,372							$	7,560
Interest rate spread							3.33	%							2.99	%
Cost of funds							0.17	%							0.24	%
Interest expense as a percent of average earning assets							0.16	%							0.23	%
Net interest margin							3.42	%							3.10	%

(1)	Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $82 and $65 thousand for the three months ended June 30, 2022 and 2021, respectively.

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

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	Six Months Ended
	June 30, 2022								June 30, 2021
	Average Balance			Interest Income/Expense		Yield/Rate			Average Balance			Interest Income/Expense		Yield/Rate
Assets
Securities:
Taxable	$	257,529		$	2,427		1.90	%	$	135,305		$	1,413		2.11	%
Tax-exempt ⁽¹⁾		58,647			777		2.67	%		38,856			499		2.59	%
Restricted		1,867			42		4.60	%		1,738			44		5.12	%
Total securities	$	318,043		$	3,246		2.06	%	$	175,899		$	1,956		2.24	%
Loans: ⁽²⁾
Taxable	$	841,608		$	19,439		4.66	%	$	628,012		$	14,157		4.55	%
Tax-exempt ⁽¹⁾		1,106			27		4.49	%		3,412			76		4.49	%
Total loans	$	842,714		$	19,466		4.66	%	$	631,424		$	14,233		4.55	%
Federal funds sold		—			—		—			67			—		0.10	%
Interest-bearing deposits with other institutions		150,222			321		0.43	%		149,786			70		0.09	%
Total earning assets	$	1,310,979		$	23,033		3.54	%	$	957,176		$	16,259		3.43	%
Less: allowance for loan losses		(5,806	)							(7,475	)
Total non-earning assets		120,409								59,929
Total assets	$	1,425,582							$	1,009,630
Liabilities and Shareholders’ Equity
Interest bearing deposits:
Checking	$	295,005		$	256		0.17	%	$	230,723		$	217		0.19	%
Regular savings		208,163			51		0.05	%		130,262			39		0.06	%
Money market accounts		233,496			126		0.11	%		157,902			88		0.11	%
Time deposits:
$100,000 and over		63,429			163		0.52	%		41,392			182		0.88	%
Under $100,000		76,566			154		0.40	%		55,667			164		0.60	%
Brokered		558			3		1.03	%		586			1		0.43	%
Total interest-bearing deposits	$	877,217		$	753		0.17	%	$	616,532		$	691		0.23	%
Federal funds purchased		2			—		—			1			—		0.47	%
Subordinated debt		5,708			138		4.89	%		9,992			308		6.22	%
Junior subordinated debt		9,279			134		2.91	%		9,279			134		2.91	%
Other borrowings		—			—		—	%		—			—		0.00	%
Total interest-bearing liabilities	$	892,206		$	1,025		0.23	%	$	635,804		$	1,133		0.36	%
Non-interest bearing liabilities
Demand deposits		421,785								284,542
Other liabilities		3,904								2,617
Total liabilities	$	1,317,895							$	922,963
Shareholders’ equity		107,686								86,667
Total liabilities and Shareholders’ equity	$	1,425,581							$	1,009,630
Net interest income				$	22,008							$	15,126
Interest rate spread							3.31	%							3.07	%
Cost of funds							0.16	%							0.25	%
Interest expense as a percent of average earning assets							0.16	%							0.24	%
Net interest margin							3.39	%							3.19	%

(1)	Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 21%. The tax-equivalent adjustment was $170 and $121 thousand for the six months ended June 30, 2022 and 2021, respectively.

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

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Provision for Loan Losses

Three Month Period Ended June 30, 2022

The provision for loan losses totaled $400 thousand for the second quarter of 2022, compared to a $1.0 million recovery of loan losses for the same period of 2021. The provision for loan losses resulted primarily from an increase in the general reserve component of the allowance for loan losses, which was attributable to loan growth during the quarter. There were no specific reserves on impaired loans at June 30, 2022, compared to $78 thousand of specific reserves at June 30, 2021. Net charge-offs totaled $26 thousand during the second quarter of 2022, compared to $1.0 million of net charge-offs for the same period of 2021.

The $1.0 million recovery of loan losses for the second quarter of 2021 resulted from the resolution of a previously impaired loan and a related decrease of the specific reserve component of the allowance for loan losses during the period.

The allowance for loan losses totaled $6.2 million, or 0.70% of total loans at June 30, 2022, compared to $5.5 million, or 0.89% of total loans at June 30, 2021. The net discount on purchased loans totaled $2.9 million, or 0.33% of total loans at June 30, 2022. There were no discounts on purchased loans at June 30, 2021.

Six Month Period Ended June 30, 2022

The provision for loan losses also totaled $400 thousand for the six months ended June 30, 2022, compared to a $1.0 million recovery of loan losses for the same period of 2021. Like the second quarter ended June 30, 2022, the provision for loan losses for the six-month period resulted primarily from an increase in the general reserve component of the allowance for loan losses and was attributable to loan growth. There were net recoveries of previously charged-off loans totaling $92 thousand for the first six months of 2022, compared to $1.0 of net charge-offs for the same period of 2021.

Noninterest Income

Three Month Period Ended June 30, 2022

Noninterest income increased $345 thousand, or 14%, to $2.8 million for the second quarter of 2022, compared to the same period of 2021. Service charges on deposits increased $251 thousand, or 56%, ATM and check card fees increased $115 thousand, or 17%, fees for other customer services increased $38 thousand, or 25%, and wealth management fees increased $103 thousand, or 16%. The increases were partially offset by a $99 thousand, or 63%, decrease in brokered mortgage fees, and a $77 thousand, or 34%, decrease in other operating income.

The increases in service charges on deposits, ATM and check card fees, and fees for other customer services were favorably impacted by an increase in customer transactions and additional deposit accounts that resulted from the acquisition of Fincastle. The increase in wealth management income was attributable to an increase in the number of client accounts. Brokered mortgage fees and net gains on sale of loans held for sale decreased from a reduction in the number of mortgage loans originated, as well as an increase in the number of mortgage loans retained in the Bank’s loan portfolio and not sold or brokered when comparing the periods. The decrease in other operating income was a result of income earned from an investment in a small business investment company partnership in the second quarter of 2021.

Six Month Period Ended June 30, 2022

Noninterest income increased $913 thousand, or 20%, to $5.5 million for the six months ended June 30, 2022, compared to the same period of 2021. Service charges on deposits increased $418 thousand, or 47%, ATM and check card fees increased $264 thousand, or 21%, fees for other customer services increased $90 thousand, or 27%, and wealth management fees increased $263 thousand, or 20%. The increases were partially offset by a $110 thousand, or 42%, decrease in brokered mortgage fees and a $25 thousand decrease in gains on sale of loans held for sale.

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Noninterest Expense

Three Month Period Ended June 30, 2022

Noninterest expense increased $2.3 million, or 35%, to $8.9 million for the three-month period ended June 30, 2022, compared to the same period one year ago. The increase was primarily attributable to a $1.4 million, or 38% increase in salaries and employee benefits, a $146 thousand, or 37%, increase in occupancy expense, a $187 thousand, or 43%, increase in equipment expense, an $85 thousand, or 62%, increase in marketing, a $79 thousand, or 30%, increase in ATM and check card expense, and a $280 thousand, or 42%, increase in other operating expense. These increases were partially offset by a $102 thousand decrease in legal and professional fees.

The increases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the loan portfolio, branch assets and the addition of employees from the SmartBank office. The increase in marketing was also related to the timing of campaigns and promotion activities. The decrease in legal and professional fees was primarily attributable to merger related costs in the second quarter of 2021. Although there were no merger expenses in the second quarter of 2022, merger expenses totaled $277 thousand in the second quarter of 2021.

Six Month Period Ended June 30, 2022

Noninterest expense increased $4.3 million, or 32%, to $17.6 million for the six-month period ended June 30, 2022, compared to the same period one year ago. The increase was primarily attributable to a $3.0 million, or 41% increase in salaries and employee benefits, a $315 thousand, or 36%, increase in equipment expense, a $271 thousand, or 32%, increase in occupancy expense, a $151 thousand, or 30%, increase in ATM and check card expense, a $137 thousand, or 93%, increase in FDIC assessment, a $130 thousand, or 53%, increase in marketing, a $114 thousand, or 34%, increase in bank franchise tax, and a $510 thousand, or 40%, increase in other operating expense. These increases were partially offset by a $506 thousand, or 41%, decrease in legal and professional fees.

The increases were primarily attributable to the increase in the number of employees, branch offices and customers that resulted from the acquisition of Fincastle and the acquisition of the loan portfolio, branch assets and the addition of employees from the SmartBank office. The increase in marketing was also related to the timing of campaigns and promotion activities. The decrease in legal and professional fees was primarily attributable to merger related costs during the first six months of 2021. Merger expenses totaled $20 thousand for the first six months of 2022 compared to $682 thousand for the same period of 2021.

Income Taxes

Three Month Period Ended June 30, 2022

Income tax expense decreased $41 thousand for the second quarter of 2022, compared to the same period one year ago. The effective tax rate for the second quarter of 2022 was 19.3% compared to 22.3% for the same period in 2021. The reduced effective tax rate for 2022 was the result of lower non-deductible expenses in 2022 compared to 2021. 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 months ended June 30, 2022, and 2021. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income, 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, 2021.

Six Month Period Ended June 30, 2022

Income tax expense increased $276 thousand, or 18%, for the first six months of 2022 compared with the same period in 2021. The effective tax rate for the first six months of 2022 was 19.2% compared with 20.9% for the same period in 2021. Like the three month period ended June 30, 2022, the reduced effective tax rate for 2022 was also the result of lower non-deductible expenses in 2022 compared to 2021.

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Financial Condition

General

Total assets increased $25.3 million to $1.4 billion at June 30, 2022, compared to December 31, 2021. The increase was primarily attributable to an $54.5 million, or 7.0%, increase in loans, net of allowance for loan losses, and a $43.7 million, or 130.7%, increase in securities held to maturity. These increases were partially offset by a decrease in interest-bearing deposits in banks of $52.8 million, or 33.5%, and a decrease in securities available for sale of $24.7 million, or 8.5%, during the first quarter of 2022.

At June 30, 2022, total liabilities increased $42.0 million to $1.3 billion compared to December 31, 2021. The increase was primarily attributable to an increase in savings and interest-bearing demand deposits of $41.1 million and in increase in noninterest-bearing deposits of $18.1 million. These increases were partially offset by a decrease in time deposits of $11.8 million during the first six months of 2022 and the Company's repayment of $5.0 million of subordinated debt on January 1, 2022.

Total shareholders’ equity decreased $16.7 million to $100.3 million at June 30, 2022, compared to $117.0 million at December 31, 2021. This was primarily attributable to a $23.0 million decrease in accumulated other comprehensive (loss) income (AOCI). The decrease in AOCI is related to unrealized losses in the securities portfolio stemming from market rate increases during the first quarter. This decrease was partially offset by a $5.8 million increase in retained earnings. The Company's capital ratios continued to exceed the minimum capital requirements for regulatory purposes.

Loans

Loans, net of the allowance for loan losses, increased $54.5 million to $873.9 million at June 30, 2022, compared to $819.4 million at December 31, 2021. This change was primarily due to increases in residential real estate, commercial real estate and commercial and industrial loans of $20.1 million, $36.1 million and $9.7 million, respectively, during the first six months of 2022. Construction loans and consumer and other loans decreased by $6.6 million and $4.4 million, respectively, during the first six months of 2022.

The Bank actively participated as a lender in the U.S. Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”) to support local small businesses and non-profit organizations by providing forgivable loans. Loan fees received from the SBA are accreted by the Bank into income evenly over the life of the loans, net of loan origination costs, through interest and fees on loans. PPP loans totaled $845 thousand at June 30, 2022, with $32 thousand scheduled to mature in the second and third quarters of 2022, and $813 thousand scheduled to mature in the first and second quarters of 2026. The total amount of deferred PPP income, net of origination costs, that has not yet been recognized through interest and fees on loans totaled $8 thousand at June 30, 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. 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.

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 lodging sector of the Bank’s commercial real estate loan portfolio and totaled $4.7 million at June 30, 2022. All modified loans were performing under their modified terms at June 30, 2022.

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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. Interest income includes amortization of purchase premiums and discounts, recognized evenly over the life of the loans.

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 $92 thousand at June 30, 2022. There were no loans greater than 90 days past due and still accruing at December 31, 2021. 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 $586 thousand and $2.3 million at June 30, 2022 and December 31, 2021, 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 $116 thousand in loans classified as TDRs as of June 30, 2022 and $1.6 million as of December 31, 2021.

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 had $1.7 million and $1.8 million in assets classified as OREO at June 30, 2022 and December 31, 2021, respectively.

Non-performing assets totaled $2.1 million and $4.2 million at June 30, 2022 and December 31, 2021, representing approximately 0.15% and 0.30% of total assets, respectively. Non-performing assets consisted of OREO and non-accrual loans at June 30, 2022 and December 31, 2021. Non-performing assets included $1.7 million in properties formerly classified as bank premises by The Bank of Fincastle which are now classified as held for sale.

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At June 30, 2022, 4% of non-performing assets were commercial real estate loans and 21% were residential real estate loans. Additionally, 79% was related to bank-owned properties acquired from The Bank of Fincastle which will not be used in the Company's operations and are classified as held for sale. 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 $308 thousand and $1.1 million at June 30, 2022 and December 31, 2021, 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 $92 thousand at June 30, 2022. There were no loans greater than 90 days past due and still accruing at December 31, 2021.

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 $6.2 million at June 30, 2022 and $5.7 million December 31, 2021, representing 0.70% and 0.69% of total loans, respectively. For further discussion regarding the allowance for loan losses, see “Provision for Loan Losses” above.

Recoveries of loan losses of $9 thousand and $40 thousand were recorded in the construction and land development and 1-4 family residential loans classes respectively, during the six months ended June 30, 2022. This recovery was offset by provision for loan losses totaling $334 thousand, $20 thousand, and $95 thousand in the other real estate, commercial and industrial, and consumer and other loan classes, respectively. For more detailed information regarding the (recovery of) provision for loan losses, see Note 4 to the Consolidated Financial Statements.

Impaired loans totaled $586 thousand and $2.3 million at June 30, 2022 and December 31, 2021, respectively. There was no related allowance for loan losses recorded for these loans at June 30, 2022. The related allowance for loan losses provided for these loans totaled $55 thousand at December 31, 2021. The average recorded investment in impaired loans during the six months ended June 30, 2022 and the year ended December 31, 2021 was $1.9 million and $4.5 million, respectively. Included in the impaired loans total are loans classified as TDRs totaling $116 thousand and $1.6 million at June 30, 2022 and December 31, 2021, 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, 2022, 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, 2022 totaled $343.8 million, an increase of $18.9 million, or 6.0%, from $324.7 million at December 31, 2021. Investment securities are comprised of U.S. Treasury securities, U.S. agency and mortgage-backed securities, obligations of state and political subdivisions, corporate debt securities, and restricted securities. As of June 30, 2022, 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 $147 thousand and $2.0 million at June 30, 2022 and December 31, 2021, respectively. Gross unrealized losses in the available for sale portfolio totaled $31.1 million and $2.6 million at June 30, 2022 and December 31, 2021, respectively. Gross unrealized gains in the held to maturity portfolio totaled $2 thousand and $242 thousand at June 30, 2022 and December 31, 2021, respectively. Gross unrealized losses in the held to maturity portfolio totaled $6.7 million and $66 thousand at June 30, 2022 and December 31, 2021. Investments in an unrealized loss position were considered temporarily impaired at June 30, 2022 and December 31, 2021. The change in the unrealized gains and losses of investment securities from December 31, 2021 to June 30, 2022 was related to changes in market interest rates and was not related to credit concerns of the issuers.

At June 30, 2022, the securities portfolio was comprised of $264.8 million of securities available for sale and $77.2 million of securities held to maturity compared to $289.5 million and $33.4 million at December 31, 2021, respectively. Securities held to maturity increased by $43.8 million during the first six months of 2022 from new purchases as a part of the Company's strategy to mitigate the risk of potential fluctuations in value and the related impact on shareholders' equity. The Company has not transferred any securities from available for sale to held to maturity during the first six months of 2022.

Deposits

At June 30, 2022, deposits totaled $1.3 billion, an increase of $47.4 million, from $1.2 billion at December 31, 2021. There was a slight change in the deposit mix when comparing the periods. At June 30, 2022, noninterest-bearing demand deposits, savings and interest-bearing demand deposits, and time deposits composed 33%, 57%, and 10% of total deposits, respectively, compared to 33%, 57%, and 10% at December 31, 2021.

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, 2022, cash, interest-bearing and noninterest-bearing deposits with banks, securities, and loans maturing within one year totaled $210.8 million. At June 30, 2022, 9.5% or $83.7 million of the loan portfolio matured within one year. Non-deposit sources of available funds totaled $385.0 million at June 30, 2022, which included $287.8 million of secured funds available from Federal Home Loan Bank of Atlanta (FHLB), $46.2 million of secured funds available through the Federal Reserve Discount Window, and $51.0 million of unsecured federal funds lines of credit with other correspondent banks.

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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 issued in February 2015 and is not obligated to report consolidated regulatory capital.

Effective January 1, 2015, the Bank became subject to 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 effective 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, 2022 and December 31, 2021, 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, 2022:

	First Bank
Total capital to risk-weighted assets		14.23	%
Tier 1 capital to risk-weighted assets		13.56	%
Common equity Tier 1 capital to risk-weighted assets		13.56	%
Tier 1 capital to average assets		8.87	%
Capital conservation buffer ratio⁽¹⁾		6.23	%

(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, 2022 and December 31, 2021.

On September 17, 2019 the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework.

In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio greater than 9%, less than $10 billion in total consolidated assets, and limited amounts of off-balance sheet exposures and trading assets and liabilities. The CARES Act temporarily lowered the tier 1 leverage ratio requirement to 8% until December 31, 2020. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the "well-capitalized" ratio requirements under the prompt corrective action regulations and will not be required to report or calculate risk-based capital. Although, the Company did not opt into the CBLR framework at June 30, 2022, it may opt into the CBLR framework in a future quarterly period.

During the fourth quarter of 2019, the Board of Directors of the Company authorized a stock repurchase plan pursuant to which the Company was authorized to repurchase up to $5.0 million of the Company’s outstanding common stock through December 31, 2020. During 2020, the Company repurchased and retired 129,035 shares at an average price paid per share of $16.05, for a total of $2.1 million. The Company’s stock repurchase plan was suspended in the second quarter of 2020, and remained suspended until it ended on December 31, 2020. The Company has not authorized another stock repurchase plan as of June 30, 2022.

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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, 2021.

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 $161.3 million at June 30, 2022, and $161.4 million at December 31, 2021, 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, 2022 and December 31, 2021, the Bank had $18.1 million and $18.9 million in outstanding standby letters of credit, respectively.

On April 21, 2020, the Company entered into interest rate swap agreements related to its outstanding junior subordinated debt. The Company uses derivatives to manage exposure to interest rate risk through the use of interest rate swaps. Interest rate swaps involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date with no exchange of underlying principal amounts.

The interest rate swaps qualified and are designated as cash flow hedges. The Company’s cash flow hedges effectively modify the Company’s exposure to interest rate risk by converting variable rates of interest on $9.0 million of the Company’s junior subordinated debt to fixed rates of interest. The cash flow hedges end and the junior subordinated debt matures between June 2034 and October 2036. The cash flow hedges’ total notional amount is $9.0 million. At June 30, 2022, the cash flow hedges had a fair value of $2.2 million, which is recorded in other assets. The net gain/loss on the cash flow hedges is recognized as a component of other comprehensive (loss) income and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 16 to the Consolidated Financial Statements.

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, 2022 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, 2021.

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, 2022 formatted in Inline eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive (Loss) Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements.

104	The cover page from First National Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 2022, formatted in Inline XBRL (included with Exhibit 101).

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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 15, 2022
Scott C. Harvard				Date
President and Chief Executive Officer

/s/ M. Shane Bell				August 15, 2022
M. Shane Bell				Date
Executive Vice President and Chief Financial Officer