HAWTHORN BANCSHARES, INC. - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2017

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to______________

Commission File Number: 0-23636

HAWTHORN BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Missouri		43-1626350
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

132 East High Street, Box 688, Jefferson City, Missouri		65102
(Address of principal executive offices)		(Zip Code)

(573) 761-6100

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report.)

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. x Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x 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 x (Do not check if a smaller reporting company)	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 x No

As of November 07, 2017, the registrant had 5,800,688 shares of common stock, par value $1.00 per share, outstanding.

Part I - Financial Information

Item 1. Financial Statements

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets (unaudited)

(In thousands, except per share data)

	September 30,			December 31,
	2017			2016
ASSETS
Cash and due from banks	$	19,200		$	25,589
Federal funds sold and other overnight interest-bearing deposits		41,227			1,406
Cash and cash equivalents		60,427			26,995
Investment in available-for-sale securities, at fair value		212,650			214,512
Other investments and securities, at cost		9,760			9,796
Total investment securities		222,410			224,308
Loans		1,045,047			974,029
Allowances for loan losses		(11,000	)		(9,886	)
Net loans		1,034,047			964,143
Premises and equipment - net		34,996			35,522
Mortgage servicing rights		2,688			2,584
Other real estate and repossessed assets - net		13,177			14,162
Accrued interest receivable		4,879			5,183
Cash surrender value - life insurance		2,464			2,409
Other assets		11,444			11,742
Total assets	$	1,386,532		$	1,287,048
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Non-interest bearing demand	$	259,457		$	235,975
Savings, interest checking and money market		539,575			468,731
Time deposits $250,000 and over		68,605			73,523
Other time deposits		240,323			232,437
Total deposits		1,107,960			1,010,666
Federal funds purchased and securities sold under agreements to repurchase		32,555			31,015
Subordinated notes		49,486			49,486
Federal Home Loan Bank advances		89,408			93,392
Accrued interest payable		486			498
Other liabilities		10,565			10,974
Total liabilities		1,290,460			1,196,031
Stockholders’ equity:
Common stock, $1 par value, authorized 15,000,000 shares; issued 6,046,907 and 5,822,357 shares, respectively		6,047			5,822
Surplus		45,441			41,498
Retained earnings		52,155			51,671
Accumulated other comprehensive loss, net of tax		(2,775	)		(3,801	)
Treasury stock; 236,465 and 205,750 shares, at cost		(4,796	)		(4,173	)
Total stockholders’ equity		96,072			91,017
Total liabilities and stockholders’ equity	$	1,386,532		$	1,287,048

See accompanying notes to the consolidated financial statements (unaudited).

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Income (unaudited)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(In thousands, except per share amounts)	2017		2016			2017		2016
INTEREST INCOME
Interest and fees on loans	$	11,856	$	10,634		$	34,577	$	30,929
Interest on investment securities:
Taxable		726		754			2,217		2,523
Nontaxable		169		119			494		381
Federal funds sold and other overnight interest-bearing deposits		84		19			144		69
Dividends on other securities		101		80			285		231
Total interest income		12,936		11,606			37,717		34,133
INTEREST EXPENSE
Interest on deposits:
Savings, interest checking and money market		682		291			1,546		874
Time deposit accounts $250,000 and over		119		107			309		235
Other time deposits		463		391			1,252		1,180
Interest on federal funds purchased and securities sold under agreements to repurchase		29		13			78		51
Interest on subordinated notes		450		375			1,290		1,095
Interest on Federal Home Loan Bank advances		440		282			1,182		732
Total interest expense		2,183		1,459			5,657		4,167
Net interest income		10,753		10,147			32,060		29,966
Provision for loan losses		555		300			1,235		975
Net interest income after provision for loan losses		10,198		9,847			30,825		28,991
NON-INTEREST INCOME
Service charges and other fees		878		882			2,565		2,544
Bank card income and fees		664		593			1,941		1,875
Trust department income		288		216			828		699
Real estate servicing fees, net		70		(4	)		557		(36	)
Gain on sale of mortgage loans, net		225		266			599		653
Gain on sale of investment securities		0		111			0		602
Other		56		61			197		185
Total non-interest income		2,181		2,125			6,687		6,522
NON-INTEREST EXPENSE
Salaries and employee benefits		5,515		5,063			16,321		15,718
Occupancy expense, net		719		730			2,027		2,037
Furniture and equipment expense		764		438			1,996		1,288
Processing, network, and bank card expense		831		878			2,803		2,490
Legal, examination, and professional fees		331		277			928		939
FDIC insurance assessment		106		196			322		560
Advertising and promotion		342		283			845		734
Postage, printing, and supplies		234		244			729		771
Real estate foreclosure expense, net		78		49			330		232
Other		846		927			2,502		2,753
Total non-interest expense		9,766		9,085			28,803		27,522
Income before income taxes		2,613		2,887			8,709		7,991
Income tax expense		847		1,003			2,923		2,697
Net income		1,766		1,884			5,786		5,294
Basic earnings per share	$	0.30	$	0.32		$	0.99	$	0.90
Diluted earnings per share	$	0.30	$	0.32		$	0.99	$	0.90

See accompanying notes to the consolidated financial statements (unaudited).

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (unaudited)

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(In thousands)	2017		2016			2017		2016
Net income	$	1,766	$	1,884		$	5,786	$	5,294
Other comprehensive income, net of tax
Investment securities available-for-sale:
Unrealized gain (loss) on investment securities available-for-sale, net of tax		84		(294	)		984		1,788
Adjustment for gain on sale of investment securities, net of tax		0		(69	)		0		(373	)
Defined benefit pension plans:
Amortization of prior service cost included in net periodic pension cost, net of tax		15		12			42		36
Total other comprehensive income (loss)		99		(351	)		1,026		1,451
Total comprehensive income	$	1,865	$	1,533		$	6,812	$	6,745

See accompanying notes to the consolidated financial statements (unaudited).

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders' Equity (unaudited)

								Accumulated						Total
								Other						Stock -
	Common				Retained			Comprehensive			Treasury			holders'
(In thousands)	Stock		Surplus		Earnings			Loss			Stock			Equity
Balance, December 31, 2015	$	5,605	$	38,549	$	48,700		$	(2,018	)	$	(3,550	)	$	87,286
Net income		0		0		5,294			0			0			5,294
Other comprehensive income		0		0		0			1,451			0			1,451
Stock based compensation expense		0		16		0			0			0			16
Purchase of treasury stock		0		0		0			0			(435	)		(435	)
Stock dividend		217		2,932		(3,149	)		0			0			0
Cash dividends declared, common stock		0		0		(824	)		0			0			(824	)
Balance, September 30, 2016	$	5,822	$	41,497	$	50,021		$	(567	)	$	(3,985	)	$	92,788

Balance, December 31, 2016	$	5,822	$	41,498	$	51,671		$	(3,801	)	$	(4,173	)	$	91,017
Net income		0		0		5,786			0			0			5,786
Other comprehensive income		0		0		0			1,026			0			1,026
Stock based compensation expense		0		3		0			0			0			3
Purchase of treasury stock		0		0		0			0			(623	)		(623	)
Stock dividend		225		3,940		(4,165	)		0			0			0
Cash dividends declared, common stock		0		0		(1,137	)		0			0			(1,137	)
Balance, September 30, 2017	$	6,047	$	45,441	$	52,155		$	(2,775	)	$	(4,796	)	$	96,072

See accompanying notes to the consolidated financial statements (unaudited).

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (unaudited)

	Nine Months Ended September 30,
(In thousands)	2017			2016
Cash flows from operating activities:
Net income	$	5,786		$	5,294
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,235			975
Depreciation expense		1,399			1,432
Net amortization of investment securities, premiums, and discounts		1,257			1,418
Stock based compensation expense		3			16
Change in fair value of mortgage servicing rights		72			690
Gain on sale of investment securities		0			(602	)
Loss (gain) on sales and dispositions of premises and equipment		123			(9	)
Gain on sales and dispositions of other real estate and repossessed assets		(42	)		(215	)
Provision for other real estate owned		243			176
Decrease in accrued interest receivable		304			229
Increase in cash surrender value - life insurance		(55	)		(48	)
Increase in other assets		(269	)		(135	)
(Decrease) increase in accrued interest payable		(12	)		26
Decrease in other liabilities		(479	)		(243	)
Origination of mortgage loans for sale		(26,446	)		(27,849	)
Proceeds from the sale of mortgage loans		26,261			28,769
Gain on sale of mortgage loans, net		(599	)		(653	)
Other, net		(162	)		(155	)
Net cash provided by operating activities		8,619			9,116
Cash flows from investing activities:
Net increase in loans		(70,572	)		(85,087	)
Purchase of available-for-sale debt securities		(32,330	)		(102,000	)
Proceeds from maturities of available-for-sale debt securities		24,192			42,441
Proceeds from calls of available-for-sale debt securities		7,675			13,535
Proceeds from sales of available-for-sale debt securities		2,656			60,720
Proceeds from sales of FHLB stock		1,239			0
Purchases of FHLB stock		(1,203	)		(1,203	)
Purchases of premises and equipment		(1,017	)		(881	)
Proceeds from sales of premises and equipment		12			9
Proceeds from sales of other real estate and foreclosed assets		1,001			3,613
Net cash used in investing activities		(68,347	)		(68,853	)
Cash flows from financing activities:
Net increase in demand deposits		23,482			21,952
Net increase in interest-bearing transaction accounts		70,844			36,865
Net increase in time deposits		2,968			12,017
Net increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		1,048			(28,330	)
Repayment of FHLB advances and other borrowings		(183,132	)		(16,000	)
FHLB advances		179,640			45,000
Purchase of treasury stock		(623	)		(435	)
Cash dividends paid - common stock		(1,067	)		(815	)
Net cash provided by financing activities		93,160			70,254
Net increase in cash and cash equivalents		33,432			10,517
Cash and cash equivalents, beginning of period		26,995			28,377
Cash and cash equivalents, end of period	$	60,427		$	38,894

See accompanying notes to the consolidated financial statements (unaudited).

HAWTHORN BANCSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued) (unaudited)

	Nine Months Ended September 30,
(In thousands)	2017		2016

Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest	$	5,669	$	4,141
Income taxes	$	2,940	$	2,705
Noncash investing activities:
Other real estate and repossessed assets acquired in settlement of loans	$	217	$	2,020

See accompanying notes to the consolidated financial statements (unaudited).

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(1)

Summary of Significant Accounting Policies

Hawthorn Bancshares, Inc. (the Company) through its subsidiary, Hawthorn Bank (the Bank), provides a broad range of banking services to individual and corporate customers located within the communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area. The Company is subject to competition from other financial and nonfinancial institutions providing financial products. Additionally, the Company and its subsidiaries are subject to the regulations of certain regulatory agencies and undergo periodic examinations by those regulatory agencies.

The accompanying unaudited consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, the unaudited consolidated financial statements do not include all of the information and disclosures required by U.S. GAAP for complete financial statements and should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

The preparation of the consolidated financial statements includes all adjustments that, in the opinion of management, are necessary in order to make those statements not misleading. Management is required to make estimates and assumptions, including the determination of the allowance for loan losses, real estate acquired in connection with foreclosure or in satisfaction of loans, and fair values of investment securities available-for-sale that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s management has evaluated and did not identify any subsequent events or transactions requiring recognition or disclosure in the consolidated financial statements.

Stock Dividend On July 1, 2017, the Company paid a special stock dividend of four percent to shareholders of record at the close of business on June 15, 2017. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

The following represents significant new accounting principles adopted in 2017:

Stock Compensation The FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, in March 2016, in order to reduce complexity in this area and improve the usefulness of information provided to users. Amendments which will affect public companies include the recognition of excess tax benefits and deficiencies in income tax expense or benefit in the income statement, guidance as to the classification of excess tax benefits on the statement of cash flows, an election to account for award forfeitures as they occur, and the ability to withhold taxes up to the maximum statutory rate in the applicable jurisdictions without triggering liability classification of the award. The Company adopted the ASU on January 1, 2017 and elected to recognize forfeitures as they occur. As allowed by the ASU, the Company’s adoption was prospective, therefore prior periods have not been adjusted. The adoption of the ASU could result in increased volatility to reported income tax expense related to excess tax benefits and tax deficiencies for employee share-based transactions, however, the actual amounts recognized in income tax expense will be dependent on the amount of employee share-based transactions and the stock price at the time of vesting or exercise. The adoption of the ASU did not have a significant effect on the Company’s consolidated financial statements.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(2)

Loans and Allowance for Loan Losses

Loans

A summary of loans, by major class within the Company’s loan portfolio, at September 30, 2017 and December 31, 2016 is as follows:

	September 30,		December 31,
(in thousands)	2017		2016
Commercial, financial, and agricultural	$	184,868	$	182,881
Real estate construction - residential		22,723		18,907
Real estate construction - commercial		91,102		55,653
Real estate mortgage - residential		250,736		259,900
Real estate mortgage - commercial		461,988		426,470
Installment and other consumer		33,630		30,218
Total loans	$	1,045,047	$	974,029

The Bank grants real estate, commercial, installment, and other consumer loans to customers located within the communities surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson and the greater Kansas City metropolitan area. As such, the Bank is susceptible to changes in the economic environment in these communities. The Bank does not have a concentration of credit in any one economic sector. Installment and other consumer loans consist primarily of the financing of automotive vehicles. At September 30, 2017, $490.8 million of loans were pledged to the Federal Home Loan Bank as collateral for borrowings and letters of credit.

Allowance for Loan Losses

The following is a summary of the allowance for loan losses during the periods indicated.

	Three Months Ended September 30, 2017
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial		Residential			Commercial			Consumer			allocated			Total
Balance at beginning of period	$	2,578		$	70		$	615	$	1,854		$	4,882		$	376		$	170		$	10,545
Additions:
Provision for loan losses		853			64			91		100			(426	)		32			(159	)		555
Deductions:
Loans charged off		37			0			0		68			4			56			0			165
Less recoveries on loans		(12	)		(12	)		0		(11	)		(5	)		(25	)		0			(65	)
Net loan charge-offs (recoveries)		25			(12	)		0		57			(1	)		31			0			100
Balance at end of period	$	3,406		$	146		$	706	$	1,897		$	4,457		$	377		$	11		$	11,000

	Nine Months Ended September 30, 2017
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			and Other			Un-
(in thousands)	Agricultural			Residential			Commercial		Residential			Commercial			Consumer			allocated			Total
Balance at beginning of period	$	2,753		$	108		$	413	$	2,385		$	3,793			274		$	160		$	9,886
Additions:
Provision for loan losses		695			(49	)		293		(407	)		658			194			(149	)		1,235
Deductions:
Loans charged off		97			0			0		149			20			167			0			433
Less recoveries on loans		(55	)		(87	)		0		(68	)		(26	)		(76	)		0			(312	)
Net loan charge-offs (recoveries)		42			(87	)		0		81			(6	)		91			0			121
Balance at end of period	$	3,406		$	146		$	706	$	1,897		$	4,457		$	377		$	11		$	11,000

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended September 30, 2016
	Commercial,			Real Estate			Real Estate		Real Estate			Real Estate			Installment
	Financial, &			Construction -			Construction -		Mortgage -			Mortgage -			Loans to			Un-
(in thousands)	Agricultural			Residential			Commercial		Residential			Commercial			Individuals			allocated		Total
Balance at beginning of period	$	2,996		$	63		$	249	$	2,293		$	3,411		$	284		$	96	$	9,392
Additions:
Provision for loan losses		(94	)		(4	)		44		(152	)		450			50			6		300
Deductions:
Loans charged off		157			0			0		92			27			86			0		362
Less recoveries on loans		(26	)		0			0		(31	)		(36	)		(47	)		0		(140	)
Net loans charged off		131			0			0		61			(9	)		39			0		222
Balance at end of period	$	2,771		$	59		$	293	$	2,080		$	3,870		$	295		$	102	$	9,470

	Nine Months Ended September 30, 2016
	Commercial,			Real Estate		Real Estate			Real Estate			Real Estate			Installment
	Financial, &			Construction -		Construction -			Mortgage -			Mortgage -			Loans to			Un-
(in thousands)	Agricultural			Residential		Commercial			Residential			Commercial			Individuals			allocated		Total
Balance at beginning of period	$	2,153		$	59	$	644		$	2,439		$	2,935		$	273		$	101	$	8,604
Additions:
Provision for loan losses		710			0		(852	)		66			944			106			1		975
Deductions:
Loans charged off		295			0		1			474			137			209			0		1,116
Less recoveries on loans		(203	)		0		(502	)		(49	)		(128	)		(125	)		0		(1,007	)
Net loans charged off		92			0		(501	)		425			9			84			0		109
Balance at end of period	$	2,771		$	59	$	293		$	2,080		$	3,870		$	295		$	102	$	9,470

Loans, or portions of loans, are charged off to the extent deemed uncollectible or a loss is confirmed. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration.

Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table provides the balance in the allowance for loan losses at September 30, 2017 and December 31, 2016, and the related loan balance by impairment methodology.

	Commercial,		Real Estate		Real Estate		Real Estate		Real Estate		Installment
	Financial, and		Construction -		Construction -		Mortgage -		Mortgage -		and Other		Un-
(in thousands)	Agricultural		Residential		Commercial		Residential		Commercial		Consumer		allocated		Total
September 30, 2017
Allowance for loan losses:
Individually evaluated for impairment	$	929	$	0	$	0	$	528	$	258	$	23	$	0	$	1,738
Collectively evaluated for impairment		2,477		146		706		1,369		4,199		354		11		9,262
Total	$	3,406	$	146	$	706	$	1,897	$	4,457	$	377	$	11	$	11,000
Loans outstanding:
Individually evaluated for impairment	$	3,522	$	0	$	0	$	5,173	$	2,023	$	168	$	0	$	10,886
Collectively evaluated for impairment		181,346		22,723		91,102		245,563		459,965		33,462		0		1,034,161
Total	$	184,868	$	22,723	$	91,102	$	250,736	$	461,988	$	33,630	$	0	$	1,045,047

December 31, 2016
Allowance for loan losses:
Individually evaluated for impairment	$	469	$	0	$	7	$	319	$	277	$	8	$	0	$	1,080
Collectively evaluated for impairment		2,284		108		406		2,066		3,516		266		160		8,806
Total	$	2,753	$	108	$	413	$	2,385	$	3,793	$	274	$	160	$	9,886
Loans outstanding:
Individually evaluated for impairment	$	1,617	$	0	$	49	$	5,471	$	1,918	$	89	$	0	$	9,144
Collectively evaluated for impairment		181,264		18,907		55,604		254,429		424,552		30,129		0		964,885
Total	$	182,881	$	18,907	$	55,653	$	259,900	$	426,470	$	30,218	$	0	$	974,029

Impaired Loans

Loans evaluated under ASC 310-10-35 include loans which are individually evaluated for impairment. All other loans are collectively evaluated for impairment under ASC 450-20. Impaired loans individually evaluated for impairment totaled $10.9 million and $9.1 million at September 30, 2017 and December 31, 2016, respectively, and are comprised of loans on non-accrual status and loans which have been classified as troubled debt restructurings (TDRs).

The net carrying value of impaired loans is based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. At September 30, 2017 and December 31, 2016, $7.1 million and $4.5 million, respectively, of impaired loans were evaluated based on the fair value less estimated selling costs of the loan’s collateral. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2017, $1.7 million of the Company’s allowance for loan losses was allocated to impaired loans totaling $10.9 million compared to $1.1 million of the Company's allowance for loan losses allocated to impaired loans totaling approximately $9.1 million at December 31, 2016. Management determined that $2.8 million, or 26%, of total impaired loans required no reserve allocation at September 30, 2017 compared to $2.1 million, or 23%, at December 31, 2016 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The categories of impaired loans at September 30, 2017 and December 31, 2016 are as follows:

	September 30,		December 31,
(in thousands)	2017		2016
Non-accrual loans	$	6,210	$	3,429
Performing TDRs		4,676		5,715
Total impaired loans	$	10,886	$	9,144

The following tables provide additional information about impaired loans at September 30, 2017 and December 31, 2016, respectively, segregated between loans for which an allowance has been provided and loans for which no allowance has been provided.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
September 30, 2017
With no related allowance recorded:
Commercial, financial and agricultural	$	1,442	$	1,473	$	0
Real estate - residential		1,024		1,049		0
Real estate - commercial		366		529		0
Total	$	2,832	$	3,051	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	2,080	$	2,288	$	929
Real estate - residential		4,149		4,220		528
Real estate - commercial		1,657		1,887		258
Installment and other consumer		168		185		23
Total	$	8,054	$	8,580	$	1,738
Total impaired loans	$	10,886	$	11,631	$	1,738

			Unpaid
	Recorded		Principal		Specific
(in thousands)	Investment		Balance		Reserves
December 31, 2016
With no related allowance recorded:
Commercial, financial and agricultural	$	564	$	706	$	0
Real estate - residential		1,550		1,557		0
Total	$	2,114	$	2,263	$	0
With an allowance recorded:
Commercial, financial and agricultural	$	1,053	$	1,078	$	469
Real estate - construction commercial		49		56		7
Real estate - residential		3,921		3,990		319
Real estate - commercial		1,918		1,988		277
Installment and other consumer		89		116		8
Total	$	7,030	$	7,228	$	1,080
Total impaired loans	$	9,144	$	9,491	$	1,080

The following table presents by class, information related to the average recorded investment and interest income recognized on impaired loans during the periods indicated.

	Three Months Ended September 30,								Nine Months Ended September 30,
	2017				2016				2017				2016
			Interest				Interest				Interest				Interest
	Average		Recognized		Average		Recognized		Average		Recognized		Average		Recognized
	Recorded		For the		Recorded		For the		Recorded		For the		Recorded		For the
(in thousands)	Investment		Period Ended		Investment		Period Ended		Investment		Period Ended		Investment		Period Ended
With no related allowance recorded:
Commercial, financial and agricultural	$	481	$	0	$	460	$	-9	$	478	$	0	$	491	$	18
Real estate - residential		341		0		2,050		27		1,412		0		1,640		63
Real estate - commercial		77		3		1,167		17		221		9		1,769		17
Installment and other consumer		0		0		0		0		22		0		0		0
Total	$	899	$	3	$	3,677	$	35	$	2,133	$	9	$	3,900	$	98
With an allowance recorded:
Commercial, financial and agricultural	$	694	$	8	$	1,398	$	-13	$	1,667	$	24	$	924	$	9
Real estate - construction commercial		0		0		51		0		37		0		64		0
Real estate - residential		1,383		33		2,992		20		4,090		121		3,741		78
Real estate - commercial		597		17		811		14		1,772		46		717		61
Installment and other consumer		56		0		118		-1		70		0		123		0
Total	$	2,730	$	58	$	5,370	$	20	$	7,636	$	191	$	5,569	$	148
Total impaired loans	$	3,629	$	61	$	9,047	$	55	$	9,769	$	200	$	9,469	$	246

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The recorded investment varies from the unpaid principal balance primarily due to partial charge-offs taken resulting from current appraisals received. The amount recognized as interest income on impaired loans continuing to accrue interest, primarily related to troubled debt restructurings, was $61,000 and $200,000, for the three months and nine months ended September 30, 2017, respectively, compared to $55,000 and $246,000 for the three and nine months ended September 30, 2016, respectively. The average recorded investment in impaired loans is calculated on a monthly basis during the periods reported.

Delinquent and Non-Accrual Loans

The delinquency status of loans is determined based on the contractual terms of the notes. Borrowers are generally classified as delinquent once payments become 30 days or more past due. The Company’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, the ultimate collectability of interest or principal is no longer probable. In general, loans are placed on non-accrual when they become 90 days or more past due. However, management considers many factors before placing a loan on non-accrual, including the delinquency status of the loan, the overall financial condition of the borrower, the progress of management’s collection efforts and the value of the underlying collateral. Non-accrual loans are returned to accrual status when, in the opinion of management, the financial condition of the borrower indicates that the timely collectability of interest and principal is probable and the borrower demonstrates the ability to pay under the terms of the note through a sustained period of repayment performance, which is generally nine months.

The following table provides aging information for the Company’s past due and non-accrual loans at September 30, 2017 and December 31, 2016.

	Current or				90 Days
	Less Than				Past Due
	30 Days		30 - 89 Days		And Still
(in thousands)	Past Due		Past Due		Accruing		Non-Accrual		Total
September 30, 2017
Commercial, Financial, and Agricultural	$	181,781	$	82	$	0	$	3,005	$	184,868
Real Estate Construction - Residential		22,723		0		0		0		22,723
Real Estate Construction - Commercial		91,005		97		0		0		91,102
Real Estate Mortgage - Residential		247,462		1,063		117		2,094		250,736
Real Estate Mortgage - Commercial		460,339		706		0		943		461,988
Installment and Other Consumer		33,224		177		61		168		33,630
Total	$	1,036,534	$	2,125	$	178	$	6,210	$	1,045,047
December 31, 2016
Commercial, Financial, and Agricultural	$	181,609	$	290	$	0	$	982	$	182,881
Real Estate Construction - Residential		18,681		226		0		0		18,907
Real Estate Construction - Commercial		55,603		0		0		50		55,653
Real Estate Mortgage - Residential		254,758		3,200		54		1,888		259,900
Real Estate Mortgage - Commercial		425,260		790		0		420		426,470
Installment and Other Consumer		29,920		198		11		89		30,218
Total	$	965,831	$	4,704	$	65	$	3,429	$	974,029

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Credit Quality

The Company categorizes loans into risk categories based upon an internal rating system reflecting management’s risk assessment. Loans are placed on watch status when one or more weaknesses that may result in the deterioration of the repayment exits or the Company’s credit position at some future date. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or by the collateral pledged, if any. Loans so classified may have a well-defined weakness or weaknesses that jeopardize the repayment of the debt. Such loans are characterized by the distinct possibility that the Company may sustain some loss if the deficiencies are not corrected. A loan is classified as a troubled debt restructuring (TDR) when a borrower is experiencing financial difficulties that lead to the restructuring of a loan, and the Company grants concessions to the borrower in the restructuring that it would not otherwise consider. Loans classified as TDRs which are accruing interest are classified as performing TDRs. Loans classified as TDRs which are not accruing interest are classified as nonperforming TDRs and are included with all other nonaccrual loans for presentation purposes. It is the Company’s policy to discontinue the accrual of interest income on loans when management believes that the collection of interest or principal is doubtful. Loans are placed on non-accrual status when (1) deterioration in the financial condition of the borrower exists for which payment of full principal and interest is not expected, or (2) payment of principal or interest has been in default for a period of 90 days or more and the asset is not both well secured and in the process of collection. Subsequent interest payments received on such loans are applied to principal if any doubt exists as to the collectability of such principal; otherwise, such receipts are recorded as interest income on a cash basis.

The following table presents the risk categories by class at September 30, 2017 and December 31, 2016.

(in thousands)	Commercial, Financial, & Agricultural		Real Estate Construction - Residential		Real Estate Construction - Commercial		Real Estate Mortgage - Residential		Real Estate Mortgage - Commercial		Installment and Other Consumer		Total
At September 30, 2017
Watch	$	9,830	$	1,236	$	1,281	$	10,330	$	48,773	$	0	$	71,450
Substandard		900		462		97		2,296		728		20		4,503
Performing TDRs		517		0		0		3,080		1,079		0		4,676
Non-accrual		3,005		0		0		2,094		943		168		6,210
Total	$	14,252	$	1,698	$	1,378	$	17,800	$	51,523	$	188	$	86,839
At December 31, 2016
Watch	$	10,295	$	665	$	1,113	$	16,577	$	44,611	$	0	$	73,261
Substandard		798		640		0		2,159		426		24		4,047
Performing TDRs		635		0		0		3,582		1,498		0		5,715
Non-accrual		982		0		50		1,888		420		89		3,429
Total	$	12,710	$	1,305	$	1,163	$	24,206	$	46,955	$	113	$	86,452

Troubled Debt Restructurings

At September 30, 2017, loans classified as TDRs totaled $5.7 million, of which $1.0 million were classified as nonperforming TDRs and included in non-accrual loans and $4.7 million were classified as performing TDRs. At December 31, 2016, loans classified as TDRs totaled $6.3 million, of which $619,000 were classified as nonperforming TDRs and included in non-accrual loans and $5.7 million were classified as performing TDRs. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. Accordingly, specific reserves of $531,000 and $410,000 related to TDRs were allocated to the allowance for loan losses at September 30, 2017 and December 31, 2016, respectively.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The following table summarizes loans that were modified as TDRs during the periods indicated.

	Three Months Ended September 30,
	2017						2016
	Recorded Investment (1)						Recorded Investment (1)
(in thousands)	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		0	$	0	$	0		2	$	32	$	32
Real estate mortgage - residential		1		14		14		4		298		296
Total		1	$	14	$	14		6	$	330	$	328

	Nine Months Ended September 30,
	2017						2016
	Recorded Investment (1)						Recorded Investment (1)
(in thousands)	Number of Contracts		Pre- Modification		Post- Modification		Number of Contracts		Pre- Modification		Post- Modification
Troubled Debt Restructurings
Commercial, financial and agricultural		1	$	131	$	130		2	$	32	$	32
Real estate mortgage - residential		1		14		14		5		376		374
Real estate mortgage - commercial		1		56		52		0		0		0
Total		3	$	201	$	196		7	$	408	$	406

(1) The amounts reported post-modification are inclusive of all partial pay-downs and charge-offs, and no portion of the debt was forgiven. Loans modified as a TDR that were fully paid down, charged-off or foreclosed upon during the period ended are not reported.

The Company’s portfolio of loans classified as TDRs include concessions for the borrower given financial condition such as interest rates below the current market rate, deferring principal payments, and extending maturity dates. There was one loan and three loans meeting the TDR criteria during the three and nine months ended September 30, 2017, respectively, compared to six loans and seven loans during the three and nine months ended September 30, 2016, respectively.

The Company considers a TDR to be in default when it is 90 days or more past due under the modified terms, a charge-off occurs, or it is the process of foreclosure. There were no loans modified as a TDR that defaulted during the three months ended September 30, 2017 and 2016, respectively, and within twelve months of their modification date. See Lending and Credit Management section for further information.

(3)

Other Real Estate and Repossessed Assets

	September 30,			December 31,
(in thousands)	2017			2016
Commercial	$	727		$	809
Real estate construction - commercial		12,380			12,380
Real estate mortgage - residential		363			647
Real estate mortgage - commercial		2,909			3,439
Repossessed assets		0			16
Total	$	16,379		$	17,291
Less valuation allowance for other real estate owned		(3,202	)		(3,129	)
Total other real estate and repossessed assets	$	13,177		$	14,162

Changes in the net carrying amount of other real estate and repossessed assets were as follows for the periods indicated:

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
Balance at beginning of period	$	16,530		$	18,462		$	17,291		$	19,225
Additions		62			386			217			2,020
Proceeds from sales		(217	)		(1,214	)		(1,001	)		(3,613	)
Charge-offs against the valuation allowance for other real estate owned, net		0			(48	)		(170	)		(149	)
Net gain on sales		4			112			42			215
Total other real estate and repossessed assets	$	16,379		$	17,698		$	16,379		$	17,698
Less valuation allowance for other real estate owned		(3,202	)		(3,260	)		(3,202	)		(3,260	)
Balance at end of period	$	13,177		$	14,438		$	13,177		$	14,438

At September 30, 2017 $101,000 of consumer mortgage loans secured by residential real estate properties were in the process of foreclosure compared to $162,000 at December 31, 2016.

Activity in the valuation allowance for other real estate owned was as follows for the periods indicated:

	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2017		2016			2017			2016
Balance, beginning of period	$	3,174	$	3,208		$	3,129		$	3,233
Provision for other real estate owned		28		100			243			176
Charge-offs		0		(48	)		(170	)		(149	)
Balance, end of period	$	3,202	$	3,260		$	3,202		$	3,260

(4)

Investment Securities

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2017 and December 31, 2016 were as follows:

	Total
	Amortized		Gross Unrealized					Fair
(in thousands)	Cost		Gains		Losses			Value
September 30, 2017
U.S. government and federal agency obligations	$	12,653	$	0	$	(180	)	$	12,473
Government sponsored enterprises		32,854		0		(235	)		32,619
Obligations of states and political subdivisions		47,730		246		(250	)		47,726
Mortgage-backed securities:
Residential - government agencies		119,961		140		(1,265	)		118,836
Commercial - government agencies		987		9		0			996
Total mortgage-backed securities		120,948		149		(1,265	)		119,832
Total available-for-sale securities	$	214,185	$	395	$	(1,930	)	$	212,650

December 31, 2016
U.S. government and federal agency obligations	$	13,667	$	0	$	(303	)	$	13,364
Government sponsored enterprises		32,786		2		(329	)		32,459
Obligations of states and political subdivisions		42,666		123		(757	)		42,032
Mortgage-backed securities:
Residential - government agencies		127,527		124		(1,995	)		125,656
Commercial - government agencies		989		12		0			1,001
Total mortgage-backed securities		128,516		136		(1,995	)		126,657
Total available-for-sale securities	$	217,635	$	261	$	(3,384	)	$	214,512

All of the Company’s investment securities are classified as available for sale. Agency bonds and notes, small business administration guaranteed loan certificates (SBA), residential and commercial agency mortgage-backed securities, and agency collateralized mortgage obligations (CMO) include securities issued by the Government National Mortgage Association (GNMA), a U.S. government agency, and the Federal National Mortgage Association (FNMA), the Federal Home Loan Mortgage Corporation (FHLMC) and the Federal Home Loan Bank (FHLB), which are U.S. government-sponsored enterprises.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Other Investments and securities primarily consist of Federal Home Loan Bank stock, subordinated debt equity securities, and the Company’s interest in statutory trusts. These securities are reported at cost in other assets in the amount of $9.8 million as of both September 30, 2017 and December 31, 2016, respectively.

Debt securities with carrying values aggregating approximately $173.1 million and $167.6 million at September 30, 2017 and December 31, 2016, respectively, were pledged to secure public funds, securities sold under agreements to repurchase, and for other purposes as required or permitted by law.

The amortized cost and fair value of debt securities classified as available-for-sale at September 30, 2017, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without prepayment penalties.

	Amortized		Fair
(in thousands)	Cost		Value
Due in one year or less	$	6,864	$	6,858
Due after one year through five years		56,996		56,846
Due after five years through ten years		25,307		25,081
Due after ten years		4,070		4,033
Total		93,237		92,818
Mortgage-backed securities		120,948		119,832
Total available-for-sale securities	$	214,185	$	212,650

Gross unrealized losses on debt securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2017 and December 31, 2016 were as follows:

	Less than 12 months					12 months or more					Total		Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
(in thousands)	Value		Losses			Value		Losses			Value		Losses
At September 30, 2017
U.S. government and federal agency obligations	$	486	$	0		$	11,987	$	(180	)	$	12,473	$	(180	)
Government sponsored enterprises		16,278		(69	)		16,041		(166	)		32,319		(235	)
Obligations of states and political subdivisions		10,820		(35	)		12,535		(215	)		23,355		(250	)
Mortgage-backed securities:
Residential - government agencies		48,651		(341	)		51,735		(924	)		100,386		(1,265	)
Total	$	76,235	$	(445	)	$	92,298	$	(1,485	)	$	168,533	$	(1,930	)

(in thousands)
At December 31, 2016
U.S. government and federal agency obligations	$	13,365	$	(303	)	$	0	$	0		$	13,365	$	(303	)
Government sponsored enterprises		29,432		(329	)		0		0			29,432		(329	)
Obligations of states and political subdivisions		32,318		(757	)		0		0			32,318		(757	)
Mortgage-backed securities:
Residential - government agencies		109,772		(1,848	)		3,742		(147	)		113,514		(1,995	)
Total	$	184,887	$	(3,237	)	$	3,742	$	(147	)	$	188,629	$	(3,384	)

The total available for sale portfolio consisted of approximately 329 securities at September 30, 2017. The portfolio included 204 securities having an aggregate fair value of $168.5 million that were in a loss position at September 30, 2017. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer totaled $92.3 million at fair value. The $1.9 million aggregate unrealized loss included in accumulated other comprehensive income at September 30, 2017 was caused by interest rate fluctuations.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The total available for sale portfolio consisted of approximately 298 securities at December 31, 2016. The portfolio included 216 securities having an aggregate fair value of $188.6 million that were in a loss position at December 31, 2016. Securities identified as temporarily impaired which had been in a loss position for 12 months or longer had a fair value of $3.7 million at December 31, 2016. The $3.4 million aggregate unrealized loss included in accumulated other comprehensive income at December 31, 2016 was caused by interest rate fluctuations.

Because the decline in fair value is attributable to changes in interest rates and not credit quality, these investments were not considered other-than-temporarily impaired at September 30, 2017 and December 31, 2016, respectively. In the absence of changes in credit quality of these investments, the fair value is expected to recover on all debt securities as they approach their maturity date or re-pricing date, or if market yields for such investments decline. In addition, the Company does not have the intent to sell these investments over the period of recovery, and it is not more likely than not that the Company will be required to sell such investment securities.

The table presents the components of investment securities gains and losses, which have been recognized in earnings:

	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2017			2016			2017			2016
Gains realized on sales	$	12		$	132		$	12		$	623
Losses realized on sales		(12	)		(21	)		(12	)		(21	)
Other-than-temporary impairment recognized		0			0			0			0
Investment securities gains	$	0		$	111		$	0		$	602

(5)

Intangible Assets

Mortgage Servicing Rights

At September 30, 2017, the Company was servicing approximately $288.7 million of loans sold to the secondary market compared to $294.4 million at December 31, 2016, and $299.7 million at September 30, 2016. Mortgage loan servicing fees, reported as non-interest income, earned on loans sold were $209,000 and $629,000 for the three and nine months ended September 30, 2017, respectively, compared to $233,000 and $654,000 for the three and nine months ended September 30, 2016, respectively.

The table below presents changes in mortgage servicing rights (MSRs) for the periods indicated.

	Three Months Ended September 30,						Nine Months Ended September 30,
(in thousands)	2017			2016			2017			2016
Balance at beginning of period	$	2,766		$	2,511		$	2,584		$	2,847
Originated mortgage servicing rights		61			96			176			213
Changes in fair value:
Due to change in model inputs and assumptions (1)		(30	)		(52	)		289			(197	)
Other changes in fair value (2)		(109	)		(185	)		(361	)		(493	)
Balance at end of period	$	2,688		$	2,370		$	2,688		$	2,370

(1)

The change in fair value resulting from changes in valuation inputs or assumptions used in the valuation model reflects the change in discount rates and prepayment speed assumptions primarily due to changes in interest rates.

(2)

Other changes in fair value reflect changes due to customer payments and passage of time.

The following key data and assumptions were used in estimating the fair value of the Company’s MSRs as of the nine months ended September 30, 2017 and 2016:

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Nine Months Ended September 30,
	2017			2016
Weighted average constant prepayment rate		10.11	%		13.20	%
Weighted average note rate		3.86	%		3.88	%
Weighted average discount rate		9.78	%		9.20	%
Weighted average expected life (in years)		5.80			4.80

(6)

Federal funds purchased and securities sold under agreements to repurchase

	September 30,		December 31,
	2017		2016
Federal funds purchased	$	0	$	992
Repurchase agreements		32,555		30,023
Total	$	32,555	$	31,015

The Company offers a sweep account program whereby amounts in excess of an established limit are “swept” from the customer’s demand deposit account on a daily basis into retail repurchase agreements pursuant to individual repurchase agreements between the Company and its customers. Repurchase agreements are agreements to sell securities subject to an obligation to repurchase the same or similar securities. They are accounted for as collateralized financing transactions, not as sales and purchases of the securities portfolio. The securities collateral pledged for the repurchase agreements with customers is maintained by a designated third party custodian. The collateral amounts pledged to repurchase agreements by remaining maturity in the table below are limited to the outstanding balances of the related asset or liability; thus amounts of excess collateral are not shown.

Repurchase Agreements	Remaining Contractual Maturity of the Agreements
	Overnight		Less		Greater
	and		than		than
(in thousands)	continuous		90 days		90 days		Total
At September 30, 2017
U.S. government and federal agency obligations	$	3,225	$	0	$	0	$	3,225
Government sponsored enterprises		9,134		0		0		9,134
Asset-backed securities		20,196		0		0		20,196
Total	$	32,555	$	0	$	0	$	32,555

At December 31, 2016
U.S. government and federal agency obligations	$	3,489	$	0	$	0	$	3,489
Government sponsored enterprises		7,324		0		0		7,324
Asset-backed securities		19,210		0		0		19,210
Total	$	30,023	$	0	$	0	$	30,023

(7)

Income Taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 32.4% for the three months ended September 30, 2017 compared to 34.7% for the three months ended September 30, 2016. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.6% for the nine months ended September 30, 2017 compared to 33.8% for the nine months ended September 30, 2016. The decrease in the tax rate for the quarter ended September 30, 2017 in comparison to the quarter ended September 30, 2016, is primarily due to an immaterial 2016 return to provision adjustment made in the third quarter of 2017, as opposed to an immaterial 2015 return to provision adjustment made in the first quarter of 2016. The tax rate was consistent for both the nine months ended September 30, 2017 and 2016.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income of the appropriate character during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income available in carryback years, and tax planning strategies in making this assessment. With the exception of certain capital losses generated during 2013 and 2014, it is management’s opinion that the Company will more likely than not realize the benefits of these temporary differences as of September 30, 2017 and, therefore, only established a valuation reserve against the Company’s capital loss carry forward. Management arrived at this conclusion based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible. As indicated above, the Company generated approximately $219,000 of capital losses during 2013 and 2014 as a result of disposing of certain limited partnership interests. The capital losses will expire between 2018 and 2019, and it is management’s opinion that the Company will not more likely than not generate the capital gain income necessary to utilize the capital loss carry forwards before the capital losses expire. As such, the Company has established an $83,000 valuation reserve against its capital loss carry forward deferred tax asset.

(8)

Stockholders’ Equity

Accumulated Other Comprehensive Loss

The following details the change in the components of the Company’s accumulated other comprehensive loss for the nine months ended September 30, 2017 and 2016:

	Nine months ended September 30, 2017
				Unrecognized Net			Accumulated
	Unrealized			Pension and			Other
	Gain (Loss)			Postretirement			Comprehensive
(in thousands)	on Securities (1)			Costs (2)			Loss
Balance at beginning of period	$	(1,936	)	$	(1,865	)	$	(3,801	)
Other comprehensive income, before reclassifications		1,588			67			1,655
Amounts reclassified from accumulated other comprehensive income (loss)		0			0			0
Current period other comprehensive income, before tax		1,588			67			1,655
Income tax expense		(604	)		(25	)		(629	)
Current period other comprehensive income, net of tax		984			42			1,026
Balance at end of period	$	(952	)	$	(1,823	)	$	(2,775	)

	Nine months ended September 30, 2016
				Unrecognized Net			Accumulated
	Unrealized			Pension and			Other
	Gain (Loss)			Postretirement			Comprehensive
(in thousands)	on Securities (1)			Costs (2)			Loss
Balance at beginning of period	$	(591	)	$	(1,427	)	$	(2,018	)
Other comprehensive income, before reclassifications		2,884			59			2,943
Amounts reclassified from accumulated other comprehensive income (loss)		(602	)		0			(602	)
Current period other comprehensive income, before tax		2,282			59			2,341
Income tax expense		(867	)		(23	)		(890	)
Current period other comprehensive income, net of tax		1,415			36			1,451
Balance at end of period	$	824		$	(1,391	)	$	(567	)

(1)

The pre-tax amounts reclassified from accumulated other comprehensive loss are included in gain on sale of investment securities in the consolidated statements of income.

(2)

The pre-tax amounts reclassified from accumulated other comprehensive loss are included in the computation of net periodic pension cost.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(9)

Employee Benefit Plans

Employee Benefits

Employee benefits charged to operating expenses are summarized in the table below for the periods indicated.

	Three Months Ended September 30,				Nine Months Ended September 30,
(in thousands)	2017		2016		2017		2016
Payroll taxes	$	267	$	251	$	911	$	883
Medical plans		595		415		1,489		1,414
401k match and profit sharing		218		201		694		585
Pension plan		349		307		1,052		920
Other		17		56		42		118
Total employee benefits	$	1,446	$	1,230	$	4,188	$	3,920

The Company’s profit-sharing plan includes a matching 401k portion, in which the Company matches the first 3% of eligible employee contributions. The Company made annual contributions in an amount up to 6% of income before income taxes and before contributions to the profit-sharing and pension plans for all participants, limited to the maximum amount deductible for federal income tax purposes, for each of the periods shown. In addition, employees were able to make additional tax-deferred contributions.

Pension

The Company provides a noncontributory defined benefit pension plan for all full-time employees. An employer is required to recognize the funded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. The Company made a pension contribution in the amount of $1.2 million on September 11, 2017. The minimum required contribution for 2017 is $842,000. Effective July 1, 2017, the Company amended the pension plan to effectuate a “soft freeze” such that no individual hired (or rehired in the case of a former employee) by the Company after September 30, 2017, whether or not such individual is or was a vested member in the plan, will be eligible to be an active member and be entitled to accrue any benefits under the plan. Certain individuals hired by the Company before July 1, 2017 are also not eligible to participate in the plan. Beginning in 2019, the Company anticipates that there may be a small reduction in the overall liability and service cost resulting from the closure of the plan to new entrants.

Components of Net Pension Cost and Other Amounts Recognized in Accumulated Other Comprehensive Income

The following items are components of net pension cost for the periods indicated:

	Estimated			Actual
(in thousands)	2017			2016
Service cost - benefits earned during the year	$	1,343		$	1,179
Interest costs on projected benefit obligations		1,008			956
Expected return on plan assets		(1,126	)		(1,057	)
Expected administrative expenses		88			70
Amortization of prior service cost		79			79
Amortization of unrecognized net loss		11			0
Net periodic pension expense	$	1,403		$	1,227

Pension expense - three months ended September 30, (actual)	$	349		$	307
Pension expense - nine months ended September 30, (actual)	$	1,052		$	920

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

(10)

Stock Compensation

The Company’s stock option plan provides for the grant of options to purchase up to 601,627 shares of the Company’s common stock to officers and other key employees of the Company and its subsidiaries. All options have been granted at exercise prices equal to fair value and vest over periods ranging from four to five years.

The following table summarizes the Company’s stock option activity:

						Weighted
				Weighted		Average		Aggregate
	Number			Average		Contractual		Intrinsic
	of			Exercise		Term		Value
	Shares			Price		(in years)		($000)
Outstanding, December 31, 2016		46,244		$	19.33
Granted		0			0.00
Exercised		0			0.00
Forfeited or expired		(26,141	)		22.84
Outstanding, September 30, 2017		20,103		$	14.77		0.98	$	119,226
Exercisable, September 30, 2017		20,103		$	14.77		0.98	$	119,226

Options have been adjusted to reflect a 4% stock dividend paid on July 1, 2017.

Total stock-based compensation expense was $1,000 and $3,000 for the three and nine months ended September 30, 2017, respectively, compared to $5,000 and $16,000 for the three and nine months ended September 30, 2016, respectively. As of September 30, 2017, there was no remaining unrecognized compensation expense related to non-vested stock awards.

(11)

Earnings per Share

Stock Dividend On July 1, 2017, the Company paid a special stock dividend of 4% to common shareholders of record at the close of business on June 15, 2017. For all periods presented, share information, including basic and diluted earnings per share, has been adjusted retroactively to reflect this change.

Basic earnings per share is computed by dividing income available to shareholders by the weighted average number of shares outstanding during the year. Diluted earnings per share gives effect to all dilutive potential shares that were outstanding during the year. The calculations of basic and diluted earnings per share are as follows for the periods indicated:

	Three Months Ended September 30,				Nine Months Ended September 30,
(dollars in thousands, except per share data)	2017		2016		2017		2016
Basic earnings per share:
Net income available to shareholders	$	1,766	$	1,884	$	5,786	$	5,294
Basic earnings per share	$	0.30	$	0.32	$	0.99	$	0.90
Diluted earnings per share:
Net income available to shareholders	$	1,766	$	1,884	$	5,786	$	5,294
Average shares outstanding		5,825,825		5,859,415		5,834,679		5,869,569
Effect of dilutive stock options		5,561		0		5,198		0
Average shares outstanding including dilutive stock options		5,831,386		5,859,415		5,839,877		5,869,569
Diluted earnings per share	$	0.30	$	0.32	$	0.99	$	0.90

Under the treasury stock method, outstanding stock options are dilutive when the average market price of the Company’s common stock, when combined with the effect of any unamortized compensation expense, exceeds the option price during the period, except when the Company has a loss from continuing operations available to shareholders. In addition, proceeds from the assumed exercise of dilutive options along with the related tax benefit are assumed to be used to repurchase common shares at the average market price of such stock during the period.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Options to purchase 46,244 shares during the three and nine months ended September 30, 2016, respectively, were not included in the respective computations of diluted earnings per share because the exercise price of the option, when combined with the effect of the unamortized compensation expense, was greater than the average market price of the common shares and were considered anti-dilutive. There were no anti-dilutive shares for the three and nine months ended September 30, 2017.

Repurchase Program On August 6, 2015, the Board of Directors authorized a share repurchase plan to purchase through open market transactions $2.0 million market value of the Company’s common stock. On August 8, 2017 the Board authorized the repurchase of an additional $1.5 million market value of the Company’s common stock. As of September 30, 2017, the Company had repurchased a total of 74,608 shares of common stock pursuant to the plan at an average price of $17.15 per share, including 30,715 shares of common stock repurchased pursuant to the plan during the nine months ended September 30, 2017 at an average price of $20.30 per share. At September 30, 2017, approximately $2.2 million remained available for the purchase of shares under the plan.

(12)

Fair Value Measurements

The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities. The FASB ASC Topic 820, Fair Value Measurements and Disclosures, defines fair value, establishes a framework for the measurement of fair value, and enhances disclosures about fair value measurements. The standard applies whenever other standards require (permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. In this standard, FASB clarified the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. As of September 30, 2017 and December 31, 2016, respectively, there were no transfers into or out of Levels 1-3.

The fair value hierarchy is as follows:

Level 1 – Inputs are unadjusted quoted prices for identical assets or liabilities in active markets.

Level 2 – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 – Inputs are unobservable inputs for the asset or liability and significant to the fair value. These may be internally developed using the Company’s best information and assumptions that a market participant would consider.

ASC Topic 820 also provides guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased and on identifying circumstances when a transaction may not be considered orderly.

The Company is required to disclose assets and liabilities measured at fair value on a recurring basis separate from those measured at fair value on a nonrecurring basis. Nonfinancial assets measured at fair value on a nonrecurring basis would include foreclosed real estate, long-lived assets, and core deposit intangible assets, which are reviewed when circumstances or other events indicate that impairment may have occurred.

Valuation Methods for Instruments Measured at Fair Value on a Recurring Basis

Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a recurring basis:

Available-for-Sale Securities

The fair value measurements of the Company’s investment securities are determined by a third party pricing service which considers observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. The fair value measurements are subject to independent verification to another pricing source by management each quarter for reasonableness. Securities classified as available-for-sale are reported at fair value utilizing Level 2 inputs.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Mortgage Servicing Rights

The fair value of mortgage servicing rights is based on the discounted value of estimated future cash flows utilizing contractual cash flows, servicing rate, constant prepayment rate, servicing cost, and discount rate factors. Accordingly, the fair value is estimated based on a valuation model that calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The valuation models estimate the present value of estimated future net servicing income. The Company classifies its servicing rights as Level 3.

			Fair Value Measurements
			Quoted Prices
			in Active
			Markets for		Other		Significant
			Identical		Observable		Unobservable
			Assets		Inputs		Inputs
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
September 30, 2017
Assets:
U.S. government and federal agency obligations	$	12,473	$	0	$	12,473	$	0
Government sponsored enterprises		32,619		0		32,619		0
Obligations of states and political subdivisions		47,726		0		47,726		0
Mortgage-backed securities		119,832		0		119,832		0
Mortgage servicing rights		2,688		0		0		2,688
Total	$	215,338	$	0	$	212,650	$	2,688

December 31, 2016
Assets:
U.S. government and federal agency obligations	$	13,364	$	0	$	13,364	$	0
Government sponsored enterprises		32,459		0		32,459		0
Obligations of states and political subdivisions		42,032		0		42,032		0
Mortgage-backed securities		126,657		0		126,657		0
Mortgage servicing rights		2,584		0		0		2,584
Total	$	217,096	$	0	$	214,512	$	2,584

The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Fair Value Measurements Using						Fair Value Measurements Using
	Significant Unobservable Inputs						Significant Unobservable Inputs
	(Level 3)						(Level 3)
	Mortgage Servicing Rights						Mortgage Servicing Rights
(in thousands)	Three Months Ended September 30,						Nine Months Ended September 30,
	2017			2016			2017			2016
Balance at beginning of period	$	2,766		$	2,511		$	2,584		$	2,847
Total gains or losses (realized/unrealized):
Included in earnings		(139	)		(237	)		(72	)		(690	)
Included in other comprehensive income		0			0			0			0
Purchases		0			0			0			0
Sales		0			0			0			0
Issues		61			96			176			213
Settlements		0			0			0			0
Balance at end of period	$	2,688		$	2,370		$	2,688		$	2,370

The change in valuation of mortgage servicing rights arising from inputs and assumptions decreased $30,000 and increased $289,000 for the three and nine months ended September 30, 2017, respectively, compared to decreases of $52,000 and $197,000 for the three and nine months ended September 30, 2016, respectively.

	Quantitative Information about Level 3 Fair Value Measurements
	Valuation Technique	Unobservable Inputs	Input Value
			Nine Months Ended September 30,
			2017			2016
Mortgage servicing rights	Discounted cash flows	Weighted average constant prepayment rate		10.11	%		13.20	%
		Weighted average note rate		3.86	%		3.88	%
		Weighted average discount rate		9.78	%		9.20	%
		Weighted average expected life (in years)		5.80			4.80

Valuation methods for instruments measured at fair value on a nonrecurring basis

Following is a description of the Company’s valuation methodologies used for assets and liabilities recorded at fair value on a nonrecurring basis:

Impaired Loans

The Company does not record loans at fair value on a recurring basis other than loans that are considered impaired. The net carrying value of impaired loans is generally based on fair values of the underlying collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. Once the fair value of the collateral has been determined and any impairment amount calculated, a specific reserve allocation is made. Because many of these inputs are not observable, the measurements are classified as Level 3. As of September 30, 2017, the Company identified $8.0 million in impaired loans that had specific allowances for losses aggregating $1.7 million. Related to these loans, there was $64,000 and $147,000 in charge-offs recorded during the three and nine months ended September 30, 2017, respectively. As of September 30, 2016, the Company identified $7.1 million in impaired loans that had specific allowances for losses aggregating $1.3 million. Related to these loans, there was $153,000 and $920,000 in charge-offs recorded during the three and nine months ended September 30, 2016, respectively.

Other Real Estate and Foreclosed Assets

Other real estate and foreclosed assets consisted of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including autos, manufactured homes, and construction equipment. Other real estate assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. Because many of these inputs are not observable, the measurements are classified as Level 3.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Fair Value Measurements Using
			Quoted Prices						Three			Nine
			in Active						Months			Months
			Markets for		Other		Significant		Ended			Ended
			Identical		Observable		Unobservable		September 30,			September 30,
	Total		Assets		Inputs		Inputs		Total Gains			Total Gains
(in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)		(Losses)*			(Losses)*
September 30, 2017
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	1,151	$	0	$	0	$	1,151	$	0		$	(1	)
Real estate mortgage - residential		3,621		0		0		3,621		(57	)		(122	)
Real estate mortgage - commercial		1,399		0		0		1,399		0			(4	)
Consumer		145		0		0		145		(7	)		(20	)
Total	$	6,316	$	0	$	0	$	6,316	$	(64	)	$	(147	)
Other real estate and
foreclosed assets	$	13,177	$	0	$	0	$	13,177	$	(26	)	$	(206	)

September 30, 2016
Assets:
Impaired loans:
Commercial, financial, & agricultural	$	392	$	0	$	0	$	392	$	0		$	(359	)
Real estate construction - commercial		43		0		0		43		0			0
Real estate mortgage - residential		3,464		0		0		3,464		(80	)		(295	)
Real estate mortgage - commercial		1,806		0		0		1,806		(71	)		(248	)
Consumer		103		0		0		103		(2	)		(18	)
Total	$	5,808	$	0	$	0	$	5,808	$	(153	)	$	(920	)
Other real estate and
foreclosed assets	$	14,438	$	0	$	0	$	14,438	$	21		$	70

* Total gains (losses) reported for other real estate and foreclosed assets includes charge-offs, valuation write downs, and net losses taken during the periods reported.

(13)

Fair Value of Financial Instruments

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate such value:

Loans

The fair values of loans are estimated by discounting the expected future cash flows using the current rates at which similar loans could be made to borrowers with similar credit ratings and for the same remaining maturities. The net carrying amount of impaired loans is generally based on the fair values of collateral obtained through independent appraisals or internal evaluations, or by discounting the total expected future cash flows. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC Topic 820.

Investment Securities

A detailed description of the fair value measurement of the debt instruments in the available-for-sale sections of the investment security portfolio is provided in the Fair Value Measurement section above. A schedule of investment securities by category and maturity is provided in the notes on Investment Securities.

Federal Home Loan Bank (FHLB) Stock

Ownership of equity securities of FHLB is restricted and there is no established market for their resale. The carrying amount is a reasonable estimate of fair value.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

Federal Funds Sold, Cash, and Due from Banks

The carrying amounts of short-term federal funds sold and securities purchased under agreements to resell, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold and securities purchased under agreements to resell classified as short-term generally mature in 90 days or less.

Mortgage Servicing Rights

Cash Surrender Value - Life Insurance

The fair value of Bank owned life insurance (BOLI) approximates the carrying amount. Upon liquidation of these investments, the Company would receive the cash surrender value which equals the carrying amount.

Accrued Interest Receivable and Payable

For accrued interest receivable and payable, the carrying amount is a reasonable estimate of fair value because of the short maturity for these financial instruments.

Deposits

The fair value of deposits with no stated maturity, such as noninterest-bearing demand, NOW accounts, savings, and money market, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Securities Sold under Agreements to Repurchase and Interest-bearing Demand Notes to U.S. Treasury

For securities sold under agreements to repurchase and interest-bearing demand notes to U.S. Treasury, the carrying amount is a reasonable estimate of fair value, as such instruments reprice in a short time period.

Subordinated Notes and Other Borrowings

The fair value of subordinated notes and other borrowings is based on the discounted value of contractual cashflows. The discount rate is estimated using the rates currently offered for other borrowed money of similar remaining maturities.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

A summary of the carrying amounts and fair values of the Company’s financial instruments at September 30, 2017 and December 31, 2016 is as follows:

					September 30, 2017
					Fair Value Measurements
					Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	September 30, 2017				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	Amount		Value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	19,200	$	19,200	$	19,200	$	0	$	0
Federal funds sold and overnight
interest-bearing deposits		41,227		41,227		41,227		0		0
Investment in available-for-sale securities		212,650		212,650		0		212,650		0
Loans, net		1,034,047		1,020,755		0		0		1,020,755
Investment in FHLB stock		5,113		5,113		0		5,113		0
Mortgage servicing rights		2,688		2,688		0		0		2,688
Cash surrender value - life insurance		2,464		2,464		0		2,464		0
Accrued interest receivable		4,879		4,879		4,879		0		0
	$	1,322,268	$	1,308,976	$	65,306	$	220,227	$	1,023,443
Liabilities:
Deposits:
Non-interest bearing demand	$	259,457	$	259,457	$	259,457	$	0	$	0
Savings, interest checking and money market		539,575		539,575		539,575		0		0
Time deposits		308,928		308,696		0		0		308,696
Federal funds purchased and securities sold
under agreements to repurchase		32,555		32,555		32,555		0		0
Subordinated notes		49,486		36,228		0		36,228		0
Federal Home Loan Bank advances		89,408		89,827		0		89,827		0
Accrued interest payable		486		486		486		0		0
	$	1,279,895	$	1,266,824	$	832,073	$	126,055	$	308,696

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

					December 31, 2016
					Fair Value Measurements
					Quoted Prices
					in Active				Net
					Markets for		Other		Significant
	December 31, 2016				Identical		Observable		Unobservable
	Carrying		Fair		Assets		Inputs		Inputs
(in thousands)	amount		value		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash and due from banks	$	25,589	$	25,589	$	25,589	$	0	$	0
Federal funds sold and overnight
interest-bearing deposits		1,406		1,406		1,406		0		0
Investment in available-for-sale securities		214,512		214,512		0		214,512		0
Loans, net		964,143		959,929		0		0		959,929
Investment in FHLB stock		5,149		5,149		0		5,149		0
Mortgage servicing rights		2,584		2,584		0		0		2,584
Cash surrender value - life insurance		2,409		2,409		0		2,409		0
Accrued interest receivable		5,183		5,183		5,183		0		0
	$	1,220,975	$	1,216,761	$	32,178	$	222,070	$	962,513
Liabilities:
Deposits:
Non-interest bearing demand	$	235,975	$	235,975	$	235,975	$	0	$	0
Savings, interest checking and money market		468,731		468,731		468,731		0		0
Time deposits		305,960		304,334		0		0		304,334
Federal funds purchased and securities sold
under agreements to repurchase		31,015		31,015		31,015		0		0
Subordinated notes		49,486		33,712		0		33,712		0
Other borrowings		93,392		93,209		0		93,209		0
Accrued interest payable		498		498		498		0		0
	$	1,185,057	$	1,167,474	$	736,219	$	126,921	$	304,334

Off-Balance Sheet Financial Instruments

The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the likelihood of the counterparties drawing on such financial instruments, and the present creditworthiness of such counterparties. The Company believes such commitments have been made on terms that are competitive in the markets in which it operates.

Limitations

The fair value estimates provided are made at a point in time based on market information and information about the financial instruments. Because no market exists for a portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the fair value estimates.

(14)

Repurchase Reserve Liability

The Company’s repurchase reserve liability for estimated losses incurred on sold loans was $160,000 at both September 30, 2017 and December 31, 2016. This liability represents management’s estimate of the potential repurchase or make-whole liability for residential mortgage loans originated for sale that may arise from representation and warranty claims that could relate to a variety of issues, including but not limited to, misrepresentation of facts, appraisal issues, or program requirements that may not meet investor guidelines. At September 30, 2017, the Company was servicing 2,777 loans sold to the secondary market with a balance of approximately $288.7 million compared to 2,877 loans sold with a balance of approximately $294.4 million at December 31, 2016.

Hawthorn Bancshares, Inc.
and subsidiaries

Notes to the Consolidated Financial Statements

(Unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
(in thousands)	2017		2016			2017		2016
Balance at beginning of year	$	160	$	160		$	160	$	160
Provision for repurchase liability		0		2			0		2
Reimbursement of expenses		0		(2	)		0		(2	)
Balance at end of year	$	160	$	160		$	160	$	160

(15)

Commitments and Contingencies

The Company issues financial instruments with off-balance-sheet risk in the normal course of business of meeting the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

The Company’s extent of involvement and maximum potential exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for financial instruments included on its consolidated balance sheets. At September 30, 2017, no amounts have been accrued for any estimated losses for these financial instruments.

The contractual amount of off-balance-sheet financial instruments were as follows as of the dates indicated:

	September 30,		December 31,
(in thousands)	2017		2016
Commitments to extend credit	$	212,420	$	253,375
Commitments to originate residential first and second mortgage loans		2,597		2,626
Standby letters of credit		29,123		2,745
Total	$	244,140	$	258,746

Commitments

Commitments to extend credit 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. Since certain of the commitments and letters of credit are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, furniture and equipment, and real estate.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support contractual obligations of the Company’s customers. The approximate remaining term of standby letters of credit range from one month to five years at September 30, 2017.

Pending Litigation

The Company and its subsidiaries are defendants in various legal actions incidental to the Company’s past and current business activities. Based on the Company’s analysis, and considering the inherent uncertainties associated with litigation, management does not believe that it is reasonably possible that these legal actions will materially adversely affect the Company’s consolidated financial condition or results of operations in the near term. The Company records a loss accrual for all legal matters for which it deems a loss is probable and can be reasonably estimated. Some legal matters, which are at early stages in the legal process, have not yet progressed to the point where a loss is deemed probable or an amount can be estimated.

Item 2 - Management’s Discussion and Analysis of Financial Condition

And Results of Operations

Forward-Looking Statements

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company, Hawthorn Bancshares, Inc., and its subsidiaries, including, without limitation:

statements that are not historical in nature, and

statements preceded by, followed by or that include the words believes, expects, may, will, should, could, anticipates, estimates, intends or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

competitive pressures among financial services companies may increase significantly,

changes in the interest rate environment may reduce interest margins,

general economic conditions, either nationally or in Missouri, may be less favorable than expected and may adversely affect the quality of our loans and other assets,

increases in non-performing assets in the Company’s loan portfolios and adverse economic conditions may necessitate increases to our provisions for loan losses,

costs or difficulties related to the integration of the business of the Company and its acquisition targets may be greater than expected,

legislative or regulatory changes may adversely affect the business in which the Company and its subsidiaries are engaged, and

changes may occur in the securities markets.

We have described under the caption Risk Factors in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, and in other reports filed with the SEC from time to time, additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that have not been identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speak only as of the date they were made.

Overview

Crucial to the Company’s community banking strategy is growth in its commercial banking services, retail mortgage lending and retail banking services. Through the branch network of its subsidiary bank, the Company, with $1.4 billion in assets at September 30, 2017, provides a broad range of commercial and personal banking services. The Bank’s specialties include commercial banking for small and mid-sized businesses, including equipment, operating, commercial real estate, Small Business Administration (SBA) loans, and personal banking services including real estate mortgage lending, installment and consumer loans, certificates of deposit, individual retirement and other time deposit accounts, checking accounts, savings accounts, and money market accounts. Other financial services that the Company provides include trust services that include estate planning, investment and asset management services and a comprehensive suite of cash management services. The geographic areas in which the Company provides products and services include the Missouri communities in and surrounding Jefferson City, Columbia, Clinton, Warsaw, Springfield, Branson, and the greater Kansas City metropolitan area.

The Company's primary source of revenue is net interest income derived primarily from lending and deposit taking activities. Much of the Company's business is commercial, commercial real estate development, and residential mortgage lending. The Company's income from mortgage brokerage activities is directly dependent on mortgage rates and the level of home purchases and refinancing activity.

The success of the Company's growth strategy depends primarily on the ability of its banking subsidiary to generate an increasing level of loans and deposits at acceptable risk levels and on acceptable terms without significant increases in non-interest expenses relative to revenues generated. The Company's financial performance also depends, in part, on its ability to manage various portfolios and to successfully introduce additional financial products and services by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction. Furthermore, the success of the Company's growth strategy depends on its ability to maintain sufficient regulatory capital levels during periods in which general economic conditions are unfavorable and despite economic conditions being beyond its control.

The Company’s subsidiary bank is a full-service bank conducting a general banking business, offering its customers checking and savings accounts, debit cards, certificates of deposit, safety deposit boxes and a wide range of lending services, including commercial and industrial loans, residential real estate loans, single payment personal loans, installment loans and credit card accounts. In addition, the Bank provides trust services.

The deposit accounts of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The operations of the Bank are supervised and regulated by the FDIC and the Missouri Division of Finance. Periodic examinations of the Bank are conducted by representatives of the FDIC and the Missouri Division of Finance. Such regulations, supervision and examinations are principally for the benefit of depositors, rather than for the benefit of shareholders. The Company is subject to supervision and examination by the Board of Governors of the Federal Reserve System.

CRITICAL ACCOUNTING POLICIES

The following accounting policies are considered most critical to the understanding of the Company’s financial condition and results of operations. These critical accounting policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. Because these estimates and judgments are based on current circumstances, they may change over time or prove to be inaccurate based on actual experiences. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of a materially different financial condition and/or results of operations could reasonably be expected. The impact and any associated risks related to the critical accounting policies on the business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, where such policies affect the reported and expected financial results.

Allowance for Loan Losses

Management has identified the accounting policy related to the allowance for loan losses as critical to the understanding of the Company's results of operations, since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change. Further discussion of the methodology used in establishing the allowance and the impact of any associated risks related to these policies on the Company’s business operations is provided in note 1 to the Company’s unaudited consolidated financial statements and is also discussed in the Lending and Credit Management section below. Many of the loans are deemed collateral dependent for purposes of the measurement of the impairment loss, thus the fair value of the underlying collateral and sensitivity of such fair values due to changing market conditions, supply and demand, condition of the collateral and other factors can be volatile over periods of time. Such volatility can have an impact on the financial performance of the Company.

Other Real Estate and Foreclosed Assets

Other real estate and foreclosed assets consist of loan collateral that has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including vehicles, manufactured homes, and construction equipment. Other real estate assets are initially recorded as held for sale at the fair value of the collateral less estimated selling costs. Any adjustment is recorded as a charge-off against the allowance for loan losses. The Company relies on external appraisals and assessment of property values by internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgment based on experience and expertise of internal specialists. Subsequent to foreclosure, valuations are updated periodically, and the assets may be written down to reflect a new cost basis. The write-downs are recorded as other real estate expense, net. The Company establishes a valuation allowance related to other real estate owned on an asset-by-asset basis. The valuation allowance is created during the holding period when the fair value less cost to sell is lower than the cost of the property.

SELECTED CONSOLIDATED FINANCIAL DATA

The following table presents selected consolidated financial information for the Company as of and for each of the three and nine months ended September 30, 2017 and 2016, respectively. The selected consolidated financial data should be read in conjunction with the unaudited consolidated financial statements of the Company, including the related notes, presented elsewhere herein.

Selected Financial Data
	Three Months Ended						Nine Months Ended
	September 30,						September 30,
*(In thousands, except per share data)*	2017			2016			2017			2016
Per Share Data
Basic earnings per share	$	0.30		$	0.32		$	0.99		$	0.90
Diluted earnings per share		0.30			0.32			0.99			0.90
Dividends paid on common stock		393			273			1,067			815
Book value per share								16.47			15.81
Market price per share								20.70			14.66
Selected Ratios
(Based on average balance sheets)
Return on total assets		0.51	%		0.59	%		0.58	%		0.57	%
Return on stockholders' equity		7.28	%		8.09	%		8.18	%		7.78	%
Stockholders' equity to total assets		7.04	%		7.33	%		7.06	%		7.31	%
Efficiency ratio (1)		75.51	%		74.03	%		74.34	%		75.43	%

(Based on end-of-period data)
Stockholders' equity to assets								6.93	%		7.26	%
Total risk-based capital ratio								13.42	%		14.11	%
Tier 1 risk-based capital ratio								11.17	%		11.63	%
Common equity Tier 1 capital								8.39	%		8.73	%
Tier 1 leverage ratio (2)								9.62	%		9.86	%

(1)

Efficiency ratio is calculated as non-interest expense as a percentage of total revenue (net interest income and non-interest income).

(2)

Tier I leverage ratio is calculated by dividing Tier 1 capital by average total consolidated assets.

RESULTS OF OPERATIONS ANALYSIS

The Company has prepared all of the consolidated financial information in this report in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). In preparing the consolidated financial statements in accordance with U.S. GAAP, the Company makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurances that actual results will not differ from those estimates.

	Three Months Ended September 30,										Nine Months Ended September 30,
					$			%							$		%
*(In thousands)*	2017		2016		Change			Change			2017		2016		Change		Change
Net interest income	$	10,753	$	10,147	$	606			6.0	%	$	32,060	$	29,966	$	2,094		7.0	%
Provision for loan losses		555		300		255			85.0			1,235		975		260		26.7
Noninterest income		2,181		2,125		56			2.6			6,687		6,522		165		2.5
Noninterest expense		9,766		9,085		681			7.5			28,803		27,522		1,281		4.7
Income before
income taxes		2,613		2,887		(274	)		(9.5	)		8,709		7,991		718		9.0
Income tax expense		847		1,003		(156	)		(15.6	)		2,923		2,697		226		8.4
Net income	$	1,766	$	1,884	$	(118	)		(6.3	)%	$	5,786	$	5,294	$	492		9.3	%

Consolidated net income of $1.8 million, or $0.30 per diluted share, for the three months ended September 30, 2017 decreased $118,000 compared to $1.9 million, or $0.32 per diluted share, for the three months ended September 30, 2016. For the three months ended September 30, 2017, the return on average assets was 0.51%, the return on average stockholders’ equity was 7.28%, and the efficiency ratio was 75.51%.

Consolidated net income increased $492,000 to $5.8 million, or $0.99 per diluted share, for the nine months ended September 30, 2017 compared to $5.3 million, or $0.90 per diluted share, for the nine months ended September 30, 2016. For the nine months ended September 30, 2017, the return on average assets was 0.58%, the return on average stockholders’ equity was 8.18%, and the efficiency ratio was 74.34%.

Net interest income was $10.8 million and $32.0 million for the three and nine months ended September 30, 2017, respectively, compared to $10.1 million and $30.0 million for the three and nine months ended September 30, 2016. The net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.35% for the three months ended September 30, 2017, compared to 3.44% for the three months ended September 30, 2016, and decreased to 3.44% for the nine months ended September 30, 2017 compared to 3.48% for the nine months ended September 30, 2016. These changes are discussed in greater detail under the Average Balance Sheets and Rate and Volume Analysis section below.

A $555,000 and $1.2 million provision for loan losses was recorded for the three and nine months ended September 30, 2017, respectively, compared to a $300,000 and $975,000 provision for the three and nine months ended September 30, 2016, respectively.

The Company’s net charge-offs were $100,000, or 0.01% of average loans, for the three months ended September 30, 2017 compared to net charge-offs of $222,000, or 0.02% of average loans, for the three months ended September 30, 2016. For the nine months ended September 30, 2017, the Company’s net charge-offs were $121,000, or 0.01% of average loans, compared to net charge-offs of $109,000, or 0.01% of average loans, for the nine months ended September 30, 2016.

Non-performing loans totaled $11.1 million, or 1.06% of total loans, at September 30, 2017 compared to $9.2 million, or 0.95% of total loans, at December 31, 2016, and $9.3 million, or 0.98% of total loans, at September 30, 2016. These changes are discussed in greater detail under the Lending and Credit Management section below.

Non-interest income increased $56,000, or 2.6%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, and increased $165,000, or 2.5%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. These changes are discussed in greater detail below under Non-interest Income.

Non-interest expense increased $681,000, or 7.5%, for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, and increased $1.3 million, or 4.7%, for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016. These changes are discussed in greater detail below under Non-interest Expense.

Average Balance Sheets

Net interest income is the largest source of revenue resulting from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table presents average balance sheets, net interest income, average yields of earning assets, average costs of interest bearing liabilities, net interest spread and net interest margin on a fully taxable equivalent basis for each of the periods ended September 30, 2017 and 2016, respectively.

	Three Months Ended September 30,
(In thousands)	2017								2016
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)
ASSETS
Loans: (2) (4)
Commercial	$	186,001		$	2,166		4.62	%	$	164,558		$	1,924		4.65	%
Real estate construction - residential		21,532			253		4.66			16,550			189		4.54
Real estate construction - commercial		83,398			952		4.53			46,104			511		4.41
Real estate mortgage - residential		252,329			2,938		4.62			251,085			2,836		4.49
Real estate mortgage - commercial		458,684			5,289		4.57			425,533			4,932		4.61
Consumer		33,852			322		3.77			26,937			292		4.31
Total loans	$	1,035,796		$	11,920		4.57	%	$	930,767		$	10,684		4.57	%
Investment securities: (3)
U.S. government and federal agency obligations	$	49,762		$	175		1.40	%	$	42,340		$	123		1.16	%
Obligations of states and political subdivisions		48,359			268		2.20			31,831			193		2.41
Mortgage-backed securities		119,160			533		1.77			156,720			615		1.56
Total investment securities	$	217,281		$	976		1.78	%	$	230,891		$	931		1.60	%
Other investments and securities, at cost		10,199			101		3.93			9,044			80		3.52
Federal funds sold and interest bearing deposits in other financial institutions		27,144			84		1.23			14,504			19		0.52
Total interest earning assets	$	1,290,420		$	13,081		4.02	%	$	1,185,206		$	11,714		3.93	%
All other assets		88,347								87,697
Allowance for loan losses		(10,603	)							(9,377	)
Total assets	$	1,368,164							$	1,263,526
LIABILITIES AND STOCKHOLDERS' EQUITY
NOW accounts	$	209,704		$	302		0.57	%	$	189,219		$	147		0.31	%
Savings		97,285			12		0.05			96,938			12		0.05
Commercial		1,450			3		0.82			646			1		0.62
Money market		239,742			365		0.60			190,137			131		0.27
Time deposits of $250,000 and over		58,765			119		0.80			71,886			107		0.59
Other time deposits		232,002			463		0.79			237,868			391		0.65
Total interest bearing deposits	$	838,948		$	1,264		0.60	%	$	786,694		$	789		0.40	%
Federal funds purchased and securities sold under agreements to repurchase		29,107			29		0.40			31,393			13		0.16
Subordinated notes		49,486			450		3.61			49,486			375		3.01
Federal Home Loan Bank Advances		100,390			440		1.74			74,109			282		1.51
Total borrowings	$	178,983		$	919		2.04	%	$	154,988		$	670		1.72	%
Total interest bearing liabilities	$	1,017,931		$	2,183		0.85	%	$	941,682		$	1,459		0.62	%
Demand deposits		242,262								220,036
Other liabilities		11,627								9,203
Total liabilities		1,271,820								1,170,921
Stockholders' equity		96,344								92,605
Total liabilities and stockholders' equity	$	1,368,164							$	1,263,526
Net interest income (FTE)					10,898								10,255
Net interest spread							3.17	%							3.31	%
Net interest margin							3.35	%							3.44	%

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $145,000 and $108,000 for the three months ended September 30, 2017 and 2016, respectively.

(2)

Non-accruing loans are included in the average amounts outstanding.

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

	Nine Months Ended September 30,
(In thousands)	2017								2016
				Interest		Rate						Interest		Rate
	Average			Income/		Earned/			Average			Income/		Earned/
	Balance			Expense(1)		Paid(1)			Balance			Expense(1)		Paid(1)
ASSETS
Loans: (2) (4)
Commercial	$	186,492		$	6,456		4.63	%	$	155,384		$	5,535		4.76	%
Real estate construction - residential		20,474			704		4.60			17,624			602		4.56
Real estate construction - commercial		73,821			2,470		4.47			41,489			1,460		4.70
Real estate mortgage - residential		257,249			8,819		4.58			251,819			8,590		4.56
Real estate mortgage - commercial		447,767			15,387		4.59			406,104			14,040		4.62
Consumer		31,975			931		3.89			25,513			854		4.47
Total loans	$	1,017,778		$	34,767		4.57	%	$	897,933		$	31,081		4.62	%
Investment securities: (3)
U.S. government and federal agency obligations	$	48,037		$	507		1.41	%	$	49,216		$	427		1.16	%
Obligations of states and
political subdivisions		46,621			784		2.25			30,549			612		2.68
Mortgage-backed securities		121,145			1,659		1.83			159,693			2,053		1.72
Total investment securities	$	215,803		$	2,950		1.83	%	$	239,458		$	3,092		1.72	%
Other investments and securities, at cost		10,192			285		3.74			8,544			231		3.61
Federal funds sold and interest bearing deposits in other financial institutions		17,885			144		1.08			17,640			69		0.52
Total interest earning assets	$	1,261,658		$	38,146		4.04	%	$	1,163,575		$	34,473		3.96	%
All other assets		88,984								88,942
Allowance for loan losses		(10,332	)							(8,959	)
Total assets	$	1,340,310							$	1,243,558
LIABILITIES AND
STOCKHOLDERS' EQUITY
NOW accounts	$	212,645		$	806		0.51	%	$	201,508		$	471		0.31	%
Savings		99,356			37		0.05			95,403			37		0.05
Commercial		1,542			8		0.69			217			1		0.62
Money market		214,526			695		0.43			183,491			365		0.27
Time deposits of $250,000 and over		59,997			309		0.69			63,179			235		0.50
Other time deposits		231,178			1,252		0.72			237,087			1,180		0.66
Total interest bearing deposits	$	819,244		$	3,107		0.51	%	$	780,885		$	2,289		0.39	%
Federal funds purchased and securities sold under agreements to repurchase		29,141			78		0.36			38,979			51		0.17
Subordinated notes		49,486			1,290		3.49			49,486			1,095		2.96
Federal Home Loan Bank Advances		101,059			1,182		1.56			61,949			732		1.58
Total borrowings	$	179,686		$	2,550		1.90	%	$	150,414		$	1,878		1.67	%
Total interest bearing liabilities	$	998,930		$	5,657		0.76	%	$	931,299		$	4,167		0.60	%
Demand deposits		235,469								211,930
Other liabilities		11,343								9,476
Total liabilities		1,245,742								1,152,705
Stockholders' equity		94,568								90,853
Total liabilities and stockholders' equity	$	1,340,310							$	1,243,558
Net interest income (FTE)					32,489								30,306
Net interest spread							3.28	%							3.36	%
Net interest margin							3.44	%							3.48	%

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $429,000 and $340,000 for the nine months ended September 30, 2017 and 2016, respectively.

(2)

Non-accruing loans are included in the average amounts outstanding.

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

Rate and Volume Analysis

The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates for the three and nine months ended September 30, 2017 compared to the three and nine months ended September 30, 2016. The change in interest due to the combined rate/volume variance has been allocated to rate and volume changes in proportion to the absolute dollar amounts of change in each.

	Three Months Ended September 30,									Nine Months Ended September 30,
	2017 vs. 2016									2017 vs. 2016
				Change due to									Change due to
	Total			Average			Average			Total			Average			Average
(In thousands)	Change			Volume			Rate			Change			Volume			Rate
Interest income on a fully taxable equivalent basis: (1)
Loans: (2) (4)
Commercial	$	242		$	250		$	(8	)	$	921		$	1,081		$	(160	)
Real estate construction - residential		64			59			5			102			98			4
Real estate construction - commercial		441			425			16			1,010			1,085			(75	)
Real estate mortgage - residential		102			14			88			229			186			43
Real estate mortgage - commercial		357			382			(25	)		1,347			1,432			(85	)
Consumer		30			69			(39	)		77			197			(120	)
Investment securities: (3)
U.S. government and federal agency obligations		52			24			28			80			(10	)		90
Obligations of states and political subdivisions		75			93			(18	)		172			282			(110	)
Mortgage-backed securities		(82	)		(160	)		78			(394	)		(521	)		127
Other investments and securities, at cost		21			11			10			54			46			8
Federal funds sold and interest bearing deposits in other financial institutions		65			26			39			75			1			74
Total interest income		1,367			1,193			174			3,673			3,877			(204	)
Interest expense:
NOW accounts		155			18			137			335			27			308
Savings		0			0			0			0			2			(2	)
Commercial		2			0			2			7			7			0
Money market		234			41			193			330			70			260
Time deposits of $250,000 and over		12			(22	)		34			74			(13	)		87
Other time deposits		72			(10	)		82			72			(30	)		102
Federal funds purchased and securities sold under agreements to repurchase		16			(1	)		17			27			(16	)		43
Subordinated notes		75			0			75			195			0			195
Federal Home Loan Bank advances		158			111			47			450			457			(7	)
Total interest expense		724			137			587			1,490			504			986
Net interest income on a fully taxable equivalent basis	$	643		$	1,056		$	(413	)	$	2,183		$	3,373		$	(1,190	)

(1)

Interest income and yields are presented on a fully taxable equivalent basis using the Federal statutory income tax rate of 34%, net of nondeductible interest expense. Such adjustments totaled $145,000 and $429,000 for the three and nine months September 30, 2017, respectively, compared to $108,000 and $340,000 for the three and nine months September 30, 2016, respectively.

(2)

Non-accruing loans are included in the average amounts outstanding.

(3)

Average balances based on amortized cost.

(4)

Fees and costs on loans are included in interest income.

Financial results for the three months ended September 30, 2017 compared to the three months ended September 30, 2016, reflected an increase in net interest income, on a tax equivalent basis, of $643,000, or 6.27%, and the financial results for the nine months ended September 30, 2017 compared to the nine months ended September 30, 2016 reflected an increase of $2.2 million, or 7.20%.

Measured as a percentage of average earning assets, the net interest margin (expressed on a fully taxable equivalent basis) decreased to 3.35% for the three months ended September 30, 2017 compared to 3.44% for the three months ended September 30, 2016, and decreased to 3.44% for the nine months ended September 30, 2017 compared to 3.48% for the nine months ended September 30, 2016. The increase in net interest income was primarily due to an increase in average loans, and the decrease in net interest margin is primarily due to the increase in interest bearing liabilities and the cost of funds. Due to loan growth net interest income has continued to increase. The increase in average cost of deposits was primarily in NOW and money market accounts resulting from market rate increases and new product offerings.

Average interest-earning assets increased $105.2 million, or 8.88%, to $1.29 billion for the three months ended September 30, 2017 compared to $1.19 billion for the three months ended September 30, 2016, and average interest bearing liabilities increased $76.2 million, or 8.10%, to $1.02 billion for the three months ended September 30, 2017 compared to $941.7 million for the three months ended September 30, 2016.

Average interest-earning assets increased $98.1 million, or 8.43%, to $1.26 billion for the nine months ended September 30, 2017 compared to $1.16 billion for the nine months ended September 30, 2016, and average interest bearing liabilities increased $67.6 million, or 7.26%, to $998.9 million for the nine months ended September 30, 2017 compared to $931.3 million for the nine months ended September 30, 2016.

Total interest income (expressed on a fully taxable equivalent basis) was $13.1 million and $38.1 million for the three and nine months ended September 30, 2017, respectively, compared to $11.7 million and $34.5 million for the three and nine months ended September 30, 2016, respectively. The Company’s rates earned on interest earning assets were 4.02% and 4.04% for the three and nine months ended September 30, 2017, respectively, compared to 3.93% and 3.96% for the three and nine months ended September 30, 2016, respectively.

Interest income on loans increased to $11.9 million and $34.8 million for the three and nine months ended September 30, 2017, respectively, compared to $10.7 million and $31.1 million for the three and nine months ended September 30, 2016, respectively.

Average loans outstanding increased $105.0 million, or 11.28%, to $1.04 billion for the three months ended September 30, 2017 compared to $930.8 million for the three months ended September 30, 2016. The average yield on loans receivable was consistent at 4.57% for both the three months ended September 30, 2017 and 2016.

For the nine months ended September 30, 2017, average loans outstanding increased $119.8 million, or 13.35%, to $1.02 billion compared to $897.9 million for the nine months ended September 30, 2016. The average yield on loans receivable decreased to 4.57% for the nine months ended September 30, 2017 compared to 4.62% for the nine months ended September 30, 2016. See the Lending and Credit Management section for further discussion of changes in the composition of the lending portfolio.

Total interest expense was to $2.2 million and $5.7 million for the three and nine months ended September 30, 2017, respectively, compared to $1.5 million and $4.2 million for the three and nine months ended September 30, 2016, respectively. The Company’s rates paid on interest bearing liabilities was 0.85% and 0.76% for the three and nine months ended September 30, 2017, respectively, compared to 0.62% and 0.60% for the three and nine months ended September 30, 2016, respectively. See the Liquidity Management section for further discussion.

Interest expense on deposits increased to $1.3 million and $3.1 million for the three and nine months ended September 30, 2017, respectively, compared to $789,000 and $2.3 million for the three and nine months ended September 30, 2016, respectively.

Average interest bearing deposits increased $52.3 million, or 6.64%, to $838.9 million for the three months ended September 30, 2017 compared to $786.7 million for the three months ended September 30, 2016. The average cost of deposits increased to 0.60% for the three months ended September 30, 2017 compared to 0.40% for the three months ended September 30, 2016.

For the nine months ended September 30, 2017, average interest bearing deposits increased $38.4 million, or 4.91%, to $819.2 million compared to $780.9 million for the nine months ended September 30, 2016. The average cost of deposits increased to 0.51% for the nine months ended September 30, 2017 compared to 0.39% for the nine months ended September 30, 2016 primarily as a result of higher market interest rates.

The Company’s management is continuing to grow core deposits by offering new products. The increase in average cost of deposits was primarily in NOW and money market accounts resulting from market rate increases and new product offerings.

Interest expense on borrowings increased to $919,000 and $2.6 million for the three and nine months ended September 30, 2017, respectively, compared to $670,000 and $1.9 million for the three and nine months ended September 30, 2016, respectively.

Average borrowings increased $24.0 million, or 15.48%, to $179.0 million for the three months ended September 30, 2017 compared to $155.0 million for the three months ended September 30, 2016. The average cost of borrowings increased to 2.04% for the three months ended September 30, 2017 compared to 1.72% for the three months ended September 30, 2016.

For the nine months ended September 30, 2017, average borrowings increased $29.3 million, or 19.46%, to $179.7 million for the nine months ended September 30, 2017 compared to $150.4 million for the nine months ended September 30, 2016. The average cost of borrowings increased to 1.90% for the nine months ended September 30, 2017 compared to 1.67% for the nine months ended September 30, 2016.

The increase in average borrowings was primarily due to an increase in Federal Home Loan advances used to fund loan growth, and the increase in the average cost of borrowings was primarily due to the increase in the LIBOR rates reflected in the subordinated notes in the periods discussed above. The increase See the Liquidity Management section for further discussion.

Non-interest Income and Expense

Non-interest income for the periods indicated was as follows:

	Three Months Ended September 30,												Nine Months Ended September 30,
							$			%									$			%
(In thousands)	2017			2016			Change			Change			2017			2016			Change			Change
Non-interest Income
Service charges and other fees	$	878		$	882		$	(4	)		(0.5	)%	$	2,565		$	2,544		$	21			0.8	%
Bank card income and fees		664			593			71			12.0			1,941			1,875			66			3.5
Trust department income		288			216			72			33.3			828			699			129			18.5
Real estate servicing fees, net		70			(4	)		74			NM			557			(36	)		593			NM
Gain on sales of mortgage loans, net		225			266			(41	)		(15.4	)		599			653			(54	)		(8.3	)
Gain on sale of investment securities		0			111			(111	)		(100.0	)		0			602			(602	)		(100.0	)
Other		56			61			(5	)		(8.2	)		197			185			12			6.5
Total non-interest income	$	2,181		$	2,125		$	56			2.6	%	$	6,687		$	6,522		$	165			2.5	%
Non-interest income as a % of total revenue *		16.2	%		16.4	%								17.5	%		18.2	%

* Total revenue is calculated as net interest income plus non-interest income.

NM = not meaningful

Total non-interest income increased $56,000, or 2.6%, to $2.2 million for the quarter ended September 30, 2017 compared to $2.1 million for the quarter ended September 30, 2016, and increased $165,000, or 2.5%, to $6.7 million for the nine months ended September 30, 2017 compared to $6.5 million for the nine months ended September 30, 2016.

Bank card income and fees increased $71,000 to $664,000 for the quarter ended September 30, 2017 compared to $593,000 for the quarter ended September 30, 2016, and increased $66,000 to $1.9 million for both the nine months ended September 30, 2017 and 2016. The increase was mainly the result of growth in debit card fees as a result of a higher volume of transactions this quarter. The table below is a summary of bank card income and fees for the three and nine months ended September 30, 2017 and 2016.

	Three Months Ended September 30,										Nine Months Ended September 30,
						$		%							$			%
(In thousands)	2017		2016			Change		Change			2017		2016		Change			Change
Debit card	$	616	$	555		$	61		11.0	%	$	1,821	$	1,724	$	97			5.6	%
Credit card		45		38			7		18.4			108		117		(9	)		(7.7	)
Merchant fees		2		(1	)		3		(300.0	)		7		29		(22	)		(75.9	)
Business card		1		1			0		0.0			5		5		0			0.0
Total	$	664	$	593		$	71		12.0	%	$	1,941	$	1,875	$	66			3.5	%

Trust department income increased $72,000 to $288,000 for the quarter ended September 30, 2017 compared to $216,000 for the quarter ended September 30, 2016, and increased $129,000 to $828,000 for the nine months ended September 30, 2017 compared to $699,000 for the nine months ended September 30, 2016. The increase was primarily due to new trust customer relationships.

Real estate servicing fees, net of the change in valuation of mortgage serving rights increased $74,000 to $70,000 for the quarter ended September 30, 2017 compared to $(4,000) for the quarter ended September 30, 2016, and increased $593,000 to $557,000 for the nine months ended September 30, 2017 compared to $(36,000) for the nine months ended September 30, 2016. The increases in both periods were primarily due to slower prepayment speeds resulting from a higher rate environment. Mortgage loan servicing fees earned on loans sold were $209,000 for the quarter ended September 30, 2017 compared to $233,000 for the quarter ended September 30, 2016, and $629,000 for the nine months ended September 30, 2017 compared to $654,000 for the nine months ended September 30, 2016.

The Company was servicing $288.7 million of mortgage loans at September 30, 2017 compared to $294.4 million and $299.7 million at December 31, 2016 and September 30, 2016, respectively.

Gain on sales of mortgage loans decreased $41,000 to $225,000 for the quarter ended September 30, 2017 compared to $266,000 for the quarter ended September 30, 2016, and decreased $54,000 to $599,000 for the nine months ended September 30, 2017 compared to $653,000 for the nine months ended September 30, 2016. The Company sold loans of $10.1 million for the quarter ended September 30, 2017 compared to $11.2 million for the quarter ended September 30, 2016, and $26.3 million for the nine months ended September 30, 2017 compared to $28.8 million for the nine months ended September 30, 2016.

Gain on sale of investment securities - During the nine months ended September 30, 2017 the Company received $2.7 million from proceeds on sales of available securities and recognized gains of $0.1 compared to $60.7 million from proceeds on sales of available-for-sale debt securities and recognized gains of $602,000 for the nine months ended September 30, 2016. These transactions in both periods reported were the result of bond sales and purchases to replace several smaller holdings with fewer, larger investments without materially changing the duration or yield of the investment portfolio.

Non-interest expense for the periods indicated was as follows:

	Three Months Ended September 30,												Nine Months Ended September 30,
							$			%									$			%
(In thousands)	2017			2016			Change			Change			2017			2016			Change			Change
Non-interest Expense
Salaries	$	4,069		$	3,833		$	236			6.2	%	$	12,133		$	11,798		$	335			2.8	%
Employee benefits		1,446			1,230			216			17.6			4,188			3,920			268			6.8
Occupancy expense, net		719			730			(11	)		(1.5	)		2,027			2,037			(10	)		(0.5	)
Furniture and equipment expense		764			438			326			74.4			1,996			1,288			708			55.0
Processing expense, network and bank card expense		831			878			(47	)		(5.4	)		2,803			2,490			313			12.6
Legal, examination, and professional fees		331			277			54			19.5			928			939			(11	)		(1.2	)
FDIC insurance assessment		106			196			(90	)		(45.9	)		322			560			(238	)		(42.5	)
Advertising and promotion		342			283			59			20.8			845			734			111			15.1
Postage, printing, and supplies		234			244			(10	)		(4.1	)		729			771			(42	)		(5.4	)
Real estate foreclosure expense, net		78			49			29			59.2			330			232			98			42.2
Other		846			927			(81	)		(8.7	)		2,502			2,753			(251	)		(9.1	)
Total non-interest expense	$	9,766		$	9,085		$	681			7.5	%	$	28,803		$	27,522		$	1,281			4.7	%
Efficiency ratio *		75.0	%		78.5	%								73.8	%		76.1	%
Number of full-time equivalent employees		335			325

* Efficiency ratio is calculated as non-interest expense as a percent of total revenue (net interest income and non-interest income).

Total non-interest expense increased $681,000, or 7.5%, to $9.8 million for the quarter ended September 30, 2017 compared to $9.1 million for the quarter ended September 30, 2016, and increased $1.3 million, or 4.7%, to $28.8 million for the nine months ended September 30, 2017 compared to $27.5 million for the nine months ended September 30, 2016.

Salaries expense increased $236,000, or 6.2%, to $4.1 million for the quarter ended September 30, 2017 compared to $3.8 million for the quarter ended September 30, 2016, and increased $335,000, or 2.8%, to $12.1 million for the nine months ended September 30, 2017 compared to $11.8 million for the nine months ended September 30, 2016. The increase was primarily due to an increase in personnel and annual merit increases.

Benefits expense increased $216,000, or 17.6%, to $1.4 million for the quarter ended September 30, 2017 compared to $1.2 million for the quarter ended September 30, 2016, and increased $268,000, or 6.8%, to $4.2 million for the nine months ended September 30, 2017 compared to $3.9 million for the nine months ended September 30, 2016. The increase was primarily due to an increase in medical insurance premiums effective July 1, 2017, and an increase in pension expense due to a lower discount rate.

Furniture and equipment expense increased $326,000, or 74.4%, to $764,000 for the quarter ended September 30, 2017 compared to $438,000 for the quarter ended September 30, 2016, and increased $708,000, or 55.0%, to $2.0 million for the nine months ended September 30, 2017 compared to $1.3 million for the nine months ended September 30, 2016. Beginning December 2016, the Company began upgrading its data processing infrastructure to a hosted network environment. The process included changes in maintenance agreements, service providers, and equipment.

Processing, network, and bank card expense decreased $47,000, or 5.4%, to $831,000 for the quarter ended September 30, 2017 compared to $878,000 for the quarter ended September 30, 2016, and increased $313,000, or 12.6%, to $2.8 million for the nine months ended September 30, 2017 compared to $2.5 million for the nine months ended September 30, 2016. The increase for both periods was primarily due to a corporate wide network upgrade and changes in processing service providers.

FDIC insurance assessment decreased $90,000, or 45.9%, to $106,000 for the quarter ended September 30, 2017 compared to $196,000 for the quarter ended September 30, 2016, and decreased $238,000, or 42.5%, to $322,000 for the nine months ended September 30, 2017 compared to $560,000 for the nine months ended September 30, 2016. In February 2011, the FDIC adopted a rule that requires large institutions to bear the burden of raising the reserve ratio form 1.15% to 1.35% in accordance with the Dodd-Frank Act. The quarter after the reserve ratio reached 1.15%, lower assessment rates, surcharges, and new pricing for small institutions under $10 billion became effective July 1, 2016 and appeared on the December 31, 2016 invoicing. Once the reserve ratio reaches 1.38%, small institutions, such as Hawthorn, will receive credits to offset their contribution to raising the reserve ratio to 1.35%.

Real estate foreclosure expense, net increased $29,000, or 59.2%, to $78,000 for the quarter ended September 30, 2017 compared to $49,000 for the quarter ended September 30, 2016, and increased $98,000, or 42.2%, to $330,000 for the nine months ended September 30, 2017 compared to $232,000 for the nine months ended September 30, 2016. Net losses (gains) recognized on other real estate owned were $24,000 for the quarter ended September 30, 2017 compared to $(17,000) for the quarter ended September 30, 2016, and $195,000 for the nine months ended September 30, 2017 compared to $(64,000) for the nine months ended September 30, 2016. Expenses to maintain foreclosed properties were $54,000 for the quarter ended September 30, 2017 compared to $64,000 for the quarter ended September 30, 2016, and $136,000 for the nine months ended September 30, 2017 compared to $296,000 for the nine months ended September 30, 2016. The decrease in expenses period over period was primarily due to sales of foreclosed assets.

Income taxes

Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 32.4% for the quarter ended September 30, 2017 compared to 34.7% for the quarter ended September 30, 2016. Income taxes as a percentage of earnings before income taxes as reported in the consolidated financial statements were 33.6% for the nine months ended September 30, 2017 compared to 33.8% for the nine months ended September 30, 2016. The decrease in the tax rate for the quarter ended September 30, 2017 in comparison to the quarter ended September 30, 2016, is primarily due to an immaterial 2016 return to provision adjustment made in the third quarter of 2017, as opposed to an immaterial 2015 return to provision adjustment made in the first quarter of 2016. The tax rate was consistent for both the nine months ended September 30, 2017 and 2016.

Lending and Credit Management

Interest earned on the loan portfolio is a primary source of interest income for the Company. Net loans represented 74.6% of total assets as of September 30, 2017 compared to 74.9% as of December 31, 2016.

Lending activities are conducted pursuant to an established loan policy approved by the Bank’s Board of Directors. The Bank’s credit review process is overseen by regional loan committees with established loan approval limits. In addition, a senior loan committee reviews all credit relationships in aggregate over an established dollar amount. The senior loan committee meets weekly and is comprised of senior managers of the Bank.

A summary of loans, by major class within the Company’s loan portfolio as of the dates indicated is as follows:

	September 30,			December 31,
(In thousands)	2017			2016
Commercial, financial, and agricultural	$	184,868		$	182,881
Real estate construction - residential		22,723			18,907
Real estate construction - commercial		91,102			55,653
Real estate mortgage - residential		250,736			259,900
Real estate mortgage - commercial		461,988			426,470
Installment loans to individuals		33,630			30,218
Total loans	$	1,045,047		$	974,029
Percent of categories to total loans:
Commercial, financial, and agricultural		17.7	%		18.8	%
Real estate construction - residential		2.2			1.9
Real estate construction - commercial		8.7			5.7
Real estate mortgage - residential		24.0			26.7
Real estate mortgage - commercial		44.2			43.8
Installment loans to individuals		3.2			3.1
Total		100.0	%		100.0	%

The Company extends credit to its local community market through traditional real estate mortgage products. The Company does not participate in extending credit to sub-prime residential real estate markets. The Company does not lend funds for the type of transactions defined as “highly leveraged” by bank regulatory authorities or for foreign loans. Additionally, the Company does not have any concentrations of loans exceeding 10% of total loans that are not otherwise disclosed in the loan portfolio composition table. The Company does not have any interest-earning assets that would have been included in nonaccrual, past due, or restructured loans if such assets were loans.

The Company generally does not retain long-term fixed rate residential mortgage loans in its portfolio. Fixed rate loans conforming to standards required by the secondary market are offered to qualified borrowers, but are not funded until the Company has a non-recourse purchase commitment from the secondary market at a predetermined price. During the three and nine months ended September 30, 2017, the Company sold approximately $10.1 million and $26.3 million of loans to investors, respectively, compared to $11.2 million and $28.8 million for the three and nine months ended September 30, 2016, respectively. At September 30, 2017, the Company was servicing approximately $288.7 million of loans sold to the secondary market compared to $294.4 million at December 31, 2016, and $299.7 million at September 30, 2016.

Risk Elements of the Loan Portfolio

Management, the senior loan committee, and internal loan review, formally review all loans in excess of certain dollar amounts (periodically established) at least annually. Currently, loans in excess of $2.0 million in aggregate and all adversely classified credits identified by management are reviewed. In addition, all other loans are reviewed on a sample basis. The senior loan committee reviews and reports to the board of directors, on a monthly basis, past due, classified, and watch list loans in order to classify or reclassify loans as loans requiring attention, substandard, doubtful, or loss. During this review, management also determines which loans should be considered impaired. Management follows the guidance provided in the FASB’s ASC Topic 310-10-35 in identifying and measuring loan impairment. If management determines that it is probable that all amounts due on a loan will not be collected under the original terms of the loan agreement, the loan is considered to be impaired. These loans are evaluated individually for impairment, and in conjunction with current economic conditions and loss experience, specific reserves are estimated as further discussed below. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic conditions, loan risk ratings and industry concentration. Management believes, but there can be no assurance, that these procedures keep management informed of potential problem loans. Based upon these procedures, both the allowance and provision for loan losses are adjusted to maintain the allowance at a level considered necessary by management to provide for probable losses inherent in the loan portfolio.

Nonperforming Assets

The following table summarizes nonperforming assets at the dates indicated:

	September 30,			December 31,
(In thousands)	2017			2016
Nonaccrual loans:
Commercial, financial, and agricultural	$	3,005		$	982
Real estate construction - commercial		0			50
Real estate mortgage - residential		2,094			1,888
Real estate mortgage - commercial		943			420
Installment and other consumer		168			89
Total	$	6,210		$	3,429
Loans contractually past - due 90 days or more and still accruing:
Real estate mortgage - residential	$	117		$	54
Installment and other consumer		61			11
Total	$	178		$	65
Performing troubled debt restructurings		4,676			5,715
Total nonperforming loans		11,064			9,209
Other real estate owned and repossessed assets		13,177			14,162
Total nonperforming assets	$	24,241		$	23,371

Loans	$	1,045,047		$	974,029
Allowance for loan losses to loans		1.05	%		1.01	%
Nonperforming loans to loans		1.06	%		0.95	%
Allowance for loan losses to nonperforming loans		99.42	%		107.35	%
Allowance for loan losses to nonperforming loans, excluding performing TDR's		172.20	%		282.94	%
Nonperforming assets to loans, other real estate owned and repossessed assets		2.29	%		2.37	%

Total nonperforming assets totaled $24.2 million at September 30, 2017 compared to $23.4 million at December 31, 2016. Nonperforming loans, defined as loans on nonaccrual status, loans 90 days or more past due and still accruing, and TDRs totaled $11.1 million, or 1.06%, of total loans at September 30, 2017 compared to $9.2 million, or 0.95%, of total loans at December 31, 2016. Non-accrual loans included $1.0 million and $619,000 of loans classified as TDRs at September 30, 2017 and December 31, 2016, respectively.

As of September 30, 2017 and December 31, 2016, approximately $4.5 million and $4.0 million, respectively, of loans classified as substandard, not included in the nonperforming asset table, were identified as potential problem loans having more than normal risk which raised doubts as to the ability of the borrower to comply with present loan repayment terms. Management believes the general allowance was sufficient to cover the risks and probable losses related to such loans at September 30, 2017 and December 31, 2016, respectively.

Total non-accrual loans at September 30, 2017 increased $2.8 million to $6.2 million compared to $3.4 million at December 31, 2016. This increase primarily consisted of a $729,000 increase in non-accrual real estate mortgage - commercial loans and real estate mortgage - residential loans, and a $2.0 million increase in non-accrual commercial, financial, and agricultural loans primarily related to four loan relationships totaling $1.9 million.

Loans past due 90 days and still accruing interest at September 30, 2017, were $178,000 compared to $65,000 at December 31, 2016. Other real estate and repossessed assets at September 30, 2017 were $13.2 million compared to $14.2 million at December 31, 2016. During the nine months ended September 30, 2017, $217,000 of nonaccrual loans, net of charge-offs taken, moved to other real estate owned and repossessed assets compared to $2.0 million during the nine months ended September 30, 2016.

The following table summarizes the Company’s TDRs at the dates indicated:

	September 30, 2017						December 31, 2016
(In thousands)	Number of Contracts		Recorded Investment		Specific Reserves		Number of Contracts		Recorded Investment		Specific Reserves
Performing TDRs
Commercial, financial and agricultural		7	$	517	$	21		8	$	635	$	11
Real estate mortgage - residential		10		3,080		223		8		3,582		99
Real estate mortgage - commercial		2		1,079		115		3		1,498		123
Total performing TDRs		19	$	4,676	$	359		19	$	5,715	$	233
Nonperforming TDRs
Commercial, financial and agricultural		2	$	194	$	8	$	-	$	-	$	-
Real estate mortgage - residential		4		246		42		6		430		58
Real estate mortgage - commercial		4		598		122		2		189		119
Total nonperforming TDRs		10	$	1,038	$	172		8	$	619	$	177
Total TDRs		29	$	5,714	$	531		27	$	6,334	$	410

At September 30, 2017, loans classified as TDRs totaled $5.7 million, with $531,000 of specific reserves, of which $1.0 million were classified as nonperforming TDRs and $4.7 million were classified as performing TDRs. This compared to $6.3 million of loans classified as TDRs, with $410,000 of specific reserves, of which $619,000 were classified as nonperforming TDRs and $5.7 million were classified as performing TDRs at December 31, 2016. Both performing and nonperforming TDRs are considered impaired loans. When an individual loan is determined to be a TDR, the amount of impairment is based upon the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the underlying collateral less applicable selling costs. The net decrease in total TDRs from December 31, 2016 to September 30, 2017 was primarily due to $811,000 of payments received partially offset by three new TDR’s totaling $201,000.

Allowance for Loan Losses and Provision

Allowance for Loan Losses

The following table is a summary of the allocation of the allowance for loan losses:

	September 30,		December 31,
(In thousands)	2017		2016
Allocation of allowance for loan losses at end of period:
Commercial, financial, and agricultural	$	3,406	$	2,753
Real estate construction - residential		146		108
Real estate construction - commercial		706		413
Real estate mortgage - residential		1,897		2,385
Real estate mortgage - commercial		4,457		3,793
Installment and other consumer		377		274
Unallocated		11		160
Total	$	11,000	$	9,886

The allowance for loan losses (ALL) was $11.0 million, or 1.05%, of loans outstanding at September 30, 2017 compared to $9.9 million, or 1.01%, of loans outstanding at December 31, 2016, and $9.5 million, or 1.00%, of loans outstanding at September 30, 2016. The ratio of the allowance for loan losses to nonperforming loans, excluding performing TDR’s, was 172.20% at September 30, 2017, compared to 282.94% at December 31, 2016.

The following table is a summary of the general and specific allocations of the allowance for loan losses:

	September 30,		December 31,
(In thousands)	2017		2016
Allocation of allowance for loan losses:
Individually evaluated for impairment - specific reserves	$	1,738	$	1,080
Collectively evaluated for impairment - general reserves		9,262		8,806
Total	$	11,000	$	9,886

The specific reserve component applies to loans evaluated individually for impairment. The net carrying value of impaired loans is generally based on the fair values of collateral obtained through independent appraisals and/or internal evaluations, or by discounting the total expected future cash flows. Once the impairment amount is calculated, a specific reserve allocation is recorded. At September 30, 2017, $1.7 million of the Company’s ALL was allocated to impaired loans totaling approximately $10.9 million compared to $1.1 million of the Company’s ALL allocated to impaired loans totaling approximately $9.1 million at December 31, 2016. Management determined that $2.8 million, or 26%, of total impaired loans required no reserve allocation at September 30, 2017 compared to $2.1 million, or 23%, at December 31, 2016 primarily due to adequate collateral values, acceptable payment history and adequate cash flow ability.

The incurred loss component of the general reserve, or loans collectively evaluated for impairment, is determined by applying loss rates to pools of loans by asset type. Loans not individually evaluated are aggregated by risk characteristics and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type. Beginning in the first quarter of 2016, the Company began to lengthen its look-back period with the intent to increase such period from three to five years over the next two years. The Company believes that the five-year look-back period, which is consistent with the Company’s practices prior to the start of the economic recession in 2008, provides a representative historical loss period in the current economic environment. These historical loss rates for each risk group are used as the starting point to determine loss rates for measurement purposes. The historical loan loss rates are multiplied by loss emergence periods (LEP) which represent the estimated time period between a borrower first experiencing financial difficulty and the recognition of a loss.

The Company’s methodology includes qualitative risk factors that allow management to adjust its estimates of losses based on the most recent information available and to address other limitations in the quantitative component that is based on historical loss rates. Such risk factors are generally reviewed and updated quarterly, as appropriate, and are adjusted to reflect changes in national and local economic conditions and developments, the nature, volume and terms of loans in the portfolio, including changes in volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans, loan concentrations, assessment of trends in collateral values, assessment of changes in the quality of the Company’s internal loan review department, and changes in lending policies and procedures, including underwriting standards and collections, charge-off and recovery practices.

The specific and general reserve allocations represent management’s best estimate of probable losses inherent in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

Provision

A $555,000 and $1.2 million provision for loan losses was required for the three and nine months ended September 30, 2017, respectively, compared to a $300,000 and $975,000 for the three and nine months ended September 30, 2016, respectively. The Company is using a nineteen quarter look-back period compared to fifteen quarters, as discussed above.

The following table summarizes loan loss experience for the periods indicated:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2017		2016		2017		2016
Analysis of allowance for loan losses:
Balance beginning of period	$	10,545	$	9,392	$	9,886	$	8,604
Charge-offs:
Commercial, financial, and agricultural		37		157		97		295
Real estate construction - commercial		-		-		-		1
Real estate mortgage - residential		68		92		149		474
Real estate mortgage - commercial		4		27		20		137
Installment and other consumer		56		86		167		209
Total charge-offs		165		362		433		1,116
Recoveries:
Commercial, financial, and agricultural	$	12	$	26	$	55	$	203
Real estate construction - residential		12		-		87		-
Real estate construction - commercial		-		-		-		502
Real estate mortgage - residential		11		31		68		49
Real estate mortgage - commercial		5		36		26		128
Installment and other consumer		25		47		76		125
Total recoveries		65		140		312		1,007
Net charge-offs		100		222		121		109
Provision for loan losses		555		300		1,235		975
Balance end of period	$	11,000	$	9,470	$	11,000	$	9,470

Net Loan Charge-offs

The Company’s net loan charge-offs were $100,000, or 0.01%, of average loans for the three months ended September 30, 2017, compared to net loan charge-offs of $222,000, or 0.02%, of average loans for the three months ended September 30, 2016. The decrease in charge-offs quarter over quarter primarily related to one commercial loan relationship recorded during the third quarter of 2016.

The Company’s net loan charge-offs were $121,000, or 0.01%, of average loans for the nine months ended September 30, 2017, compared to net loan charge-offs of $109,000, or 0.01%, of average loans for the nine months ended September 30, 2016. Although loan charge-offs decreased year over year, loan recoveries also decreased from the prior year resulting in a net increase in charge-offs. During the nine months ended September 30, 2016, the Company received a significant recovery primarily related to one commercial loan relationship, along with a real estate construction loan recovery resulting from the sale of collateral.

Liquidity and Capital Resources

Liquidity Management

The role of liquidity management is to ensure funds are available to meet depositors' withdrawal and borrowers' credit demands while at the same time maximizing profitability. This is accomplished by balancing changes in demand for funds with changes in the supply of those funds. Liquidity to meet the demands is provided by maturing assets, short-term liquid assets that can be converted to cash and the ability to attract funds from external sources, principally depositors. Due to the nature of services offered by the Company, management prefers to focus on transaction accounts and full service relationships with customers.

The Company’s Asset/Liability Committee (ALCO), primarily made up of senior management, has direct oversight responsibility for the Company's liquidity position and profile. A combination of daily, weekly, and monthly reports provided to management detail the following: internal liquidity metrics, composition and level of the liquid asset portfolio, timing differences in short-term cash flow obligations, available pricing and market access to the financial markets for capital, and exposure to contingent draws on the Company's liquidity.

The Company has a number of sources of funds to meet liquidity needs on a daily basis. The Company’s most liquid assets are comprised of available for sale investment securities, federal funds sold, and excess reserves held at the Federal Reserve.

	September 30,		December 31,
(In thousands)	2017		2016
Federal funds sold and other overnight interest-bearing deposits	$	41,227	$	1,406
Available-for-sale investment securities		212,650		214,512
Total	$	253,877	$	215,918

Federal funds sold and resale agreements normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available-for-sale investment portfolio was $212.7 million at September 30, 2017 and included an unrealized net loss of $1.5 million. The portfolio includes projected maturities and mortgage backed securities pay-downs of approximately $46.1 million over the next twelve months, which offer resources to meet either new loan demand or reductions in the Company’s deposit base.

The Company pledges portions of its investment securities portfolio to secure public fund deposits, federal funds purchase lines, securities sold under agreements to repurchase, borrowing capacity at the Federal Reserve Bank, and for other purposes required by law. At September 30, 2017 and December 31, 2016, the Company’s unpledged securities in the available for sale portfolio totaled approximately $39.6 million and $46.9 million, respectively.

Total investment securities pledged for these purposes were as follows:

	September 30,		December 31,
(In thousands)	2017		2016
Investment securities pledged for the purpose of securing:
Federal Reserve Bank borrowings	$	10,131	$	9,211
Federal funds purchased and securities sold under agreements to repurchase		45,205		43,054
Other deposits		117,749		115,330
Total pledged, at fair value	$	173,085	$	167,595

Liquidity is available from the Company’s base of core customer deposits, defined as demand, interest checking, savings, money market deposit accounts, and time deposits less than $250,000, less all brokered deposits under $250,000. At September 30, 2017, such deposits totaled $977.1 million and represented 88.2% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time deposits and certificates of deposit of $250,000 and over totaled $130.8 million at September 30, 2017. These accounts are normally considered more volatile and higher costing representing 11.8% of total deposits at September 30, 2017.

Core deposits at September 30, 2017 and December 31, 2016 were as follows:

	September 30,		December 31,
(In thousands)	2017		2016
Core deposit base:
Non-interest bearing demand	$	259,457	$	235,975
Interest checking		201,317		177,414
Savings and money market		318,150		276,295
Other time deposits		198,189		206,088
Total	$	977,113	$	895,772

Other components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of securities sold under agreements to repurchase, Federal Home Loan Bank advances, and subordinated notes. Federal funds purchased are overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved credit lines. As of September 30, 2017, under agreements with these unaffiliated banks, the Bank may borrow up to $40.0 million in federal funds on an unsecured basis and $17.9 million on a secured basis. There were no federal funds purchased outstanding at September 30, 2017. Securities sold under agreements to repurchase are generally borrowed overnight and are secured by a portion of the Company’s investment portfolio. At September 30, 2017, there was $32.6 million in repurchase agreements. The Company may periodically borrow additional short-term funds from the Federal Reserve Bank through the discount window; although no such borrowings were outstanding at September 30, 2017.

The Bank is a member of the Federal Home Loan Bank of Des Moines (FHLB). As a member of the FHLB, the Bank has access to credit products of the FHLB. As of September 30, 2017, the Bank had $89.4 million in outstanding borrowings with the FHLB. In addition, the Company has $49.5 million in outstanding subordinated notes issued to wholly-owned grantor trusts, funded by preferred securities issued by the trusts.

Borrowings outstanding at September 30, 2017 and December 31, 2016 were as follows:

	September 30,		December 31,
(In thousands)	2017		2016
Borrowings:
Federal funds purchased and securities sold under agreements to repurchase	$	32,555	$	31,015
Subordinated notes		49,486		49,486
Federal Home Loan Bank advances		89,408		92,900
Other borrowings		-		492
Total	$	171,449	$	173,893

The Company pledges certain assets, including loans and investment securities to the Federal Reserve Bank, FHLB, and other correspondent banks as security to establish lines of credit and borrow from these entities. Based on the type and value of collateral pledged, the FHLB establishes a collateral value from which the Company may draw advances against this collateral. This collateral is also used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged to support borrowings from the discount window. The following table reflects collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company as follows:

	September 30,										December 31,
	2017										2016
(In thousands)	FHLB			Federal Reserve Bank		Federal Funds Purchased Lines		Total			FHLB			Federal Reserve Bank		Federal Funds Purchased Lines			Total
Advance equivalent	$	312,610		$	9,916	$	47,935	$	370,461		$	314,602		$	9,015	$	49,020		$	372,637
Letters of credit		(25,000	)		0		0		(25,000	)		0			0		0			0
Advances outstanding		(89,408	)		0		0		(89,408	)		(92,900	)		0		(992	)		(93,892	)
Total available	$	198,202		$	9,916	$	47,935	$	256,053		$	221,702		$	9,015	$	48,028		$	278,745

At September 30, 2017, loans of $490.8 million were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit. At September 30, 2017, investments totaling $20.4 million were pledged to secure federal funds purchased lines and borrowing capacity at the Federal Reserve Bank.

Sources and Uses of Funds

Cash and cash equivalents were $60.4 million at September 30, 2017 compared to $27.0 million at December 31, 2016. The $33.4 million increase resulted from changes in the various cash flows produced by operating, investing, and financing activities of the Company, as shown in the accompanying consolidated statement of cash flows for the nine months ended September 30, 2017. Cash flow provided from operating activities consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $8.6 million for the nine months ended September 30, 2017.

Investing activities consisting mainly of purchases, sales and maturities of available-for-sale securities, and changes in the level of the loan portfolio used total cash of $68.3 million. The cash outflow primarily consisted of a $70.6 million increase in loans and $32.3 million purchases of investment securities, partially offset by $34.5 million from maturities, calls and sales of investment securities.

Financing activities provided cash of $93.2 million, resulting primarily from a $23.5 million increase in demand deposits, a $70.8 million increase in interest bearing transaction accounts. Future short-term liquidity needs arising from daily operations are not expected to vary significantly during 2017.

In the normal course of business, the Company enters into certain forms of off-balance sheet transactions, including unfunded loan commitments and letters of credit. These transactions are managed through the Company's various risk management processes. Management considers both on-balance sheet and off-balance sheet transactions in its evaluation of the Company's liquidity. The Company had $244.1 million in unused loan commitments and standby letters of credit as of September 30, 2017. Although the Company's current liquidity resources are adequate to fund this commitment level the nature of these commitments is such that the likelihood of such a funding demand is very low.

The Company is a legal entity, separate and distinct from the Bank, which must provide its own liquidity to meet its operating needs. The Company’s ongoing liquidity needs primarily include funding its operating expenses and paying cash dividends to its shareholders. The Company paid cash dividends to its shareholders totaling approximately $1.1 million and $815,000 for the nine months ended September 30, 2017 and 2016, respectively. A large portion of the Company’s liquidity is obtained from the Bank in the form of dividends. The Bank declared and paid a $2.6 million dividend to the Company during the nine months ended September 30, 2017 compared to no dividends were declared or paid for the same period of 2016. At September 30, 2017 and December 31, 2016, the Company had cash and cash equivalents totaling $2.8 million and $3.9 million, respectively.

Capital Management

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification of the Company and the Bank are subject to qualitative judgments by the regulators about components, risk-weightings, and other factors.

In July 2013, the federal banking agencies issued final rules to implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The phase-in period for the Company began on January 1, 2015. The Federal Reserve System’s (FRB) capital adequacy guidelines require that bank holding companies maintain a Common Equity Tier 1 risk-based capital ratio equal to at least 4.5% of its risk-weighted assets, a Tier 1 risk-based capital ratio equal to at least 6% of its risk-weighted assets and a total risk-based capital ratio equal to at least 8% of its risk-weighted assets. In addition, bank holding companies generally are required to maintain a Tier 1 leverage ratio of at least 4%.

In addition, the final rules establish a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets applicable to all banking organizations. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning in 2016. On January 1, 2016, the first phase of the requirement went into effect at 0.625% of risk-weighted assets, and the requirement will increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of risk weighted assets on January 1, 2019. Once fully phase in , the capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis.

Under the Basel III requirements, at September 30, 2017 and December 31, 2016, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table as of periods indicated:

											Well-Capitalized Under
						Required for Capital					Prompt Corrective Action
	Actual					Adequacy Purposes					Provision
*(in thousands)*	Amount		Ratio			Amount		Ratio			Amount		Ratio
September 30, 2017
Total Capital (to risk-weighted assets):
Company	$	158,007		13.42	%	$	94,201		8.00	%	$	N.A.		N.A.	%
Bank		154,448		13.16			93,874		8.00			117,343		10.00
Tier I Capital (to risk-weighted assets):
Company	$	131,479		11.17	%	$	70,650		6.00	%	$	N.A.		N.A.	%
Bank		143,288		12.21			70,406		6.00			93,874		8.00
Common Equity Tier I Capital
(to risk-weighted assets)
Company	$	98,847		8.39	%	$	52,988		4.50	%	$	N.A.		N.A.	%
Bank		143,288		12.21			52,804		4.50			76,273		6.50
Tier I Capital (to adjusted average assets):
Company	$	131,479		9.62	%	$	54,682		4.00	%	$	N.A.		N.A.	%
Bank		143,288		10.52			54,503		4.00			68,129		5.00

(in thousands)
December 31, 2016
Total Capital (to risk-weighted assets):
Company	$	152,864		13.88	%	$	88,125		8.00	%		N.A.		N.A.	%
Bank		148,304		13.51			87,810		8.00		$	109,763		10.00
Tier I Capital (to risk-weighted assets):
Company	$	125,779		11.42	%	$	66,093		6.00	%		N.A.		N.A.	%
Bank		138,258		12.60			65,858		6.00		$	87,810		8.00
Common Equity Tier I Capital
(to risk-weighted assets):
Company	$	94,818		8.61	%	$	49,570		4.50	%	$	N.A.		N.A.	%
Bank		138,258		12.60			49,393		4.50			71,346		6.50
Tier I capital (to adjusted average assets):
Company	$	125,779		9.87	%	$	50,998		4.00	%	$	N.A.		N.A.	%
Bank		138,258		10.88			50,810		4.00			63,513		5.00

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Sensitivity

Market risk arises from exposure to changes in interest rates and other relevant market rate or price risk. The Company faces market risk in the form of interest rate risk through transactions other than trading activities. The Company uses financial modeling techniques to measure interest rate risk. These techniques measure the sensitivity of future earnings due to changing interest rate environments. Guidelines established by the Company's Asset/Liability Committee and approved by the board of directors are used to monitor exposure of earnings at risk. General interest rate movements are used to develop sensitivity as the Company feels it has no primary exposure to specific points on the yield curve. For the three months ended September 30, 2017, our Company utilized a 400 basis point immediate and gradual move in interest rates (both upward and downward) applied to both a parallel and proportional yield curve. However, there are no assurances that the change will not be more or less than this estimate.

The following table represents estimated interest rate sensitivity and periodic and cumulative gap positions calculated as of September 30, 2017. Significant assumptions used for this table included: loans will repay at historic repayment rates; certain interest-bearing demand accounts are interest sensitive due to immediate repricing, and fixed maturity deposits will not be withdrawn prior to maturity. A significant variance in actual results from one or more of these assumptions could materially affect the results reflected in the table.

														Over
														5 Years or
														No Stated
(In thousands)	Year 1			Year 2			Year 3			Year 4		Year 5		Maturity		Total
ASSETS
Investment securities	$	46,099		$	42,682		$	40,968		$	29,344	$	19,301	$	34,256	$	212,650
Federal funds sold and other over-night interest-bearing deposits		41,227			-			-			-		-		-		41,227
Other investments and securities, at cost		6,760			-			3,000			-		-		-		9,760
Loans		370,670			159,645			169,916			123,762		127,023		94,031		1,045,047
Total	$	464,756		$	202,327		$	213,884		$	153,106	$	146,324	$	128,287	$	1,308,684

LIABILITIES
Savings, interest checking, and money market deposits	$	326,738		$	-			212,837		$	-	$	-	$	-	$	539,575
Time deposits		203,943			45,742			27,348			6,318		25,577		-		308,928
Federal funds purchased and securities sold under agreements to repurchase		32,555			-			-			-		-		-		32,555
Subordinated notes		49,486			-			-			-		-		-		49,486
Federal Home Loan Bank advances		22,225			27,230			31,234			4,240		4,479		-		89,408
Total	$	634,947		$	72,972		$	271,419		$	10,558	$	30,056	$	-	$	1,019,952
Interest-sensitivity GAP
Periodic GAP	$	(170,191	)	$	129,355		$	(57,535	)	$	142,548	$	116,268	$	128,287	$	288,732
Cumulative GAP	$	(170,191	)	$	(40,836	)	$	(98,371	)	$	44,177	$	160,445	$	288,732	$	288,732

Ratio of interest-earning assets to interest-bearing liabilities
Periodic GAP		0.73			2.77			0.79			14.50		4.87		NM		1.28
Cumulative GAP		0.73			0.94			0.90			1.04		1.16		1.28		1.28

Effects of Inflation

The effects of inflation on financial institutions are different from the effects on other commercial enterprises since financial institutions make few significant capital or inventory expenditures, which are directly affected by changing prices. Because bank assets and liabilities are virtually all monetary in nature, inflation does not affect a financial institution as much as do changes in interest rates. The general level of inflation does underlie the general level of most interest rates, but interest rates do not increase at the rate of inflation as do prices of goods and services. Rather, interest rates react more to changes in the expected rate of inflation and to changes in monetary and fiscal policy.

Inflation does have an impact on the growth of total assets in the banking industry, often resulting in a need to increase capital at higher than normal rates to maintain an appropriate capital to asset ratio. In the opinion of management, inflation did not have a significant effect on the Company's operations for the three months ended September 30, 2017.

Item 4. Controls and Procedures

Our Company's management has evaluated, with the participation of our principal executive and principal financial officers, the effectiveness of our disclosure controls and procedures as defined in Rules 13a – 15(e) or 15d – 15(e) of the Securities Exchange Act of 1934 as of September 30, 2017. Based upon and as of the date of that evaluation, our principal executive and principal financial officers concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports we file and submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as and when required. It should be noted that any system of disclosure controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any system of disclosure controls and procedures is based in part upon assumptions about the likelihood of future events. Because of these and other inherent limitations of any such system, there can be no assurance that any design will always succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

There has been no change in our Company's internal control over financial reporting that occurred during the three months ended September 30, 2017 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Impact of New Accounting Standards

Revenue from Contracts with Customers The FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), in May 2014. The ASU supersedes revenue recognition requirements in Topic 605, Revenue Recognition, including most industry-specific revenue recognition guidance in the FASB Accounting Standards Codification. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance identifies specific steps that entities should apply in order to achieve this principle. The amendments are effective for interim and annual periods beginning January 1, 2018 and must be applied retrospectively.

In March 2016, the FASB began to issue targeted guidance to clarify specific implementation issues of ASU 2014-09. The FASB issued ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which provides guidance on determining an entity's role in providing goods and services as a principal versus an agent, and whether it controls each specified good or service before it is transferred to the customer. In April 2016, ASU 2016-10, Identifying Performance Obligations and Licensing, was issued which clarifies the guidance related to whether goods or services are distinct within the contract and therefore are a performance obligation, and clarifies the timing and pattern of revenue recognition for licenses of intellectual property. The effective date and transition requirements of these ASUs are the same as those of ASU 2014-09.

In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients. The amendments in this update address narrow-scope improvements to the accounting guidance on collectability, noncash consideration, and completed contracts at transition. Additionally, the amendments in this Update provide a practical expedient for contract modifications at transition and an accounting policy election related to the presentation of sales taxes and other similar taxes collected from customers. The amendments also included a rescission issued in May 2016, ASU 2016-11, Revenue Recognition and Derivatives and Hedging: Rescission of SEC Guidance Because of ASU 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 Emerging Task Force meeting, and relates to revenue and expense recognition for freight services in process, accounting for shipping and handling fees and costs, and accounting for consideration given by a vendor to a customer.

The FASB continues to issue additional ASU’s clarifying the revenue recognition guidance for certain implementation issues. Under the ASU 2014-09 and related amendments, the guidance is effective for periods beginning January 1, 2018 and must be applied retroactively, whether through a full restatement of prior periods or a cumulative adjustment upon adoption of the ASU. The Company is currently evaluating certain non-interest income financial statement line items that contain revenue streams that are in the scope of this update such as service charges and fees, trust department revenue, debit card income, ATM surcharge income, and real-estate sales, and expects to adopt the ASU in the first quarter of 2018. Based on preliminary analysis of the Company’s review of its contracts and other agreements that are within the scope of this guidance, no material changes to the timing of revenue recognition have been identified. The Company will continue to evaluate the impact of this accounting guidance, including any additional guidance issued, during the completion of this internal assessment, and expects to expand its qualitative and quantitative disclosures of revenue recognition upon adoption.

Debt Instruments The FASB issued ASU 2016-06, Contingent Put and Call Options in Debt Instruments, in March 2016. The ASU clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. Under the new guidance, the embedded options should be assessed solely in accordance with a four-step decision sequence, with no additional assessment of whether the triggering event is indexed to interest rates or credit risk. The amendments are effective January 1, 2017 and are not expected to have a significant effect on the Company's consolidated financial statements.

Financial Instruments The FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, in January 2016. The amendments require all equity investments to be measured at fair value with changes in the fair value recognized through net income, other than those accounted for under the equity method of accounting or those that result in the consolidation of the investee. Additionally, these amendments require presentation in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk for those liabilities measured at fair value. The amendments also require use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements, including potential changes to the Company's note disclosure of the fair value of its loan portfolio.

In September 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The revised accounting guidance will remove all recognition thresholds and will require a company to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument's contractual life. It also amends the credit loss measurement guidance for available-for-sale debt securities and beneficial interests in securitized financial assets. This new accounting guidance will be effective for interim and annual reporting periods beginning after December 15, 2019. While the Company generally expects to recognize a one-time cumulative effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective, the Company has not determined the magnitude of any such one-time adjustment or the overall impact of the new guidance on the Company’s consolidated financial statements. The Company has formed a committee and is continuing to evaluate the impact of the ASU's adoption on the Company's consolidated financial statements.

Leases In February 2016, the FASB issued ASU 2016-02, Leases, in order to increase transparency and comparability by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The ASU primarily affects lessee accounting, which requires the lessee to recognize a right-of-use asset and a liability to make lease payments for those leases classified as operating leases under previous GAAP. For leases with a term of 12 months or less, an election by class of underlying asset not to recognize lease assets and lease liabilities is permitted. The ASU also provides additional guidance as to the definition of a lease, identification of lease components, and sale and leaseback transactions. The amendments in the ASU are effective for interim and annual periods beginning January 1, 2019. The Company continues to evaluate the provision of the new lease standard, but due to the small number of lease agreements, the impact of the adoption is not expected to have a significant effect on the Company's consolidated financial statements.

Liabilities The FASB issued ASU 2016-04, Recognition of Breakage for Certain Prepaid Store-Value Products, in March 2016, in order to address current and potential future diversity in practice related to the derecognition of a prepaid store-value product liability. Such products include prepaid gift cards issued on a specific payment network and redeemable at network-accepting merchant locations, prepaid telecommunication cards, and traveler's checks. The amendments require that the portion of the dollar value of prepaid stored-value products that is ultimately unredeemed (that is, the breakage) be accounted for consistent with the breakage guidance for stored-value product transactions provided in ASC Topic 606 - Revenue from Contracts with Customers. These amendments are effective for interim and annual periods beginning January 1, 2018. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.

Statement of Cash Flows The FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, in August 2016, in order to address concerns regarding diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. In particular, this ASU addresses eight specific cash flow issues in an effort to reduce this diversity in practice: (1) debt prepayment or debt extinguishment costs; (2) settlement of zero-coupon bonds; (3) contingent consideration payments made after a business combination; (4) proceeds from the settlement of insurance claims; (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (6) distributions received from equity method investees; (7) beneficial interests in securitization transactions; and (8) separately identifiable cash flows and application of the predominance principle. The amendments are effective for annual periods beginning after December 15, 2017, and for interim periods within those annual periods. The Company is in the process of evaluating the impact of the ASU's adoption on the Company's consolidated financial statements.

The FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, in November 2016. The ASU addresses the current diversity in the classification and presentation of changes in restricted cash on the statement of cash flows. The ASU requires that amounts described as restricted cash and restricted cash equivalents be included with cash and cash equivalents when reconciling the beginning and end of period amounts shown on the statement of cash flows. Disclosures are to be provided on the nature of restrictions on cash and cash equivalents. When presented in more than one line item within the statement of financial position, the entity shall disclose the amounts, disaggregated by line item, of cash, cash equivalents, restricted cash, and restricted cash equivalents reported within the statement of financial position. The amendments are effective January 1, 2018 and are not expected to have a significant effect on the Company's consolidated financial statements.

Pension The FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost in March 2017. Under the new guidance, employers will present the service cost component of the net periodic benefit cost in the same income statement line item (e.g., Salaries and Benefits) as other employee compensation costs arising from services rendered during the period. In addition, only the service cost component will be eligible for capitalization in assets. Employers will present the other components separately (e.g., Other Noninterest Expense) from the line item that includes the service cost. The ASU is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted, however, the Company has decided not to early adopt. Employers will apply the guidance on the presentation of the components of net periodic benefit cost in the income statement retrospectively. The guidance limiting the capitalization of net periodic benefit cost in assets to the service cost component will be applied prospectively. The Company expects to utilize the ASU’s practical expedient allowing entities to estimate amounts for comparative periods using the information previously disclosed in their pension and other postretirement benefit plan footnote. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

Callable Debt Securities The FASB issued ASU 2017-08, Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities in March 2017. This ASU shortens the amortization period for the premium on certain purchased callable debt securities to the earliest call date. Today, entities generally amortize the premium over the contractual life of the security. The new guidance does not change the accounting for purchased callable debt securities held at a discount; the discount continues to be amortized to maturity. The ASU is effective for interim and annual reporting periods beginning after December 15, 2018 and early adoption is permitted. The guidance calls for a modified retrospective transition approach under which a cumulative-effect adjustment will be made to retained earnings as of the beginning of the first reporting period in which the guidance is adopted. The Company is currently evaluating the provisions of ASU 2017-08 to determine the potential impact the new standard will have on the Company’s Consolidated Financial Statements.

Stock Compensation The FASB issued ASU 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting in May 2017. Under the new guidance an entity may change the terms or conditions of a share-based payment award for many different reasons, and the nature and effect of the change can vary significantly. Modification is currently defined as "a change in any of the terms or conditions of a share-based payment award." The amendments in this ASU provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in accordance with Topic 718. The amendments will be effective for interim and annual reporting periods beginning after December 15, 2017. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

Derivatives and Hedging The FASB issued guidance within ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities in August 2017. The amendments in ASU 2017-12 to Topic 815, Derivatives and Hedging, is intended to more closely align hedge accounting with companies' risk management strategies, simplify the application of hedge accounting, and increase transparency as to the scope and results of hedging programs. The guidance also amends the presentation and disclosure requirements and changes how companies assess effectiveness. Under the new guidance, public companies will have until the end of the first quarter in which a hedge is designated to perform an initial assessment of a hedge's effectiveness. After initial qualification, the new guidance permits a qualitative effectiveness assessment for certain hedges instead of a quantitative test if the company can reasonably support an expectation of high effectiveness throughout the term of the hedge. Additional disclosures include cumulative basis adjustments for fair value hedges and the effect of hedging on individual income statement line items. The amendments in this Update are effective for fiscal years beginning after December 15, 2018, and interim period within those fiscal years. Early adoption is permitted in any interim period after issuance of the Update. The ASU is not expected to have a significant effect on the Company’s Consolidated Financial Statements.

PART II - OTHER INFORMATION

Item 1.

Legal Proceedings

The information required by this Item is set forth in Commitments and Contingencies, Pending Litigation, in our Company’s Notes to Consolidated Financial Statements (unaudited).

Item 1A.	Risk Factors	None

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

The following table summarizes the purchases made by or on behalf of the Company or certain affiliated purchasers of shares of the Company's common stock during the three months ended September 30, 2017:

Period	(a) Total Number of Shares (or Units) Purchased		(b) Average Price Paid per Share (or Unit)		(c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs *
July 1-31, 2017		3,717	$	20.78		3,717	$	1,177,099
August 1-31, 2017		12,116	$	20.47		12,116	$	2,429,101
September 1-30, 2017		10,167	$	20.53		10,167	$	2,220,401
Total		26,000	$	20.54		26,000	$	2,220,401

* On August 6, 2015, the Company announced that its Board of Directors authorized the purchase, through open market transactions, of up to $2.0 million market value of the Company's common stock. On August 8, 2017, the Board authorized the repurchase of an additional $1.5 million market value of the Company’s common stock. Management was given discretion to determine the number and pricing of the shares to be purchased, as well as, the timing of any such purchases.

Item 3.	Defaults Upon Senior Securities	None

Item 4.	Mine Safety Disclosures	None

Item 5.	Other Information	None

Item 6. Exhibits

Exhibit No.		Description

3.1		Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company's current report on Form 8-K on August 9, 2007 and incorporated herein by reference).

3.2		Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company's current report on Form 8-K on June 8, 2009 and incorporated herein by reference).

4.1		Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s current report on Form 8-K on June 23, 2017 and incorporated herein by reference).

31.1		Certificate of the Chief Executive Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certificate of the Chief Financial Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certificate of the Chief Executive Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certificate of the Chief Financial Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL).

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.

HAWTHORN BANCSHARES, INC.

Date
	/s/ David T. Turner

November 9, 2017	David T. Turner, Chairman of the Board and
	Chief Executive Officer (Principal Executive Officer)

	/s/ W. Bruce Phelps

November 9, 2017	W. Bruce Phelps, Chief Financial Officer (Principal Financial
	Officer and Principal Accounting Officer)

HAWTHORN BANCSHARES, INC.

INDEX TO EXHIBITS

September 30, 2017 Form 10-Q

Exhibit No.		Description

3.1		Restated Articles of Incorporation of our Company (filed as Exhibit 3.1 to our Company's current report on Form 8-K on August 9, 2007 and incorporated herein by reference).

3.2		Amended and Restated Bylaws of our Company (filed as Exhibit 3.1 to our Company's current report on Form 8-K on June 8, 2009 and incorporated herein by reference).

4.1		Specimen certificate representing shares of our Company’s $1.00 par value common stock (filed as Exhibit 4.1 to our Company’s current report on Form 8-K/A on June 23, 2017 and incorporated herein by reference).

31.1		Certificate of the Chief Executive Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certificate of the Chief Financial Officer of our Company pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certificate of the Chief Executive Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *

32.2		Certificate of the Chief Financial Officer of our Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *

101		Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Changes in Equity, (iv) the Consolidated Statements of Cash Flows and (v) the Notes to Consolidated Financial Statements, tagged as blocks of text and in detail (XBRL).

* This information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and Section 18 of the Securities Exchange Act of 1934, as amended.