QNB CORP - Quarter Report: 2016 June (Form 10-Q)

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QNB Corp. and Subsidiary
CONSOLIDATED BALANCE SHEETS
			(in thousands, except share data) (current period unaudited)
		June 30, 2016				December 31, 2015
Assets
Cash and due from banks		$	10,691			$	9,159
Interest-bearing deposits in banks			47,258				7,832
Total cash and cash equivalents			57,949				16,991
Investment securities
Trading			3,459				4,189
Available-for-sale (amortized cost $339,595 and $362,742)			344,253				361,915
Held-to-maturity (fair value $149 and $151)			147				147
Restricted investment in bank stocks			522				508
Loans held-for-sale			184				987
Loans receivable			604,478				615,270
Allowance for loan losses			(7,550	)			(7,554	)
Net loans			596,928				607,716
Bank-owned life insurance			11,122				10,978
Premises and equipment, net			8,913				9,257
Accrued interest receivable			2,376				2,562
Net deferred tax assets			1,891				3,673
Other assets			2,494				2,013
Total assets		$	1,030,238			$	1,020,936
Liabilities
Deposits
Demand, non-interest bearing		$	117,650			$	98,543
Interest-bearing demand			243,858				274,925
Money market			69,763				67,172
Savings			233,641				221,770
Time			133,684				135,251
Time of $100 or more			94,689				92,125
Total deposits			893,285				889,786
Short-term borrowings			36,693				37,163
Accrued interest payable			330				330
Other liabilities			2,723				3,214
Total liabilities			933,031				930,493
Shareholders' Equity
Common stock, par value $0.625 per share; authorized 10,000,000 shares; 3,555,769 shares and 3,524,363 shares issued; 3,391,200 and 3,359,794 shares outstanding			2,222				2,203
Surplus			16,762				15,973
Retained earnings			77,625				75,289
Accumulated other comprehensive income (loss), net of tax			3,074				(546	)
Treasury stock, at cost; 164,569 shares			(2,476	)			(2,476	)
Total shareholders' equity			97,207				90,443
Total liabilities and shareholders' equity		$	1,030,238			$	1,020,936

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QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF INCOME
		(in thousands, except per share data - unaudited)
		Three Months Ended June 30,								Six Months Ended June 30,
		2016				2015				2016				2015
Interest income
Interest and fees on loans		$	6,332			$	5,965			$	12,684			$	11,846
Interest and dividends on investment securities (AFS & HTM):
Taxable			1,291				1,256				2,647				2,598
Tax-exempt			489				469				1,005				955
Interest on trading securities			30				40				70				81
Interest on interest-bearing balances and other interest income			42				16				58				73
Total interest income			8,184				7,746				16,464				15,553
Interest expense
Interest on deposits
Interest-bearing demand			163				154				315				320
Money market			47				38				94				74
Savings			229				200				455				396
Time			371				389				744				785
Time of $100 or more			319				295				637				590
Interest on short-term borrowings			36				28				79				59
Total interest expense			1,165				1,104				2,324				2,224
Net interest income			7,019				6,642				14,140				13,329
Provision for loan losses			-				60				125				60
Net interest income after provision for loan losses			7,019				6,582				14,015				13,269
Non-interest income
Total other-than-temporary impairment loss on investment securities			(122	)			-				(192	)			-
Net gain on sale of investment securities			137				214				526				717
Net gain on investment securities			15				214				334				717
Net gain (loss) on trading activites			52				(34	)			86				(19	)
Fees for services to customers			397				404				780				806
ATM and debit card			422				394				810				756
Retail brokerage and advisory income			126				204				296				377
Bank-owned life insurance			73				72				144				142
Merchant Income			83				81				156				151
Net gain on sale of loans			71				119				120				182
Other			135				145				224				164
Total non-interest income			1,374				1,599				2,950				3,276
Non-interest expense
Salaries and employee benefits			2,988				3,053				6,042				6,049
Net occupancy			426				455				867				909
Furniture and equipment			440				432				865				861
Marketing			265				212				461				422
Third party services			403				445				806				846
Telephone, postage and supplies			174				175				360				369
State taxes			141				173				321				347
FDIC insurance premiums			157				150				327				317
Other			599				569				1,063				1,071
Total non-interest expense			5,593				5,664				11,112				11,191
Income before income taxes			2,800				2,517				5,853				5,354
Provision for income taxes			702				583				1,490				1,284
Net income		$	2,098			$	1,934			$	4,363			$	4,070
Earnings per share - basic		$	0.62			$	0.58			$	1.29			$	1.22
Earnings per share - diluted		$	0.62			$	0.58			$	1.29			$	1.22
Cash dividends per share		$	0.30			$	0.29			$	0.60			$	0.58

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QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
		(in thousands - unaudited)
Three months ended June 30,		2016												2015
		Before tax amount				Tax expense (benefit)				Net of tax amount				Before tax amount				Tax expense (benefit)				Net of tax amount
Net income		$	2,800			$	702			$	2,098			$	2,517			$	583			$	1,934
Other comprehensive income:
Net unrealized holding gains on securities:
Unrealized holding gains (losses) arising during the period			1,333				453				880				(2,674	)			(909	)			(1,765	)
Reclassification adjustment for gains included in net income			(15	)			(5	)			(10	)			(214	)			(73	)			(141	)
Other comprehensive income (loss)			1,318				448				870				(2,888	)			(982	)			(1,906	)
Total comprehensive income (loss)		$	4,118			$	1,150			$	2,968			$	(371	)		$	(399	)		$	28
Six months ended June 30,		2016												2015
		Before tax amount				Tax expense (benefit)				Net of tax amount				Before tax amount				Tax expense (benefit)				Net of tax amount
Net income		$	5,853			$	1,490			$	4,363			$	5,354			$	1,284			$	4,070
Other comprehensive income:
Net unrealized holding gains on securities:
Unrealized holding gains (losses) arising during the period			5,819				1,979				3,840				(214	)			(73	)			(141	)
Reclassification adjustment for gains included in net income			(334	)			(114	)			(220	)			(717	)			(244	)			(473	)
Other comprehensive income (loss)			5,485				1,865				3,620				(931	)			(317	)			(614	)
Total comprehensive income		$	11,338			$	3,355			$	7,983			$	4,423			$	967			$	3,456

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QNB Corp. and Subsidiary
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(unaudited) (in thousands, except share and per share data)		Number of Shares Outstanding				Common Stock				Surplus				Retained Earnings				Accumulated Other Comprehensive Income (Loss)				Treasury Stock				Total
Balance, December 31, 2015			3,359,794			$	2,203			$	15,973			$	75,289			$	(546	)		$	(2,476	)		$	90,443
Net income			-				-				-				4,363				-				-				4,363
Other comprehensive income, net of tax			-				-				-				-				3,620				-				3,620
Cash dividends declared ($0.60 per share)			-				-				-				(2,027	)			-				-				(2,027	)
Stock issued in connection with dividend  reinvestment and stock purchase plan			16,314				10				467				-				-				-				477
Stock issued for employee stock purchase plan			1,540				1				40				-				-				-				41
Stock issued for options exercised			13,552				8				228				-				-				-				236
Tax benefit of stock options exercised			-				-				12				-				-				-				12
Stock-based compensation expense			-				-				42				-				-				-				42
Balance, June 30, 2016			3,391,200			$	2,222			$	16,762			$	77,625			$	3,074			$	(2,476	)		$	97,207
(unaudited) (in thousands, except share and per share data)		Number of Shares Outstanding				Common Stock				Surplus				Retained Earnings				Accumulated Other Comprehensive Income (Loss)				Treasury Stock				Total
Balance, December 31, 2014			3,316,658			$	2,176			$	14,819			$	70,928			$	907			$	(2,476	)		$	86,354
Net income			-				-				-				4,070				-				-				4,070
Other comprehensive loss, net of tax			-				-				-				-				(614	)			-				(614	)
Cash dividends declared ($0.58 per share)			-				-				-				(1,931	)			-				-				(1,931	)
Stock issued in connection with dividend reinvestment and stock purchase plan			16,123				10				443				-				-				-				453
Stock issued for employee stock purchase plan			1,721				1				42				-				-				-				43
Stock issued for options exercised			7,802				5				91				-				-				-				96
Tax benefit of stock options exercised			-				-				20				-				-				-				20
Stock-based compensation expense			-				-				46				-				-				-				46
Balance, June 30, 2015			3,342,304			$	2,192			$	15,461			$	73,067			$	293			$	(2,476	)		$	88,537

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QNB Corp. and Subsidiary
CONSOLIDATED STATEMENTS OF CASH FLOWS
		(in thousands, unaudited)
Six months ended June 30,		2016				2015
Operating Activities
Net income		$	4,363			$	4,070
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			449				524
Provision for loan losses			125				60
Net gain on investment securities available-for-sale			(334	)			(717	)
Provision for repossessed assets and other real estate owned			-				89
Net gain on sale of other real estate owned, repossessed assets and premises and equipment			(1	)			(70	)
Net gain on sale of loans			(120	)			(182	)
Proceeds from sales of residential mortgages held-for-sale			3,556				6,487
Origination of residential mortgages held-for-sale			(2,633	)			(6,391	)
Income on bank-owned life insurance			(144	)			(142	)
Stock-based compensation expense			42				46
Net decrease in trading securities			730				336
Deferred income tax provision			(83	)			49
Net increase (decrease) in income taxes payable			6				(453	)
Net decrease in accrued interest receivable			186				244
Amortization of mortgage servicing rights and change in valuation allowance			36				31
Net amortization of premiums and discounts on investment securities			940				1,101
Net decrease in accrued interest payable			-				(7	)
Increase in other assets			(493	)			(304	)
Decrease in other liabilities			(27	)			(1,008	)
Net cash provided by operating activities			6,598				3,763
Investing Activities
Proceeds from payments, maturities and calls of investment securities available-for-sale			51,888				51,926
Proceeds from the sale of investment securities available-for-sale			28,814				26,795
Purchases of investment securities available-for-sale			(58,655	)			(30,319	)
Proceeds from redemption of investment in restricted bank stock			1,482				1,318
Purchase of restricted bank stock			(1,496	)			(1,179	)
Net decrease (increase) in loans			10,663				(23,595	)
Net purchases of premises and equipment			(105	)			(214	)
Proceeds from sales of other real estate owned and repossessed assets			1				3,007
Net cash provided by investing activities			32,592				27,739
Financing Activities
Net increase in non-interest bearing deposits			19,107				10,140
Net decrease in interest-bearing deposits			(15,608	)			(35,651	)
Net decrease in short-term borrowings			(470	)			(2,293	)
Tax benefit from exercise of stock options			12				20
Cash dividends paid, net of reinvestment			(1,772	)			(1,717	)
Proceeds from issuance of common stock			499				378
Net cash provided by (used in) financing activities			1,768				(29,123	)
Increase in cash and cash equivalents			40,958				2,379
Cash and cash equivalents at beginning of year			16,991				18,245
Cash and cash equivalents at end of period		$	57,949			$	20,624
Supplemental Cash Flow Disclosures
Interest paid		$	2,324			$	2,231
Income taxes paid			1,555				1,650
Non-cash transactions:
Transfer of loans to repossessed assets or other real estate owned			-				215
Unsettled trades to purchase securities			-				4,729
The accompanying notes are an integral part of the consolidated financial statements

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1. BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements include the accounts of QNB Corp. and its wholly-owned subsidiary, QNB Bank (the “Bank”). The consolidated entity is referred to herein as “QNB” or the “Company”. All significant intercompany accounts and transactions are eliminated in the consolidated financial statements.

 

These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in QNB's 2015 Annual Report incorporated in the Form 10-K. Operating results for the three and six month periods ended June 30, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016.

 

The unaudited consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of operations for the period and are of a normal and recurring nature.

 

Tabular information, other than share and per share data, is presented in thousands of dollars.

 

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from such estimates.

 

The Company has evaluated events and transactions occurring subsequent to the balance sheet date of June 30, 2016, for items that should potentially be recognized or disclosed in these financial statements.

2. RECENT ACCOUNTING PRONOUNCEMENTS

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU was issued to help improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets. The ASU’s core principle is that a company will recognize revenue to depict the transfer of 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. In addition, this update specifies the accounting for certain costs to obtain or fulfill a contract with a customer and expands disclosure requirements for revenue recognition. This ASU is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted for annual reporting periods beginning after December 31, 2015. QNB does not anticipate the adoption of this guidance will have a material impact on its consolidated financial statements.

 

On January 9, 2015, the FASB issued ASU 2015-01, Extraordinary and Unusual Items (Subtopic 225-20) which eliminates from U.S. Generally Accepted Accounting Principles (GAAP) the concept of an extraordinary item. The Board released the new guidance as part of its simplification initiative, which, as explained in the ASU, is intended to “identify, evaluate, and improve areas of U.S. GAAP for which cost and complexity can be reduced while maintaining or improving the usefulness of the information provided to the users of financial statements.” To be considered an extraordinary item under existing U.S. GAAP, an event or transaction must be unusual in nature and must occur infrequently. Stakeholders often questioned the decision-usefulness of labeling a transaction or event as extraordinary and indicated that it is difficult to ascertain whether an event or transaction satisfies both criteria. In light of this feedback and in a manner consistent with its simplification initiative, the FASB decided to eliminate the concept of an extraordinary item. As a result, an entity will no longer (1) segregate an extraordinary item from the results of ordinary operations; (2) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and (3) disclose income taxes and earnings-per-share data applicable to an extraordinary item. However, the ASU does not affect the reporting and disclosure requirements for an event that is unusual in nature or that occurs infrequently. For all entities, the ASU is effective for annual periods beginning after December 15, 2015, and interim periods within those annual periods. Entities may apply the guidance prospectively or retrospectively to all prior periods presented in the financial statements. If an entity chooses to apply the guidance prospectively, it must disclose whether amounts included in income from continuing operations after adoption of the ASU are related to events and transactions previously recognized and classified as extraordinary items before the date of adoption. The adoption of this guidance did not have a material impact on QNB’s consolidated financial statements.

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

2. RECENT ACCOUNTING PRONOUNCEMENTS (continued)

 

On February 18, 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis, which amends the consolidation requirements in ASC 810 and significantly changes the consolidation analysis required under U.S. GAAP. The amendments include the following:

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Limited partnerships will be variable interest entities (VIEs), unless the limited partners have either substantive kick-out or participating rights. Although more partnerships will be VIEs, it is less likely that a general partner will consolidate a limited partnership.

●

The ASU changes the effect that fees paid to a decision maker or service provider have on the consolidation analysis. Specifically, it is less likely that the fees themselves will be considered a variable interest, that an entity will be a VIE, or that consolidation will result.

●

The ASU significantly amends how variable interests held by a reporting entity’s related parties or de facto agents affect its consolidation conclusion. Specifically, the ASU will result in less frequent performance of the related-party tiebreaker test (and mandatory consolidation by one of the related parties) than under current U.S. GAAP.

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For entities other than limited partnerships, the ASU clarifies how to determine whether the equity holders (as a group) have power over the entity (this will most likely result in a change to current practice). The clarification could affect whether the entity is a VIE.

This ASU will be effective for periods beginning after December 15, 2015, for public companies. The adoption of this guidance did not have a material impact on QNB’s consolidated financial statements.

 

On April 7, 2015, the FASB issued ASU 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which changes the presentation of debt issuance costs in financial statements. Under the ASU, an entity presents such costs in the balance sheet as a direct deduction from the related debt liability rather than as an asset. Amortization of the costs is reported as interest expense. For public business entities, the guidance in the ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is allowed for all entities for financial statements that have not been previously issued. Entities would apply the new guidance retrospectively to all prior periods (i.e., the balance sheet for each period is adjusted). QNB has no debt issued at this time so the adoption of this ASU did not have a material impact on the Company.

 

On January 5, 2016, the FASB issued ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. This ASU was issued to enhance the reporting model for financial instruments to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. It will require the following:

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Equity investments with readily determinable fair values must be measured at fair value with changes in fair value recognized in net income.

●

Equity investments without readily determinable fair values must be measured at either fair value or at cost adjusted for changes in observable prices minus impairment. Changes in value under either of these methods would be recognized in net income.

  

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

2. RECENT ACCOUNTING PRONOUNCEMENTS (continued)

 

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Entities that record financial liabilities at fair value due to a fair value option election must recognize changes in fair value in other comprehensive income if it is related to instrument-specific credit risk.

●

Entities must assess whether a valuation allowance is required for deferred tax assets related to available-for-sale debt securities.

This ASU is effective for public companies for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. If QNB had adopted this guidance in 2016 it would have resulted in an increase in net income of $15,000 and $41,000 for the three and six months ended June 30, 2016. There would have been no impact on shareholder’s equity as the equity securities held by QNB are already recorded at fair value through accumulated other comprehensive income (loss).

 

On February 25, 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This new standard on accounting for leases introduces a lessee model that brings most leases on the balance sheet, but recognizes expenses in the income statement similar to how items are recorded today. The new standard eliminates the requirement in current U.S. GAAP for an entity to use bright-line tests in determining lease classification. The ASU also eliminates the current real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs and lease executory costs for all entities. All entities will classify leases to determine how to recognize the related revenue and expense and this classification will affect amounts that lessors record on the balance sheet. The new guidance will be effective for public companies for annual periods beginning after December 15, 2018, and interim periods therein. Early adoption is permitted. QNB is evaluating the impact of this new standard on its consolidated financial statements.

 

On March 15, 2016, the FASB issued ASU 2016-07, Investments – Equity Method and Joint Ventures (Topic 323), Simplifying the Transition to the Equity Method of Accounting. This ASU simplifies the equity method of accounting by eliminating the requirement to retrospectively apply the equity method to an investment that subsequently qualifies for such accounting as a result of an increase in the level of ownership interest or degree of influence. The ASU further requires that unrealized holding gains or losses in accumulated other comprehensive income related to an available-for-sale security that becomes eligible for the equity method be recognized in earnings as of the date on which the investment qualifies for the equity method. The guidance in the ASU is effective for all entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years; early adoption is permitted for all entities. QNB does not anticipate the adoption of this guidance will have a material impact on its consolidated financial statements.

 

On March 17, 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606), Principal versus Agent Considerations (Reporting Revenue Gross versus Net). This ASU amends the principal-versus agent implementation guidance and illustrations in the Board’s new revenue standard (ASU 2014-09). The FASB issued the ASU in response to concerns identified by stakeholders, including those related to (1) determining the appropriate unit of account under the revenue standard’s principal-versus-agent guidance and (2) applying the indicators of whether an entity is a principal or an agent in accordance with the revenue standard’s control principle. This ASU clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. The ASU has the same effective date as the new revenue standard (as amended by the one-year deferral and the early adoption provisions in ASU 2015-14).

 

On March 30, 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting. This ASU simplifies several aspects of the accounting for employee share-based payment transactions for both public and nonpublic entities, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. Entities will be required to recognize the income tax effects of awards in the income statement when awards vest or are settled which will eliminate additional-paid-in-capital or APIC pools. For public companies, the ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within those annual reporting periods. QNB is evaluating this new standard, but does not anticipate the adoption of this guidance will have a material impact on its consolidated financial statements.

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

2. RECENT ACCOUNTING PRONOUNCEMENTS (continued)

On June 16, 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts.

To that end, the new guidance:

●

Eliminates the probable initial recognition threshold in current U.S. GAAP and, instead, reflects an organization’s current estimate of all expected credit losses over the contractual term of its financial assets

●

Broadens the information an entity can consider when measuring credit losses to include forward-looking information

●

Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses

●

Increases comparability of purchased financial assets with credit deterioration (PCD assets) with other purchased assets that do not have credit deterioration as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses for all assets

●

Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage)

●

For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write down

The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income. The new guidance affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

 

For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, the new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. QNB is evaluating the impact of this new standard on its consolidated financial statements.

3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY

 

QNB sponsors stock-based compensation plans, administered by a Board Committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.

 

Stock-based compensation expense was $26,000 and $25,000 for the three months ended June 30, 2016 and 2015, respectively. Stock-based compensation expense was $42,000 and $46,000 for the six months ended June 30, 2016 and 2015, respectively. As of June 30, 2016, there was approximately $120,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 32 months.

 

Options are granted to certain employees at prices equal to the market value of the stock on the date the options are granted. The 1998 Plan authorized the issuance of 220,500 shares. The time period during which any option is exercisable under the Plan is determined by the Committee but shall not commence before the expiration of six months after the date of grant or continue beyond the expiration of ten years after the date the option is awarded. The granted options vest after a three-year period. As of June 30, 2016, there were 225,058 options granted, 60,244 options forfeited, 164,814 options exercised and no remaining options outstanding under this Plan. The 1998 Plan expired on March 10, 2008.

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (continued) 

 

The 2005 Plan authorized the issuance of 200,000 shares. The terms of the 2005 Plan are identical to the 1998 Plan, except options expire five years after the grant date. As of June 30, 2016, there were 184,200 options granted, 65,050 options forfeited, 63,980 options exercised, and 55,170 options outstanding under this Plan. The 2005 Plan expired on March 15, 2015.

 

The 2015 Plan authorizes the issuance of 300,000 shares. The terms of the 2015 Plan are identical to the 2005 Plan. There were 23,500 options granted and outstanding under this Plan as of June 30, 2016. There were no options forfeited or exercised as of June 30, 2016. The 2015 Plan expires on February 24, 2025.

 

The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimated the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.

 

The following assumptions were used in the option pricing model in determining the fair value of options granted during the period:

 

 

 

The risk-free interest rate was selected based upon yields of U.S. Treasury issues with a term approximating the expected life of the option being valued. Historical information was the primary basis for the selection of the expected dividend yield, expected volatility and expected lives of the options.

 

The fair market value of options granted in the first six months of 2016 and 2015 was $3.79 and $4.38, respectively.

 

Stock option activity during the six months ended June 30, 2016 and 2015 is as follows:

 

  

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (continued)

 

 

 

4. SHARE REPURCHASE PLAN

 

The Board of Directors has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. There were no shares repurchased during the six months ended June 30, 2016 and 2015. As of June 30, 2016, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000.

5. EARNINGS PER SHARE

 

The following sets forth the computation of basic and diluted earnings per share:

 

 

 

There were 41,350 stock options that were anti-dilutive for both the three and six-month periods ended June 30, 2016. There were 21,000 stock options that were anti-dilutive for both the three and six-month periods ended June 30, 2015. These stock options were not included in the above calculation.

 

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6. COMPREHENSIVE INCOME

 

The following shows the components of accumulated other comprehensive (loss) income at June 30, 2016 and December 31, 2015:

 

 

The following tables present amounts reclassified out of accumulated other comprehensive (loss) income for the three and six months ended June 30, 2016 and 2015:

 

 

Three months ended June 30,		Amount reclassified from accumulated other comprehensive income
Details about accumulated other comprehensive income		2016				2015			Affected line item in the statement of income
Unrealized net holding gains on available-for-sale securities		$	137			$	214		Net gain on sale of investment securities
Other-than-temporary impairment losses on investment securities			(122	)			-		Net other-than-temporary impairment losses on investment securities
			15				214
Tax effect			(5	)			(73	)	Provision for income taxes
Total reclass out of accumulated other comprehensive income, net of tax		$	10			$	141		Net of tax
Six months ended June 30,		Amount reclassified from accumulated other comprehensive income
Details about accumulated other comprehensive income		2016				2015			Affected line item in the statement of income
Unrealized net holding gains on available-for-sale securities		$	526			$	717		Net gain on sale of investment securities
Other-than-temporary impairment losses on investment securities			(192	)			-		Net other-than-temporary impairment losses on investment securities
			334				717
Tax effect			(114	)			(244	)	Provision for income taxes
Total reclass out of accumulated other comprehensive income, net of tax		$	220			$	473		Net of tax

 

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7. INVESTMENT SECURITIES

 

QNB engages in trading activities for its own account. Municipal securities that are held principally for resale in the near term are recorded in the trading account at fair value with changes in fair value recorded in non-interest income. There were net realized and unrealized gains of $52,000 and losses of $34,000 recorded for the three months ended June 30, 2016 and 2015, respectively. There were net realized and unrealized gains of $86,000 and losses of $19,000 recorded for the six months ended at June 30, 2016 and 2015, respectively. Unrealized gains on trading activity related to trading securities still held at June 30, 2016 and December 31, 2015 totaled $53,000 and $31,000, respectively. Interest and dividends are included in interest income.

 

Trading securities, at fair value, at June 30, 2016 and December 31, 2015 were as follows:

 

 

 

The amortized cost and estimated fair values of investment securities available-for-sale at June 30, 2016 and December 31, 2015 were as follows:

 

 

 

 

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at June 30, 2016 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities are assigned to categories based on contractual maturity except for mortgage-backed securities and CMOs which are based on the estimated average life of these securities and municipal securities that have been pre-refunded.

 

 

For the three months ended June 30, 2016 and 2015, proceeds from sales of investment securities available-for-sale were approximately $4,198,000 and $19,200,000. Proceeds from sales of investment securities available-for-sale were approximately $28,814,000 and $26,795,000 for the six months ended June 30, 2016 and 2015, respectively.

 

Due to favorable conditions in the U.S. equities markets, QNB sold 10 equity holdings, with a book value of $2,731,000 in mid-July 2016, which resulted in a gain on sale of $209,000, net of taxes.

 

At June 30, 2016 and December 31, 2015, investment securities available-for-sale totaling approximately $160,631,000 and $197,149,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.

 

The following table presents information related to the Company’s gains and losses on the sales of equity and debt securities, and losses recognized for the other-than-temporary impairment (“OTTI”) of these investments. Gains and losses on available-for-sale securities are computed on the specific identification method and included in non-interest income. Gross realized losses on equity and debt securities are net of other-than-temporary impairment charges:

 

 

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

The tax expense applicable to the net realized gains for the quarters and six-month periods ended June 30, 2016 and 2015 were $5,000 and $73,000 for the quarter and $114,000 and $244,000 year-to-date, respectively.

 

QNB recognizes OTTI for debt securities classified as available-for-sale in accordance with FASB ASC 320, Investments – Debt and Equity Securities, which requires that we assess whether we intend to sell or it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted at the security’s effective yield. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and, therefore, is not required to be recognized as a loss in the income statement, but is recognized in other comprehensive income. For equity securities, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced to fair value and a corresponding charge to earnings is recognized. QNB believes that we will fully collect the carrying value of securities on which we have recorded a non-credit related impairment in other comprehensive income.

 

The following table presents a roll forward of the credit loss component recognized in earnings. The credit loss component of the amortized cost represents the difference between the present value of expected future cash flows and the amortized cost basis of the security prior to considering credit losses. The beginning balance represents the credit loss component for debt securities for which OTTI occurred prior to the beginning of the year. Credit-impaired debt securities must be presented in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). No credit impairments were recognized on debt securities during the quarter or six months ended June 30, 2016 or 2015, respectively.

 

The following table presents a summary of the cumulative credit-related other-than-temporary impairment charges recognized as components of earnings for debt securities still held by QNB:

 

 

 

The amortized cost and estimated fair values of investment securities held-to-maturity at June 30, 2016 and December 31, 2015 were as follows:

 

 

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

The amortized cost and estimated fair value of securities held-to-maturity by contractual maturity at June 30, 2016 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

There were no sales of investment securities classified as held-to-maturity during the three and six months ended June 30, 2016 or 2015.

 

The following table indicates the length of time individual securities have been in a continuous unrealized loss position at June 30, 2016 and December 31, 2015:

 

 

 

 

 

Management evaluates debt securities, which are comprised of U.S. Government agencies, state and municipalities, mortgage-backed securities, CMOs and corporate debt securities, for other-than-temporary impairment and considers the current economic conditions, the length of time and the extent to which the fair value has been less than cost, interest rates and the bond rating of each security. The unrealized losses at June 30, 2016 in U.S. Government securities, state and municipal securities, mortgage-backed securities, CMOs and corporate debt securities are primarily the result of interest rate fluctuations. If held to maturity, these bonds will mature at par, and QNB will not realize a loss. The Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs.

 

  

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

The Company’s investment in marketable equity securities primarily consists of investments in large cap stock companies. These equity securities are analyzed for impairment on an ongoing basis. Management believes these equity securities will recover in the foreseeable future. QNB evaluated the near-term prospects of the issuers in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold those securities for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these equity securities to be other-than-temporarily impaired.

 

QNB holds six pooled trust preferred securities as of June 30, 2016. These securities have a total amortized cost of approximately $3,094,000 and a fair value of $2,400,000. Five of the six securities have been in an unrealized loss position for more than twelve months. All of the pooled trust preferred securities are available-for-sale securities and are carried at fair value.

 

The following table provides additional information related to pooled trust preferred securities (PreTSLs) as of June 30, 2016:

 

 

Mezzanine* - only class of bonds still outstanding (represents the senior-most obligation of the trust)

 

On January 14, 2014, Regulators released a final rule authorizing retention of pooled trust preferred securities backed primarily by bank-issued trust preferred securities which included the PreTSLs held by QNB. Due to the uncertainty invoked between the original release of the Volcker Rule and the final rule, there was a noticeable increase in trading activity. However, we believe most of these trades occurred under distress and do not represent trades made in an orderly market. Despite the trades that took place as discussed previously, the market for these securities at June 30, 2016 was not active and markets for similar securities also are not active. The new issue market is also inactive and the market values for these securities are depressed relative to historical levels. Lack of liquidity in the market for trust preferred collateralized debt obligations, credit rating downgrades and market uncertainties related to the financial industry are all factors contributing to the temporary impairment of these securities. Although these securities are classified as available-for-sale, the Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs. As illustrated in the previous table, these securities are comprised mainly of securities issued by banks, and to a lesser degree, insurance companies. QNB owns the mezzanine tranches of these securities, except for PreTSL IV which represents the senior-most obligation of the trust.

 

  

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

On a quarterly basis we evaluate our debt securities for other-than-temporary impairment (OTTI), which involves the use of a third-party valuation firm to assist management with the valuation. When evaluating these investments a credit-related portion and a non-credit related portion of impairment are determined. The credit related portion is recognized in earnings and represents the expected shortfall in future cash flows. The non-credit related portion is recognized in other comprehensive income and represents the difference between the book value and the fair value of the security less any current quarter credit related impairment. For the three and six months ended June 30, 2016 and 2015, no other-than-temporary impairment charges representing credit impairment were recognized on our pooled trust preferred collateralized debt obligations. A discounted cash flow analysis provides the best estimate of credit related OTTI for these securities. Additional information related to this analysis follows:

 

All of the pooled trust preferred collateralized debt obligations held by QNB are rated lower than AA and are measured for OTTI within the scope of ASC 325 (formerly known as EITF 99-20), Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to be Held by a Transferor in Securitized Financial Assets, and Amendments to the Impairment Guidance of EITF Issue No. 99-20 (formerly known as EITF 99-20-1). QNB performs a discounted cash flow analysis on all of its impaired debt securities to determine if the amortized cost basis of an impaired security will be recovered. In determining whether a credit loss exists, QNB uses its best estimate of the present value of cash flows expected to be collected from the debt security and discounts them at the effective yield implicit in the security at the date of acquisition or the prospective yield for those securities with prior OTTI charges. The discounted cash flow analysis is considered to be the primary evidence when determining whether credit related other-than-temporary impairment exists.

 

Results of a discounted cash flow test are significantly affected by other variables such as the estimate of future cash flows (including prepayments), credit worthiness of the underlying banks and insurance companies and determination of probability and severity of default of the underlying collateral. The following provides additional information for each of these variables:

 

●

Estimate of Future Cash Flows – Cash flows are constructed in an INTEXcalc valuation model. INTEX is a proprietary cash flow model recognized as the industry standard for analyzing all types of structured debt products. It includes each deal’s structural features updated with trustee information, including asset-by-asset detail, as it becomes available. The modeled cash flows are then used to determine if all the scheduled principal and interest payments of the investments will be returned. For purposes of the cash flow analysis, relatively modest rates of prepayment of 1% were forecasted. In addition to the base prepayment assumption, due to the enactment of the Dodd-Frank Act’s revised Tier 1 capital treatment, additional prepayment analysis was performed. Trust preferred securities issued by banks with more than $15 billion in total assets at December 31, 2009 were identified. The current credit rating of these institutions was reviewed and it was assumed that any U.S. bank holding company with an investment grade credit rating and any foreign banking organization would prepay their issuance as soon as possible. For those institutions rated below investment grade we assumed that any holding company that could refinance for a cost savings of more than 2 percent when compared to the approximate cost of long-term funding given their rating and marketplace interest rates, will refinance as soon as possible. For issuers not impacted by the Tier 1 regulatory capital legislation enacted by the Dodd-Frank Act, the issuers that have shown a recent history of prepayment of both floating rate and fixed rate issues were identified and it was assumed these issuers will prepay as soon as possible.

 

●

Credit Analysis – A quarterly credit evaluation is performed for the companies comprising the collateral across the various pooled trust preferred securities. This credit evaluation considers any available evidence and focuses on capitalization, asset quality, profitability, liquidity, stock price performance, whether the institution has received TARP funding, whether the TARP funding was redeemed or resold through a Treasury Department auction at a premium or discount, and whether the institution has shown the ability to generate additional capital either internally or externally.

 

 

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

 

7. INVESTMENT SECURITIES (continued)

 

●

Probability of Default – A near-term probability of default is determined for each issuer based on its financial condition and is used to calculate the expected impact of future deferrals and defaults on the expected cash flows. Each issuer in the collateral pool is assigned a near-term probability of default based on individual performance and financial characteristics. Various studies suggest that the rate of bank failures between 1934 and 2015 were approximately 0.37%. Thus, in addition to the specific bank default assumptions used for the near term, for future defaults on the individual banks in the analysis for 2016 and beyond the rate used is calculated based on historic default averages and factoring that number based on a comparison of key financial ratios of active individual issuers without a short-term probability of default compared to all FDIC insured banks. Default factors used in the cash flow analysis range from 0.25% to 0.53%.

 

●

Severity of Loss – In addition to the probability of default discussed above, a severity of loss (projected recovery) is determined in all cases. In the current analysis, the severity of loss ranges from 0% to 100% depending on the estimated credit worthiness of the individual issuer. Based on information from various published studies, a 95% severity of loss was utilized for defaults projected in 2016 and thereafter.

 

Based upon the analysis performed by management as of June 30, 2016, it is probable that we will collect all contractual principal and interest payments on one of our six pooled trust preferred securities, PreTSL XIX. The expected principal shortfall on the remaining pooled trust preferred securities has resulted in credit related other-than-temporary impairment charges in previous years. All of these pooled trust preferred securities held by QNB could be subject to additional writedowns in the future if additional deferrals and defaults occur.