QNB CORP - Quarter Report: 2021 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2021

☐	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 0-17706

QNB Corp.

(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania

23-2318082

(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)

15 North Third Street, P.O. Box 9005 Quakertown, PA		18951-9005
(Address of Principal Executive Offices)		(Zip Code)

(215) 538-5600

Registrant's Telephone Number, Including Area Code

Not Applicable

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.

Securities registered pursuant to Section 12(b) of the Act: None.

Title of each class

Trading

Symbol(s)

Name of each exchange on which registered

Common Stock

QNBC

N/A

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

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

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

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

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

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class		Outstanding at April 30, 2021
Common Stock, par value $0.625		3,555,169

QNB CORP. AND SUBSIDIARY

FORM 10-Q

QUARTER ENDED March 31, 2021

INDEX

	PART I - FINANCIAL INFORMATION

ITEM 1.	CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)	PAGE

	Consolidated Balance Sheets at March 31, 2021 and December 31, 2020	3

	Consolidated Statements of Income for the Three a Months Ended March 31, 2021 and 2020	4

	Consolidated Statements of Comprehensive Income (Loss) for the Three Months Ended March 31, 2021 and 2020	5

	Consolidated Statement of Shareholders’ Equity for the Three Months Ended March 31, 2021 and 2020	6

	Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2021 and 2020	7

	Notes to Consolidated Financial Statements	8

ITEM 2.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	36

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK	54

ITEM 4.	CONTROLS AND PROCEDURES	54

	PART II - OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	55

ITEM 1A.	RISK FACTORS	55

ITEM 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	55

ITEM 3.	DEFAULTS UPON SENIOR SECURITIES	55

ITEM 4.	MINE SAFETY DISCLOSURES	55

ITEM 5.	OTHER INFORMATION	55

ITEM 6.	EXHIBITS	56

SIGNATURES

CERTIFICATIONS

QNB Corp. and Subsidiary

CONSOLIDATED BALANCE SHEETS

	(in thousands, except share data)
	(current period unaudited)
	March 31, 2021			December 31, 2020
Assets
Cash and due from banks	$	16,650		$	13,422
Interest-bearing deposits in banks		92,083			25,909
Total cash and cash equivalents		108,733			39,331
Investments:
Available-for-sale (amortized cost $469,961 and $428,495)		469,103			435,646
Equity securities (cost of $13,361 and $12,784)		14,522			12,849
Restricted investment in stocks		1,041			1,041
Loans held-for-sale		3,210			6,570
Loans receivable		945,645			920,042
Allowance for loan losses		(11,115	)		(10,826	)
Net loans		934,530			909,216
Bank-owned life insurance		11,257			11,791
Premises and equipment, net		17,584			15,404
Accrued interest receivable		4,707			4,825
Net deferred tax assets		1,457			66
Other assets		4,375			3,490
Total assets	$	1,570,519		$	1,440,229

Liabilities
Deposits
Demand, non-interest bearing	$	253,857		$	204,584
Interest-bearing demand		410,899			395,364
Money market		113,247			96,811
Savings		381,620			334,223
Time less than $100		100,610			107,582
Time of $100 or more		81,383			89,503
Total deposits		1,341,616			1,228,067
Short-term borrowings		64,947			58,838
Long-term debt		10,000			10,000
Accrued interest payable		246			350
Other liabilities		21,714			8,529
Total liabilities		1,438,523			1,305,784

Shareholders' Equity
Common stock, par value $0.625 per share;
authorized 10,000,000 shares; 3,736,538 shares and 3,725,202
shares issued; 3,559,169 and 3,556,533 shares outstanding		2,335			2,328
Surplus		22,781			22,430
Retained earnings		110,451			106,644
Accumulated other comprehensive (loss) gain, net of tax		(678	)		5,649
Treasury stock, at cost; 177,369 and 168,669 shares		(2,893	)		(2,606	)
Total shareholders' equity		131,996			134,445
Total liabilities and shareholders' equity	$	1,570,519		$	1,440,229

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF INCOME

	For the Three Months Ended March 31,
(in thousands, except per share data - unaudited)	2021		2020
Interest income
Interest and fees on loans	$	10,011	$	9,376
Interest and dividends on investment securities (Available-for-sale & Equity):
Taxable		1,314		1,565
Tax-exempt		386		350
Interest on interest-bearing balances and other interest income		20		40
Total interest income		11,731		11,331
Interest expense
Interest on deposits
Interest-bearing demand		238		580
Money market		82		147
Savings		290		368
Time		279		463
Time of $100,000 or more		231		501
Interest on short-term borrowings		55		92
Interest on long-term debt		39		17
Total interest expense		1,214		2,168
Net interest income		10,517		9,163
Provision for loan losses		275		500
Net interest income after provision for loan losses		10,242		8,663
Non-interest income
Net gain on sales and calls of investments available-for-sale and equity securities		342		—
Unrealized gain (loss) on investment equity securities		1,096		(2,940	)
Fees for services to customers		299		411
ATM and debit card		593		488
Retail brokerage and advisory		167		113
Bank-owned life insurance		263		68
Merchant		104		91
Net gain on sale of loans		352		81
Other		188		117
Total non-interest income		3,404		(1,571	)
Non-interest expense
Salaries and employee benefits		4,017		4,072
Net occupancy		618		523
Furniture and equipment		670		675
Marketing		214		322
Third party services		488		454
Telephone, postage and supplies		198		195
State taxes		273		243
FDIC insurance premiums		171		137
Other		674		657
Total non-interest expense		7,323		7,278
Income before income taxes		6,323		(186	)
Provision (benefit) for income taxes		1,273		(406	)
Net income	$	5,050	$	220
Earnings per share - basic	$	1.42	$	0.06
Earnings per share - diluted	$	1.42	$	0.06
Cash dividends per share	$	0.35	$	0.34
The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

	(in thousands - unaudited)
	2021									2020
For the Three Months Ended March 31,	Before tax amount			Tax expense (benefit)			Net of tax amount			Before tax amount			Tax expense (benefit)			Net of tax amount
Net income	$	6,323		$	1,273		$	5,050		$	(186	)	$	(406	)	$	220
Other comprehensive income:
Net unrealized holding (losses) gains on available-for-sale securities:
Unrealized holding (losses) gains arising during the period		(8,006	)		(1,681	)		(6,325	)		5,812			1,221			4,591
Reclassification adjustment for gains included in net income		(3	)		(1	)		(2	)		—			—			—
Other comprehensive (loss) income		(8,009	)		(1,682	)		(6,327	)		5,812			1,221			4,591
Total comprehensive (loss) income	$	(1,686	)	$	(409	)	$	(1,277	)	$	5,626		$	815		$	4,811

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

For the Three Months Ended March 31, 2021 and 2020

											Accumulated
	Number of										Other
(unaudited)	Shares			Common				Retained			Comprehensive			Treasury
(in thousands, except share and per share data)	Outstanding			Stock		Surplus		Earnings			Income (Loss)			Stock			Total
Balance, January 1, 2021		3,556,533		$	2,328	$	22,430	$	106,644		$	5,649		$	(2,606	)	$	134,445
Net income					—		—		5,050			—			—			5,050
Other comprehensive loss, net of tax					—		—		—			(6,327	)		—			(6,327	)
Cash dividends declared ($0.35 per share)					—		—		(1,243	)		—			—			(1,243	)
Stock issued in connection with dividend reinvestment and stock purchase plan		6,319			4		203		—			—			—			207
Stock issued for options exercised		5,017			3		128		—			—			—			131
Stock-based compensation expense					—		20		—			—			—			20
Treasury stock purchase		(8,700	)		—		—		—			—			(287	)		(287	)
Balance, March 31, 2021		3,559,169		$	2,335	$	22,781	$	110,451		$	(678	)	$	(2,893	)	$	131,996


											Accumulated
	Number of										Other
(unaudited)	Shares			Common				Retained			Comprehensive			Treasury
(in thousands, except share and per share data)	Outstanding			Stock		Surplus		Earnings			Income (Loss)			Stock			Total
Balance, January 1, 2020		3,519,767		$	2,303	$	21,261	$	99,372		$	257		$	(2,476	)	$	120,717
Net income					—		—		220			—			—			220
Other comprehensive income. net of tax					—		—		—			4,591			—			4,591
Cash dividends declared ($0.34 per share)					—		—		(1,197	)		—			—			(1,197	)
Stock issued in connection with dividend reinvestment and stock purchase plan		7,782			4		216		—			—			—			220
Stock issued for options exercised		3,121			2		35		—			—			—			37
Stock-based compensation expense					—		25		—			—			—			25
Balance, March 31, 2020		3,530,670		$	2,309	$	21,537	$	98,395		$	4,848		$	(2,476	)	$	124,613

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF CASH FLOWS

	(in thousands, unaudited)
For the Three Months Ended March 31,	2021			2020
Operating Activities
Net income	$	5,050		$	220
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		470			498
Provision for loan losses		275			500
Net gain on calls and sales of debt and equity securities		(342	)		—
Net unrealized (gain) loss on equity securities		(1,096	)		2,940
Net gain on sale of loans		(352	)		(81	)
Proceeds from sales of residential mortgages held-for-sale		9,105			2,498
Origination of residential mortgages held-for-sale		(4,890	)		(1,656	)
Increase in cash surrender value of bank-owned life insurance		(263	)		(68	)
Stock-based compensation expense		20			25
Deferred income tax provision (benefit)		401			(787	)
Net increase in income taxes payable		333			380
Net increase (decrease) in accrued interest receivable		117			(196	)
Amortization of mortgage servicing rights and change in valuation allowance		23			21
Net amortization of premiums and discounts on investment securities		737			412
Net increase in accrued interest payable		(104	)		(402	)
Operating lease payments		(171	)		(161	)
(Increase) decrease in other assets		(1,051	)		668
Decrease in other liabilities		(159	)		(2,714	)
Net cash provided by operating activities		8,103			2,097
Investing Activities
Proceeds from payments, maturities and calls of investments available-for-sale		27,377			54,977
Proceeds from the sale of investments available-for-sale		—			5,975
Proceeds from the sale of equity securities		1,185			—
Purchases of investments available-for-sale		(56,123	)		(32,167	)
Purchases of equity securities		(1,423	)		(3,193	)
Proceeds from redemption of investment in restricted stock		—			1,495
Purchases of restricted stock		—			(1,422	)
Net increase in loans		(26,091	)		(720	)
Net purchases of premises and equipment		(2,892	)		(216	)
Redemption of Bank Owned Life Insurance investment		797			—
Net cash (used in) provided by investing activities		(57,170	)		24,729
Financing Activities
Net increase (decrease) in non-interest bearing deposits		49,275			(127	)
Net increase in interest-bearing deposits		64,278			5,788
Net increase (decrease) in short-term borrowings		6,109			(12,666	)
Increase in long-term debt		—			10,000
Cash dividends paid, net of reinvestment		(1,092	)		(1,054	)
Purchase of treasury shares		(287	)		—
Proceeds from issuance of common stock		187			114
Net cash provided by financing activities		118,470			2,055
Increase in cash and cash equivalents		69,403			28,881
Cash and cash equivalents at beginning of year		39,331			17,608
Cash and cash equivalents at end of period	$	108,734		$	46,489
Supplemental Cash Flow Disclosures
Interest paid	$	1,318		$	2,570
Net income taxes paid		538			—
Non-cash transactions:
Unsettled trades to purchase securities		(13,454	)		(1,000	)
Right-of-use assets obtained in exchange for new operating lease liabilities		698			1,086

The accompanying notes are an integral part of the consolidated financial statements.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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 2020 Annual Report incorporated in the Form 10-K. Operating results for the three-month period ended March 31, 2021 are not necessarily indicative of the results that may be expected for the year ending December 31, 2021.

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.

QNB has evaluated events and transactions occurring subsequent to the balance sheet date of March 31, 2021 for items that should potentially be recognized or disclosed in these consolidated financial statements.

Recent COVID-19 Developments

Currently all QNB office lobbies are opened with their normal operating hours but are operating under limited capacities, our banking by appointment service remains available. Our Quakertown Commons office inside GIANT Food Store has also reopened; however, staff is limited due to social distancing requirements. Drive-ups are also operating under normal hours. All visitors to any QNB office are required to wear face masks upon entering the building, in accordance with the state mandates. All QNB employees are required to wear face masks when working on company premises. Employees with remote access are strongly encouraged to work from home. QNB has not incurred any significant disruptions to its business continuity.

Under the Economic Aid Act, the SBA and Department of the Treasury reopened the Paycheck Protection Program (“PPP”) to certain borrowers on January 11, 2021 and released the applications for first- and second-draw loans. QNB originated 251 new PPP loans for a total of $30,706,000 during first quarter of 2021. Second-draw customers made up 205 of these loans, or $28,700,000 and first-draw customers made up the remaining 46 loans, or $2,006,000. Additionally, 262 PPP loans, or $27,639,000, were forgiven during the first quarter of 2021. QNB closed a total of 911 loans totaling $113,181,000 of which 546 loans, totaling $75,887,000, were outstanding at March 31, 2021. QNB received origination fees from the SBA ranging from a flat fee of $2,500 per loan to one to five basis points of the loan origination balance which are recognized in interest income as a yield adjustment over the term of the loan. Funds are primarily being transferred into the borrowers’ deposit accounts, and disbursement on these PPP loan proceeds are being funded by cash held at the Federal Reserve and proceeds from calls and payments of investment securities. QNB has ample resources to cover future disbursements through short-term Federal Home Loan Bank (“FHLB”) advances and participation in the Federal Reserve’s Paycheck Protection Program Liquidity Facility (“PPPLF”), if necessary.

On March 30, 2021, the president signed into law the PPP Extension Act of 2021 (the Act), which extends the PPP application deadline from March 31, 2021 to May 31, 2021. The PPP authorization was also extended through June 30, 2021 to provide the Small Business Administration additional time to process applications received by the application deadline.

Upon requests from customers, QNB has provided payment relief to those affected by the COVID-19 Pandemic. QNB has: offered an interest only payment option, granted in 90 days increments; has provided payment deferment for mortgage and consumer loans with no late fee during the deferment period; has granted foreclosure and motor vehicle repossession reprieve; and will not adversely impact credit reporting for customers who were granted relief on mortgage or consumer loans. None of these modifications are considered troubled-debt restructurings as the customers were not experiencing financial difficulty prior to the COVID-19 Pandemic. Interest continues to be accrued on all COVID-19 modifications during the deferment period. QNB had modified a total 286 commercial loans or $155,016,000 and 59 retail loans or $8,781,000 during 2020 and 2021 due to COVID-19. As of March 31, 2021, QNB had modifications on approximately 3.3% of the March 31, 2021 commercial portfolio, consisting of nine loans with an outstanding balance of $26,277,000, of which eight loans totaling $26,150,000 had extended the initial modification period, and had modifications to approximately 1.6% of the March 31, 2021 retail portfolio, consisting of 11 loans with an outstanding balance of $2,453,000, of which ten loans totaling $2,223,000 had extended the initial deferment period. We will continue work with our borrowers during this difficult time.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The full impact of the COVID-19 Pandemic is unknown and rapidly evolving. Uncertainties exist related to the duration of the COVID-19 Pandemic and its potential effects on QNB’s customers and prospects, including impacts on national and local economies, unemployment, maintaining a competent workforce, and disruptions in the supply chain. There are no assurances as to how the COVID-19 Pandemic might affect QNB’s loan, investment and deposit portfolios.

2. RECENT ACCOUNTING PRONOUNCEMENTS

On June 16, 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326) (CECL). 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 accounting principles generally accepted in the United States (“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.

On October 16, 2019, FASB adopted its August 15, 2019 proposal to delay the effective dates for certain smaller reporting companies for the implementation CECL. 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, except for smaller reporting companies, whose effective date is effective for fiscal years, and interim periods with those fiscal years, beginning after December 15, 2022. QNB continues to evaluate the impact of this new standard on its consolidated financial statements and currently anticipates a material change to its allowance for loan losses upon the eventual implementation of CECL.

3. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY

QNB sponsors stock-based compensation plans, administered by a Board committee (the “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.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Stock-based compensation expense was $20,000 and $25,000 for the three months ended March 31, 2021 and 2020, respectively. As of March 31, 2021, there was approximately $136,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 35 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 2015 Plan authorized the issuance of 300,000 shares. The time period during which any option is exercisable under the 2015 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 five years after the date the option is awarded. The granted options vest after a three-year period. As of March 31, 2021, there were 148,200 options granted, 12,300 options forfeited, 19,325 options exercised, and 120,900 options outstanding under this Plan. The 2015 Plan expires on February 24, 2025.

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

For the Three Months Ended March 31,	2021			2020
Risk free interest rate		0.20	%		1.52	%
Dividend yield		4.17	%		3.60	%
Volatility		21.14	%		13.46	%
Expected life (years)		4.88			4.03

The risk-free interest rate was selected based upon yields of U.S. Treasury securities with a term approximating the expected life of the option being valued. Historical information was the 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 three months ended March 31, 2021 and 2020 was $3.08 and $2.42, respectively.

Stock option activity during the nine months ended March 31, 2021 and 2020 is as follows:

	Number of options			Weighted average exercise price		Weighted average remaining contractual term (in years)		Aggregate intrinsic value
Outstanding at December 31, 2020		116,550		$	37.42
Granted		25,000			32.50
Exercised		(17,525	)		30.40
Forfeited		(3,125	)		30.40
Outstanding at March 31, 2021		120,900		$	37.60		2.17	$	-
Exercisable at March 31, 2021		46,975		$	40.63		0.64	$	-

	Number of options			Weighted average exercise price		Weighted average remaining contractual term (in years)		Aggregate intrinsic value
Outstanding at December 31, 2019		103,350		$	36.96
Granted		25,000			36.50
Exercised		(9,550	)		29.39
Forfeited		—			—
Outstanding at March 31, 2020		118,800		$	27.47		2.96	$	-
Exercisable at March 31, 2020		44,600		$	34.27		1.42	$	-

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. EARNINGS PER SHARE & SHARE REPURCHASE PLAN

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

	For the Three Months Ended March 31,
	2021		2020
Numerator for basic and diluted earnings per share - net income	$	5,050	$	220
Denominator for basic earnings per share - weighted average shares outstanding		3,555,028		3,522,667
Effect of dilutive securities - employee stock options		—		2,788
Denominator for diluted earnings per share - adjusted weighted average shares outstanding		3,555,028		3,525,455
Earnings per share - basic	$	1.42	$	0.06
Earnings per share - diluted		1.42		0.06

There were 120,900 and 98,150 stock options that were anti-dilutive for the three-month periods ended March 31, 2021 and 2020, respectively. These stock options were not included in the above calculation.

QNB’s current stock repurchase plan was approved by the Board of Directors on January 21, 2008 and subsequently increased on February 9, 2009 and has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately negotiated transactions. The repurchase authorization has no termination date. There were 8,700 and no shares repurchased during the three months ended March 31, 2021 and 2020. As of March 31, 2021, 70,683 shares were repurchased under this authorization at an average price of $19.79 and a total cost of approximately $1,399,000.

5. COMPREHENSIVE INCOME (LOSS)

The following shows the components of accumulated other comprehensive income (loss) at March 31, 2021 and December 31, 2020:

	March 31,			December 31,
	2021			2020
Unrealized net holding (losses) gains on available-for-sale securities	$	(858	)	$	7,151
Unrealized gains (losses) on available-for-sale securities for which a portion of an other-than-temporary impairment loss has been recognized in earnings		—			—
Accumulated other (loss) income		(858	)		7,151
Tax effect		180			(1,502	)
Accumulated other comprehensive (loss) gain, net of tax	$	(678	)	$	5,649

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following tables present amounts reclassified out of accumulated other comprehensive income (loss) for the three months ended March 31, 2021 and 2020:

For the Three Months Ended March 31,	Amount reclassified from accumulated other comprehensive loss
Details about accumulated other comprehensive income (loss)	2021			2020		Affected line item in statement of income
Unrealized net holding gains on available-for-sale securities	$	3		$	—	Net gain on sales of investments available-for-sale
Other-than-temporary impairment gains (losses) on investment securities		—			—	Net other-than-temporary impairment losses on investment securities
		3			—
Tax effect		(1	)		—	Provision for income taxes
Total reclassification out of accumulated other comprehensive income (loss), net of tax	$	2		$	—	Net of tax

6. INVESTMENT SECURITIES

Available-For-Sale Securities

The amortized cost and estimated fair values of investment securities available-for-sale at March 31, 2021 and December 31, 2020 were as follows:

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
March 31, 2021	value		gains		losses			cost
U.S. Government agency	$	68,742	$	6	$	(2,213	)	$	70,949
State and municipal		103,187		1,447		(1,840	)		103,580
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		204,047		2,048		(1,901	)		203,900
Collateralized mortgage obligations (CMOs)		85,791		1,545		(49	)		84,295
Pooled trust preferred		74		—		(10	)		84
Corporate debt		7,262		109		—			7,153
Total investment debt securities available-for-sale	$	469,103	$	5,155	$	(6,013	)	$	469,961

			Gross		Gross
			unrealized		unrealized
	Fair		holding		holding			Amortized
December 31, 2020	value		gains		losses			cost
U.S. Government agency	$	69,776	$	26	$	(246	)	$	69,996
State and municipal		87,812		2,350		(45	)		85,507
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		175,847		3,328		(24	)		172,543
Collateralized mortgage obligations (CMOs)		94,948		1,751		(5	)		93,202
Pooled trust preferred		70		—		(14	)		84
Corporate debt		7,193		59		(29	)		7,163
Total investment debt securities available-for-sale	$	435,646	$	7,514	$	(363	)	$	428,495

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at March 31, 2021 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.


March 31, 2021	Fair value		Amortized cost
Due in one year or less	$	6,250	$	6,227
Due after one year through five years		236,661		233,894
Due after five years through ten years		146,166		148,755
Due after ten years		80,026		81,085
Total investment debt securities available-for-sale	$	469,103	$	469,961

There were no investment sales for the three months ended March 31, 2021. Proceeds from sales of investment securities available-for-sale were approximately $5,975,000 for the three months ended 2020, respectively.

At March 31, 2021 and December 31, 2020, investment securities available-for-sale totaling approximately $233,868,000 and $220,934,000, 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 securities available-for-sale, 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 debt securities are net of other-than-temporary impairment charges:

	For the Three Months Ended March 31,
	2021		2020
Gross realized gains	$	3	$	—
Gross realized losses		—		—
Other-than-temporary impairment		—		—
Total net gains (losses) on AFS securities	$	3	$	—

The tax expense applicable to the net realized gains for the three-month periods ended March 31, 2021 and 2020 was $1,000 and $0, 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 statement of income but is recognized in other comprehensive income. 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. No credit impairments were recognized on debt securities during the three months ended March 31, 2021 and 2020, respectively.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table indicates the length of time individual debt securities have been in a continuous unrealized loss position at March 31, 2021 and December 31, 2020:


			Less than 12 months					12 months or longer					Total
	No. of		Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
March 31, 2021	securities		value		losses			value		losses			value		losses
U.S. Government agency		33	$	63,736	$	(2,213	)	$	—	$	—		$	63,736	$	(2,213	)
State and municipal		90		53,664		(1,774	)		780		(66	)		54,444		(1,840	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		35		104,579		(1,901	)		—		—			104,579		(1,901	)
Collateralized mortgage obligations (CMOs)		5		6,933		(49	)		—		—			6,933		(49	)
Pooled trust preferred		1		—		—			74		(10	)		74		(10	)
Corporate debt		1		—		—			1		—			1		—
Total		165	$	228,912	$	(5,937	)	$	855	$	(76	)	$	229,767	$	(6,013	)


			Less than 12 months					12 months or longer					Total
	No. of		Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
December 31, 2020	securities		value		losses			value		losses			value		losses
U.S. Government agency		19	$	37,754	$	(246	)	$	—	$	—		$	37,754	$	(246	)
State and municipal		11		6,821		(45	)		—		—			6,821		(45	)
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed		4		8,626		(24	)		—		—			8,626		(24	)
Collateralized mortgage obligations (CMOs)		3		3,262		(5	)		—		—			3,262		(5	)
Pooled trust preferred		1		—		—			70		(14	)		70		(14	)
Corporate debt		1		2,971		(29	)		—		—			2,971		(29	)
Total		39	$	59,434	$	(349	)	$	70	$	(14	)	$	59,504	$	(363	)

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 March 31, 2021 in U.S. Government agency securities, state and municipal securities, mortgage-backed securities, and CMOs 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 holds one pooled trust preferred security as of March 31, 2021. This security has a total amortized cost of approximately $84,000 and a fair value of $74,000. The pooled trust preferred security is available-for-sale and is carried at fair value.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Marketable Equity Securities

The Company’s investment in marketable equity securities primarily consists of investments with readily determinable fair values in large cap stock companies. Changes in fair value is recorded in unrealized gain/(losses) in non-interest income.

At March 31, 2021 and December 31, 2020, the Company had $14,522,000 and $12,849,000, respectively, in equity securities recorded at fair value. The following is a summary of unrealized and realized gains and losses recognized in net income on equity securities during the three months ended March 31, 2021 and 2020:

	For the Three Months Ended March 31,

	2021			2020
Net gains (loss) recognized during the period on equity securities	$	1,435		$	(2,940	)
Less: Net gains recognized during the period on equity securities sold during the period		(339	)		—
Net unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date	$	1,096		$	(2,940	)

Tax expense applicable to the net gains recognized for the three months ended March 31, 2021 was $415,000. Tax benefit applicable to the net losses recognized for the three months ended March 31, 2020 was $849,000. Proceeds from sales of investment equity securities were approximately $1,185,000 for the three months ended March 31, 2021. There were no such sales for the same period in 2020.

7. RESTRICTED INVESTMENT IN STOCKS

Restricted investment in stocks includes Federal Home Loan Bank of Pittsburgh (“FHLB”) with a carrying cost of $1,029,000, Atlantic Community Bankers Bank (ACBB) stock with a carrying cost of $12,000 and VISA Class B stock with a carrying cost of $0 at March 31, 2021. FHLB and ACBB stock was issued to the Bank as a requirement to facilitate the Bank’s participation in borrowing and other banking services. The Bank’s investment in FHLB stock may fluctuate, as it is based on the member banks’ use of FHLB’s services.

The Bank owns 6,502 shares of Visa Class B stock, which was necessary to participate in Visa services in support of the Bank’s credit card, debit card, and related payment programs (permissible activities under banking regulations) as a member institution. Following the resolution of Visa’s covered litigation, shares of Visa’s Class B stock will be converted to Visa Class A shares using a conversion factor (1.6228 as of September 27, 2019), which is periodically adjusted to reflect VISA’s ongoing litigation costs. There is a very limited market for this stock, as only current owners of Class B shares are permitted to transact in Class B. Due to the lack of orderly trades and public information of such trades, Visa Class B stock does not have a readily determinable fair value.

These restricted investments are carried at cost and evaluated for OTTI periodically. As of March 31, 2021, there was no OTTI associated with these shares.

8. LOANS & ALLOWANCE FOR LOAN LOSSES

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding, net of deferred loan fees and costs. Interest income is accrued on the principal amount outstanding. Loan origination and commitment fees and related direct costs are deferred and amortized to income over the term of the respective loan and loan commitment period as a yield adjustment.

Loans held-for-sale consists of residential mortgage loans that are carried at the lower of aggregate cost or fair value. Net unrealized losses, if any, are recognized through a valuation allowance charged to income. Gains and losses on residential mortgages held-for-sale are included in non-interest income.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates. These loss rates are based on a three-year history of charge-offs and are more heavily weighted for recent experience for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:

Lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.

Effect of external factors, such as legal and regulatory requirements.

National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.

Nature and volume of the portfolio including growth.

Experience, ability, and depth of lending management and staff.

Volume and severity of past due, classified and nonaccrual loans.

Quality of the Company’s loan review system, and the degree of oversight by the Company’s Board of Directors.

Existence and effect of any concentrations of credit and changes in the level of such concentrations.

The duration of the COVID-19 Pandemic, modifications and stimulus packages masking underlying credit issues

Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation.

An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collectability. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent firm reviews risk assessment and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments using information available to them at the time of their examination.

Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Major classes of loans are as follows:

	March 31,			December 31,
	2021			2020
Commercial:
Commercial and industrial	$	232,996		$	227,431
Construction		52,173			57,594
Secured by commercial real estate		399,236			377,586
Secured by residential real estate		81,147			81,897
State and political subdivisions		24,703			25,302
Retail:
1-4 family residential mortgages		88,163			82,739
Home equity loans and lines		64,206			63,943
Consumer		5,222			5,364
Total loans		947,846			921,856
Net unearned (fees) costs		(2,201	)		(1,814	)
Loans receivable	$	945,645		$	920,042

Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the expressed purpose of conducting commercial real estate transactions.

Overdrafts are reclassified as loans and are included in consumer loans above and total loans receivable on the Consolidated Balance Sheets. At March 31, 2021 and December 31, 2020 overdrafts were approximately $79,000 and $258,000, respectively.

QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at March 31, 2021, there was a concentration of loans to lessors of residential buildings and dwellings of 14.9% of total loans and to lessors of nonresidential buildings of 19.9% of total loans, compared with 14.9% and 19.6% of total loans, respectively, at December 31, 2020. These concentrations were primarily within the commercial real estate categories.

QNB continues to provide solutions to customers experiencing financial hardship caused by the COVID-19 Pandemic. As of March 31, 2021, QNB had modifications to approximately 3.3% of the March 31, 2021 commercial portfolio and had modifications to approximately 1.6% of the March 31, 2021 retail portfolio, related to the COVID-19 Pandemic. Loans modified one time included two credits and totaled $357,000 with deferred interest and or principal payments between two and three months. Loans modified two times included three credits and totaled $508,000 with deferred interest and or principal payments between five and 11 months. Loans modified three times included one credit and totaled $4,000 with deferred interest and or principal payments of nine months. Loans modified four times included six credits and totaled $10,707,000 with deferred interest and or principal payments between nine and 12 months. Loans modified five times included eight credits and totaled $17,154,000 with deferred interest and or principal payments between 14 and 15 months. The following table illustrates the modified loans by major loan class and total deferral by number of months.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

	March 31, 2021
	Total Number of Months Deferred
	0-3 Months		4-6 Months		7-9 Months		10-12 Months		13+ Months		Total
Commercial:
Commercial and industrial	$	128	$	486	$	—	$	1,190	$	—	$	1,804
Construction		—		—		—		—		—		—
Secured by commercial real estate		—		—		—		9,162		15,311		24,473
Secured by residential real estate		—		—		—		—		—		—
State and political subdivisions		—		—		—		—		—		—
Retail:												—
1-4 family residential mortgages		229		—		—		116		1,319		1,664
Home equity loans and lines		—		—		38		222		525		785
Consumer		—		—		4		—		—		4
Total COVID-19 Modified Loans	$	357	$	486	$	42	$	10,690	$	17,155	$	28,730

At March 31, 2021, QNB had 546 PPP loans totaling $75,887,000 reported in commercial and industrial loans. The PPP loans are 100% guaranteed by the SBA. QNB received origination fees from the SBA ranging from a flat fee of $2,500 to one to five basis points of the originated loan amount which are recognized in interest income as a yield adjustment over the term of the loan. At March 31, 2021 and December 31, 2020, net unearned (fees) costs included $2,135,000 and $1,909,000, respectively, in PPP loan origination fees net of costs

The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.

Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.

Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.

The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.

The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks,

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.

The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.

The Company employs a ten-grade risk rating system related to the credit quality of commercial loans and loans to state and political subdivisions of which the first six categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.

Excellent - no apparent risk

Good - minimal risk

Acceptable - lower risk

Acceptable - average risk

Acceptable – higher risk

Pass watch

Special Mention - potential weaknesses

Substandard - well defined weaknesses

Doubtful - full collection unlikely

Loss - considered uncollectible

The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to all loans in the portfolio at the time the loan is originated. Loans with risk ratings of one through five are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of six are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of seven through ten are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Company’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.

The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of March 31, 2021 and December 31, 2020:

March 31, 2021	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	225,513	$	39	$	7,444	$	—	$	232,996
Construction		52,173		—		—		—		52,173
Secured by commercial real estate		383,434		2,910		12,892		—		399,236
Secured by residential real estate		79,548		—		1,599		—		81,147
State and political subdivisions		24,703		—		—		—		24,703
Total	$	765,371	$	2,949	$	21,935	$	—	$	790,255

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

December 31, 2020	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	219,104	$	77	$	8,250	$	—	$	227,431
Construction		57,594		—		—		—		57,594
Secured by commercial real estate		361,393		3,914		12,279		—		377,586
Secured by residential real estate		80,233		—		1,664		—		81,897
State and political subdivisions		25,302		—		—		—		25,302
Total	$	743,626	$	3,991	$	22,193	$	—	$	769,810

For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of March 31, 2021 and December 31, 2020:

March 31, 2021	Performing		Non-performing		Total
Retail:
1-4 family residential mortgages	$	87,255	$	908	$	88,163
Home equity loans and lines		63,435		771		64,206
Consumer		5,070		152		5,222
Total	$	155,760	$	1,831	$	157,591

December 31, 2020	Performing		Non-performing		Total
Retail:
1-4 family residential mortgages	$	82,103	$	636	$	82,739
Home equity loans and lines		63,191		752		63,943
Consumer		5,259		105		5,364
Total	$	150,553	$	1,493	$	152,046

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of March 31, 2021 and December 31, 2020:

March 31, 2021	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	2,378	$	—	$	664	$	3,042	$	229,954	$	232,996
Construction		—		—		—		—		52,173		52,173
Secured by commercial real estate		1,112		—		—		1,112		398,124		399,236
Secured by residential real estate		—		—		321		321		80,826		81,147
State and political subdivisions		—		—		—		—		24,703		24,703
Retail:
1-4 family residential mortgages		449		427		134		1,010		87,153		88,163
Home equity loans and lines		—		34		45		79		64,127		64,206
Consumer		17		26		49		92		5,130		5,222
Total	$	3,956	$	487	$	1,213	$	5,656	$	942,190	$	947,846

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

December 31, 2020	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	2,392	$	31	$	1,157	$	3,580	$	223,851	$	227,431
Construction		—		—		—		—		57,594		57,594
Secured by commercial real estate		318		—		40		358		377,228		377,586
Secured by residential real estate		189		—		340		529		81,368		81,897
State and political subdivisions		—		—		—		—		25,302		25,302
Retail:
1-4 family residential mortgages		396		303		282		981		81,758		82,739
Home equity loans and lines		16		2		51		69		63,874		63,943
Consumer		178		5		—		183		5,181		5,364
Total	$	3,489	$	341	$	1,870	$	5,700	$	916,156	$	921,856

The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of March 31, 2021 and December 31, 2020:

March 31, 2021	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	3,748
Construction		—		—
Secured by commercial real estate		—		2,479
Secured by residential real estate		—		829
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		908
Home equity loans and lines		—		771
Consumer		—		152
Total	$	—	$	8,887

December 31, 2020	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	4,367
Construction		—		—
Secured by commercial real estate		—		2,905
Secured by residential real estate		—		875
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		636
Home equity loans and lines		—		752
Consumer		—		105
Total	$	—	$	9,640

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Activity in the allowance for loan losses for the three months ended March 31, 2021 and 2020 are as follows:

For the Three Months Ended March 31, 2021	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	4,050	$	(147	)	$	—		$	13	$	3,916
Construction		346		(33	)		—			—		313
Secured by commercial real estate		3,736		358			—			—		4,094
Secured by residential real estate		871		(57	)		—			11		825
State and political subdivisions		89		(3	)		—			—		86
Retail:
1-4 family residential mortgages		533		77			—			—		610
Home equity loans and lines		386		(20	)		—			2		368
Consumer		265		10			(32	)		20		263
Unallocated		550		90		N/A			N/A			640
Total	$	10,826	$	275		$	(32	)	$	46	$	11,115

For the Three Months Ended March 31, 2020	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	4,689	$	(41	)	$	—		$	9	$	4,657
Construction		590		(304	)		—			—		286
Secured by commercial real estate		2,519		767			—			—		3,286
Secured by residential real estate		629		(40	)		—			19		608
State and political subdivisions		115		19			—			—		134
Retail:
1-4 family residential mortgages		549		111			—			—		660
Home equity loans and lines		310		22			—			1		333
Consumer		230		130			(92	)		10		278
Unallocated		256		(164	)	N/A			N/A			92
Total	$	9,887	$	500		$	(92	)	$	39	$	10,334

As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans and loans to state and political subdivisions by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired or are classified as a troubled debt restructuring or on non-accrual.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.

For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.

The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible. TDR loans that are in compliance with their modified terms and that yield a market rate may be removed from the TDR status after a period of performance.

Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $4,379,000 and $4,469,000 as of March 31, 2021 and December 31, 2020, respectively. Non-performing TDRs totaled $803,000 and $843,000 as of March 31, 2021 and December 31, 2020, respectively. All TDRs are included in impaired loans.

The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment.

	March 31, 2021				December 31, 2020
	Unpaid principal balance		Related allowance		Unpaid principal balance		Related allowance

TDRs with no specific allowance recorded	$	1,922	$	—	$	2,008	$	—
TDRs with an allowance recorded		3,260		459		3,304		503
Total	$	5,182	$	459	$	5,312	$	503

There were no newly identified TDRs during the three months ended March 31, 2021. As of March 31, 2021, QNB had $41,000 in commitments to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings and $14,000 commitments at December 31, 2020. There were no charge-offs during the three months ended March 31, 2021 and 2020, resulting from loans previously modified as TDRs.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

There were no loans modified as TDRs within 12 months prior to March 31, 2021 and 2020 for which there was a payment default (60 days or more past due) during the three months ended March 31, 2021 and 2020.

The Company has two loans secured by residential real estate for which foreclosure proceedings are in process at March 31, 2021. The total recorded investment is $135,000.

The following tables present the balance in the allowance for loan losses at March 31, 2021 and December 31, 2020 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:

	Allowance for Loan Losses						Loans Receivable
March 31, 2021	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	3,916	$	2,261	$	1,655	$	232,996	$	3,858	$	229,138
Construction		313		—		313		52,173		—		52,173
Secured by commercial real estate		4,094		396		3,698		399,236		5,853		393,383
Secured by residential real estate		825		73		752		81,147		1,981		79,166
State and political subdivisions		86		—		86		24,703		—		24,703
Retail:
1-4 family residential mortgages		610		—		610		88,163		1,084		87,079
Home equity loans and lines		368		114		254		64,206		781		63,425
Consumer		263		5		258		5,222		59		5,163
Unallocated		640	N/A		N/A		N/A		N/A		N/A
Total	$	11,115	$	2,849	$	7,626	$	947,846	$	13,616	$	934,230

	Allowance for Loan Losses						Loans Receivable
December 31, 2020	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	4,050	$	2,421	$	1,629	$	227,431	$	4,503	$	222,928
Construction		346		—		346		57,594		—		57,594
Secured by commercial real estate		3,736		432		3,304		377,586		6,323		371,263
Secured by residential real estate		871		73		798		81,897		2,051		79,846
State and political subdivisions		89		—		89		25,302		—		25,302
Retail:
1-4 family residential mortgages		533		—		533		82,739		813		81,926
Home equity loans and lines		386		117		269		63,943		765		63,178
Consumer		265		7		258		5,364		61		5,303
Unallocated		550	N/A		N/A		N/A		N/A		N/A
Total	$	10,826	$	3,050	$	7,226	$	921,856	$	14,516	$	907,340

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table summarizes additional information, in regards to impaired loans by loan portfolio class, as of March 31, 2021 and December 31, 2020:

	March 31, 2021						December 31, 2020
	Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance		Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance
With no specific allowance recorded:
Commercial:
Commercial and industrial	$	131	$	138			$	647	$	722
Construction		—		—				—		—
Secured by commercial real estate		2,584		2,920				3,018		3,671
Secured by residential real estate		1,327		1,513				1,417		1,608
Retail:
1-4 family residential mortgages								813		894
Home equity loans and lines		1,084		1,173				537		577
Consumer		556		599				—		—
Total	$	5,682	$	6,343			$	6,432	$	7,472

With an allowance recorded:
Commercial:
Commercial and industrial	$	3,727	$	5,376	$	2,261	$	3,856	$	5,462	$	2,421
Construction		—		—		—		—		—		—
Secured by commercial real estate		3,269		3,393		396		3,305		3,418		432
Secured by residential real estate		654		663		73		634		642		73
Retail:
1-4 family residential mortgages		—		—		—		—		—		—
Home equity loans and lines		225		239		114		228		239		117
Consumer		59		72		5		61		73		7
Total	$	7,934	$	9,743	$	2,849	$	8,084	$	9,834	$	3,050

Total:
Commercial:
Commercial and industrial	$	3,858	$	5,514	$	2,261	$	4,503	$	6,184	$	2,421
Construction		—		—		—		—		—		—
Secured by commercial real estate		5,853		6,313		396		6,323		7,089		432
Secured by residential real estate		1,981		2,176		73		2,051		2,250		73
Retail:
1-4 family residential mortgages		—		—		—		813		894		—
Home equity loans and lines		1,309		1,412		114		765		816		117
Consumer		615		671		5		61		73		7
Total	$	13,616	$	16,086	$	2,849	$	14,516	$	17,306	$	3,050

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table presents additional information regarding the average recorded investment and interest income recognized on impaired loans:

For the Three Months Ended March 31,	2021				2020
	Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized
Commercial:
Commercial and industrial	$	4,075	$	1	$	5,710	$	2
Construction		—		—		—		—
Secured by commercial real estate		6,006		41		7,124		43
Secured by residential real estate		2,017		16		2,039		18
Retail:
1-4 family residential mortgages		877		1		885		3
Home equity loans and lines		763		—		586		—
Consumer		60		—		68		—
Total	$	13,798	$	59	$	16,412	$	66

9. FAIR VALUE MEASUREMENTS AND DISCLOSURES

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (fair values are not adjusted for transaction costs). ASC 820 also establishes a framework (fair value hierarchy) for measuring fair value under U.S. GAAP and expands disclosures about fair value measurements.

ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:

Level 1:

Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2:

Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.

Level 3:

Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The measurement of fair value should be consistent with one of the following valuation techniques: market approach, income approach, and/or cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis and the fair value measurements by level within the fair value hierarchy as of March 31, 2021:

March 31, 2021	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Balance at end of period
Recurring fair value measurements
Available-for-sale securities:
U.S. Government agency securities	$	—	$	68,742	$	—	$	68,742
State and municipal securities		—		103,187		—		103,187
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		—		204,047		—		204,047
Collateralized mortgage obligations (CMOs)		—		85,791		—		85,791
Pooled trust preferred securities		—		—		74		74
Corporate debt securities		—		7,262		—		7,262
Total debt securities available-for-sale		—		469,029		74		469,103
Equity securities		14,522		—		—		14,522
Total recurring fair value measurements	$	14,522	$	469,029	$	74	$	483,625

Nonrecurring fair value measurements*
Impaired loans	$	—	$	—	$	5,085	$	5,085
Loans held-for-sale		—		—		507		507
Mortgage servicing rights		—		—		118		118
Total nonrecurring fair value measurements	$	—	$	—	$	5,710	$	5,710
*Impairment

There were no transfers in and out of Level 1, Level 2, or Level 3 fair value measurements during the three months ended March 31, 2021. There were no losses included in earnings attributable to the change in unrealized gains or losses relating to the available-for-sale securities above with fair value measurements utilizing significant unobservable inputs for the three-month period ended March 31, 2021.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis, showing the fair value measurements by level within the fair value hierarchy, as of December 31, 2020:

December 31, 2020	Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)		Balance at end of period
Recurring fair value measurements
Debt securities available-for-sale
U.S. Government agency securities	$	—	$	69,776	$	—	$	69,776
State and municipal securities		—		87,812		—		87,812
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed securities		—		175,847		—		175,847
Collateralized mortgage obligations (CMOs)		—		94,948		—		94,948
Pooled trust preferred securities		—		—		70		70
Corporate debt securities		—		7,193		—		7,193
Total debt securities available-for-sale		—		435,576		70		435,646
Equity securities		12,849		—		—		12,849
Total recurring fair value measurements	$	12,849	$	435,576	$	70	$	448,495

Nonrecurring fair value measurements*
Impaired loans	$	—	$	—	$	5,034	$	5,034
Mortgage servicing rights		—		—		291		291
Total nonrecurring fair value measurements	$	—	$	—	$	5,325	$	5,325
*Impairment

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which QNB has utilized Level 3 inputs to determine fair value:

Quantitative information about Level 3 fair value measurements

March 31, 2021

Fair value

Valuation

techniques

Unobservable

inputs

Value or range

of values

Impaired loans

4,806

Appraisal of collateral

(1)

Appraisal adjustments

(2)

-10% to -30%

Liquidation expenses

(3)

-10

Impaired loans

279

Financial statement values for UCC collateral

Financial statement value discounts

(4)

-20% to -100%

Loans held for sale

507

Secondary market rates for similar instruments

FHLMC pricing

20 to 30 years 99.3% to 99.9%

Mortgage servicing rights

118

Discounted cash flow

Remaining term

3 to 30 years

Discount rate

12.0% to 13.0%

Quantitative information about Level 3 fair value measurements

December 31, 2020

Fair value

Valuation

techniques

Unobservable

inputs

Value or range

of values

Impaired loans

4,754

Appraisal of collateral

(1)

Appraisal adjustments

(2)

-10% to -30%

Liquidation expenses

(3)

-10

Impaired loans

280

Financial statement values for UCC collateral

Financial statement value discounts

(4)

-87.5% to -100%

Mortgage servicing rights

291

Discounted cash flow

Remaining term

2 to 30 years

Discount rate

12.0% to 12.5%

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(1)	Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally includes various Level 3 inputs which are not always identifiable.

(2)	Appraisals may be adjusted by management for qualitative factors such as economic conditions and the age of the appraisal. The range is presented as a percent of the initial appraised value.

(3)	Appraisals and pending agreements of sale are adjusted by management for estimated liquidation expenses. The range is presented as a percent of the initial appraised value.

(4)	Values obtained from financial statements for UCC collateral (fixed assets and inventory) are discounted to estimated realizable liquidation value.

The following table presents additional information about the available-for-sale securities measured at fair value on a recurring basis and for which QNB utilized significant unobservable inputs (Level 3 inputs) to determine fair value for the three months ended March 31, 2021 and 2020:

	Fair value measurements using significant unobservable inputs (Level 3)
	2021		2020
Balance, January 1,	$	70	$	79
Payments received		—		—
Total gains or losses (realized/unrealized)
Included in earnings		—		—
Included in other comprehensive (loss) income		4		(8	)
Transfers in and/or out of Level 3		—		—
Balance, March 31,	$	74	$	71

The Level 3 securities consist of one collateralized debt obligation security, the PreTSL security, which is backed by trust preferred securities issued by banks. The market for this security at March 31, 2021 was not active and markets for similar securities also are not active. The new issue market is also inactive and there are currently very few market participants who are willing and or able to transact for these securities.

Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:

•

The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at March 31, 2021;

•

An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and

•

The PreTSL will be classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date.

QNB used an independent third party to value this security using a discounted cash flow analysis. Based on management’s review of the bond’s three underlying issuers, there are no expected credit losses or prepayments; cashflows used were contractual based on the Bloomberg YA screen. The assumed cashflows have been discounted using an estimated market discount rate based on the 30-year swap rate. The 30-year is used as the reference rate since it is indicative of market expectation for short-term rates in the future. This is consistent with the 30-year nature of the PreTSL security, which is priced using the 3-month LIBOR as a reference rate. The discount rate of 6.01% includes the risk-free rate, a credit component and a spread for illiquidity.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of QNB’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between QNB’s disclosures and those of other companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of each major classification of financial instrument and non-financial asset at March 31, 2021 and December 31, 2020:

Cash and cash equivalents, accrued interest receivable and accrued interest payable (carried at cost): The carrying amounts reported in the balance sheet approximate those assets’ fair value.

Investment securities (carried at fair value): The fair value of securities are primarily determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 debt securities are valued by a third-party pricing service commonly used in the banking industry. Level 2 fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) were used to support fair values of certain Level 3 investments.

Restricted investment in stocks (carried at cost): The fair value of stock in Atlantic Community Bankers Bank, the Federal Home Loan Bank and VISA Class B is the carrying amount, based on redemption provisions, and considers the limited marketability of and restrictions on such securities.

Loans Held for Sale (carried at lower of cost or fair value): The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted prices exist, the fair value of a loan is determined using quoted prices for a similar loan or loans, adjusted for the specific attributes of that loan.

Loans Receivable (carried at cost): The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the liquidity, credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired Loans (generally carried at fair value): Impaired loans are loans for which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Mortgage Servicing Rights (carried at lower of cost or fair value): The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The mortgage servicing rights are stratified into tranches based on predominant characteristics, such as interest rate, loan type and investor type. The valuation incorporates assumptions that market participants would use in estimating future net servicing income.

Deposit liabilities (carried at cost): The fair value of deposits with no stated maturity (e.g. demand deposits, interest-bearing demand accounts, money market accounts and savings accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. Deposits with a stated maturity (time deposits) have been valued using the present value of cash flows discounted at rates approximating the current market for similar deposits.

Short-term borrowings (carried at cost): The carrying amount of short-term borrowings approximates their fair values.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Long-term debt (carried at cost): Long-term debt has stated maturities and have been valued using the present value of cash flows discounted at rates approximating the current market for similar debt instruments.

Off-balance-sheet instruments (disclosed at cost): The fair values for QNB’s off-balance sheet instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in sales transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.

The estimated fair values and carrying amounts of the Company’s financial and off-balance sheet instruments are summarized as follows:

					Fair value measurements
March 31, 2021	Carrying amount		Fair value		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial assets
Cash and cash equivalents	$	108,733	$	108,733	$	108,733	$	—	$	—
Investment securities:
Equities		14,522		14,522		14,522		—		—
Available-for-sale		469,103		469,103		—		469,029		74
Restricted investment in stocks		1,041		1,041		—		1,041		—

Loans held-for-sale		3,210		3,261		—		3,261		—
Net loans		934,530		934,736		—		—		934,736
Mortgage servicing rights		576		659		—		—		659
Accrued interest receivable		4,707		4,707		—		4,707		—

Financial liabilities
Deposits with no stated maturities	$	1,159,623	$	1,159,623	$	1,159,623	$	—	$	—
Deposits with stated maturities		181,993		182,767		—		182,767		—
Short-term borrowings		64,947		64,947		64,947		—		—
Long-term debt		10,000		10,237		10,237		—		—
Accrued interest payable		246		246		—		246		—

Off-balance sheet instruments
Commitments to extend credit	$	—	$	—	$	—	$	—	$	—
Standby letters of credit		—		—		—		71		—

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

					Fair value measurements
December 31, 2020	Carrying amount		Fair value		Quoted prices in active markets for identical assets (Level 1)		Significant other observable inputs (Level 2)		Significant unobservable inputs (Level 3)
Financial assets
Cash and cash equivalents	$	39,331	$	39,331	$	39,331	$	—	$	—
Investment securities:
Equities		12,849		12,849		12,849		—		—
Available-for-sale		435,646		435,646		—		435,576		70
Restricted investment in stocks		1,041		1,041		—		1,041		—
Loans held-for-sale		6,570		6,886		—		6,886		—
Net loans		909,216		915,726		—		—		915,726
Mortgage servicing rights		533		568		—		—		568
Accrued interest receivable		4,825		4,825		—		4,825		—

Financial liabilities
Deposits with no stated maturities	$	1,030,982	$	1,030,982	$	1,030,982	$	—	$	—
Deposits with stated maturities		197,085		199,127		—		199,127		—
Short-term borrowings		58,838		58,838		58,838		—		—
Long-term debt		10,000		10,269		10,269		—		—
Accrued interest payable		350		350		—		350		—

Off-balance sheet instruments
Commitments to extend credit	$	—	$	—	$	—	$	—	$	—
Standby letters of credit		—		88		—		88		—

10. COMMITMENTS AND CONTINGENCIES

Financial Instruments with off-balance sheet risk:

In the normal course of business there are various legal proceedings, commitments, and contingent liabilities which are not reflected in the consolidated financial statements. Management does not anticipate any material losses as a result of these transactions and activities. They include, among other things, commitments to extend credit and standby letters of credit. The maximum exposure to credit loss, which represents the possibility of sustaining a loss due to the failure of the other parties to a financial instrument to perform according to the terms of the contract, is represented by the contractual amount of these instruments. QNB uses the same lending standards and policies in making credit commitments as it does for on-balance sheet instruments. The activity is controlled through credit approvals, control limits, and monitoring procedures.

A summary of the Company's financial instrument commitments is as follows:

	March 31,		December 31,
	2021		2020
Commitments to extend credit and unused lines of credit	$	321,227	$	296,537
Standby letters of credit		19,377		22,567
Total financial instrument commitments	$	340,604	$	319,104

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 the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. QNB evaluates each customer’s creditworthiness on a case-by-case basis.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Standby letters of credit are conditional commitments issued by the Company to guarantee the financial or performance obligation of a customer to a third party. QNB’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making conditional obligations as it does for on-balance sheet instruments. Standby letters of credit of $18,137,000 will expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Company requires collateral and personal guarantees supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral and the enforcement of personal guarantees would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of March 31, 2021 and December 31, 2020 for guarantees under standby letters of credit issued is not material.

The amount of collateral obtained for letters of credit and commitments to extend credit is based on management’s credit evaluation of the customer. Collateral varies, but may include real estate, accounts receivable, marketable securities, pledged deposits, inventory or equipment.

Other commitments:

QNB has committed to various operating leases for several of their branch and office facilities. Some of these leases include specific provisions relating to rent increases. Some of the leases contain renewal options to extend the initial terms of the lease for periods ranging from five to ten years and certain leases allow for multiple extensions. During the three months ended March 31, 2021, QNB renewed one lease and recorded an additional right-of-use asset in exchange for an operating lease liability of $698,000.

During the three months ended March 31, 2021, QNB purchased the underlying assets of one lease which had a right-of-use asset of $945,000 and an operating liability of $952,000.

11. REGULATORY RESTRICTIONS

Dividends payable by QNB and the Bank are subject to various limitations imposed by statutes, regulations and policies adopted by bank regulatory agencies. Under Federal and Pennsylvania banking law, the Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. Under Federal Reserve regulations, the Bank is limited as to the amount it may lend affiliates, including QNB, unless such loans are collateralized by specific obligations.

Both the QNB and the Bank are subject to regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can initiate actions by regulators that could have an effect on the financial statements. Under the framework for prompt corrective action, the Bank must meet capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items. The capital amounts and classification are also subject to qualitative judgments by the regulators. Management believes, as of March 31, 2021, that the Company and the Bank met capital adequacy requirements to which they were subject.

As of the most recent notification, the primary regulator of the Bank considered it to be “well capitalized” under the regulatory framework. There are no conditions or events since that notification that management believes have changed the classification. To be categorized as well capitalized, bank holding companies and insured depository institutions must maintain minimum ratios as set forth in the following table below.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The Company and the Bank’s actual capital amounts and ratios are presented as follows:

	Capital levels
	Actual					Adequately capitalized					Well capitalized
March 31, 2021	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk-weighted assets):
The Company	$	143,872		13.93	%	$	82,609		8.00	%	$	103,261		10.00	%
Bank		129,160		13.06			79,132	8.00				98,915	10.00

Tier I capital (to risk-weighted assets):
The Company		132,666		12.85			61,957	6.00				61,957	6.00
Bank		117,954		11.92			59,349	6.00				79,132	8.00

Common equity tier 1 capital (to risk-weighted assets):
The Company		132,666		12.85			46,468	4.50			N/A		N/A
Bank		117,954		11.92			44,512	4.50				64,295	6.50

Tier I capital (to average assets):
The Company		132,666		9.05			58,660	4.00			N/A		N/A
Bank		117,954		8.12			58,114	4.00				72,643	5.00

	Capital levels
	Actual					Adequately capitalized					Well capitalized
As of December 31, 2020	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk-weighted assets):
The Company	$	139,705		13.95	%	$	80,125		8.00	%	$	100,156		10.00	%
Bank		126,687		13.15			77,047	8.00				96,308	10.00

Tier I capital (to risk-weighted assets):
The Company		128,788		12.86			60,094	6.00				60,094	6.00
Bank		115,770		12.02			57,785	6.00				77,047	8.00

Common equity tier 1 capital (to risk-weighted assets):
The Company		128,788		12.86			45,070	4.50			N/A		N/A
Bank		115,770		12.02			43,339	4.50				62,600	6.50

Tier I capital (to average assets):
The Company		128,788		9.07			56,776	4.00			N/A		N/A
Bank		115,770		8.23			56,286	4.00				70,357	5.00

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12. REVENUE RECOGNITION FROM CONTRACTS WITH CUSTOMERS

The Company generally fully satisfies its performance obligations on its contracts with customers as services are rendered and the transaction prices are typically fixed; charged either on a periodic basis or based on activity. Because performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers. The main types of revenue contracts included in non-interest income within the consolidated statements of operations are as follows:

•

Fees for services to customers—fees include service charges on deposits which are included as liabilities in the consolidated statement of financial position and consist of transaction-based fees, stop payment fees, Automated Clearing House (ACH) fees, account maintenance fees, and overdraft services fees for various retail and business checking customers. These fees are charged as earned on the day of the transaction or within the month of the service, with the exception of Enhanced Account Analysis Fees, which are calculated on the previous month’s activity and assessed on the following month. The Enhanced Account Analysis Fees are currently being accrued; the revenue is currently being recorded in the month it is earned. Service charges on deposits are withdrawn directly from the customer’s account balance.

•

ATM and debit card – fees are recognized at the time the transaction is executed as that is the point in time the Company fulfills the customer’s request.

•

Retail brokerage and advisory—fee income and related expenses are accrued monthly to properly record the revenues in the month they are earned. Advisory fees are collected in advance on a quarterly basis. These advisory fees are recorded in the first month of the quarter for which the service is being performed. Fees that are transaction based are recognized at the point in time that the transaction is executed (i.e. trade date).

•

Merchant – QNB earns interchange fees from credit/debit cardholder transactions conducted through VISA/MasterCard payment networks. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.

•

Other—includes credit card fees, sales of checks to depositors, miscellaneous fees and gain/losses on sale of OREO.

•

Credit card fees are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.

•

Sales of checks to depositors are commissions earned from a third-party who provides checks to QNB’s customers. There is a pre-paid incentive with the third party which is recognized over the term of the contract. Other commissions on the sales of checks are recorded weekly.

•

Miscellaneous fees, such as wire, cashier check and garnishment fees, are charged as earned on the day of the transaction.

•

Gain (loss) on sales of OREO – QNB records a gain or loss from the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the QNB finances the sale of OREO to the buyer, QNB assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on the sale, QNB adjusts the transaction prices and related gain (loss) on sale if a significant financing component is present.

QNB CORP. AND SUBSIDIARY

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact. The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB” or the “Company”.

Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.

FORWARD-LOOKING STATEMENTS

In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.

Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2020 Form 10-K, could affect the future financial results of QNB Corp. and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:

•

Volatility in interest rates and shape of the yield curve;

•

Credit risk;

•

Liquidity risk;

•

Operating, legal and regulatory risks;

•

Economic, political and competitive forces affecting QNB’s business;

•

The effects of unforeseen external events, including acts of terrorism, natural disasters, and pandemics, including the COVID-19 Pandemic; and

•

The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful.

QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Other-Than-Temporary Investment Security Impairment

Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, it indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities that do not have readily-determinable fair values, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized. There were no other-than-temporary impairment charges recorded during the quarter ended March 31, 2021 and 2020, respectively.

The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. There were no credit-related other-than-temporary impairment charges in the quarter ended March 31, 2021 or 2020, respectively.

Allowance for Loan Losses

The determination of the allowance for loan losses involves a higher degree of judgment and complexity than the Company’s other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral or present value of future estimated cash flows. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collection. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.

Stock-Based Compensation

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. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. 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. 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 estimates 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.

Income Taxes

QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.

RESULTS OF OPERATIONS - OVERVIEW

QNB reported net income for the first quarter of 2021 of $5,050,000, or $1.42 per share on a diluted basis, compared to net income of $220,000, or $0.06 per share on a diluted basis, for the same period in 2020. The Bank contributed $4,038,000 to net income for the first quarter of 2021 compared to $2,316,000 for the first quarter of 2020; and the holding company contributed $1,012,000 to net income to the first quarter of 2021 compared to a net loss of $2,096,000 for the first quarter of 2020. The results at the holding company are due primarily to the change in the fair value of the equity portfolio during the quarters.

Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.40% and 15.70%, respectively, for the quarter ended March 31, 2021 compared with 0.07% and 0.73%, respectively, for the quarter ended March 30, 2020.

Total assets as of March 31, 2021 were $1,570,519,000, compared with $1,440,229,000 at December 31, 2020. Loans receivable at March 31, 2021 were $945,645,000, compared with $920,042,000 at December 31, 2020, an increase of $25,603,000, or 2.8%, with commercial lending as the largest contributor to the growth. QNB participates in the Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”). In 2020, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation. Of this first round of funding, 365 loans have been forgiven in full and $37,293,000 in balances have been forgiven. The Bank originated 251 PPP loans, or $30,706,000 during the second round of funding which started in January 2021. Excluding PPP loans net of deferred fees, loans receivable at March 31, 2021 would have increased $22,926,000, or 2.7%, since year-end 2020. Total deposits of $1,341,616,000 at March 31, 2021 increased $113,549,000, or 9.2%, compared with total deposits of $1,228,067,000 at December 31, 2020. Most of the PPP loans proceeds were deposited to deposit accounts at the Bank.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Results for the three months ended March 31, 2021 include the following significant components:

•

Net interest income increased $1,354,000, or 14.8%, to $10,517,000 for the three months ended March 31, 2021.

•

Net interest margin on a tax-equivalent basis decreased eleven basis points for the quarter to 3.07%.

•

QNB recorded $275,000 in provision for loan losses for the three months ended March 31, 2021, compared with $500,000 for the same period in 2020.

•

Non-interest income increased $4,975,000, to $3,404,000 for the three months ended March 31, 2021 compared with the same period in 2020. Excluding realized and unrealized gains (losses) on equity securities, non-interest income increased $600,000, or 43.8%, to $1,969,000 for the three months ended March 31, 2021 compared with the same period in 2020.

•

Non-interest expense increased $45,000, or 0.6%, to $7,323,000 for the three months ended March 31, 2021 compared to the same period in 2020.

•

Total non-performing loans were $13,266,000, or 1.40% of loans receivable at March 31, 2021, compared to $14,109,000, or 1.53% of loans receivable at December 31, 2020. Loans on non-accrual status were $8,887,000 at March 31, 2021 compared with $9,640,000 at December 31, 2020. Net loan recoveries for the three months ended March 31, 2021 were $14,000, compared with $53,000 in charge-offs for the same period in 2020.

These items, as well as others, are explained more thoroughly in the next sections.

NET INTEREST INCOME

QNB earns its net income primarily through the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. Management seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors.

The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three-month periods ended March 31, 2021 and 2020.

	For the Three Months Ended March 31,
	2021		2020
Total interest income	$	11,731	$	11,331
Total interest expense		1,214		2,168
Net interest income		10,517		9,163
Tax-equivalent adjustment		162		176
Net interest income (fully taxable-equivalent)	$	10,679	$	9,339

Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits.

For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.

The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)

	Three Months Ended
	March 31, 2021								March 31, 2020
	Average			Average					Average			Average
	Balance			Rate			Interest		Balance			Rate			Interest
Assets
Investment securities (AFS & Equity):
U.S. Government agencies	$	70,229			1.02	%	$	178	$	56,163			1.86	%	$	261
State and municipal		93,723			2.59			608		54,445			3.43			467
Mortgage-backed and CMOs		262,937			1.30			856		217,020			2.07			1,125
Pooled trust preferred securities		84			2.51			1		85			4.15			1
Corporate debt securities		7,158			3.72			67		8,007			3.65			73
Equities		13,159			3.26			106		11,352			3.26			92
Total investment securities		447,290			1.62			1,816		347,072			2.33			2,019
Loans:
Commercial real estate		530,672			4.34			5,680		478,146			4.76			5,661
Residential real estate		88,506			3.50			775		69,858			3.95			690
Home equity loans		58,738			3.47			502		64,222			4.18			667
Commercial and industrial		228,337			5.00			2,814		165,171			4.87			2,000
Consumer loans		5,333			4.91			65		6,440			5.57			89
Tax-exempt loans		25,075			3.57			221		38,003			3.60			341
Total loans, net of unearned income*		936,661			4.35			10,057		821,840			4.62			9,448
Other earning assets		28,562			0.29			20		11,461			1.41			40
Total earning assets		1,412,513			3.41			11,893		1,180,373			3.92			11,507
Cash and due from banks		26,844								13,769
Allowance for loan losses		(10,935	)							(9,951	)
Other assets		38,098								37,296
Total assets	$	1,466,520							$	1,221,487

Liabilities and Shareholders' Equity
Interest-bearing deposits:
Interest-bearing demand	$	281,728			0.21	%		148	$	226,307			0.41	%		231
Municipals		112,550			0.32			90		105,725			1.33			349
Money market		105,556			0.31			82		79,567			0.74			147
Savings		354,018			0.33			290		251,445			0.59			368
Time		103,783			1.09			279		118,921			1.56			463
Time of $100,000 or more		84,887			1.10			231		113,231			1.78			501
Total interest-bearing deposits		1,042,522			0.44			1,120		895,196			0.93			2,059
Short-term borrowings		58,086			0.39			55		47,683			0.78			92
Long-term debt		10,000			1.57			39		4,231			1.57			17
Total interest-bearing liabilities		1,110,608			0.44			1,214		947,110			0.92			2,168
Non-interest-bearing deposits		216,293								142,398
Other liabilities		9,146								10,295
Shareholders' equity		130,473								121,684
Total liabilities and shareholders' equity	$	1,466,520							$	1,221,487
Net interest rate spread					2.97	%							3.00	%
Margin/net interest income					3.07	%	$	10,679					3.18	%	$	9,339

Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent for three months ended March 31, 2021 and 2020.

Non-accrual loans are included in earning assets.

* Includes loans held-for-sale

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.

	For the Three Months Ended
	March 31, 2021 compared
	to March 31, 2020
	Total			Due to change in:
	Change			Volume			Rate
Interest income:
Investment securities (AFS & Equity):
U.S. Government agencies	$	(83	)	$	64		$	(147	)
State and municipal		141			337			(196	)
Mortgage-backed and CMOs		(269	)		238			(507	)
Pooled trust preferred securities		—			—			—
Corporate debt securities		(6	)		(7	)		1
Equities		14			14			—
Total Investment securities (AFS & Equity)		(203	)		646			(849	)
Loans:
Commercial real estate		19			569			(550	)
Residential real estate		85			184			(99	)
Home equity loans		(165	)		(62	)		(103	)
Commercial and industrial		814			742			72
Consumer loans		(24	)		(15	)		(9	)
Tax-exempt loans		(120	)		(118	)		(2	)
Total Loans		609			1,300			(691	)
Other earning assets		(20	)		59			(79	)
Total interest income		386			2,005			(1,619	)
Interest expense:
Interest-bearing deposits:
Interest-bearing demand		(83	)		54			(137	)
Municipals		(259	)		19			(278	)
Money market		(65	)		47			(112	)
Savings		(78	)		145			(223	)
Time		(184	)		(62	)		(122	)
Time of $100,000 or more		(270	)		(128	)		(142	)
Total interest-bearing deposits		(939	)		75			(1,014	)
Short-term borrowings		(37	)		19			(56	)
Long-term debt		22			22			—
Total interest expense		(954	)		116			(1,070	)
Net interest income	$	1,340		$	1,889		$	(549	)

Net Interest Income and Net Interest Margin – Quarterly Comparison

Average earning assets for the first quarter of 2021 were $1,412,513,000, an increase of $232,140,000, or 19.7%, from the first quarter of 2020, with average loans increasing $114,821,000, or 14.0%, and average investment securities increasing $100,218,000, or 28.9%, over the same period. Excess cash from deposit growth was deployed to the securities portfolio, which earns a better yield than Fed Funds or deposits at the Federal Reserve Bank. Average loans as a percent of average earning assets were 66.3% for the first quarter of 2021, compared with 69.6% for the first quarter of 2020. On the funding side, average deposits increased $221,221,000, or 21.3%, to $1,258,815,000 for the first quarter of 2021 primarily due to growth in non-interest-bearing and interest-bearing demand, money market and savings deposits. Customers continue to reinvest funds into more liquid accounts. Average short-term borrowed funds for the first quarter of 2021 increased $10,403,000, to $58,086,000, which consisted entirely of average commercial repurchase

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

agreements during the first quarter of 2021. For the same period in 2020, borrowings consisted of average commercial repurchase agreements of $40,695,000 and average overnight borrowings of $6,988,000.

The net interest margin for the first quarter of 2021 decreased 11 basis points to 3.07% from 3.18% at the same period in 2020. While competition for quality loans in our local market continues to exert pressure on the net interest margin, the decline in interest rates starting in March 2020 resulted in significantly lower bond yields and prepayments and calls of existing higher-yielding, seasoned investments.

The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis increased $386,000, or 3.4%, to $11,893,000 for the first quarter of 2021; total interest expense decreased $954,000, or 44.0%, to $1,214,000. Decreases in rates on earning assets were offset by $744,000 of net deferred origination fees and costs recorded as income on forgiven PPP loans. All categories of interest-bearing deposits experienced lower rates in the first quarter of 2021 compared to first quarter of 2020.

The yield on earning assets on a tax-equivalent basis decreased 51 basis points from 3.92% for the first quarter of 2020, to 3.41% for the first quarter of 2021. The cost of interest-bearing liabilities was 0.44% for the first quarter ended March 31, 2021, compared with 0.92% for the same period in 2020.

Interest income on investment securities (available-for-sale and equity) decreased $203,000 when comparing the quarters ended March 31, 2021 and 2020. The average yield on the investment portfolio was 1.62% for the first quarter of 2021 compared with 2.33% for the first quarter of 2020.

Income on U.S. Government agency securities decreased $83,000 as the rate decreased 84 basis points, partially offset by an increase in average balances of $14,066,000.

Interest income on municipal securities, which are primarily tax-exempt, increased due to a $39,278,000 increase in average balances, partially offset by an 84 basis-point decrease in rates. Proceeds from matured, called securities and proceeds from deposits were invested back into the U.S. Government agency, municipal and mortgage-backed securities portfolios. Typically, QNB purchases municipal bonds with 10-20-year maturities and may have call dates between 2-10 years.

Interest income on mortgage-backed securities and CMOs decreased $269,000 due to a 77-basis point decline in yield partially offset by a $45,917,000 increase in average balances. This portfolio generally provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase. Since most of these securities were purchased at a premium, any prepayments result in a shorter amortization period of this premium and therefore a reduction in income.

Income on loans increased $609,000 to $10,057,000 when comparing the first quarters of 2021 and 2020, with a 14.0% growth in average balances contributing an increase in interest income of $1,300,000. The yield on loans, at 4.35%, was 27 basis points lower than the first quarter of 2020, contributing to a $691,000 decrease in interest income. Falling interest rates as well as competitive pressures compressed the yields on new loans being originated.

The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans increased $19,000 when comparing the first quarters of 2021 and 2020, primarily due to increased average balances of $52,526,000, or 11.0%, offset in part by a 42-basis point decrease in rate from 4.76% in 2020 to 4.34% in 2021.

Income on commercial and industrial loans increased $814,000 when comparing the first quarters of 2021 and 2020. The average yield on these loans increased 13 basis points to 5.00% resulting in an increase in income of $72,000; average balances increased $63,166,000, to $228,337,000 for the first quarter of 2021 resulting in an $742,000 increase in interest income. Many of the loans in this category are indexed to the prime interest rate, which decreased a total of 150 basis points in March 2020. Included in this category are the PPP loans which contributed $70,516,000 of the net volume increase. The PPP loans yield one percent to the customer, however QNB received origination fees from the SBA ranging from a flat fee of $2,500 to one to five basis points. The accretion of SBA origination fees is accelerated upon forgiveness of the loan. The yield on PPP loans was 6.57% for the first quarter of 2021.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Tax-exempt loan income was $221,000 for the first quarter of 2021, a decrease of $120,000, or 35.2%, from the same period in 2020. Average balances decreased $12,928,000, or 34.0%, to $25,075,000 for the first quarter of 2021, resulting in a decrease of $118,000 in income. The yield on municipal loans decreased three basis points, to 3.57% for the first quarter of 2021, compared with the same period in 2020, resulting in a decrease of $2,000 in interest income. The decrease in volume during 2021 was a result of municipal loans being refinanced as bonds.

QNB desires to be the “local consumer lender of choice”, focusing its retail lending efforts on product offerings and marketing and promotion. Interest income on residential mortgage loans secured by first lien 1-4 family increased $85,000 when comparing the first quarter of 2021 to the same period in 2020. Average residential mortgage loan balances increased by $18,648,000, or 26.7%, to $88,506,000 for the first quarter of 2021 compared to the same period in 2020, which contributed a $184,000 increase in interest income. However, the average yield on the portfolio decreased 45 basis points to 3.50% for the first quarter of 2021, which resulted in a $99,000 decrease. QNB chose to retain certain mortgage loans instead of selling them in the secondary market, as the yield on our originated mortgages was higher than comparable mortgage backed securities. Average home equity loans decreased by $5,484,000, or 8.5%, to $58,738,000 and the average yield decreased 71 basis points to 3.47% resulting in a combined decrease in interest income of $165,000. The yield on the consumer portfolio decreased 66 basis points to 4.91% for the first quarter of 2021 and there was a $1,107,000 decrease in average balances resulting in a combined $24,000 decrease in interest income.

Earning assets are funded by deposits and borrowed funds. Interest expense decreased $954,000, when comparing the first quarter of 2021 to the same period in 2020. The growth in average deposits continues to be centered in accounts with greater liquidity, such as non-interest and interest-bearing demand deposits. Average non-interest-bearing demand accounts increased $73,895,000, or 51.9%, to $216,293,000 for the first quarter of 2021. Average interest-bearing demand accounts increased $55,421,000, or 24.5%, to $281,728,000 for the first quarter of 2021. Interest expense on interest-bearing demand accounts decreased $83,000 to $148,000 for the same period, as the average rate paid decreased 20 basis points to 0.21% for the first quarter 2021. Included in this category is QNB-Rewards checking, a higher-rate checking account product that pays 1.00% on balances up to $25,000 and 0.20% for balances over $25,000. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the first quarter of 2021, the average balance in this product was $89,966,000 and the related interest expense was $79,000 for an average yield of 0.36%. In comparison, the average balance of the QNB-Rewards accounts for the first quarter of 2020 was $65,926,000 and the related interest expense was $98,000 for an average yield of 0.60%. This product also generates fee income through the use of the check card.

Interest expense on municipal interest-bearing demand accounts decreased $259,000 to $90,000 for the first quarter of 2021. The average interest rate paid on municipal interest-bearing demand accounts decreased 101 basis points to 0.32% for the first quarter of 2021 and average balances increased $6,825,000, or 6.5%, to $112,550,000. Many of these accounts are indexed to the Federal funds rate with rate floors between 0.25% and 0.50%; therefore the 150-basis point decrease in the Federal funds rate in March 2020, affected the yield of these deposits. Municipal deposits are seasonal in nature and are received during the second and third quarters as tax receipts are collected and are withdrawn over the course of the year.

Average money market accounts increased $25,989,000, or 32.7%, to $105,556,000 for the first quarter of 2021 compared with the same period in 2020. Interest expense on money market accounts decreased $65,000 to $82,000, and the average interest rate paid on money market accounts decreased 43 basis points to 0.31% for the first quarter of 2021. Most of the balances in this category are in a product that pays a tiered rate based on account balances.

Interest expense on savings accounts decreased $78,000 when comparing the first quarter of 2021 to the first quarter of 2020. The average interest rate paid on savings accounts decreased 26 basis points to 0.33% for the first quarter of 2021. When comparing these same periods, average savings accounts increased $102,573,000, or 40.8%, to $354,018 for the first quarter of 2021 primarily due to increases in the e-Savings product. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the first quarter of 2021 of $263,038,000 compared to $179,741,000 in the same period of 2020. The average yield paid on these accounts was 0.40% for the first quarter of 2021 and 0.75% for the same period in 2020. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts increased $19,276,000 when comparing the first quarter of 2021 average to the same period in 2020. Many of the Bank’s maturing time deposits throughout 2020 and into 2021 were deposited to these liquid interest-bearing accounts.

Interest expense on time deposits totaled $510,000 for the first quarter of 2021 compared to $964,000 in 2020. Average total time deposits decreased $43,482,000 to $188,670,000 for the first quarter of 2021. As with fixed-rate loans and investment securities, these deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment,

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

however, the maturity and repricing characteristics of time deposits tend to be shorter. The average rate paid on total time deposits decreased 57 basis points from 1.67% to 1.10% when comparing the first quarter of 2020 to the same period in 2021.

Approximately $108,426,000, or 60%, of time deposits at March 31, 2021 will mature over the next 12 months. The average rate paid on these time deposits is approximately 0.80%. The yield on the time deposit portfolio may change slightly in the next quarter as short-term time deposits reprice. However, given the short-term nature of these deposits, interest expense may increase if short-term time deposit rates were to increase suddenly or if customers select higher paying time deposits.

Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight FHLB borrowings. Interest expense on short-term borrowings decreased $37,000 for the first quarter of 2021 to $55,000 when compared to the same period in 2020. When comparing these same periods, average balances increased $10,403,000 to $58,086,000, net of a decrease in average FHLB borrowings of $6,988,000 offset by an increase in average repurchase agreement balances of $17,391,000, with a combined 39-basis point decrease in rate. During 2020, QNB borrowed long-term debt of $10,000,000 to lock in borrowing at a low yield.

PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES

The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s estimates of the allowance for loan losses and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance.

Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers several relevant factors including specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.

Based on this analysis, QNB recorded $275,000 in provision for loan losses in the three months ended March 31, 2021, compared with $500,000 for the same period in 2020. QNB's allowance for loan losses of $11,115,000 represents 1.18% of loans receivable at March 31, 2021 compared with an allowance for loan losses of $10,826,000, or 1.18% of loans receivable, at December 31, 2020, and $10,334,000, or 1.26% of loans receivable at March 31, 2020. Management believes the allowance for loan losses at March 31, 2021 is adequate as of that date based on its analysis of known and inherent losses in the portfolio. Excluding PPP loans, the allowance level stated as a percent of loans receivable at March 31, 2021 and at December 31, 2020 was 1.27%.

Net recoveries were $14,000 for the three months ended March 31, 2021 compared to net charge-offs of $53,000 for the same period in 2020. Charge-offs of approximately $32,000 during the three months ended March 31, 2021 consisted of overdraft charge-offs of $9,000 and student loans of $23,000. These were offset by $46,000 in recoveries comprising $29,000 in repayments from borrowers of previously charged-off credits, and $17,000 related to overdraft recoveries. Annualized net recoveries as a percentage of average loans receivable were 0.01% for the three months ended March 31, 2021 compared with annualized net charge-offs as a percentage of average loans receivable of 0.03% for the same period in 2020.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Non-performing assets were $13,266,000 at March 31, 2021 compared to $14,109,000 as of December 31, 2020 and $15,861,000 at March 31, 2020. Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans, were 1.40% of loans receivable at March 31, 2021 compared with 1.53% of loans receivable at December 31, 2020 and 1.93% of loans receivable at March 31, 2020. In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. At March 31, 2021, $4,809,000, or approximately 54% of the loans classified as non-accrual are current or past due less than 30 days. Commercial loans classified as substandard or doubtful totaled $21,935,000, a decrease of $258,000, or 1.2%, from the $22,193,000 reported at December 31, 2020 and an increase of $6,762,000, or 44.6%, from the $15,173,000 reported at March 31, 2020. The increase in classified loans since March 2020 is due to the downgrade of three large credits, partially offset by repayments on existing substandard loans.

QNB had no loans past due 90 days or more and still accruing interest at March 31, 2021, December 31, 2020, or March 31, 2020. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.60% of loans receivable at March 31, 2021 compared with 0.62% at December 31, 2020 and 1.32% at March 31, 2020.

Troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $4,379,000 at March 31, 2021, compared with $4,469,000 at December 31, 2020, and $4,727,000 at March 31, 2020. There were no newly identified troubled debt restructurings during the three months ended March 31, 2021. QNB had no other real estate owned or repossessed assets at March 31, 2021, December 31, 2020, or March 31, 2020.

A loan is considered impaired, based on current information and events, if it is probable that QNB will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:

	March 31,			December 31,			March 31,
	2021			2020			2020
Non-accrual loans	$	8,887		$	9,640		$	11,134
Loans past due 90 days or more and still accruing interest		—			—			—
Troubled debt restructured loans (not already included above)		4,379			4,469			4,727
Total non-performing loans		13,266			14,109			15,861
Total non-performing assets	$	13,266		$	14,109		$	15,861

Total loans (excluding loans held-for-sale):
Average total loans (YTD)	$	932,617		$	868,461		$	821,695
Total loans		945,645			920,042			821,283

Allowance for loan losses		11,115			10,826			10,334

Allowance for loan losses to:
Non-performing loans		83.79	%		76.73	%		65.15	%
Total loans (excluding held-for-sale)		1.18	%		1.18	%		1.26	%
Average total loans (excluding held-for-sale)		1.19	%		1.25	%		1.26	%

Non-performing loans / total loans (excluding held-for-sale)		1.40	%		1.53	%		1.93	%
Non-performing assets / total assets		0.84	%		0.98	%		1.29	%

An analysis of net loan charge-offs for the three months ended March 31, 2021 compared to 2020 is as follows:

	For the Three Months Ended March 31,
	2021			2020
Net charge-offs	$	(14	)	$	53

Net annualized charge-offs to:
Total loans		(0.01	%)		0.03	%
Average total loans excluding held-for-sale		(0.01	%)		0.03	%
Allowance for loan losses		(0.51	%)		2.06	%

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

At March 31, 2021 and December 31, 2020, the recorded investment in loans for which impairment has been identified totaled $13,616,000 and $14,516,000 of which $5,682,000 and $6,432,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $7,934,000 and $8,084,000 at March 31, 2021 and December 31, 2020, respectively, and the related allowance for loan losses associated with these loans was $2,849,000 and $3,050,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.

NON-INTEREST INCOME

Non-Interest Income Comparison
	For the Three Months Ended March 31,					Change from prior year
	2021		2020			Amount			Percent
Net gain on sales of investment securities	$	342	$	—		$	342			#DIV/0	!
Unrealized gain (loss) on investment equity securities		1,096		(2,940	)		4,036		N/M
Fees for services to customers		299		411			(112	)		(27.3	)
ATM and debit card		593		488			105			21.5
Retail brokerage and advisory		167		113			54			47.8
Bank-owned life insurance		263		68			195			286.8
Merchant		104		91			13			14.3
Net gain on sale of loans		352		81			271		N/M
Other		188		117			71			60.7
Total	$	3,404	$	(1,571	)	$	4,975			-316.7	%

Quarter to Quarter Comparison

Total non-interest income for the first quarter of 2021 was $3,404,000, an increase of $4,975,000, compared to a loss of $1,571,000 for the first quarter of 2020. Excluding net realized and unrealized gains (losses) on equity securities for both periods, total non-interest income was $1,969,000 and $1,369,000 for the quarters ended March 31, 2021 and 2020, respectively, an increase of $600,000 or 43.8%.

During the first quarter of 2021, unrealized gains of $1,096,000 were recorded compared to unrealized losses of $2,940,000 in the same period of 2020. The unrealized gains and losses for the three months ended March 31, 2021 and 2020 resulted from the change in the fair value of the equities portfolio, the performance of which was consistent with the overall performance of the U.S. stock market for the periods. The equities portfolio comprises blue-chip large-capitalized stocks, providing a taxable equivalent dividend yield of 3.16%. The estimated cumulative contribution (realized and unrealized net gains (losses), plus dividends) of the equity portfolio to earnings per share from January 1, 2011 through March 31, 2021 is $2.14 per diluted share. Details of the equity portfolio’s contribution to net income is detailed in the following table.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Net Income (Expense) on Equity Securities
	For the Year Ended December 31,																			For the Three Months Ended March 31,
		2015			2016			2017			2018			2019			2020			2021			2020

Equity Securities:
Tax-equivalent dividends*		$	244		$	233		$	249		$	300		$	274		$	392		$	106		$	92
Net gain (loss) on sales			691			758			1,557			(79	)		1,781			585			339			—
OTTI			(55	)		(192	)		(80	)	N/A			N/A			N/A			N/A			N/A
Unrealized (loss) gain		N/A			N/A			N/A				(336	)		770			(47	)		1,096			(2,940	)
Tax-equivalent income before tax			880			799			1,726			(115	)		2,825			930			1,541			(2,848	)
Tax expense (benefit)*			357			324			700			(33	)		816			269			445			(823	)
Net income		$	523		$	475		$	1,026		$	(82	)	$	2,009		$	661		$	1,096		$	(2,025	)

Earnings per share - basic		$	0.16		$	0.14		$	0.30		$	(0.02	)	$	0.57		$	0.19		$	0.31		$	(0.57	)
Earnings per share - diluted		$	0.16		$	0.14		$	0.30		$	(0.02	)	$	0.57		$	0.19		$	0.31		$	(0.57	)
Tax-equivalent yield*			3.35	%		3.13	%		3.49	%		3.08	%		3.31	%		3.54	%		3.16	%		3.32	%

*Based on Federal tax rates of 34% for the 2015 and 2016 periods and 21% for all 2017, 2018, 2019, 2020 and 2021 periods.

QNB originates residential mortgage loans for sale in the secondary market. Net gain on sale of loans increased $271,000 when comparing the two periods. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. Proceeds from the sale of residential mortgages were $9,105,000 and $2,498,000 for the first quarters of 2021 and 2020, respectively.

Fees for services to customers decreased $112,000 to $299,000 for the first quarter of 2021, due primarily to a decrease in net overdraft income. ATM and debit card income increased $105,000 to $593,000 for the first quarter of 2021, compared to the same period in 2020, due primarily to debit card interchange fee income.

QNB provides securities and advisory services under the name QNB Financial Services. Retail brokerage and advisory fees increased for the first quarter of 2021 compared to the same period in 2020. Advisory fees increased $59,000 for the first quarter of 2021 compared with the same period in 2020, while transactional fees declined $5,000 when comparing first quarters of 2021 and 2020.

Bank-owned life insurance income includes a life insurance benefit claim of $193,000. Merchant income increased by $13,000 to $104,000 for the first quarter of 2021, compared to the same period in 2020. Other non-interest income increased $71,000, or 60.7%. Other non-interest income includes broker-dealer conversion cost reimbursements of $15,000 and $17,000 in the first quarter of 2021 and 2020, respectively. Mortgage serving income increased $7,000 when comparing the two quarters primarily due to an increase in the fair value of servicing rights. There was an increase in title company income of $37,000 due to the increased volume of mortgage originations and an increase in letter of credit fees of $24,000.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

NON-INTEREST EXPENSE

Non-Interest Expense Comparison
	For the Three Months Ended March 31,				Change from prior year
	2021		2020		Amount			Percent
Salaries and employee benefits	$	4,017	$	4,072	$	(55	)		-1.4	%
Net occupancy		618		523		95			18.2
Furniture and equipment		670		675		(5	)		(0.7	)
Marketing		214		322		(108	)		(33.5	)
Third-party services		488		454		34			7.5
Telephone, postage and supplies		198		195		3			1.5
State taxes		273		243		30			12.3
FDIC insurance premiums		171		137		34			24.8
Other		674		657		17			2.6
Total	$	7,323	$	7,278	$	45			0.6	%

Quarter to Quarter Comparison

Total non-interest expense was $7,323,000 for the first quarter of 2021, an increase of $45,000, or 0.6%, compared to the first quarter of 2020.

Salaries and benefits comprise the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense decreased $55,000, or 1.4%, to $4,017,000 when comparing the two quarters. Salary expense and related payroll taxes decreased $3,000 to $3,428,000 during the first quarter of 2021 compared to the same period in 2020 due increased loan origination deferred costs of $122,000. Medical and dental premiums, net of employee contributions decreased $77,000 to $281,000 when comparing the two quarters due to a decrease in medical claims. Bonus expense increased $74,000.

Net occupancy and furniture and equipment expenses combined increased $90,000, or 7.5%. This is due primarily to increased building repairs and maintenance expense. Marketing expense decreased $108,000, or 33.5%, to $214,000 for the quarter ended March 31, 2021 due to cancellation of events resulting from the COVID-19 pandemic.

Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, IT services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense increased $34,000 when comparing the two periods, due primarily to decreases in fees paid to outside vendors for support services. State taxes increased $30,000 due to an increase bank shares tax expense. FDIC insurance premiums increased $34,000 due to capital and asset growth.

Other non-interest expense increased $17,000, or 2.6%, primarily due to Checkcard expense.

INCOME TAXES

QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of March 31, 2021, QNB’s net deferred federal tax asset was $1,457,000 and a net deferred state tax liability of $110,000. The primary components of deferred taxes are deferred tax assets of which $2,334,000 relates to the allowance for loan losses. As of December 31, 2020, QNB’s net deferred tax asset was $66,000. The increase in the balance of net deferred tax assets when comparing March 31, 2021 to December 31, 2020 is due to the decrease in unrealized gains on available for sale securities at March 31, 2021 compared to December 31, 2020, contributing to $1,682,000 of the increase. This increase was partially offset by the deferred tax on unrealized gains at March 31, 2021 compared to gains at December 31, 2020 on equity securities, resulting in a decrease of $316,000.

The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Applicable income tax expense was $1,273,000 for the quarter ended March 31, 2021, compared to a benefit of $406,000 for the same period in 2020. The effective tax rate for first quarter 2021 was 20.1%, compared with 218.3% for the same period in 2020. The decrease in the effective tax rate for the quarter ended March 31, 2021 is due to the state income tax benefit at the parent company related to the unrealized losses on the equities portfolio and to the proportion of tax-exempt net interest income to income before taxes.

FINANCIAL CONDITION ANALYSIS

Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. Rate competition for quality loans is anticipated to continue through 2021. It is also anticipated that the rate competition for attracting and retaining deposits may continue in 2021, which could result in a lower net interest margin and a decline in net interest income.

QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. QNB is committed to make credit available to its customers.

Total assets at March 31, 2021 were $1,570,519,000 compared with $1,440,229,000 at December 31, 2020. Cash and cash equivalents increased $69,402,000 from $39,331,000 at December 31, 2020 to $108,733,000 at March 31, 2021, due primarily to increases in deposits during the three months ended March 31, 2021.

The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio.

Loans receivable grew $25,603,000, or 2.8%, with commercial loans increasing $20,445,000, or 2.7%, to $790,255,000 at March 31, 2021, compared with $769,810,000 at year-end 2020. Retail loan balances increased $5,545,000 comparing March 31, 2021 to December 31, 2020. Under the CARES Act, QNB continues to provide solutions to customers experiencing financial hardship caused by the COVID-19 Pandemic. As of March 31, 2021, QNB had modifications to approximately 3.3% of the commercial portfolio, with an outstanding balance of $26,277,000, and modifications to approximately 1.6% of the retail portfolio, with an outstanding balance of $2,453,000, related to the COVID-19 Pandemic. At March 31, 2021, QNB had 546 PPP loans totaling $75,887,000 reported in commercial and industrial loans. In 2020, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation. Of this first round of funding, 365 loans have been forgiven in full and $37,293,000 in balances have been forgiven. The Bank originated 251 PPP loans, or $30,706,000, during the second round of funding which started in January 2021. Second-draw customers made up 205 of these loans, or $28,700,000 and first-draw customers made of the remaining 46 loans, or $2,006,000. Excluding PPP loans net of deferred fees, loans receivable at March 31, 2021 would have increased $22,926,000, or 2.7%, since year-end 2020.

Deposits grew $113,549,000, or 9.2%, from December 31, 2020 to March 31, 2021. Non-interest-bearing demand deposits increased $49,273,000, or 24.1%, with balances of $253,857,000 at March 31, 2021 compared with $204,584,000 at year-end 2020. Interest-bearing demand balances, excluding municipal deposits, increased $18,790,000, or 6.7%, to $297,953,000, with increases in all personal checking products and in the business checking product. The $47,397,000 increase in savings and $16,436,000 increase in money markets was partially offset by the decline in time deposits as balances were moved to more liquid accounts. Total time deposits declined $15,092,000 from December 31, 2020 to March 31, 2021. Municipal deposit balances decreased $3,255,000, or 2.8%, to $112,946,000. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. Municipal deposits increase as tax money is received from the local school districts during second and third quarters and it is anticipated that these funds will flow out for the subsequent twelve months as the schools use the funds for operations. These deposits provide incremental income as they are invested in short-term investment securities but will further reduce the net interest margin as the spread earned is significantly less than the current net interest margin.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Short-term borrowings increased 10.4%, from $58,838,000 at December 31, 2020 to $64,947,000 at March 31, 2021. Commercial sweep accounts increased $6,109,000, as these funds may be volatile based on businesses’ receipt and disbursement of funds and is offset by business non-interest-bearing demand accounts. There were no overnight borrowings from FHLB at March 31, 2021 or December 31, 2020. In 2020, QNB borrowed long-term debt from the FHLB of $10,000,000 to lock in a rate at a low yield.

LIQUIDITY

Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.

Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At March 31, 2021, the Bank had a maximum borrowing capacity with the FHLB of approximately $295,895,000, which is net of the $10,000,000 in long-term borrowings and a $350,000 letter of credit. The maximum borrowing depends upon qualifying collateral assets and the Bank’s asset quality and capital adequacy. In addition, the Bank maintains unsecured Federal funds lines with five correspondent banks totaling $101,000,000. At March 31, 2021 there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn.

Liquid sources of funds, including cash, available-for-sale and equity investment securities, and loans held-for-sale have increased $101,172,000 since December 31, 2020, totaling $595,568,000 at March 31, 2021. Growth in deposits since year-end 2020 has been used to fund loans, excess cash was invested in debt securities, primarily amortizing securities, and to cover operating expenses. Management expects these liquid sources will be adequate to meet normal fluctuations in loan demand or deposit withdrawals. The investment portfolio is expected to continue to provide sufficient liquidity, as municipal bonds are called or mature and cash flow on mortgage-backed and CMO securities continues to be steady.

Approximately $233,868,000 and $220,934,000 of available-for-sale debt securities at March 31, 2021 and December 31, 2020, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. The level of pledged securities corresponds with the municipal deposit and repurchase agreement balances.

QNB is a member of the Certificate of Deposit Account Registry Services (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is a product similar to CDARS, but one that provides liquidity like a money market or savings account.

CAPITAL ADEQUACY

A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at March 31, 2021 was $131,996,000, or 8.40% of total assets, compared with shareholders' equity of $134,445,000, or 9.33% of total assets, at December 31, 2020. Shareholders’ equity at March 31, 2021 included a negative adjustment of $678,000 compared to a positive adjustment of $5,649,000 at December 31, 2020, related to unrealized holding losses and gains, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 8.44% and 8.98% at March 31, 2021 and December 31, 2020, respectively.

Average shareholders' equity and average total assets were $130,473,000 and $1,466,520,000 for the three months ended March 31, 2021, an increase of 7.2% and 20.1%, respectively, from the averages for the three months ended March 31, 2020. The ratio of average total equity to average total assets was 8.90% for the three months ended March 31, 2021 compared to 9.96% for the same period in 2020.

Retained earnings at March 31, 2021 were impacted by three months of net income totaling $5,050,000 offset by dividends declared and paid of $1,243,000 for the three-month period. QNB offers a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stock. Stock purchases under the Plan contributed $207,000 to capital during the three months ended March 31, 2021.

The Board of Directors has authorized the repurchase of up to 100,000 shares of QNB common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of March 31, 2021, 70,683 shares have been repurchased since the initial authorization at an average price of $19.79 and a total cost of $1,399,000.

QNB is subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier 1 capital and Tier 2 capital. Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk.

The required minimum Common equity Tier 1 capital to risk-weighted assets ratio is 4.5%, the required minimum ratio of Tier 1 capital to risk-weighted assets is 6.0%, the required minimum ratio of Total Capital to risk-weighted assets is 8.0%, and the required minimum Tier 1 leverage ratio is 4.0%. A capital conservation buffer of 2.5% of risk-weighted assets also applies to avoid limitations on certain capital distributions.

The following table sets forth consolidated information for QNB:

	March 31,			December 31,
Capital Analysis	2021			2020
Regulatory Capital
Shareholders' equity	$	131,996		$	134,445
Net unrealized securities losses, net of tax		678			(5,649	)
Deferred tax assets on net operating loss		—			—
Disallowed intangible assets		(8	)		(8	)
Common equity tier I capital		132,666			128,788

Tier I capital		132,666			128,788
Allowable portion: Allowance for loan losses and reserve for unfunded commitments		11,206			10,917
Total regulatory capital	$	143,872		$	139,705
Risk-weighted assets	$	1,032,611		$	1,001,561
Quarterly average assets for leverage capital purposes	$	1,466,512		$	1,419,404

	March 31,			December 31,
Capital Ratios	2021			2020
Common equity tier I capital / risk-weighted assets		12.85	%		12.86	%
Tier I capital / risk-weighted assets		12.85			12.86
Total regulatory capital / risk-weighted assets		13.93			13.95
Tier I capital / average assets (leverage ratio)		9.05			9.07

At March 31, 2021, common equity Tier I, Tier I capital, and total regulatory capital ratios were fairly level with December 31, 2020. The Company remains well-capitalized by all applicable regulatory requirements as of March 31, 2021.

MARKET RISK MANAGEMENT

Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section.

QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.

QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation considers current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster than its earning assets (loans and securities). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at March 31, 2021 is liability sensitive. Management expects that market interest rates will remain level over the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System.

The following table shows the estimated impact of changes in interest rates on net interest income as of March 31, 2021 and 2020 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates.

Estimated Change in Net Interest Income
Changes in Interest rates	March 31,
(in basis points)	2021			2020
+300		-2.30	%		-0.37	%
+200		-0.52	%		0.58	%
+100		0.26	%		1.05	%
-100		-5.85	%		-5.06	%

Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

QNB is not subject to foreign currency exchange or commodity price risk. At March 31, 2021, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The information required in response to this item is set forth in Item 2, above.

ITEM 4. CONTROLS AND PROCEDURES

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

QNB CORP. AND SUBSIDIARY

PART II. OTHER INFORMATION

March 31, 2021

Item 1. Legal Proceedings

No material proceedings.

Item 1A. Risk Factors

There were no material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2020.

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

QNB repurchased 8,700 shares of its common stock during the quarter ended March 31, 2021. The following provides certain information relating to QNB's stock repurchase plan.

Period	Total Number of Shares Purchased		Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plan		Maximum Number of Shares that may yet be Purchased Under the Plan

January 1, 2021 through January 31, 2021		3,000	$	32.46		3,000		35,017
February 1, 2021 through February 28, 2021		4,000		32.78		4,000		31,017
March 1, 2021 through March 31, 2021		1,700		34.10		1,700		29,317
Total		8,700	$	32.93		8,700		29,317

(1)	Transactions are reported as of trade dates.

(2)	QNB’s current stock repurchase plan was approved by its Board of Directors and announced on January 24, 2008 and subsequently increased on February 9, 2009.

(3)	The total number of shares approved for repurchase under QNB’s current stock repurchase plan is 100,000.

(4)	QNB’s current stock repurchase plan has no expiration date.

(5)	QNB has no stock repurchase plan that it has determined to terminate or under which it does not intend to make further purchases.

Item 3. Default Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

Item 6. Exhibits

Exhibit 3.1		Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).

Exhibit 3.2		By-laws of Registrant, as amended January 26, 2021. (Incorporated by reference to Exhibit 3.1 of the Registrant's Report on Form 8-K, SEC File No. 0-17706, filed with the Commission on January 27, 2021)

Exhibit 31.1		Section 302 Certification of Chief Executive Officer

Exhibit 31.2		Section 302 Certification of Chief Financial Officer

Exhibit 32.1		Section 906 Certification of Chief Executive Officer

Exhibit 32.2		Section 906 Certification of Chief Financial Officer

The following Exhibits are being furnished* as part of this report:

No.		Description

101.SCH		iXBRL Taxonomy Extension Schema Document.*
101.CAL		iXBRL Taxonomy Extension Calculation Linkbase Document.*
101.LAB		iXBRL Taxonomy Extension Label Linkbase Document.*
101.PRE		iXBRL Taxonomy Extension Presentation Linkbase Document.*
101.DEF		iXBRL Taxonomy Extension Definitions Linkbase Document.*
104		Cover Page Interactive Data File (formatted as inline iXBRL and contained in Exhibit 101)

These interactive data files are being furnished as part of this Quarterly Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections.

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.

	QNB Corp.

Date: May 7, 2021	By:	/s/ David W. Freeman
		David W. Freeman
		Chief Executive Officer

Date: May 7, 2021	By:	/s/ Janice McCracken Erkes
		Janice McCracken Erkes
		Chief Financial Officer

Date: May 7, 2021	By:	/s/ Mary E. Liddle
		Mary E. Liddle
		Chief Accounting Officer, QNB Bank