Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED June 30, 2018.
o
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:  0-12820

AMERICAN NATIONAL BANKSHARES INC.
(Exact name of registrant as specified in its charter)
VIRGINIA
 
54-1284688
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
628 Main Street
 
 
Danville, Virginia
 
24541
(Address of principal executive offices)
 
(Zip Code)

(434) 792-5111
(Registrant's telephone number, including area code)

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
x
No
o
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
x
No
o

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 the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer  o
Accelerated filer  x
Non-accelerated filer  o  (Do not check if a smaller reporting company)
Smaller reporting company o
 
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes
o
No
x
At July 27, 2018, the Company had 8,711,427 shares of Common Stock outstanding, $1 par value.


AMERICAN NATIONAL BANKSHARES INC.
Index
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


PART I.   FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS
American National Bankshares Inc.
Consolidated Balance Sheets
(Dollars in thousands, except per share data)
Assets
(Unaudited)
June 30, 2018
 
(*) December 31, 2017
Cash and due from banks
$
24,042

 
$
28,594

Interest-bearing deposits in other banks
9,300

 
23,883

 
 
 
 
Equity securities, at fair value
2,177

 
—

Securities available for sale, at fair value
341,247

 
321,337

Restricted stock, at cost
5,463

 
6,110

Loans held for sale
2,296

 
1,639

 
 
 
 
Loans, net of unearned income
1,339,379

 
1,336,125

Less allowance for loan losses
(13,508
)
 
(13,603
)
Net loans
1,325,871

 
1,322,522

 
 
 
 
Premises and equipment, net
25,879

 
25,901

Other real estate owned, net of valuation allowance of $114 in 2018 and $147 in 2017
1,124

 
1,225

Goodwill
43,872

 
43,872

Core deposit intangibles, net
1,037

 
1,191

Bank owned life insurance
18,674

 
18,460

Accrued interest receivable and other assets
23,549

 
21,344

Total assets
$
1,824,531

 
$
1,816,078

 
 
 
 
Liabilities
 

 
 

Demand deposits -- noninterest bearing
$
420,795

 
$
394,344

Demand deposits -- interest bearing
251,056

 
226,914

Money market deposits
383,963

 
403,024

Savings deposits
132,839

 
126,786

Time deposits
372,093

 
383,658

Total deposits
1,560,746

 
1,534,726

 
 
 
 
Short-term borrowings:
 
 
 
Customer repurchase agreements
6,776

 
10,726

Other short-term borrowings
5,500

 
24,000

Junior subordinated debt
27,876

 
27,826

Accrued interest payable and other liabilities
10,285

 
10,083

Total liabilities
1,611,183

 
1,607,361

 
 
 
 
Shareholders' equity
 

 
 

Preferred stock, $5 par, 2,000,000 shares authorized, none outstanding
—

 
—

Common stock, $1 par, 20,000,000 shares authorized, 8,708,127 shares outstanding at June 30, 2018 and 8,650,547 shares outstanding at December 31, 2017
8,654

 
8,604

Capital in excess of par value
77,496

 
76,179

Retained earnings
135,108

 
127,010

Accumulated other comprehensive loss, net
(7,910
)
 
(3,076
)
Total shareholders' equity
213,348

 
208,717

Total liabilities and shareholders' equity
$
1,824,531

 
$
1,816,078

(*) -  Derived from audited consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.

3


American National Bankshares Inc.
Consolidated Statements of Income
(Dollars in thousands, except per share data) (Unaudited)
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2018
 
2017
 
2018
 
2017
Interest and Dividend Income:
 
 
 
 
 
 
 
Interest and fees on loans
$
14,766

 
$
13,752

 
$
29,423

 
$
26,456

Interest and dividends on securities:
 

 
 

 
 
 
 
Taxable
1,540

 
1,133

 
2,864

 
2,287

Tax-exempt
423

 
509

 
842

 
1,144

Dividends
78

 
84

 
158

 
163

Other interest income
185

 
125

 
373

 
234

Total interest and dividend income
16,992

 
15,603

 
33,660

 
30,284

Interest Expense:
 

 
 

 
 

 
 

Interest on deposits
1,873

 
1,352

 
3,698

 
2,552

Interest on short-term borrowings
2

 
14

 
12

 
42

Interest on long-term borrowings
—

 
81

 
—

 
161

Interest on junior subordinated debt
329

 
244

 
619

 
483

Total interest expense
2,204

 
1,691

 
4,329

 
3,238

Net Interest Income
14,788

 
13,912

 
29,331

 
27,046

Provision for Loan Losses
(30
)
 
350

 
(74
)
 
650

Net Interest Income After Provision for Loan Losses
14,818

 
13,562

 
29,405

 
26,396

Noninterest Income:
 

 
 

 
 

 
 

Trust fees
945

 
908

 
1,874

 
1,820

Service charges on deposit accounts
592

 
607

 
1,204

 
1,196

Other fees and commissions
679

 
627

 
1,321

 
1,234

Mortgage banking income
491

 
462

 
941

 
991

Securities gains, net
289

 
331

 
410

 
590

Brokerage fees
209

 
192

 
431

 
384

Income from Small Business Investment Companies
171

 
6

 
326

 
32

Other
187

 
215

 
389

 
372

Total noninterest income
3,563

 
3,348

 
6,896

 
6,619

Noninterest Expense:
 

 
 

 
 

 
 

Salaries
5,095

 
4,733

 
10,092

 
9,532

Employee benefits
1,111

 
1,061

 
2,286

 
2,181

Occupancy and equipment
1,100

 
1,148

 
2,228

 
2,216

FDIC assessment
132

 
134

 
278

 
263

Bank franchise tax
291

 
263

 
572

 
519

Core deposit intangible amortization
77

 
203

 
154

 
368

Data processing
467

 
502

 
889

 
989

Software
354

 
271

 
659

 
550

Other real estate owned, net
25

 
68

 
55

 
111

Other
2,350

 
2,328

 
4,491

 
4,423

Total noninterest expense
11,002

 
10,711

 
21,704

 
21,152

Income Before Income Taxes
7,379

 
6,199

 
14,597

 
11,863

Income Taxes
1,399

 
1,920

 
2,805

 
3,521

Net Income
$
5,980

 
$
4,279

 
$
11,792

 
$
8,342

 
 
 
 
 
 
 
 

4


Net Income Per Common Share:
 

 
 

 
 

 
 

Basic
$
0.69

 
$
0.50

 
$
1.36

 
$
0.97

Diluted
$
0.69

 
$
0.49

 
$
1.36

 
$
0.96

Average Common Shares Outstanding:
 

 
 

 
 

 
 

Basic
8,692,107

 
8,640,648

 
8,680,739

 
8,636,954

Diluted
8,704,726

 
8,659,165

 
8,695,860

 
8,655,173

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

5


American National Bankshares Inc.
Consolidated Statements of Comprehensive Income
(Dollars in thousands) (Unaudited)
 
Three Months Ended 
 June 30,
 
2018
 
2017
Net income
$
5,980

 
$
4,279

 
 
 
 
Other comprehensive income (loss):
 

 
 

 
 
 
 
Unrealized gains (losses) on securities available for sale
(1,446
)
 
879

Tax effect
325

 
(307
)
 
 
 
 
Reclassification adjustment for gains on sales of securities
—

 
(331
)
Tax effect
—

 
116

 
 
 
 
Unrealized losses on cash flow hedges
(237
)
 
—

Tax effect
53

 
—

 
 
 
 
Other comprehensive income (loss)
(1,305
)
 
357

 
 
 
 
Comprehensive income
$
4,675

 
$
4,636

The accompanying notes are an integral part of the consolidated financial statements.
American National Bankshares Inc.
Consolidated Statements of Comprehensive Income
(Dollars in thousands) (Unaudited)
 
Six Months Ended 
 June 30,
 
2018
 
2017
Net income
$
11,792

 
$
8,342

 
 
 
 
Other comprehensive income (loss):
 

 
 

 
 
 
 
Unrealized gains (losses) on securities available for sale
(5,180
)
 
1,890

Tax effect
1,186

 
(661
)
 
 
 
 
Reclassification adjustment for gains on sales of securities
(8
)
 
(590
)
Tax effect
2

 
207

 
 
 
 
Unrealized losses on cash flow hedges
(237
)
 
—

Tax effect
53

 
—

 
 
 
 
Other comprehensive income (loss)
(4,184
)
 
846

 
 
 
 
Comprehensive income
$
7,608

 
$
9,188

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

6



American National Bankshares Inc.
Consolidated Statements of Changes in Shareholders' Equity
Six Months Ended June 30, 2018 and 2017
(Dollars in thousands, except per share data) (Unaudited)
 
Common
Stock
 
Capital in
Excess of
Par Value
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Total
Shareholders'
Equity
Balance, December 31, 2016
$
8,578

 
$
75,076

 
$
119,600

 
$
(1,874
)
 
$
201,380

 
 
 
 
 
 
 
 
 
 
Net income
—

 
—

 
8,342

 
—

 
8,342

 
 
 
 
 
 
 
 
 
 
Other comprehensive income
—

 
—

 
—

 
846

 
846

 
 
 
 
 
 
 
 
 
 
Stock options exercised (3,300 shares)
3

 
70

 
—

 
—

 
73

 
 
 
 
 
 
 
 
 
 
Vesting of restricted stock (6,468 shares)
7

 
(7
)
 
—

 
—

 
—

 
 
 
 
 
 
 
 
 
 
Equity based compensation (21,562 shares)
7

 
552

 
—

 
—

 
559

 
 
 
 
 
 
 
 
 
 
Cash dividends paid, $0.48 per share
—

 
—

 
(4,147
)
 
—

 
(4,147
)
 
 
 
 
 
 
 
 
 
 
Balance, June 30, 2017
$
8,595

 
$
75,691

 
$
123,795

 
$
(1,028
)
 
$
207,053

 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2017
$
8,604

 
$
76,179

 
$
127,010

 
$
(3,076
)
 
$
208,717

 
 
 
 
 
 
 
 
 
 
Net income
—

 
—

 
11,792

 
—

 
11,792

 
 
 
 
 
 
 
 
 
 
Other comprehensive loss
—

 
—

 
—

 
(4,184
)
 
(4,184
)
 
 
 
 
 
 
 
 
 
 
Reclassification for ASU 2016-01 adoption
—

 
—

 
650

 
(650
)
 
—

 
 
 
 
 
 
 
 
 
 
Stock options exercised (32,010 shares)
32

 
743

 
—

 
—

 
775

 
 
 
 
 
 
 
 
 
 
Vesting of restricted stock (10,101 shares)
10

 
(10
)
 
—

 
—

 
—

 
 
 
 
 
 
 
 
 
 
Equity based compensation (25,570 shares)
8

 
584

 
—

 
—

 
592

 
 
 
 
 
 
 
 
 
 
Cash dividends paid, $0.50 per share
—

 
—

 
(4,344
)
 
—

 
(4,344
)
 
 
 
 
 
 
 
 
 
 
Balance, June 30, 2018
$
8,654

 
$
77,496

 
$
135,108

 
$
(7,910
)
 
$
213,348

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

7

American National Bankshares Inc.
Consolidated Statements of Cash Flows
(Dollars in thousands) (Unaudited)
 
Six Months Ended 
 June 30,
 
2018
 
2017
Cash Flows from Operating Activities:
 
 
 
Net income
$
11,792

 
$
8,342

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Provision for loan losses
(74
)
 
650

Depreciation
933

 
913

Net accretion of acquisition accounting adjustments
(804
)
 
(1,029
)
Core deposit intangible amortization
154

 
368

Net amortization of securities
859

 
996

Net gains on sale or call of securities
(8
)
 
(590
)
Unrealized holding gains on equity securities
(402
)
 
—

Gain on sale of loans held for sale
(941
)
 
(774
)
Proceeds from sales of loans held for sale
39,145

 
43,421

Originations of loans held for sale
(38,861
)
 
(39,030
)
Net (gain) loss on other real estate owned
(25
)
 
3

Valuation allowance on other real estate owned
22

 
74

Net gain on sale of premises and equipment
(3
)
 
—

Equity based compensation expense
592

 
559

Earnings on bank owned life insurance
(214
)
 
(218
)
Deferred income tax (benefit) expense
(27
)
 
1,138

Net change in interest receivable
(62
)
 
263

Net change in other assets
(875
)
 
(1,232
)
Net change in interest payable
(2
)
 
(13
)
Net change in other liabilities
(34
)
 
(1,204
)
Net cash provided by operating activities
11,165

 
12,637

 
 
 
 
Cash Flows from Investing Activities:
 

 
 

Proceeds from sales of equity securities
431

 
—

Proceeds from sales of securities available for sale
22,066

 
55,403

Proceeds from maturities, calls and paydowns of securities available for sale
16,000

 
26,075

Purchases of securities available for sale
(66,221
)
 
(14,585
)
Net change in restricted stock
647

 
723

Net increase in loans
(2,952
)
 
(123,113
)
Proceeds from sale of premises and equipment
24

 
—

Purchases of premises and equipment
(932
)
 
(1,739
)
Proceeds from sales of other real estate owned
636

 
78

Net cash used in investing activities
(30,301
)
 
(57,158
)
 
 
 
 
Cash Flows from Financing Activities:
 

 
 

Net change in demand, money market, and savings deposits
37,585

 
81,875

Net change in time deposits
(11,565
)
 
10,326

Net change in customer repurchase agreements
(3,950
)
 
9,116

Net change in other short-term borrowings
(18,500
)
 
(20,000
)
Common stock dividends paid
(4,344
)
 
(4,147
)
Proceeds from exercise of stock options
775

 
73

Net cash provided by financing activities
1

 
77,243

 
 
 
 
Net Increase (Decrease) in Cash and Cash Equivalents
(19,135
)
 
32,722

 
 
 
 
Cash and Cash Equivalents at Beginning of Period
52,477

 
53,207

 
 
 
 
Cash and Cash Equivalents at End of Period
$
33,342

 
$
85,929

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

8



AMERICAN NATIONAL BANKSHARES INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 – Accounting Policies
The consolidated financial statements include the accounts of American National Bankshares Inc. (the "Company") and its wholly owned subsidiary, American National Bank and Trust Company (the "Bank").  The Bank offers a wide variety of retail, commercial, secondary market mortgage lending, and trust and investment services which also include non-deposit products such as mutual funds and insurance policies.
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, goodwill and intangible assets, unfunded pension liability, other-than-temporary impairment of securities, accounting for merger and acquisition activity, accounting for acquired loans with specific credit-related deterioration, the valuation of deferred tax assets and liabilities, and the valuation of other real estate owned ("OREO").
All significant inter-company transactions and accounts are eliminated in consolidation, with the exception of the AMNB Trust and the MidCarolina Trusts, as detailed in Note 8.
In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the results of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results that may occur for any other period.  Certain reclassifications have been made to prior period balances to conform to the current period presentation. These reclassifications did not have an impact on net income and were considered immaterial. These statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017.
Adoption of New Accounting Standards
On January 1, 2018, the Company adopted Accounting Standards Update ("ASU") 2016-01, "Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which amended the guidance on the classification and measurement of financial instruments. Upon adoption of ASU 2016-01, the Company reclassified $650,000 from accumulated other comprehensive loss to retained earnings for the difference in amortized cost and fair value. In 2018, the Company recognized the equity securities fair value change in net income. Previously, the fair value changes were recognized, net of tax, in other comprehensive loss. The adoption of ASU 2016-01 did not have a material effect on the Company's consolidated financial statements.
During the first quarter of 2018, the Company adopted ASU 2014-09, "Revenue from Contracts with Customers", and all subsequent amendments to the ASU (collectively "ASC 606"), which (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as OREO. The majority of the Company's revenue is from interest income, including loans and securities, that are outside the scope of the standard. The services that fall within the scope of the standard are presented within noninterest income on the consolidated statement of income and are recognized as revenue as the Company satisfies its obligations to the customer. The revenue that falls within the scope of ASC 606 is primarily related to service charges on deposit accounts, cardholder and merchant income, wealth advisory services income, other service charges and fees, sales of other real estate, insurance commissions and miscellaneous fees. ASC 606 did not result in a change to the accounting for any in-scope revenue streams; as such, no cumulative effect adjustment was recorded.
Recent Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-02, "Leases (Topic 842)." Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) a lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use asset, which is an asset that represents the lessee's right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted

9


upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company has analyzed all leases currently in place and determined the adoption of ASU 2016-02 will not have a material impact on its consolidated financial statements.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments." The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for Securities and Exchange Commission ("SEC") filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company has formed a committee to address the adoption of the standard and engaged a third party vendor to assist with the data gathering and analysis. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements.
In January 2017, the FASB issued ASU 2017-04, "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment". The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Public business entities that are SEC filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.
In March 2017, the FASB issued ASU 2017-08, "Receivables-Nonrefundable Fees and Other Costs (Subtopic 310‐20), Premium Amortization on Purchased Callable Debt Securities." The amendments in this ASU shorten the amortization period for certain callable debt securities purchased at a premium. Upon adoption of the standard, premiums on these qualifying callable debt securities will be amortized to the earliest call date. Discounts on purchased debt securities will continue to be accreted to maturity. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. Upon transition, entities should apply the guidance on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and provide the disclosures required for a change in accounting principle. The Company is currently assessing the impact that ASU 2017-08 will have on its consolidated financial statements.
In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The amendments in this ASU modify the designation and measurement guidance for hedge accounting as well as provide for increased transparency regarding the presentation of economic results on both the financial statements and related footnotes. Certain aspects of hedge effectiveness assessments will also be simplified upon implementation of this update. The amendments are effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted, including adoption in any interim period. The Company is currently assessing the impact that ASU 2017-12 will have on its consolidated financial statements.
In February 2018, the FASB issued ASU 2018-03, “Technical Corrections and Improvements to Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The amendments provide targeted improvements to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Specifically, the amendments include clarifications related to: measurement elections, transition requirements, and adjustments associated with equity securities without readily determinable fair values; fair value measurement requirements for forward contracts and purchased options on equity securities; presentation requirements for hybrid financial liabilities for which the fair value option has been elected; and measurement requirements for liabilities denominated in a foreign currency for which the fair value option has been elected. The amendments are effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years beginning after June 15, 2018. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-03 to have a material impact on its consolidated financial statements.


10


In June 2018, the FASB issued ASU 2018-07, “Compensation- Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting.” The amendments expand the scope of Topic 718 to include share-based payments issued to non-employees for goods or services, which were previously excluded. The amendments will align the accounting for share-based payments to nonemployees and employees more similarly. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-07 to have a material impact on its consolidated financial statements.
Note 2 – Securities 
The amortized cost and fair value of investments in debt and equity securities at June 30, 2018 and December 31, 2017 were as follows (dollars in thousands):
 
June 30, 2018
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
 
Fair Value
Securities available for sale:
 
 
 
 
 
 
 
Federal agencies and GSEs
$
137,147

 
$
—

 
$
4,302

 
$
132,845

Mortgage-backed and CMOs
110,341

 
145

 
3,014

 
107,472

State and municipal
92,952

 
706

 
656

 
93,002

Corporate
7,826

 
131

 
29

 
7,928

Total securities available for sale
$
348,266

 
$
982

 
$
8,001

 
$
341,247

The Company adopted ASU 2016-01 effective January 1, 2018 and had equity securities with a fair value of $2,177,000 at June 30, 2018 and recognized in income $402,000 of unrealized holding gains in the first six months of 2018. During the six months ended June 30, 2018, the Company sold $431,000 in equity securities at fair value.
 
December 31, 2017
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
 
Fair Value
Securities available for sale:
 
 
 
 
 
 
 
Federal agencies and GSEs
$
114,246

 
$
8

 
$
2,127

 
$
112,127

Mortgage-backed and CMOs
106,163

 
293

 
1,140

 
105,316

State and municipal
92,711

 
1,262

 
347

 
93,626

Corporate
7,842

 
234

 
14

 
8,062

Equity securities
1,383

 
823

 
—

 
2,206

Total securities available for sale
$
322,345

 
$
2,620

 
$
3,628

 
$
321,337

Restricted Stock
Due to restrictions placed upon the Bank's common stock investment in the Federal Reserve Bank of Richmond ("FRB") and Federal Home Loan Bank of Atlanta ("FHLB"), these securities have been classified as restricted equity securities and carried at cost.  The restricted securities are not subject to the investment security classification and are included as a separate line item on the Company's consolidated balance sheets.  The FRB requires the Bank to maintain stock with a par value equal to 3.00% of its outstanding capital and an additional 3.00% is on call.  The FHLB requires the Bank to maintain stock in an amount equal to 4.25% of outstanding borrowings and a specific percentage of the Bank's total assets. The cost of restricted stock at June 30, 2018 and December 31, 2017 was as follows (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
FRB stock
$
3,603

 
$
3,587

FHLB stock
1,860

 
2,523

Total restricted stock
$
5,463

 
$
6,110

Temporarily Impaired Securities
The following table shows estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2018.  The reference point for determining when securities are in an unrealized loss position is month-end.  Therefore, it is possible that a security's market value exceeded its amortized cost on other days during the past twelve-month period.

11


Available for sale securities that have been in a continuous unrealized loss position are as follows (dollars in thousands):
 
Total
 
Less than 12 Months
 
12 Months or More
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
Federal agencies and GSEs
$
127,846

 
$
4,302

 
$
75,470

 
$
1,206

 
$
52,376

 
$
3,096

Mortgage-backed and CMOs
99,504

 
3,014

 
75,725

 
1,887

 
23,779

 
1,127

State and municipal
46,908

 
656

 
39,967

 
320

 
6,941

 
336

Corporate
1,497

 
29

 
481

 
19

 
1,016

 
10

Total
$
275,755

 
$
8,001

 
$
191,643

 
$
3,432

 
$
84,112

 
$
4,569

Federal agencies and GSEs: The unrealized losses on the Company's investment in 28 government sponsored entities ("GSE") securities were caused by interest rate increases. Twelve of these securities were in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2018.
Mortgage-backed securities: The unrealized losses on the Company's investment in 65 GSE mortgage-backed securities were caused by interest rate increases. Seventeen of these securities were in an unrealized loss position for 12 months or more. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost basis of the Company's investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2018.
Collateralized Mortgage Obligations: The unrealized losses associated with three private GSE collateralized mortgage obligations ("CMO") were due to normal market fluctuations. One of these securities was in an unrealized loss position for 12 months or more. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost basis of the Company's investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2018.
State and municipal securities:  The unrealized losses on 66 state and municipal securities were caused by interest rate increases. Eleven of these securities were in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2018.
Corporate securities:  The unrealized losses on two corporate securities were caused by interest rate increases. One of these securities was in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2018.
Restricted stock: When evaluating restricted stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider restricted stock to be other-than-temporarily impaired at June 30, 2018, and no impairment has been recognized.

12


The table below shows estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position, at December 31, 2017 (dollars in thousands):
 
Total
 
Less than 12 Months
 
12 Months or More
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
 
Fair
Value
 
Unrealized
Loss
Federal agencies and GSEs
$
99,133

 
$
2,127

 
$
45,474

 
$
321

 
$
53,659

 
$
1,806

Mortgage-backed and CMOs
90,806

 
1,140

 
64,449

 
533

 
26,357

 
607

State and municipal
34,550

 
347

 
27,442

 
159

 
7,108

 
188

Corporate
1,529

 
14

 
495

 
5

 
1,034

 
9

Total
$
226,018

 
$
3,628

 
$
137,860

 
$
1,018

 
$
88,158

 
$
2,610

Other-Than-Temporarily-Impaired Securities 
As of June 30, 2018 and December 31, 2017, there were no securities classified as other-than-temporarily impaired.
Realized Gains and Losses
The following table presents the gross realized gains and losses on and the proceeds from the sale of securities available for sale during the three and six months ended June 30, 2018 and 2017 (dollars in thousands):
 
Three Months Ended June 30, 2018
 
Six Months Ended June 30, 2018
Realized gains (losses):
 
 
 
Gross realized gains
$
—

 
$
105

Gross realized losses
—

 
(97
)
Net realized gains
$
—

 
$
8

Proceeds from sales of securities
$
—

 
$
22,066

 
 
 
 
 
Three Months Ended June 30, 2017
 
Six Months Ended June 30, 2017
Realized gains (losses):
 
 
 
Gross realized gains
$
341

 
$
605

Gross realized losses
(10
)
 
(15
)
Net realized gains
$
331

 
$
590

Proceeds from sales of securities
$
13,884

 
$
55,403

Note 3 – Loans
Loans, excluding loans held for sale, at June 30, 2018 and December 31, 2017, were comprised of the following (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Commercial
$
291,454

 
$
251,666

Commercial real estate:
 

 
 

Construction and land development
96,740

 
123,147

Commercial real estate
633,128

 
637,701

Residential real estate:
 

 
 

Residential
207,374

 
209,326

Home equity
105,558

 
109,857

Consumer
5,125

 
4,428

Total loans
$
1,339,379

 
$
1,336,125


13


Acquired Loans 
The outstanding principal balance and the carrying amount of these loans, including FASB Accounting Standards Codification ("ASC") 310-30, included in the consolidated balance sheets at June 30, 2018 and December 31, 2017 are as follows (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Outstanding principal balance
$
70,321

 
$
79,523

Carrying amount
65,136

 
73,796

The outstanding principal balance and related carrying amount of acquired impaired loans, for which the Company applies ASC 310-30 to account for interest earned, as of the indicated dates are as follows (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Outstanding principal balance
$
25,839

 
$
27,876

Carrying amount
21,720

 
23,430

The following table presents changes in the accretable yield on acquired impaired loans, for which the Company applies FASB ASC 310-30, for the six months ended June 30, 2018 and the year ended December 31, 2017 (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Balance at January 1
$
4,890

 
$
6,103

Accretion
(1,348
)
 
(3,117
)
Reclassification from nonaccretable difference
478

 
1,006

Other changes, net*
1,192

 
898

 
$
5,212

 
$
4,890

* This line item represents changes in the cash flows expected to be collected due to the impact of non-credit changes such as prepayment assumptions, changes in interest rates on variable rate acquired impaired loans, and discounted payoffs that occurred in the period.
Past Due Loans
The following table shows an analysis by portfolio segment of the Company's past due loans at June 30, 2018 (dollars in thousands):
 
30- 59 Days
Past Due
 
60-89 Days
Past Due
 
90 Days +
Past Due
and Still
Accruing
 
Non-
Accrual
Loans
 
Total
Past
Due
 
Current
 
Total
Loans
Commercial
$
75

 
$
—

 
$
—

 
$
526

 
$
601

 
$
290,853

 
$
291,454

Commercial real estate:
 

 
 

 
 

 
 

 
 

 
 

 
 

Construction and land development
—

 
—

 
—

 
33

 
33

 
96,707

 
96,740

Commercial real estate
48

 
30

 
—

 
228

 
306

 
632,822

 
633,128

Residential:
 

 
 

 
 

 
 

 
 

 
 

 
 

Residential
257

 
—

 
229

 
941

 
1,427

 
205,947

 
207,374

Home equity
55

 
—

 
—

 
133

 
188

 
105,370

 
105,558

Consumer
32

 
—

 
—

 
—

 
32

 
5,093

 
5,125

Total
$
467

 
$
30

 
$
229

 
$
1,861

 
$
2,587

 
$
1,336,792

 
$
1,339,379


14


The following table shows an analysis by portfolio segment of the Company's past due loans at December 31, 2017 (dollars in thousands):
 
30- 59 Days
Past Due
 
60-89 Days
Past Due
 
90 Days +
Past Due
and Still
Accruing
 
Non-
Accrual
Loans
 
Total
Past
Due
 
Current
 
Total
Loans
Commercial
$
92

 
$
—

 
$
—

 
$
90

 
$
182

 
$
251,484

 
$
251,666

Commercial real estate:
 

 
 

 
 

 
 

 
 

 
 

 
 

Construction and land development
—

 
—

 
—

 
36

 
36

 
123,111

 
123,147

Commercial real estate
86

 
—

 
280

 
489

 
855

 
636,846

 
637,701

Residential:
 

 
 

 
 

 
 

 
 

 
 

 
 

Residential
282

 
71

 
79

 
1,343

 
1,775

 
207,551

 
209,326

Home equity
141

 
16

 
—

 
243

 
400

 
109,457

 
109,857

Consumer
21

 
5

 
—

 
—

 
26

 
4,402

 
4,428

Total
$
622

 
$
92

 
$
359

 
$
2,201

 
$
3,274

 
$
1,332,851

 
$
1,336,125


15


Impaired Loans
The following table presents the Company's impaired loan balances by portfolio segment, excluding acquired impaired loans, at June 30, 2018 (dollars in thousands):
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Commercial
$
159

 
$
158

 
$
—

 
$
161

 
$
6

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development
—

 
—

 
—

 
—

 
—

Commercial real estate
516

 
513

 
—

 
612

 
19

Residential:
 

 
 

 
 

 
 

 
 

Residential
1,142

 
1,144

 
—

 
1,023

 
14

Home equity
158

 
158

 
—

 
147

 
6

Consumer
—

 
—

 
—

 
5

 
—

 
$
1,975

 
$
1,973

 
$
—

 
$
1,948

 
$
45

With a related allowance recorded:
 

 
 

 
 

 
 

 
 

Commercial
$
387

 
$
384

 
$
196

 
$
435

 
$
9

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development*
33

 
34

 
—

 
35

 
—

Commercial real estate*
28

 
28

 
—

 
30

 
—

Residential
 

 
 

 
 

 
 

 
 

Residential
182

 
181

 
12

 
465

 
5

Home equity*
132

 
135

 
—

 
200

 
1

Consumer*
—

 
—

 
—

 
—

 
—

 
$
762

 
$
762

 
$
208

 
$
1,165

 
$
15

Total:
 

 
 

 
 

 
 

 
 

Commercial
$
546

 
$
542

 
$
196

 
$
596

 
$
15

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development
33

 
34

 
—

 
35

 
—

Commercial real estate
544

 
541

 
—

 
642

 
19

Residential:
 

 
 

 
 

 
 

 
 

Residential
1,324

 
1,325

 
12

 
1,488

 
19

Home equity
290

 
293

 
—

 
347

 
7

Consumer
—

 
—

 
—

 
5

 
—

 
$
2,737

 
$
2,735

 
$
208

 
$
3,113

 
$
60

* Allowance is reported as zero in the table due to presentation in thousands and rounding.
In the table above, recorded investment may exceed unpaid principal balance due to acquired loans with a premium and loans where unearned costs exceed unearned fees.

16


The following table presents the Company's impaired loan balances by portfolio segment, excluding acquired impaired loans, at December 31, 2017 (dollars in thousands):
 
Recorded
Investment
 
Unpaid
Principal
Balance
 
Related
Allowance
 
Average
Recorded
Investment
 
Interest
Income
Recognized
With no related allowance recorded:
 
 
 
 
 
 
 
 
 
Commercial
$
4

 
$
4

 
$
—

 
$
19

 
$
1

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development
—

 
—

 
—

 
56

 
4

Commercial real estate
791

 
789

 
—

 
1,069

 
66

Residential:
 

 
 

 
 

 
 

 
 

Residential
717

 
719

 
—

 
575

 
41

Home equity
142

 
142

 
—

 
109

 
10

Consumer
5

 
5

 
—

 
6

 
1

 
$
1,659

 
$
1,659

 
$
—

 
$
1,834

 
$
123

With a related allowance recorded:
 

 
 

 
 

 
 

 
 

Commercial
$
202

 
$
201

 
$
154

 
$
150

 
$
16

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development*
37

 
37

 
—

 
56

 
—

Commercial real estate*
34

 
32

 
—

 
126

 
11

Residential:
 

 
 

 
 

 
 

 
 

Residential
1,022

 
1,022

 
12

 
1,174

 
27

Home equity
263

 
261

 
1

 
251

 
1

Consumer*
—

 
—

 
—

 
5

 
—

 
$
1,558

 
$
1,553

 
$
167

 
$
1,762

 
$
55

Total:
 

 
 

 
 

 
 

 
 

Commercial
$
206

 
$
205

 
$
154

 
$
169

 
$
17

Commercial real estate:
 

 
 

 
 

 
 

 
 

Construction and land development
37

 
37

 
—

 
112

 
4

Commercial real estate
825

 
821

 
—

 
1,195

 
77

Residential:
 

 
 

 
 

 
 

 
 

Residential
1,739

 
1,741

 
12

 
1,749

 
68

Home equity
405

 
403

 
1

 
360

 
11

Consumer
5

 
5

 
—

 
11

 
1

 
$
3,217

 
$
3,212

 
$
167

 
$
3,596

 
$
178

* Allowance is reported as zero in the table due to presentation in thousands and rounding.
In the table above, recorded investment may exceed unpaid principal balance due to acquired loans with a premium and loans where unearned costs exceed unearned fees.


17


The following tables show the detail of loans modified as troubled debt restructurings ("TDRs") during the three and six months ended June 30, 2018 included in the impaired loan balances (dollars in thousands):
 
 
Loans Modified as a TDR for the
 
 
Three Months Ended June 30, 2018
Loan Type
 
Number of Contracts
 
Pre-Modification
Outstanding Recorded
Investment
 
Post-Modification
Outstanding Recorded
Investment
Commercial
 
—

 
$
—

 
$
—

Commercial real estate
 
—

 
—

 
—

Construction and land development
 
—

 
—

 
—

Home Equity
 
—

 
—

 
—

Residential real estate
 
—

 
—

 
—

Consumer
 
—

 
—

 
—

Total
 
—

 
$
—

 
$
—

 
 
Loans Modified as a TDR for the
 
 
Six Months Ended June 30, 2018
Loan Type
 
Number of Contracts
 
Pre-Modification
Outstanding Recorded
Investment
 
Post-Modification
Outstanding Recorded
Investment
Commercial
 
—

 
$
—

 
$
—

Commercial real estate
 
—

 
—

 
—

Construction and land development
 
—

 
—

 
—

Home Equity
 
—

 
—

 
—

Residential real estate
 
1

 
11

 
11

Consumer
 
—

 
—

 
—

Total
 
1

 
$
11

 
$
11


18


The following tables show the detail of loans modified as TDRs during the three and six months ended June 30, 2017 included in the impaired loan balances (dollars in thousands):
 
 
Loans Modified as a TDR for the
 
 
Three Months Ended June 30, 2017
Loan Type
 
Number of Contracts
 
Pre-Modification
Outstanding Recorded
Investment
 
Post-Modification
Outstanding Recorded
Investment
Commercial
 
1

 
$
5

 
$
5

Commercial real estate
 
—

 
—

 
—

Construction and land development
 
—

 
—

 
—

Home Equity
 
1

 
36

 
36

Residential real estate
 
—

 
—

 
—

Consumer
 
—

 
—

 
—

Total
 
2

 
$
41

 
$
41

 
 
Loans Modified as a TDR for the
 
 
Six Months Ended June 30, 2017
Loan Type
 
Number of Contracts
 
Pre-Modification
Outstanding Recorded
Investment
 
Post-Modification
Outstanding Recorded
Investment
Commercial
 
3

 
$
73

 
$
73

Commercial real estate
 
—

 
—

 
—

Construction and land development
 
—

 
—

 
—

Home Equity
 
2

 
57

 
57

Residential real estate
 
—

 
—

 
—

Consumer
 
—

 
—

 
—

Total
 
5

 
$
130

 
$
130

During the three and six months ended June 30, 2018 and 2017, the Company had no loans that subsequently defaulted within twelve months of modification. The Company defines defaults as one or more payments that occur more than 90 days past the due date, charge-off or foreclosure subsequent to modification.
Residential Real Estate in Process of Foreclosure
The Company had $195,000 in residential real estate loans in the process of foreclosure at June 30, 2018 and $808,000 and $629,000 in residential OREO at June 30, 2018 and December 31, 2017, respectively.

19


Risk Grades
The following table shows the Company's loan portfolio broken down by internal risk grading as of June 30, 2018 (dollars in thousands):
Commercial and Consumer Credit Exposure
Credit Risk Profile by Internally Assigned Grade
 
Commercial
 
Construction and Land Development
 
Commercial
Real Estate
Other
 
Residential
 
Home
Equity
Pass
$
287,321

 
$
93,064

 
$
625,248

 
$
200,852

 
$
104,771

Special Mention
3,111

 
1,814

 
4,188

 
2,090

 
—

Substandard
1,022

 
1,862

 
3,692

 
4,432

 
787

Doubtful
—

 
—

 
—

 
—

 
—

Total
$
291,454

 
$
96,740

 
$
633,128

 
$
207,374

 
$
105,558

Consumer Credit Exposure
Credit Risk Profile Based on Payment Activity
 
Consumer
Performing
$
5,125

Nonperforming
—

Total
$
5,125

 
The following table shows the Company's loan portfolio broken down by internal risk grading as of December 31, 2017 (dollars in thousands):
Commercial and Consumer Credit Exposure
Credit Risk Profile by Internally Assigned Grade
 
Commercial
 
Construction and Land Development
 
Commercial
Real Estate
Other
 
Residential
 
Home
Equity
Pass
$
248,714

 
$
114,502

 
$
625,861

 
$
200,405

 
$
107,705

Special Mention
1,763

 
7,114

 
6,914

 
4,438

 
1,325

Substandard
1,189

 
1,531

 
4,926

 
4,483

 
827

Doubtful
—

 
—

 
—

 
—

 
—

Total
$
251,666

 
$
123,147

 
$
637,701

 
$
209,326

 
$
109,857

Consumer Credit Exposure
Credit Risk Profile Based on Payment Activity
 
Consumer
Performing
$
4,415

Nonperforming
13

Total
$
4,428

 
Loans classified in the Pass category typically are fundamentally sound and risk factors are reasonable and acceptable.
Loans classified in the Special Mention category typically have been criticized internally, by loan review or the loan officer, or by external regulators under the current credit policy regarding risk grades.
Loans classified in the Substandard category typically have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are typically characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected.
Loans classified in the Doubtful category typically have all the weaknesses inherent in loans classified as substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts,

20


conditions, and values highly questionable and improbable. However, these loans are not yet rated as loss because certain events may occur that may salvage the debt.
Consumer loans are classified as performing or nonperforming.  A loan is nonperforming when payments of interest and principal are past due 90 days or more, or payments are less than 90 days past due, but there are other good reasons to doubt that payment will be made in full.
Note 4 – Allowance for Loan Losses and Reserve for Unfunded Lending Commitments
Changes in the allowance for loan losses and the reserve for unfunded lending commitments as of the indicated dates and periods are presented below (dollars in thousands):
 
Six Months Ended 
 June 30, 2018
 
Year Ended December 31, 2017
 
Six Months Ended 
 June 30, 2017
Allowance for Loan Losses
 
 
 
 
 
Balance, beginning of period
$
13,603

 
$
12,801

 
$
12,801

Provision for loan losses
(74
)
 
1,016

 
650

Charge-offs
(174
)
 
(690
)
 
(134
)
Recoveries
153

 
476

 
315

Balance, end of period
$
13,508

 
$
13,603

 
$
13,632

 
 
 
 
 
 
Reserve for Unfunded Lending Commitments
 

 
 

 
 

Balance, beginning of period
$
206

 
$
203

 
$
203

Provision for unfunded commitments
13

 
3

 
4

Charge-offs
—

 
—

 
—

Balance, end of period
$
219

 
$
206

 
$
207

The reserve for unfunded loan commitments is included in other liabilities.
The following table presents changes in the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at and for the six months ended June 30, 2018 (dollars in thousands):
 
Commercial
 
Commercial
Real Estate
 
Residential
Real Estate
 
Consumer
 
Total
Allowance for Loan Losses
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017:
$
2,413

 
$
8,321

 
$
2,825

 
$
44

 
$
13,603

Provision for loan losses
352

 
(434
)
 
(14
)
 
22

 
(74
)
Charge-offs
(10
)
 
(11
)
 
(86
)
 
(67
)
 
(174
)
Recoveries
63

 
3

 
36

 
51

 
153

Balance at June 30, 2018:
$
2,818

 
$
7,879

 
$
2,761

 
$
50

 
$
13,508

 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2018:
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
196

 
$
—

 
$
12

 
$
—

 
$
208

Collectively evaluated for impairment
2,622

 
7,842

 
2,576

 
50

 
13,090

Acquired impaired loans
—

 
37

 
173

 
—

 
210

Total
$
2,818

 
$
7,879

 
$
2,761

 
$
50

 
$
13,508

 
 
 
 
 
 
 
 
 
 
Loans
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
546

 
$
577

 
$
1,614

 
$
—

 
$
2,737

Collectively evaluated for impairment
290,555

 
718,552

 
300,705

 
5,110

 
1,314,922

Acquired impaired loans
353

 
10,739

 
10,613

 
15

 
21,720

Total
$
291,454

 
$
729,868

 
$
312,932

 
$
5,125

 
$
1,339,379


21


The following table presents changes in the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at and for the year ended December 31, 2017 (dollars in thousands):
 
Commercial
 
Commercial
Real Estate
 
Residential
Real Estate
 
Consumer
 
Total
Allowance for Loan Losses
 
 
 
 
 
 
 
 
 
Balance at December 31, 2016:
$
2,095

 
$
7,355

 
$
3,303

 
$
48

 
$
12,801

Provision for loan losses
377

 
999

 
(391
)
 
31

 
1,016

Charge-offs
(282
)
 
(93
)
 
(172
)
 
(143
)
 
(690
)
Recoveries
223

 
60

 
85

 
108

 
476

Balance at December 31, 2017:
$
2,413

 
$
8,321

 
$
2,825

 
$
44

 
$
13,603

 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017:
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
154

 
$
—

 
$
13

 
$
—

 
$
167

Collectively evaluated for impairment
2,259

 
8,203

 
2,645

 
44

 
13,151

Acquired impaired loans
—

 
118

 
167

 
—

 
285

Total
$
2,413

 
$
8,321

 
$
2,825

 
$
44

 
$
13,603

 
 
 
 
 
 
 
 
 
 
Loans
 

 
 

 
 

 
 

 
 

Individually evaluated for impairment
$
206

 
$
862

 
$
2,144

 
$
5

 
$
3,217

Collectively evaluated for impairment
251,185

 
747,819

 
306,066

 
4,408

 
1,309,478

Acquired impaired loans
275

 
12,167

 
10,973

 
15

 
23,430

Total
$
251,666

 
$
760,848

 
$
319,183

 
$
4,428

 
$
1,336,125

 
The allowance for loan losses is allocated to loan segments based upon historical loss factors, risk grades on individual loans, portfolio analysis of smaller balance homogenous loans, and qualitative factors.  Qualitative factors include trends in delinquencies, nonaccrual loans, and loss rates; trends in volume and terms of loans, effects of changes in risk selection, underwriting standards, and lending policies; experience of lending officers, other lending staff and loan review; national, regional, and local economic trends and conditions; legal, regulatory and collateral factors; and concentrations of credit.
Note 5 – Goodwill and Other Intangible Assets
The Company records as goodwill the excess of the purchase price over the fair value of the identifiable net assets acquired. Impairment testing is performed annually, as well as when an event triggering impairment may have occurred. The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment.  No indicators of impairment were identified as of June 30, 2018.
Core deposit intangibles resulting from the acquisition of MidCarolina Financial Corporation ("MidCarolina") in July 2011 were $6,556,000 and are being amortized on an accelerated basis over 108 months. Core deposit intangibles resulting from the acquisition of MainStreet BankShares, Inc. ("MainStreet") in January 2015 were $1,839,000 and are being amortized on an accelerated basis over 120 months.
The changes in the carrying amount of goodwill and intangibles for the six months ended June 30, 2018, are as follows (dollars in thousands):
 
Goodwill
 
Intangibles
Balance at December 31, 2017
$
43,872

 
$
1,191

Additions
—

 
—

Amortization
—

 
(154
)
Impairment
—

 
—

Balance at June 30, 2018
$
43,872

 
$
1,037


22


Note 6 – Short-term Borrowings
Short-term borrowings consist of customer repurchase agreements, overnight borrowings from the FHLB, and federal funds purchased.  The Company has federal funds lines of credit established with two correspondent banks in the amounts of $15,000,000, each, and, additionally, has access to the FRB's discount window. All short-term borrowings at December 31, 2017 and June 30,2018 were FHLB advances. Customer repurchase agreements are collateralized by securities of the U.S. Government or its agencies ("GSEs").  They mature daily.  The interest rates may be changed at the discretion of the Company. The securities underlying these agreements remain under the Company's control. FHLB overnight borrowings contain floating interest rates that may change daily at the discretion of the FHLB.  Federal funds purchased are unsecured overnight borrowings from other financial institutions. Short-term borrowings consisted of the following at June 30, 2018 and December 31, 2017 (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Customer repurchase agreements
$
6,776

 
$
10,726

Other short-term borrowings
5,500

 
24,000

 
$
12,276

 
$
34,726

Note 7 – Long-term Borrowings 
Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans, second mortgage loans, home equity lines of credit, and commercial real estate loans.  In addition, the Company pledges as collateral its capital stock in the FHLB and deposits with the FHLB.  The Company has a line of credit with the FHLB equal to 30% of the Company's assets, subject to the amount of collateral pledged.  As of June 30, 2018, $551,670,000 in eligible collateral was pledged under the blanket floating lien agreement which covers both short-term and long-term borrowings. 
 
In the regular course of conducting its business, the Company takes deposits from political subdivisions of the states of Virginia and North Carolina. At June 30, 2018, the Bank's public deposits totaled $241,400,000.  The Company is required to provide collateral to secure the deposits that exceed the insurance coverage provided by the Federal Deposit Insurance Corporation ("FDIC"). This collateral can be provided in the form of certain types of government or agency bonds or letters of credit from the FHLB. At June 30, 2018, the Company had $190,000,000 in letters of credit with the FHLB outstanding, as well as $101,944,000 in agency, state, and municipal securities pledged to provide collateral for such deposits.
Note 8 – Junior Subordinated Debt 
On April 7, 2006, AMNB Statutory Trust I, a Delaware statutory trust and a wholly owned unconsolidated subsidiary of the Company, issued $20,000,000 of preferred securities (the "Trust Preferred Securities") in a private placement pursuant to an applicable exemption from registration.  The Trust Preferred Securities mature on June 30, 2036, but may be redeemed at the Company's option beginning on September 30, 2011.  Distributions are cumulative and will accrue from the date of original issuance, but may be deferred by the Company from time to time for up to 20 consecutive quarterly periods.  The Company has guaranteed the payment of all required distributions on the Trust Preferred Securities. The proceeds of the Trust Preferred Securities received by the trust, along with proceeds of $619,000 received by the trust from the issuance of common securities by the trust to the Company, were used to purchase $20,619,000 of the Company's junior subordinated debt securities (the "Junior Subordinated Debt"), issued pursuant to junior subordinated debentures entered into between the Company and Wilmington Trust Company, as trustee.  The proceeds of the Junior Subordinated Debt were used to fund the cash portion of the merger consideration to the former shareholders of Community First Financial Corporation in connection with the Company's acquisition of that company in 2006, and for general corporate purposes.
On July 1, 2011, in connection with the MidCarolina merger, the Company assumed $8,764,000 in junior subordinated debt to MidCarolina Trust I and MidCarolina Trust II, two separate Delaware statutory trusts (the "MidCarolina Trusts"), to fully and unconditionally guarantee the preferred securities issued by the MidCarolina Trusts. These long-term obligations, which currently qualify as Tier 1 capital, constitute a full and unconditional guarantee by the Company of the MidCarolina Trusts' obligations. The MidCarolina Trusts were not consolidated in the Company's financial statements.
In accordance with ASC 810-10-15-14, "Consolidation – Overall – Scope and Scope Exceptions," the Company did not eliminate through consolidation the Company's $619,000 equity investment in AMNB Statutory Trust I or the $264,000 equity investment in the MidCarolina Trusts.  Instead, the Company reflected this equity investment in the "Accrued interest receivable and other assets" line item in the consolidated balance sheets.

23


A description of the junior subordinated debt securities outstanding payable to the trusts is shown below as of June 30, 2018 and December 31, 2017 (dollars in thousands):
Issuing Entity
Date Issued
 
Interest Rate
 
Maturity Date
 
Principal Amount
 
 
 
June 30, 2018
 
December 31, 2017
AMNB Trust I
4/7/2006
 
Libor plus
1.35%
 
6/30/2036
 
$
20,619

 
$
20,619

 
 
 
 
 
 
 
 
 
 
 
MidCarolina Trust I
10/29/2002
 
Libor plus
3.45%
 
11/7/2032
 
4,349

 
4,322

 
 
 
 
 
 
 
 
 
 
 
MidCarolina Trust II
12/3/2003
 
Libor plus
2.95%
 
10/7/2033
 
2,908

 
2,885

 
 
 
 
 
 
 
 
 

 
 

 
 
 
 
 
 
 
 
$
27,876

 
$
27,826

The principal amounts reflected above for the MidCarolina Trusts are net of fair value adjustments of $1,506,000 and $1,557,000 at June 30, 2018 and December 31, 2017, respectively. The original fair value adjustments of $1,197,000 and $1,021,000 were recorded as a result of the acquisition of MidCarolina on July 1, 2011, and are being amortized into interest expense over the remaining lives of the respective borrowings.
Note 9 - Derivative Financial Instruments and Hedging Activities
The Company uses derivative financial instruments ("derivatives") primarily to manage risks to the Company associated with changing interest rates. The Company's derivatives are hedging instruments in a qualifying hedge accounting relationship (cash flow or fair value hedge).
The Company designates derivatives as cash flow hedges when they are used to manage exposure to variability in cash flows on variable rate borrowings such as the Company's trust preferred capital notes. The Company uses interest rate swap agreements as part of its hedging strategy by exchanging variable-rate interest payments on a notional amount equal to the principal amount of the borrowings for fixed-rate interest payments, with such interest rates set based on benchmarked interest rates.
All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.
Terms and conditions of the interest rate swaps vary and amounts receivable or payable are recognized as accrued under the terms of the agreements. The Company assesses the effectiveness of each hedging relationship on a periodic basis. In accordance with ASC 815, "Derivatives and Hedging," the effective portions of the derivatives' unrealized gains or losses are recorded as a component of other comprehensive income. Based on the Company's assessment, its cash flow hedges are highly effective, but to the extent that any ineffectiveness exists in the hedge relationships, the amounts would be recorded in interest income and interest expense in the Company's consolidated statements of income.
(Dollars in thousands)
June 30, 2018
 
Notional Amount
 
Positions
 
Assets
 
Liabilities
 
Cash Collateral Pledged
Cash flow hedges:
 
 
 
 
 
 
 
 
 
Interest rate swaps:
 
 
 
 
 
 
 
 
 
Variable-rate to fixed-rate swaps with counterparty
$
28,500

 
3

 
$
—

 
$
237

 
$
350,000

Note 10 – Stock Based Compensation 
 The Company's 2018 Equity Compensation Plan ("2018 Plan") was adopted by the Board of Directors of the Company on February 20, 2018, and approved by shareholders on May 15, 2018, at the Company's 2018 Annual Meeting of Shareholders.  The 2018 Plan provides for the granting of restricted stock awards and incentive and non-statutory options to employees and directors on a periodic basis, at the discretion of the Board of Directors or a Board designated committee.  The 2018 Plan authorizes the issuance of up to 675,000 shares of common stock. The 2018 Plan replaced the Company's stock incentive plan that was approved by the shareholders at the 2008 Annual Meeting and expired in February 2018 (the "2008 Plan").

24


Stock Options
Accounting guidance requires that compensation cost relating to share-based payment transactions be recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued.
A summary of stock option transactions for the six months ended June 30, 2018 is as follows:
 
Option
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual Term
 
Aggregate
Intrinsic
Value
($000)
Outstanding at December 31, 2017
50,985

 
$
24.09

 
 
 
 
Acquired in acquisition
—

 
—

 
 
 
 
Granted
—

 
—

 
 
 
 
Exercised
(32,010
)
 
24.23

 
 
 
 
Forfeited
—

 
—

 
 
 
 
Expired
(1,650
)
 
33.33

 
 
 
 
Outstanding at June 30, 2018
17,325

 
$
22.94

 
0.45 years
 
$
295

Exercisable at June 30, 2018
17,325

 
$
22.94

 
0.45 years
 
$
295

The fair value of options is estimated at the date of grant using the Black-Scholes option pricing model and expensed over the options' vesting period.  No stock options have been granted since 2009. As of June 30, 2018, there were no unrecognized compensation expenses related to nonvested stock option grants.
Restricted Stock
The Company from time-to-time grants shares of restricted stock to key employees and non-employee directors.  These awards help align the interests of these employees and directors with the interests of the shareholders of the Company by providing economic value directly related to increases in the value of the Company's common stock.  The value of the stock awarded is established as the fair value of the stock at the time of the grant.  The Company recognizes expense, equal to the total value of such awards, ratably over the vesting period of the stock grants. The majority of the restricted stock granted cliff vests at the end of a 36 month period beginning on the date of the grant. The remainder vests one-third each year beginning on the date of the grant. Nonvested restricted stock activity for the six months ended June 30, 2018 is summarized in the following table.
Restricted Stock
Shares
 
Weighted Average Grant Date Value
Nonvested at December 31, 2017
46,501

 
$
26.28

Granted
18,192

 
39.52

Vested
(10,101
)
 
21.62

Forfeited
(483
)
 
34.70

Nonvested at June 30, 2018
54,109

 
$
31.53

As of June 30, 2018 and December 31, 2017, there was $965,000 and $538,000, respectively, in unrecognized compensation cost related to nonvested restricted stock granted under the 2008 Plan.  The weighted average period over which this cost is expected to be recognized is 1.46 years.  The share based compensation expense for nonvested restricted stock was $292,000 and $304,000 during the first six months of 2018 and 2017, respectively. 
The Company offers its outside directors alternatives with respect to director compensation. For 2018, the regular quarterly board retainer will be received in the form of shares of immediately vested, but restricted stock with a market value of $7,500. Monthly meeting fees can be received as $725 per meeting in cash or $900 in immediately vested, but restricted stock.  Only outside directors receive board fees. The Company issued 7,861 and 7,109 shares and recognized share based compensation expense of $300,000 and $255,000 during the first six months of 2018 and 2017, respectively.

25


Note 11 – Earnings Per Common Share
The following shows the weighted average number of shares used in computing earnings per common share and the effect on weighted average number of shares of potentially dilutive common stock. Potentially dilutive common stock had no effect on income available to common shareholders. Nonvested restricted shares are included in the computation of basic earnings per share as the holder is entitled to full shareholder benefits during the vesting period including voting rights and sharing in nonforfeitable dividends. The following table presents basic and diluted earnings per share for the three and six month periods ended June 30, 2018 and 2017.
 
Three Months Ended June 30,
 
2018
 
2017
 
Shares
 
Per
Share
Amount
 
Shares
 
Per
Share
Amount
Basic earnings per share
8,692,107

 
$
0.69

 
8,640,648

 
$
0.50

Effect of dilutive securities - stock options
12,619

 
—

 
18,517

 
(0.01
)
Diluted earnings per share
8,704,726

 
$
0.69

 
8,659,165

 
$
0.49

 
Six Months Ended June 30,
 
2018
 
2017
 
Shares
 
Per
Share
Amount
 
Shares
 
Per
Share
Amount
Basic earnings per share
8,680,739

 
$
1.36

 
8,636,954

 
$
0.97

Effect of dilutive securities - stock options
15,121

 
—

 
18,219

 
(0.01
)
Diluted earnings per share
8,695,860

 
$
1.36

 
8,655,173

 
$
0.96

Outstanding stock options on common stock that were not included in computing diluted earnings per share for the six month periods ended June 30, 2018 and 2017 because their effects were anti-dilutive, averaged 0 and 660 shares, respectively. There were no anti-dilutive stock options for the three month periods ended June 30, 2018 and 2017.
Note 12 – Employee Benefit Plans
The following information for the six months ended June 30, 2018 and 2017 pertains to the Company's non-contributory defined benefit pension plan which was frozen in 2009.  If lump sum payments exceed the service cost plus interest cost, an additional settlement charge will apply (dollars in thousands):
Components of Net Periodic Benefit Cost
Six Months Ended June 30,
 
2018
 
2017
Service cost
$
—

 
$
—

Interest cost
118

 
118

Expected return on plan assets
(177
)
 
(177
)
Recognized loss due to settlement
111

 
70

Recognized net actuarial loss
124

 
109

Net periodic cost
$
176

 
$
120

Note 13 – Fair Value of Financial Instruments
Determination of Fair Value 
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the fair value measurements and disclosures topic of FASB ASC 820, the fair value of an instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. 

26


The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.
Fair Value Hierarchy 
In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.
Level 1 –
Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –
Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –
Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.
 The following describes the valuation techniques used by the Company to measure certain financial assets and financial liabilities recorded at fair value on a recurring basis in the financial statements:
Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). If no observable market data is available, valuations are based upon third party model based techniques (Level 3). There were no securities recorded with a Level 3 valuation at June 30, 2018 or December 31, 2017.
Derivative asset (liability) - cash flow hedges: Cash flow hedges are recorded at fair value on a recurring basis. Cash flow hedges are valued by a third party using significant assumptions that are observable in the market and can be corroborated by market data. All of the Company's cash flow hedges are classified as Level 2.

27


The following table presents the balances of financial assets measured at fair value on a recurring basis at the dates indicated (dollars in thousands):
 
Fair Value Measurements at June 30, 2018 Using
 
Balance at June 30,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
Description
2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Securities available for sale:
 
 
 
 
 
 
 
Federal agencies and GSEs
$
132,845

 
$
—

 
$
132,845

 
$
—

Mortgage-backed and CMOs
107,472

 
—

 
107,472

 
—

State and municipal
93,002

 
—

 
93,002

 
—

Corporate
7,928

 
—

 
7,928

 
—

Total securities available for sale
$
341,247

 
$
—

 
$
341,247

 
$
—

Equity securities
$
2,177

 
$
—

 
$
2,177

 
$
—

Liabilities:
 
 
 
 
 
 
 
Derivative - cash flow hedges
$
237

 
$
—

 
$
237

 
$
—

 
Fair Value Measurements at December 31, 2017 Using
 
Balance at December 31,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
Description
2017
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Securities available for sale:
 
 
 
 
 
 
 
Federal agencies and GSEs
$
112,127

 
$
—

 
$
112,127

 
$
—

Mortgage-backed and CMOs
105,316

 
—

 
105,316

 
—

State and municipal
93,626

 
—

 
93,626

 
—

Corporate
8,062

 
—

 
8,062

 
—

Equity securities
2,206

 
—

 
2,206

 
—

Total securities available for sale
$
321,337

 
$
—

 
$
321,337

 
$
—

 
  Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.
The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:
Loans held for sale: Loans held for sale are carried at fair value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the six month period ended June 30, 2018 or the year ended December 31, 2017. Gains and losses on the sale of loans are recorded within mortgage banking income on the consolidated statements of income.
Impaired loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected when due. The measurement of the loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable.  The vast majority of the Company's collateral is real estate.  The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal, of one year or less, conducted by an independent, licensed appraiser using observable market data (Level 2).  However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables

28


or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value.  The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business's financial statements if not considered significant using observable market data.  Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3).  Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis.  Any fair value adjustments are recorded in the period incurred as provision for loan losses on the consolidated statements of income.
OREO:  Measurement for fair values for OREO are the same as impaired loans. Any fair value adjustments are recorded in the period incurred as a valuation allowance against other real estate owned with the associated expense included in other real estate owned expense, net on the consolidated statements of income.
The following table summarizes the Company's assets that were measured at fair value on a nonrecurring basis at the dates indicated (dollars in thousands):
 
Fair Value Measurements at June 30, 2018 Using
 
Balance at June 30,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
Description
2018
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Loans held for sale
$
2,296

 
$
—

 
$
2,296

 
$
—

Impaired loans, net of valuation allowance
554

 
—

 
—

 
554

Other real estate owned, net
1,124

 
—

 
—

 
1,124

 
Fair Value Measurements at December 31, 2017 Using
 
Balance at December 31,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
Description
2017
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
Loans held for sale
$
1,639

 
$
—

 
$
1,639

 
$
—

Impaired loans, net of valuation allowance
1,391

 
—

 
—

 
1,391

Other real estate owned, net
1,225

 
—

 
—

 
1,225

The following tables summarize the Company's quantitative information about Level 3 fair value measurements at the dates indicated:
Quantitative Information About Level 3 Fair Value Measurements at June 30, 2018
Assets
 
Valuation Technique
 
Unobservable Input
 

Rate
 
 
 
 
 
 
 
Impaired loans
 
Discounted appraised value
 
Selling cost
 
8.00%
 
 
Discounted cash flow analysis
 
Market rate for borrower (discount rate)
 
3.25% - 9.80%
 
 
 
 
 
 
 
Other real estate owned, net
 
Discounted appraised value
 
Selling cost
 
8.00%

29


Quantitative Information About Level 3 Fair Value Measurements at December 31, 2017
Assets
 
Valuation Technique
 
Unobservable Input
 
Rate
 
 
 
 
 
 
 
Impaired loans
 
Discounted appraised value
 
Selling cost
 
8.00%
 
 
Discounted cash flow analysis
 
Market rate for borrower (discount rate)
 
3.25% - 9.80%
 
 
 
 
 
 
 
Other real estate owned, net
 
Discounted appraised value
 
Selling cost
 
8.00%
ASC 825, "Financial Instruments," requires disclosure about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.
The carrying values and the exit pricing concept fair values of the Company's financial instruments at June 30, 2018 are as follows (dollars in thousands):
 
Fair Value Measurements at June 30, 2018 Using
 
 
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Fair Value
 
Carrying Value
 
Level 1
 
Level 2
 
Level 3
 
Balance
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
33,342

 
$
33,342

 
$
—

 
$
—

 
$
33,342

Equity securities
2,177

 
 
 
2,177

 
 
 
2,177

Securities available for sale
341,247

 
—

 
341,247

 
—

 
341,247

Restricted stock
5,463

 
—

 
5,463

 
—

 
5,463

Loans held for sale
2,296

 
—

 
2,296

 
—

 
2,296

Loans, net of allowance
1,325,871

 
—

 
—

 
1,325,283

 
1,325,283

Bank owned life insurance
18,674

 
—

 
18,674

 
—

 
18,674

Accrued interest receivable
5,293

 
—

 
5,293

 
—

 
5,293

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 

 
 

 
 

 
 

 
 

Deposits
$
1,560,746

 
$
—

 
$
1,566,931

 
$
—

 
$
1,566,931

Repurchase agreements
6,776

 
—

 
6,776

 
—

 
6,776

Other short-term borrowings
5,500

 
—

 
5,500

 
—

 
5,500

Junior subordinated debt
27,876

 
—

 
—

 
22,554

 
22,554

Accrued interest payable
672

 
—

 
672

 
—

 
672

Derivative - cash flow hedges
237

 
—

 
237

 
—

 
237


30


The carrying values and estimated fair values of the Company's financial instruments at December 31, 2017 are as follows (dollars in thousands):
 
Fair Value Measurements at December 31, 2017 Using
 
 
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Fair Value
 
Carrying Value
 
Level 1
 
Level 2
 
Level 3
 
Balance
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
52,477

 
$
52,477

 
$
—

 
$
—

 
$
52,477

Securities available for sale
321,337

 
—

 
321,337

 
—

 
321,337

Restricted stock
6,110

 
—

 
6,110

 
—

 
6,110

Loans held for sale
1,639

 
—

 
1,639

 
—

 
1,639

Loans, net of allowance
1,322,522

 
—

 
—

 
1,317,737

 
1,317,737

Bank owned life insurance
18,460

 
—

 
18,460

 
—

 
18,460

Accrued interest receivable
5,231

 
—

 
5,231

 
—

 
5,231

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 

 
 

 
 

 
 

 
 

Deposits
$
1,534,726

 
$
—

 
$
1,527,956

 
$
—

 
$
1,527,956

Repurchase agreements
10,726

 
—

 
10,726

 
—

 
10,726

Other short-term borrowings
24,000

 
—

 
24,000

 
—

 
24,000

Junior subordinated debt
27,826

 
—

 
—

 
28,358

 
28,358

Accrued interest payable
674

 
—

 
674

 
—

 
674

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:
Cash and cash equivalents.  The carrying amount is a reasonable estimate of fair value.
Securities.  Fair values are based on quoted market prices or dealer quotes.
Restricted stock. The carrying value of restricted stock approximates fair value based on the redemption provisions of the respective entity.
Loans held for sale.  The carrying amount is at fair value. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale
Loans.  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.  Fair values for fixed-rate loans are estimated based upon discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Fair values for nonperforming loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable.
Bank owned life insurance. Bank owned life insurance represents insurance policies on officers, directors, and past directors of the Company.  The cash values of the policies are estimates using information provided by insurance carriers.  These policies are carried at their cash surrender value, which approximates the fair value.
Accrued interest receivable.  The carrying amount is a reasonable estimate of fair value.
Deposits.  The fair value of demand deposits, savings deposits, and money market deposits equals the carrying value. The fair value of fixed-rate certificates of deposit is estimated by discounting the future cash flows using the current rates at which similar deposit instruments would be offered to depositors for the same remaining maturities.
Repurchase agreements.  The carrying amount is a reasonable estimate of fair value.
Other short-term borrowings.  The carrying amount is a reasonable estimate of fair value.

31


Long-term borrowings.  The fair values of long-term borrowings are estimated using discounted cash flow analysis based on the interest rates for similar types of borrowing arrangements.
Junior subordinated debt.  Fair value is calculated by discounting the future cash flows using the estimated current interest rates at which similar securities would be issued.
Accrued interest payable.  The carrying amount is a reasonable estimate of fair value.
Derivative - cash flow hedges. Fair values are based on observable market data.
Off-balance sheet instruments.  The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.  At June 30, 2018 and December 31, 2017, the fair value of off-balance sheet instruments was deemed immaterial, and therefore was not included in the previous table.
The Company assumes interest rate risk (the risk that interest rates will change) in its normal operations.  As a result, the fair values of the Company's financial instruments will change when interest rates change and that change may be either favorable or unfavorable to the Company.
Note 14 – Segment and Related Information
The Company has two reportable segments, community banking and trust and investment services.
Community banking involves making loans to and generating deposits from individuals and businesses.  All assets and liabilities of the Company are allocated to community banking.  Investment income from securities is also allocated to the community banking segment.  Loan fee income, service charges from deposit accounts, and non-deposit fees such as automated teller machine fees and insurance commissions generate additional income for the community banking segment.
Trust and investment services include estate planning, trust account administration, investment management, and retail brokerage.  Investment management services include purchasing equity, fixed income, and mutual fund investments for customer accounts. The trust and investment services segment receives fees for investment and administrative services.
Amounts shown in the "Other" column includes activities of the Company which are primarily debt service on trust preferred securities and corporate items. 
Segment information as of and for the three and six months ended June 30, 2018 and 2017 (unaudited), is shown in the following tables (dollars in thousands):
 
Three Months Ended June 30, 2018
 
Community
Banking
 
Trust and
Investment
Services
 
Other
 
Intersegment
Eliminations
 
Total
Interest income
$
16,900

 
$
—

 
$
92

 
$
—

 
$
16,992

Interest expense
1,874

 
—

 
330

 
—

 
2,204

Noninterest income
2,111

 
1,155

 
297

 
—

 
3,563

Income (loss) before income taxes
7,071

 
567

 
(259
)
 
—

 
7,379

Net income (loss)
5,725

 
459

 
(204
)
 
—

 
5,980

Depreciation and amortization
541

 
3

 
—

 
—

 
544

Total assets
1,814,730

 
—

 
241,617

 
(231,816
)
 
1,824,531

Goodwill
43,872

 
—

 
—

 
—

 
43,872

Capital expenditures
587

 
—

 
—

 
—

 
587


32


 
Three Months Ended June 30, 2017
 
Community
Banking
 
Trust and
Investment
Services
 
Other
 
Intersegment
Eliminations
 
Total
Interest income
$
15,518

 
$
—

 
$
85

 
$
—

 
$
15,603

Interest expense
1,447

 
—

 
244

 
—

 
1,691

Noninterest income
2,242

 
1,100

 
6

 
—

 
3,348

Income (loss) before income taxes
6,129

 
518

 
(448
)
 
—

 
6,199

Net income (loss)
4,217

 
358

 
(296
)
 
—

 
4,279

Depreciation and amortization
669

 
3

 
—

 
—

 
672

Total assets
1,755,185

 
—

 
234,913

 
(225,625
)
 
1,764,473

Goodwill
43,872

 
—

 
—

 
—

 
43,872

Capital expenditures
1,071

 
5

 
—

 
—

 
1,076

 
Six Months Ended June 30, 2018
 
Community
Banking
 
Trust and
Investment
Services
 
Other
 
Intersegment
Eliminations
 
Total
Interest income
$
33,480

 
$
—

 
$
180

 
$
—

 
$
33,660

Interest expense
3,709

 
—

 
620

 
—

 
4,329

Noninterest income
4,174

 
2,306

 
416

 
—

 
6,896

Income (loss) before income taxes
14,097

 
1,020

 
(520
)
 
—

 
14,597

Net income (loss)
11,378

 
824

 
(410
)
 
—

 
11,792

Depreciation and amortization
1,081

 
6

 
—

 
—

 
1,087

Total assets
1,814,730

 
—

 
241,617

 
(231,816
)
 
1,824,531

Goodwill
43,872

 
—

 
—

 
—

 
43,872

Capital expenditures
932

 
—

 
—

 
—

 
932

 
Six Months Ended June 30, 2017
 
Community
Banking
 
Trust and
Investment
Services
 
Other
 
Intersegment
Eliminations
 
Total
Interest income
$
30,114

 
$
—

 
$
170

 
$
—

 
$
30,284

Interest expense
2,755

 
—

 
483

 
—

 
3,238

Noninterest income
4,403

 
2,204

 
12

 
—

 
6,619

Income (loss) before income taxes
11,586

 
1,059

 
(782
)
 
—

 
11,863

Net income (loss)
8,113

 
746

 
(517
)
 
—

 
8,342

Depreciation and amortization
1,275

 
6

 
—

 
—

 
1,281

Total assets
1,755,185

 
—

 
234,913

 
(225,625
)
 
1,764,473

Goodwill
43,872

 
—

 
—

 
—

 
43,872

Capital expenditures
1,728

 
11

 
—

 
—

 
1,739


33


Note 15 – Supplemental Cash Flow Information
 
Six Months Ended 
 June 30,
 
2018
 
2017
Supplemental Schedule of Cash and Cash Equivalents:
 
 
 
Cash and due from banks
$
24,042

 
$
23,765

Interest-bearing deposits in other banks
9,300

 
62,164

Cash and Cash Equivalents
$
33,342

 
$
85,929

 


 


Supplemental Disclosure of Cash Flow Information:
 

 
 

Cash paid for:
 

 
 

Interest on deposits and borrowed funds
$
4,332

 
$
3,250

Income taxes
2,548

 
3,707

Noncash investing and financing activities:


 


Transfer of loans to other real estate owned
532

 
513

Unrealized (losses) gains on securities available for sale
(5,188
)
 
1,300

Unrealized losses on cash flow hedges
(237
)
 
—

Note 16 – Accumulated Other Comprehensive Income (Loss)
Changes in each component of accumulated other comprehensive income (loss) ("AOCI") for the three and six months ended June 30, 2018 and 2017 (unaudited) were as follows (dollars in thousands):
For the Three Months Ended
Net Unrealized Gains (Losses) on Securities
 
Unrealized Losses on Cash Flow Hedges
 
Adjustments Related to Pension Benefits
 
Accumulated Other Comprehensive Income (Loss)
 
 
 
 
 
 
 
 
Balance at March 31, 2017
$
339

 
$
—

 
$
(1,724
)
 
$
(1,385
)
 
 
 
 
 
 
 
 
Net unrealized gains on securities available for sale, net of tax, $307
572

 
—

 
—

 
572

 
 
 
 
 
 
 
 
Reclassification adjustment for realized gains on securities, net of tax, $(116)
(215
)
 
—

 
—

 
(215
)
 
 
 
 
 
 
 
 
Balance at June 30, 2017
$
696

 
$
—

 
$
(1,724
)
 
$
(1,028
)
 
 
 
 
 
 
 
 
Balance at March 31, 2018
$
(4,325
)
 
$
—

 
$
(2,280
)
 
$
(6,605
)
 
 
 
 
 
 
 
 
Net unrealized losses on securities available for sale, net of tax, $(325)
(1,121
)
 
—

 
—

 
(1,121
)
 
 
 
 
 
 
 
 
Unrealized losses on cash flow hedges, net of tax, $(53)
—

 
(184
)
 
—

 
(184
)
 
 
 
 
 
 
 
 
Balance at June 30, 2018
$
(5,446
)
 
$
(184
)
 
$
(2,280
)
 
$
(7,910
)

34


For the Six Months Ended
Net Unrealized Gains (Losses) on Securities
 
Unrealized Losses on Cash Flow Hedges
 
Adjustments Related to Pension Benefits
 
Accumulated Other Comprehensive Income (Loss)
 
 
 
 
 
 
 
 
Balance at December 31, 2016
$
(150
)
 
$
—

 
$
(1,724
)
 
$
(1,874
)
 
 
 
 
 
 
 
 
Net unrealized gains on securities available for sale, net of tax, $661
1,229

 
—

 
—

 
1,229

 
 
 
 
 
 
 
 
Reclassification adjustment for realized gains on securities, net of tax, $(207)
(383
)
 
—

 
—

 
(383
)
 
 
 
 
 
 
 
 
Balance at June 30, 2017
$
696

 
$
—

 
$
(1,724
)
 
$
(1,028
)
 
 
 
 
 
 
 
 
Balance at December 31, 2017
$
(796
)
 
$
—

 
$
(2,280
)
 
$
(3,076
)
 
 
 
 
 
 
 
 
Net unrealized losses on securities available for sale, net of tax, $(1,186)
(3,994
)
 
—

 
—

 
(3,994
)
 
 
 
 
 
 
 
 
Reclassification adjustment for gains on sales of securities, net of tax, $(2)
(6
)
 
—

 
—

 
(6
)
 
 
 
 
 
 
 
 
Reclassification for ASU 2016-01 adoption
(650
)
 
—

 
—

 
(650
)
 
 
 
 
 
 
 
 
Unrealized losses on cash flow hedges, net of tax, $(53)
—

 
(184
)
 
—

 
(184
)
 
 
 
 
 
 
 
 
Balance at June 30, 2018
$
(5,446
)
 
$
(184
)
 
$
(2,280
)
 
$
(7,910
)
Reclassifications Out of Accumulated Other Comprehensive Income
For the three and six months ended June 30, 2018 and 2017
(dollars in thousands)
For the Three Months Ended June 30, 2018
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
 
 
 
Available for sale securities:
 
 
  
Realized gain on sale of securities
$
—

 
Securities gains, net
 
—

 
Income taxes
Total reclassifications
$
—

 
Net of tax
For the Three Months Ended June 30, 2017
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
 
 
 
Available for sale securities:
 
 
  
Realized gain on sale of securities
$
331

 
Securities gains, net
 
(116
)
 
Income taxes
Total reclassifications
$
215

 
Net of tax

35


For the Six Months Ended June 30, 2018
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
 
 
 
Available for sale securities:
 
 
  
Realized gain on sale of securities
$
8

 
Securities gains, net
 
(2
)
 
Income taxes
 
6

 
Net of tax
Reclassification for ASU 2016-01 adoption
650

 
*
Total reclassifications
$
656

 
 
*
Reclassification from AOCI to retained earnings for unrealized holding gains on equity securities due to adoption of ASU 2016-01.
For the Six Months Ended June 30, 2017
Amount Reclassified from AOCI
 
Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
 
 
 
Available for sale securities:
 
 
  
Realized gain on sale of securities
$
590

 
Securities gains, net
 
(207
)
 
Income taxes
Total reclassifications
$
383

 
Net of tax
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The purpose of this discussion is to focus on important factors affecting the financial condition and results of operations of the Company.  The discussion and analysis should be read in conjunction with the Consolidated Financial Statements.
Forward-Looking Statements
This report contains forward-looking statements with respect to the financial condition, results of operations and business of American National Bankshares Inc. (the "Company") and its wholly owned subsidiary, American National Bank and Trust Company (the "Bank").  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on information available to management at the time these statements and disclosures were prepared.  Forward-looking statements are subject to numerous assumptions, estimates, risks, and uncertainties that could cause actual conditions, events, or results to differ materially from those stated or implied by such forward-looking statements.
A variety of factors, some of which are discussed in more detail in Item 1A – Risk Factors of the Company's Annual Report on Form 10-K for the year ended December 31, 2017, may affect the operations, performance, business strategy, and results of the Company.  Those factors include, but are not limited to, the following:
•
financial market volatility, including the level of interest rates, could affect the values of financial instruments and the amount of net interest income earned;
•
general economic or business conditions, either nationally or in the market areas in which the Company does business, may be less favorable than expected, resulting in deteriorating credit quality, reduced demand for credit, or a weakened ability to generate deposits;
•
competition among financial institutions may increase, and competitors may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than the Company;
•
businesses that the Company is engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards and tax laws;
•
the ability to retain key personnel;
•
the failure of assumptions underlying the allowance for loan losses; and
•
risks associated with mergers and acquisitions and other expansion activities.

36


Reclassification
In certain circumstances, reclassifications have been made to prior period information to conform to the 2018 presentation.  There were no material reclassifications.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies followed by the Company conform with U.S. generally accepted accounting principles ("GAAP") and they conform to general practices within the banking industry.  The Company's critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses, (2) mergers and acquisitions, (3) acquired loans with specific credit-related deterioration (4) goodwill and intangible assets, (5) other real estate owned, (6) deferred tax assets and liabilities, (7) other-than-temporary impairment of securities and (8) the unfunded pension liability.  A summary of the Company's significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements contained in the Form 10-K for the year ended December 31, 2017.
The financial information contained within the Company's financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred.  A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset, or relieving a liability.  In addition, GAAP itself may change from one previously acceptable method to another method.
Allowance for Loan Losses
The purpose of the allowance for loan losses ("ALLL") is to provide for probable losses inherent in the loan portfolio.  The allowance is increased by the provision for loan losses and by recoveries of previously charged-off loans.  Loan charge-offs decrease the allowance.
The goal of the Company is to maintain an appropriate, systematic, and consistently applied process to determine the amounts of the ALLL and the provision for loan loss expense.
The Company uses certain practices to manage its credit risk.  These practices include (1) appropriate lending limits for loan officers, (2) a loan approval process, (3) careful underwriting of loan requests, including analysis of borrowers, cash flows, collateral, and market risks, (4) regular monitoring of the portfolio, including diversification by type and geography, (5) review of loans by the Loan Review department, which operates independently of loan production, (6) regular meetings of the Credit Committee to discuss portfolio and policy changes and make decisions on large or unusual loan requests, and (7) regular meetings of the Asset Quality Committee which reviews the status of individual loans.
Risk grades are assigned as part of the loan origination process. From time to time, risk grades may be modified as warranted by the facts and circumstances surrounding the credit.
Calculation and analysis of the ALLL is prepared quarterly by the Finance Department.  The Company's Credit Committee, Risk and Compliance Committee, Audit Committee, and the Board of Directors review the allowance for adequacy.
The Company's ALLL has two basic components:  the formula allowance and the specific allowance.  Each of these components is determined based upon estimates and judgments.
The formula allowance uses historical loss experience as an indicator of future losses, along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries, trends in volume and terms of loans, effects of changes in underwriting standards, experience of lending staff, economic conditions, portfolio concentrations, regulatory, legal, competition, quality of loan review system, and value of underlying collateral. In the formula allowance for commercial and commercial real estate loans, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans.  The period-end balances for each loan risk-grade category are multiplied by the adjusted loss factor.  Allowance calculations for residential real estate and consumer loans are calculated based on historical losses for each product category without regard to risk grade. This loss rate is combined with qualitative factors resulting in an adjusted loss factor for each product category.
The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. These include:
•
The present value of expected future cash flows discounted at the loan's effective interest rate.  The effective interest rate on a loan is the rate of return implicit in the loan (that is, the contractual interest rate adjusted for any net deferred loan fees or costs and any premium or discount existing at the origination or acquisition of the loan);
•
The loan's observable market price, or

37


•
The fair value of the collateral, net of estimated costs to dispose, if the loan is collateral dependent.
The use of these computed values is inherently subjective and actual losses could be greater or less than the estimates.
No single statistic, formula, or measurement determines the adequacy of the allowance.  Management makes subjective and complex judgments about matters that are inherently uncertain, and different amounts would be reported under different conditions or using different assumptions.  For analytical purposes, management allocates a portion of the allowance to specific loan categories and specific loans.  However, the entire allowance is used to absorb credit losses inherent in the loan portfolio, including identified and unidentified losses.
The relationships and ratios used in calculating the allowance, including the qualitative factors, may change from period to period as facts and circumstances evolve.  Furthermore, management cannot provide assurance that in any particular period the Bank will not have sizable credit losses in relation to the amount reserved.  Management may find it necessary to significantly adjust the allowance, considering current factors at the time.
Mergers and Acquisitions
Business combinations are accounted for under the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions.
Acquisition-related costs are costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of costs to the Company include systems conversions, integration planning consultants and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP. These acquisition-related costs have been and will be included within the consolidated statements of income classified within the noninterest expense caption.
Acquired Loans with Specific Credit-Related Deterioration
Acquired loans with specific credit deterioration are accounted for by the Company in accordance with FASB ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality. Certain acquired loans, those for which specific credit-related deterioration, since origination, is identified, are recorded at fair value reflecting the present value of the amounts expected to be collected. Income recognition on these loans is based on a reasonable expectation about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.
Goodwill and Intangible Assets
The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment.  No indicators of impairment were identified during the six months ended June 30, 2018 or 2017.
Other Real Estate Owned
Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of similar properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Company may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further deterioration in market conditions.
Deferred Tax Assets and Liabilities
The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is "more likely than not" that all or a portion of the deferred tax asset will not be realized.  "More likely than not" is defined as greater than a 50%

38


chance. Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed.
Other-than-temporary Impairment of Securities
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (1) the Company intends to sell the security or (2) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-likely-than-not that it will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income.
Unfunded Pension Liability
The Company previously maintained a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. The Company froze its pension plan to new participants and converted its pension plan to a cash balance plan effective December 31, 2009. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the interest crediting rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.
Derivative Financial Instruments
The Company uses derivatives primarily to manage risk associated with changing interest rates. The Company's derivative financial instruments consist of interest rate swaps that qualify as cash flow hedges of the Company's trust preferred notes. The Company recognizes derivative financial instruments at fair value as either an other asset or other liability in the consolidated balance sheets. The effective portion of the gain or loss on the Company's cash flow hedges is reported as a component of other comprehensive income, net of deferred income taxes, and is reclassified into earnings in the same period or periods during which the hedged transactions affect earnings.
Non-GAAP Presentations
Non-GAAP presentations are provided because the Company believes these may be valuable to investors. These include (1) the analysis of net interest income presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets and (2) the calculation of the efficiency ratio.
Internet Access to Corporate Documents
The Company provides access to its Securities and Exchange Commission ("SEC") filings through a link on the Investor Relations page of the Company's web site at www.amnb.com.  Reports available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are filed electronically with the SEC.  The information on the Company's website is not incorporated into this report or any other filing the Company makes with the SEC.  The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

39


RESULTS OF OPERATIONS
Earnings Performance
Three months ended June 30, 2018 and 2017
For the quarter ended June 30, 2018, the Company reported net income of $5,980,000 compared to $4,279,000 for the comparable quarter in 2017. The $1,701,000 or 39.8% increase was driven primarily by higher net interest income, resulting mostly from higher yields on the loan portfolio and greater loans volume. Also positively impacting income was the recent reduction in the corporate income tax rate, to 21% from 35% and a lower loan loss provision. The Company's tax expense for the quarter was $521,000 or 27.1% less than the comparable quarter of 2017. The Company had a small negative provision in the 2018 quarter compared to a $350,000 expense in the 2017 quarter.
SUMMARY INCOME STATEMENT
(Dollars in thousands)
 
 
 
 
 
 
 
 
Three Months Ended June 30,
2018
 
2017
 
$ Change
 
% Change
Interest income
$
16,992

 
$
15,603

 
$
1,389

 
8.9
 %
Interest expense
(2,204
)
 
(1,691
)
 
(513
)
 
30.3

Net interest income
14,788

 
13,912

 
876

 
6.3

Provision for loan losses
30

 
(350
)
 
380

 
(108.6
)
Noninterest income
3,563

 
3,348

 
215

 
6.4

Noninterest expense
(11,002
)
 
(10,711
)
 
(291
)
 
2.7

Income tax expense
(1,399
)
 
(1,920
)
 
521

 
(27.1
)
 
 
 
 
 
 
 
 
Net income
$
5,980

 
$
4,279

 
$
1,701

 
39.8

Six Months Ended June 30, 2018 and 2017
For the six month period ended June 30, 2018, the Company reported net income of $11,792,000 compared to $8,342,000 for the comparable period in 2017. The $3,450,000 or 41.36% increase was driven by the same factors discussed above for the quarter.
SUMMARY INCOME STATEMENT
(Dollars in thousands)
 
 
 
 
 
 
 
 
Six Months Ended June 30,
2018
 
2017
 
$ Change
 
% Change
Interest income
$
33,660

 
$
30,284

 
$
3,376

 
11.1
 %
Interest expense
(4,329
)
 
(3,238
)
 
(1,091
)
 
33.7

Net interest income
29,331

 
27,046

 
2,285

 
8.4

Provision for loan losses
74

 
(650
)
 
724

 
(111.4
)
Noninterest income
6,896

 
6,619

 
277

 
4.2

Noninterest expense
(21,704
)
 
(21,152
)
 
(552
)
 
2.6

Income tax expense
(2,805
)
 
(3,521
)
 
716

 
(20.3
)
 
 
 
 
 
 
 
 
Net income
$
11,792

 
$
8,342

 
$
3,450

 
41.4

Net Interest Income
Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits and other funding sources.  Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income.  The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities.  A tax rate of 21% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis in 2018, and a tax rate of 35% was used in 2017.  Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the weighted rate earned on average earning assets and the weighted rate paid on average interest-bearing liabilities.

40


Three months ended June 30, 2018 and 2017
Net interest income on a taxable equivalent basis increased $693,000 or 4.9%, for the second quarter of 2018 compared to the same quarter of 2017.  The increase was driven by higher yields and higher loan volume.
For the second quarter of 2018, the Company's yield on interest-earning assets was 4.02%, compared to 3.96% for the second quarter of 2017.  The cost of interest-bearing liabilities was 0.75% compared to 0.60%, primarily related to a 14 basis point (0.14%) increase in the cost of deposits. The interest rate spread was 3.27% compared to 3.36%. The net interest margin, on a fully taxable equivalent basis, was 3.50% compared to 3.54%, a decrease of four basis points (0.04%). The decrease in net interest margin related mostly to increases in the cost of deposits.

41


The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the three months ended June 30, 2018 and 2017.  Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.
 
Net Interest Income Analysis (dollars in thousands)
 
Three Months Ended June 30,
 
 
 
 
 

 
 
 
 
 
Average Balance
 
Income/Expense
 
Yield/Rate
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
267,996

 
$
229,690

 
$
2,652

 
$
2,241

 
3.97
%
 
3.91
%
Real estate
1,052,105

 
1,026,010

 
12,087

 
11,502

 
4.60

 
4.48

Consumer
4,327

 
5,072

 
77

 
89

 
7.14

 
7.04

Total loans
1,324,428

 
1,260,772

 
14,816

 
13,832

 
4.48

 
4.39

 
 
 
 
 
 
 
 
 
 
 
 
Securities:
 

 
 

 
 

 
 

 
 

 
 

Federal agencies and GSEs
127,033

 
96,339

 
707

 
454

 
2.23

 
1.89

Mortgage-backed and CMOs
108,789

 
80,003

 
609

 
412

 
2.24

 
2.06

State and municipal
91,636

 
104,115

 
653

 
938

 
2.85

 
3.60

Other securities
15,028

 
15,406

 
176

 
179

 
4.68

 
4.65

Total securities
342,486

 
295,863

 
2,145

 
1,983

 
2.51

 
2.68

 
 
 
 
 
 
 
 
 
 
 
 
Deposits in other banks
40,309

 
53,497

 
185

 
125

 
1.84

 
0.94

 
 
 
 
 
 
 
 
 
 
 
 
Total interest-earning assets
1,707,223

 
1,610,132

 
17,146

 
15,940

 
4.02

 
3.96

 
 
 
 
 
 
 
 
 
 
 
 
Non-earning assets
118,637

 
126,554

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Total assets
$
1,825,860

 
$
1,736,686

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 

 
 

 
 

 
 

 
 

 
 

Demand
$
246,493

 
$
219,743

 
13

 
11

 
0.02

 
0.02

Money market
395,135

 
322,737

 
802

 
342

 
0.81

 
0.43

Savings
132,190

 
125,134

 
10

 
9

 
0.03

 
0.03

Time
371,883

 
380,214

 
1,048

 
990

 
1.13

 
1.04

Total deposits
1,145,701

 
1,047,828

 
1,873

 
1,352

 
0.66

 
0.52

 
 
 
 
 
 
 
 
 
 
 
 
Customer repurchase agreements
11,347

 
49,239

 
1

 
14

 
0.04

 
0.11

Other short-term borrowings
247

 
—

 
1

 
—

 
1.62

 
—

Long-term borrowings
27,861

 
37,748

 
329

 
325

 
4.72

 
3.44

Total interest-bearing
 

 
 

 
 

 
 

 
 

 
 

liabilities
1,185,156

 
1,134,815

 
2,204

 
1,691

 
0.75

 
0.60

 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing demand deposits
419,620

 
386,024

 
 

 
 

 
 

 
 

Other liabilities
8,828

 
9,073

 
 

 
 

 
 

 
 

Shareholders' equity
212,256

 
206,774

 
 

 
 

 
 

 
 

Total liabilities and
 

 
 

 
 

 
 

 
 

 
 

shareholders' equity
$
1,825,860

 
$
1,736,686

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Interest rate spread
 

 
 

 
 

 
 

 
3.27
%
 
3.36
%
Net interest margin
 

 
 

 
 

 
 

 
3.50
%
 
3.54
%
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income (taxable equivalent basis)
 
 

 
14,942

 
14,249

 
 

 
 

Less: Taxable equivalent adjustment (1)
 

 
 

 
154

 
337

 
 

 
 

Net interest income
 

 
 

 
$
14,788

 
$
13,912

 
 

 
 

(1) - Calculated using 21% and 35% statutory tax rate in 2018 and 2017, respectively, due to tax rate change.

42


Changes in Net Interest Income (Rate/Volume Analysis)
(in thousands)
 
Three Months Ended June 30,
 
2018 vs. 2017
 
 
 
Change
 
Increase
 
Attributable to
Interest income
(Decrease)
 
Rate
 
Volume
Loans:
 
 
 
 
 
Commercial
$
411

 
$
32

 
$
379

Real estate
585

 
289

 
296

Consumer
(12
)
 
1

 
(13
)
Total loans
984

 
322

 
662

Securities:
 

 
 

 
 

Federal agencies and GSEs
253

 
92

 
161

Mortgage-backed and CMOs
197

 
38

 
159

State and municipal
(285
)
 
(181
)
 
(104
)
Other securities
(3
)
 
1

 
(4
)
Total securities
162

 
(50
)
 
212

Deposits in other banks
60

 
97

 
(37
)
Total interest income
1,206

 
369

 
837

 
 
 
 
 
 
Interest expense
 

 
 

 
 

Deposits:
 

 
 

 
 

Demand
2

 
1

 
1

Money market
460

 
369

 
91

Savings
1

 
—

 
1

Time
58

 
80

 
(22
)
Total deposits
521

 
450

 
71

Customer repurchase agreements
(13
)
 
(6
)
 
(7
)
Other short-term borrowings
1

 
1

 
—

Long-term borrowings
4

 
102

 
(98
)
Total interest expense
513

 
547

 
(34
)
Net interest income (taxable equivalent basis)
$
693

 
$
(178
)
 
$
871


Six months ended June 30, 2018 and 2017
Net interest income on a taxable equivalent basis increased $1,867,000 or 6.7%, for the six months ended June 30, 2018 compared to the same period of 2017.  The increase was driven by higher yields and higher loan volume.
For the first six months of 2018, the Company's yield on interest-earning assets was 3.99%, compared to 3.90% for the same period of 2017.  The cost of interest-bearing liabilities was 0.73% compared to 0.58%, primarily related to a 15 basis point (0.15%) increase in the cost of deposits. The interest rate spread was 3.26% compared to 3.32%. The net interest margin, on a fully taxable equivalent basis, was 3.48% compared to 3.49%, a decrease of one basis point (0.01%). The decrease in net interest margin related mostly to increases in the cost of deposits.

43


The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the six months ended June 30, 2018 and 2017.  Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.
 
Net Interest Income Analysis (dollars in thousands)
 
Six Months Ended June 30,
 
 
 
 
 
 
 
 
 
 
 
 
 
Average Balance
 
Income/Expense
 
Yield/Rate
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Loans:
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
263,300

 
$
224,833

 
$
5,096

 
$
4,294

 
3.90
%
 
3.85
%
Real estate
1,064,605

 
999,484

 
24,277

 
22,126

 
4.56

 
4.43

Consumer
4,313

 
5,230

 
153

 
181

 
7.15

 
6.98

Total loans
1,332,218

 
1,229,547

 
29,526

 
26,601

 
4.44

 
4.33

 
 
 
 
 
 
 
 
 
 
 
 
Securities:
 

 
 

 
 

 
 

 
 

 
 

Federal agencies and GSEs
115,182

 
96,651

 
1,224

 
896

 
2.13

 
1.85

Mortgage-backed and CMOs
108,808

 
79,033

 
1,208

 
825

 
2.22

 
2.09

State and municipal
89,000

 
117,681

 
1,287

 
2,090

 
2.89

 
3.55

Other securities
15,153

 
16,781

 
351

 
365

 
4.63

 
4.35

Total securities
328,143

 
310,146

 
4,070

 
4,176

 
2.48

 
2.69

 
 
 
 
 
 
 
 
 
 
 
 
Deposits in other banks
42,926

 
52,702

 
373

 
234

 
1.75

 
0.90

 
 
 
 
 
 
 
 
 
 
 
 
Total interest-earning assets
1,703,287

 
1,592,395

 
33,969

 
31,011

 
3.99

 
3.90

 
 
 
 
 
 
 
 
 
 
 
 
Non-earning assets
118,878

 
125,915

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Total assets
$
1,822,165

 
$
1,718,310

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 

 
 

 
 

 
 

 
 

 
 

Demand
$
239,477

 
$
217,847

 
24

 
21

 
0.02

 
0.02

Money market
402,612

 
314,235

 
1,585

 
583

 
0.79

 
0.37

Savings
131,453

 
124,694

 
20

 
19

 
0.03

 
0.03

Time
377,838

 
377,766

 
2,069

 
1,929

 
1.10

 
1.03

Total deposits
1,151,380

 
1,034,542

 
3,698

 
2,552

 
0.65

 
0.50

 
 
 
 
 
 
 
 
 
 
 
 
Customer repurchase agreements
11,795

 
47,184

 
2

 
15

 
0.03

 
0.06

Other short-term borrowings
1,210

 
5,884

 
10

 
27

 
1.65

 
0.92

Long-term borrowings
27,848

 
37,733

 
619

 
644

 
4.45

 
3.41

Total interest-bearing
 

 
 

 
 

 
 

 
 

 
 

liabilities
1,192,233

 
1,125,343

 
4,329

 
3,238

 
0.73

 
0.58

 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing demand deposits
409,878

 
378,558

 
 

 
 

 
 

 
 

Other liabilities
9,202

 
9,283

 
 

 
 

 
 

 
 

Shareholders' equity
210,852

 
205,126

 
 

 
 

 
 

 
 

Total liabilities and
 

 
 

 
 

 
 

 
 

 
 

shareholders' equity
$
1,822,165

 
$
1,718,310

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
Interest rate spread
 

 
 

 
 

 
 

 
3.26
%
 
3.32
%
Net interest margin
 

 
 

 
 

 
 

 
3.48
%
 
3.49
%
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income (taxable equivalent basis)
 
 

 
29,640

 
27,773

 
 

 
 

Less: Taxable equivalent adjustment
 

 
 

 
309

 
727

 
 

 
 

Net interest income
 

 
 

 
$
29,331

 
$
27,046

 
 

 
 


44


Changes in Net Interest Income (Rate/Volume Analysis)
(in thousands)
 
Six Months Ended June 30,
 
2018 vs. 2017
 
 
 
Change
 
Increase
 
Attributable to
Interest income
(Decrease)
 
Rate
 
Volume
Loans:
 
 
 
 
 
Commercial
$
802

 
$
58

 
$
744

Real estate
2,151

 
680

 
1,471

Consumer
(28
)
 
4

 
(32
)
Total loans
2,925

 
742

 
2,183

Securities:
 

 
 

 
 

Federal agencies and GSEs
328

 
142

 
186

Mortgage-backed and CMOs
383

 
55

 
328

State and municipal
(803
)
 
(347
)
 
(456
)
Other securities
(14
)
 
23

 
(37
)
Total securities
(106
)
 
(127
)
 
21

Deposits in other banks
139

 
189

 
(50
)
Total interest income
2,958

 
804

 
2,154

 
 
 
 
 
 
Interest expense
 

 
 

 
 

Deposits:
 

 
 

 
 

Demand
3

 
1

 
2

Money market
1,002

 
801

 
201

Savings
1

 
—

 
1

Time
140

 
140

 
—

Total deposits
1,146

 
942

 
204

Customer repurchase agreements
(13
)
 
(5
)
 
(8
)
Other short-term borrowings
(17
)
 
13

 
(30
)
Long-term borrowings
(25
)
 
167

 
(192
)
Total interest expense
1,091

 
1,117

 
(26
)
Net interest income (taxable equivalent basis)
$
1,867

 
$
(313
)
 
$
2,180


45


Noninterest Income, three months ended June 30, 2018 and 2017
For the quarter ended June 30, 2018, noninterest income increased $215,000 or 6.4% compared to the comparable 2017 quarter. Details of individual accounts are shown in the table below.
 
Three Months Ended June 30,
 
(Dollars in thousands)
 
2018
 
2017
 
$ Change
 
% Change
Noninterest income:
 
 
 
 
 
 
 
Trust fees
$
945

 
$
908

 
$
37

 
4.1
 %
Service charges on deposit accounts
592

 
607

 
(15
)
 
(2.5
)
Other fees and commissions
679

 
627

 
52

 
8.3

Mortgage banking income
491

 
462

 
29

 
6.3

Securities gains, net
289

 
331

 
(42
)
 
(12.7
)
Brokerage fees
209

 
192

 
17

 
8.9

Income from SBICs
171

 
6

 
165

 
2,750.0

Other
187

 
215

 
(28
)
 
(13.0
)
Total noninterest income
$
3,563

 
$
3,348

 
$
215

 
6.4

Trust fees increased $37,000 and brokerage fees increased $17,000 in the second quarter of 2018 compared to the same quarter last year. Mortgage banking income increased $29,000 in the 2018 quarter compared to the 2017 quarter. Other fees and commissions were positively impacted by higher levels of debit card transaction volume. Net securities gains decreased $42,000 in the 2018 quarter compared to the same quarter in 2017. Gains in the 2018 quarter were almost entirely related to unrealized changes in the fair value of equity securities held by the Company, recorded in conformity with new accounting requirements. Income from Small Business Investment Companies ("SBICs") reflected a $165,000 increase compared to the 2017 quarter; this category of income is highly unpredictable.
Noninterest Income, six months ended June 30, 2018 and 2017
For the six months ended June 30, 2018, noninterest income increased $277,000 or 4.2% compared to the comparable 2017 period. Details of individual accounts are shown in the table below.
 
Six Months Ended June 30,
 
(Dollars in thousands)
 
2018
 
2017
 
$ Change
 
% Change
Noninterest income:
 
 
 
 
 
 
 
 Trust fees
$
1,874

 
$
1,820

 
$
54

 
3.0
 %
 Service charges on deposit accounts
1,204

 
1,196

 
8

 
0.7

 Other fees and commissions
1,321

 
1,234

 
87

 
7.1

 Mortgage banking income
941

 
991

 
(50
)
 
(5.0
)
 Securities gains, net
410

 
590

 
(180
)
 
(30.5
)
Brokerage fees
431

 
384

 
47

 
12.2

Income from SBICs
326

 
32

 
294

 
918.8

Other
389

 
372

 
17

 
4.6

Total noninterest income
$
6,896

 
$
6,619

 
$
277

 
4.2

Trust fees increased $54,000 and brokerage fees increased $47,000 in the second quarter of 2018 compared to the same period last year. Mortgage banking income decreased $50,000 in the 2018 period compared to the 2017 period. Other fees and commissions were positively impacted by higher levels of debit card transaction volume. Net securities gains decreased $180,000 in the 2018 period compared to the same period in 2017. Gains in the 2018 period were almost entirely related to unrealized changes in the fair value of equity securities held by the Company, recorded in conformity with new accounting requirements. Income from SBICs reflected a $294,000 increase compared to the 2017 period; this category of income is highly unpredictable.

46


Noninterest Expense, three months ended June 30, 2018 and 2017
For the three months ended June 30, 2018, noninterest expense increased $291,000 or 2.7%. Details of individual accounts are shown in the table below.
 
Three Months Ended June 30,
 
(Dollars in thousands)
 
2018
 
2017
 
$ Change
 
% Change
Noninterest Expense
 
 
 
 
 
 
 
 Salaries
$
5,095

 
$
4,733

 
$
362

 
7.6
 %
 Employee benefits
1,111

 
1,061

 
50

 
4.7

 Occupancy and equipment
1,100

 
1,148

 
(48
)
 
(4.2
)
 FDIC assessment
132

 
134

 
(2
)
 
(1.5
)
 Bank franchise tax
291

 
263

 
28

 
10.6

 Core deposit intangible amortization
77

 
203

 
(126
)
 
(62.1
)
 Data processing
467

 
502

 
(35
)
 
(7.0
)
 Software
354

 
271

 
83

 
30.6

 Other real estate owned, net
25

 
68

 
(43
)
 
(63.2
)
 Other
2,350

 
2,328

 
22

 
0.9

Total noninterest expense
$
11,002

 
$
10,711

 
$
291

 
2.7

Salaries expense increased $362,000 in the 2018 quarter as compared to the 2017 quarter primarily as a result of normal annual salary adjustments. Core deposit intangible amortization decreased $126,000 in the 2018 quarter compared to 2017 as the amortization expense relating to the Company's acquisition of MidCarolina Financial Corporation ("MidCarolina") in July 2011 was treated under the accelerated method and will be fully amortized in 2020.
Noninterest Expense, six months ended June 30, 2018 and 2017
For the six months ended June 30, 2018, noninterest expense increased $552,000 or 2.6%. Details of individual accounts are shown in the table below.
 
Six months ended June 30,
 
(Dollars in thousands)
 
2018
 
2017
 
$ Change
 
% Change
Noninterest Expense
 
 
 
 
 
 
 
 Salaries
$
10,092

 
$
9,532

 
$
560

 
5.9
 %
 Employee benefits
2,286

 
2,181

 
105

 
4.8

 Occupancy and equipment
2,228

 
2,216

 
12

 
0.5

 FDIC assessment
278

 
263

 
15

 
5.7

 Bank franchise tax
572

 
519

 
53

 
10.2

 Core deposit intangible amortization
154

 
368

 
(214
)
 
(58.2
)
 Data processing
889

 
989

 
(100
)
 
(10.1
)
 Software
659

 
550

 
109

 
19.8

Other real estate owned, net
55

 
111

 
(56
)
 
(50.5
)
 Other
4,491

 
4,423

 
68

 
1.5

Total noninterest expense
$
21,704

 
$
21,152

 
$
552

 
2.6

Salaries expense increased $560,000 in the 2018 period as compared to the 2017 period primarily as a result of normal annual salary adjustments. Core deposit intangible amortization decreased $214,000 in the 2018 period compared to 2017 as the amortization expense relating to the Company's acquisition of MidCarolina was treated under the accelerated method and will be fully amortized in 2020.

47


Non-GAAP Financial Measures
The efficiency ratio is calculated by dividing noninterest expense excluding gains or losses on the sale of OREO by net interest income including tax equivalent income on nontaxable loans and securities and noninterest income and excluding (1) gains or losses on securities and (2) gains or losses on sale of premises and equipment. The efficiency ratio for the 2018 quarter was 60.38% compared to 61.76% for the 2017 quarter. The Company expects gradual improvement in this ratio in coming quarters. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands):
 
Three Months Ended June 30,
 
2018
 
2017
Efficiency Ratio
 
 
 
Noninterest expense
$
11,002

 
$
10,711

Add loss/subtract gain on sale OREO
(3
)
 
(48
)
 
$
10,999

 
$
10,663

 
 
 
 
Net interest income
$
14,788

 
$
13,912

Tax equivalent adjustment
154

 
337

Noninterest income
3,563

 
3,348

Subtract gain on securities
(289
)
 
(331
)
 
$
18,216

 
$
17,266

 
 
 
 
Efficiency ratio
60.38
%
 
61.76
%
Net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit is 21% for the 2018 quarter and 35% for the 2017 quarter. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands):
 
Three Months Ended June 30,
 
2018
 
2017
Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
 
 
 
Non-GAAP measures:
 
 
 
Interest income - loans
$
14,816

 
$
13,832

Interest income - investments and other
2,330

 
2,108

Interest expense - deposits
(1,873
)
 
(1,352
)
Interest expense - customer repurchase agreements
(1
)
 
(14
)
Interest expense - other short-term borrowings
(1
)
 
—

Interest expense - long-term borrowings
(329
)
 
(325
)
Total net interest income
$
14,942

 
$
14,249

Less non-GAAP measures:
 
 
 
Tax benefit realized on non-taxable interest income - loans
$
(50
)
 
$
(79
)
Tax benefit realized on non-taxable interest income - municipal securities
(104
)
 
(258
)
GAAP measures
$
14,788

 
$
13,912


48


Income Taxes
The effective tax rate for the second quarter of 2018 was 18.96% compared to 30.97% for the second quarter of 2017. The effective tax rate for the six months ended June 30, 2018 and 2017 was 19.22% and 29.68%, respectively. The primary reason for the decrease in the effective rate is the Tax Cuts and Jobs Act that was adopted on December 22, 2017 which lowered the statutory rate from 35% to 21%. The effective tax rate is lower than the statutory rate each year as a result of income that is not taxable for federal income tax purposes in both years and the tax benefit from the exercise of stock options.
Fair Value Impact to Net Income
The following table presents the impact for the three and six month period ended June 30, 2018 of the accretable and amortizable fair value adjustments attributable to the July 2011 acquisition of MidCarolina and the January 2015 acquisition of MainStreet BankShares, Inc. ("MainStreet") on net interest income and pretax income (dollars in thousands):
 
 
 
June 30, 2018

Income Statement Effect
 
Accretion (Amortization) Three Months Ended
 
Accretion (Amortization) Six Months Ended
Interest income/(expense):
 
 
 
 
 
Acquired performing loans
Income
 
$
112

 
$
215

Purchase impaired loans
Income
 
291

 
640

Junior subordinated debt
Expense
 
(26
)
 
(51
)
Net interest income
 
 
377

 
804

 
 
 
 
 
 
Noninterest (expense):
 
 
 

 
 
Amortization of core deposit intangible
Expense
 
(77
)
 
(154
)
 
 
 
 
 
 
Change in pretax income
 
 
$
300

 
$
650

During the first quarter of 2018, the Company received $231,000 in cash basis accretion income related to the early payoff of several acquired loans, compared to $209,000 for the comparable quarter of 2017.
The following table presents the impact for the three and six month period ended June 30, 2017 of the accretable and amortizable fair value adjustments attributable to the two acquisitions mentioned above on net interest income and pretax income (dollars in thousands):
 
 
 
June 30, 2017

Income Statement Effect
 
Accretion (Amortization) Three Months Ended
 
Accretion (Amortization) Six Months Ended
Interest income/(expense):
 
 
 
 
 
Acquired performing loans
Income
 
$
247

 
$
442

Purchase impaired loans
Income
 
380

 
649

FHLB Advances
Expense
 
(6
)
 
(11
)
Junior subordinated debt
Expense
 
(26
)
 
(51
)
Net interest income
 
 
595

 
1,029

 
 
 
 
 
 
Noninterest (expense):
 
 
 

 
 
Amortization of core deposit intangible
Expense
 
(203
)
 
(368
)
 
 
 
 
 
 
Change in pretax income
 
 
$
392

 
$
661

 

49


The MidCarolina acquisition was effective July 1, 2011 and the MainStreet acquisition was effective January 1, 2015. Management expects that the acquisition accounting financial impact of these acquisitions will continue to decline in future quarters.
Impact of Inflation and Changing Prices
The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories.  The most significant effect of inflation is on noninterest expense, which tends to rise during periods of inflation.  Changes in interest rates have a greater impact on a financial institution's profitability than do the effects of higher costs for goods and services.  Through its balance sheet management practices, the Company has the ability to react to those changes and measure and monitor its interest rate and liquidity risk.  During the reported periods, inflation has been low, and interest rates have been rising.
CHANGES IN FINANCIAL POSITION
BALANCE SHEET ANALYSIS
Securities
The securities portfolio generates income, plays a major role in the management of interest rate sensitivity, provides a source of liquidity, and is used to meet collateral requirements. The securities portfolio consists primarily of high credit quality investments, mostly federal agency, mortgage-backed, and state and municipal securities.
The available for sale securities portfolio was $341,247,000 at June 30, 2018, compared to $321,337,000 at December 31, 2017, an increase of $19,910,000 or 6.20%. The increase is net of $2,206,000 of equity securities classified as available for sale prior to the adoption of ASU 2016-01 which were reclassified on January 1, 2018 to fair value on the balance sheet. Also, as a result, the Company reclassified $650,000 of the unrealized holding gains on these equity securities from accumulated other comprehensive loss to retained earnings. Accordingly, the Company recognized $402,000 in unrealized gains on these equity securities for the six months ended June 30, 2018. At June 30, 2018, the available for sale portfolio had an amortized cost of $348,266,000 resulting in a net unrealized loss of $7,019,000.  At December 31, 2017, the available for sale portfolio had an amortized cost of $322,345,000, resulting in a net unrealized loss of $1,008,000.
The Company is cognizant of the continuing historically low, but increasing interest rate environment and has elected to maintain a defensive asset liability strategy of purchasing high quality taxable securities of relatively short duration.
The Company experienced significant growth rates for earning assets and deposits in calendar year 2017. The magnitude and unpredictable timing of this growth has generated periodic liquidity constraints. Consequently, management elected to selectively reduce portions of its securities portfolio in an effort to mitigate actual and anticipated liquidity challenges. During the six months ended June 30, 2018, the Company sold $22,025,000 in par value bonds and realized a net gain of $8,000. This compares to the six months ended June 30, 2017, when the Company sold $53,930,000 in par value bonds and realized a net gain of $590,000. During the six months ended June 30, 2018, the Company sold $431,000 in equity securities at fair value.
The Company manages its investment portfolio on an aggregate portfolio basis for purposes of monitoring and controlling average life and duration. Accordingly, some individual purchases may fall outside these overall guidelines. The Company will continue to purchase high quality, relatively low optionality bonds to the maximum extent practical and prudent, consistent with its liquidity and asset liability strategies, and regulatory requirements.
Loans
The loan portfolio consists primarily of commercial and residential real estate loans, commercial loans to small and medium-sized businesses, construction and land development loans, and home equity loans.
Total loans were $1,339,379,000 at June 30, 2018, compared to $1,336,125,000 at December 31, 2017, an increase of $3,254,000 or 0.24%. The minimal increase is the result of several large payoffs of multi-family construction loans that moved into the permanent, non-recourse market in the first quarter of 2018. These payoffs were anticipated by management.
Average loans were $1,324,428,000 for the second quarter of 2018, compared to $1,260,772,000 for the second quarter of 2017, an increase of $63,656,000 or 5.05%.

50


Loans held for sale totaled $2,296,000 at June 30, 2018 and $1,639,000 at December 31, 2017. Loan production volume was $38,861,000 for the six month period ended June 30, 2018 and $39,030,000 for the same period of 2017. These loans were approximately 60% purchase and 40% refinancing.
Management of the loan portfolio is organized around portfolio segments. Each segment is comprised of various loan types that are reflective of operational and regulatory reporting requirements. The following table presents the Company's loan portfolio by segment as of June 30, 2018 and December 31, 2017 (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Commercial
$
291,454

 
$
251,666

Commercial real estate:
 

 
 

Construction and land development
96,740

 
123,147

Commercial real estate
633,128

 
637,701

Residential real estate:
 

 
 

Residential
207,374

 
209,326

Home equity
105,558

 
109,857

Consumer
5,125

 
4,428

Total loans
$
1,339,379

 
$
1,336,125

 
Provision for Loan Losses
The Company had a negative provision for loan losses of $74,000 for the six month period ended June 30, 2018, compared to a provision of $650,000 for the same period ended June 30, 2017. The negative provision related to favorable adjustments on the acquired impaired loan loss allowance. The need for any additional provision in the six month period ended June 30, 2018 was mitigated by slower growth in loans, continued strong asset quality metrics, and improvements in various qualitative factors used in computing loss reserve.
Allowance for Loan Losses
The purpose of the ALLL is to provide for probable losses inherent in the loan portfolio. The allowance is increased by the provision for loan losses and by recoveries of previously charged-off loans. Loan charge-offs decrease the allowance.
At June 30, 2018, the ALLL was $13,508,000 compared to $13,603,000 at December 31, 2017. The ALLL as a percentage of total loans at such dates was 1.01% and 1.02%, respectively. 
As part of the Company's methodology to evaluate the adequacy of its ALLL, the Company computes its ASC 450 loan balance by reducing total loans by acquired loans and loans that were evaluated for impairment individually or smaller balance nonaccrual loans evaluated for impairment in homogeneous pools. The FASB ASC 450 loan loss reserve balance is the total ALLL reduced by allowances associated with these other pools of loans.
The general allowance, ASC 450 (FAS 5) reserves to FASB ASC 450 loans, was 1.00% at June 30, 2018, compared to 1.04% at December 31, 2017. On a dollar basis, the reserve was $13,090,000 at June 30, 2018, compared to $13,151,000 at December 31, 2017. The percentage of the reserve to total loans has declined due to improving local and national economic conditions and continued strong asset quality metrics. This segment of the allowance represents by far the largest portion of the loan portfolio and the largest aggregate risk.
The specific allowance, ASC 310-40 (FAS 114) reserves to FASB ASC 310-40 loans, was 7.61% at June 30, 2018, compared to 5.18% at December 31, 2017. On a dollar basis, the reserve was $208,000 at June 30, 2018, compared to $167,000 at December 31, 2017. There is ongoing turnover in the composition of the impaired loan population, which decreased by a net $480,000 over December 31, 2017.

51


The specific allowance does not include reserves related to acquired loans with deteriorated credit quality. This reserve was $210,000 at June 30, 2018 compared to $285,000 at December 31, 2017. This is the only portion of the reserve related to acquired impaired loans. Cash flow expectations for these loans are reviewed on a quarterly basis and unfavorable changes in those estimates relative to the initial estimates can result in the need for additional loan loss provision. The following table presents the Company's loan loss and recovery experience for the periods indicated (dollars in thousands):
Summary of Loan Loss Experience
 
Six Months Ended June 30, 2018
 
Year Ended December 31, 2017
Balance at beginning of period
$
13,603

 
$
12,801

 
 
 
 
Charge-offs:
 

 
 

Construction and land development
—

 
35

Commercial real estate
11

 
58

Residential real estate
—

 
159

Home equity
86

 
13

Total real estate
97

 
265

Commercial and industrial
10

 
282

Consumer
67

 
143

Total charge-offs
174

 
690

 
 
 
 
Recoveries:
 

 
 

Construction and land development
—

 
43

Commercial real estate
3

 
17

Residential real estate
24

 
45

Home equity
12

 
40

Total real estate
39

 
145

Commercial and industrial
63

 
223

Consumer
51

 
108

Total recoveries
153

 
476

 
 
 
 
Net charge-offs
21

 
214

Provision for loan losses
(74
)
 
1,016

Balance at end of period
$
13,508

 
$
13,603


52


Asset Quality Indicators
The following table provides qualitative indicators relevant to the Company's loan portfolio for the six month period and year indicated below.
Asset Quality Ratios
 
June 30, 2018
 
December 31, 2017
Allowance to loans
1.01
%
 
1.02
%
ASC 450 (FAS 5) ALLL
1.00

 
1.04

Net charge-offs (recoveries) to allowance (1)
0.31

 
1.57

Net charge-offs (recoveries) to average loans (1)
0.00

 
0.02

Nonperforming assets to total assets
0.18

 
0.21

Nonperforming loans to loans
0.16

 
0.19

Provision to net charge-offs (recoveries) (1)
(352.38
)
 
474.77

Provision to average loans (1)
(0.01
)
 
0.08

Allowance to nonperforming loans
646.32

 
531.37

(1) - Annualized.
Nonperforming Assets (Loans and Other Real Estate Owned)
Nonperforming loans include loans on which interest is no longer accrued and accruing loans that are contractually past due 90 days or more. Nonperforming loans include loans originated and loans acquired.
Nonperforming loans to total loans were 0.16% at June 30, 2018 and 0.19% at December 31, 2017.
Nonperforming assets include nonperforming loans and OREO.  Nonperforming assets represented 0.18% and 0.21% of total assets at June 30, 2018 and December 31, 2017, respectively. 
In most cases, it is the policy of the Company that any loan that becomes 90 days past due will automatically be placed on nonaccrual loan status, accrued interest reversed out of income, and further interest accrual ceased. Any payments received on such loans will be credited to principal. In some cases a loan in process of renewal may become 90 days past due. In these instances the loan may still be accruing because of a delayed renewal process in which the customer has not been billed. In accounting for acquired impaired loans, such loans are not classified as nonaccrual when they become 90 days past due. They are considered to be accruing because their interest income relates to the accretable yield and not to contractual interest payments.
Loans will only be restored to full accrual status after six consecutive months of payments that were each less than 30 days delinquent. The Company strictly adheres with this policy before restoring a loan to normal accrual status.

53


The following table presents the Company's nonperforming assets as of June 30, 2018 and December 31, 2017 (dollars in thousands):
Nonperforming Assets
 
June 30, 2018
 
December 31, 2017
Nonaccrual loans:
 
 
 
Real estate
$
1,335

 
$
2,111

Commercial
526

 
90

Consumer
—

 
—

Total nonaccrual loans
1,861

 
2,201

 
 
 
 
Loans past due 90 days and accruing interest:
 

 
 

Real estate
229

 
359

Total past due 90 days and accruing interest
229

 
359

 
 
 
 
Total nonperforming loans
2,090

 
2,560

 
 
 
 
Other real estate owned
1,124

 
1,225

 
 
 
 
Total nonperforming assets
$
3,214

 
$
3,785

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. The following table shows loans that were considered impaired, exclusive of acquired impaired loans, as of June 30, 2018 and December 31, 2017 (dollars in thousands):
Impaired Loans
 
June 30, 2018
 
December 31, 2017
Accruing
$
876

 
$
1,016

Nonaccruing
1,861

 
2,201

Total impaired loans
$
2,737

 
$
3,217

Troubled Debt Restructurings ("TDRs")
TDRs exist whenever the Company makes a concession to a customer based on the customer's financial distress that would not have otherwise been made in the normal course of business.
There were $1,157,000 in TDRs at June 30, 2018 compared to $1,306,000 at December 31, 2017. These loans are included in the impaired loan table above.

54


Other Real Estate Owned
Other real estate owned was $1,124,000 and $1,225,000 as of June 30, 2018 and December 31, 2017, respectively. OREO is initially recorded at fair value, less estimated costs to sell, at the date of foreclosure. Loan losses resulting from foreclosure are charged against the ALLL at that time. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of the new cost basis or fair value, less estimated costs to sell with any additional write-downs charged against earnings.  For significant assets, these valuations are typically outside annual appraisals. The following table shows the Company's OREO as of June 30, 2018 and December 31, 2017 (dollars in thousands):
Other Real Estate Owned
 
June 30, 2018
 
December 31, 2017
Construction and land development
$
78

 
$
318

1-4 family residential
808

 
629

Commercial real estate
238

 
278

 
$
1,124

 
$
1,225

Deposits
The Company's deposits consist primarily of checking, money market, savings, and consumer and commercial time deposits.  Total deposits were $1,560,746,000 at June 30, 2018 compared to $1,534,726,000 at December 31, 2017, an increase of $26,020,000 or 1.70%. This growth is mostly in non-maturity, savings and money market accounts.
Average interest bearing deposits were $1,145,701,000 for the second quarter of 2018, compared to $1,047,828,000 for the second quarter of 2017, an increase of $97,873,000 or 9.34%. Noninterest bearing deposits for the 2018 quarter were $419,620,000, compared to $386,024,000 for the 2017 quarter, an increase of $33,596,000 or 8.70%.
The Company's primary focus on the liability side of the balance sheet is growing core deposits and their affiliated relationships. The increasing challenge in this rising rate environment is to fund the Bank in a cost effective and competitive manner. The Company's cost of deposits for the second quarter of 2018 was 0.66%, up from 0.52% for the second quarter of 2017.
Junior Subordinated Debt
The Company had three junior subordinated notes in the amounts of $20,619,000, $4,349,000, and $2,908,000 outstanding at June 30, 2018. These notes accrue at 1.35%, 3.45%, and 2.95%, respectively, above the 90-day LIBOR rate, adjusted quarterly. To add stability to net interest income and manage exposure to interest rate movement, the Company entered into three interest rate swaps in June 2018 on these notes. The swap contracts involve the payment of fixed-rate amounts to a counterparty in exchange for receipt of variable rate payments over the ten year life of the contracts. The effective interest rates on the swapped notes were 4.33%, 6.44%, and 5.93%, respectively at June 30, 2018.
Shareholders' Equity
The Company's capital management strategy is to be classified as "well capitalized" under regulatory capital ratios and provide as high as possible total return to shareholders.
Shareholders' equity was $213,348,000 at June 30, 2018 compared to $208,717,000 at December 31, 2017, an increase of $4,631,000 or 2.22%. 
The Company paid cash dividends of $0.50 per share during the first six months of 2018 while the aggregate basic and diluted earnings per share for the same period was $1.36.
In July 2013, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency issued final rules that make technical changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules maintain the general structure of the prompt corrective action framework in effect at such time while incorporating certain increased minimum requirements.  Effective January 1, 2015, the final rules require the Company and the Bank to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements, which will be phased-in over a four-year period. When fully phased-in on January 1, 2019, the rules will require the Company and the Bank to maintain such minimum ratios plus a 2.5% "capital conservation buffer" (other than for

55


the leverage ratio). The phase-in of the capital conservation buffer began on January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. Management believes the Company and the Bank will be compliant with the fully phased-in requirements when they become effective January 1, 2019.
The following table provides information on the regulatory capital ratios for the Company and the Bank at June 30, 2018 and December 31, 2017. Management believes, as of June 30, 2018, that the Company and the Bank more than satisfy all capital adequacy requirements to which they are subject.
 
Percentage
At June 30, 2018
 
Percentage
At December 31, 2017
Risk-Based Capital Ratios:
Company
 
Bank
 
Company
 
Bank
 
 
 
 
 
 
 
 
Common equity tier 1 capital ratio
12.18
%
 
13.37
%
 
11.50
%
 
12.79
%
Tier 1 capital ratio
14.11

 
13.37

 
13.42

 
12.79

Total capital ratio
15.06

 
14.32

 
14.39

 
13.75

 
 
 
 
 
 
 
 
Leverage Capital Ratio:
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
Tier 1 leverage ratio
11.41

 
10.80

 
10.95

 
10.43

Stock Repurchase Plan
On November 19, 2015, the Company filed a Form 8-K with the SEC to announce the approval by its Board of Directors of a stock repurchase program. The plan authorized the repurchase of up to 300,000 shares of the Company's common shares over a two year period. The share purchase limit was established at such number to equal to approximately 3.5% of the 8,622,000 shares then outstanding at the time the Board approved the program. The program expired on November 19, 2017.
On January 19, 2018, the Company filed a Form 8-K with the SEC to announce the approval by its Board of another stock repurchase program. The program authorizes the repurchase of up to 300,000 shares of the Company's common stock over a two year period.
In the six month periods ended June 30, 2018 and 2017, the Company did not repurchase any shares.
Liquidity
Liquidity is the ability of the Company to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities in a timely manner.  Liquidity management involves maintaining the Company's ability to meet the daily cash flow requirements of its customers, whether they are borrowers requiring funds or depositors desiring to withdraw funds.  Additionally, the Company requires cash for various operating needs including dividends to shareholders, the servicing of debt, and the payment of general corporate expenses.  The Company manages its exposure to fluctuations in interest rates through policies approved by the Asset Liability Committee ("ALCO") and Board of Directors, both of which receive periodic reports of the Company's interest rate risk and liquidity position.  The Company uses a computer simulation model to assist in the management of the future liquidity needs of the Company. 
Liquidity sources include on balance sheet and off balance sheet sources.
Balance sheet liquidity sources include cash, amounts due from banks, loan repayments, and increases in deposits. The Company also maintains a large, high quality, very liquid bond portfolio, which is generally 50% to 60% unpledged and would, accordingly, be available for sale if necessary.     
Off balance sheet sources include lines of credit from the Federal Home Loan Bank of Atlanta ("FHLB"), federal funds lines of credit, and access to the Federal Reserve Bank of Richmond's discount window. 
The Company has a line of credit with the FHLB, equal to 30% of the Bank's assets, subject to the amount of collateral pledged.  Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans, second mortgage loans, home equity lines of credit, and commercial real estate loans.  In addition, the Company pledges as collateral its capital stock in and deposits with the FHLB.  The Company had $190,250,000 outstanding in letters of credit at June 30, 2018 and $190,700,000 outstanding at December 31, 2017. The letters of credit provide the Bank with alternate collateral for securing public entity deposits above FDIC insurance levels, thereby providing less need for collateral pledging from the securities portfolio, and thereby maximizing on balance sheet liquidity.

56


Short-term borrowings are discussed in Note 6 and long-term borrowings are discussed in Note 7 in the Consolidated Financial Statements included in this report.
The Company has federal funds lines of credit established with two correspondent banks in the amounts of $15,000,000 each, and has access to the Federal Reserve Bank's discount window. 
The Company has a relationship with Promontory Network, the sponsoring entity for the Certificate of Deposit Account Registry Service® ("CDARS"). Through CDARS, the Company is able to provide deposit customers with access to aggregate FDIC insurance in amounts exceeding $250,000.  This gives the Company the ability, as and when needed, to attract and retain large deposits from insurance conscious customers.  Under the Economic Growth, Regulatory Relief, and Consumer Protection Act signed into law on May 24, 2018, a well-capitalized bank with a CAMELS rating of 1 or 2 may hold reciprocal deposits up to the lesser of 20 percent of its total liabilities or $5 billion without those deposits being treated as brokered deposits. With CDARS, the Company has the option to keep deposits on balance sheet or sell them to other members of the network.  Additionally, subject to certain limits, the Bank can use CDARS to purchase cost-effective funding without collateralization and in lieu of generating funds through traditional brokered CDs or the FHLB.  In this manner, CDARS can provide the Company with another funding option. Thus, CDARS serves as a deposit-gathering tool and an additional liquidity management tool.  Deposits through the CDARS program as of June 30, 2018 and December 31, 2017, were $16,225,000 and $25,838,000, respectively.
Management believes that these sources provide sufficient and timely liquidity, both on and off the balance sheet.
Off-Balance Sheet Activities
The Company enters into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions.  Other than subsidiaries to issue trust preferred securities, the Company does not have any off-balance sheet subsidiaries.  Off-balance sheet transactions at June 30, 2018 and at December 31, 2017 were as follows (dollars in thousands):
 
June 30, 2018
 
December 31, 2017
Commitments to extend credit
$
349,671

 
$
341,760

Standby letters of credit
11,606

 
13,647

Mortgage loan rate-lock commitments
11,538

 
5,089

Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates or other termination clauses.  Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future funding requirements.  Standby letters of credit are conditional commitments issued by the Company guaranteeing the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.
ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk Management
Effectively managing market risk is essential to achieving the Company's financial objectives.  Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices.  The Company is generally not subject to currency exchange risk or commodity price risk.  The Company's primary market risk exposure is interest rate risk; however, market risk also includes liquidity risk.  Both are discussed in the following sections.
Interest Rate Risk Management
Interest rate risk and its impact on net interest income is a primary market risk exposure.  The Company manages its exposure to fluctuations in interest rates through policies approved by the ALCO and Board of Directors, both of which receive and review periodic reports of the Company's interest rate risk position.
The Company uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates.  Simulation takes into account current balance sheet volumes and the scheduled repricing dates instrument level optionality, and maturities of assets and liabilities.  It incorporates numerous assumptions including 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.

57


A balance sheet is considered asset sensitive when its earning assets (loans and securities) reprice faster or to a greater extent than its liabilities (deposits and borrowings).  An asset sensitive balance sheet will produce relatively more net interest income when interest rates rise and less net interest income when they decline.  Based on the Company's simulation analysis, management believes the Company's interest sensitivity position at June 30, 2018 is asset sensitive. Management expects that the general direction of market interest rates will be gradually up over the remainder of 2018.
Earnings Simulation
The following table shows the estimated impact of changes in interest rates on net interest income as of June 30, 2018 (dollars in thousands), assuming gradual and parallel changes in interest rates, and consistent levels of assets and liabilities.   Net interest income for the following twelve months is projected to increase when interest rates are higher than current rates.
Estimated Changes in Net Interest Income
 
June 30, 2018
 
Change in Net Interest Income
Change in interest rates
Amount
 
Percent
Up 4.00%
$
7,131

 
12.1
 %
Up 3.00%
5,501

 
9.3

Up 2.00%
3,893

 
6.6

Up 1.00%
2,079

 
3.5

Flat
—

 
—

Down 0.25%
(532
)
 
(0.9
)
Down 1.00%
(3,491
)
 
(5.9
)
Management cannot predict future interest rates or their exact effect on net interest income.  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.  Certain limitations are inherent in such computations.  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 the Company'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.
Economic Value Simulation
Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.
The following table reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the quarterly period ended June 30, 2018 (dollars in thousands):
Estimated Changes in Economic Value of Equity
 
June 30, 2018
Change in interest rates
Amount
 
$ Change
 
% Change
Up 4.00%
$
369,339

 
$
77,653

 
26.6
 %
Up 3.00%
357,206

 
65,520

 
22.5

Up 2.00%
341,395

 
49,709

 
17.0

Up 1.00%
319,952

 
28,266

 
9.7

Flat
291,686

 
—

 
—

Down 0.25%
282,538

 
(9,148
)
 
(3.1
)
Down 1.00%
249,343

 
(42,343
)
 
(14.5
)

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Due to the current low interest rate environment, no measurement was considered necessary for a further decline in interest rates. There have been no material changes to market risk as disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2017.  Refer to those disclosures for further information.
ITEM 4.  CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
The Company's management, including the Chief Executive Officer and Chief Financial Officer, evaluated the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of June 30, 2018.  Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms.  There were no significant changes in the Company's internal controls over financial reporting that occurred during the quarter ended June 30, 2018, that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting.

59


PART II. OTHER INFORMATION
ITEM 1.  LEGAL PROCEEDINGS
The nature of the business of the Company ordinarily results in a certain amount of litigation. The Company is involved in various legal proceedings, all of which are considered incidental to the normal conduct of business. Management believes that these proceedings will not have a material adverse effect on the consolidated financial position or consolidated results of operations of the Company.
ITEM 1A.  RISK FACTORS
There have been no material changes to the risk factors disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 9, 2018.
ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
On January 16, 2018, the Company's Board of Directors authorized a share repurchase program of up to 300,000 shares of the Company's outstanding common stock for a period of two years.  Repurchases may be made through open market purchases or in privately negotiated transactions, and shares repurchased will be returned to the status of authorized and unissued shares of common stock.  The actual timing, number, and value of shares repurchased under the program will be determined by management.
No shares of the Company's common stock were repurchased during the three months ended June 30, 2018. Under the share repurchase program, the Company has the remaining authority to repurchase up to 300,000 shares of the Company's common stock as of June 30, 2018.
 
 
ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4.  MINE SAFETY DISCLOSURES
Not applicable
ITEM 5.  OTHER INFORMATION
(a)  Required 8-K disclosures
None
(b)  Changes in Nominating Process
None

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ITEM 6.  EXHIBITS
11.0        Refer to EPS calculation in the Notes to Financial Statements
31.1        Section 302 Certification of Jeffrey V. Haley, President and Chief Executive Officer
31.2        Section 302 Certification of William W. Traynham, Executive Vice President and Chief Financial Officer
32.1        Section 906 Certification of Jeffrey V. Haley, President and Chief Executive Officer
32.2        Section 906 Certification of William W. Traynham, Executive Vice President and Chief Financial Officer
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Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of June 30, 2018 and December 31, 2017, (ii) the Consolidated Statements of Income for the three and six months ended June 30, 2018 and June 30, 2017, (iii) the Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2018 and June 30, 2017, (iv) the Consolidated Statements of Changes in Shareholders' Equity for the six months ended June 30, 2018 and June 30, 2017, (v) the Consolidated Statements of Cash Flows for the six months ended June 30, 2018 and June 30, 2017, and (vi) the Notes to the Consolidated Financial Statements (furnished herewith).

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

AMERICAN NATIONAL BANKSHARES INC.
 
 
 
 
 
 
 
 
 
 
 
 
 
By:
/s/ Jeffrey V. Haley
 
 
 
Jeffrey V. Haley
 
 
 
President and Chief Executive Officer
 
Date - August 3, 2018
 
(principal executive officer)
 
 
 
 
 
 
By:
/s/ William W. Traynham
 
 
 
William W. Traynham
 
 
 
Executive Vice President and
 
 
 
Chief Financial Officer
 
Date - August 3, 2018
 
(principal financial officer)
 
 
 
 
 
 
By:
/s/ Cathy W. Liles
 
 
 
Cathy W. Liles
 
 
 
Senior Vice President and
 
 
 
Chief Accounting Officer
 
Date - August 3, 2018
 
(principal accounting officer)
 

62