Edgar Filing: SURREY BANCORP

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Form 10-Q

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, 2012

¨	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from to

COMMISSION FILE NO. 000-50313

SURREY BANCORP

(Exact name of registrant as specified in its charter)

North Carolina

59-3772016

(State or other jurisdiction of

incorporation or organization)

(IRS Employer

Identification No.)

145 North Renfro Street, Mount Airy, NC 27030

(Address of principal executive offices)

(336) 783-3900

(Registrant’s telephone number)

Check whether the registrant: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practical date:

On August 10, 2012 there were 3,542,984 common shares issued and outstanding.


PART I – FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements

	Consolidated Balance Sheets June 30, 2012 (Unaudited) and December 31, 2011	3

	Consolidated Statements of Income, Six Months Ended June 30, 2012 and 2011 (Unaudited)	4

	Consolidated Statements of Income, Three Months Ended June 30, 2012 and 2011 (Unaudited)	5

	Consolidated Statements of Comprehensive Income, Six Months Ended June 30, 2012 and 2011 (Unaudited)	6

	Consolidated Statements of Cash Flows, Six Months Ended June 30, 2012 and 2011 (Unaudited)	7

	Consolidated Statements of Changes in Stockholders’ Equity Six Months Ended June 30, 2012 and 2011 (Unaudited)	8

	Notes to Consolidated Financial Statements	9-23

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24-31

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	32

Item 4.	Controls and Procedures	33

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	34

Item 1A.	Risk Factors	34

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	34

Item 3.	Defaults Upon Senior Securities	34

Item 4.	Mine Safety Disclosures	34

Item 5.	Other Information	34

Item 6.	Exhibits	34

SIGNATURES		35

CERTIFICATIONS		36-38

Consolidated Balance Sheets

June 30, 2012 (Unaudited) and December 31, 2011 (Audited)


	June 2012			December 2011
Assets
Cash and due from banks	$	8,180,734		$	2,269,116
Interest-bearing deposits with banks		18,512,558			30,757,636
Federal funds sold		709,203			709,836
Investment securities available for sale		2,995,711			2,506,426
Restricted equity securities		766,904			809,754
Loans, net of allowance for loan losses of $3,802,204 at June 30, 2012 and $3,880,581 at December 31, 2011		175,177,109			175,446,206
Property and equipment, net		4,578,128			4,569,301
Foreclosed assets		251,046			560,018
Accrued income		958,873			962,614
Goodwill		120,000			120,000
Bank owned life insurance		5,213,610			3,389,447
Other assets		2,700,815			2,627,410

Total assets	$	220,164,691		$	224,727,764

Liabilities and Stockholders’ Equity
*Liabilities*
Deposits:
Noninterest-bearing	$	37,195,963		$	30,750,902
Interest-bearing		141,444,417			153,187,474

Total deposits		178,640,380			183,938,376
Long-term debt		7,750,000			8,100,000
Dividends payable		45,605			576,741
Accrued interest payable		191,559			185,362
Other liabilities		2,333,064			1,700,723

Total liabilities		188,960,608			194,501,202

Commitments and contingencies
*Stockholders’ equity*
Preferred stock, 1,000,000 shares authorized, 189,356 shares of Series A, issued and outstanding with no par value, 4.5% convertible non-cumulative, perpetual, with a liquidation value of $14 per share;		2,620,325			2,620,325
181,154 shares of Series D, issued and outstanding with no par value 5.0% convertible non-cumulative, perpetual; with a liquidation value of $7.08 per share;		1,248,482			1,248,482
Common stock, 10,000,000 shares authorized at no par value; 3,542,984 and 3,536,724 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively		12,051,203			12,009,588
Retained earnings		15,345,895			14,405,467
Accumulated other comprehensive loss		(61,822	)		(57,300	)

Total stockholders’ equity		31,204,083			30,226,562

Total liabilities and stockholders’ equity	$	220,164,691		$	224,727,764

See Notes to Consolidated Financial Statements

Consolidated Statements of Income

Six months ended June 30, 2012 and 2011 (Unaudited)


	2012			2011
*Interest income*
Loans and fees on loans	$	5,435,450		$	5,376,596
Federal funds sold		779			795
Investment securities, taxable		26,418			26,358
Deposits with banks		23,806			8,004

Total interest income		5,486,453			5,411,753

*Interest expense*
Deposits		719,681			933,423
Fed funds purchased		150			—
Long-term debt		151,854			182,900

Total interest expense		871,685			1,116,323

Net interest income		4,614,768			4,295,430
*Provision for loan losses*		738,988			(120,928	)

Net interest income after provision for loan losses		3,875,780			4,416,358

*Noninterest income*
Service charges on deposit accounts		461,730			508,885
Fees and yield spread premiums on loans delivered to correspondents		70,234			53,618
Other service charges and fees		276,704			247,027
Other operating income		423,420			359,979

Total noninterest income		1,232,088			1,169,509

*Noninterest expense*
Salaries and employee benefits		1,788,521			1,761,997
Occupancy expense		225,213			197,180
Equipment expense		117,612			120,497
Data processing		182,419			185,588
Foreclosed assets, net		32,294			140,332
Postage, printing and supplies		97,233			102,754
Professional fees		206,673			190,460
FDIC insurance premiums		84,505			139,577
Other expense		742,382			694,440

Total noninterest expense		3,476,852			3,532,825

Net income before income taxes		1,631,016			2,053,042
Income tax expense		599,378			789,674

Net income		1,031,638			1,263,368
*Preferred stock dividends*		(91,210	)		(90,957	)

Net income available to common stockholders	$	940,428		$	1,172,411

*Basic earnings per common share*	$	0.27		$	0.33

*Diluted earnings per common share*	$	0.25		$	0.30

*Basic weighted average common shares outstanding*		3,538,822			3,530,932

*Diluted weighted average common shares outstanding*		4,172,757			4,164,867

See Notes to Consolidated Financial Statements

Consolidated Statements of Income

Three months ended June 30, 2012 and 2011 (Unaudited)


	2012			2011
*Interest income*
Loans and fees on loans	$	2,690,474		$	2,652,444
Federal funds sold		387			458
Investment securities, taxable		12,215			13,944
Deposits with banks		13,359			2,673

Total interest income		2,716,435			2,669,519

*Interest expense*
Deposits		346,669			459,353
Fed funds purchased		150			—
Long-term debt		75,448			91,364

Total interest expense		422,267			550,717

Net interest income		2,294,168			2,118,802
*Provision for loan losses*		671,770			(279,825	)

Net interest income after provision for loan losses		1,622,398			2,398,627

*Noninterest income*
Service charges on deposit accounts		225,788			260,994
Fees and yield spread premiums on loans delivered to correspondents		29,413			26,442
Other service charges and fees		144,798			128,068
Other operating income		172,252			160,527

Total noninterest income		572,251			576,031

*Noninterest expense*
Salaries and employee benefits		861,138			883,412
Occupancy expense		107,051			101,720
Equipment expense		54,399			61,634
Data processing		90,004			98,757
Foreclosed assets, net		(936	)		120,908
Postage, printing and supplies		56,041			60,251
Professional fees		74,628			67,253
FDIC insurance premiums		35,650			56,287
Other expense		345,233			352,231

Total noninterest expense		1,623,208			1,802,453

Net income before income taxes		571,441			1,172,205
Income tax expense		203,860			461,028

Net income		367,581			711,177
*Preferred stock dividends*		(45,605	)		(45,729	)

Net income available to common stockholders	$	321,976		$	665,448

*Basic earnings per common share*	$	0.09		$	0.19

*Diluted earnings per common share*	$	0.09		$	0.17

*Basic weighted average common shares outstanding*		3,540,920			3,532,855

*Diluted weighted average common shares outstanding*		4,174,855			4,166,790

See Notes to Consolidated Financial Statements

Consolidated Statements of Comprehensive Income

Six months ended June 30, 2012 and 2011 (Unaudited)


	2012			2011
Net income	$	1,031,638		$	1,263,368

Other comprehensive income:
Unrealized gains (losses) arising during the period		(7,360	)		7,476
Tax (expense) benefits related to unrealized gains (losses)		2,838			(2,882	)

Total other comprehensive income (loss)		(4,522	)		4,594

Total comprehensive income	$	1,027,116		$	1,267,962

See Notes to Consolidated Financial Statements

Consolidated Statements of Cash Flows

Six months ended June 30, 2012 and 2011 (Unaudited)


	2012			2011
*Cash flows from operating activities*
Net income	$	1,031,638		$	1,263,368
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization		115,562			120,055
Gain on sale of property and equipment		(650	)		(670	)
(Gain)/Loss on the sale of foreclosed assets		(63,705	)		50,254
Stock-based compensation, net of tax benefit		11,504			11,213
Provision for loan losses		738,988			(120,928	)
Deferred income taxes		3,895			(1,156	)
Accretion of discount on securities, net of amortization of premiums		395			870
Increase in cash surrender value of life insurance		(74,163	)		(52,535	)
Changes in assets and liabilities:
Accrued income		3,741			29,660
Other assets		(74,462	)		410,231
Accrued interest payable		6,197			19,130
Other liabilities		632,341			221,198

Net cash provided by operating activities		2,331,281			1,950,690

*Cash flows from investing activities*
Net (increase) decrease in interest-bearing deposits with banks		12,245,078			(14,463,715	)
Net increase (decrease) in federal funds sold		633			(3,332	)
Purchases of investment securities		(2,000,000	)		(1,502,500	)
Sales and maturities of investment securities		1,502,960			1,004,648
Purchase of Bank Owned Life Insurance		(1,750,000	)		—
Redemption of restricted equity securities		45,000			49,100
Purchase of restricted equity securities		(2,150	)		(25	)
Net increase in loans		(617,530	)		(315,466	)
Proceeds from the sale of foreclosed assets		520,316			438,673
Purchases of property and equipment		(124,389	)		(88,088	)
Proceeds from the sale of property and equipment		650			670

Net cash provided by (used in) investing activities		9,820,568			(14,880,035	)

*Cash flows from financing activities*
Net increase (decrease) in deposits		(5,297,996	)		13,590,925
Maturity of long-term debt		(350,000	)		(350,000	)
Dividends paid		(622,346	)		(80,742	)
Common stock options exercised		30,111			12,313

Net cash provided by (used in) financing activities		(6,240,231	)		13,172,496

Net increase in cash and cash equivalents		5,911,618			243,151
*Cash and due from banks, beginning*		2,269,116			2,398,433

*Cash and due from banks, ending*	$	8,180,734		$	2,641,584

*Supplemental disclosures of cash flow information*
Interest paid	$	865,488		$	1,097,193

Taxes paid	$	255,000		$	424,019

Loans transferred to foreclosed properties	$	147,639		$	225,125

See Notes to Consolidated Financial Statements

Consolidated Statements of Changes in Stockholders’ Equity

Six months ended June 30, 2012 and 2011 (Unaudited)


										Accumulated
	Preferred									Other
	Stock		Common Stock				Retained			Comprehensive
	Amount		Shares		Amount		Earnings			Loss			Total
*Balance, January 1, 2011*	$	3,868,807		3,206,495	$	9,464,178	$	15,380,083		$	(68,913	)	$	28,644,155
Net income		—		—		—		1,263,368			—			1,263,368
Net change in unrealized gain (loss) on investment securities available for sale, net of income tax of $2,882		—		—		—		—			4,594			4,594
Common stock options exercised		—		6,735		12,313		—			—			12,313
Stock-based compensation, net of tax benefit		—		—		11,213		—			—			11,213
Dividends declared and accrued on convertible Series A preferred stock ($.31 per share)		—		—		—		(59,157	)		—			(59,157	)
Dividends declared and accrued on convertible Series D preferred stock ($.18 per share)		—		—		—		(31,800	)		—			(31,800	)

*Balance, June 30, 2011*	$	3,868,807		3,213,230	$	9,487,704	$	16,552,494		$	(64,319	)	$	29,844,686

*Balance, January 1, 2012*	$	3,868,807		3,536,724	$	12,009,588	$	14,405,467		$	(57,300	)	$	30,226,562
Net income		—		—		—		1,031,638			—			1,031,638
Net change in unrealized gain (loss) on investment securities available for sale, net of income tax of $2,838		—		—		—		—			(4,522	)		(4,522	)
Common stock options exercised		—		6,260		30,111		—			—			30,111
Stock-based compensation, net of tax benefit		—		—		11,504		—			—			11,504
Dividends declared and accrued on convertible Series A preferred stock ($.31 per share)		—		—		—		(59,322	)		—			(59,322	)
Dividends declared and accrued on convertible Series D preferred stock ($.18 per share)		—		—		—		(31,888	)		—			(31,888	)

*Balance, June 30, 2012*	$	3,868,807		3,542,984	$	12,051,203	$	15,345,895		$	(61,822	)	$	31,204,083

See Notes to Consolidated Financial Statements

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures required by generally accepted accounting principles for a complete presentation of financial statements. In the opinion of management, the consolidated financial statements contain all adjustments necessary to present fairly the financial condition of Surrey Bancorp, (the “Company), as of June 30, 2012, the results of operations for the six and three months ended June 30, 2012 and 2011, and its changes in stockholders’ equity, comprehensive income and cash flows for the six months ended June 30, 2012 and 2011. The results of operations for the six months ended June 30, 2012, are not necessarily indicative of the results expected for the full year. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and related disclosures for the year ended December 31, 2011, included in the Company’s Form 10-K. The balance sheet at December 31, 2011, has been taken from the audited financial statements at that date.

Organization

Surrey Bancorp began operation on May 1, 2003 and was created for the purpose of acquiring all the outstanding shares of common stock of Surrey Bank & Trust. Stockholders of the bank received six shares of Surrey Bancorp common stock for every five shares of Surrey Bank & Trust common stock owned. The Company is subject to regulation by the Federal Reserve.

Surrey Bank & Trust (the “Bank”) was organized and incorporated under the laws of the State of North Carolina on July 15, 1996 and commenced operations on July 22, 1996. The Bank currently serves Surry County, North Carolina and Patrick County, Virginia and surrounding areas through five banking offices. As a state chartered bank, which is not a member of the Federal Reserve, the Bank is subject to regulation by the State of North Carolina Banking Commission and the Federal Deposit Insurance Corporation.

Surrey Investment Services, Inc., (“Subsidiary”) was organized and incorporated under the laws of the State of North Carolina on February 10, 1998. The subsidiary provides insurance services through SB&T Insurance and investment advice and brokerage services through LPL Financial.

On July 31, 2000, Surrey Bank & Trust formed Freedom Finance, LLC, a subsidiary operation specializing in the purchase of sales finance contracts from local automobile dealers.

The accounting and reporting policies of the Company, the Bank, and its subsidiaries follow generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.

Critical Accounting Policies

The notes to the audited consolidated financial statements for the year ended December 31, 2011 contain a summary of the significant accounting policies. The Company believes our policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments, including the recoverability of intangible assets involve a higher degree of complexity and require management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could cause reported results to differ materially. These critical policies and their application are periodically reviewed with the Audit Committee and our Board of Directors. See our Annual Report for full details on critical accounting policies.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company, the Bank and the subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. BASIS OF PRESENTATION, CONTINUED

Presentation of Cash Flows

For purposes of reporting cash flows, cash and cash equivalents includes cash and amounts due from depository institutions (including cash items in process of collection). Overnight interest bearing deposits and federal funds sold are shown separately. Federal funds purchased are shown with securities sold under agreements to repurchase.

Investment Securities

Investments classified as available for sale are intended to be held for indefinite periods of time and include those securities that management may employ as part of asset/liability strategy or that may be sold in response to changes in interest rates, prepayments, regulatory capital requirements or similar factors. These securities are carried at fair value and are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments or significant other observable inputs.

Investment securities classified as held to maturity are those debt securities that the Bank has the ability and intent to hold to maturity. Accordingly, these securities are carried at cost adjusted for amortization of premiums and accretion of discount, computed by the interest-method over their contractual lives. At June 30, 2012 and December 31, 2011, the Bank had no investments classified as held to maturity.

Loans Held for Sale

The Bank originates and holds Small Business Administration (SBA) and United States Department of Agriculture (USDA) guaranteed loans in its portfolio in the normal course of business. Occasionally, the Bank sells the guaranteed portions of these loans into the secondary market. The loans are generally variable rate loans, which eliminates the market risk to the Bank and are therefore carried at cost. The Bank recognizes gains on the sale of the guaranteed portion upon the consummation of the transaction. The Bank plans to continue to originate guaranteed loans for sales, however no such loans were funded at June 30, 2012 and December 31, 2011.

Loans Receivable

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding principal amount adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or cost on originated loans and unamortized premiums or discounts on purchased loans.

Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan using the interest method. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method.

Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When the interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. Payments received on nonaccrual loans are first applied to principal and any residual amounts are then applied to interest. When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status. Past due loans are determined on the basis of contractual terms.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. BASIS OF PRESENTATION, CONTINUED

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

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

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In September 2011, the Intangibles topic was amended to permit an entity to consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. These amendments were effective for the Company on January 1, 2012.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments were effective for the Company on January 1, 2012 and had no effect on the financial statements.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. BASIS OF PRESENTATION, CONTINUED

Recent Accounting Pronouncements, continued

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments were effective for the Company beginning January 1, 2012 and have been included in Note 8.

The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and requires consecutive presentation of the statement of net income and other comprehensive income. The amendments were applicable to the Company on January 1, 2012 and have been applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements. Companies should continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect prior to the amendments while FASB redeliberates future requirements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements. Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management has reviewed events occurring through the date the financial statements were issued and no subsequent events have occurred requiring accrual or disclosure.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. SECURITIES

Debt and equity securities have been classified in the balance sheets according to management’s intent. The amortized costs of securities available for sale and their approximate fair values at June 30, 2012 and December 31, 2011 follow:


	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
June 30, 2012
Government-sponsored enterprises	$	2,500,000	$	1,045	$	(1,435	)	$	2,499,610
Mortgage-backed securities		46,317		1,534		—			47,851
Corporate bonds		550,000		—		(101,750	)		448,250

	$	3,096,317	$	2,579	$	(103,185	)	$	2,995,711

December 31, 2011
Government-sponsored enterprises	$	2,000,374	$	4,311	$	—		$	2,004,685
Mortgage-backed securities		49,298		1,443		—			50,741
Corporate bonds		550,000		—		99,000			451,000

	$	2,599,672	$	5,754	$	99,000		$	2,506,426

At June 30, 2012 and December 31, 2011, substantially all government-sponsored enterprises securities were pledged as collateral on public deposits and for other purposes as required or permitted by law. The mortgage-backed securities were pledged to the Federal Home Loan Bank.

Maturities of mortgage-backed bonds are stated based on contractual maturities. Actual maturities of these bonds may vary as the underlying mortgages are prepaid. The scheduled maturities of securities (all available for sale) at June 30, 2012, were as follows:


	Amortized Cost		Fair Value
Due in one year or less	$	—	$	—
Due after one year through five years		2,500,000		2,499,610
Due after five years through ten years		582,812		482,145
Due after ten years		13,505		13,956

	$	3,096,317	$	2,995,711

The following table shows investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at June 30, 2012 and December 31, 2011. These unrealized losses on investment securities are a result of volatility in interest rates and primarily relate to corporate bonds issued by other banks at June 30, 2012 and December 31, 2011.


	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
June 30, 2012
Government-sponsored enterprises	$	1,498,565	$	1,435	$	—	$	—	$	1,498,565	$	1,435
Corporate bonds		—		—		448,250		101,750		448,250		101,750

	$	1,498,565	$	1,435	$	448,250	$	101,750	$	1,946,815	$	103,185

December 31, 2011
Corporate bonds	$	—	$	—	$	451,000	$	99,000	$	451,000	$	99,000

	$	—	$	—	$	451,000	$	99,000	$	451,000	$	99,000

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2. SECURITIES, CONTINUED

Management considers the nature of the investment, the underlying causes of the decline in the market value and the severity and duration of the decline in market value in determining if impairment is other than temporary. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Based upon this evaluation, there are two securities in the portfolio with unrealized losses for a period greater than 12 months. We have analyzed each individual security for Other Than Temporary Impairment (“OTTI”) purposes by reviewing delinquencies, loan-to-value ratios, and credit quality and concluded that all unrealized losses presented in the tables above are not related to an issuer’s financial condition but are due to changes in the level of interest rates and no declines are deemed to be other than temporary in nature.

The Company had no gross realized gains or losses from the sales of investment securities for the six and three month periods ended June 30, 2012 and 2011.

NOTE 3. EARNINGS PER SHARE

Basic earnings per share for the six and three months ended June 30, 2012 and 2011 were calculated by dividing net income available to common stockholders by the weighted average number of shares outstanding during the period.

The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. The potential dilutive shares are represented by common stock options and by the Series A and D convertible preferred stock. Each share of the Series A preferred is convertible into 2.2955 shares of common stock. Each share of Series D preferred is convertible into 1.10 shares of common stock.

NOTE 4. COMMITMENTS AND LETTERS OF CREDIT

At June 30, 2012, the Company had commitments to extend credit, including unused lines of credit of approximately $38,676,000. Letters of credit totaling $1,232,886 were outstanding.

NOTE 5. LOANS

The major components of loans in the balance sheets at June 30, 2012 and December 31, 2011 are below.


	2012			2011
Commercial	$	79,246,988		$	73,756,422
Real estate:
Construction and land development		5,876,857			6,213,443
Residential, 1-4 families		36,568,561			39,499,189
Residential, 5 or more families		1,985,429			2,214,365
Farmland		2,439,577			2,722,872
Nonfarm, nonresidential		45,463,526			47,867,333
Agricultural		25,714			29,493
Consumer, net of discounts of $21,443 in 2012 and $21,742 in 2011		7,351,882			7,041,846

		178,958,534			179,344,963
Deferred loan origination costs, net of (fees)		20,779			(18,176	)

		178,979,313			179,326,787
Allowance for loan losses		(3,802,204	)		(3,880,581	)

	$	175,177,109		$	175,446,206

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5. LOANS, CONTINUED

Residential, 1-4 family loans pledged as collateral against FHLB advances approximated $18,272,000 and $19,112,000 at June 30, 2012 and December 31, 2011, respectively.

NOTE 6. ALLOWANCE FOR LOAN LOSSES

The activity of the allowance for loan losses by loan components during the six months ending June 30, 2012 and 2011 was as follows:


	Construction & Development			1-4 Family Residential			Nonfarm, Nonresidential			Commercial & Industrial			Consumer			Other			Total
June 30, 2012
*Allowance for credit losses:*
Beginning balance	$	103,200		$	836,860		$	865,854		$	1,808,260		$	210,807		$	55,600		$	3,880,581
Charge-offs		(7,286	)		(268,006	)		(21,831	)		(579,503	)		(128,611	)		—			(1,005,237	)
Recoveries		100			532			83,506			89,538			14,196			—			187,872
Provision		9,386			161,912			(87,540	)		541,671			119,559			(6,000	)		738,988

Ending balance	$	105,400		$	731,298		$	839,989		$	1,859,966		$	215,951		$	49,600		$	3,802,204

Ending balance: individually evaluated for impairment	$	—		$	23,598		$	318,189		$	383,366		$	—		$	—		$	725,153

Ending balance: collectively evaluated for impairment	$	105,400		$	707,700		$	521,800		$	1,476,600		$	215,951		$	49,600		$	3,077,051

Ending balance: loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—		$	—

*Loans Receivable:*
Ending balance	$	5,876,857		$	36,568,561		$	45,463,526		$	79,246,988		$	7,351,882		$	4,450,720		$	178,958,534

Ending balance: individually evaluated for impairment	$	90,391		$	336,705		$	3,302,888		$	3,199,855		$	—		$	—		$	6,929,839

Ending balance: collectively evaluated for impairment	$	5,786,466		$	36,231,856		$	42,160,638		$	76,047,133		$	7,351,882		$	4,450,720		$	172,028,695

Ending balance: loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—		$	—

June 30, 2011
*Allowance for credit losses:*
Beginning balance	$	118,797		$	1,696,068		$	1,199,292		$	3,411,403		$	205,662		$	52,700		$	6,683,922
Charge-offs		(27,468	)		(1,105,516	)		(203,418	)		(959,152	)		(27,387	)		—			(2,322,941	)
Recoveries		996			54,285			83,772			71,500			17,869			—			228,422
Provision		6,720			77,596			(204,924	)		(537	)		(3,383	)		3,600			(120,928	)

Ending balance	$	99,045		$	722,433		$	874,722		$	2,523,214		$	192,761		$	56,300		$	4,468,475

Ending balance: individually evaluated for impairment	$	645		$	42,233		$	301,922		$	1,468,614		$	—		$	—		$	1,813,414

Ending balance: collectively evaluated for impairment	$	98,400		$	680,200		$	572,800		$	1,054,600		$	192,761		$	56,300		$	2,655,061

Ending balance: loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—		$	—

*Loans Receivable:*
Ending balance	$	5,544,068		$	42,991,762		$	48,365,786		$	67,791,434		$	6,697,606		$	5,042,967		$	176,433,623

Ending balance: individually evaluated for impairment	$	95,121		$	1,052,398		$	4,094,870		$	6,998,129		$	16,896		$	—		$	12,257,414

Ending balance: collectively evaluated for impairment	$	5,448,947		$	41,939,364		$	44,270,916		$	60,793,305		$	6,680,710		$	5,042,967		$	164,176,209

Ending balance: loans acquired with deteriorated credit quality	$	—		$	—		$	—		$	—		$	—		$	—		$	—

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6. ALLOWANCE FOR LOAN LOSSES, CONTINUED

The following table presents impaired loans individually evaluated by class of loan as of June 30, 2012 and December 31, 2011:


	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
June 30, 2012
With no related allowance recorded:
Construction and development	$	90,391	$	90,391	$	—	$	92,033	$	500
1-4 family residential		153,334		153,334		—		160,318		—
Nonfarm, nonresidential		1,212,440		1,212,440		—		1,231,396		34,681
Commercial and industrial		1,786,213		2,055,278		—		1,841,485		48,137
Consumer		—		—		—		—		—
Other loans		—		—		—		—		—

		3,242,378		3,511,443		—		3,325,232		83,318

With an allowance recorded:
Construction and development	$	—	$	—	$	—	$	—	$	—
1-4 family residential		183,371		216,455		23,598		190,739		—
Nonfarm, nonresidential		2,090,447		2,112,279		318,189		2,134,088		—
Commercial and industrial		1,413,643		1,473,718		383,366		1,521,241		9,723
Consumer		—		—		—		—		—
Other loans		—		—		—		—		—

		3,687,461		3,802,452		725,153		3,846,068		9,723

Combined:
Construction and development	$	90,391	$	90,391	$	—	$	92,033	$	500
1-4 family residential		336,705		369,789		23,598		351,057		—
Nonfarm, nonresidential		3,302,887		3,324,719		318,189		3,365,484		34,681
Commercial and industrial		3,199,856		3,528,996		383,366		3,362,726		57,860
Consumer		—		—		—		—		—
Other loans		—		—		—		—		—

	$	6,929,839	$	7,313,895	$	725,153	$	7,171,300	$	93,041

December 31, 2011
With no related allowance recorded:
Construction and development	$	92,504	$	92,504	$	—	$	92,504	$	4,398
1-4 family residential		469,514		502,598		—		504,456		20,970
Nonfarm, nonresidential		1,548,288		1,711,019		—		1,720,582		90,633
Commercial and industrial		1,526,985		1,701,473		—		1,679,148		99,979
Consumer		10,452		10,452		—		6,753		6,738
Other loans		—		—		—		—		—

		3,647,743		4,018,046		—		4,003,443		222,718

With an allowance recorded:
Construction and development	$	—	$	—	$	—	$	—	$	—
1-4 family residential		235,812		235,812		83,460		236,822		13,693
Nonfarm, nonresidential		2,079,602		2,079,602		280,454		2,079,917		109,936
Commercial and industrial		1,633,189		1,633,189		449,260		1,843,975		97,007
Consumer		—		—		—		—		—
Other loans		—		—		—		—		—

		3,948,603		3,948,603		813,174		4,160,714		220,636

Combined:
Construction and development	$	92,504	$	92,504	$	—	$	92,504	$	4,398
1-4 family residential		705,326		738,410		83,460		741,278		34,663
Nonfarm, nonresidential		3,627,890		3,790,621		280,454		3,800,499		200,569
Commercial and industrial		3,160,174		3,334,662		449,260		3,523,123		196,986
Consumer		10,452		10,452		—		6,753		6,738
Other loans		—		—		—		—		—

	$	7,596,346	$	7,966,649	$	813,174	$	8,164,157	$	443,354

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6. ALLOWANCE FOR LOAN LOSSES, CONTINUED

The following presents by class, an aging analysis of the recorded investment in loans.


	30-59 Days Past Due			60-89 Days Past Due			90 Days Plus Past Due			Total Past Due			Current			Total Financing Receivables			Recorded Investment > 90 Days and Accruing
June 30, 2012
Construction and development	$	14,721		$	—		$	—		$	14,721		$	5,862,136		$	5,876,857		$	—
1-4 family residential		497,072			149,147			227,799			874,018			35,694,543			36,568,561			49,668
Nonfarm, nonresidential		314,706			35,631			201,227			551,564			44,911,962			45,463,526			79,500
Commercial and industrial		533,614			260,768			751,276			1,545,658			77,701,330			79,246,988			582,291
Consumer		261,805			19,450			20,735			301,990			7,049,892			7,351,882			16,019
Other loans		—			212,293			—			212,293			4,238,427			4,450,720			—

Total	$	1,621,918		$	677,289		$	1,201,037		$	3,500,224		$	175,458,290		$	178,958,534		$	727,478

Percentage of total loans		0.91	%		0.38	%		0.67	%		1.96	%		98.04	%		100.00	%

Non-accruals included above
Construction and development	$	—		$	—		$	—		$	—		$	90,391		$	90,391
1-4 family residential		37,647			128,262			178,131			344,040			241,752			585,792
Nonfarm, nonresidential		22,147			—			121,727			143,874			2,091,685			2,235,559
Commercial and industrial		—			—			168,985			168,985			936,033			1,015,018
Consumer		—			4,748			4,716			9,464			—			9,464
Other loans		—			—			—			—			—			—

	$	59,794		$	133,010		$	473,559		$	666,363		$	3,359,861		$	4,026,224

December 31, 2011
Construction and development	$	273,412		$	23,727		$	—		$	297,139		$	5,916,304		$	6,213,443		$	—
1-4 family residential		621,656			77,631			72,774			772,061			38,727,128			39,499,189			—
Nonfarm, nonresidential		98,922			119,046			—			217,968			47,649,365			47,867,333			—
Commercial and industrial		764,276			56,117			218,516			1,038,909			72,717,513			73,756,422			44,543
Consumer		170,447			229,368			15,790			415,605			6,626,241			7,041,846			5,338
Other loans		—			—			—			—			4,966,730			4,966,730			—

Total	$	1,928,713		$	505,889		$	307,080		$	2,741,682		$	176,603,281		$	179,344,963		$	49,881

Percentage of total loans		1.08	%		0.28	%		0.17	%		1.53	%		98.47	%		100.00	%

Non-accruals included above
Construction and development	$	—		$	—		$	—		$	—		$	92,504		$	92,504
1-4 family residential		92,736			217,814			72,774			383,324			322,003			705,327
Nonfarm, nonresidential		—			—			—			—			2,517,311			2,517,311
Commercial and industrial		—			—			173,973			173,973			895,643			1,069,616
Consumer		—			—			10,452			10,452			—			10,452
Other loans		—			—			—			—			—			—

	$	92,736		$	217,814		$	257,199		$	567,749		$	3,827,461		$	4,395,210

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. Loans classified as substandard or special mention are reviewed quarterly by the Company for further impairment or improvement to determine if appropriately classified. All other loans greater than $500,000, commercial lines greater than $250,000 and personal lines of credit greater than $100,000, and unsecured loans greater than $100,000 are specifically reviewed at least annually to determine the appropriate loan grading. In addition, during the renewal process of any loan, as well as when a loan becomes past due, the Company will evaluate the loan grade.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6. ALLOWANCE FOR LOAN LOSSES, CONTINUED

Loans excluded from the scope of the annual review process above are generally classified as pass credits until: (a) they become past due; (b) management becomes aware of deterioration in the credit worthiness of the borrower; or (c) the customer contacts the Company for a modification. In these circumstances, the loan is specifically evaluated for potential classification as to special mention, substandard or even charged off. The Company uses the following definitions for risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans by credit quality indicator are provided in the following table.


	Total			Pass Credits			Special Mention			Substandard			Doubtful
June 30, 2012
Construction and development	$	5,876,857		$	5,786,466		$	90,391		$	—		$	—
1-4 family residential		36,568,561			36,045,220			523,341			—			—
Nonfarm, nonresidential		45,463,526			44,028,351			1,178,320			256,855
Commercial and industrial		79,246,988			77,596,227			1,650,761			—			—
Consumer		7,351,882			7,341,460			8,911			1,511			—
Other loans		4,450,720			4,449,606			1,114			—			—

	$	178,958,534		$	175,247,330		$	3,452,838		$	258,366		$	—

		100.0	%		97.9	%		1.9	%		0.2	%		0.0	%

Guaranteed portion of loans	$	40,294,597		$	39,239,354		$	1,055,243		$	—		$	—


	Total			Pass Credits			Special Mention			Substandard			Doubtful
December 31, 2011
Construction and development	$	6,213,443		$	6,120,939		$	92,504		$	—		$	—
1-4 family residential		39,499,189			38,839,069			660,120			—			—
Nonfarm, nonresidential		47,867,333			46,159,505			1,071,939			635,889			—
Commercial and industrial		73,756,422			72,268,150			1,488,272			—			—
Consumer		7,041,846			7,039,155			411			2,280			—
Other loans		4,966,730			4,966,730			—			—			—

	$	179,344,963		$	175,393,548		$	3,313,246		$	638,169		$	—

		100.0	%		97.8	%		1.8	%		0.4	%		0.0	%

Guaranteed portion of loans	$	38,917,951		$	38,077,329		$	840,622		$	—		$	—

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7. TROUBLED DEBT RESTRUCTURINGS

For the quarters ended June 30, 2012 and 2011, the following table presents loans modified during the period that were considered to be troubled debt restructurings.


	For the three months ended June 30, 2012						For the six months ended June 30, 2012
	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Construction and development		0	$	0	$	0		1	$	237,883	$	237,883
1-4 Family residential		0		0		0		1		113,743		116,438
Nonfarm, nonresidential		0		0		0		1		96,028		96,028
Commercial and industrial		1		76,358		76,358		2		343,060		343,060


	For the three months ended June 30, 2011						For the six months ended June 30, 2011
	Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Number of Contracts		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Troubled Debt Restructurings
Construction and development		1	$	63,711	$	30,627		1	$	63,711	$	30,627
1-4 Family residential		0		0		0		1		15,928		15,928
Nonfarm, nonresidential		1		347,455		347,455		6		1,841,718		1,678,987
Commercial and industrial		1		63,105		63,105		6		544,812		370,324

During the six months ended June 30, 2012, the Bank modified five loans that were considered to be troubled debt restructurings. The terms for these loans were extended. The interest rate was lowered on one loan.

During the six months ended June 30, 2012, no loans that had previously been restructured were in default.

In the determination of the allowance for loan losses, management considers troubled debt restructurings and subsequent defaults in these restructurings by adjusting the loan grades of such loans, which figure into the environmental factors associated with the allowance. Defaults resulting in charge-offs affect the historical loss experience ratios which are a component of the allowance calculation. Additionally, specific reserves may be established on restructured loans evaluated individually.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. FAIR VALUE

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale, trading securities and derivatives, if present, are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under the Fair Value Measurements and Disclosures Topic of the FASB ASC, the Company groups assets and liabilities 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. These levels are:


Level 1		Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2		Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3		Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with the Receivables Topic of the FASB ASC. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At June 30, 2012, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with the Fair Value and Measurement Topic of the FASB ASC, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. FAIR VALUE, CONTINUED

Servicing Assets

A valuation of loan servicing rights is performed on an individual basis due to the small number of loans serviced. Loans are evaluated on a discounted earnings basis to determine the present value of future earnings. The present value of the future earnings is the estimated market value for the loan, calculated using consensus assumptions that a first party purchaser would utilize in evaluating a potential acquisition of the servicing. As such, the Company classifies loan servicing rights as Level 3.

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis.


*(in thousands)*
June 30, 2012	Total		Level 1		Level 2		Level 3
Government-sponsored enterprises	$	2,500	$	—	$	2,500	$	—
Mortgage-backed securities		48		—		48		—
Corporate bonds		448		—		448		—
Servicing assets		90		—		—		90

Total assets at fair value	$	3,086	$	—	$	2,996	$	90

Total liabilities at fair value	$	—	$	—	$	—	$	—


*(in thousands)*
December 31, 2011	Total		Level 1		Level 2		Level 3
Government-sponsored enterprises	$	2,004	$	—	$	2,004	$	—
Mortgage-backed securities		51		—		51		—
Corporate bonds		451		—		451		—
Servicing assets		93		—		—		93

Total assets at fair value	$	2,599	$	—	$	2,506	$	93

Total liabilities at fair value	$	—	$	—	$	—	$	—

For the six months ended June 30, 2012 and 2011, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis were as follows:


	Level 3
	2012			2011
	Fair Value			Fair Value
*Balance, January 1*	$	92,682		$	94,878
Capitalized		—			—
Amortization included in other income		(2,293	)		(1,427	)

*Balance, June 30*	$	90,389		$	93,451

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. FAIR VALUE, CONTINUED

Changes in Level 3 assets and liabilities measured at fair value on a recurring basis for the three month period ended June 30, 2012 and 2011, was $781 and $695, respectively, which was amortized to other income.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets or liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets and liabilities that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets and liabilities measured at fair value on a nonrecurring basis are included in the table below.


*(in thousands)*
June 30, 2012	Total		Level 1		Level 2		Level 3
Loans-commercial and industrial	$	1,030	$	—	$	—	$	1,030
Loans-nonfarm, non-residential		1,772		—		—		1,772
Loans-other		160		—		—		160
Foreclosed assets		251		—		—		251

Total assets at fair value	$	3,213	$	—	$	—	$	3,213

Total liabilities at fair value	$	—	$	—	$	—	$	—


*(in thousands)*
December 31, 2011	Total		Level 1		Level 2		Level 3
Loans-commercial and industrial	$	1,184	$	—	$	—	$	1,184
Loans-nonfarm, non-residential		1,799		—		—		1,799
Loans- 1- 4 family residential		152		—		—		152
Loans-other		—		—		—		—
Foreclosed assets		560		—		—		560

Total assets at fair value	$	3,695	$	—	$	—	$	3,695

Total liabilities at fair value	$	—	$	—	$	—	$	—

Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and due from banks: The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.

Interest-bearing deposits with banks: Fair values for time deposits are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

Federal funds sold: Due to the short-term nature of these assets, the carrying value approximates fair value.

Securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. The carrying values of restricted equity securities approximate fair values.

SURREY BANCORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8. FAIR VALUE, CONTINUED

Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.

Bank owned life insurance: The carrying amount reported in the balance sheet approximates the fair value as it represents the cash surrender value of the life insurance.

Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

Federal funds purchased, securities sold under agreements to repurchase and short-term debt: The carrying amounts of federal funds purchased, securities sold under agreements to repurchase and short-term debt approximate their fair values.

Long-term debt: The fair value of long-term debt is estimated using a discounted cash flow calculation that applies interest rates currently available on similar instruments.

Other liabilities: For fixed-rate loan commitments, fair value considers the difference between current levels of interest rates and the committed rates. The carrying amounts of other liabilities approximate fair value.

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments as of June 30, 2012 and December 31, 2011. This table excludes financial instruments for which the carrying amount approximates fair value.


					Fair Value Measurements
*(dollars in thousands)*	Carrying Amount		Fair Value		Quoted Prices in Active Markets for Identical Assets or Liabilities (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
June 30, 2012
Financial Instruments - Assets
Loans	$	175,177	$	180,229	$	—	$	—	$	180,229
Financial Instruments – Liabilities
Deposits		178,640		171,259		—		171,259		—
Long-Term Debt		7,750		8,257		—		8,257		—
December 31, 2011
Financial Instruments - Assets
Loans	$	175,446	$	163,835	$	—	$	—	$	163,835
Financial Instruments – Liabilities
Deposits		183,938		174,610		—		174,610		—
Long-Term Debt		8,100		8,704		—		8,704		—

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

This discussion, analysis and related financial information are presented to explain the significant factors which affected Surrey Bancorp’s financial condition and results of operations for the six months ending June 30, 2012 and 2011. This discussion should be read in conjunction with the financial statements and related notes contained within this report.

Surrey Bancorp (“Company”) is a North Carolina corporation, located in Mount Airy, North Carolina. The Company was incorporated on February 6, 2003, and began business on May 1, 2003.

Surrey Bank & Trust (“Bank”) is a North Carolina state chartered bank, located in Mount Airy, North Carolina. The Bank was chartered on July 15, 1996, and began operations on July 22, 1996. The Bank has two operating subsidiaries: Surrey Investment Services, Inc. and Freedom Finance, LLC.

Effective June 5, 1998, the Bank became a member of the Federal Home Loan Bank.

Highlights

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

Net income available for common stockholders for the three months ended June 30, 2012, was $321,976 or $0.09 per diluted share outstanding, compared to a $665,448 or $0.19 per diluted share outstanding, for the same period in 2011. Earnings for the three months ended June 30, 2012, are approximately 51.6% lower than for the same period in 2011. The decrease results from an increase in the provision for loan losses. The provision for loan losses increased from a recapture of $279,825 in the second quarter of 2011 to a provision of $671,770 in 2012. This increase is due to an increase in net loan charge offs during the second quarter of 2012 compared to the second quarter of 2011. Net loan charge offs in the second quarter of 2012 amounted to $771,324 compared to net recoveries of $99,278 in 2011, a difference of $870,602. The majority of the net charge offs were commercial and revolving 1-4 family loans. Charge off of these problem assets resulted in an overall increase in the credit quality of the loan portfolio. At June 30, 2012, the percentage of loans receiving pass credit risk grades was 97.9%, compared to 96.3% at June 30, 2011. Credit quality was further enhanced by an increase in loans carrying government guarantees. At June 30, 2012, the guaranteed portion of loans equaled 22.5% of total loans compared to 20.2% at June 30, 2011. Net interest income increased from $2,118,802 in the second quarter of 2011 to $2,294,168 in 2012. A reduction in the cost of deposits from the second quarter of 2011 to 2012 contributed to the margin improvement. Asset yields increased from 4.97% to 5.27% from 2011 to 2012 due to the change in earning asset mix from lower yielding deposits in other banks to higher yielding loans. The cost of funds continued to decrease from 1.14% in the second quarter of 2011 to 0.89% in the second quarter of 2012. Noninterest income remained relatively flat decreasing 0.7% in 2012. Noninterest expenses decreased 9.9% from $1,802,453 in the second quarter of 2011, to $1,623,208 in 2012. This decrease is primarily attributable to decreased costs associated with foreclosed assets. Net expenses associated from foreclosed asset activity decreased from $120,908 in 2011 to a net income of $936 in 2012. Salaries and employee benefits decreased from $883,412 in 2011 to $861,138 in 2012 primarily due to in increase in salary cost deferred for loan production. FDIC insurance premiums dropped due to shrinkage in deposits. The remaining noninterest expenses did not materially change from quarter to quarter.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Net income available for common stockholders for the six months ended June 30, 2012, was $940,428 or $0.25 per diluted share outstanding compared to $1,172,411 or $0.33 per diluted share outstanding for the same period in 2011. This represents a 19.8% decrease in earnings for the first six months of 2012 compared to the same period in 2011. This decrease is attributable to an increase in the provision for loan losses. The provision increased from a recapture of $120,928 in the first six months of 2011 to a provision of $738,988 during the same period in 2012. The charge off of nonperforming loans and their effect on the historical loss component of the loan loss reserve resulted in the provision increase. Loan charge offs were greater for the first six months of 2011 than in 2012 but most of the loans charged off in 2011 had specific reserves already established. When these loans were charged off it had minimal effect on the loan loss provision in 2011 since both the loan and the corresponding reserve were removed. However, the historical loss component was enhanced. This increase coupled with second quarter losses required the current provision to be increased. Net interest income increased from $4,295,430 in the first six months of 2011 to $4,614,768 in 2012. This increase is due to an increase in average loans as a percentage of total earning assets for the six month period ended June 30, 2012 versus the same period in 2011. Overall assets yields have increased as a result of this increase in higher yielding average loans. Additionally, corresponding reductions in the cost of funds further increased the margin. The cost of funds decreased from 1.19% in 2011 to 0.92% in 2012. Noninterest income increased 5.4% in 2012 primarily due to an increase in revenues from the Bank’s insurance subsidiary. Noninterest expenses decreased 1.6% from $3,532,825 in the six months ended June 30, 2011, to $3,476,852 for the same period in 2012. Most of the decrease is associated with gains on the sales and reduced expenses associated with foreclosed assets. Foreclosed asset expense decreased from $140,332 in first six months of 2011 to $32,294 in 2011.

On June 30, 2012, Surrey Bancorp’s assets totaled $220,164,691 compared to $224,727,764 on December 31, 2011. Net loans were $175,177,109 compared to $175,446,206 on December 31, 2011. This decrease was primarily attributable to a decrease in gross loans of approximately $347,000. Commercial loans increased 7.4% during the six month period ended June 30, 2012; however real estate loans decreased over 5.4% leading to an overall decrease in gross loans of 0.2%. Interest-bearing deposits with banks decreased from $30,757,636 at December 31, 2011 to $18,512,558 at June 30, 2012, due to an increase in deposits due from banks of approximately $5,912,000 and a decrease in total deposits of $5,298,000. The increase in deposits with other banks resulted from changing our correspondent banking relationship for deposit clearings to a correspondent that does not automatically sweep the account to overnight funds. In addition, deposit clearings at the end of June were above the bank’s normal average.

Total deposits on June 30, 2012, were $178,640,380 compared to $183,938,376 at the end of 2011. This decrease is attributable to decreases in all primary deposit categories except demand deposits and savings deposits. Demand deposits increased 9.4% from 2011 totals, while savings deposits, including money market accounts, increased 5.7%. Certificates of deposit decreased 12.8% from December 31, 2011 totals.

Common stockholders’ equity increased by $977,521, or 3.71%, during the six months ended June 30, 2012. The increase is comprised of net income of $1,031,638, exercised common stock options of $30,111 and other stock based compensation of $11,504. Decreases included the payment and accrual of preferred dividends of $91,210 and adjustments to Accumulated Other Comprehensive Income of $4,522. The net increase resulted in a common stock book value of $7.72 per share, up from $7.45 on December 31, 2011.

The book value per common share is calculated by taking total stockholders’ equity, subtracting all preferred equity, and then dividing by the total number of common shares outstanding at the end of the reporting period.

Preferred stockholders’ equity remained the same during the period ended June 30, 2012. Combined preferred and common stockholders’ equity increased $977,521, or 3.23%, for the six months ended June 30, 2012.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Financial Condition, Liquidity and Capital Resources

Investments

The Bank maintains a portfolio of securities as part of its asset/liability and liquidity management programs which emphasize effective yields and maturities to match its needs. The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest rate sensitivity needs for the Bank.

Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held to maturity securities.

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders’ equity. Realized gains and losses on the sale of available for sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.

Declines in the fair value of individual held to maturity and available for sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses.

Investments in available for sale securities of $2,995,711 consisted of U.S. Governmental Agency obligations with maturities ranging from 20 to 33 months, corporate bonds with maturities of 6.0 years to 6.25 years, that reprice quarterly, and GNMA adjustable rate mortgage securities, which adjust annually.

Loans

Net loans outstanding on June 30, 2012, were $175,177,109 compared to $175,446,206 on December 31, 2011. The Bank maintains a loan portfolio dominated by real estate and commercial loans diversified among various industries. Approximately 73.1% of the Bank’s loans as of June 30, 2012, are fixed rate loans with 26.9% floating with the Bank’s prime rate or other appropriate internal or external indices.

Deposits

Deposits on June 30, 2012, were $178,640,380, compared to $183,938,376 on December 31, 2011. The June total consists of a base of approximately 12,292 accounts compared to 12,126 accounts at December 31, 2011. Interest-bearing accounts represent 79.2% of June 30, 2012 period end deposits versus 83.3% at December 31, 2011.

Federal Funds Purchased

The Company had no federal funds purchased at June 30, 2012 or December 31, 2011. Federal funds purchased were not utilized due to the adequate liquidity resulting from the increase in deposits.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Stockholders’ Equity

Surrey Bancorp and Surrey Bank & Trust are subject to various regulatory capital requirements administered by federal banking agencies. The Company and the Bank maintain strong capital positions which exceed all capital adequacy requirements of federal regulatory authorities. The Company’s and the Bank’s capital ratios are presented in the following table.


	Ratio			Minimum Required For Capital Adequacy Purposes
*June 30, 2012:*
Total Capital
(to Risk-Weighted Assets)
Surrey Bancorp (Consolidated)		19.52	%		8.0	%
Surrey Bank & Trust		19.50	%		8.0	%
Tier I Capital
(to Risk-Weighted Assets)
Surrey Bancorp (Consolidated)		18.26	%		4.0	%
Surrey Bank & Trust		18.23	%		4.0	%
Tier I Capital
(to Average Assets)
Surrey Bancorp (Consolidated)		13.35	%		4.0	%
Surrey Bank & Trust		13.33	%		4.0	%
*December 31, 2011:*
Total Capital
(to Risk-Weighted Assets)
Surrey Bancorp (Consolidated)		18.54	%		8.0	%
Surrey Bank & Trust		18.53	%		8.0	%
Tier I Capital
(to Risk-Weighted Assets)
Surrey Bancorp (Consolidated)		17.28	%		4.0	%
Surrey Bank & Trust		17.26	%		4.0	%
Tier I Capital
(to Average Assets)
Surrey Bancorp (Consolidated)		12.67	%		4.0	%
Surrey Bank & Trust		12.65	%		4.0	%

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Asset Quality

The Company actively monitors delinquencies, nonperforming assets and potential problem loans. Unsecured loans past due more than 90 days are placed into nonaccrual status. Secured loans reach nonaccrual status when they surpass 120 days past due. When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status.

Management reviews all criticized loans on a periodic basis for possible charge offs. Any unsecured loans that are 90 plus days past due must be charged off in full. If secured, a reserve equal to the potential loss will be established. Any charge off must be reported to the Board of Directors within 30 days. On a monthly basis, a management report of recovery actions is provided to the Board of Directors.

Nonperforming assets are detailed below.


	June 30, 2012			December 31, 2011
Nonaccrual loans	$	4,026,224		$	4,395,210
Loans past due 90 days and still accruing		727,478			49,881
Foreclosed assets		251,046			560,018

Total	$	5,004,748		$	5,005,109

Total assets	$	220,164,691		$	224,727,764

Ratio of nonperforming assets to total assets		2.27	%		2.23	%

At June 30, 2012, the Bank had loans totaling $4,026,224 in nonaccrual status. Approximately $3,360,000 of the nonaccrual loans were current at the end of June. Approximately $662,000 of loans past due 90 days and still accruing are less than 120 days past due. These loans are government guaranteed loans that are not moved to nonaccrual status until they are 120 days past due. The guaranteed portion of these loans is $538,300. Foreclosed assets at June 30, 2012 primarily include 1-4 family dwellings. Loans that were considered impaired but were still accruing interest at June 30, 2012, including troubled debt restructurings, totaled $3,162,167. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due under the contractual terms of the loan agreement. Specific reserves on nonaccrual and impaired loans totaled $804,797 at quarter end, or 10.8% of the balances outstanding.

Nonaccrual and impaired loans still accruing are summarized below:


	June 30, 2012		December 31, 2011
Construction and development	$	90,391	$	92,504
1-4 family residential		585,792		705,326
Nonfarm, nonresidential		3,302,888		3,627,890
Commercial and industrial		3,199,856		3,160,174
Consumer		9,464		10,452

Total impaired and nonaccrual	$	7,188,391	$	7,596,346

At June 30, 2012, consumer loans totaling $255,431 are included above that were not individually evaluated for impairment in the determination of the allowance for loan loss reserve (See Note 6). These loans are primarily home equity loans collateralized by 1-4 family properties which are considered consumer loans. These loans are on nonaccrual status at the end of the quarter and therefore considered impaired.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

The loan portfolio is dominated by real estate and commercial loans. The general composition of the loan portfolio is as follows:


	June 30, 2012				December 31, 2011
Construction and development	$	5,876,857	3.28	%	$	6,213,443	3.46	%
1-4 family residential		36,568,561	20.43	%		39,499,189	22.02	%
Multi-family		1,985,429	1.11	%		2,214,365	1.23	%
Farmland		2,439,577	1.36	%		2,722,872	1.52	%
Nonfarm, non-residential		45,463,526	25.41	%		47,867,333	26.69	%

Total real estate		92,333,950	51.59	%		98,517,202	54.92	%
Agricultural		25,714	0.01	%		29,493	0.02	%
Commercial and industrial		79,246,988	44.29	%		73,756,422	41.13	%
Consumer		7,351,882	4.11	%		7,041,846	3.93	%

Total loans	$	178,958,534	100.00	%	$	179,344,963	100.00	%

The concentrations represented above do not, based on managements’ assessment, expose the Bank to any unusual concentration risk. Based on the Bank’s asset size, the only concentration that is above area peer group analysis is commercial and industrial loans. Management recognizes the inherent risk associated with commercial lending, including a borrower’s actual results of operations not corresponding to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and increases in interest rates, etc.; depression of collateral values; and completion of projects within the original cost and time estimates. The Bank mitigates some of that risk by actively seeking government guarantees on these loans. Collectively, the Bank has approximately $50,185,372 in loans that carry government guarantees. The guaranteed portion of these loans amounts to $40,294,597 at June 30, 2012. Loan guarantees by loan class are below:


	June 30, 2012		Guaranteed Portion
	June 30, 2012		Amount		Percentage
Construction and development	$	5,876,857	$	—		—	%
1-4 family residential		36,568,561		865,117		2.37	%
Multi-family		1,985,429		20,095		1.01	%
Farmland		2,439,577		453,455		18.59	%
Nonfarm, non-residential		45,463,526		14,503,236		31.90	%

Total real estate		92,333,950		15,841,903		17.16	%
Agricultural		25,714		—		—	%
Commercial and industrial		79,246,988		24,452,694		30.86	%
Consumer		7,351,882		—		—	%

Total loans	$	178,958,534	$	40,294,597		22.52	%

Loans in higher risk categories, such as non-owner occupied nonfarm, non-residential property and commercial real estate construction represent a small segment of our loan portfolio. Commercial construction loans included in construction and development loans amounted to $3,015,896 at June 30, 2012. Non-owner occupied nonfarm, non-residential properties included in nonfarm, non-residential loans above amounted to $9,228,209 at June 30, 2012.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

The consolidated provision for loan losses was $738,988 for the first six months of 2012 compared to a recapture of $120,928 for the same period in 2011. The charge off of nonperforming loans and their effect on the historical loss component of the loan reserve resulted in the provision increase. Loan charge offs were greater for the first six months of 2011 than in 2012 but most of the loans charged off in 2011 had specific reserves already established. When these loans were charged off it had minimal effect on the loan loss provision in 2011 since both the loan and the corresponding reserve were removed. However, the historical loss component was enhanced. This increase coupled with second quarter losses required the current provision to be increased. Reserves for nonaccrual and impaired loans at June 30, 2012 amounted to $725,153, compared to $813,174 at December 31, 2011.

The reserve for loan losses on June 30, 2012, was $3,802,204 or 2.12% of period end loans. This percentage is derived from total loans. Approximately $50,185,000 of total loans outstanding at June 30, 2012, are government guaranteed loans which carry guarantees ranging from 49% to 100% of the outstanding loan balance. When the guaranteed portion of the loans, for which the Bank has no credit exposure, is removed from the equation the loan loss reserve is approximately 2.74% of outstanding loans. At December 31, 2011 the loan loss reserve percentage was 2.16% of total loans and 2.76% of loans net of government guarantees.

The level of reserve is established based upon management’s evaluation of historical loss data and the effects of certain environmental factors on the loan portfolio. The historical loss portion of the reserve is computed using the average loss data from the past applied to its corresponding category of loans. However, historical losses only reflect a small portion of the Bank’s loan loss reserve, although that portion did increase during the first six months of 2012 due to the effect of charged off loans. The environmental factors represent risk from external economic influences on the credit quality of the loan portfolio. These factors include the movement of interest rates, unemployment rates, past due and charge off trends, loan grading migrations, movement in collateral values and the Bank’s exposure to certain loan concentrations. Positive or negative movements in any of these factors have an effect on the credit quality of the loan portfolio. As a result, management continues to actively monitor the Bank’s asset quality affected by these environmental factors. The following table is a summary of loans past due at June 30, 2012 and December 31, 2011.


	June 30, 2012						December 31, 2011
	30-89 Days			90 Days Plus			30-89 Days			90 Days Plus
Construction and development	$	14,721		$	—		$	297,139		$	—
1-4 family residential		646,219			227,799			699,287			72,774
Nonfarm, non-residential		350,337			201,227			217,968			—
Commercial and industrial		794,382			751,276			820,393			218,516
Consumer		281,255			20,735			399,815			15,790
Other loans		212,293			—			—			—

	$	2,299,207		$	1,201,037		$	2,434,602		$	307,080

Non-accrual loans included above	$	192,804		$	473,559		$	310,550		$	257,199

Guaranteed portion	$	371,815		$	676,151		$	422,069		$	33,407

Ratio to total loans		1.17	%		0.41	%		1.36	%		0.17	%

Ratio to total loans, net of guarantees		1.39	%		0.38	%		1.44	%		0.19	%

Past due loans are reviewed weekly and collection efforts assessed to determine potential problems arising in the loan portfolio. Proactive monitoring of past due accounts allows management to anticipate trends within the portfolio and make appropriate adjustments to collection efforts and to the allowance for loan losses. Collectively, past dues increased from December 31, 2011 to June 30, 2012. All of the increase is in the 90 days plus time frame. Since many of these loans carry government guarantees they are not put on nonaccrual status until the loans are 120 days past due. The largest increases were in 1-4 family loans, nonfarm, non-residential loans and commercial loans. The increase in 1-4 family loans is attributable to one loan (home equity) that was not past due at December 31, 2011. The non-farm, non-residential loans past due at June 30, 2012 consist of two customers that carry government guarantees of $131,045. Commercial loans over 90 days past due consist of loans due from five customers. Two of these loans are past due less than 95 days. The guaranteed portion of commercial loans past due over 90 days is $545,106. Overall past dues increased approximately 27.7% from the end of 2011 to June 30, 2012. At June 30, 2012, the guaranteed portion of total past due loans equals 30% compared to 17% at December 31, 2011.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Management believes that its loan portfolio is sufficiently diversified such that a downturn in a particular market or industry will not have a significant impact on the loan portfolio or the Bank’s financial condition. Management believes that its provision and reserve offer an adequate allowance for loan losses and provide an appropriate reserve for the loan portfolio. The Bank lends primarily in Surry County, North Carolina and Patrick Country, Virginia and surrounding counties.

Interest Rate Sensitivity and Liquidity

One of the principal duties of the Bank’s Asset/Liability Committee is management of interest rate risk. The Bank utilizes quarterly asset/liability reports prepared by a regional correspondent bank to project the impact on net interest income that might occur with hypothetical interest rate changes. The committee monitors and manages asset and liability strategies and pricing.

Another function of the Asset/Liability Committee is maintaining adequate liquidity and planning for future liquidity needs. Having adequate liquidity means the ability to meet current funding needs, including deposit withdrawals and commitments, in an orderly manner without sacrificing earnings. The Bank funds its investing activities, including making loans and purchasing investments, by attracting deposits and utilizing short-term borrowings when necessary.

At June 30, 2012, the liquidity position of the Company was good, in management’s opinion, with short-term liquid assets of $27,402,495 compared to $33,736,588 at December 31, 2011. Deposit decreases of $5,297,996 account for most of the decrease in liquidity. The Bank also increased its investment in Bank Owned Life Insurance (BOLI) by $1,750,000. To provide supplemental liquidity, the Bank has six unsecured lines of credit with correspondent banks totaling $25,500,000. At June 30, 2012, there were no advances against these lines. Additionally, the Bank has a secured borrowing arrangement with the Federal Home Loan Bank (FHLB). The maximum credit available under this agreement approximates $13,037,000 of which $7,750,000 of advances had been taken down at June 30, 2012.

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable as a “Smaller Reporting Company”.

ITEM 4.

CONTROLS AND PROCEDURES

As of the end of the period covered by the report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15e. Based on the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There have not been any changes in the Company’s internal control over financial reporting that occurred during the Company’s last quarter that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1.

Legal Proceedings

None

Item 1A.

Risk Factors

Not Applicable as a “Smaller Reporting Company”

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3.

Defaults Upon Senior Securities

Not Applicable

Item 4.

Mine Safety Disclosures

Not Applicable

Item 5.

Other Information

None

Item 6.

Exhibits



31.1		Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act

31.2		Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act

32.1		Certification of PEO/PFO Pursuant to Section 906 of the Sarbanes Oxley Act

101		Interactive Data File

SIGNATURES

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


				Surrey Bancorp

Date: August 10, 2012				/s/ EDWARD C. ASHBY, III
				Edward C. Ashby, III
				President and Chief Executive Officer
				(Principal Executive Officer)

Date: August 10, 2012				/s/ MARK H. TOWE
				Mark H. Towe
				Sr. Vice President and Chief Financial Officer
				(Principal Financial Officer)

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company