Note 10 – Fair Value Measurements and Fair Values of Financial Instruments

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

 

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

 

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. At September 30, 2015 and December 31, 2014, the Company had no liabilities subject to fair value reporting measurement requirements.

The fair value of securities available for sale are determined by matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for specific securities, but rather by relying on the securities’ relationship to other benchmark quoted prices. For these securities, the Company obtains fair value measurements from an independent pricing service. For financial assets measured at fair value on a recurring basis, the fair value measurements by level within the fair value hierarchy used at September 30, 2015 and December 31, 2014 were as follows:

 

Description		Balance				(Level 1) Quoted Prices in Active Markets for Identical Assets				(Level 2) Significant Other Observable Inputs				(Level 3) Significant Unobservable Inputs
		(In thousands)
September 30, 2015:
U.S. Government agency securities		$	807			$	—			$	807			$	—
State and municipal			27,442				—				27,442				—
U.S. Government agencies and sponsored enterprises (GSEs) – residential:
Mortgage-backed securities			18,701				—				18,701				—
Collateralized mortgage obligations (CMOs)			1,909				—				1,909				—
Corporate debt obligations			4,509				—				4,509				—
Equity securities, financial services			485				485				—				—
Securities available-for- sale		$	53,853			$	485			$	53,368			$	—
December 31, 2014:
U.S. Government agency securities		$	817			$	—			$	817			$	—
State and municipal			23,708				—				23,708				—
U.S. Government agencies and sponsored enterprises (GSEs) – residential:
Mortgage-backed securities			20,902				—				20,902				—
Collateralized mortgage obligations (CMOs)			2,391				—				2,391				—
Corporate debt obligations			505				—				505				—
Equity securities, financial services			495				495				—				—
Securities available-for- sale		$	48,818			$	495			$	48,323			$	—

 

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with accounting principles generally accepted in the United States of America. Adjustments to the fair value of these assets usually results from the application of lower-of-cost-or-market accounting or write-downs of individual assets. The following discussion describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements.

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value. These loans typically 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.

Other Real Estate Owned

Certain assets such as other real estate owned (OREO) are measured at fair value of real estate acquired through foreclosure at an estimated fair value less cost to sell. At or near the time of foreclosure, real estate appraisals are obtained on the properties acquired through foreclosure. The real estate is then valued at the lesser of the appraised value or the loan balance, including interest receivable, at the time of foreclosure less an estimate of costs to sell the property. Appraised values are typically determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the acquired property is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered a Level 3. The estimate of costs to sell the property is based on historical transactions of similar holdings.

Impaired Loans

ASC 820 applies to loans measured for impairment using the practical expedients permitted by generally accepted accounting principles (GAAP), including impaired loans measured at an observable market price (if available), or at the fair value of the loan’s collateral (if the loan is collateral dependent). Fair value of the loan’s collateral, when the loan is dependent on collateral, is determined by appraisals or independent valuation which is then adjusted for the cost related to liquidation of collateral. The value of the collateral is typically determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company 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 real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value of the applicable business’ 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 are measured at the lower of cost or fair value of the underlying collateral less estimated costs to sell on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as a provision for loan losses on the Consolidated Statements of Income. The Company had impaired loans of $9,688,000 at September 30, 2015, of which $1,501,000 required a valuation allowance of $133,000. This level compares with impaired loans of $8,408,000 at December 31, 2014, of which $738,000 required a valuation allowance of $82,000.

Goodwill

The fair value of goodwill is determined in the same manner as goodwill recognized in a business combination and uses standard valuation methodologies. Fair value may be determined using market prices, comparison to similar assets, market multiples, discounted cash flow analysis and other factors. Estimated cash flows may extend far into the future and by their nature are difficult to determine over an extended time frame. Factors that may significantly affect the estimates include specific industry or market sector conditions, changes in revenue growth trends, customer behavior, competitive forces, cost structures and changes in discount rates. The Company did not record any goodwill impairment during the three and nine months ended September 30, 2015 or 2014.

 

A summary of assets at September 30, 2015 and December 31, 2014, measured at estimated fair value on a nonrecurring basis follows:

 

		Level 1				Level 2				Level 3				Total				Total Gains/(Losses)
		(In thousands)
September 30, 2015:
Loans held for sale		$	—			$	—			$	—			$	—			$	—
Other real estate owned			—				1,057				—				1,057				(92	)
Impaired loans, net of related allowance			—				1,368				—				1,368				—
Total		$	—			$	2,425			$	—			$	2,425			$	(92	)
		Level 1				Level 2				Level 3				Total				Total Gains/(Losses)
		(In thousands)
December 31, 2014:
Loans held for sale		$	—			$	216			$	—			$	216			$	—
Other real estate owned			—				1,022				—				1,022				(317	)
Impaired loans, net of related allowance			—				656				—				656				—
Total		$	—			$	1,894				—			$	1,894			($	317	)

The following information should not be interpreted as an estimate of the fair value of the Company since a fair value calculation is only provided for a limited portion of the Company’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between the Company’s disclosures and those of other companies may not be meaningful. The following methods and assumptions were used to estimate the fair values of the Company’s financial instruments at September 30, 2015 and December 31, 2014.

Cash and cash equivalents (carried at cost):

The carrying amount reported in the balance sheet for cash, due from banks, federal funds sold and interest-bearing deposits approximate those assets’ fair values.

Interest-bearing time deposits with banks (carried at cost):

Fair values for fixed-rate time certificates of deposit approximate cost. The Company generally purchases amounts below the insured limit, thus limiting the amount of credit risk on these time deposits.

Securities (carried at fair value):

The fair value of securities available-for-sale (carried at fair value) are determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Internal cash flow models using a present value formula that include assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) are used to support fair values of certain Level 3 investments, if applicable.

Mortgage loans held for sale (carried at lower of cost or fair value):

The fair value of mortgages held for sale is determined, when possible, using quoted secondary market prices. If no such quoted prices exist, the fair value of the loan is determined using quoted market prices for a similar loan or loans, adjusted for the specific attributes of that loan.

 

Loans (carried at cost)

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

Impaired loans (generally carried at fair value)

Impaired loans are those that are accounted for under the standard regarding Accounting by Creditors for Impairment of a Loan, in which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 2 fair values, based upon the lowest level of input that is significant to the fair value measurement.

Restricted investment in Bank stocks (carried at cost):

The carrying amount of restricted investment in Bank stock approximates fair value, and considers the limited marketability of such securities.

Accrued interest receivable and payable (carried at cost):

The carrying amount of accrued interest receivable and accrued interest payable approximates its fair value.

Deposit liabilities (carried at cost):

The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Lease payable (carried at cost)

The carrying amounts of lease payables approximate their fair values.

Short-term borrowings (carried at cost):

The carrying amounts of short-term borrowings approximate their fair values.

Long-term borrowings (carried at cost):

Fair values of FHLB advances are estimated using discounted cash flow analysis, based on quoted prices for new FHLB advances with similar credit risk characteristics, terms and remaining maturity. The prices were obtained from an active market and represent a fair value that is deemed to represent the transfer price if the liability were assumed by a third party.

Off-balance sheet financial instruments (disclosed at cost):

Fair values for the Company’s off-balance sheet financial instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

 

The estimated fair values of the Company’s financial instruments at September 30, 2015 and December 31, 2014 are presented as follows:

 

						Fair Value Measurements at September 30, 2015 Using:
(In thousands)		Carrying Amount				Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	14,262			$	14,262			$	14,262			$	—			$	—
Interest-bearing time deposits			991				991				991				—				—
Investment securities			53,853				53,853				485				53,368				—
Loans, net			348,314				350,554				—				350,554				—
Accrued interest receivable			1,368				1,368				—				1,368				—
Restricted investments in bank stocks			1,478				1,478				—				—				1,478
Financial liabilities:
Deposits			378,735				375,788				—				375,788				—
Short-term borrowings			23,333				23,353				—				23,353				—
Long-term borrowings			7,350				7,354				—				7,354				—
Accrued interest payable			93				93				—				93				—
Off balance sheet financial instruments			—				—				—				—				—

 

						Fair Value Measurements at December 31, 2014 Using:
		Carrying Amount				Fair Value				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Financial assets:
Cash and cash equivalents		$	14,580			$	14,580			$	14,580			$	—			$	—
Interest-bearing time deposits			992				992				992				—				—
Investment securities			48,818				48,818				495				48,323				—
Mortgage loans held for sale			216				216				—				216				—
Loans, net			338,901				341,121				—				341,121				—
Accrued interest receivable			1,237				1,237				—				1,237				—
Restricted investments in bank stocks			1,002				1,002				—				—				1,002
Financial liabilities:
Deposits			372,262				366,510				—				366,510				—
Capital lease payable			1,655				1,655				—				1,655				—
Short-term borrowings			12,500				12,499				—				12,499				—
Long-term borrowings			7,000				7,283				—				7,283				—
Accrued interest payable			154				154				—				154				—
Off balance sheet financial instruments			—				—				—				—				—