FAIR VALUE OF FINANCIAL INSTRUMENTS

The majority of LCNB’s financial debt securities are classified as available-for-sale. The securities are reported at fair value with unrealized holding gains and losses reported net of income taxes in accumulated other comprehensive income.

The Company utilizes a pricing service for determining the fair values of most of its investment securities. Fair value for U.S. Treasury Notes and corporate securities are determined based on market quotations (level 1). Fair value for most of the other investment securities is calculated using the discounted cash flow method for each security. The discount rates for these cash flows are estimated by the pricing service using rates observed in the market (level 2). Cash flow streams are dependent on estimated prepayment speeds and the overall structure of the securities given existing market conditions. In addition, the Company has invested in two mutual funds that invest in debt securities or loans that qualify for credit under the Community Reinvestment Act. The investment in one of the mutual funds is considered to have level 1 inputs because it is publically traded in an active market and it publishes a daily net asset value. The investment in the other mutual fund is considered to have level 2 inputs because, although its shares are not traded in an active market, an investor can have its interest in the fund redeemed for the balance of its capital account at any quarter-end assuming the fund is given a 60 day notice. The investment in this Fund is carried at fair value, which approximates cost. Additionally, LCNB owns trust preferred securities in various financial institutions, equity securities in various financial and non-financial companies, and a mutual fund that invests primarily in floating rate loans. Market quotations (level 1) are used to determine fair values for these investments. The investment in the mutual fund is considered to have level 1 inputs because it is publicly traded in an active market and it publishes a daily net asset value.

Assets that may be recorded at fair value on a nonrecurring basis include impaired loans, other real estate owned, and other repossessed assets. A loan is considered impaired when management believes it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement. Impaired loans are carried at the present value of estimated future cash flows using the loan’s existing rate or the fair value of collateral if the loan is collateral dependent, if this value is less than the loan balance. When the fair value of the collateral is based on an observable market price or current appraised value, the inputs are considered to be level 2. When an appraised value is not available and there is not an observable market price, the inputs are considered to be level 3.

Other real estate owned is adjusted to fair value upon transfer of the loan to foreclosed assets, usually based on an appraisal of the property. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. The inputs for a valuation based on current appraised value are considered to be level 2.

The following table summarizes the valuation of LCNB’s assets recorded at fair value by input levels as of December 31 (in thousands):



			Fair Value Measurements at the End of the Reporting Period Using
	Fair Value Measurements		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)	Total Gains (Losses)
December 31, 2013
Recurring fair value measurements:
Investment securities available-for-sale:
U.S. Treasury notes	$	12,894	12,894	—	—
U.S. Agency notes	106,675		—	106,675	—
U.S. Agency mortgage-backed securities	40,309		—	40,309	—
Certificates of deposit	1,501		—	1,501	—
Municipal securities:
Non-taxable	75,333		—	75,333	—
Taxable	17,309		—	17,309	—
Mutual funds	2,380		1,380	1,000	—
Trust preferred securities	147		147	—	—
Equity securities	1,693		1,693	—	—
Total recurring fair value measurements	$	258,241	16,114	242,127	—

Nonrecurring fair value measurements:
Impaired loans	$	8,530	—	773	7,757	—
Other real estate owned and repossessed assets (a)	1,463		—	1,463	—	178
Total nonrecurring fair value measurements	$	9,993	—	2,236	7,757	178

December 31, 2012
Recurring fair value measurement:
Investment securities available-for-sale:
U.S. Treasury notes	$	18,686	18,686	—	—
U.S. Agency notes	90,606		—	90,606	—
U.S. Agency mortgage-backed securities	52,541		—	52,541	—
Corporate securities	3,067		3,067	—	—
Municipal securities:
Non-taxable	73,882		—	73,882	—
Taxable	15,841		—	15,841	—
Mutual funds	2,168		1,168	1,000	—
Trust preferred securities	245		245	—	—
Equity securities	1,470		1,470	—	—
Total recurring fair value measurements	$	258,506	24,636	233,870	—

Nonrecurring fair value measurements:
Impaired loans	$	4,276	—	161	4,115	—
Other real estate owned and repossessed assets (b)	2,189		—	2,189	—	(295	)
Total nonrecurring fair value measurements	$	6,465	—	2,350	4,115	(295	)

(a)

Seven other real estate owned properties with a total carrying amount of $404,000 were written down to their combined fair value of $328,000, resulting in an impairment charge of $76,000. Twelve properties were sold for a combined net gain of $256,000. The write-downs and net gain were included in other real estate owned expense for the period. A repossessed asset was sold for a loss of $2,000, which was included in other non-interest expense for the period.

(b)

Eight other real estate owned properties with a total carrying amount of $1,809,000 were written down to their combined fair value of $1,525,000, resulting in an impairment charge of $284,000. Another property was sold at a loss of $8,000. The write-downs and loss were included in other non-interest expense for the period. Repossessed assets with a carrying value of $23,000 were sold for a combined total of $20,000, resulting in a net loss of $3,000, which was included in other non-interest expense for the period.

Carrying amounts and estimated fair values of financial instruments as of December 31 were as follows (in thousands):



	2013			2012
	Carrying Amount		Fair Value	Carrying Amount	Fair Value
FINANCIAL ASSETS:
Cash and cash equivalents	$	14,688	14,688	13,475	13,475
Investment securities:
Available-for-sale	258,241		258,241	258,506	258,506
Held-to-maturity	16,323		16,196	15,424	15,424
Federal Reserve Bank stock	1,603		1,603	949	949
Federal Home Loan Bank stock	2,854		2,854	2,091	2,091
Loans, net	570,766		573,163	450,346	453,060

FINANCIAL LIABILITIES:
Deposits	785,761		788,096	671,471	675,964
Short-term borrowings	8,655		8,655	13,756	13,756
Long-term debt	12,102		12,842	13,705	14,724

The fair value of off-balance-sheet financial instruments at December 31, 2013 and 2012 was not material.

Fair values of financial instruments are based on various assumptions, including the discount rate and estimates of future cash flows. Therefore, the fair values presented may not represent amounts that could be realized in actual transactions. In addition, because the required disclosures exclude certain financial instruments and all nonfinancial instruments, any aggregation of the fair value amounts presented would not represent the underlying value of the Company. The following methods and assumptions were used to estimate the fair value of certain financial instruments:

Cash and cash equivalents

The carrying amounts presented are deemed to approximate fair value.

Investment securities

Fair values for securities, excluding Federal Home Loan Bank and Federal Reserve Bank stock, are based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and/or discounted cash flow analyses. The carrying value of Federal Home Loan Bank and Federal Reserve Bank stock approximates fair value based on the respective redemptive provisions.

Loans

Fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities, incorporating assumptions of current and projected prepayment speeds. These current rates approximate market rates.

Deposits

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities, which approximates market rates.

Borrowings

The carrying amounts of federal funds purchased, repurchase agreements, and U.S. Treasury demand note borrowings are deemed to approximate fair value of short-term borrowings. For long-term debt, fair values are estimated based on the discounted value of expected net cash flows using current interest rates.

The following table summarizes the categorization by input level of the Company’s financial assets and liabilities not recorded at fair value but for which fair value is disclosed at December 31 (in thousands):



			Fair Value Measurements at the End of the Reporting Period Using
	Fair Value Measurements		Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)	Significant Unobservable Inputs (Level 3)
December 31, 2013
Assets:
Loans, net	$	564,633	—	564,633	—
Investment securities, non-taxable, held-to-maturity	16,196		—	—	16,196
Federal Reserve Bank stock	1,603		1,603	—	—
Federal Home Loan Bank stock	2,854		2,854	—	—

Liabilities:
Deposits	788,096		—	788,096	—
Long-term debt	12,842		—	12,842	—

December 31, 2012
Assets:
Loans, net	448,784		—	448,784	—
Investment securities, non-taxable, held-to-maturity	15,424		—	—	15,424
Federal Reserve Bank stock	949		949	—	—
Federal Home Loan Bank stock	2,091		2,091	—	—

Liabilities:
Deposits	675,964		—	675,964	—
Long-term debt	14,724		—	14,724	—