FAIR VALUE OF FINANCIAL INSTRUMENTS

LCNB measures certain assets at fair value using various valuation techniques and assumptions, depending on the nature of the asset. Fair value is defined as the price that would be received from the sale of an asset in an orderly transaction between market participants at the measurement date.

The inputs to the valuation techniques used to measure fair value are assigned to one of three broad levels:


•	Level 1 – quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the reporting date.

•

Level 2 – inputs other than quoted prices included within level 1 that are observable for the asset or liability either directly or indirectly. Level 2 inputs may include quoted prices for similar assets in active markets, quoted prices for identical assets or liabilities in markets that are not active, inputs other than quoted prices (such as interest rates or yield curves) that are observable for the asset or liability, and inputs that are derived from or corroborated by observable market data.


•	Level 3 – inputs that are unobservable for the asset or liability.

Equity Securities With a Readily Determinable Fair Value

Equity securities with a readily determinable fair value are reported at fair value with changes in fair value reported in other operating income in the consolidated statements of income. Fair values for trust preferred and equity securities are determined based on market quotations (level 1). LCNB has invested in two mutual funds that are traded in active markets and their fair values are based on market quotations (level 1). Investments in another two mutual funds are measured at fair value using net asset values ("NAV") and are considered level 1 because the NAVs are determined and published and are the basis for current transactions.

Debt Securities, Available-for-Sale

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 (loss). LCNB utilizes a pricing service for determining the fair values of its debt securities. Methods and significant assumptions used to estimate fair value are as follows:


•	Fair value for U.S. Treasury notes are determined based on market quotations (level 1).


•	Fair values for the other debt securities are 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.

Assets Recorded at Fair Value on a Nonrecurring Basis

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. These inputs are considered to be level 3.

Other real estate owned is adjusted to fair value, less costs to sell, 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. Other repossessed assets are valued at estimated sales prices, less costs to sell. The inputs for real estate owned and other repossessed assets are considered to be level 3.

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)
2018
Recurring fair value measurements:
Equity securities with a readily determinable fair value:
Equity securities	$	519	519	—	—
Mutual funds	39		39	—	—
Mutual funds measured at net asset value	1,520		1,520	—	—

Debt securities available-for-sale:
U.S. Treasury notes	2,235		2,235	—	—
U.S. Agency notes	78,340		—	78,340	—
U.S. Agency mortgage-backed securities	55,610		—	55,610	—
Municipal securities:
Non-taxable	84,714		—	84,714	—
Taxable	17,522		—	17,522	—
Total recurring fair value measurements	$	240,499	4,313	236,186	—

Nonrecurring fair value measurements:
Impaired loans	$	1,039	—	—	1,039
Other real estate owned and repossessed assets	244		—	—	244
Total nonrecurring fair value measurements	$	1,283	—	—	1,283

2017
Recurring fair value measurement:
Equity securities with a readily determinable fair value:
Trust preferred securities	50		50	—	—
Equity securities	568		568	—	—
Mutual funds	23		23	—	—
Mutual funds measured at net asset value	1,519		1,519	—	—

Debt securities available-for-sale:
U.S. Treasury notes	$	2,259	2,259	—	—
U.S. Agency notes	83,261		—	83,261	—
U.S. Agency mortgage-backed securities	67,153		—	67,153	—
Municipal securities:
Non-taxable	102,174		—	102,174	—
Taxable	20,366		—	20,366	—
Total recurring fair value measurements	$	277,373	4,419	272,954	—

Nonrecurring fair value measurements:
Impaired loans	$	3,359	—	—	3,359

The following table presents quantitative information about unobservable inputs used in nonrecurring Level 3 fair value measurements at December 31, 2018 and 2017 (dollars in thousands):



					Range
	Fair Value		Valuation Technique	Unobservable Inputs	High		Low		Weighted Average
2018
Impaired loans	$	45	Estimated sales price	Adjustments for comparable properties, discounts to reflect current market conditions	Not applicable
	994		Discounted cash flows	Discount rate	8.25	%	4.50	%	6.86	%
Other real estate owned	244		Estimated sales price	Adjustments for comparable properties, discounts to reflect current market conditions	Not applicable

2017
Impaired loans	$	1,753	Estimated sales price	Adjustments for comparable properties, discounts to reflect current market conditions	Not applicable
	1,606		Discounted cash flows	Discount rate	8.25	%	3.25	%	6.27	%

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



				Fair Value Measurements at the End of the Reporting Period 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)
2018
FINANCIAL ASSETS:
Cash and cash equivalents	$	20,040	20,040	20,040	—	—
Debt securities, held-to-maturity	29,721		29,024	—	—	29,024
Federal Reserve Bank stock	4,653		4,653	4,653	—	—
Federal Home Loan Bank stock	4,845		4,845	4,845	—	—
Loans, net	1,194,577		1,183,041	—	—	1,183,041
Accrued interest receivable	4,317		4,317	—	4,317	—

FINANCIAL LIABILITIES:
Deposits	1,300,919		1,301,298	1,004,057	297,241	—
Short-term borrowings	56,230		56,230	56,230	—	—
Long-term debt	47,032		48,255	—	48,255	—
Accrued interest payable	690		690	—	690	—

2017
FINANCIAL ASSETS:
Cash and cash equivalents	$	25,386	25,386	25,386	—	—
Debt securities, held-to-maturity	32,571		32,350	—	—	32,350
Federal Reserve Bank stock	2,732		2,732	2,732	—	—
Federal Home Loan Bank stock	3,638		3,638	3,638	—	—
Loans, net	845,657		813,368	—	—	813,368
Accrued interest receivable	3,511		3,511	—	3,511	—

FINANCIAL LIABILITIES:
Deposits	1,085,821		1,087,086	894,046	193,040	—
Short-term borrowings	47,000		47,000	47,000	—	—
Long-term debt	303		307	—	307	—
Accrued interest payable	329		329	—	329	—

The fair values of off-balance-sheet financial instruments such as loan commitments and letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements. The fair values of such instruments were not material at December 31, 2018 and 2017.

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.

Equity securities without a readily determinable fair value

Equity securities without a readily determinable fair value are measured at cost, less impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investments of the same issuer.

Debt securities, held-to-maturity

Fair values for debt securities, held-to-maturity are based on quoted market prices for similar securities and/or discounted cash flow analysis or other methods.

Federal Home Loan Bank and Federal Reserve Bank stock

The carrying value of Federal Home Loan Bank and Federal Reserve Bank stock approximates fair value based on the respective redemptive provisions.

Loans

The estimated fair value of loans as of December 31, 2018 follows the guidance in ASU 2016-01, which prescribes an “exit price” approach in estimating and disclosing fair value of financial instruments. The fair value calculation at that date discounted estimated future cash flows using rates that incorporated discounts for credit, liquidity, and marketability factors. The fair value estimate shown as of December 31, 2017 used an “entry price” approach. The fair value calculation for that date discounted estimated future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Consequently, the fair value disclosures for December 31, 2018 and 2017 are not directly comparable.

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.

Accrued interest receivable and Accrued interest payable

Carrying amount approximates fair value.