Note 17. Fair Value Measurement

The Company adopted ASC 820 "Fair Value Measurement and Disclosures" (previously Statement of Financial Accounting Standards ("SFAS") No. 157, "Fair Value Measurements") on January 1, 2008 to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions. The three levels of the fair value hierarchy under ASC 820 based on these two types of inputs are as follows:

Level 1 –

Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 –

Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 –

Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data (Level 2). If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any, market activity then the security would fall to the lowest level of the hierarchy (Level 3). The Company's investment portfolio is primarily valued using fair value measurements that are considered to be Level 2. The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities portfolio. The vendor's primary source for security valuation is Interactive Data Corporation ("IDC"), which evaluates securities based on market data. IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary modes, vast descriptive terms and conditions databases, as well as extensive quality control programs. The carrying value of restricted Federal Reserve Bank, Community Bankers Bank and FHLB stock approximates fair value based on the redemption provisions of each entity and are therefore excluded from the following table.

Interest rate swaps: The Company uses interest rate swaps to reduce interest rate risks and to manage net interest income. Interest rate swaps are recorded at fair value on a recurring basis. The Company utilizes interest rate swap agreements as part of the management of interest rate risk to modify the repricing characteristics of certain portions of the Company's interest-bearing assets and liabilities. The Company has contracted with a third party vendor to provide valuations for interest rate swaps using standard swap valuation techniques and therefore classifies such valuations as Level 2. The Company has considered counterparty credit risk in the valuation of its interest rate swap assets and has considered its own credit risk in the valuation of its interest rate swap liabilities.

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and December 31, 2011 by levels within the valuation hierarchy:

	Fair Value Measurements Using
(In thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets at December 31, 2012
Available for sale securities:
Obligations of U.S. Government corporations and agencies	$	40,014	$	-	$	40,014	$	-
Obligations of states and political subdivisions		7,390		-		7,390		-
Corporate bonds		325		-		-		325
Mutual funds		363		363		-		-
Total available for sale securities		48,092		363		47,404		325

Interest rate swaps		-		-		-		-
Total assets at fair value	$	48,092	$	363	$	47,404	$	325

Liabilities at December 31, 2012
Interest rate swaps	$	841	$	-	$	841	$	-
Total liabilities at fair value	$	841	$	-	$	841	$	-

Assets at December 31, 2011
Available for sale securities:
Obligations of U.S. Government corporations and agencies	$	39,572	$	-	$	39,572	$	-
Obligations of states and political subdivisions		7,393		-		7,393		-
Corporate bonds		335		-		-		335
Mutual funds		349		349		-		-
Total available for sale securities		47,649		349		46,965		335

Interest rate swaps		179		-		179		-
Total assets at fair value	$	47,828	$	349	$	47,144	$	335

Liabilities at December 31, 2011
Interest rate swaps	$	452	$	-	$	452	$	-
Total liabilities at fair value	$	452	$	-	$	452	$	-

Change in Level 3 Fair Value

The changes in Level 3 assets measured at estimated fair value on a recurring basis during the years ended December 31, 2012 and 2011 were as follows:

	Total Gains (Losses) Realized/Unrealized
(In thousands)	Balance January 1, 2012		Included in earnings		Included in Other Comprehensive Income			Transfers in and/or out of Level 3 and 2		Balance December 31, 2012
Available for sale securities	$	335	$	-	$	(10	)	$	-	$	325

Notes to Consolidated Financial Statements

	Total Gains (Losses) Realized/Unrealized
(In thousands)	Balance January 1, 2011		Included in earnings			Included in Other Comprehensive Income			Transfers in and/or out of Level 3 and 2		Balance December 31, 2011
Available for sale securities	$	552	$	(189	)	$	(28	)	$	-	$	335

Certain assets are measured at fair value on a nonrecurring basis in accordance with U.S GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company's collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal, of one year or less, 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 more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business' financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. At December 31, 2012, the Company's Level 3 loans for which a reserve has been taken, consisted of one loan totaling $136,000 secured by non-residential real estate with reserves of $90,000, one loan totaling $181,000 secured by residential real estate with a reserve of $112,000, and four loans totaling $862,000 secured with business assets and inventory with a reserve of $600,000. Four commercial loans totaling $31,000 were unsecured and fully reserved.

Other Real Estate Owned ("OREO"): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. 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 considers the OREO as nonrecurring Level 2. When a current 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 considers records the OREO as nonrecurring Level 3. Total valuation of OREO property was $1.4 million at December 31, 2012 and $1.8 million at December 31, 2011.

The following table summarizes the Company's financial assets that were measured at fair value on a nonrecurring basis during the period:

	Carrying Value at December 31, 2012
(In thousands)	Balance as of December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)
Assets:
Impaired loans, net	$	868	$	-	$	491	$	377
Other real estate owned, net		1,406		-		1,406		-

	Carrying Value at December 31, 2011
(In thousands)	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Unobservable Inputs (Level 2)		Significant Other Observable Inputs (Level 3)
Assets:
Impaired loans, net	$	1,855	$	-	$	-	$	1,855
Other real estate owned, net		1,776		-		-		1,776

The following table displays quantitative information about Level 3 Fair Value Measurements for December 31, 2012:

	Quantitative Information about Level 3 Fair Value Measurements
(In thousands)	Fair Value		Valuation Technique(s)	Unobservable Input	Weighted Average
Corporate securities available for sale	$	325	Discounted cash flow	Discount based on prepayment rate, probability of default and loss severity		42	%
Impaired Loans:
Commercial and industrial loans		262	Appraised values	*		20	%
Commercial real estate loans		-	Appraised values	*		-
Construction and land loans		46	Appraised values	*		55	%
Residential real estate loans		69	Appraised values	*		10	%
Total Impaired Loans		377
Total	$	702

* Discount applied based on age of appraisals, current market conditions, and experience within local market.

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. ASC 820 (previously SFAS No. 107 "Disclosures about Fair Value of Financial Instruments") excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and cash equivalents

The carrying amounts of cash and short-term instruments with a maturity of three months or less approximate fair value. Instruments with maturities of greater than three months are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar instruments.

Securities

For securities and marketable equity securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. For other securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair values are based on quoted market prices for similar securities. See Note 2 "Securities" of the Notes to Consolidated Financial Statements for further discussion on determining fair value for pooled trust preferred securities.

Loans Receivable

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (e.g., one-to-four family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for other loans (i.e., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Life Insurance

The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value. This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Interest Rate Swaps

The fair values are based on quoted market prices or mathematical models using current and historical data.

Deposit Liabilities

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

Federal Funds Purchased

The carrying amounts of the Company's federal funds purchased approximate fair value.

Borrowed Funds

The fair values of the Company's FHLB advances and other borrowings are estimated using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments

The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At December 31, 2012 and December 31, 2011, the fair value of loan commitments and standby letters of credit were deemed immaterial.

The estimated fair values of the Company's financial instruments are as follows:

	Fair Value Measurements at December 31, 2012
(In thousands)	Carrying Value as of December 31, 2012		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Fair Value as of December 31, 2012
Assets
Cash and short-term investments	$	64,435	$	61,935	$	2,530	$	-	$	64,465
Securities available for sale		48,092		363		47,404		325		48,092
Restricted investments		2,337		-		2,337		-		2,337
Net Loans		445,108		-		443,045		377		443,422
Accrued interest receivable		1,283		-		1,283		-		1,283
Interest rate swaps		-		-		-		-		-
BOLI		12,038		-		12,038		-		12,038
Total Financial Assets	$	573,293	$	62,298	$	508,638	$	702	$	571,637

Liabilities
Deposits	$	515,134	$	-	$	517,811	$	-	$	517,811
Borrowings		28,200		-		28,877		-		28,877
Company obligated mandatorily										-
redeemable capital securities		4,124		-		5,258		-		5,258
Accrued interest payable		312		-		312		-		312
Interest rate swaps		841		-		841		-		841
Total Financial Liabilities	$	548,611	$	-	$	553,099	$	-	$	553,099

	Fair Value Measurements at December 31, 2011
(In thousands)	Balance as of December 31, 2011		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Other Unobservable Inputs (Level 3)		Fair Value as of December 31, 2011
Assets
Cash and short-term investments	$	72,161	$	69,660	$	2,547	$	-	$	72,207
Securities available for sale		47,649		349		46,965		335		47,649
Restricted investments		2,543		-		2,543		-		2,543
Net Loans		452,086		-		461,564		1,885		463,449
Accrued interest receivable		1,534		-		1,534		-		1,534
Interest rate swaps		179		-		179		-		179
BOLI		11,621		-		11,621		-		11,621
Total Financial Assets	$	587,773	$	70,009	$	526,953	$	2,220	$	599,182

Liabilities
Deposits	$	530,569	$	-	$	535,567	$	-	$	535,567
Borrowings		25,000		-		26,023		-		26,023
Company obligated mandatorily
redeemable capital securities		4,124		-		4,982		-		4,982
Accrued interest payable		401		-		401		-		401
Interest rate swaps		452		-		452		-		452
Total Financial Liabilities	$	560,546	$	-	$	567,425	$	-	$	567,425

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.