Note 9. Fair Value Measurement

U.S. GAAP requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes, effective for financial statement periods beginning after December 15, 2017. Therefore, the fair value presented herein may not be comparable to prior periods. Methodologies utilized are as follows:

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Income Approach: Fair value is determined based on a discounted cash flow analysis. The discounted cash flow analysis is based on the contractual maturity of the loan and market indications of rates, prepayment speeds, defaults and credit risk.

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Asset Approach: Fair value is determined based on the estimated values of the underlying collateral or individual analysis of receipts. This provides a better indication of value than the contractual income streams when loans are not performing or exhibit strong signs indicative of nonperformance.

Fair value has been estimated in accordance with U.S. GAAP, and is intended to represent the price that would be received in an orderly transaction between market participants as of the measurement date. In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, at least one significant assumption not observable in the market was utilized. These unobservable assumptions reflect estimates that market participants would use in pricing the asset or liability. Inputs to these valuation techniques are subjective in nature, involve uncertainties and require significant judgement and therefore cannot be determined with precision. Accordingly, the fair value estimates presented are not necessarily indicative of the amounts to be realized in a current market exchange.

U.S. GAAP also indicates that fair value estimates are presented according to a fair value hierarchy comprised of three levels. The levels are based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The level within the fair value hierarchy for an asset or liability is based on the highest level of input that is significant to the fair value measurement (with Level 1 considered highest and Level 3 considered lowest). A brief description of each level follows:

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Level 1:Inputs are defined as quoted prices (unadjusted) in active markets for identical assets or liabilities.

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Level 2:Inputs are defined as inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.

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Level 3:Inputs are defined as unobservable inputs for the asset or liability.

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. 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 models, vast descriptive terms and conditions databases, as well as extensive quality control programs.

Interest rate swaps: 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 to provide valuations for interest rate swaps using standard valuation techniques and therefore classifies such valuation 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 September 30, 2018 and December 31, 2017 by levels within the valuation hierarchy:

	Fair Value Measurements
(In thousands)	Balance		Level 1		Level 2		Level 3
Assets at September 30, 2018:
Available for sale securities:
Obligations of U.S. Government corporations and agencies	$	57,396	$	-	$	57,396	$	-
Obligations of states and political subdivisions		14,383		-		14,383		-
Corporate bonds		850		-		850		-
Total available for sale securities		72,629		-		72,629		-
Interest rate swaps		594		-		594		-
Total assets at fair value	$	73,223	$	-	$	73,223	$	-
Liabilities at September 30, 2018:
Interest rate swaps	$	22	$	-	$	22	$	-
Total liabilities at fair value	$	22	$	-	$	22	$	-

Assets at December 31, 2017:
Available for sale securities:
Obligations of U.S. Government corporations and agencies	$	52,377	$	-	$	52,377	$	-
Obligations of states and political subdivisions		15,255		-		15,255		-
Corporate bonds		4,139		-		4,139		-
Mutual funds		382		382		-		-
Total available for sale securities		72,153		382		71,771		-
Interest rate swaps		233		-		233		-
Total assets at fair value	$	72,386	$	382	$	72,004	$	-
Liabilities at December 31, 2017:
Interest rate swaps	$	119	$	-	$	119	$	-
Total liabilities at fair value	$	119	$	-	$	119	$	-

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:

Mortgage Loans Held for Sale: Mortgage loans held for sale are carried at lower of cost or market value. These loans currently consist of 1-4 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. No nonrecurring fair value adjustments were recorded on mortgage loans held for sale during the three and nine months ended September 30, 2018. Gains and losses on the sale of loans are recorded as a component of noninterest income on the consolidated statements of income.

Impaired Loans: A loan is 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 loans or the fair value of the collateral securing the loans, or the present value of the cash flows. 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.

Other Real Estate Owned (“OREO”): OREO is measured at fair value less estimated 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. The Company considers the OREO as nonrecurring Level 3.

The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis at September 30, 2018 and December 31, 2017.

	September 30, 2018
(In thousands)	Balance		Level 1		Level 2		Level 3
Assets:
Impaired loans, net	$	2,689	$	-	$	2,568	$	121
Other real estate owned, net		1,356		-		-		1,356

	December 31, 2017
(In thousands)	Balance		Level 1		Level 2		Level 3
Assets:
Impaired loans, net	$	5,087	$	-	$	5,041	$	46
Other real estate owned, net		1,356		-		-		1,356

The following table displays quantitative information about Level 3 Fair Value Measurements at September 30, 2018 and December 31, 2017.

	September 30, 2018
(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Weighted Average Discount
Impaired loans, net	$	121	Appraised values	Age of appraisal, current market conditions, experience within local market, and U.S. Government guarantees		40	%
Other real estate owned, net		1,356	Appraised values	Age of appraisal, current market conditions and selling costs		18	%
Total	$	1,477

	December 31, 2017
(Dollars in thousands)	Fair Value		Valuation Technique	Unobservable Input	Weighted Average Discount
Impaired loans, net	$	46	Appraised values	Age of appraisal, current market conditions, experience within local market, and U.S. Government guarantees		90	%
Other real estate owned, net		1,356	Appraised values	Age of appraisal, current market conditions and selling costs		18	%
Total	$	1,402

The estimated fair values and related carrying amounts of the Company’s financial instruments are as follows:

	September 30, 2018
(In thousands)	Carrying Amount		Level 1		Level 2		Level 3		Fair Value
Assets
Cash and short-term investments	$	20,989	$	20,989	$	-	$	-	$	20,989
Securities available for sale		72,629		-		72,629		-		72,629
Restricted investments		2,495		-		2,495		-		2,495
Loans, net		527,802		-		-		509,568		509,568
Accrued interest receivable		1,944		-		1,944		-		1,944
Interest rate swaps		594		-		594		-		594
Bank-owned life insurance		13,505		-		13,505		-		13,505
Total financial assets	$	639,958	$	20,989	$	91,167	$	509,568	$	621,724

Liabilities
Deposits	$	566,231	$	-	$	565,159	$	-	$	565,159
Federal funds purchased		5,000		-		4,997		-		4,997
FHLB advances		29,800		-		29,603		-		29,603
Junior subordinated debt		4,124		-		4,795		-		4,795
Accrued interest payable		244		-		244		-		244
Interest rate swaps		22		-		22		-		22
Total financial liabilities	$	605,421	$	-	$	604,820	$	-	$	604,820

	December 31, 2017
(In thousands)	Carrying Amount		Level 1		Level 2		Level 3		Fair Value
Assets
Cash and short-term investments	$	29,300	$	29,091	$	-	$	-	$	29,091
Securities available for sale		72,153		382		71,771		-		72,153
Restricted investments		1,546		-		1,546		-		1,546
Loans, net		497,705		-		494,143		46		494,189
Accrued interest receivable		1,940		-		1,940		-		1,940
Interest rate swaps		233		-		233		-		233
Bank-owned life insurance		13,234		-		13,234		-		13,234
Total financial assets	$	616,111	$	29,473	$	582,867	$	46	$	612,386

Liabilities
Deposits	$	570,023	$	-	$	569,297	$	-	$	569,297
FHLB advances		7,860		-		7,766		-		7,766
Junior subordinated debt		4,124		-		4,116		-		4,116
Accrued interest payable		128		-		128		-		128
Interest rate swaps		119		-		119		-		119
Total financial liabilities	$	582,254	$	-	$	581,426	$	-	$	581,426

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. U.S. GAAP 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 held for investment purposes, fair values are based on quoted market prices or dealer quotes. If quoted market prices are not available, fair values are based on quoted market prices for similar securities. Restricted securities are carried at cost based on redemption provisions of the issuers. See Note 2 “Securities” for further discussion on determining fair value for pooled trust preferred securities.

Mortgage loans held for sale: Fair value for mortgage loans held for sale is based on the price secondary markets are currently offering for similar loans.

Loans: 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., 1-4 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 value for impaired loans is described above.

Accrued Interest: The carrying amounts of accrued interest approximate fair value.

Bank-owned life insurance: The carrying amount of life insurance contracts is assumed to be a reasonably appropriate 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.

Deposits: The fair values disclosed for demand deposits (i.e., interest and noninterest-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.

Borrowings: The fair values of the Company’s advances from the Federal Home Loan Bank of Atlanta 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 are 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 September 30, 2018 and December 31, 2017, the fair value of loan commitments and standby letters of credit were deemed immaterial.

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.