EX-13 2 pebk_ex13.htm ANNUAL REPORT TO SECURITY HOLDERS FOR THE LAST FISCAL YEAR, FORM 10-Q OR 10-QSB OR QUARTERLY REPORT TO SECURITY HOLDERS Blueprint
 

EXHIBIT (13)
 
The Annual Report to Security Holders is Appendix A to the Proxy Statement for the 2019 Annual Meeting of Shareholders and is incorporated herein by reference.
 
 
APPENDIX A
 
ANNUAL REPORT
OF
PEOPLES BANCORP OF NORTH CAROLINA, INC.
 
 
 
 
 
 
 
 

PEOPLES BANCORP OF NORTH CAROLINA, INC.
 
General Description of Business
 
Peoples Bancorp of North Carolina, Inc. (“Bancorp”), was formed in 1999 to serve as the holding company for Peoples Bank (the “Bank”). Bancorp is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”). Bancorp’s principal source of income is dividends declared and paid by the Bank on its capital stock, if any. Bancorp has no operations and conducts no business of its own other than owning the Bank. Accordingly, the discussion of the business which follows concerns the business conducted by the Bank, unless otherwise indicated. Bancorp and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries are collectively called the “Company”.
 
The Bank, founded in 1912, is a state-chartered commercial bank serving the citizens and business interests of the Catawba Valley and surrounding communities through 20 banking offices, as of December 31, 2018, located in Lincolnton, Newton, Denver, Catawba, Conover, Maiden, Claremont, Hiddenite, Hickory, Charlotte, Cornelius, Mooresville, Raleigh, and Cary North Carolina. The Bank also operates loan production offices in Denver and Durham, North Carolina. At December 31, 2018, the Company had total assets of $1.1 billion, net loans of $797.6 million, deposits of $877.2 million, total securities of $198.9 million, and shareholders’ equity of $123.6 million.
 
The Bank operates three banking offices focused on the Latino population that were formerly operated as a division of the Bank under the name Banco de la Gente (“Banco”). These offices are now branded as Bank branches and considered a separate market territory of the Bank as they offer normal and customary banking services as are offered in the Bank’s other branches such as the taking of deposits and the making of loans.
 
The Bank has a diversified loan portfolio, with no foreign loans and few agricultural loans. Real estate loans are predominately variable rate and fixed rate commercial property loans, which include residential development loans to commercial customers. Commercial loans are spread throughout a variety of industries with no one particular industry or group of related industries accounting for a significant portion of the commercial loan portfolio. The majority of the Bank’s deposit and loan customers are individuals and small to medium-sized businesses located in the Bank’s market area. The Bank’s loan portfolio also includes Individual Taxpayer Identification Number (ITIN) mortgage loans generated thorough the Bank’s Banco offices. Additional discussion of the Bank’s loan portfolio and sources of funds for loans can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages A-4 through A-23 of the Annual Report, which is included in this Form 10-K as Exhibit (13).
 
The operations of the Bank and depository institutions in general are significantly influenced by general economic conditions and by related monetary and fiscal policies of depository institution regulatory agencies, including the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”) and the North Carolina Commissioner of Banks (the “Commissioner”).
 
The Company’s fiscal year ends December 31. This Form 10-K is also being used as the Bank’s Annual Disclosure Statement under FDIC Regulations. This Form 10-K has not been reviewed, or confirmed for accuracy or relevance by the FDIC.
 
At December 31, 2018, the Company employed 310 full-time employees and 35 part-time employees, which equated to 334 full-time equivalent employees.
 
Subsidiaries
 
The Bank is a subsidiary of the Company. At December 31, 2018, the Bank had four subsidiaries, Peoples Investment Services, Inc., Real Estate Advisory Services, Inc., Community Bank Real Estate Solutions, LLC (“CBRES”) and PB Real Estate Holdings, LLC. Through a relationship with Raymond James Financial Services, Inc., Peoples Investment Services, Inc. provides the Bank’s customers access to investment counseling and non-deposit investment products such as stocks, bonds, mutual funds, tax deferred annuities, and related brokerage services. Real Estate Advisory Services, Inc. provides real estate appraisal and real estate brokerage services. CBRES serves as a “clearing-house” for appraisal services for community banks. Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property to be appraised is located. This type of service ensures that the appraisal process remains independent from the financing process within the Bank. PB Real Estate Holdings, LLC acquires, manages and disposes of real property, other collateral and other assets obtained in the ordinary course of collecting debts previously contracted.
 
 
A-1
 
 
In June 2006, the Company formed a wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three-month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures were used in December 2006 to repay the trust preferred securities issued in December 2001 by PEBK Capital Trust, a wholly owned Delaware statutory trust of the Company, and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.
 
The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments. The net combined effect of the trust preferred securities transaction is that the Company is obligated to make the distributions and other payments required on the trust preferred securities.
 
These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, which became effective on June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount plus any accrued but unpaid interest.
 
This report contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on the information available to management at the time that these disclosures were prepared. These statements can be identified by the use of words like “expect,” “anticipate,” “estimate” and “believe,” variations of these words and other similar expressions. Readers should not place undue reliance on forward-looking statements as a number of important factors could cause actual results to differ materially from those in the forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, (1) competition in the markets served by the Bank, (2) changes in the interest rate environment, (3) general national, regional or local economic conditions may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and the possible impairment of collectibility of loans, (4) legislative or regulatory changes, including changes in accounting standards, (5) significant changes in the federal and state legal and regulatory environment and tax laws, (6) the impact of changes in monetary and fiscal policies, laws, rules and regulations and (7) other risks and factors identified in the Company’s other filings with the Securities and Exchange Commission. The Company undertakes no obligation to update any forward-looking statements.
 
 
 
 
A-2
 
 
SELECTED FINANCIAL DATA
Dollars in Thousands Except Per Share Amounts
 
 
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
Summary of Operations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
 $45,350 
  41,949 
  39,809 
  38,666 
  38,420 
Interest expense
  2,146 
  2,377 
  3,271 
  3,484 
  4,287 
Net interest income
  43,204 
  39,572 
  36,538 
  35,182 
  34,133 
Provision for loan losses
  790 
  (507)
  (1,206)
  (17)
  (699)
Net interest income after provision
    
    
    
    
    
for loan losses
  42,414 
  40,079 
  37,744 
  35,199 
  34,832 
Non-interest income (1)
  16,166 
  15,364 
  16,236 
  15,256 
  13,824 
Non-interest expense (1)
  42,574 
  41,228
 
  42,242 
  37,722 
  37,331 
Earnings before income taxes
  16,006 
  14,215
 
  11,738 
  12,733 
  11,325 
Income tax expense
  2,624 
  3,947
 
  2,561 
  3,100 
  1,937 
Net earnings
 $13,382 
  10,268 
  9,177 
  9,633 
  9,388 
 
    
    
    
    
    
Selected Year-End Balances
    
    
    
    
    
Assets
 $1,093,251 
  1,092,166 
  1,087,991 
  1,038,481 
  1,040,494 
Investment securities available for sale
  194,578 
  229,321 
  249,946 
  268,530 
  281,099 
Net loans
  797,578 
  753,398 
  716,261 
  679,502 
  640,809 
Mortgage loans held for sale
  680 
  857 
  5,709 
  4,149 
  1,375 
Interest-earning assets
  1,007,078 
  996,509 
  999,201 
  977,079 
  956,900 
Deposits
  877,213 
  906,952 
  892,918 
  832,175 
  814,700 
Interest-bearing liabilities
  657,110 
  679,922 
  698,120 
  679,937 
  722,991 
Shareholders' equity
 $123,617 
  115,975 
  107,428 
  104,864 
  98,665 
Shares outstanding
  5,995,256 
  5,995,256 
  5,417,800 
  5,510,538 
  5,612,588 
 
    
    
    
    
    
Selected Average Balances
    
    
    
    
    
Assets
 $1,094,707 
  1,098,992 
  1,076,604 
  1,038,594 
  1,036,486 
Investment securities available for sale
  209,742 
  234,278 
  252,725 
  266,830 
  287,371 
Net loans
  777,098 
  741,655 
  703,484 
  669,628 
  631,025 
Interest-earning assets
  1,007,484 
  998,821 
  985,236 
  952,251 
  949,537 
Deposits
  903,120 
  895,129 
  856,313 
  816,628 
  808,399 
Interest-bearing liabilities
  665,165 
  700,559 
  705,291 
  707,611 
  731,786 
Shareholders' equity
 $123,797 
  116,883 
  113,196 
  106,644 
  96,877 
Shares outstanding (2)
  5,995,256 
  5,988,183 
  6,024,970 
  6,115,159 
  6,177,233 
 
    
    
    
    
    
Profitability Ratios
    
    
    
    
    
Return on average total assets
  1.22%
  0.93%
  0.85%
  0.93%
  0.91%
Return on average shareholders' equity
  10.81%
  8.78%
  8.11%
  9.03%
  9.69%
Dividend payout ratio
  23.41%
  25.67%
  22.95%
  16.34%
  10.89%
 
    
    
    
    
    
Liquidity and Capital Ratios (averages)
    
    
    
    
    
Loan to deposit
  86.05%
  82.85%
  82.15%
  82.00%
  78.06%
Shareholders' equity to total assets
  11.31%
  10.64%
  10.51%
  10.27%
  9.35%
 
    
    
    
    
    
Per share of Common Stock (2)
    
    
    
    
    
Basic net earnings
 $2.23 
  1.71 
  1.53 
  1.57 
  1.52 
Diluted net earnings
 $2.22 
  1.69 
  1.50 
  1.56 
  1.51 
Cash dividends
 $0.52 
  0.44 
  0.35 
  0.25 
  0.16 
Book value
 $20.62 
  19.34 
  18.03 
  17.30 
  15.98 
 
(1)
Appraisal management fee income and expense from the Bank’s subsidiary, CBRES, was reported as a net amount prior to March 31, 2018, which was included in miscellaneous non-interest income. This income and expense is now reported on separate line items under non-interest income and non-interest expense. Prior periods have been restated to reflect this change.
 
(2)
Average shares outstanding and per share computations have been restated to reflect a 10% stock dividend paid during the fourth quarter of 2017.
 
 
A-3
 


 
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
 
The following is a discussion of our financial position and results of operations and should be read in conjunction with the information set forth under Item 1A Risk Factors in the Company’s annual report on Form 10-K and the Company’s consolidated financial statements and notes thereto on pages A-24 through A-68.
 
Introduction
Management’s discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. (“Bancorp”), for the years ended December 31, 2018, 2017 and 2016. Bancorp is a registered bank holding company operating under the supervision of the Federal Reserve Board (the “FRB”) and the parent company of Peoples Bank (the “Bank”). The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Wake and Durham counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).
 
Overview
Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.
 
Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System (the “Federal Reserve”), inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating the allowance for loan losses and changes in these economic factors could result in increases or decreases to the provision for loan losses.
 
Our business emphasis has been and continues to be to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We expect growth to be achieved in our local markets and through expansion opportunities in contiguous or nearby markets. While we would be willing to consider growth by acquisition in certain circumstances, we do not consider the acquisition of another company to be necessary for our continued ability to provide a reasonable return to our shareholders. We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability and experience of our Bank officers and managers.
 
The Federal Reserve maintained the Federal Funds rate at 0.25% from December 2008 to December 2015 before increasing the Fed Funds rate nine times since December 2015 to the Fed Funds rate of 2.50% at December 31, 2018. These increases have had a positive impact on earnings in recent periods and should continue to have a positive impact on the Bank’s net interest income in future periods.
 
The Company plans to open a Loan Production Office in the Ballantyne area of Charlotte, North Carolina during 2019. The Company does not have specific plans for additional offices in 2019 but will continue to look for growth opportunities in nearby markets and may expand if considered a worthwhile opportunity.
 
 
A-4
 
 
On August 31, 2015, the FDIC and the North Carolina Office of the Commissioner of Banks (“Commissioner”) issued a Consent Order (the “Order”) in connection with compliance by the Bank with the Bank Secrecy Act and its implementing regulations (collectively, the “BSA”). The Order was issued pursuant to the consent of the Bank. In consenting to the issuance of the Order, the Bank did not admit or deny any unsafe or unsound banking practices or violations of law or regulation.
 
The Order required the Bank to take certain affirmative actions to comply with its obligations under the BSA, including, without limitation, strengthening its Board of Directors’ oversight of BSA activities; reviewing, enhancing, adopting and implementing a revised BSA compliance program; completing a BSA risk assessment; developing a revised system of internal controls designed to ensure full compliance with the BSA;reviewing and revising customer due diligence and risk assessment processes, policies and procedures; developing, adopting and implementing effective BSA training programs; assessing BSA staffing needs and resources and appointing a qualified BSA officer;establishing an independent BSA testing program; ensuring that all reports required by the BSA are accurately and properly filed and engaging an independent firm to review past account activity to determine whether suspicious activity was properly identified and reported.
 
During the third quarter of 2017 the Bank received notice that the Order was terminated effective August 30, 2017.
 
Summary of Significant and Critical Accounting Policies
The consolidated financial statements include the financial statements of Bancorp and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc., Real Estate Advisory Services, Inc. (“REAS”), Community Bank Real Estate Solutions, LLC (“CBRES”) and PB Real Estate Holdings, LLC (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.
 
The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2018 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 2, 2019 Annual Meeting of Shareholders.
 
The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.
 
Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in this management’s discussion and analysis and the Notes to Consolidated Financial Statements.
 
There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).
 
The disclosure requirements for derivatives and hedging activities are intended to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of, and gains and losses, on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
 
 
A-5
 
 
The Company has an overall interest rate risk management strategy that has, in prior years, incorporated the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility. When using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative. The Company minimized the credit risk in derivative instruments by entering into transactions with high-quality counterparties that were reviewed periodically by the Company. The Company did not have any interest rate derivatives outstanding as of December 31, 2018 or 2017.
 
Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates.
 
Results of Operations
Summary. The Company reported earnings of $13.4 million or $2.23 basic net earnings per share and $2.22 diluted net earnings per share for the year ended December 31, 2018, as compared to $10.3 million or $1.71 basic net earnings per share and $1.69 diluted net earnings per share for the same period one year ago. The increase in year-to-date net earnings is primarily attributable to an increase in net interest income, an increase in non-interest income and a decrease in income tax expense, which were partially offset by an increase in the provision for loan losses and an increase in non-interest expense, as discussed below.
 
The Company reported earnings of $10.3 million or $1.71 basic net earnings per share and $1.69 diluted net earnings per share for the year ended December 31, 2017, as compared to $9.2 million or $1.53 basic net earnings per share and $1.50 diluted net earnings per share for the year ended December 31, 2016. The increase in year-to-date net earnings from 2016 to 2017 is primarily attributable to an increase in net interest income and a decrease in non-interest expense, which were partially offset by a decrease in non-interest income and a decrease in the credit to the provision for loan losses, as discussed below. Earnings for the year ended December 31, 2017 were reduced by a charge to income tax expense of $588,000 due to the revaluation of deferred taxes as required due to the passing of the Tax Cuts and Jobs Act (“TCJA”) in December, 2017. Without this charge to earnings, the Company would have had net earnings totaling $10.9 million for the year ended December 31, 2017.
 
The return on average assets in 2018 was 1.22%, compared to 0.93% in 2017 and 0.85% in 2016. The return on average shareholders’ equity was 10.81% in 2018 compared to 8.78% in 2017 and 8.11% in 2016.
 
Net Interest Income. Net interest income, the major component of the Company’s net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them. Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid. Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.
 
Net interest income for 2018 was $43.2 million compared to $39.6 million in 2017. The increase in net interest income was primarily due to a $3.4 million increase in interest income, which was primarily attributable to an increase in the average outstanding balance of loans and a 1.00% increase in the prime rate since December 31, 2017, combined with a $231,000 decrease in interest expense, which was primarily attributable to a decrease in the average outstanding balances of Federal Home Loan Bank (“FHLB”) borrowings during the year ended December 31, 2018, as compared to the same period one year ago due to the payoff of remaining FHLB borrowings in October 2017. Net interest income increased to $39.6 million in 2017 from $36.5 million in 2016.
 
Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2018, 2017 and 2016. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 22.98% for securities that are both federal and state tax exempt and an effective tax rate of 20.48% for federal tax exempt securities. Non-accrual loans and the interest income that was recorded on non-accrual loans, if any, are included in the yield calculations for loans in all periods reported.
 
 
A-6
 
 
Table 1- Average Balance Table                                            
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
December 31, 2017
 
 
December 31, 2016
 
(Dollars in thousands)
 
Average Balance
 
 
Interest
 
 
Yield / Rate
 
 
Average Balance
 
 
Interest
 
 
Yield / Rate
 
 
Average Balance
 
 
Interest
 
 
Yield / Rate
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 $777,098 
  38,654 
  4.97%
 $741,655 
  34,888 
  4.70%
  703,484 
  32,452 
  4.61%
Investments - taxable
  71,093 
  1,936 
  2.72%
  64,341 
  1,693 
  2.63%
  78,575 
  1,925 
  2.45%
Investments - nontaxable*
  142,832 
  5,508 
  3.86%
  173,069 
  7,314 
  4.23%
  178,379 
  7,577 
  4.25%
Other
  16,461 
  304 
  1.85%
  19,756 
  219 
  1.11%
  24,798 
  123 
  0.50%
 
    
    
    
    
    
    
    
    
    
Total interest-earning assets
  1,007,484 
  46,402 
  4.61%
  998,821 
  44,114 
  4.42%
  985,236 
  42,077 
  4.27%
 
    
    
    
    
    
    
    
    
    
Cash and due from banks
  41,840 
    
    
  53,805 
    
    
  44,732 
    
    
Other assets
  51,704 
    
    
  53,557 
    
    
  59,537 
    
    
Allowance for loan losses
  (6,321)
    
    
  (7,191)
    
    
  (8,884)
    
    
 
    
    
    
    
    
    
    
    
    
Total assets
 $1,094,707 
    
    
  1,098,992 
    
    
  1,080,621 
    
    
 
    
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
Interest-bearing liabilities:
    
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
NOW, MMDA & savings deposits
 $484,180 
  769 
  0.16%
 $481,455 
  598 
  0.12%
  447,582 
  495 
  0.11%
Time deposits
  112,398 
  472 
  0.42%
  132,626 
  466 
  0.35%
  150,641 
  586 
  0.39%
FHLB borrowings
  - 
  - 
  - 
  16,329 
  662 
  4.05%
  42,903 
  1,661 
  3.87%
Trust preferred securities
  20,619 
  790 
  3.83%
  20,619 
  590 
  2.86%
  20,619 
  485 
  2.35%
Other
  47,968 
  115 
  0.24%
  49,530 
  61 
  0.12%
  43,546 
  44 
  0.10%
 
    
    
    
    
    
    
    
    
    
Total interest-bearing liabilities
  665,165 
  2,146 
  0.32%
  700,559 
  2,377 
  0.34%
  705,291 
  3,271 
  0.46%
 
    
    
    
    
    
    
    
    
    
Demand deposits
  306,544 
    
    
  281,048 
    
    
  258,091 
    
    
Other liabilities
  (799)
    
    
  502 
    
    
  4,043 
    
    
Shareholders' equity
  123,797 
    
    
  116,883 
    
    
  113,196 
    
    
 
    
    
    
    
    
    
    
    
    
Total liabilities and shareholder's equity
 $1,094,707 
    
    
  1,098,992 
    
    
  1,080,621 
    
    
 
    
    
    
    
    
    
    
    
    
Net interest spread
    
 $44,256 
  4.29%
    
 $41,737 
  4.08%
    
 $38,806 
  3.81%
 
    
    
    
    
    
    
    
    
    
Net yield on interest-earning assets
    
    
  4.39%
    
    
  4.18%
    
    
  3.94%
 
    
    
    
    
    
    
    
    
    
Taxable equivalent adjustment
    
    
    
    
    
    
    
    
    
        Investment securities
    
 $1,052 
    
    
 $2,165 
    
    
 $2,268 
    
 
    
    
    
    
    
    
    
    
    
Net interest income
    
 $43,204 
    
    
 $39,572 
    
    
 $36,538 
    
 
*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $38.0 million in 2018, $40.3 million in 2017 and $38.7 million in 2016. The tax rates of 2.50%, 3.00% and 4.00% were used to calculate the tax equivalent yields on these securities in 2018, 2017 and 2016, respectively.
 
Changes in interest income and interest expense can result from variances in both volume and rates. Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated. The changes in interest due to both volume and rate have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.
 
 
A-7
 
  
Table 2 - Rate/Volume Variance Analysis-Tax Equivalent Basis
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
December 31, 2017
 
(Dollars in thousands)
 
Changes in average volume
 
 
Changes in average rates
 
 
Total Increase (Decrease)
 
 
Changes in average volume
 
 
Changes in average rates
 
 
Total Increase (Decrease)
 
Interest income:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans: Net of unearned income
 $1,715 
  2,051 
  3,766 
  1,778 
  658 
  2,436 
 
    
    
    
    
    
    
Investments - taxable
  181 
  62 
  243 
  (362)
  130 
  (232)
Investments - nontaxable
  (1,222)
  (584)
  (1,806)
  (225)
  (38)
  (263)
Other
  (49)
  134 
  85 
  (40)
  136 
  96 
Total interest income
  625 
  1,663 
  2,288 
  1,151 
  886 
  2,037 
 
    
    
    
    
    
    
Interest expense:
    
    
    
    
    
    
NOW, MMDA & savings deposits
  4 
  167 
  171 
  40 
  63 
  103 
Time deposits
  (78)
  84 
  6 
  (66)
  (54)
  (120)
FHLB / FRB Borrowings
  (331)
  (331)
  (662)
  (1,053)
  54 
  (999)
Trust Preferred Securities
  - 
  200 
  200 
  - 
  105 
  105 
Other
  (3)
  57 
  54 
  7 
  10 
  17 
Total interest expense
  (408)
  177 
  (231)
  (1,072)
  178 
  (894)
Net interest income
 $1,033 
  1,486 
  2,519 
  2,223 
  708 
  2,931 
 
Net interest income on a tax equivalent basis totaled $44.3 million in 2018 as compared to $41.7 million in 2017. The net interest rate spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 4.29% in 2018, as compared to a net interest rate spread of 4.08% in 2017. The net yield on interest-earning assets was 4.39% in 2018 and 4.18% in 2017.
 
Tax equivalent interest income increased $2.3 million in 2018 primarily due to an increase in interest income resulting from an increase in the average outstanding principal balance of loans, which was partially offset by a decrease in the average outstanding balance of investment securities. The average outstanding principal balance of loans increased $35.4 million to $777.1 million in 2018 compared to $741.7 million in 2017. The average outstanding balance of investment securities decreased $23.5 million to $213.9 million in 2018 compared to $237.4 million in 2017. The yield on interest-earning assets was 4.61% in 2018 compared to 4.42% in 2017.
 
Interest expense decreased $231,000 in 2018 compared to 2017. The decrease in interest expense is primarily due to a decrease in the average outstanding balance of FHLB borrowings. Average interest-bearing liabilities decreased by $35.4 million to $665.2 million in 2018 compared to $700.6 million in 2017. The cost of funds decreased to 0.32% in 2018 from 0.34% in 2017.
 
In 2017 net interest income on a tax equivalent basis was $41.7 million compared to $38.8 million in 2016. The net interest spread was 4.08% in 2017 compared to 3.81% in 2016. The net yield on interest-earning assets was 4.18% in 2017 compared to 3.94% in 2016.
 
Provision for Loan Losses. Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Bank’s loan portfolio, including the valuation of impaired loans, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.
 
The provision for loan losses for the year ended December 31, 2018 was an expense of $790,000, as compared to a credit of $507,000 for the year ended December 31, 2017. The increase in the provision for loan losses is primarily attributable to a $44.2 million increase in loans from December 31, 2017 to December 31, 2018. The credits to provision for loan losses for the years ended December 31, 2017 and 2016 resulted from, and were considered appropriate as part of, management’s assessment and estimate of the risks in the total loan portfolio and determination of the total allowance for loan losses. The primary factors contributing to the continued decrease in the allowance for loan losses as a percent of total loans outstanding were the continuing positive trends in indicators of potential losses on loans, primarily non-accrual loans and the reduction in the level of net charge-offs since 2014, as shown in Table 3 below: 
 
 
A-8
 
 

Table 3 - Net Charge-off Analysis
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net charge-offs/(recoveries)      
 
 
Net charge-offs/(recoveries) as a percent of average loans outstanding
 
 
 
Years ended December 31,      
 
 
Years ended December 31,    
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
Real estate loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $43 
  (14)
  (3)
  153 
  456 
  0.05%
  (0.02%)
  (0.01%)
  0.25%
  0.78%
Single-family residential
  10 
  164 
  220 
  584 
  237 
  0.00%
  0.07%
  0.09%
  0.27%
  0.12%
Single-family residential -
    
    
    
    
    
    
    
    
    
    
Banco de la Gente non-traditional
  - 
  - 
  - 
  95 
  174 
  0.00%
  0.00%
  0.00%
  0.21%
  0.36%
Commercial
  348 
  (21)
  299 
  308 
  119 
  0.13%
  (0.01%)
  0.12%
  0.13%
  0.05%
Multifamily and farmland
  4 
  66 
  - 
  - 
  - 
  0.01%
  0.23%
  0.00%
  0.00%
  0.00%
Total real estate loans
  405 
  195 
  516 
  1,140 
  986 
  0.06%
  0.03%
  0.09%
  0.20%
  0.18%
 
    
    
    
    
    
    
    
    
    
    
Loans not secured by real estate
    
    
    
    
    
    
    
    
    
    
Commercial loans
  22 
  163 
  (25)
  (64)
  376 
  0.02%
  (0.03%)
  (0.03%)
  (0.07%)
  0.53%
Farm loans
  - 
  - 
  - 
  - 
  - 
  0.00%
  0.00%
  0.00%
  0.00%
  0.00%
Consumer loans (1)
  284 
  319 
  342 
  400 
  358 
  3.11%
  3.10%
  3.38%
  4.00%
  3.63%
All other loans
  - 
  - 
  - 
  - 
  - 
  0.00%
  0.00%
  0.00%
  0.00%
  0.00%
Total loans
 $711 
  677 
  833 
  1,476 
  1,720 
  0.09%
  0.09%
  0.12%
  0.22%
  0.27%
 
    
    
    
    
    
    
    
    
    
    
Provision for (reduction of) loan losses
    
    
    
    
    
    
    
    
    
    
for the period
 $790 
  (507)
  (1,206)
  (17)
  (699)
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
Allowance for loan losses at end of period
 $6,445 
  6,366 
  7,550 
  9,589 
  11,082 
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
Total loans at end of period
 $804,023 
  759,764 
  723,811 
  689,091 
  651,891 
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
Non-accrual loans at end of period
 $3,314 
  3,711 
  3,825 
  8,432 
  10,728 
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
Allowance for loan losses as a percent of
    
    
    
    
    
    
    
    
    
    
total loans outstanding at end of period
  0.80%
  0.84%
  1.04%
  1.39%
  1.70%
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
Non-accrual loans as a percent of
    
    
    
    
    
    
    
    
    
    
total loans outstanding at end of period
  0.41%
  0.49%
  0.53%
  1.22%
  1.65%
    
    
    
    
    
 
(1) The loss ratio for consumer loans is elevated because overdraft charge-offs related to DDA and NOW accounts are reported in consumer loan charge-offs and recoveries. The net overdraft charge-offs are not considered material and are therefore not shown separately.
 
Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.
 
Non-Interest Income. Non-interest income was $16.2 million for the year ended December 31, 2018, compared to $15.4 million for the year ended December 31, 2017. The increase in non-interest income is primarily attributable to a $893,000 increase in miscellaneous non-interest income, which was partially offset by a $339,000 decrease in mortgage banking income during the year ended December 31, 2018, as compared to the year ended December 31, 2017. The increase in miscellaneous non-interest income is primarily due to a $576,000 increase in net gains associated with the disposal of premises and equipment, as compared to the year ended December 31, 2017. The decrease in mortgage banking income is primarily due to a decrease in mortgage loan volume resulting from an increase in mortgage loan rates.
 
Non-interest income was $15.4 million for the year ended December 31, 2017, compared to $16.2 million for the year ended December 31, 2016. The decrease in non-interest income is primarily attributable to a $729,000 decrease in gains on the sale of securities, a $341,000 decrease in service charges and fees and a $238,000 decrease in mortgage banking income during the year ended December 31, 2017, as compared to the year ended December 31, 2016.
 
 The Company periodically evaluates its investments for any impairment which would be deemed other-than-temporary.   No investment impairments were deemed other-than-temporary in 2018, 2017 or 2016.
 
 
 
A-9
 
 
 
Table 4 presents a summary of non-interest income for the years ended December 31, 2018, 2017 and 2016.
 
Table 4 - Non-Interest Income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
Service charges
 $4,355 
  4,453 
  4,497 
Other service charges and fees
  705 
  593 
  890 
Gain on sale of securities
  15 
  - 
  729 
Mortgage banking income
  851 
  1,190 
  1,428 
Insurance and brokerage commissions
  824 
  761 
  632 
Gain/(loss) on sale and write-down of other real estate
  17 
  (239)
  64 
Visa debit card income
  3,911 
  3,757 
  3,589 
Appraisal management fee income
  3,206 
  3,306 
  3,146 
Miscellaneous
  2,282 
  1,543 
  1,261 
Total non-interest income
 $16,166 
  15,364 
  16,236 
 
Non-Interest Expense. Non-interest expense was $42.6 million for the year ended December 31, 2018, as compared to $41.2 million for the year ended December 31, 2017. The increase in non-interest expense was primarily due to a $1.5 million increase in salaries and benefits expense and a $469,000 increase in occupancy expense, which were partially offset by decreases in adverting expense, debit card expense and other non-interest expense, during the year ended December 31, 2018, as compared to the year ended December 31, 2017. The increase in salaries and benefits expense is primarily due to an increase in the number of full-time equivalent employees and annual salary increases. The increase in occupancy expense is primarily due to an increase in depreciation expense during the year ended December 31, 2018, as compared to the year ended December 31, 2017.
 
Non-interest expense was $41.2 million for the year ended December 31, 2017, as compared to $42.2 million for the year ended December 31, 2016. The decrease in non-interest expense was primarily due to a $1.2 million decrease in professional fees and a $878,000 decrease in other non-interest expense, which were partially offset by a $794,000 increase in salaries and benefits expense during the year ended December 31, 2017, as compared to the year ended December 31, 2016. The decrease in professional fees is primarily due to a $1.5 million decrease in consulting fees resulting from the termination of the Order. The decrease in other non-interest expense is primarily due to a $752,000 decrease in FHLB prepayment penalties and the increase in salaries and benefits expense is primarily due to an increase in the number of full-time equivalent employees, annual salary increases and an increase in expenses associated with restricted stock units due to an increase in the Company’s stock price.
 
 
Table 5 presents a summary of non-interest expense for the years ended December 31, 2018, 2017 and 2016.
 
Table 5 - Non-Interest Expense
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
Salaries and employee benefits
 $21,530 
  20,058 
  19,264 
Occupancy expense
  7,170 
  6,701 
  6,765 
Office supplies
  503 
  517 
  465 
FDIC deposit insurance
  328 
  347 
  494 
Visa debit card expense
  994 
  1,248 
  1,141 
Professional services
  513 
  451 
  182 
Postage
  249 
  258 
  224 
Telephone
  678 
  855 
  754 
Director fees and expense
  312 
  317 
  326 
Advertising
  922 
  1,195 
  1,136 
Consulting fees
  1,012 
  785 
  2,257 
Taxes and licenses
  288 
  263 
  272 
Foreclosure/OREO expense
  58 
  46 
  120 
Internet banking expense
  603 
  720 
  710 
FHLB advance prepayment penalty
  - 
  508 
  1,260 
Appraisal management fee expense
  2,460 
  2,526 
  2,260 
Other operating expense
  4,954 
  4,433 
  4,612 
Total non-interest expense
 $42,574 
  41,228 
  42,242 
 

 
A-10
 
  
 
Income Taxes. The Company reported income tax expense of $2.6 million, $3.9 million and $2.6 million for the years ended December 31, 2018, 2017 and 2016, respectively. The Company’s effective tax rates were 16.39%, 28.03% and 21.82% in 2018, 2017 and 2016, respectively. Income tax expense for the year ended December 31, 2017 includes $588,000 additional tax expense due to the revaluation of the Company’s deferred tax asset as a result of the TCJA, which reduced the Company’s federal corporate tax rate from 34% to 21% effective January 1, 2018.
 
Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements. Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities. In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit. As of December 31, 2018, such unfunded commitments to extend credit were $268.7 million, while commitments in the form of standby letters of credit totaled $3.7 million.
 
The Company uses several funding sources to meet its liquidity requirements. The primary funding source is core deposits, which includes demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $250,000. The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships. As of December 31, 2018, the Company’s core deposits totaled $859.2 million, or 98% of total deposits.
 
The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings. The Bank is also able to borrow from the FRB on a short-term basis. The Bank’s policies include the ability to access wholesale fundingup to 40% of total assets. The Bank’s wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits and internet certificates of deposit. The Company’s ratio of wholesale funding to total assets was 0.31% as of December 31, 2018.
 
The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with no balances outstanding at December 31, 2018. At December 31, 2018, the carrying value of loans pledged as collateral totaled approximately $140.0 million. The remaining availability under the line of credit with the FHLB was $84.9 million at December 31, 2018. The Bank had no borrowings from the FRB at December 31, 2018. The FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2018, the carrying value of loans pledged as collateral to the FRB totaled approximately $442.6 million.
 
The Bank also had the ability to borrow up to $82.5 million for the purchase of overnight federal funds from six correspondent financial institutions as of December 31, 2018.
 
The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 16.09%, 20.62% and 24.78% at December 31, 2018, 2017 and 2016, respectively. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy for on balance sheet liquidity was 10% at December 31, 2018, 2017 and 2016.
 
As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $17.2 million during 2018. Net cash used in investing activities was $18.6 million during 2018 and net cash used by financing activities was $12.5 million during 2018.
 
Asset Liability and Interest Rate Risk Management. The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities. This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 6 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2018.
 
 
A-11
 
  
Table 6 - Interest Sensitivity Analysis
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Immediate
 
 
1-3 months
 
 
4-12 months
 
 
Total Within One Year
 
 
Over One Year & Non-sensitive
 
 
Total
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
 $284,260 
  12,993 
  16,371 
  313,624 
  490,399 
  804,023 
Mortgage loans held for sale
  680 
  - 
  - 
  680 
  - 
  680 
Investment securities available for sale
  - 
  5,261 
  22,383 
  27,644 
  166,934 
  194,578 
Interest-bearing deposit accounts
  2,817 
  - 
  - 
  2,817 
  - 
  2,817 
Other interest-earning assets
  - 
  - 
  - 
  - 
  4,980 
  4,980 
Total interest-earning assets
  287,757 
  18,254 
  38,754 
  344,765 
  662,313 
  1,007,078 
 
    
    
    
    
    
    
Interest-bearing liabilities:
    
    
    
    
    
    
NOW, savings, and money market deposits
  475,223 
  - 
  - 
  475,223 
  - 
  475,223 
Time deposits
  11,574 
  13,990 
  36,365 
  61,929 
  41,244 
  103,173 
FHLB borrowings
  - 
  - 
  - 
  - 
  - 
  - 
Securities sold under
    
    
    
    
    
    
agreement to repurchase
  58,095 
  - 
  - 
  58,095 
  - 
  58,095 
Trust preferred securities
  - 
  20,619 
  - 
  20,619 
  - 
  20,619 
Total interest-bearing liabilities
  544,892 
  34,609 
  36,365 
  615,866 
  41,244 
  657,110 
 
    
    
    
    
    
    
Interest-sensitive gap
 $(257,135)
  (16,355)
  2,389 
  (271,101)
  621,069 
  349,968 
 
    
    
    
    
    
    
Cumulative interest-sensitive gap
 $(257,135)
  273,490)
  (271,101)
  (271,101)
  349,968 
    
 
    
    
    
    
    
    
Interest-earning assets as a percentage of interest-bearing liabilities
  52.81%
  52.74%
  106.57%
  55.98%
  1605.84%
    
 
The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank. The ALCO meets quarterly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company. ALCO tries to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements. The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.
 
The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year. Rate sensitive assets therefore include both loans and available for sale (“AFS”) securities. Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds. At December 31, 2018, rate sensitive assets and rate sensitive liabilities totaled $1.0 billion and $657.1 million, respectively.
 
Included in the rate sensitive assets are $279.1 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”). The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate. At December 31, 2018, the Bank had $161.4 million in loans with interest rate floors. The floors were in effect on $2.5 million of these loans pursuant to the terms of the promissory notes on these loans. The weighted average rate on these loans is 0.47% higher than the indexed rate on the promissory notes without interest rate floors.
 
An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities. A discussion of these changes and trends follows.
 
Analysis of Financial Condition
 
Investment Securities. The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.
 
All of the Company’s investment securities are held in the AFS category. At December 31, 2018, the market value of AFS securities totaled $194.6 million, compared to $229.3 million and $249.9 million at December 31, 2017 and 2016, respectively. Table 7 presents the fair value of the AFS securities held at December 31, 2018, 2017 and 2016.
 
 
 
A-12
 
 
Table 7 - Summary of Investment Portfolio
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
U. S. Government sponsored enterprises
 $34,634 
  40,380 
  38,222 
State and political subdivisions
  107,591 
  133,570 
  141,856 
Mortgage-backed securities
  52,103 
  53,609 
  67,585 
Corporate bonds
  - 
  1,512 
  1,533 
Trust preferred securities
  250 
  250 
  750 
Total securities
 $194,578 
  229,321 
  249,946 
 
The Company’s investment portfolio consists of U.S. Government sponsored enterprise securities, municipal securities, U.S. Government sponsored enterprise mortgage-backed securities, corporate bonds, trust preferred securities and equity securities. AFS securities averaged $209.7 million in 2018, $234.3 million in 2017 and $252.7 million in 2016. Table 8 presents the book value of AFS securities held by the Company by maturity category at December 31, 2018. Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity. Yields are calculated on a tax equivalent basis. Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 22.98% for securities that are both federal and state tax exempt and an effective tax rate of 20.48% for federal tax exempt securities.
 
Table 8 - Maturity Distribution and Weighted Average Yield on Investments                               
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
After One Year
 
 
After 5 Years
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One Year or Less
 
 
Through 5 Years
 
 
Through 10 Years
 
 
After 10 Years
 
 
Totals
 
(Dollars in thousands)
 
Amount
 
 
Yield
 
 
Amount
 
 
Yield
 
 
Amount
 
 
Yield
 
 
Amount
 
 
Yield
 
 
Amount
 
 
Yield
 
Book value:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
sponsored enterprises
 $2,356 
  -0.86%
  13,956 
  2.01%
  16,307 
  2.94%
  2,737 
  4.34%
  35,356 
  1.35%
State and political subdivisions
  19,023 
  3.80%
  66,976 
  3.17%
  15,965 
  3.28%
  3,581 
  3.95%
  105,545 
  3.52%
Mortgage-backed securities
  6,215 
  3.29%
  20,056 
  3.29%
  12,534 
  3.34%
  13,340 
  3.33%
  52,145 
  3.30%
Trust preferred securities
  - 
  - 
  - 
  - 
  - 
  - 
  250 
  8.11%
  250 
  8.11%
Total securities
 $27,594 
  2.99%
  100,988 
  3.05%
  44,806 
  3.10%
  19,908 
  3.91%
  193,296 
  3.14%
 
 
Loans. The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Bank grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Wake and Durham counties in North Carolina.
 
Although the Company has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Real estate mortgage loans include both commercial and residential mortgage loans. At December 31, 2018, the Company had $102.1 million in residential mortgage loans, $106.9 million in home equity loans and $376.6 million in commercial mortgage loans, which include $300.3 million secured by commercial property and $76.3 million secured by residential property. Residential mortgage loans include $34.3 million in non-traditional mortgage loans from the former Banco division of the Bank. All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.
 
At December 31, 2018, the Bank had $94.1 million in construction and land development loans. Table 9 presents a breakout of these loans.
 
Table 9 - Construction and Land Development Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Number of Loans
 
 
Balance Outstanding
 
 
Non-accrual Balance
 
Land acquisition and development - commercial purposes
  44 
 $9,777 
  - 
Land acquisition and development - residential purposes
  196 
  19,097 
  1 
1 to 4 family residential construction
  137 
  26,933 
  - 
Commercial construction
  25 
  38,371 
  - 
Total acquisition, development and construction
  402 
 $94,178 
  1 
 

A-13
 
 
The mortgage loans originated in the traditional banking offices are generally 15 to 30 year fixed rate loans with attributes that prevent the loans from being sellable in the secondary market. These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type. These loans are generally made to existing Bank customers and have been originated throughout the Bank’s seven county service area, with no geographic concentration.
 
 
The composition of the Bank’s loan portfolio at December 31 is presented in Table 10.
 
Table 10 - Loan Portfolio
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
(Dollars in thousands)
 
Amount
 
 
% of Loans
 
 
Amount
 
 
% of Loans
 
 
Amount
 
 
% of Loans
 
 
Amount
 
 
% of Loans
 
 
Amount
 
 
% of Loans
 
Real estate loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $94,178 
  11.71%
  84,987 
  11.19%
  61,749 
  8.53%
  65,791 
  9.55%
  57,617 
  8.84%
Single-family residential
  252,983 
  31.47%
  246,703 
  32.47%
  240,700 
  33.25%
  220,690 
  32.03%
  206,417 
  31.66%
Single-family residential- Banco de la
    
    
    
    
    
    
    
    
    
    
Gente non-traditional
  34,261 
  4.26%
  37,249 
  4.90%
  40,189 
  5.55%
  43,733 
  6.35%
  47,015 
  7.21%
Commercial
  270,055 
  33.59%
  248,637 
  32.73%
  247,521 
  34.20%
  228,526 
  33.16%
  228,558 
  35.06%
Multifamily and farmland
  33,163 
  4.12%
  28,937 
  3.81%
  21,047 
  2.91%
  18,080 
  2.62%
  12,400 
  1.90%
Total real estate loans
  684,640 
  85.15%
  646,513 
  85.10%
  611,206 
  84.44%
  576,820 
  83.71%
  552,007 
  84.68%
 
    
    
    
    
    
    
    
    
    
    
Loans not secured by real estate
    
    
    
    
    
    
    
    
    
    
Commercial loans
  97,465 
  12.12%
  89,022 
  11.71%
  87,596 
  12.11%
  91,010 
  13.22%
  76,262 
  11.71%
Farm loans
  926 
  0.12%
  1,204 
  0.16%
  - 
  0.00%
  3 
  0.00%
  7 
  0.00%
Consumer loans
  9,165 
  1.14%
  9,888 
  1.30%
  9,832 
  1.36%
  10,027 
  1.46%
  10,060 
  1.54%
All other loans
  11,827 
  1.47%
  13,137 
  1.73%
  15,177 
  2.10%
  11,231 
  1.63%
  13,555 
  2.08%
Total loans
  804,023 
  100.00%
  759,764 
  100.00%
  723,811 
  100.00%
  689,091 
  100.00%
  651,891 
  100.00%
 
    
    
    
    
    
    
    
    
    
    
Less: Allowance for loan losses
  6,445 
    
  6,366 
    
  7,550 
    
  9,589 
    
  11,082 
    
 
    
    
    
    
    
    
    
    
    
    
Net loans
 $797,578 
    
  753,398 
    
  716,261 
    
  679,502 
    
  640,809 
    
 
As of December 31, 2018, gross loans outstanding were $804.0 million, compared to $759.8 million at December 31, 2017. Average loans represented 71% and 74% of total earning assets for the years ended December 31, 2018 and 2017, respectively. The Bank had $680,000 and $857,000 in mortgage loans held for sale as of December 31, 2018 and 2017, respectively.
 
Troubled debt restructured (“TDR”) modified in 2018, past due TDR loans and non-accrual TDR loans totaled $4.7 million and $4.5 million at December 31, 2018 and December 31, 2017, respectively. The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower. There were $92,000 and $21,000 in performing loans classified as TDR loans at December 31, 2018 and December 31, 2017, respectively.
 
Table 11 identifies the maturities of all loans as of December 31, 2018 and addresses the sensitivity of these loans to changes in interest rates. 
 
 
A-14
 
 

 
Table 11 - Maturity and Repricing Data for Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Within one year or less
 
 
After one year through five years
 
 
After five years
 
 
Total loans
 
Real estate loans
 
 
 
 
 
 
 
 
 
 
 
 
    Construction and land development
 $44,536 
  17,357 
  32,285 
  94,178 
    Single-family residential
  118,229 
  88,338 
  46,416 
  252,983 
    Single-family residential- Banco de la Gente
    
    
    
    
    stated income
  15,061 
  - 
  19,200 
  34,261 
    Commercial
  82,210 
  141,347 
  46,498 
  270,055 
    Multifamily and farmland
  4,560 
  14,761 
  13,842 
  33,163 
          Total real estate loans
  264,596 
  261,803 
  158,241 
  684,640 
 
    
    
    
    
Loans not secured by real estate
    
    
    
    
Commercial loans
  56,679 
  23,910 
  16,876 
  97,465 
Farm loans
  691 
  235 
  - 
  926 
Consumer loans
  5,127 
  3,777 
  261 
  9,165 
All other loans
  6,130 
  3,042 
  2,655 
  11,827 
Total loans
 $333,223 
  292,767 
  178,033 
  804,023 
 
    
    
    
    
Total fixed rate loans
 $19,599 
  245,838 
  178,033 
  443,470 
Total floating rate loans
  313,624 
  46,929 
  - 
  360,553 
 
    
    
    
    
Total loans
 $333,223 
  292,767 
  178,033 
  804,023 
 
In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2018, outstanding loan commitments totaled $272.4 million. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Additional information regarding commitments is provided below in the section entitled “Contractual Obligations and Off-Balance Sheet Arrangements” and in Note 10 to the Consolidated Financial Statements.
 
Allowance for Loan Losses. The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
 
the Bank’s loan loss experience;
the amount of past due and non-performing loans;
specific known risks;
the status and amount of other past due and non-performing assets;
underlying estimated values of collateral securing loans;
current and anticipated economic conditions; and
other factors which management believes affect the allowance for potential credit losses.
 
Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.
 
 
 
 
A-15
 
 

As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than $1.0 million, excluding loans in default, and loans in process of litigation or liquidation. The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.
 
Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.
 
Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses. The provision for loan losses charged or credited to earnings is based upon management’s judgment of the amount necessary to maintain the allowance at a level appropriate to absorb probable incurred losses in the loan portfolio at the balance sheet date. The amount each quarter is dependent upon many factors, including growth and changes in the composition of the loan portfolio, net charge-offs, delinquencies, management’s assessment of loan portfolio quality, the value of collateral, and other macro-economic factors and trends. The evaluation of these factors is performed quarterly by management through an analysis of the appropriateness of the allowance for loan losses.
 
The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment. When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Bank’s loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.
 
The general allowance reflects reserves established under GAAP for collective loan impairment. These reserves are based upon historical net charge-offs using the greater of the last two, three, four or five years’ loss experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves.
 
The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.
 
There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2018 as compared to the year ended December 31, 2017. Revisions, estimates and assumptions may be made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.
 
Effective December 31, 2012, certain mortgage loans from the former Banco division of the Bank were analyzed separately from other single family residential loans in the Bank’s loan portfolio. These loans are first mortgage loans made to the Latino market, primarily in Mecklenburg, North Carolina and surrounding counties. These loans are non-traditional mortgages in that the customer normally did not have a credit history, so all credit information was accumulated by the loan officers.
 
Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations. Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment. Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Bank’s loan portfolio as of the date of the financial statements. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.
 
 
A-16
 
 

 
Net charge-offs for 2018, 2017 and 2016 were $711,000, $677,000 and $833,000, respectively. The ratio of net charge-offs to average total loans was 0.09% in 2018, 0.09% in 2017 and 0.12% in 2016. The Bank strives to proactively work with its customers to identify potential problems. If found, the Bank works to quickly recognize identifiable losses and to establish a plan, with the borrower, if possible, to have the loans paid off. This process of early identification increased the levels of charge-offs and provision for loan losses in 2009 through 2013 as compared to historical periods prior to 2009. The years ended December 31, 2016, 2017 and 2018 saw net charge-offs at historically low levels.. The current level of past due and non-accrual loans currently indicate that net charge-offs may remain near these historical lows. The allowance for loan losses was $6.4 million or 0.80% of total loans outstanding at December 31, 2018. For December 31, 2017 and 2016, the allowance for loan losses amounted to $6.4 million or 0.84% of total loans outstanding and $7.6 million, or 1.04% of total loans outstanding, respectively.
 
Table 12 presents the percentage of loans assigned to each risk grade at December 31, 2018 and 2017.
 
Table 12 - Loan Risk Grade Analysis
 
 
 
 
 
 
 
 
Percentage of Loans
 
 
 
By Risk Grade
 
Risk Grade
 
2018
 
 
2017
 
Risk Grade 1 (Excellent Quality)
  0.94%
  1.31%
Risk Grade 2 (High Quality)
  25.47%
  26.23%
Risk Grade 3 (Good Quality)
  60.85%
  60.67%
Risk Grade 4 (Management Attention)
  10.19%
  8.19%
Risk Grade 5 (Watch)
  1.72%
  2.54%
Risk Grade 6 (Substandard)
  0.84%
  1.04%
Risk Grade 7 (Doubtful)
  0.00%
  0.00%
Risk Grade 8 (Loss)
  0.00%
  0.00%
 
 
Table 13 presents an analysis of the allowance for loan losses, including charge-off activity.
 
Table 13 - Analysis of Allowance for Loan Losses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
Allowance for loan losses at beginning
 $6,366 
  7,550 
  9,589 
  11,082 
  13,501 
 
    
    
    
    
    
Loans charged off:
    
    
    
    
    
Commercial
  54 
  194 
  146 
  38 
  430 
Real estate - mortgage
  574 
  315 
  593 
  1,064 
  789 
Real estate - construction
  53 
  - 
  7 
  197 
  884 
Consumer
  452 
  473 
  492 
  545 
  534 
Total loans charged off
  1,133 
  982 
  1,238 
  1,844 
  2,637 
 
    
    
    
    
    
Recoveries of losses previously charged off:
    
    
    
    
    
Commercial
  32 
  31 
  170 
  101 
  54 
Real estate - mortgage
  212 
  106 
  74 
  77 
  259 
Real estate - construction
  10 
  14 
  10 
  45 
  428 
Consumer
  168 
  154 
  151 
  145 
  176 
Total recoveries
  422 
  305 
  405 
  368 
  917 
Net loans charged off
  711 
  677 
  833 
  1,476 
  1,720 
 
    
    
    
    
    
Provision for loan losses
  790 
  (507)
  (1,206)
  (17)
  (699)
 
    
    
    
    
    
Allowance for loan losses at end of year
 $6,445 
  6,366 
  7,550 
  9,589 
  11,082 
 
    
    
    
    
    
Loans charged off net of recoveries, as
    
    
    
    
    
a percent of average loans outstanding
  0.09%
  0.09%
  0.12%
  0.22%
  0.27%
 
    
    
    
    
    
Allowance for loan losses as a percent
    
    
    
    
    
of total loans outstanding at end of year
  0.80%
  0.84%
  1.04%
  1.39%
  1.70%
 

 
A-17
 
 
Non-performing Assets. Non-performing assets were $3.3 million or 0.31% of total assets at December 31, 2018, compared to $3.8 million or 0.35% of total assets at December 31, 2017. Non-performing loans include $3.2 million in commercial and residential mortgage loans, $1,000 in construction and land development loans and $99,000 in other loans at December 31, 2018, as compared to $3.6 million in commercial and residential mortgage loans, $14,000 in construction and land development loans and $112,000 in other loans at December 31, 2017. Other real estate owned totaled $27,000 and $118,000 as of December 31, 2018 and 2017, respectively. The Bank had no repossessed assets as of December 31, 2018 and 2017.
 
At December 31, 2018, the Bank had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $3.3 million or 0.41% of total loans. Non-performing loans at December 31, 2017 were $3.7 million or 0.49% of total loans.
 
 
Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing. Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans. Management expects the level of non-accrual loans to continue to be in-line with the level of non-accrual loans at December 31, 2018 and 2017.
 
It is the general policy of the Bank to stop accruing interest income when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income. Generally a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.
 
A summary of non-performing assets at December 31 for each of the years presented is shown in Table 14.
 
Table 14 - Non-performing Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
 
2017
 
 
2016
 
 
2015
 
 
2014
 
Non-accrual loans
 $3,314 
  3,711 
  3,825 
  8,432 
  10,728 
Loans 90 days or more past due and still accruing
  - 
  - 
  - 
  17 
  - 
Total non-performing loans
  3,314 
  3,711 
  3,825 
  8,449 
  10,728 
All other real estate owned
  27 
  118 
  283 
  739 
  2,016 
Repossessed assets
  - 
  - 
  - 
  - 
  - 
Total non-performing assets
 $3,341 
  3,829 
  4,108 
  9,188 
  12,744 
 
    
    
    
    
    
TDR loans not included in above,
    
    
    
    
    
(not 90 days past due or on nonaccrual)
  3,173 
  2,543 
  3,337 
  5,102 
  7,217 
 
    
    
    
    
    
As a percent of total loans at year end
    
    
    
    
    
Non-accrual loans
  0.41%
  0.49%
  0.53%
  1.22%
  1.65%
Loans 90 days or more past due and still accruing
  0.00%
  0.00%
  0.00%
  0.00%
  0.00%
 
    
    
    
    
    
Total non-performing assets
    
    
    
    
    
as a percent of total assets at year end
  0.31%
  0.35%
  0.38%
  0.88%
  1.22%
 
    
    
    
    
    
Total non-performing loans
    
    
    
    
    
 as a percent of total loans at year-end
  0.41%
  0.49%
  0.53%
  1.23%
  1.65%
 
Deposits. The Company primarily uses deposits to fund its loan and investment portfolios. The Company offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits. As of December 31, 2018, total deposits were $877.2 million, compared to $907.0 million at December 31, 2017.  Core deposits, which include demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $250,000, amounted to $859.2 million at December 31, 2018, compared to $887.4 million at December 31, 2017.
 
Time deposits in amounts of $250,000 or more totaled $16.2 million and $18.8 million at December 31, 2018 and 2017, respectively. At December 31, 2018, brokered deposits amounted to $3.4 million as compared to $5.2 million at December 31, 2017. Certificates of deposit participated through the Certificate of Deposit Account Registry Service (“CDARS”) included in brokered deposits amounted to $3.4 million and $5.2 million as of December 31, 2018 and 2017, respectively. Brokered deposits are generally considered to be more susceptible to withdrawal as a result of interest rate changes and to be a less stable source of funds, as compared to deposits from the local market. Brokered deposits outstanding as of December 31, 2018 have a weighted average rate of 0.07% with a weighted average original term of 41 months.
 
 
A-18
 
 
Table 15 is a summary of the maturity distribution of time deposits in amounts of $250,000 or more as of December 31, 2018.
 
Table 15 - Maturities of Time Deposits of $250,000 or greater
 
 
 
 
 
 
 
(Dollars in thousands)
 
2018
 
Three months or less
 $4,199 
Over three months through six months
  1,347 
Over six months through twelve months
  2,176 
Over twelve months
  8,517 
Total
 $16,239 
 
Borrowed Funds. The Company has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions. There were no FHLB borrowings outstanding at December 31, 2018 and 2017. Average FHLB borrowings for 2018 and 2017 were zero and $16.3 million, respectively. The maximum amount of outstanding FHLB borrowings was $20.0 million in 2017. Additional information regarding FHLB borrowings is provided in Note 6 to the Consolidated Financial Statements.
 
The Bank had no borrowings from the FRB at December 31, 2018 and 2017. FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2018, the carrying value of loans pledged as collateral totaled approximately $442.6 million.
 
Securities sold under agreements to repurchase were $58.1 million at December 31, 2018, as compared to $37.8 million at December 31, 2017.
 
Junior subordinated debentures were $20.6 million as of December 31, 2018 and 2017.
 
Contractual Obligations and Off-Balance Sheet Arrangements. The Company’s contractual obligations and other commitments as of December 31, 2018 are summarized in Table 16 below. The Company’s contractual obligations include junior subordinated debentures, as well as certain payments under current lease agreements. Other commitments include commitments to extend credit. Because not all of these commitments to extend credit will be drawn upon, the actual cash requirements are likely to be significantly less than the amounts reported for other commitments below.
 
Table 16 - Contractual Obligations and Other Commitments
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Within One Year
 
 
One to Three Years
 
 
Three to Five Years
 
 
Five Years or More
 
 
Total
 
Contractual Cash Obligations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Junior subordinated debentures
 $- 
  - 
  - 
  20,619 
  20,619 
Operating lease obligations
  734 
  1,416 
  703 
  1,465 
  4,318 
Total
 $734 
  1,416 
  703 
  22,084 
  24,937 
 
    
    
    
    
    
Other Commitments
    
    
    
    
    
Commitments to extend credit
 $104,152 
  27,335 
  24,902 
  112,319 
  268,708 
Standby letters of credit
    
    
    
    
    
and financial guarantees written
  3,651 
  - 
  - 
  - 
  3,651 
Income tax credits
  535 
  101 
  63 
  56 
  755 
Total
 $108,338 
  27,436 
  24,965 
  112,375 
  273,114 
    
               The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-11 and in Notes 1, 10 and 15 to the Consolidated Financial Statements. There were no derivatives at December 31, 2018 or 2017.
 
A-19
 
 

 
Capital Resources. Shareholders’ equity was $123.6 million, or 11.31% of total assets, as of December 31, 2018, compared to $116.0 million, or 10.62% of total assets, as of December 31, 2017. The increase in shareholders’ equity is primarily due to an increase in retained earnings due to net income.
 
Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength. Average shareholders’ equity as a percentage of total average assets was 11.31%, 10.64% and 10.51% for 2018, 2017 and 2016, respectively. The return on average shareholders’ equity was 10.81% at December 31, 2018 as compared to 8.78% and 8.11% at December 31, 2017 and December 31, 2016, respectively. Total cash dividends paid on common stock were $3.1 million, $2.6 million and $2.1 million during 2018, 2017 and 2016 respectively. The Company did not pay any dividends on preferred stock during 2018 and 2017.
 
The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.
 
In 2016, the Company’s Board of Directors authorized a stock repurchase program, pursuant to which up to $2.0 million was allocated to repurchase the Company’s common stock. Any purchases under the Company’s stock repurchase program were made periodically as permitted by securities laws and other legal requirements in the open market or in privately negotiated transactions. The timing and amount of any repurchase of shares were determined by the Company’s management, based on its evaluation of market conditions and other factors. The Company has repurchased approximately $2.0 million, or 92,738 shares of its common stock, under this program as of December 31, 2017.
 
In 2013, the FRB approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations. The Basel III capital standards, which became effective January 1, 2015, include new risk-based capital and leverage ratios, which are being phased in from 2015 to 2019. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are as follows: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total risk based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% (unchanged from previous rules). An additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes beginning on January 1, 2016 at 0.625% and is being phased in through 2019 (increasing by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019). This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained earnings that could be utilized for such actions.
 
Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 6.0% or greater and a common equity Tier 1 capital ratio of 4.5% or greater, as required by the Basel III capital standards referenced above. Tier 1 capital is generally defined as shareholders’ equity and trust preferred securities less all intangible assets and goodwill. Tier 1 capital at December 31, 2018 and December 31, 2017 includes $20.0 million in trust preferred securities. The Company’s Tier 1 capital ratio was 15.46% and 15.32% at December 31, 2018 and December 31, 2017, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company’s allowance for loan losses, not exceeding 1.25% of the Company’s risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 16.15% and 16.06% at December 31, 2018 and December 31, 2017, respectively. The Company’s common equity Tier 1 capital consists of common stock and retained earnings. The Company’s common equity Tier 1 capital ratio was 13.29% and 13.00% at December 31, 2018 and December 31, 2017, respectively. Financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 13.05% and 11.94% at December 31, 2018 and December 31, 2017, respectively.
 

The Bank’s Tier 1 risk-based capital ratio was 15.21% and 15.09% at December 31, 2018 and December 31, 2017, respectively. The total risk-based capital ratio for the Bank was 15.91% and 15.83% at December 31, 2018 and December 31, 2017, respectively. The Bank’s common equity Tier 1 capital ratio was 15.21% and 15.09% at December 31, 2018 and December 31, 2017, respectively. The Bank’s Tier 1 leverage capital ratio was 12.76% and 11.69% at December 31, 2018 and December 31, 2017, respectively.
 
 
 
 
A-20
 

A bank is considered to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater and a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be “well capitalized” at December 31, 2018.
 
The Company’s key equity ratios as of December 31, 2018, 2017 and 2016 are presented in Table 17.
 
Table 17 - Equity Ratios
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
2018
 
 
2017
 
 
2016
 
Return on average assets
  1.22%
  0.93%
  0.85%
Return on average equity
  10.81%
  8.78%
  8.11%
Dividend payout ratio
  23.41%
  25.67%
  22.95%
Average equity to average assets
  11.31%
  10.64%
  10.51%
 
 Quarterly Financial Data. The Company’s consolidated quarterly operating results for the years ended December 31, 2018 and 2017 are presented in Table 18.
 
Table 18 - Quarterly Financial Data
 
 
 
2018       
 
 
2017       
 
(Dollars in thousands, except per share amounts)
 
 First
 
 
 Second
 
 
 Third
 
 
 Fourth
 
 
 First
 
 
 Second
 
 
 Third
 
 
 Fourth
 
Total interest income
 $10,759 
  11,059 
  11,608 
  11,924 
 $10,064 
  10,461 
  10,698 
  10,726 
Total interest expense
  467 
  513 
  557 
  609 
  598 
  622 
  650 
  507 
Net interest income
  10,292 
  10,546 
  11,051 
  11,315 
  9,466 
  9,839 
  10,048 
  10,219 
 
    
    
    
    
    
    
    
    
(Reduction of) provision for loan losses
  31 
  231 
  110 
  418 
  (236)
  49 
  (218)
  (102)
Other income
  3,736 
  4,016 
  3,915 
  4,499 
  3,442 
  3,929 
  4,159 
  3,834 
Other expense
  10,042 
  10,560 
  10,702 
  11,270 
  10,361 
  9,983 
  10,006 
  10,878 
Income before income taxes
  3,955 
  3,771 
  4,154 
  4,126 
  2,783 
  3,736 
  4,419 
  3,277 
 
    
    
    
    
    
    
    
    
Income taxes (benefit)
  652 
  595 
  687 
  690 
  578 
  925 
  1,177 
  1,267 
Net earnings
  3,303 
  3,176 
  3,467 
  3,436 
  2,205 
  2,811 
  3,242 
  2,010 
 
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
Basic net earnings per share
 $0.55 
  0.53 
  0.58 
  0.57 
 $0.36 
  0.47 
  0.54 
  0.34 
Diluted net earnings per share
 $0.55 
  0.53 
  0.57 
  0.57 
 $0.36 
  0.46 
  0.53 
  0.34 
 
 
A-21
 
 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Market risk reflects the risk of economic loss resulting from adverse changes in market prices and interest rates. This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods.
 
The Company’s market risk arises primarily from interest rate risk inherent in its lending and deposit taking activities. The structure of the Company’s loan and deposit portfolios is such that a significant decline (increase) in interest rates may adversely (positively) impact net market values and interest income. Management seeks to manage the risk through the utilization of its investment securities and off-balance sheet derivative instruments. During the years ended December 31, 2018, 2017 and 2016, the Company used interest rate contracts to manage market risk as discussed above in the section entitled “Asset Liability and Interest Rate Risk Management.”
 
Table 19 presents in tabular form the contractual balances and the estimated fair value of the Company’s on-balance sheet financial instruments at their expected maturity dates for the period ended December 31, 2018. The expected maturity categories take into consideration historical prepayment experience as well as management’s expectations based on the interest rate environment at December 31, 2018. For core deposits without contractual maturity (i.e. interest-bearing checking, savings, and money market accounts), the table presents principal cash flows based on management’s judgment concerning their most likely runoff or repricing behaviors.
 
Table 19 - Market Risk Table
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
Loans Receivable
 
2019
 
 
2020
 
 
2021
 
 
2022
 
 
2023
 
 
Thereafter
 
 
Total
 
 
Fair Value
 
Fixed rate
 $34,451 
  33,452 
  54,215 
  66,253 
  91,918 
  180,479 
  460,768 
  411,427 
Average interest rate
  4.90%
  4.95%
  4.78%
  4.88%
  5.24%
  5.03%
    
    
Variable rate
 $65,371 
  31,409 
  22,619 
  22,166 
  33,255 
  169,115 
  343,935 
  344,615 
Average interest rate
  6.10%
  5.90%
  6.11%
  6.12%
  5.87%
  5.51%
    
    
Total
    
    
    
    
    
    
  804,703 
  756,042 
 
    
    
    
    
    
    
    
    
Investment Securities
    
    
    
    
    
    
    
    
Interest bearing cash
 $2,817 
  - 
  - 
  - 
  - 
  - 
  2,817 
  2,817 
Average interest rate
  2.35%
  - 
  - 
  - 
  - 
  - 
    
    
Securities available for sale
 $21,207 
  18,467 
  16,674 
  22,980 
  22,387 
  92,863 
  194,578 
  194,578 
Average interest rate
  4.36%
  4.03%
  4.56%
  4.44%
  4.46%
  4.27%
    
    
Nonmarketable equity securities
 $- 
  - 
  - 
  - 
  - 
  4,361 
  4,361 
  4,361 
Average interest rate
  - 
  - 
  - 
  - 
  - 
  2.87%
    
    
 
    
    
    
    
    
    
    
    
Debt Obligations
    
    
    
    
    
    
    
    
Deposits
 $58,782 
  21,661 
  14,093 
  2,655 
  3,145 
  776,877 
  877,213 
  857,999 
Average interest rate
  0.24%
  0.42%
  0.62%
  0.65%
  0.98%
  0.05%
    
    
Securities sold under agreement
    
    
    
    
    
    
    
    
to repurchase
 $58,095 
  - 
  - 
  - 
  - 
  - 
  58,095 
  58,095 
Average interest rate
  0.44%
  - 
  - 
  - 
  - 
  - 
    
    
Junior subordinated debentures
 $- 
  - 
  - 
  - 
  - 
  20,619 
  20,619 
  20,619 
Average interest rate
  - 
  - 
  - 
  - 
  - 
  4.42%
    
    
  
 
A-22
 
 
Table 20 presents the simulated impact to net interest income under varying interest rate scenarios and the theoretical impact of rate changes over a twelve-month period referred to as “rate ramps.” The table shows the estimated theoretical impact on the Company’s tax equivalent net interest income from hypothetical rate changes of plus and minus 1%, 2% and 3% as compared to the estimated theoretical impact of rates remaining unchanged. The table also shows the simulated impact to market value of equity under varying interest rate scenarios and the theoretical impact of immediate and sustained rate changes referred to as “rate shocks” of plus and minus 1%, 2% and 3% as compared to the theoretical impact of rates remaining unchanged. The prospective effects of the hypothetical interest rate changes are based upon various assumptions, including relative and estimated levels of key interest rates. This type of modeling has limited usefulness because it does not allow for the strategies management would utilize in response to sudden and sustained rate changes. Also, management does not believe that rate changes of the magnitude presented are likely in the forecast period presented.
 
Table 20 - Interest Rate Risk
 
 
 
 
 
(Dollars in thousands)
 
 
 
Estimated Resulting Theoretical Net Interest Income
Hypothetical rate change (ramp over 12 months)
Amount
% Change
+3%
 $50,196
3.32%
+2%
 $50,008
2.94%
+1%
 $49,363
1.61%
0%
 $48,582
0.00%
-1%
 $47,315
-2.61%
-2%
 $46,160
-4.99%
-3%
 $45,727
-5.88%
 
 
 
 
 
 
 
 
 
 
Estimated Resulting Theoretical Market Value of Equity
Hypothetical rate change (immediate shock)
Amount
% Change
+3%
 $183,598
8.06%
+2%
 $188,528
10.96%
+1%
 $184,838
8.79%
0%
 $169,908
0.00%
-1%
 $145,669
-14.27%
-2%
 $114,949
-32.35%
-3%
 $91,103
-46.38%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 
 
 
 
 
 
 
 
A-23
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Financial Statements
December 31, 2018, 2017 and 2016
 
INDEX
 
 
 
PAGE(S)
 
 
 
Reports of Independent Registered Public Accounting Firm on the Consolidated Financial Statements
 
A-25 - A-27
 
 
 
Financial Statements
 
 
 
 
 
Consolidated Balance Sheets at December 31, 2018 and 2017
 
A-28
 
 
 
Consolidated Statements of Earnings for the years ended December 31, 2018, 2017 and 2016
 
A-29
 
 
 
Consolidated Statements of Comprehensive Income for the years ended December 31, 2018, 2017 and 2016
 
A-30
 
 
 
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2018, 2017 and 2016
 
A-31
 
 
 
Consolidated Statements of Cash Flows for the years ended December 31, 2018, 2017 and 2016
 
A-32 - A-33
 
 
 
Notes to Consolidated Financial Statements
 
A-34 - A-68
 
 
  
 
 
 
 
 
 
A-24
 
 
 
Report of Independent Registered Public Accounting Firm
 
To the Shareholders and the Board of Directors of Peoples Bancorp of North Carolina, Inc.
 
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Peoples Bancorp of North Carolina, Inc. and its subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of earnings, comprehensive income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with accounting principles generally accepted in the United States of America.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated March 14, 2019 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
 
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
 
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
 
/s/ Elliott Davis, PLLC
 
We have served as the Company's auditor since 2015.
 
Charlotte, North Carolina
March 14, 2019
 
  elliottdavis.com
A-25
 
 
 
Report of Independent Registered Public Accounting Firm
 
 
To the Shareholders and the Board of Directors of Peoples Bancorp of North Carolina, Inc.:
 
 
Opinion on the Internal Control Over Financial Reporting
We have audited Peoples Bancorp of North Carolina, Inc.'s (the Company) internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, the related consolidated statements of earnings, comprehensive income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes to the consolidated financial statements and our report dated March 14, 2019 expressed an unqualified opinion.
 
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting in the accompanying Management’s Annual Report on Internal Controls over Financial Reporting Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
 
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

elliottdavis.com
A-26
 
 
 
   
Definition and Limitations of Internal Control Over Financial Reporting
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
/s/ Elliott Davis, PLLC
 
Charlotte, North Carolina
March 14, 2019
 
 
 

A-27
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Balance Sheets
December 31, 2018 and December 31, 2017
(Dollars in thousands)
 
 
 
December 31,
 
 
December 31,
 
Assets
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Cash and due from banks, including reserve requirements
 $40,553 
  53,186 
of $8,918 at 12/31/18 and $7,472 at 12/31/17
    
    
Interest-bearing deposits
  2,817 
  4,118 
Cash and cash equivalents
  43,370 
  57,304 
 
    
    
Investment securities available for sale
  194,578 
  229,321 
Other investments
  4,361 
  1,830 
Total securities
  198,939 
  231,151 
 
    
    
Mortgage loans held for sale
  680 
  857 
 
    
    
Loans
  804,023 
  759,764 
Less allowance for loan losses
  (6,445)
  (6,366)
Net loans
  797,578 
  753,398 
 
    
    
Premises and equipment, net
  18,450 
  19,911 
Cash surrender value of life insurance
  15,936 
  15,552 
Other real estate
  27 
  118 
Accrued interest receivable and other assets
  18,271 
  13,875 
Total assets
 $1,093,251 
  1,092,166 
 
    
    
Liabilities and Shareholders' Equity
    
    
 
    
    
Deposits:
    
    
Noninterest-bearing demand
 $298,817 
  285,406 
NOW, MMDA & savings
  475,223 
  498,445 
Time, $250,000 or more
  16,239 
  18,756 
Other time
  86,934 
  104,345 
Total deposits
  877,213 
  906,952 
 
    
    
Securities sold under agreements to repurchase
  58,095 
  37,757 
Junior subordinated debentures
  20,619 
  20,619 
Accrued interest payable and other liabilities
  13,707 
  10,863 
Total liabilities
  969,634 
  976,191 
 
    
    
Commitments (Note 10)
    
    
 
    
    
Shareholders' equity:
    
    
Series A preferred stock, $1,000 stated value; authorized
    
    
5,000,000 shares; no shares issued and outstanding
  - 
  - 
Common stock, no par value; authorized
    
    
20,000,000 shares; issued and outstanding 5,995,256 shares
    
    
at December 31, 2018 and December 31, 2017
  62,096 
  62,096 
Retained earnings
  60,535 
  50,286 
Accumulated other comprehensive income
  986 
  3,593 
Total shareholders' equity
  123,617 
  115,975 
 
    
    
Total liabilities and shareholders' equity
 $1,093,251 
  1,092,166 
 
See accompanying Notes to Consolidated Financial Statements.
 
 
A-28
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Earnings
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands, except per share amounts)
 
 
 
 2018
 
 
 2017
 
 
 2016
 
 
 
 
 
 
 
 
 
 
 
Interest income:
 
 
 
 
 
 
 
 
 
Interest and fees on loans
 $38,654 
  34,888 
  32,452 
Interest on due from banks
  304 
  219 
  123 
Interest on investment securities:
    
    
    
U.S. Government sponsored enterprises
  2,333 
  2,404 
  2,531 
States and political subdivisions
  3,877 
  4,236 
  4,454 
Other
  182 
  202 
  249 
Total interest income
  45,350 
  41,949 
  39,809 
 
    
    
    
Interest expense:
    
    
    
NOW, MMDA & savings deposits
  769 
  598 
  495 
Time deposits
  472 
  466 
  586 
FHLB borrowings
  - 
  662 
  1,661 
Junior subordinated debentures
  790 
  590 
  485 
Other
  115 
  61 
  44 
Total interest expense
  2,146 
  2,377 
  3,271 
 
    
    
    
Net interest income
  43,204 
  39,572 
  36,538 
 
    
    
    
Provision for (reduction of) loan losses
  790 
  (507)
  (1,206)
 
    
    
    
Net interest income after provision for loan losses
  42,414 
  40,079 
  37,744 
 
    
    
    
Non-interest income:
    
    
    
Service charges
  4,355 
  4,453 
  4,497 
Other service charges and fees
  705 
  593 
  890 
Gain on sale of securities
  15 
  - 
  729 
Mortgage banking income
  851 
  1,190 
  1,428 
Insurance and brokerage commissions
  824 
  761 
  632 
Appraisal management fee income
  3,206 
  3,306 
  3,146 
Gain (loss) on sales and write-downs of
    
    
    
other real estate
  17 
  (239)
  64 
Miscellaneous
  6,193 
  5,300 
  4,850 
Total non-interest income
  16,166 
  15,364 
  16,236 
 
    
    
    
Non-interest expense:
    
    
    
Salaries and employee benefits
  21,530 
  20,058 
  19,264 
Occupancy
  7,170 
  6,701 
  6,765 
Professional fees
  1,525 
  1,236 
  2,439 
Advertising
  922 
  1,195 
  1,136 
Debit card expense
  994 
  1,248 
  1,141 
FDIC insurance
  328 
  347 
  494 
Appraisal management fee expense
  2,460 
  2,526 
  2,260 
Other
  7,645 
  7,917 
  8,743 
Total non-interest expense
  42,574 
  41,228 
  42,242 
 
    
    
    
Earnings before income taxes
  16,006 
  14,215 
  11,738 
 
    
    
    
Income tax expense
  2,624 
  3,947 
  2,561 
 
    
    
    
Net earnings
 $13,382 
  10,268 
  9,177 
 
    
    
    
Basic net earnings per share
 $2.23 
  1.71 
  1.53 
Diluted net earnings per share
 $2.22 
  1.69 
  1.50 
Cash dividends declared per share
 $0.52 
  0.44 
  0.35 
 
See accompanying Notes to Consolidated Financial Statements.
 
A-29
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Comprehensive Income
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands)
 
 
 
 2018
 
 
 2017
 
 
 2016
 
 
 
 
 
 
 
 
 
 
 
Net earnings
 $13,382 
  10,268 
  9,177 
 
    
    
    
Other comprehensive income (loss):
    
    
    
Unrealized holding losses on securities
    
    
    
available for sale
  (3,370)
  (355)
  (3,274)
Reclassification adjustment for gains on
    
    
    
securities available for sale
    
    
    
included in net earnings
  (15)
  - 
  (729)
 
    
    
    
Total other comprehensive loss,
    
    
    
before income taxes
  (3,385)
  (355)
  (4,003)
 
    
    
    
Income tax benefit related to other
    
    
    
comprehensive loss:
    
    
    
 
    
    
    
Unrealized holding losses on securities
    
    
    
available for sale
  (774)
  (354)
  (1,196)
Reclassification adjustment for gains on
    
    
    
securities available for sale
    
    
    
included in net earnings
  (4)
  - 
  (284)
 
    
    
    
Total income tax benefit related to
    
    
    
other comprehensive loss
  (778)
  (354)
  (1,480)
 
    
    
    
Total other comprehensive loss,
    
    
    
net of tax
  (2,607)
  (1)
  (2,523)
 
    
    
    
Total comprehensive income
 $10,775 
  10,267 
  6,654 
 
See accompanying Notes to Consolidated Financial Statements.
 
 
A-30
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Changes in Shareholders' Equity
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 Accumulated
 
 
 
 
 
 
 Common
 
 
 Common
 
 
 
 
 
 Other
 
 
 
 
 
 
 Stock
 
 
 Stock
 
 
 Retained
 
 
 Comprehensive
 
 
 
 
 
 
Shares
 
 
Amount
 
 
 Earnings
 
 
 Income
 
 
 Total
 
Balance, December 31, 2015
  5,510,538 
 $46,171 
  53,183 
  5,510 
  104,864 
 
    
    
    
    
    
Common stock
    
    
    
    
    
repurchase
  (92,738)
  (1,984)
  - 
  - 
  (1,984)
Cash dividends declared on
    
    
    
    
    
common stock
  - 
  - 
  (2,106)
  - 
  (2,106)
Net earnings
  - 
  - 
  9,177 
  - 
  9,177 
Change in accumulated other
    
    
    
    
    
comprehensive income,
    
    
    
    
    
net of tax
  - 
  - 
  - 
  (2,523)
  (2,523)
Balance, December 31, 2016
  5,417,800 
 $44,187 
  60,254 
  2,987 
  107,428 
 
    
    
    
    
    
Cash dividends declared on
    
    
    
    
    
common stock
  - 
  - 
  (2,629)
  - 
  (2,629)
10% stock dividend
  544,844 
  16,994 
  (17,000)
  - 
  (6)
Restricted stock units exercised
  32,612 
  915 
  - 
  - 
  915 
Net earnings
  - 
  - 
  10,268 
  - 
  10,268 
Change in accumulated other
    
    
    
    
    
comprehensive income due to
    
    
    
    
    
Tax Cuts and Jobs Act
  - 
  - 
  (607)
  607 
  - 
Change in accumulated other
    
    
    
    
    
comprehensive income,
    
    
    
    
    
net of tax
  - 
  - 
  - 
  (1)
  (1)
Balance, December 31, 2017
  5,995,256 
 $62,096 
  50,286 
  3,593 
  115,975 
 
    
    
    
    
    
Cash dividends declared on
    
    
    
    
    
common stock
  - 
  - 
  (3,133)
  - 
  (3,133)
Net earnings
  - 
  - 
  13,382 
  - 
  13,382 
Change in accumulated other
    
    
    
    
    
comprehensive income,
    
    
    
    
    
net of tax
  - 
  - 
  - 
  (2,607)
  (2,607)
Balance, December 31, 2018
  5,995,256 
 $62,096 
  60,535 
  986 
  123,617 
 
See accompanying Notes to Consolidated Financial Statements.
 
 
A-31
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands)
 
 
 
 2018
 
 
 2017
 
 
 2016
 
 
 
 
 
 
 
 
 
 
 
Cash flows from operating activities:
 
 
 
 
 
 
 
 
 
Net earnings
 $13,382 
  10,268 
  9,177 
Adjustments to reconcile net earnings to
    
    
    
net cash provided by operating activities:
    
    
    
Depreciation, amortization and accretion
  4,571 
  5,018 
  5,423 
Provision for (reduction of) loan losses
  790 
  (507)
  (1,206)
Deferred income taxes
  78 
  2,120 
  1,097 
Gain on sale of investment securities
  (15)
  - 
  (729)
Gain on sale of other real estate
  (17)
  - 
  (81)
Write-down of other real estate
  - 
  239 
  17 
Gain on sale of premises and equipment
  (544)
  - 
  - 
Restricted stock expense
  85 
  592 
  932 
Proceeds from sales of loans held for sale
  35,922 
  59,193 
  67,764 
Origination of loans held for sale
  (35,745)
  (54,341)
  (69,324)
Change in:
    
    
    
Cash surrender value of life insurance
  (384)
  (600)
  (406)
Other assets
  (3,695)
  (3,982)
  (636)
Other liabilities
  2,759 
  594 
  211 
 
    
    
    
Net cash provided by operating activities
  17,187 
  18,594 
  12,239 
 
    
    
    
Cash flows from investing activities:
    
    
    
Purchases of investment securities available for sale
  (34,692)
  (10,014)
  (12,707)
Proceeds from sales, calls and maturities of investment securities
    
    
    
available for sale
  48,241 
  10,162 
  4,053 
Proceeds from paydowns of investment securities available for sale
  15,556 
  17,202 
  20,675 
Purchases of other investments
  (2,611)
  (45)
  (255)
Proceeds from paydowns of other investment securities
  117 
  - 
  - 
Net change in FHLB stock
  (4)
  850 
  1,256 
Net change in loans
  (45,094)
  (36,748)
  (36,116)
Purchases of premises and equipment
  (1,742)
  (5,557)
  (1,610)
Proceeds from sale of premises and equipment
  1,410 
  - 
  - 
Proceeds from sale of other real estate and repossessions
  232 
  44 
  1,083 
 
    
    
    
Net cash used by investing activities
  (18,587)
  (24,106)
  (23,621)
 
    
    
    
Cash flows from financing activities:
    
    
    
Net change in deposits
  (29,739)
  14,034 
  60,743 
Net change in securities sold under agreement to repurchase
  20,338 
  1,323 
  8,560 
Proceeds from FHLB borrowings
  - 
  1 
  6,000 
Repayments of FHLB borrowings
  - 
  (20,001)
  (29,500)
Proceeds from FRB borrowings
  1 
  1 
  1 
Repayments of FRB borrowings
  (1)
  (1)
  (1)
Proceeds from Fed Funds Purchased
  4,277 
  187 
  9,112 
Repayments of Fed Funds Purchased
  (4,277)
  (187)
  (9,112)
Common stock repurchased
  - 
  - 
  (1,984)
Cash dividends paid in lieu of fractional shares
  - 
  (6)
  - 
Cash dividends paid on common stock
  (3,133)
  (2,629)
  (2,106)
 
    
    
    
Net cash (used) provided by financing activities
  (12,534)
  (7,278)
  41,713 
 
    
    
    
Net change in cash and cash equivalents
  (13,934)
  (12,790)
  30,331 
 
    
    
    
Cash and cash equivalents at beginning of period
  57,304 
  70,094 
  39,763 
 
    
    
    
Cash and cash equivalents at end of period
 $43,370 
  57,304 
  70,094 
 
 
A-32
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
Consolidated Statements of Cash Flows, continued
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands)
 
 
 
 2018
 
 
 2017
 
 
 2016
 
 
 
 
 
 
 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
 
 
 
 
 
Cash paid during the year for:
 
 
 
 
 
 
 
 
 
Interest
 $2,128 
  2,526 
  3,415 
Income taxes
 $1,163 
  2,408 
  2,028 
 
    
    
    
Noncash investing and financing activities:
    
    
    
Change in unrealized (loss) gain on investment securities
    
    
    
 available for sale, net
 $(2,607)
  (1)
  (2,523)
Transfer of loans to other real estate and repossessions
 $124 
  118 
  563 
Issuance of accrued restricted stock units
 $- 
  (915)
  - 
 
See accompanying Notes to Consolidated Financial Statements.
 
 
A-33
 
 
PEOPLES BANCORP OF NORTH CAROLINA, INC.
 
Notes to Consolidated Financial Statements
 
(1) 
Summary of Significant Accounting Policies
 
Organization
Peoples Bancorp of North Carolina, Inc. (“Bancorp”) received regulatory approval to operate as a bank holding company on July 22, 1999, and became effective August 31, 1999. Bancorp is primarily regulated by the Board of Governors of the Federal Reserve System, and serves as the one-bank holding company for Peoples Bank (the “Bank”).
 
The Bank commenced business in 1912 upon receipt of its banking charter from the North Carolina Commissioner of Banks (the “Commissioner”). The Bank is primarily regulated by the Commissioner and the Federal Deposit Insurance Corporation (the “FDIC”) and undergoes periodic examinations by these regulatory agencies. The Bank, whose main office is in Newton, North Carolina, provides a full range of commercial and consumer banking services primarily in Catawba, Alexander, Lincoln, Mecklenburg, Iredell, Wake and Durham counties in North Carolina.
 
Peoples Investment Services, Inc. is a wholly owned subsidiary of the Bank and began operations in 1996 to provide investment and trust services through agreements with an outside party.
 
Real Estate Advisory Services, Inc. (“REAS”) is a wholly owned subsidiary of the Bank and began operations in 1997 to provide real estate appraisal and property management services to individuals and commercial customers of the Bank.
 
Community Bank Real Estate Solutions, LLC (“CBRES”) is a wholly owned subsidiary of the Bank and began operations in 2009 as a “clearing house” for appraisal services for community banks. Other banks are able to contract with CBRES to find and engage appropriate appraisal companies in the area where the property is located.
 
PB Real Estate Holdings, LLC (“PBREH”) is a wholly owned subsidiary of the Bank and began operation in 2015. PBREH acquires, manages and disposes of real property, other collateral and other assets obtained in the ordinary course of collecting debts previously contracted.
 
The Bank operates three banking offices focused on the Latino population that were formerly operated as a division of the Bank under the name Banco de la Gente (“Banco”). These offices are now branded as Bank branches and considered a separate market territory of the Bank as they offer normal and customary banking services as are offered in the Bank’s other branches such as the taking of deposits and the making of loans.
 
Principles of Consolidation
The consolidated financial statements include the financial statements of Bancorp and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc., REAS, CBRES and PBREH (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation. 
 
Basis of Presentation
The accounting principles followed by the Company, and the methods of applying these principles, conform with accounting principles generally accepted in the United States of America (“GAAP”) and with general practices in the banking industry. In preparing the financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from these estimates. Material estimates common to the banking industry that are particularly susceptible to significant change in the near term include, but are not limited to, the determination of the allowance for loan losses and valuation of real estate acquired in connection with or in lieu of foreclosure on loans.
 
Cash and Cash Equivalents
Cash, due from banks and interest-bearing deposits are considered cash and cash equivalents for cash flow reporting purposes.
 
  A-34
 

 
 
Investment Securities
There are three classifications the Company is able to classify its investment securities: trading, available for sale, or held to maturity. Trading securities are bought and held principally for sale in the near term. Held to maturity securities are those securities for which the Company has the ability and intent to hold until maturity. All other securities not included in trading or held to maturity are classified as available for sale. At December 31, 2018 and 2017, the Company classified all of its investment securities as available for sale.
 
Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, are excluded from earnings and are reported as a separate component of shareholders’ equity until realized.
 
Management evaluates investment securities for other-than-temporary impairment on an annual basis. A decline in the market value of any investment below cost that is deemed other-than-temporary is charged to earnings for the decline in value deemed to be credit related and a new cost basis in the security is established. The decline in value attributed to non-credit related factors is recognized in comprehensive income.
 
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to the yield. Realized gains and losses for securities classified as available for sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.
 
Other Investments
Other investments include equity securities with no readily determinable fair value. These investments are carried at cost.
 
Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at lower of aggregate cost or market value. The cost of mortgage loans held for sale approximates the market value.
 
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity are reported at the principal amount outstanding, net of the allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amount outstanding. The recognition of certain loan origination fee income and certain loan origination costs is deferred when such loans are originated and amortized over the life of the loan.
 
A loan is impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected. Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent.
 
Accrual of interest is discontinued on a loan when management believes, after considering economic conditions and collection efforts, that the borrower’s financial condition is such that collection of interest is doubtful. Interest previously accrued but not collected is reversed against current period earnings.
 
Allowance for Loan Losses
The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:
 
the Bank’s loan loss experience;
the amount of past due and non-performing loans;
specific known risks;
the status and amount of other past due and non-performing assets;
underlying estimated values of collateral securing loans;
current and anticipated economic conditions; and
other factors which management believes affect the allowance for potential credit losses.
 
 
A-35
 
 
Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank’s Board of Directors reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.
 
As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than $1.0 million, excluding loans in default, and loans in process of litigation or liquidation. The third party’s evaluation and report is shared with management and the Bank’s Board of Directors.
 
Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.
 
Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance for loan losses. The provision for loan losses charged or credited to earnings is based upon management’s judgment of the amount necessary to maintain the allowance at a level appropriate to absorb probable incurred losses in the loan portfolio at the balance sheet date. The amount each quarter is dependent upon many factors, including growth and changes in the composition of the loan portfolio, net charge-offs, delinquencies, management’s assessment of loan portfolio quality, the value of collateral, and other macro-economic factors and trends. The evaluation of these factors is performed quarterly by management through an analysis of the appropriateness of the allowance for loan losses.
 
The allowance for loan losses is comprised of three components: specific reserves, general reserves and unallocated reserves. After a loan has been identified as impaired, management measures impairment. When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Bank’s loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.
 
The general allowance reflects reserves established under GAAP for collective loan impairment. These reserves are based upon historical net charge-offs using the greater of the last two, three, four or five years’ loss experience. This charge-off experience may be adjusted to reflect the effects of current conditions. The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves.
 
The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk. Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.
 
There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for loan losses for the year ended December 31, 2018 as compared to the year ended December 31, 2017. Revisions, estimates and assumptions may be made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates.
 
 
A-36
 
 
Effective December 31, 2012, certain mortgage loans from the former Banco division of the Bank were analyzed separately from other single family residential loans in the Bank’s loan portfolio. These loans are first mortgage loans made to the Latino market, primarily in Mecklenburg, North Carolina and surrounding counties. These loans are non-traditional mortgages in that the customer normally did not have a credit history, so all credit information was accumulated by the loan officers.
 
Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance for loan losses. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations. Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment. Management considers the allowance for loan losses adequate to cover the estimated losses inherent in the Bank’s loan portfolio as of the date of the financial statements. Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.
 
Mortgage Banking Activities
Mortgage banking income represents net gains from the sale of mortgage loans and fees received from borrowers and loan investors related to the Bank’s origination of single-family residential mortgage loans.
 
Mortgage loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of mortgage loans serviced for others was approximately $866,000, $1.0 million and $1.4 million at December 31, 2018, 2017 and 2016, respectively.
 
The Bank originates certain fixed rate mortgage loans and commits these loans for sale. The commitments to originate fixed rate mortgage loans and the commitments to sell these loans to a third party are both derivative contracts. The fair value of these derivative contracts is immaterial and has no effect on the recorded amounts in the financial statements.
 
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily using the straight-line method over the estimated useful lives of the assets. When assets are retired or otherwise disposed, the cost and related accumulated depreciation are removed from the accounts, and any gain or loss is reflected in earnings for that period. The cost of maintenance and repairs that do not improve or extend the useful life of the respective asset is charged to earnings as incurred, whereas significant renewals and improvements are capitalized. The range of estimated useful lives for premises and equipment are generally as follows:
 
Buildings and improvements
10 - 50 years
Furniture and equipment
3 - 10 years
 
Other Real Estate
Foreclosed assets include all assets received in full or partial satisfaction of a loan. Foreclosed assets are reported at fair value less estimated selling costs. Any write-downs at the time of foreclosure are charged to the allowance for loan losses. Subsequent to foreclosure, valuations are periodically performed by management, and a valuation allowance is established if fair value less estimated selling costs declines below carrying value. Costs relating to the development and improvement of the property are capitalized. Revenues and expenses from operations are included in other expenses. Changes in the valuation allowance are included in loss on sale and write-down of other real estate.
 
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Additionally, the recognition of future tax benefits, such as net operating loss carryforwards, is required to the extent that the realization of such benefits is more likely than not to occur. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the assets and liabilities are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income tax expense in the period that includes the enactment date.
 
In the event the future tax consequences of differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities results in a deferred tax asset, an evaluation of the probability of being able to realize the future benefits indicated by such asset is required. A valuation allowance is provided for the portion of 
 
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the deferred tax asset when it is more likely than not that some portion or all of the deferred tax asset will not be realized. In assessing the realizability of a deferred tax asset, management considers the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning  strategies.
 
Tax effects from an uncertain tax position can be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more likely than not recognition threshold is measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. Previously recognized tax positions that no longer meet the more likely than not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met. The Company assessed the impact of this guidance and determined that it did not have a material impact on the Company’s financial position, results of operations or disclosures.
 
Derivative Financial Instruments and Hedging Activities
In the normal course of business, the Company enters into derivative contracts to manage interest rate risk by modifying the characteristics of the related balance sheet instruments in order to reduce the adverse effect of changes in interest rates. All material derivative financial instruments are recorded at fair value in the financial statements. The fair value of derivative contracts related to the origination of fixed rate mortgage loans and the commitments to sell these loans to a third party is immaterial and has no effect on the recorded amounts in the financial statements.
 
The disclosure requirements for derivatives and hedging activities have the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The disclosure requirements include qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of, and gains and losses on, derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
 
On the date a derivative contract is entered into, the Company designates the derivative as a fair value hedge, a cash flow hedge, or a trading instrument. Changes in the fair value of instruments used as fair value hedges are accounted for in the earnings of the period simultaneous with accounting for the fair value change of the item being hedged. Changes in the fair value of the effective portion of cash flow hedges are accounted for in other comprehensive income rather than earnings. Changes in fair value of instruments that are not intended as a hedge are accounted for in the earnings of the period of the change.
 
If a derivative instrument designated as a fair value hedge is terminated or the hedge designation removed, the difference between a hedged item’s then carrying amount and its face amount is recognized into income over the original hedge period. Likewise, if a derivative instrument designated as a cash flow hedge is terminated or the hedge designation removed, related amounts accumulated in other accumulated comprehensive income are reclassified into earnings over the original hedge period during which the hedged item affects income.
 
The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risks, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
 
The Company formally documents all hedging relationships, including an assessment that the derivative instruments are expected to be highly effective in offsetting the changes in fair values or cash flows of the hedged items.
 
Advertising Costs
Advertising costs are expensed as incurred.
 
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Stock-Based Compensation
The Company has an Omnibus Stock Ownership and Long Term Incentive Plan that was approved by shareholders on May 7, 2009 (the “Plan”) whereby certain stock-based rights, such as stock options, restricted stock, restricted stock units, performance units, stock appreciation rights or book value shares, may be granted to eligible directors and employees. A total of 280,933 shares are currently reserved for possible issuance under the Plan. All stock-based rights under the Plan must be granted or awarded by May 7, 2019 (i.e., ten years from the Plan effective date).
 
The Company granted 32,465 restricted stock units under the Plan at a grant date fair value of $7.18 per share during the first quarter of 2012, of which 5,891 restricted stock units were forfeited by the executive officers of the Company as required by the agreement with the U.S. Department of the Treasury in conjunction with the Company’s participation in the Capital Purchase Program under the Troubled Asset Relief Program. In July 2012, the Company granted 5,891 restricted stock units at a grant date fair value of $7.50 per share. The Company granted 29,475 restricted stock units under the Plan at a grant date fair value of $10.82 per share during the second quarter of 2013. The Company granted 23,162 restricted stock units under the Plan at a grant date fair value of $14.27 per share during the first quarter of 2014. The Company granted 16,583 restricted stock units under the Plan at a grant date fair value of $16.34 per share during the first quarter of 2015. The Company granted 5,544 restricted stock units under the Plan at a grant date fair value of $16.91 per share during the first quarter of 2016. The Company granted 4,114 restricted stock units under the Plan at a grant date fair value of $25.00 per share during the first quarter of 2017. The Company granted 3,725 restricted stock units under the Plan at a grant date fair value of $31.43 per share during the first quarter of 2018. The number of restricted stock units granted and grant date fair values have been restated to reflect the 10% stock dividend during the fourth quarter of 2017. The Company recognizes compensation expense on the restricted stock units over the period of time the restrictions are in place (five years from the grant date for the 2012 grants, four years from the grant date for the 2013, 2015, 2016, 2017 and 2018 grants and three years from the grant date for the 2014 grants). The amount of expense recorded each period reflects the changes in the Company’s stock price during such period. As of December 31, 2018, the total unrecognized compensation expense related to the restricted stock unit grants under the Plan was $165,000.
 
The Company recognized compensation expense for restricted stock units granted under the Plan of $85,000, $592,000 and $932,000 for the years ended December 31, 2018, 2017 and 2016, respectively.
 
Net Earnings Per Share
Net earnings per common share is based on the weighted average number of common shares outstanding during the period while the effects of potential common shares outstanding during the period are included in diluted earnings per common share. The average market price during the year is used to compute equivalent shares.
 
The reconciliations of the amounts used in the computation of both “basic earnings per common share” and “diluted earnings per common share” for the years ended December 31, 2018, 2017 and 2016 are as follows:
 
For the year ended December 31, 2018
 
 
 
 Net Earnings (Dollars in thousands)
 
 
 Weighted Average Number of Shares
 
 
 Per Share Amount
 
Basic earnings per share
 $13,382 
  5,995,256 
 $2.23 
Effect of dilutive securities:
    
    
    
Restricted stock units
  - 
  20,240 
    
Diluted earnings per share
 $13,382 
  6,015,496 
 $2.22 
 
 
A-39
 
 
For the year ended December 31, 2017
 
 
 
 Net Earnings (Dollars in thousands)
 
 
 Weighted Average Number of Shares
 
 
 Per Share Amount
 
Basic earnings per share
 $10,268 
  5,988,183 
 $1.71 
Effect of dilutive securities:
    
    
    
Restricted stock units
  - 
  74,667 
    
Diluted earnings per share
 $10,268 
  6,062,850 
 $1.69 
 
For the year ended December 31, 2016
 
 
 
 Net Earnings (Dollars in thousands)
 
 
 Weighted Average Number of Shares
 
 
 Per Share Amount
 
Basic earnings per share
 $9,177 
  6,024,970 
 $1.53 
Effect of dilutive securities:
    
    
    
Restricted stock units
  - 
  77,807 
    
Diluted earnings per share
 $9,177 
  6,102,777 
 $1.50 
 
In November 2017, the Board of Directors of the Company declared a 10% stock dividend. As a result of the stock dividend, each shareholder received one new share of stock for every ten shares of stock they held as of the record date of December 4, 2017. The payable date for the stock dividend was December 15, 2017. All previously reported per share amounts have been restated to reflect this stock dividend.
 
Recent Accounting Pronouncements
 
The following tables provide a summary of Accounting Standards Updates (“ASU”) issued by the Financial Accounting Standards Board (“FASB”)that the Company has recently adopted.
 
 
Recently Adopted Accounting Guidance
 
 
 
 
 
 
 
 
ASU
 
Description
 
Effective Date
 
Effect on Financial Statements or Other Significant Matters
ASU 2014-09: Revenue from Contracts with Customers
 
Provides guidance on the recognition of revenue from contracts with customers. The core principle of this guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive.
 
January 1, 2018
 
See section titled "ASU 2014-09" below for a despription of the effect on the Company’s results of operations, financial position and disclosures.
ASU 2016-01: Recognition and Measurement of Financial Assets and Financial Liabilities
 
Addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-01: Clarifying the Definition of a Business
 
Adds guidance to assist companies and other reporting organizations with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-05: Clarifying the Scope of Asset Derecognition Guidance and Accounting for Partial Sales of Nonfinancial Assets
 
Clarifies the scope of established guidance on nonfinancial asset derecognition (issued as part of the new revenue standard, ASU 2014-09, Revenue from Contracts with Customers), as well as the accounting for partial sales of nonfinancial assets.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
 
 
 
 
 
 
 
 
 
A-40
 
 
ASU
 
Description
 
Effective Date
 
Effect on Financial Statements or Other Significant Matters
ASU 2017-07: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Costs
 
Amended the requirements related to the income statement presentation of the components of net periodic benefit cost for an entity’s sponsored defined benefit pension and other postretirement plans.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-09: Scope of Modification Accounting
 
Amended the requirements related to changes to the terms or conditions of a share-based payment award.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-13: Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842)
 
Updated the Revenue from Contracts with Customers and the Leases Topics of the Accounting Standards Codification (“ASC”). The amendments incorporate into the ASC recent Securities Exchange Commission (“SEC”) guidance about certain public business entities (“PBEs”) electing to use the non-PBE effective dates solely to adopt the FASB’s new standards on revenue and leases.
 
Effective upon issuance
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-14: Income Statement—Reporting Comprehensive, Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606)
 
Incorporates into the ASC recent SEC guidance related to revenue recognition.
 
Effective upon issuance
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-02: Income Statement (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
 
Requires companies to reclassify the stranded effects in other comprehensive income to retained earnings as a result of the change in the tax rates under the Tax Cuts and Jobs Act (“TCJA”).
 
Effective upon issuance
 
The Company opted to early adopt this pronouncement by retrospective application to each period in which the effect of the change in the tax rate under the TCJA is recognized. The impact of the reclassification from other comprehensive income to retained earnings at December 31, 2017 was $607,000.
ASU 2018-03: Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities
 
Clarifies certain aspects of the guidance issued in ASU 2016-01.
 
January 1, 2018
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-04: Investments—Debt Securities (Topic 320) and Regulated Operations (Topic 980): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 117 and SEC Release No. 33-9273 (SEC Update)
 
Incorporates recent SEC guidance which was issued in order to make the relevant interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulation.
 
Effective upon issuance
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-05: Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 (SEC Update)
 
Incorporates recent SEC guidance related to the income tax accounting implications of the TCJA.
 
Effective upon issuance
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-06: Codification Improvements to Topic 942: Financial Services—Depository and Lending
 
Eliminates a reference to the Office of the Comptroller of the Currency’s Banking Circular 202, Accounting for Net Deferred Tax Charges, from the ASC. The Office of the Comptroller of the Currency published the guidance in 1985 but has since rescinded it.
 
Effective upon issuance
 
The adoption of this guidance did not have a material impact on the Company’s results of operations, financial position or disclosures.
 
 
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ASU 2014-09
The Company has applied ASU 2014-09 using a modified retrospective approach. The Company’s revenue is comprised of net interest income and noninterest income. The scope of ASU 2014-09 explicitly excludes net interest income as well as many other revenues for financial assets and liabilities including loans, leases, securities, and derivatives. Accordingly, the majority of the Company’s revenues are not affected. Appraisal management fee income and expense from the Bank’s subsidiary, CBRES, was reported as a net amount prior to March 31, 2018, which was included in miscellaneous non-interest income. This income and expense is now reported on separate line items under non-interest income and non-interest expense. See below for additional information related to revenue generated from contracts with customers.
 
Revenue and Method of Adoption
The majority of the Company’s revenue is derived primarily from interest income from receivables (loans) and securities. Other revenues are derived from fees received in connection with deposit accounts, investment advisory, and appraisal services. On January 1, 2018, the Company adopted the requirements of ASU 2014-09. The core principle of the new standard is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
 
The Company adopted ASU 2014-09 using the modified retrospective transition approach which does not require restatement of prior periods. The method was selected as there were no material changes in the timing of revenue recognition resulting in no comparability issues with prior periods. This adoption method is considered a change in accounting principle requiring additional disclosure of the nature of and reason for the change, which is solely a result of the adoption of the required standard. When applying the modified retrospective approach under ASU 2014-09, the Company has elected, as a practical expedient, to apply this approach only to contracts that were not completed as of January 1, 2018. A completed contract is considered to be a contract for which all (or substantially all) of the revenue was recognized in accordance with revenue guidance that was in effect before January 1, 2018. There were no uncompleted contracts as of January 1, 2018 for which application of the new standard required an adjustment to retained earnings.
 
The following disclosures involve the Company’s material income streams derived from contracts with customers which are within the scope of ASU 2014-09. Through the Company’s wholly-owned subsidiary, PIS, the Company contracts with a registered investment advisor to perform investment advisory services on behalf of the Company’s customers. The Company receives commissions from this third party investment advisor based on the volume of business that the Company’s customers do with such investment advisor. Total revenue recognized from these contracts for the year ended December 31, 2018 was $823,000. The Company utilizes third parties to contract with the Company’s customers to perform debit and credit card clearing services. These third parties pay the Company commissions based on the volume of transactions that they process on behalf of the Company’s customers. Total revenue recognized for the year ended December 31, 2018 from the contract with these third parties was $3.9 million. Through the Company’s wholly-owned subsidiary, REAS, the Company provides property appraisal services for negotiated fee amounts on a per appraisal basis. Total revenue recognized for the year ended December 31, 2018 from these contracts with customers was $597,000. Through the Company’s wholly-owned subsidiary, CBRES, the Company provides appraisal management services. Total revenue recognized for the year ended December 31, 2018 from these contracts with customers was $3.2 million. Due to the nature of the Company’s relationship with the customers that the Company provides services, the Company does not incur costs to obtain contracts and there are no material incremental costs to fulfill these contracts that should be capitalized.
 
Disaggregation of Revenue. The Company’s portfolio of services provided to the Company’s customers consists of over 50,000 active contracts. The Company has disaggregated revenue according to timing of the transfer of service. Total revenue for the year ended December 31, 2018 derived from contracts in which services are transferred at a point in time was approximately $8.5 million. None of the Company’s revenue is derived from contracts in which services are transferred over time. Revenue is recognized as the services are provided to the customers. Economic factors impacting the customers could affect the nature, amount, and timing of these cash flows, as unfavorable economic conditions could impair the customers’ ability to provide payment for services. For the Company’s deposit contracts, this risk is mitigated as the Company generally deducts payments from customers’ accounts as services are rendered. For the Company’s appraisal services, the risk is mitigated in that the appraisal is not released until payment is received.
 
              Contract Balances. The timing of revenue recognition, billings, and cash collections results in billed accounts receivable on the balance sheet. Most contracts call for payment by a charge or deduction to the respective customer account but there are some that require a receipt of payment from the customer.
              For fee per transaction contracts, the customers are billed as the transactions are processed. The Company has no contracts in which 
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customers are billed in advance for services to be performed. These types of contracts would create contract liabilities or deferred revenue, as the customers pay in advance for services. There are no contract liabilities or accounts receivables balances that are material to the Company’s balance sheet.
 
Performance Obligations. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in ASU 2014-09. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Performance obligations are satisfied as the service is provided to the customer at a point in time. There are no significant financing components in the Company’s contracts. Excluding deposit and appraisal service revenues which are primarily billed at a point in time as a fee for services incurred, all other contracts within the scope of ASU 2014-09 contain variable consideration in that fees earned are derived from market values of accounts which determine the amount of consideration to which the Company is entitled. The variability is resolved when the services are provided. The contracts do not include obligations for returns, refunds, or warranties. The contracts are specific to the amounts owed to the Company for services performed during a period should the contracts be terminated.
 
Significant Judgements. All of the Company’s contracts create performance obligations that are satisfied at a point in time excluding some immaterial deposit revenues. Revenue is recognized as services are billed to the customers. Variable consideration does exist for contracts related to the Company’s contract with its registered investment advisor as some revenues earned pursuant to that contract are based on market values of accounts at the end of the period.
 
The following tables provide a summary of ASU’s issued by the FASB that the Company has not adopted as of December 31, 2018, which may impact the Company’s financial statements.
 
 
 
Recently Issued Accounting Guidance Not Yet Adopted
 
 
 
 
 
 
 
 
ASU
 
Description
 
Effective Date
 
Effect on Financial Statements or Other Significant Matters
ASU 2016-02: Leases
 
Increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements.
 
January 1, 2019
 
The Company expects to adopt this guidance using the modified retrospective method and practical expedients for transition. The practical expedients allow the Company to largely account for its existing leases consistent with current guidance except for the incremental balance sheet recognition for lessees. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures. The Company epects to record an increase in assets and liabilities of approximatley $4.4 million as a result of recording lease contracts where the Company is lessee and expects to adopt the new guidance prospectively as of January 1, 2019 and to not restate comparative periods.
ASU 2016-13: Measurement of Credit Losses on Financial Instruments
 
Provides guidance to change the accounting for credit losses and modify the impairment model for certain debt securities.
 
January 1, 2020 Early adoption permitted
 
The Company will apply this guidance through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. The Company is still evaluating the impact of this guidance on its consolidated financial statements. The Company has formed a Current Expected Credit Losses (“CECL”) committee and implemented a model from a third-party vendor for running CECL calculations. The Company is currently developing CECL model assumptions and comparing results to current allowance for loan loss calculations. The Company plans to run parallel calculations leading up to the effective date of this guidance to ensure it is prepared for implementation by the effective date. In addition to the Company’s allowance for loan losses, it will also record an allowance for credit losses on debt securities instead of applying the impairment model currently utilized. The amount of the adjustments will be impacted by each portfolio’s composition and credit quality at the adoption date as well as economic conditions and forecasts at that time.
ASU 2017-04: Simplifying the Test for Goodwill Impairment
 
Provides guidance to simplify the accounting related to goodwill impairment.
 
January 1, 2020
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2017-08: Premium Amortization on Purchased Callable Debt Securities
 
Amended the requirements related to the amortization period for certain purchased callable debt securities held at a premium.
 
January 1, 2019
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
 

 
A-43
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ASU
 
Description
 
Effective Date
 
Effect on Financial Statements or Other Significant Matters
ASU 2018-11: Leases (Topic 842): Targeted Improvements
 
Intended to reduce costs and ease implementation of ASU 2016-02.
 
January 1, 2019
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-13: Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement (Topic 820)
 
Updates the disclosure requirements on fair value measurements in ASC 820, Fair Value Measurement.
 
January 1, 2020
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-14: Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans (Subtopic 715-20)
 
Updates disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans.
 
January 1, 2021
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-15: Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40)
 
Reduces complexity of the accounting for costs of implementing a cloud computing service arrangement.
 
January 1, 2020
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-16: Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes
 
Expand the list of U.S. benchmark interest rates permitted in the application of hedge accounting.
 
January 1, 2019
 
The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-17: Targeted Improvements to Related Party Guidance for Variable Interest Entities
 
Amended the Consolidation topic of the ASC for determining whether a decision-making fee is a variable interest. The amendments require organizations to consider indirect interests held through related parties under common control on a proportional basis rather than as the equivalent of a direct interest in its entirety.
 
January 1, 2020 Early adoption permitted
 
The Company does not intend to adopt this guidance early. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-18: Clarifying the Interaction between Topic 808 and Topic 606
 
Clarifies the interaction between the guidance for certain collaborative arrangements and the new revenue recognition financial accounting and reporting standard.
 
January 1, 2020 Early adoption permitted
 
The Company does not intend to adopt this guidance early. The adoption of this guidance is not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
ASU 2018-19: Codification Improvements to Topic 326, Financial Instruments—Credit Losses
 
Aligns the implementation date of the topic for annual financial statements of nonpublic companies with the implementation date for their interim financial statements. The guidance also clarifies that receivables arising from operating leases are not within the scope of the topic, but rather, should be accounted for in accordance with the leases topic.
 
January 1, 2020 Early adoption permitted
 
See comments for ASU 2016-13 above.
ASU 2018-20: Narrow- Scope Improvements for Lessors
 
Provides narrow-scope improvements for lessors, that provide relief in the accounting for sales, use and similar taxes, the accounting for other costs paid by a lessee that may benefit a lessor, and variable payments when contracts have lease and non-lease components.
 
January 1, 2019
 
See comments for ASU 2016-02 above.
 
               Other accounting standards that have been issued or proposed by FASB or other standards-setting bodies are not expected to have a material impact on the Company’s results of operations, financial position or disclosures.
 
Reclassification
Certain amounts in the 2017 and 2016 consolidated financial statements have been reclassified to conform to the 2018 presentation.
 
 A-44
 
 
 
 
 
(2) 
Investment Securities
 
Investment securities available for sale at December 31, 2018 and 2017 are as follows:
 
(Dollars in thousands)
 
 
 
 December 31, 2018
 
 
 
 Amortized Cost
 
 
 Gross Unrealized Gains
 
 
 Gross Unrealized Losses
 
 
 Estimated Fair Value
 
Mortgage-backed securities
 $52,145 
  516 
  558 
  52,103 
U.S. Government
    
    
    
    
sponsored enterprises
  35,356 
  71
  793 
  34,634 
State and political subdivisions
  105,545 
  2,089 
  43 
  107,591 
Trust preferred securities
  250 
  - 
  - 
  250 
Total
 $193,296 
  2,676 
  1,394 
  194,578 
 
(Dollars in thousands)
 
 
 
 December 31, 2017
 
 
 
 Amortized Cost
 
 
 Gross Unrealized Gains
 
 
 Gross Unrealized Losses
 
 
 Estimated Fair Value
 
Mortgage-backed securities
 $53,124 
  814 
  329 
  53,609 
U.S. Government
    
    
    
    
sponsored enterprises
  40,504 
  140 
  264 
  40,380 
State and political subdivisions
  129,276 
  4,310 
  16 
  133,570 
Corporate bonds
  1,500 
  12 
  - 
  1,512 
Trust preferred securities
  250 
  - 
  - 
  250 
Total
 $224,654 
  5,276 
  609 
  229,321 
 
The current fair value and associated unrealized losses on investments in debt securities with unrealized losses at December 31, 2018 and 2017 are summarized in the tables below, with the length of time the individual securities have been in a continuous loss position.
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
 
 Less than 12 Months
 
 
 12 Months or More
 
 
 Total
 
 
 
 Fair Value
 
 
 Unrealized Losses
 
 
 Fair Value
 
 
 Unrealized Losses
 
 
 Fair Value
 
 
 Unrealized Losses
 
Mortgage-backed securities
 $6,932 
  56 
  17,670 
  502 
  24,602 
  558 
U.S. Government
    
    
    
    
    
    
sponsored enterprises
  1,784 
  69 
  25,172 
  724 
  26,956 
  793 
State and political subdivisions
  4,815 
  26 
  1,578 
  17 
  6,393 
  43 
Total
 $13,531 
  151 
  44,420 
  1,243 
  57,951 
  1,394 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
 Less than 12 Months
 
 
 12 Months or More
 
 
 Total    
 
 
 
 Fair Value
 
 
 Unrealized Losses
 
 
 Fair Value
 
 
 Unrealized Losses
 
 
 Fair Value
 
 
 Unrealized Losses
 
Mortgage-backed securities
 $8,701 
  75 
  11,259 
  254 
  19,960 
  329 
U.S. Government
    
    
    
    
    
    
sponsored enterprises
  12,661 
  98 
  10,067 
  166 
  22,728 
  264 
State and political subdivisions
  798 
  2 
  1,501 
  14 
  2,299 
  16 
Total
 $22,160 
  175 
  22,827 
  434 
  44,987 
  609 
 
At December 31, 2018, unrealized losses in the investment securities portfolio relating to debt securities totaled $1.4 million. The unrealized losses on these debt securities arose due to changing interest rates and are considered
 
 
A-45
 
 
       
 
               to be temporary. From the December 31, 2018 tables above, 11 out of 130 securities issued by state and political subdivisions contained unrealized losses and 31 out of 46 securities issued by U.S. Government sponsored enterprises, including mortgage-backed securities, contained unrealized losses. These                unrealized losses are considered temporary because of acceptable financial condition and results of operations on each security and the repayment sources of principal and interest on U.S. Government sponsored enterprises, including mortgage-backed securities, are government backed.
 
The Company periodically evaluates its investments for any impairment which would be deemed other-than-temporary.   No investment impairments were deemed other-than-temporary in 2018, 2017 or 2016.
 
The amortized cost and estimated fair value of investment securities available for sale at December 31, 2018, by contractual maturity, are shown below. Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
 
December 31, 2018
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 Amortized Cost
 
 
 Estimated Fair Value
 
Due within one year
 $21,379 
  21,426 
Due from one to five years
  80,932 
  82,325 
Due from five to ten years
  32,271 
  32,174 
Due after ten years
  6,569 
  6,550 
Mortgage-backed securities
  52,145 
  52,103 
Total
 $193,296 
  194,578 
 
During 2018, proceeds from sales of securities available for sale were $36.0 million and resulted in gross gains of $15,000. No securities available for sale were sold during the year ended December 31, 2017. During 2016, proceeds from sales of securities available for sale were $1.5 million and resulted in gross gains of $729,000.
 
Securities with a fair value of approximately $93.0 million and $105.6 million at December 31, 2018 and 2017, respectively, were pledged to secure public deposits, Federal Home Loan Bank of Atlanta (“FHLB”) borrowings and for other purposes as required by law.
 
GAAP establishes a framework for measuring fair value and expands disclosures about fair value measurements. There is a three-level fair value hierarchy for fair value measurements. Level 1 inputs are quoted prices in active markets for identical assets or liabilities that a company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. The table below presents the balance of securities available for sale, which are measured at fair value on a recurring basis by level within the fair value hierarchy as of December 31, 2018 and 2017.
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
 
Fair Value Measurements
 
 
Level 1 Valuation
 
 
Level 2 Valuation
 
 
Level 3 Valuation
 
Mortgage-backed securities
 $52,103 
  - 
  52,103 
  - 
U.S. Government
    
    
    
    
sponsored enterprises
 $34,634 
  - 
  34,634 
  - 
State and political subdivisions
 $107,591 
  - 
  107,591 
  - 
Trust preferred securities
 $250 
  - 
  - 
  250 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2017
 
 
 
Fair Value Measurements
 
 
Level 1 Valuation
 
 
Level 2 Valuation
 
 
Level 3 Valuation
 
Mortgage-backed securities
 $53,609 
  - 
  53,609 
  - 
U.S. Government
    
    
    
    
sponsored enterprises
 $40,380 
  - 
  40,380 
  - 
State and political subdivisions
 $133,570 
  - 
  133,570 
  - 
Corporate bonds
 $1,512 
  - 
  1,512 
  - 
Trust preferred securities
 $250 
  - 
  - 
  250 
 
 
A-46
 
 
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.
 
The following is an analysis of fair value measurements of investment securities available for sale using Level 3, significant unobservable inputs, for the year ended December 31, 2018.
 
(Dollars in thousands)
 
 
 
 
 
 Investment Securities Available for Sale
 
 
 
 Level 3 Valuation
 
Balance, beginning of period
 $250 
Change in book value
  - 
Change in gain/(loss) realized and unrealized
  - 
Purchases/(sales and calls)
  - 
Transfers in and/or (out) of Level 3
  - 
Balance, end of period
 $250 
 
    
Change in unrealized gain/(loss) for assets still held in Level 3
 $- 
 
 (3) 
Loans
 
Major classifications of loans at December 31, 2018 and 2017 are summarized as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
December 31,
2018
 
 
December 31,
2017
 
Real estate loans:
 
 
 
 
 
 
Construction and land development
 $94,178 
  84,987 
Single-family residential
  252,983 
  246,703 
Single-family residential -
    
    
Banco de la Gente non-traditional
  34,261 
  37,249 
Commercial
  270,055 
  248,637 
Multifamily and farmland
  33,163 
  28,937 
Total real estate loans
  684,640 
  646,513 
 
    
    
Loans not secured by real estate:
    
    
Commercial loans
  97,465 
  89,022 
Farm loans
  926 
  1,204 
Consumer loans
  9,165 
  9,888 
All other loans
  11,827 
  13,137 
 
    
    
Total loans
  804,023 
  759,764 
 
    
    
Less allowance for loan losses
  6,445 
  6,366 
 
    
    
Net loans
 $797,578 
  753,398 
 
The above table includes deferred costs, net of deferred fees, totaling $1.6 million at December 31, 2018 and 2017.
 
The Bank grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Wake and Durham counties of North Carolina. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by improved and unimproved real estate, the value of which is dependent upon the real estate market. Risk characteristics of the major components of the Bank’s loan portfolio are discussed below:
 
 
 
A-47
 
 

Construction and land development loans – The risk of loss is largely dependent on the initial estimate of whether the property’s value at completion equals or exceeds the cost of property construction and the availability of take-out financing. During the construction phase, a number of factors can result in delays or cost overruns. If the estimate is inaccurate or if actual construction costs exceed estimates, the value of the property securing the loan may be insufficient to ensure full repayment when completed through a permanent loan, sale of the property, or by seizure of collateral. As of December 31, 2018, construction and land development loans comprised approximately 12% of the Bank’s total loan portfolio.
 
Single-family residential loans – Declining home sales volumes, decreased real estate values and higher than normal levels of unemployment could contribute to losses on these loans. As of December 31, 2018, single-family residential loans comprised approximately 36% of the Bank’s total loan portfolio, including Banco single-family residential non-traditional loans which were approximately 4% of the Bank’s total loan portfolio.
 
Commercial real estate loans – Repayment is dependent on income being generated in amounts sufficient to cover operating expenses and debt service. These loans also involve greater risk because they are generally not fully amortizing over a loan period, but rather have a balloon payment due at maturity. A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property. As of December 31, 2018, commercial real estate loans comprised approximately 34% of the Bank’s total loan portfolio.
 
Commercial loans – Repayment is generally dependent upon the successful operation of the borrower’s business. In addition, the collateral securing the loans may depreciate over time, be difficult to appraise, be illiquid, or fluctuate in value based on the success of the business. As of December 31, 2018, commercial loans comprised approximately 12% of the Bank’s total loan portfolio.
 
Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.
 
 
The following tables present an age analysis of past due loans, by loan type, as of December 31, 2018 and 2017:
 
December 31, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Loans 30-89 Days Past Due
 
 
 Loans 90 or More Days Past Due
 
 
 Total Past Due Loans
 
 
 Total Current Loans
 
 
 Total Loans
 
 
 Accruing Loans 90 or More Days Past Due
 
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $3 
  - 
  3 
  94,175 
  94,178 
  - 
Single-family residential
  4,162 
  570 
  4,732 
  248,251 
  252,983 
  - 
Single-family residential -
    
    
    
    
    
    
Banco de la Gente non-traditional
  4,627 
  580 
  5,207 
  29,054 
  34,261 
  - 
Commercial
  228 
  - 
  228 
  269,827 
  270,055 
  - 
Multifamily and farmland
  - 
  - 
  - 
  33,163 
  33,163 
  - 
Total real estate loans
  9,020 
  1,150 
  10,170 
  674,470 
  684,640 
  - 
 
    
    
    
    
    
    
Loans not secured by real estate:
    
    
    
    
    
    
Commercial loans
  445 
  90 
  535 
  96,930 
  97,465 
  - 
Farm loans
  - 
  - 
  - 
  926 
  926 
  - 
Consumer loans
  99 
  4 
  103 
  9,062 
  9,165 
  - 
All other loans
  - 
  - 
  - 
  11,827 
  11,827 
  - 
Total loans
 $9,564 
  1,244 
  10,808 
  793,215 
  804,023 
  - 
 
A-48
 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Loans 30-89 Days Past Due
 
 
 Loans 90 or More Days Past Due
 
 
 Total Past Due Loans
 
 
 Total Current Loans
 
 
 Total Loans
 
 
 Accruing Loans 90 or More Days Past Due
 
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $277 
  - 
  277 
  84,710 
  84,987 
  - 
Single-family residential
  3,241 
  193 
  3,434 
  243,269 
  246,703 
  - 
Single-family residential -
    
    
    
    
    
    
Banco de la Gente non-traditional
  4,078 
  465 
  4,543 
  32,706 
  37,249 
  - 
Commercial
  588 
  - 
  588 
  248,049 
  248,637 
  - 
Multifamily and farmland
  - 
  12 
  12 
  28,925 
  28,937 
  - 
Total real estate loans
  8,184 
  670 
  8,854 
  637,659 
  646,513 
  - 
 
    
    
    
    
    
    
Loans not secured by real estate:
    
    
    
    
    
    
Commercial loans
  53 
  100 
  153 
  88,869 
  89,022 
  - 
Farm loans
  - 
  - 
  - 
  1,204 
  1,204 
  - 
Consumer loans
  113 
  5 
  118 
  9,770 
  9,888 
  - 
All other loans
  - 
  - 
  - 
  13,137 
  13,137 
  - 
Total loans
 $8,350 
  775 
  9,125 
  750,639 
  759,764 
  - 
 
 
The following table presents the Bank’s non-accrual loans as of December 31, 2018 and 2017:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
December 31,
2018
 
 
December 31,
2017
 
Real estate loans:
 
 
 
 
 
 
Construction and land development
 $1 
  14 
Single-family residential
  1,530 
  1,634 
Single-family residential -
    
    
Banco de la Gente non-traditional
  1,440 
  1,543 
Commercial
  244 
  396 
     Multifamily and farmland
  - 
  12 
Total real estate loans
  3,215 
  3,599 
 
    
    
Loans not secured by real estate:
    
    
Commercial loans
  89 
  100 
Consumer loans
  10 
  12 
Total
 $3,314 
  3,711 
 
At each reporting period, the Bank determines which loans are impaired. Accordingly, the Bank’s impaired loans are reported at their estimated fair value on a non-recurring basis. An allowance for each impaired loan that is collateral-dependent is calculated based on the fair value of its collateral. The fair value of the collateral is based on appraisals performed by REAS, a subsidiary of the Bank. REAS is staffed by certified appraisers that also perform appraisals for other companies. Factors, including the assumptions and techniques utilized by the appraiser, are considered by management. If the recorded investment in the impaired loan exceeds the measure of fair value of the collateral, a valuation allowance is recorded as a component of the allowance for loan losses. An allowance for each impaired loan that is not collateral dependent is calculated based on the present value of projected cash flows. If the recorded investment in the impaired loan exceeds the present value of projected cash flows, a valuation allowance is recorded as a component of the allowance for loan losses. Impaired loans under $250,000 are not individually evaluated for impairment with the exception of the Bank’s troubled debt restructured (“TDR”) loans in the residential mortgage loan portfolio, which are individually evaluated for impairment. Impaired loans collectively evaluated for impairment totaled $4.8 million and $4.9 million at December 31, 2018 and 2017, respectively. Accruing impaired loans were $22.8 million and $24.6 million at December 31, 2018 and December 31, 2017, respectively. Interest income recognized on accruing impaired loans was $1.3 million and $1.4 million for the years ended December 31, 2018 and 2017, respectively. No interest income is recognized on non-accrual impaired loans subsequent to their classification as non-accrual.
  
 
 
A-49
 
 
The following tables present the Bank’s impaired loans as of December 31, 2018, 2017 and 2016:
 
December 31, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Unpaid Contractual Principal Balance
 
 
 Recorded Investment With No Allowance
 
 
 Recorded Investment With Allowance
 
 
 Recorded Investment in Impaired Loans
 
 
 Related Allowance
 
 
 Average Outstanding Impaired Loans
 
 
 YTD Interest Income Recognized
 
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $281 
  - 
  279 
  279 
  5 
  327 
  19 
Single-family residential
  5,059 
  422 
  4,188 
  4,610 
  32 
  6,271 
  261 
Single-family residential -
    
    
    
    
    
    
    
Banco de la Gente non-traditional
  16,424 
  - 
  15,776 
  15,776 
  1,042 
  14,619 
  944 
Commercial
  1,995 
  - 
  1,925 
  1,925 
  17 
  2,171 
  111 
Total impaired real estate loans
  23,759 
  422 
  22,168 
  22,590 
  1,096 
  23,388 
  1,335 
 
    
    
    
    
    
    
    
Loans not secured by real estate:
    
    
    
    
    
    
    
Commercial loans
  251 
  89 
  1 
  90 
  - 
  96 
  - 
Consumer loans
  116 
  - 
  113 
  113 
  2 
  137 
  7 
Total impaired loans
 $24,126 
  511 
  22,282 
  22,793 
  1,098 
  23,621 
  1,342 
 
December 31, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Unpaid Contractual Principal Balance
 
 
 Recorded Investment With No Allowance
 
 
 Recorded Investment With Allowance
 
 
 Recorded Investment in Impaired Loans
 
 
 Related Allowance
 
 
 Average Outstanding Impaired Loans
 
 
 YTD Interest Income Recognized
 
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $282 
  - 
  277 
  277 
  6 
  253 
  17 
Single-family residential
  5,226 
  1,135 
  3,686 
  4,821 
  41 
  5,113 
  265 
Single-family residential -
    
    
    
    
    
    
    
Banco de la Gente non-traditional
  17,360 
  - 
  16,805 
  16,805 
  1,149 
  16,867 
  920 
Commercial
  2,761 
  807 
  1,661 
  2,468 
  1 
  3,411 
  148 
Multifamily and farmland
  78 
  - 
  12 
  12 
  - 
  28 
  - 
Total impaired real estate loans
  25,707 
  1,942 
  22,441 
  24,383 
  1,197 
  25,672 
  1,350 
 
    
    
    
    
    
    
    
Loans not secured by real estate:
    
    
    
    
    
    
    
Commercial loans
  264 
  100 
  4 
  104 
  - 
  149 
  3 
Consumer loans
  158 
  - 
  154 
  154 
  2 
  194 
  9 
Total impaired loans
 $26,129 
  2,042 
  22,599 
  24,641 
  1,199 
  26,015 
  1,362 
 
 
December 31, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Unpaid Contractual Principal Balance
 
 
 Recorded Investment With No Allowance
 
 
 Recorded Investment With Allowance
 
 
 Recorded Investment in Impaired Loans
 
 
 Related Allowance
 
 
 Average Outstanding Impaired Loans
 
 
 YTD Interest Income Recognized
 
Real estate loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $282 
  - 
  278 
  278 
  11 
  330 
  13 
Single-family residential
  5,354 
  703 
  4,323 
  5,026 
  47 
  7,247 
  164 
Single-family residential -
    
    
    
    
    
    
    
Banco de la Gente non-traditional
  18,611 
  - 
  18,074 
  18,074 
  1,182 
  17,673 
  861 
Commercial
  3,750 
  1,299 
  2,197 
  3,496 
  166 
  4,657 
  152 
Multifamily and farmland
  78 
  - 
  78 
  78 
  - 
  78 
  - 
Total impaired real estate loans
  28,075 
  2,002 
  24,950 
  26,952 
  1,406 
  29,985 
  1,190 
 
    
    
    
    
    
    
    
Loans not secured by real estate:
    
    
    
    
    
    
    
Commercial loans
  27 
  - 
  27 
  27 
  - 
  95 
  - 
Consumer loans
  211 
  - 
  202 
  202 
  3 
  222 
  8 
Total impaired loans
 $28,313 
  2,002 
  25,179 
  27,181 
  1,409 
  30,302 
  1,198 
 
The fair value measurements for mortgage loans held for sale, impaired loans and other real estate on a non-recurring basis at December 31, 2018 and 2017 are presented below. The Company’s valuation methodology is discussed in Note 15.
 
A-50
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value Measurements December 31,
2018
 
 
Level 1 Valuation
 
 
Level 2 Valuation
 
 
Level 3 Valuation
 
Mortgage loans held for sale
 $680 
  - 
  - 
  680 
Impaired loans
 $21,695 
  - 
  - 
  21,695 
Other real estate
 $27 
  - 
  - 
  27 
 
    
    
    
    
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value Measurements December 31,
2017
 
 
Level 1 Valuation
 
 
Level 2 Valuation
 
 
Level 3 Valuation
 
Mortgage loans held for sale
 $857 
  - 
  - 
  857 
Impaired loans
 $23,442 
  - 
  - 
  23,442 
Other real estate
 $118 
  - 
  - 
  118 
 
    
    
    
    
 
 
Changes in the allowance for loan losses for the year ended December 31, 2018 were as follows:
 
(Dollars in thousands)                                                 
 
 
Real Estate Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Land Development
 
 
Single-Family Residential
 
 
Single-Family Residential - Banco de la Gente Non-traditional
 
 
Commercial
 
 
Multifamily and Farmland
 
 
Commercial
 
 
Farm
 
 
Consumer and All Other
 
 
Unallocated
 
 
Total
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 $804 
  1,812 
  1,280 
  1,193 
  72 
  574 
  - 
  155 
  476 
  6,366 
Charge-offs
  (53)
  (116)
  - 
  (453)
  (5)
  (54)
  - 
  (452)
  - 
  (1,133)
Recoveries
  10 
  106 
  - 
  105 
  1 
  32 
  - 
  168 
  - 
  422 
Provision
  52 
  (477)
  (103)
  433 
  15 
  74 
  - 
  290 
  506 
  790 
Ending balance
 $813 
  1,325 
  1,177 
  1,278 
  83 
  626 
  - 
  161 
  982 
  6,445 
 
    
    
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $- 
  - 
  1,023 
  15 
  - 
  - 
  - 
  - 
  - 
  1,038 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
  813 
  1,325 
  154 
  1,263 
  83 
  626 
  - 
  161 
  982 
  5,407 
Ending balance
 $813 
  1,325 
  1,177 
  1,278 
  83 
  626 
  - 
  161 
  982 
  6,445 
 
    
    
    
    
    
    
    
    
    
    
Loans:
    
    
    
    
    
    
    
    
    
    
Ending balance
 $94,178 
  252,983 
  34,261 
  270,055 
  33,163 
  97,465 
  926 
  20,992 
  - 
  804,023 
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $96 
  1,779 
  14,310 
  1,673 
  - 
  89 
  - 
  - 
  - 
  17,947 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $94,082 
  251,204 
  19,951 
  268,382 
  33,163 
  97,376 
  926 
  20,992 
  - 
  786,076 
 
 
A-51
 
 
Changes in the allowance for loan losses for the year ended December 31, 2017 were as follows:
 
(Dollars in thousands)                                                 
 
 
Real Estate Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Land Development
 
 
Single-Family Residential
 
 
Single-Family Residential - Banco de la Gente Non-traditional
 
 
Commercial
 
 
Multifamily and Farmland
 
 
Commercial
 
 
Farm
 
 
Consumer and All Other
 
 
Unallocated
 
 
Total
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 $1,152 
  2,126 
  1,377 
  1,593 
  52 
  675 
  - 
  204 
  371 
  7,550 
Charge-offs
  - 
  (249)
  - 
  - 
  (66)
  (194)
  - 
  (473)
  - 
  (982)
Recoveries
  14 
  85 
  - 
  21 
  - 
  31 
  - 
  154 
  - 
  305 
Provision
  (362)
  (150)
  (97)
  (421)
  86 
  62 
  - 
  270 
  105 
  (507)
Ending balance
 $804 
  1,812 
  1,280 
  1,193 
  72 
  574 
  - 
  155 
  476 
  6,366 
 
    
    
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $- 
  - 
  1,093 
  37 
  - 
  - 
  - 
  - 
  - 
  1,130 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
  804 
  1,812 
  187 
  1,156 
  72 
  574 
  - 
  155 
  476 
  5,236 
Ending balance
 $804 
  1,812 
  1,280 
  1,193 
  72 
  574 
  - 
  155 
  476 
  6,366 
 
    
    
    
    
    
    
    
    
    
    
Loans:
    
    
    
    
    
    
    
    
    
    
Ending balance
 $84,987 
  246,703 
  37,249 
  248,637 
  28,937 
  89,022 
  1,204 
  23,025 
  - 
  759,764 
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $98 
  1,855 
  15,460 
  2,251 
  - 
  100 
  - 
  - 
  - 
  19,764 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $84,889 
  244,848 
  21,789 
  246,386 
  28,937 
  88,922 
  1,204 
  23,025 
  - 
  740,000 
 
 
Changes in the allowance for loan losses for the year ended December 31, 2016 were as follows:
 
(Dollars in thousands)                                                 
 
 
Real Estate Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Land Development
 
 
Single-Family Residential
 
 
Single-Family Residential - Banco de la Gente Non-traditional
 
 
Commercial
 
 
Multifamily and Farmland
 
 
Commercial
 
 
Farm
 
 
Consumer and All Other
 
 
Unallocated
 
 
Total
 
Allowance for loan losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 $2,185 
  2,534 
  1,460 
  1,917 
  - 
  842 
  - 
  172 
  479 
  9,589 
Charge-offs
  (7)
  (275)
  - 
  (318)
  - 
  (146)
  - 
  (492)
  - 
  (1,238)
Recoveries
  10 
  55 
  - 
  19 
  - 
  170 
  - 
  151 
  - 
  405 
Provision
  (1,036)
  (188)
  (83)
  (25)
  52 
  (191)
  - 
  373 
  (108)
  (1,206)
Ending balance
 $1,152 
  2,126 
  1,377 
  1,593 
  52 
  675 
  - 
  204 
  371 
  7,550 
 
    
    
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $- 
  - 
  1,160 
  159 
  - 
  - 
  - 
  - 
  - 
  1,319 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
  1,152 
  2,126 
  217 
  1,434 
  52 
  675 
  - 
  204 
  371 
  6,231 
Ending balance
 $1,152 
  2,126 
  1,377 
  1,593 
  52 
  675 
  - 
  204 
  371 
  7,550 
 
    
    
    
    
    
    
    
    
    
    
Loans:
    
    
    
    
    
    
    
    
    
    
Ending balance
 $61,749 
  240,700 
  40,189 
  247,521 
  21,047 
  87,596 
  - 
  25,009 
  - 
  723,811 
 
    
    
    
    
    
    
    
    
    
    
 
Ending balance: individually
 
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $- 
  935 
  16,718 
  3,648 
  - 
  - 
  - 
  - 
  - 
  21,301 
Ending balance: collectively
    
    
    
    
    
    
    
    
    
    
evaluated for impairment
 $61,749 
  239,765 
  23,471 
  243,873 
  21,047 
  87,596 
  - 
  25,009 
  - 
  702,510 
 
The Bank utilizes an internal risk grading matrix to assign a risk grade to each of its loans. Loans are graded on a scale of 1 to 8. These risk grades are evaluated on an ongoing basis. A description of the general characteristics of the eight risk grades is as follows:
 
Risk Grade 1 – Excellent Quality: Loans are well above average quality and a minimal amount of credit risk exists. CD or cash secured loans or properly margined actively traded stock or bond secured loans would fall in this grade.
Risk Grade 2 – High Quality: Loans are of good quality with risk levels well within the Company’s range of acceptability. The organization or individual is established with a history of successful performance though somewhat susceptible to economic changes.
 
 
A-52
 
 
Risk Grade 3 – Good Quality: Loans of average quality with risk levels within the Company’s range of acceptability but higher than normal. This may be a new organization or an existing organization in a transitional phase (e.g. expansion, acquisition, market change).
Risk Grade 4 – Management Attention: These loans have higher risk and servicing needs but still are acceptable. Evidence of marginal performance or deteriorating trends is observed. These are not problem credits presently, but may be in the future if the borrower is unable to change its present course.
Risk Grade 5 – Watch: These loans are currently performing satisfactorily, but there has been some recent past due history on repayment and there are potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Company’s position at some future date.
Risk Grade 6 – Substandard: A Substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or the collateral pledged (if there is any). There is a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Risk Grade 7 – Doubtful: Loans classified as Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off.
Risk Grade 8 – Loss: Loans classified as Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this worthless loan even though partial recovery may be realized in the future. Loss is a temporary grade until the appropriate authority is obtained to charge the loan off.
 
The following tables present the credit risk profile of each loan type based on internally assigned risk grades as of December 31, 2018 and 2017.
 
December 31, 2018                                       
 
 
 
 
 
 
(Dollars in thousands)                                       
 
 
 
 
 
 
 
 
Real Estate Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Land Development
 
 
Single-Family Residential
 
 
Single-Family Residential - Banco de la Gente Non-traditional
 
 
Commercial
 
 
Multifamily and Farmland
 
 
Commercial
 
 
Farm
 
 
Consumer
 
 
All Other
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1- Excellent Quality
 $504 
  5,795 
  - 
  - 
  - 
  605 
  - 
  673 
  - 
  7,577 
2- High Quality
  24,594 
  128,588 
  - 
  25,321 
  395 
  20,520 
  - 
  3,229 
  2,145 
  204,792 
3- Good Quality
  59,549 
  92,435 
  13,776 
  211,541 
  27,774 
  69,651 
  785 
  4,699 
  8,932 
  489,142 
4- Management Attention
  5,707 
  19,200 
  15,012 
  30,333 
  3,906 
  6,325 
  141 
  529 
  750 
  81,903 
5- Watch
  3,669 
  3,761 
  2,408 
  2,616 
  1,088 
  264 
  - 
  18 
  - 
  13,824 
6- Substandard
  155 
  3,204 
  3,065 
  244 
  - 
  100 
  - 
  17 
  - 
  6,785 
7- Doubtful
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
8- Loss
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
Total
 $94,178 
  252,983 
  34,261 
  270,055 
  33,163 
  97,465 
  926 
  9,165 
  11,827 
  804,023 
 
 
December 31, 2017                                                 
(Dollars in thousands)                                                 
 
 
Real Estate Loans
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and Land Development
 
 
Single-Family Residential
 
 
Single-Family Residential - Banco de la Gente Non-traditional
 
 
Commercial
 
 
Multifamily and Farmland
 
 
Commercial
 
 
Farm
 
 
Consumer
 
 
All Other
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1- Excellent Quality
 $152 
  8,590 
  - 
  - 
  - 
  446 
  - 
  791 
  - 
  9,979 
2- High Quality
  20,593 
  120,331 
  - 
  34,360 
  561 
  17,559 
  - 
  3,475 
  2,410 
  199,289 
3- Good Quality
  53,586 
  89,120 
  14,955 
  196,439 
  25,306 
  65,626 
  1,085 
  5,012 
  9,925 
  461,054 
4- Management Attention
  4,313 
  20,648 
  15,113 
  13,727 
  1,912 
  5,051 
  119 
  562 
  802 
  62,247 
5- Watch
  6,060 
  4,796 
  3,357 
  3,671 
  1,146 
  223 
  - 
  23 
  - 
  19,276 
6- Substandard
  283 
  3,218 
  3,824 
  440 
  12 
  117 
  - 
  25 
  - 
  7,919 
7- Doubtful
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
8- Loss
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
  - 
Total
 $84,987 
  246,703 
  37,249 
  248,637 
  28,937 
  89,022 
  1,204 
  9,888 
  13,137 
  759,764 
 
 
A-53
 
TDR loans modified in 2018, past due TDR loans and non-accrual TDR loans totaled $4.7 million and $4.5 million at December 31, 2018 and December 31, 2017, respectively. The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower. There were $92,000 and $21,000 in performing loans classified as TDR loans at December 31, 2018 and December 31, 2017, respectively.
 
The following table presents an analysis of loan modifications during the year ended December 31, 2018:
 
Year ended December 31, 2018
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
Number of Contracts
 
 
Pre-Modification Outstanding Recorded Investment
 
 
Post-Modification Outstanding Recorded Investment
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Single-family residential
  2 
 $94 
  94 
 
    
    
    
Total TDR loans
  2 
 $94 
  94 
 
During the year ended December 31, 2018, two loans were modified that were considered to be new TDR loans. The interest rate was modified on these TDR loans.
 
 
The following table presents an analysis of loan modifications during the year ended December 31, 2017:
 
Year ended December 31, 2017
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
Number of Contracts
 
 
Pre-Modification Outstanding Recorded Investment
 
 
Post-Modification Outstanding Recorded Investment
 
Real estate loans:
 
 
 
 
 
 
 
 
 
Single-family residential
  2 
 $22 
  22 
 
    
    
    
Total TDR loans
  2 
 $22 
  22 
 
During the year ended December 31, 2017, two loans were modified that were considered to be new TDR loans. The interest rate was modified on these TDR loans.
 
There were no TDR loans with a payment default occurring within 12 months of the restructure date, and the payment default occurring during the years ended December 31, 2018 and 2017. TDR loans are deemed to be in default if they become past due by 90 days or more.
 
(4) 
Premises and Equipment
 
Major classifications of premises and equipment at December 31, 2018 and 2017 are summarized as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Land
 $3,456 
  3,700 
Buildings and improvements
  19,357 
  19,312 
Furniture and equipment
  22,315 
  21,115 
Construction in process
  381 
  847 
 
    
    
Total premises and equipment
  45,509 
  44,974 
 
    
    
Less accumulated depreciation
  27,059 
  25,063 
 
    
    
Total net premises and equipment
 $18,450 
  19,911 
 

 
A-54
 
 
The Company recognized approximately $2.3 million in depreciation expense for the year ended December 31, 2018. Depreciation expense was approximately $2.1 million and $2.1 million for the years ended December 31, 2017 and 2016, respectively.
 
The Company had $544,000 net gains on the sale of premises and equipment for the year ended December 31, 2018, which was primarily due to the sale of a Bank building that housed primarily administrative staff. Staff working at this location have been relocated to other Bank locations.
 
 
(5) 
Time Deposits
 
At December 31, 2018, the scheduled maturities of time deposits are as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
2019
 $61,723 
2020
  21,566 
2021
  14,121 
2022
  2,618 
2023 and thereafter
  3,145 
 
    
Total
 $103,173 
 
At December 31, 2018 and 2017, the Bank had approximately $3.4 million and $5.2 million, respectively, in time deposits purchased through third party brokers, including certificates of deposit participated through the Certificate of Deposit Account Registry Service (“CDARS”) on behalf of local customers. CDARS balances totaled $3.4 million and $5.2 million as of December 31, 2018 and 2017, respectively. The weighted average rate of brokered deposits as of December 31, 2018 and 2017 was 0.07% and 0.07%, respectively.
 
(6) 
Federal Home Loan Bank and Federal Reserve Bank Borrowings
 
The Bank had no borrowings from the FHLB at December 31, 2018 and 2017. FHLB borrowings are collateralized by a blanket assignment on all residential first mortgage loans, home equity lines of credit and loans secured by multi-family real estate that the Bank owns. At December 31, 2018, the carrying value of loans pledged as collateral totaled approximately $140.0 million. The remaining availability under the line of credit with the FHLB was $84.9 million at December 31, 2018.
 
The Bank is required to purchase and hold certain amounts of FHLB stock in order to obtain FHLB borrowings. No ready market exists for the FHLB stock, and it has no quoted market value. The stock is redeemable at $100 per share subject to certain limitations set by the FHLB. The Bank owned $982,000 and $978,000 of FHLB stock, included in other investments, at December 31, 2018 and 2017, respectively.
 
The Bank prepaid FHLB borrowings totaling $20.0 million in 2017 with prepayment penalties totaling $508,000.
 
As of December 31, 2018 and 2017, the Bank had no borrowings from the Federal Reserve Bank (“FRB”). FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB. At December 31, 2018, the carrying value of loans pledged as collateral totaled approximately $442.6 million. Availability under the line of credit with the FRB was $335.8 million at December 31, 2018.
 
(7) 
Junior Subordinated Debentures
 
In June 2006, the Company formed a second wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company. The proceeds received by the Company from the sale of the junior subordinated debentures were used to repay in December 2006 the trust preferred securities issued in December 2001 by PEBK Capital Trust, a wholly owned Delaware statutory trust of the Company, and for general purposes. The debentures represent the sole assets of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

 
A-55
 
 
The trust preferred securities issued by PEBK Trust II accrue and pay interest quarterly at a floating rate of three-month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II does not have funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

  
These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, which became effective on June 28, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount plus any accrued but unpaid interest.
 
(8) 
Income Taxes
 
On December 22, 2017, the President of the United States signed into law the TCJA. The TCJA includes a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate from 34 percent to 21 percent for tax years beginning after December 31, 2017.
 
The Company recognized the income tax effects of the TCJA in its 2017 financial statements in accordance with Staff Accounting Bulletin No. 118, which provides SEC staff guidance for the application of ASC Topic 740, Income Taxes, in the reporting period in which the TCJA was signed into law. As such, the Company’s financial results reflect the income tax effects of the TCJA for which the accounting under ASC Topic 740 is complete and provisional amounts for those specific income tax effects of the TCJA for which the accounting under ASC Topic 740 is incomplete but a reasonable estimate could be determined. The Company did not identify items for which the income tax effects of the TCJA have not been completed and a reasonable estimate could not be determined as of December 31, 2017.
 
The provision for income taxes is summarized as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 2016
 
Current expense
 $2,546 
  1,827 
  1,464 
Deferred income tax expense
  78 
  2,120 
  1,097 
Total income tax
 $2,624 
  3,947 
  2,561 
 
The differences between the provision for income taxes and the amount computed by applying the statutory federal income tax rate to earnings before income taxes are as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 2016
 
Tax expense at statutory rate (21% in 2018)
 $3,361 
  4,833 
  3,991 
State income tax, net of federal income tax effect
  358 
  307 
  339 
Tax-exempt interest income
  (990)
  (1,594)
  (1,681)
Increase in cash surrender value of life insurance
  (81)
  (136)
  (138)
Nondeductible interest and other expense
  23 
  46 
  78 
Impact of TCJA
  - 
  588 
  - 
Other
  (47)
  (97)
  (28)
Total
 $2,624 
  3,947 
  2,561 
 
 
The following summarizes the tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities. The net deferred tax asset is included as a component of other assets at December 31, 2018 and 2017.
 
 
A-56
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
Deferred tax assets:
 
 
 
 
 
 
Allowance for loan losses
 $1,481 
  1,463 
Accrued retirement expense
  1,119 
  1,073 
Federal credit carryforward
  - 
  88 
Restricted stock
  262 
  243 
Accrued bonuses
  211 
  171 
Interest income on nonaccrual loans
  1 
  5 
Other than temporary impairment
  - 
  9 
Total gross deferred tax assets
  3,074 
  3,052 
 
    
    
Deferred tax liabilities:
    
    
Deferred loan fees
  379 
  365 
Accumulated depreciation
  610 
  498 
Prepaid expenses
  10 
  14 
Other
  5 
  28 
Unrealized gain on available for sale securities
  294 
  1,072 
Total gross deferred tax liabilities
  1,298 
  1,977 
 
    
    
Net deferred tax asset
 $1,776 
  1,075 
 
The Company measures deferred tax assets and liabilities using enacted tax rates that will apply in the years in which the temporary differences are expected to be recovered or paid. Accordingly, the Company’s deferred tax assets and liabilities were remeasured to reflect the reduction in the U.S. corporate income tax rate from 34 percent to 21 percent, resulting in a $588,000 increase in income tax expense for the year ended December 31, 2017 and a corresponding $588,000 decrease in net deferred tax assets as of December 31, 2017.
 
The Company has analyzed the tax positions taken or expected to be taken in its tax returns and has concluded that it has no liability related to uncertain tax positions.
 
The Company’s Federal income tax filings for years 2015 through 2018 were at year end 2018 open to audit under statutes of limitations by the Internal Revenue Service. The Company's North Carolina income tax returns are currently under audit for tax years 2014-2016, tax years 2017 and 2018 are open to audit under the statutes of limitations by the North Carolina Department of Revenue.
 
(9)            
Related Party Transactions
 
The Company conducts transactions with its directors and executive officers, including companies in which they have beneficial interests, in the normal course of business. It is the policy of the Company that loan transactions with directors and officers are made on substantially the same terms as those prevailing at the time made for comparable loans to other persons. The following is a summary of activity for related party loans for 2018 and 2017:
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
2018
 
 
2017
 
Beginning balance
 $3,679 
  4,503 
New loans
  8,030 
  5,879 
Repayments
  (8,517)
  (6,703)
Ending balance
 $3,192 
  3,679 
 
At December 31, 2018 and 2017, the Company had deposit relationships with related parties of approximately $31.6 million and $26.6 million, respectively.
 
A director of the Company is an officer and partial owner of the construction company that renovated the Bank’s Corporate Center located at 518 West C Street, Newton, North Carolina during 2017. During 2017 the Company paid a total of approximately $2.6 million to this construction company for such renovation work. The Company did not make any payments to this construction company during 2018.

 
A-57
 
(10) 
Commitments and Contingencies
 
The Company leases various office spaces for banking and operational facilities and equipment under operating lease arrangements. Future minimum lease payments required for all operating leases having a remaining term in excess of one year at December 31, 2018 are as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
Year ending December 31,
 
 
 
2019
 $820 
2020
  809 
2021
  793 
2022
  501 
2023
  393 
Thereafter
  1,624 
Total minimum obligation
 $4,940 
 
Total rent expense was approximately $785,000, $756,000 and $752,000 for the years ended December 31, 2018, 2017 and 2016, respectively.
 
The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.
 
The exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
  
In most cases, the Bank requires collateral or other security to support financial instruments with credit risk.
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 Contractual Amount
 
 
 
 2018
 
 
 2017
 
Financial instruments whose contract amount represent credit risk:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commitments to extend credit
 $268,708 
  233,972 
 
    
    
Standby letters of credit and financial guarantees written
 $3,651 
  3,325 
 
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and because they may expire without being drawn upon, the total commitment amount of $272.4 million does not necessarily represent future cash requirements.
 
Standby letters of credit and financial guarantees written are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to businesses in the Bank’s delineated market area. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds real estate, equipment, automobiles and customer deposits as collateral supporting those commitments for which collateral is deemed necessary.
 
In the normal course of business, the Company is a party (both as plaintiff and defendant) to a number of lawsuits. In the opinion of management and counsel, none of these cases should have a material adverse effect on the financial position of the Company.
 

 
 A-58
 
Bancorp and the Bank have employment agreements with certain key employees. The agreements, among other things, include salary, bonus, incentive compensation, and change in control provisions.
 
At December 31, 2017, the Bank committed to invest $3.0 million in an income tax credit partnership owning and developing two multifamily housing developments in Charlotte, North Carolina, with $1.5 million allocated to each property. The Bank has funded $2.4 million of this commitment at December 31, 2018.
 
(11) 
Employee and Director Benefit Programs
 
The Company has a profit sharing and 401(k) plan for the benefit of substantially all employees subject to certain minimum age and service requirements. Under the 401(k) plan, the Company matched employee contributions to a maximum of 4.00% of annual compensation in 2016, 2017 and 2018. The Company’s contribution pursuant to this formula was approximately $670,000, $622,000 and $565,000 for the years 2018, 2017 and 2016, respectively. Investments of the 401(k) plan are determined by a committee comprised of senior management. No investments in Company stock have been made by the 401(k) plan. Contributions to the 401(k) plan are vested immediately.
 
In December 2001, the Company initiated a postretirement benefit plan to provide retirement benefits to key officers and its Board of Directors and to provide death benefits for their designated beneficiaries. Under the postretirement benefit plan, the Company purchased life insurance contracts on the lives of the key officers and each director. The increase in cash surrender value of the contracts constitutes the Company’s contribution to the postretirement benefit plan each year. Postretirement benefit plan participants are to be paid annual benefits for a specified number of years commencing upon retirement. Expenses incurred for benefits relating to the postretirement benefit plan were approximately $423,000, $411,000 and $428,000 for the years 2018, 2017 and 2016, respectively.
 
The Company is currently paying medical benefits for certain retired employees. The Company did not incur any postretirement medical benefits expense in 2018, 2017 and 2016 due to an excess accrual balance.
 
The following table sets forth the change in the accumulated benefit obligation for the Company’s two postretirement benefit plans described above:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Benefit obligation at beginning of period
 $4,361 
  4,174 
Service cost
  362 
  348 
Interest cost
  70 
  68 
Benefits paid
  (227)
  (229)
 
    
    
Benefit obligation at end of period
 $4,566 
  4,361 
 
The amounts recognized in the Company’s Consolidated Balance Sheet as of December 31, 2018 and 2017 are shown in the following two tables:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Benefit obligation
 $4,566 
  4,361 
Fair value of plan assets
  - 
  - 
 
 A-59
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Funded status
 $(4,566)
  (4,361)
Unrecognized prior service cost/benefit
  - 
  - 
Unrecognized net actuarial loss
  - 
  - 
 
    
    
Net amount recognized
 $(4,566)
  (4,361)
 
    
    
Unfunded accrued liability
 $(4,566)
  (4,361)
Intangible assets
  - 
  - 
 
    
    
Net amount recognized
 $(4,566)
  (4,361)
 
 
Net periodic benefit cost of the Company’s postretirement benefit plans for the years ended December 31, 2018, 2017 and 2016 consisted of the following:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 2016
 
 
 
 
 
 
 
 
 
 
 
Service cost
 $362 
  348 
  346 
Interest cost
  70 
  68 
  67 
 
    
    
    
Net periodic cost
 $432 
  416 
  413 
 
    
    
    
Weighted average discount rate assumption
    
    
    
used to determine benefit obligation
  5.49%
  5.49%
  5.47%
 
The Company paid benefits under the two postretirement plans totaling $227,000 and $229,000 during the years ended December 31, 2018 and 2017, respectively. Information about the expected benefit payments for the Company’s two postretirement benefit plans is as follows:
 
(Dollars in thousands)
 
 
 
 
 
 
 
Year ending December 31,
 
 
 
2019
 $235 
2020
 $353 
2021
 $353 
2022
 $342 
2023
 $342 
Thereafter
 $8,709 
 
    
 
(12) 
Regulatory Matters
 
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of capital in relation to both on- and off-balance sheet items at various risk weights. Total capital consists of two tiers of capital. Tier 1 capital includes common shareholders’ equity and trust preferred securities less adjustments for intangible assets. Tier 2 capital consists of the allowance for loan losses, up to 1.25% of risk-weighted assets and other adjustments. Management believes, as of December 31, 2018, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

 
 
A-60
 
  
 
As of December 31, 2018, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There have been no conditions or events since that notification that management believes have changed the Bank’s category.
 
In 2013, the Federal Reserve Board approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations. The Basel III capital standards, which became effective January 1, 2015, include new risk-based capital and leverage ratios, which are being phased in from 2015 to 2019. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are as follows: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total risk based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% (unchanged from previous rules). An additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes beginning on January 1, 2016 at 0.625% and is being phased in through 2019 (increasing by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019). This will result in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained earnings that could be utilized for such actions.
 
The Company’s and the Bank’s actual capital amounts and ratios are presented below:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Actual
 
 
 For Capital Adequacy Purposes
 
 
 To Be Well Capitalized Under Prompt Corrective Action Provisions
 
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2018:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Capital (to Risk-Weighted Assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 $149,076 
  16.15%
  91,133 
  9.88%
  N/A 
  N/A 
Bank
 $146,640 
  15.91%
  90,995 
  9.88%
  92,147 
  10.00%
Tier 1 Capital (to Risk-Weighted Assets)
    
    
    
    
    
    
Consolidated
 $142,631 
  15.46%
  72,676 
  7.88%
  N/A 
  N/A 
Bank
 $140,195 
  15.21%
  72,566 
  7.88%
  73,717 
  8.00%
Tier 1 Capital (to Average Assets)
    
    
    
    
    
    
Consolidated
 $142,631 
  13.05%
  43,723 
  4.00%
  N/A 
  N/A 
Bank
 $140,195 
  12.76%
  43,950 
  4.00%
  54,937 
  5.00%
 
Common Equity Tier 1 (to Risk-Weighted Assets)
 
    
    
    
    
    
Consolidated
 $122,631 
  13.29%
  58,833 
  6.38%
  N/A 
  N/A 
Bank
 $140,195 
  15.21%
  58,744 
  6.38%
  59,895 
  6.50%
 
 
A-61
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 Actual
 
 
 For Capital Adequacy Purposes
 
 
 To Be Well Capitalized Under Prompt Corrective Action Provisions
 
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
As of December 31, 2017:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total Capital (to Risk-Weighted Assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 $138,492 
  16.06%
  79,758 
  9.25%
  N/A 
  N/A 
Bank
 $136,299 
  15.83%
  79,627 
  9.25%
  86,084 
  10.00%
Tier 1 Capital (to Risk-Weighted Assets)
    
    
    
    
    
    
Consolidated
 $132,126 
  15.32%
  62,513 
  7.25%
  N/A 
  N/A 
Bank
 $129,933 
  15.09%
  62,411 
  7.25%
  68,867 
  8.00%
Tier 1 Capital (to Average Assets)
    
    
    
    
    
    
Consolidated
 $132,126 
  11.94%
  44,255 
  4.00%
  N/A 
  N/A 
Bank
 $129,933 
  11.69%
  44,475 
  4.00%
  55,594 
  5.00%
 
Common Equity Tier 1 (to Risk-Weighted Assets)
 
    
    
    
    
    
Consolidated
 $112,126 
  13.00%
  49,579 
  5.75%
  N/A 
  N/A 
Bank
 $129,933 
  15.09%
  49,498 
  5.75%
  55,954 
  6.50%
 
 (13) 
Shareholders’ Equity
 
Shareholders’ equity was $123.6 million, or 11.31% of total assets, as of December 31, 2018, compared to $116.0 million, or 10.62% of total assets, as of December 31, 2017. The increase in shareholders’ equity is primarily due to an increase in retained earnings due to net income.
 
Annualized return on average equity for the year ended December 31, 2018 was 10.81% compared to 8.78% for the year ended December 31, 2017. Total cash dividends paid on common stock were $3.1 million and $2.6 million for the years ended December 31, 2018 and 2017, respectively.
 
The Board of Directors, at its discretion, can issue shares of preferred stock up to a maximum of 5,000,000 shares. The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights. The Board of Directors does not currently anticipate issuing shares of preferred stock.
 
In 2016, the Company’s Board of Directors authorized a stock repurchase program, pursuant to which up to $2 million was allocated to repurchase the Company’s common stock. Any purchases under the Company’s stock repurchase program were made periodically as permitted by securities laws and other legal requirements in the open market or in privately negotiated transactions. The timing and amount of any repurchase of shares were determined by the Company’s management, based on its evaluation of market conditions and other factors. The Company repurchased approximately $2.0 million, or 92,738 shares of its common stock, under this program as of December 31, 2017.
 
 
 
(14) 
Other Operating Income and Expense
 
Miscellaneous non-interest income for the years ended December 31, 2018, 2017 and 2016 included the following items:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 2016
 
Visa debit card income
 $3,911 
  3,757 
  3,589 
Bank owned life insurance income
  384 
  400 
  407 
Gain (loss) on sale of capital assets
  544 
  (32)
  - 
Other
  1,354 
  1,175 
  854 
 
 $6,193 
  5,300 
  4,850 
 
A-62
 
 
Other non-interest expense for the years ended December 31, 2018, 2017 and 2016 included the following items:
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 2018
 
 
 2017
 
 
 2016
 
ATM expense
 $542 
  673 
  658 
Consulting
  1,012 
  785 
  2,257 
Data processing
  466 
  426 
  418 
Deposit program expense
  586 
  539 
  371 
Dues and subscriptions
  421 
  354 
  451 
FHLB advance prepayment penalty
  - 
  508 
  1,260 
Internet banking expense
  603 
  720 
  710 
Office supplies
  503 
  517 
  465 
Telephone
  678 
  855 
  754 
Other
  2,834 
  2,540 
  1,399 
 
 $7,645 
  7,917 
  8,743 
 
(15) 
Fair Value of Financial Instruments
 
The Company is required to disclose fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are detailed below. Where quoted prices are not available, fair values are based on estimates using discounted cash flows and other valuation techniques. The use of discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following disclosures should not be considered a surrogate of the liquidation value of the Company, but rather a good faith estimate of the increase or decrease in the value of financial instruments held by the Company since purchase, origination, or issuance.
 
 
The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
 
Level 1 – Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2 – Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 – Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
 
Cash and Cash Equivalents
For cash, due from banks and interest-bearing deposits, the carrying amount is a reasonable estimate of fair value. Cash and cash equivalents are reported in the Level 1 fair value category.
 
Investment Securities Available for Sale
Fair values of investment securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges when available. If quoted prices are not available, fair value is determined using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities. Fair values for investment securities with quoted market prices are reported in the Level 1 fair value category. Fair value measurements obtained from independent pricing services are reported in the Level 2 fair value category. All other fair value measurements are reported in the Level 3 fair value category.
 
Other Investments
For other investments, the carrying value is a reasonable estimate of fair value. Other investments are reported in the Level 3 fair value category.
 
Mortgage Loans Held for Sale
Mortgage loans held for sale are carried at lower of aggregate cost or market value. The cost of mortgage loans held for sale approximates the market value. Mortgage loans held for sale are reported in the Level 3 fair value category.
 
A-63
 
 
Loans
The fair value of fixed rate loans 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. For variable rate loans, the carrying amount is a reasonable estimate of fair value. Loans are reported in the Level 3 fair value category, as the pricing of loans is more subjective than the pricing of other financial instruments.
 
Cash Surrender Value of Life Insurance
For cash surrender value of life insurance, the carrying value is a reasonable estimate of fair value. Cash surrender value of life insurance is reported in the Level 2 fair value category.
 
Other Real Estate
The fair value of other real estate is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. Other real estate is reported in the Level 3 fair value category.
 
Deposits
The fair value of demand deposits, interest-bearing demand deposits and savings is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities. Deposits are reported in the Level 2 fair value category.
 
Securities Sold Under Agreements to Repurchase
For securities sold under agreements to repurchase, the carrying value is a reasonable estimate of fair value. Securities sold under agreements to repurchase are reported in the Level 2 fair value category.
 
FHLB Borrowings
The fair value of FHLB borrowings is estimated based upon discounted future cash flows using a discount rate comparable to the current market rate for such borrowings. FHLB borrowings are reported in the Level 2 fair value category.
 
Junior Subordinated Debentures
Because the Company’s junior subordinated debentures were issued at a floating rate, the carrying amount is a reasonable estimate of fair value. Junior subordinated debentures are reported in the Level 2 fair value category.
 
Commitments to Extend Credit and Standby Letters of Credit
Commitments to extend credit and standby letters of credit are generally short-term and at variable interest rates. Therefore, both the carrying value and estimated fair value associated with these instruments are immaterial.
 
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on many judgments. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
 
Fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial instruments include deferred income taxes and premises and equipment. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
 
The fair value presentation for recurring assets is presented in Note 2. There were no recurring liabilities at December 31, 2018 and 2017. The fair value presentation for non-recurring assets is presented in Note 3. There were no non-recurring liabilities at December 31, 2018 and 2017. The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2018 and 2017 are as follows:
 
A-64
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value Measurements at December 31, 2018
 
 
 
 Carrying Amount
 
 
 Level 1
 
 
 Level 2
 
 
 Level 3
 
 
 Total
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 $43,370 
  43,370 
  - 
  - 
  43,370 
Investment securities available for sale
 $194,578 
  - 
  194,328 
  250 
  194,578 
Other investments
 $4,361 
  - 
  - 
  4,361 
  4,361 
Mortgage loans held for sale
 $680 
  - 
  - 
  680 
  680 
Loans, net
 $797,578 
  - 
  - 
  748,917 
  748,917 
Cash surrender value of life insurance
 $15,936 
  - 
  15,936 
  - 
  15,936 
 
    
    
    
    
    
Liabilities:
    
    
    
    
    
Deposits
 $877,213 
  - 
  - 
  857,999 
  857,999 
Securities sold under agreements
    
    
    
    
    
to repurchase
 $58,095 
  - 
  58,095 
  - 
  58,095 
Junior subordinated debentures
 $20,619 
  - 
  20,619 
  - 
  20,619 
 
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Fair Value Measurements at December 31, 2017
 
 
 
 Carrying Amount
 
 
 Level 1
 
 
 Level 2
 
 
 Level 3
 
 
 Total
 
Assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 $57,304 
  57,304 
  - 
  - 
  57,304 
Investment securities available for sale
 $229,321 
  - 
  229,071 
  250 
  229,321 
Other investments
 $1,830 
  - 
  - 
  1,830 
  1,830 
Mortgage loans held for sale
 $857 
  - 
  - 
  857 
  857 
Loans, net
 $753,398 
  - 
  - 
  735,837 
  735,837 
Cash surrender value of life insurance
 $15,552 
  - 
  15,552 
  - 
  15,552 
 
    
    
    
    
    
Liabilities:
    
    
    
    
    
Deposits
 $906,952 
  - 
  - 
  894,932 
  894,932 
Securities sold under agreements
    
    
    
    
    
to repurchase
 $37,757 
  - 
  37,757 
  - 
  37,757 
Junior subordinated debentures
 $20,619 
  - 
  20,619 
  - 
  20,619 
  
  A-65
 
(16) 
Peoples Bancorp of North Carolina, Inc. (Parent Company Only) Condensed Financial Statements
 
Balance Sheets
December 31, 2018 and 2017
(Dollars in thousands)
 
Assets
 
 2018
 
 
 2017
 
 
 
 
 
 
 
 
Cash
 $689 
  428 
Interest-bearing time deposit
  1,000 
  1,000 
Investment in subsidiaries
  141,181 
  133,781 
Investment in PEBK Capital Trust II
  619 
  619 
Investment securities available for sale
  250 
  250 
Other assets
  533 
  546 
 
    
    
Total assets
 $144,272 
  136,624 
 
    
    
Liabilities and Shareholders' Equity
    
    
 
    
    
Junior subordinated debentures
 $20,619 
  20,619 
Liabilities
  36 
  30 
Shareholders' equity
  123,617 
  115,975 
 
    
    
Total liabilities and shareholders' equity
 $144,272 
  136,624 
 
Statements of Earnings
For the Years Ended December 31, 2018, 2017 and 2016
(Dollars in thousands)
 
Revenues:
 
2018
 
 
2017
 
 
2016
 
 
 
 
 
 
 
 
 
 
 
Interest and dividend income
 $4,544 
  1,839 
  4,569 
Gain on sale of securities
  - 
  - 
  405 
 
    
    
    
Total revenues
  4,544 
  1,839 
  4,974 
 
    
    
    
Expenses:
    
    
    
 
    
    
    
Interest
  790 
  590 
  485 
Other operating expenses
  678 
  725 
  513 
 
    
    
    
Total expenses
  1,468 
  1,315 
  998 
 
    
    
    
Income before income tax benefit and equity in
    
    
    
undistributed earnings of subsidiaries
  3,076 
  524 
  3,976 
 
    
    
    
Income tax benefit
  299 
  434 
  178 
 
    
    
    
Income before equity in undistributed
    
    
    
earnings of subsidiaries
  3,375 
  958 
  4,154 
 
    
    
    
Equity in undistributed earnings of subsidiaries
  10,007 
  9,310 
  5,023 
 
    
    
    
Net earnings
 $13,382 
  10,268 
  9,177 
 
 
A-66
 
 
Statements of Cash Flows
For the Years Ended December 31, 20178, 2017 and 2016
(Dollars in thousands)
 
 
 
2018
 
 
2017
 
 
2016
 
Cash flows from operating activities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net earnings
 $13,382 
  10,268 
  9,177 
Adjustments to reconcile net earnings to net
    
    
    
cash provided by operating activities:
    
    
    
Equity in undistributed earnings of subsidiaries
  (10,007)
  (9,310)
  (5,023)
Gain on sale of investment securities
  - 
  - 
  (405)
Change in:
    
    
    
Other assets
  13 
  (272)
  61 
Other liabilities
  6 
  5 
  5 
 
    
    
    
Net cash provided by operating activities
  3,394 
  691 
  3,815 
 
    
    
    
Cash flows from investing activities:
    
    
    
 
    
    
    
Proceeds from calls and maturities of investment securities
    
    
    
available for sale
  - 
  500 
  669 
In kind transfer from parent to Bank
  - 
  - 
  10 
 
    
    
    
Net cash provided by investing activities
  - 
  500 
  679 
 
    
    
    
Cash flows from financing activities:
    
    
    
 
    
    
    
Cash dividends paid on common stock
  (3,133)
  (2,629)
  (2,106)
Cash in lieu stock dividend
  - 
  (6)
  - 
Stock repurchase
  - 
  - 
  (1,984)
Proceeds from exercise of restricted stock units
  - 
  915 
  - 
 
    
    
    
Net cash used by financing activities
  (3,133)
  (1,720)
  (4,090)
 
    
    
    
Net change in cash
  261 
  (529)
  404 
 
    
    
    
Cash at beginning of year
  428 
  957 
  553 
 
    
    
    
Cash at end of year
 $689 
  428 
  957 
 
    
    
    
Noncash investing and financing activities:
    
    
    
Change in unrealized gain on investment securities
    
    
    
 available for sale, net
 $(2,607)
  (1)
  (2,523)
 
 
A-67
 
  
(17) 
Quarterly Data
 
(Dollars in thousands, except per share amounts)
 
 First
 
 
 Second
 
 
 Third
 
 
 Fourth
 
 
 First
 
 
 Second
 
 
 Third
 
 
 Fourth
 
Total interest income
 $10,759 
  11,059 
  11,608 
  11,924 
 $10,064 
  10,461 
  10,698 
  10,726 
Total interest expense
  467 
  513 
  557 
  609 
  598 
  622 
  650 
  507 
Net interest income
  10,292 
  10,546 
  11,051 
  11,315 
  9,466 
  9,839 
  10,048 
  10,219 
 
    
    
    
    
    
    
    
    
(Reduction of) provision for loan losses
  31 
  231 
  110 
  418 
  (236)
  49 
  (218)
  (102)
Other income
  3,736 
  4,016 
  3,915 
  4,499 
  3,442 
  3,929 
  4,159 
  3,834 
Other expense
  10,042 
  10,560 
  10,702 
  11,270 
  10,361 
  9,983 
  10,006 
  10,878 
Income before income taxes
  3,955 
  3,771 
  4,154 
  4,126 
  2,783 
  3,736 
  4,419 
  3,277 
 
    
    
    
    
    
    
    
    
Income taxes (benefit)
  652 
  595 
  687 
  690 
  578 
  925 
  1,177 
  1,267 
Net earnings
  3,303 
  3,176 
  3,467 
  3,436 
  2,205 
  2,811 
  3,242 
  2,010 
 
    
    
    
    
    
    
    
    
 
    
    
    
    
    
    
    
    
Basic net earnings per share
 $0.55 
  0.53 
  0.58 
  0.57 
 $0.36 
  0.47 
  0.54 
  0.34 
Diluted net earnings per share
 $0.55 
  0.53 
  0.57 
  0.57 
 $0.36 
  0.46 
  0.53 
  0.34 
 
 
 
A-68
 
 
 
DIRECTORS AND OFFICERS OF THE COMPANY
 
DIRECTORS
 
Robert C. Abernethy – Chairman
Chairman of the Board, Peoples Bancorp of North Carolina, Inc. and Peoples Bank;
President, Secretary and Treasurer, Carolina Glove Company, Inc. (glove manufacturer)
Secretary and Assistant Treasurer, Midstate Contractors, Inc. (paving company)
 
James S. Abernethy
Vice President, Carolina Glove Company, Inc. (glove manufacturer)
President and Assistant Secretary, Midstate Contractors, Inc. (paving company)
Vice President, Secretary and Chairman of the Board of Directors, Alexander Railroad Company
 
Douglas S. Howard
Vice President and Treasurer, Denver Equipment Company of Charlotte, Inc.
 
John W. Lineberger, Jr.
President, Lincoln Bonded Warehouse Company (commercial warehousing facility)
 
Gary E. Matthews
President and Director, Matthews Construction Company, Inc. (general contractor)
 
Billy L. Price, Jr. MD
Practitioner of Internal Medicine, BL Price Jr. Medical Consultants, PLLC
 
Larry E. Robinson
Shareholder, Director, Chairman of the Board and Chief Executive Officer, The Blue Ridge Distributing Co., Inc. (beer and wine distributor)
Director and member of the Board of Directors, United Beverages of North Carolina, LLC (beer distributor)
 
William Gregory (Greg) Terry
President, DFH Holdings
Operator/General Manager, Drum & Willis-Reynolds Funeral Homes and Crematory
 
Dan Ray Timmerman, Sr.
Chairman of the Board and Chief Executive Officer, Timmerman Manufacturing, Inc. (wrought iron furniture, railings and gates manufacturer)
 
Benjamin I. Zachary
President, Treasurer, General Manager and Director, Alexander Railroad Company
 
OFFICERS
 
Lance A. Sellers
President and Chief Executive Officer
 
A. Joseph Lampron, Jr.
Executive Vice President, Chief Financial Officer, Corporate Treasurer and Assistant Corporate Secretary
 
William D. Cable, Sr.
Executive Vice President, Corporate Secretary and Assistant Corporate Treasurer
 
  A-69