Note 7. Fair Value Measurement

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

Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 - Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 - Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

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

Securities available for sale:

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).

The following table presents the balances of financial

assets and liabilities measured at fair value on a recurring basis as of June 30, 2016 and December 31, 2015:

(Dollars In Thousands)

Carrying value at June 30, 2016

Description

Balance as of June 30,

2016

Quoted Prices

in Active Markets for

Identical Assets

(Level 1)

Significant Other Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Assets:

U.S. Government agency securities

13,858

–

13,858

–

Mortgage-backed securities and CMO’s

21,578

–

21,578

–

Corporate securities

2,500

–

2,500

–

Municipal securities

16,562

–

16,562

–

(Dollars In Thousands)

Carrying value at December 31, 2015

Description

Balance as of December 31,

2015

Quoted Prices

in Active Markets for

Identical Assets

(Level 1)

Significant Other Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Assets:

U.S. Government agency securities

17,019

–

17,019

–

Mortgage-backed securities and CMO’s

18,190

–

18,190

–

Municipal securities

17,335

–

17,335

–

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

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

Impaired Loans:

The Company does not record loans at fair value on a recurring basis. However, from time to time a loan is considered impaired and a specific reserve is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures the extent of any loss. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value, and discounted cash flow. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investment in such loans. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. If carried at market price based on appraised value using observable market data, it is recorded as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraisal value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.

Loans held for sale:

The carrying value of these loans approximates the fair value. These loans close in the name of the Bank’s consolidated joint venture subsidiary HomeTown Residential Mortgage, LLC, but are generally sold within a two-week period.

Other Real Estate Owned (OREO)

: The carrying amount of real estate owned by the Company resulting from foreclosures is estimated at the lesser of cost or the fair value of the real estate based on an observable market price or a current appraised value less selling costs. If carried at market price based on appraised value using observable market data, it is recorded as nonrecurring Level 2. When an appraised value is not available or is not current, or management determines the fair value of the real estate is further impaired below the appraised value or there is no observable market price, the Company records the real estate as nonrecurring Level 3.

The following table summarizes the Company’s assets that were measured at fair value on a nonrecurring basis as of June 30, 2016 and December 31, 2015.

(Dollars In Thousands)			Carrying value at June 30, 2016
Description	Balance as of June 30, 2016		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans, net of valuation allowance	$	105	$	–	$	–	$	105
Loans held for sale		915		–		915		–
Other real estate owned		4,337		–		448		3,889

(Dollars In Thousands)			Carrying value at December 31, 2015
Description	Balance as of December 31, 2015		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired loans, net of valuation allowance	$	110	$	–	$	–	$	110
Loans held for sale		1,643		–		1,643		–
Other real estate owned		5,237		–		1,300		3,937

At June 30, 2016 and December 31, 2015, the Company did not have any liabilities measured at fair value on a nonrecurring basis.

The following table displays quantitative information about Level 3 Fair Value Measurements for June 30, 2016:

(Dollars In Thousands)	Quantitative information about Level 3 Fair Value Measurements for June 30, 2016
Assets	Fair Value		Valuation Technique(s)	Unobservable input	Range (Weighted Average)
Impaired loans	$	105	Discounted cash flows	Residual cash flows discount rate	6%	-	6%	(6%)

Other real estate owned	$	1,735	Discounted appraised value	Selling cost	6%	-	6%	(6%)
				Discount for lack of marketability and age of appraisal	4%	-	9%	(8%)

	$	2,154	Internal evaluations	Internal evaluations	4%	-	35%	(22%)

The following table displays quantitative information about Level 3 Fair Value Measurements for December 31, 2015:

(Dollars In Thousands)	Quantitative information about Level 3 Fair Value Measurements for December 31, 2015
Assets	Fair Value		Valuation Technique(s)	Unobservable input	Range (Weighted Average)
Impaired loans	$	110	Discounted cash flows	Residual cash flows discount rate	6%	-	6%	(6%)

Other real estate owned	$	1,735	Discounted appraised value	Selling cost	6%	-	6%	(6%)
				Discount for lack of marketability and age of appraisal	4%	-	9%	(8%)

	$	2,202	Internal evaluations	Internal evaluations	4%	-	39%	(21%)

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and due from banks: The carrying amounts reported in the consolidated balance sheet for cash on hand and amounts due from correspondent banks approximate their fair values. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of deposit to a schedule of contractual maturities on such time deposits.

Federal funds sold: Federal funds sold consist of overnight loans to other financial institutions and mature within one to three days. At June 30, 2016 and December 31, 2015, management believes the carrying value of federal funds sold approximates estimated market value.

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).

Restricted equity securities: For these restricted equity securities, the carrying amount is a reasonable estimate of fair value based on the redemption provisions of the related securities.

Loans held for sale: The carrying value of these loans approximates the fair value. These loans close in the name of the Bank’s joint venture subsidiary HomeTown Residential Mortgage, LLC, but are generally sold within a two-week period.

Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts. Their fair values are measured utilizing independent valuation techniques of similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.

Bank owned life insurance: The cash values of these policies are estimates using information provided by insurance carriers. The policies are carried at their cash surrender value, which approximates fair value.

Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit and individual retirement accounts are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of contractual maturities on such time deposits.

FHLB borrowings: The fair values for FHLB borrowings are estimated using a discounted cash flow calculation that applies interest rates currently being offered on FHLB borrowings to the contractual maturities on such FHLB borrowings.

Subordinated notes: The fair values is measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).

Other borrowings: The warehouse line of credit is a short term revolving credit facility used to fund mortgage loans originations until the underlying loan is sold.

The warehouse line of credit, federal funds purchased, borrowings under repurchase agreements mature within 30 days and approximate their fair values.

Accrued interest: The carrying amount of accrued interest receivable and payable approximates fair value.

Off-balance sheet financial instruments: The fair values of commitments to extend credit and standby letters of credit are estimated using the fees currently charged to enter into similar agreements. At June 30, 2016 and December 31, 2015, the fair value of loan commitments and standby letters of credit were deemed to be immaterial.

The carrying amounts and approximate fair values of the Company's financial instruments are as follows at June 30, 2016:

(Dollars In Thousands)			Fair value at June 30, 2016
Description	Carrying value as of June 30, 2016		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Approximate Fair Values
Financial assets
Cash and due from banks	$	28,101	$	26,351	$	1,757	$	–	$	28,108
Federal funds sold		954		954		–		–		954
Securities available-for-sale		54,498		–		54,498		–		54,498
Restricted equity securities		2,479		–		2,479		–		2,479
Loans held for sale		915		–		915		–		915
Loans, net		390,219		–		–		393,924		393,924
Bank owned life insurance		6,371		–		6,371		–		6,371
Accrued income		2,071		–		2,071		–		2,071
Financial liabilities
Total deposits		433,275		–		433,602		–		433,602
FHLB borrowings		14,650		–		14,789		–		14,789
Subordinated notes		7,209		–		7,651		–		7,651
Other borrowings		896		–		896		–		896
Accrued interest payable		411		–		411		–		411

The carrying amounts and approximate fair values of the Company's financial instruments are as follows at December 31, 2015:

(Dollars In Thousands)			Fair value at December 31, 2015
Description	Carrying value as of December 31, 2015		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Approximate Fair Values
Financial assets
Cash and due from banks	$	28,745	$	26,995	$	1,767	$	–	$	28,762
Federal funds sold		1,329		1,329		–		–		1,329
Securities available for sale		52,544		–		52,544		–		52,544
Restricted equity securities		2,535		–		2,535		–		2,535
Loans held for sale		1,643		–		1,643		–		1,643
Loans, net		364,060		–		–		362,440		362,440
Bank owned life insurance		6,285		–		6,285		–		6,285
Accrued income		2,057		–		2,057		–		2,057
Financial liabilities
Total deposits		399,546		–		400,117		–		400,117
FHLB borrowings		22,000		–		22,191		–		22,191
Subordinated notes		7,194		–		7,354		–		7,354
Other borrowings		2,361		–		2,361		–		2,361
Accrued interest payable		372		–		372		–		372