Note 7. Fair Value Measurements

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the "Fair Value Measurements and Disclosures" topic of FASB ASC 825, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured 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.

	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 tables present the balances measured at fair value on a recurring basis as of March 31, 2014 and December 31, 2013:

			Fair Value Measurements at March 31, 2014 Using:
(dollars in thousands)
			Quoted Prices in				Significant
	Balance as of		Active Markets for		Significant Other		Unobservable
	March 31,		Identical Assets		Observable Inputs		Inputs
Description	2014		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Government agencies	$	37,864	$	-	$	37,864	$	-
Corporate bonds		9,068		-		9,068		-
Asset-backed securities		2,110		-		2,110		-
Mortgage-backed securities/CMOs		64,606		-		64,606		-
Municipal bonds		23,529		-		23,529		-
Total securities available for sale	$	137,177	$	-	$	137,177	$	-

			Fair Value Measurements at December 31, 2013 Using:
(dollars in thousands)
			Quoted Prices in				Significant
	Balance as of		Active Markets for		Significant Other		Unobservable
	December 31,		Identical Assets		Observable Inputs		Inputs
Description	2013		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Government agencies	$	44,005	$	-	$	44,005	$	-
Corporate bonds		9,053		-		9,053		-
Asset-backed securities		2,100		-		2,100		-
Mortgage-backed securities/CMOs		55,597		-		55,597		-
Municipal bonds		22,272		-		22,272		-
Total securities available for sale	$	133,027	$	-	$	133,027	$	-

Certain assets are measured at fair value on a nonrecurring basis in accordance with 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

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3.

The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business' financial statements if not considered significant. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3).

Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. The Company had $1,839,000 and $1,736,000 in impaired loans as of March 31, 2014 and December 31, 2013, respectively. None of these impaired loans required a valuation allowance after consideration was given for each borrowing as to the fair value of the collateral on the loan or the present value of expected future cash flows from the customer.

Other Real Estate Owned

Other real estate owned ("OREO") is measured at fair value less cost to sell, based on an appraisal conducted by an independent, licensed appraiser outside of the Company. If the collateral value is significantly adjusted due to differences in the comparable properties, or is discounted by the Company because of marketability, then the fair value is considered Level 3. OREO is measured at fair value on a nonrecurring basis. Any initial fair value adjustment is charged against the Allowance for Loan Losses. Subsequent fair value adjustments are recorded in the period incurred and included in other noninterest expense on the Consolidated Statements of Income.

The following table presents the Company's assets that were measured at fair value on a nonrecurring basis as of March 31, 2014 and December 31, 2013:

Fair Value Measurements at March 31, 2014 Using:

(dollars in thousands)

Quoted Prices in

Significant Other

Significant

Balance as of

Active Markets for

Observable

Unobservable

March 31,

Identical Assets

Inputs

Description

2014

(Level 1)

(Level 2)

(Level 3)

Assets:

Other Real Estate Owned

2,267

Fair Value Measurements at December 31, 2013 Using:

(dollars in thousands)

Quoted Prices in

Significant Other

Significant

Balance as of

Active Markets for

Observable

Unobservable

December 31,

Identical Assets

Inputs

Description

2013

(Level 1)

(Level 2)

(Level 3)

Assets:

Other Real Estate Owned

2,372

For the assets measured at fair value on a nonrecurring basis as of March 31, 2014, the following table displays quantitative information about Level 3 Fair Value Measurements:

(dollars in thousands)
					Weighted
Description	Fair Value		Valuation Technique	Unobservable Inputs	Average
Assets:
Other Real Estate Owned	$	2,267	Market comparables	Discount applied to market comparables *	6	%

A discount percentage is applied based on age of independent appraisals, current market conditions, and experience within the local market.

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

Cash and Short-Term Investments

For those short-term instruments, including cash, due from banks and federal funds sold, the carrying amount is a reasonable estimate of fair value.

Interest bearing deposits

The carrying amounts of interest bearing deposits maturing within ninety days approximate their fair value.

Securities

Fair values for securities, excluding restricted securities, are based on third party vendor pricing models. The carrying value of restricted FRB and FHLB stock is based on the redemption provisions of each entity and is therefore excluded from the following table.

Loan Receivables

The fair value of performing loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar remaining maturities. This calculation ignores loan fees and certain factors affecting the interest rates charged on various loans such as the borrower's creditworthiness and compensating balances and dissimilar types of real estate held as collateral. The fair value of impaired loans is measured as described within the Impaired Loans section of this note.

Bank Owned Life Insurance

The carrying amounts of Bank Owned Life Insurance approximate fair value.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Deposit Liabilities

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Short-Term Borrowings

The carrying amounts of securities sold under agreements to repurchase approximate fair value.

Off-Balance Sheet Financial Instruments

The fair values of loan commitments and standby letters of credit are immaterial. Therefore, they have not been included in the following tables.

The carrying values and estimated fair values of the Company's financial instruments as of March 31, 2014 and December 31, 2013 are as follows:

			Fair Value Measurement at March 31, 2014 using:
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
(dollars in thousands)			Identical Assets		Inputs		Inputs
	Carrying value		Level 1		Level 2		Level 3		Fair Value
Assets
Cash and cash equivalent	$	76,847	$	76,847	$	-	$	-	$	76,847
Securities		137,177		-		137,177		-		137,177
Loans, net		288,685		-		-		289,803		289,803
Bank owned life insurance		12,702		-		12,702		-		12,702
Accrued interest receivable		1,151		-		503		648		1,151

Liabilities
Demand deposits and	$	334,965	$	-	$	334,965	$	-	$	334,965
interest-bearing transaction
and money market accounts
Certificates of deposit		125,156		-		125,382		-		125,382
Securities sold under		13,448		-		13,448		-		13,448
agreements to repurchase
Accrued interest payable		108		-		108		-		108

			Fair Value Measurement at December 31, 2013 using:
			Quoted Prices		Significant
			in Active		Other		Significant
			Markets for		Observable		Unobservable
(dollars in thousands)			Identical Assets		Inputs		Inputs
	Carrying value		Level 1		Level 2		Level 3		Fair Value
Assets
Cash and cash equivalent	$	40,072	$	40,072	$	-	$	-	$	40,072
Securities		133,027		-		133,027		-		133,027
Loans, net		296,674		-		-		297,765		297,765
Bank owned life insurance		12,595		-		12,595		-		12,595
Accrued interest receivable		1,247		-		566		681		1,247

Liabilities
Demand deposits and	$	306,298	$	-	$	306,298	$	-	$	306,298
interest-bearing transaction
and money market accounts
Certificates of deposit		124,162		-		124,391		-		124,391
Securities sold under		16,297		-		16,297		-		16,297
agreements to repurchase
Accrued interest payable		125		-		125		-		125

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