10-Q 1 vnb30097849-10q.htm QUARTERLY REPORT

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

___________

FORM 10-Q
___________

(Mark One)
[X]       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
 
[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________________ to __________________

Commission File Number: 000-55117

VIRGINIA NATIONAL BANKSHARES CORPORATION
(Exact name of registrant as specified in its charter)

Virginia 46-2331578
   
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
 
404 People Place, Charlottesville, Virginia 22911
(Address of principal executive offices) (Zip Code)

(434) 817-8621
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

☒  Yes              ☐ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

☒  Yes              ☐ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer Accelerated filer
       
Non-accelerated filer Smaller reporting company
       
Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.                ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).           ☐ Yes            ☒ No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of November 5, 2018:

Class of Stock Shares Outstanding
Common Stock, Par Value $2.50 2,543,452


VIRGINIA NATIONAL BANKSHARES CORPORATION

FORM 10-Q

TABLE OF CONTENTS

Part I. Financial Information      
Item 1       Financial Statements
Consolidated Balance Sheets (unaudited) Page 3
Consolidated Statements of Income (unaudited) Page 4
Consolidated Statements of Comprehensive Income (unaudited) Page 5
Consolidated Statements of Changes in Shareholders’ Equity (unaudited) Page 6
Consolidated Statements of Cash Flows (unaudited) Page 7
Notes to Consolidated Financial Statements (unaudited) Page 8
 
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations Page 30
Application of Critical Accounting Policies and Estimates Page 30
Financial Condition Page 31
Results of Operations Page 36
 
Item 3 Quantitative and Qualitative Disclosures About Market Risk Page 44
 
Item 4 Controls and Procedures Page 44
 
Part II. Other Information
Item 1 Legal Proceedings Page 44
Item 1A Risk Factors Page 44
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds Page 44
Item 3 Defaults Upon Senior Securities Page 44
Item 4 Mine Safety Disclosures Page 44
Item 5 Other Information Page 44
Item 6 Exhibits Page 45
 
Signatures Page 46

2


PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

VIRGINIA NATIONAL BANKSHARES CORPORATION
CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

      September 30, 2018       December 31, 2017 *
ASSETS (Unaudited)
Cash and due from banks $                   7,669 $                   11,390
Federal funds sold 1,093 6,887
Securities:
Available for sale, at fair value 62,100 67,501
Restricted securities, at cost 2,108 2,284
Total securities 64,208 69,785
Loans 527,327 528,784
Allowance for loan losses (4,678 ) (4,043 )
Loans, net 522,649 524,741
Premises and equipment, net 7,195 7,371
Bank owned life insurance 16,677 16,344
Goodwill 372 372
Other intangible assets, net 503 579
Accrued interest receivable and other assets 6,430 6,417
Total assets $ 626,796 $ 643,886
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Demand deposits:
Noninterest-bearing $ 170,623 $ 193,081
Interest-bearing 87,418 102,583
Money market and savings deposit accounts 153,271 138,065
Certificates of deposit and other time deposits 127,190 109,233
Total deposits 538,502 542,962
Repurchase agreements and other borrowings 17,193 34,092
Accrued interest payable and other liabilities 1,977 1,727
Total liabilities 557,672 578,781
 
Shareholders' equity:
Preferred stock, $2.50 par value, 2,000,000 shares authorized, no shares outstanding - -
Common stock, $2.50 par value, 10,000,000 shares authorized; 2,543,452 and 2,410,680 issued and outstanding at September 30, 2018 and December 31, 2017, respectively 6,359 6,027
Capital surplus 26,989 22,038
Retained earnings 37,729 37,923
Accumulated other comprehensive loss (1,953 ) (883 )
Total shareholders' equity 69,124 65,105
Total liabilities and shareholders' equity $ 626,796 $ 643,886

* Derived from audited Consolidated Financial Statements

See Notes to Consolidated Financial Statements

3


VIRGINIA NATIONAL BANKSHARES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share data)
(Unaudited)

For the three months ended For the nine months ended
   September 30, 2018    September 30, 2017    September 30, 2018    September 30, 2017
Interest and dividend income:
Loans, including fees $      6,200 $               5,348 $               17,849 $               15,454
Federal funds sold 46 30 120 208
Investment securities:
Taxable 265 328 814 838
Tax exempt 86 78 257 203
Dividends 42 23 103 69
Other - 1 - 7
Total interest and dividend income 6,639 5,808 19,143 16,779
 
Interest expense:
Demand and savings deposits 277 108 773 341
Certificates and other time deposits 413 179 815 516
Repurchase agreements and other borrowings 158 38 376 58
Total interest expense 848 325 1,964 915
Net interest income 5,791 5,483 17,179 15,864
Provision for loan losses 285 168 890 213
Net interest income after provision for loan losses 5,506 5,315 16,289 15,651
 
Noninterest income:
Trust income 409 394 1,250 1,171
Advisory and brokerage income 144 132 426 387
Royalty income 17 22 569 198
Customer service fees 210 225 693 678
Debit/credit card and ATM fees 176 206 567 650
Earnings/increase in value of bank owned life insurance 113 103 333 312
Fees on mortgage sales 73 55 155 104
Losses on sales of securities - (78 ) - (74 )
Losses on sales of other assets - - (33 ) -
Other 128 99 331 308
Total noninterest income 1,270 1,158 4,291 3,734
 
Noninterest expense:
Salaries and employee benefits 2,049 1,998 6,022 5,770
Net occupancy 458 461 1,387 1,390
Equipment 128 124 374 398
Other 1,454 1,334 4,350 3,897
Total noninterest expense 4,089 3,917 12,133 11,455
 
Income before income taxes 2,687 2,556 8,447 7,930
Provision for income taxes 527 811 1,659 2,530
Net income $ 2,160 $ 1,745 $ 6,788 $ 5,400
Net income per common share, basic * $ 0.85 $ 0.69 $ 2.67 $ 2.15
Net income per common share, diluted * $ 0.84 $ 0.68 $ 2.65 $ 2.13
Weighted average common shares outstanding, basic * 2,542,094 2,521,137 2,538,712 2,507,358
Weighted average common shares outstanding, diluted * 2,561,638 2,543,150 2,559,144 2,529,889

* Shares and per share data have been adjusted to reflect a 5% stock dividend effective April 13, 2018.

See Notes to Consolidated Financial Statements

4


VIRGINIA NATIONAL BANKSHARES CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands)
(Unaudited)

For the three months ended For the nine months ended
      September 30, 2018       September 30, 2017       September 30, 2018       September 30, 2017
Net income $                    2,160 $                    1,745 $                    6,788 $                    5,400
 
Other comprehensive income (loss)
 
Unrealized gain (loss) on securities, net of tax of ($59) and ($285) for the three and nine months ended September 30, 2018; and net of tax of ($105) and $224 for the three and nine months ended September 30, 2017 (222 ) (206 ) (1,070 ) 434
 
Reclassification adjustment for realized losses on sales of securities, net of tax of $0 and $0 for the three and nine months ended September 30, 2018; and net of tax of $27 and $25 for the three and nine months ended September 30, 2017 - 51 - 49
 
Total other comprehensive income (loss) (222 ) (155 ) (1,070 ) 483
 
Total comprehensive income $ 1,938 $ 1,590 $ 5,718 $ 5,883

See Notes to Consolidated Financial Statements

5


VIRGINIA NATIONAL BANKSHARES CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2018 AND 2017
(Dollars in thousands, except per share data)
(Unaudited)

Accumulated
Other
Common Capital Retained Comprehensive
      Stock *       Surplus *       Earnings       Income (Loss)       Total
Balance, December 31, 2016 $      5,922 $      21,152 $       32,759 $              (779 ) $      59,054
Stock options exercised 105 876 - - 981
Stock option expense - 8 - - 8
Cash dividend declared ($0.45 per share) - - (1,077 ) - (1,077 )
Net income - - 5,400 - 5,400
Other comprehensive income - - - 483 483
Balance, September 30, 2017 $ 6,027 $ 22,036 $ 37,082 $ (296 ) $ 64,849
 
Balance, December 31, 2017 $ 6,027 $ 22,038 $ 37,923 $ (883 ) 65,105
Stock options exercised 31 237 - - 268
Stock option expense - 41 - - 41
Stock dividend distributed * 301 4,673 (4,974 ) - -
Cash dividends declared ($0.79 per share) - - (2,008 ) - (2,008 )
Net income - - 6,788 - 6,788
Other comprehensive loss - - - (1,070 ) (1,070 )
Balance, September 30, 2018 $ 6,359 $ 26,989 $ 37,729 $ (1,953 ) $ 69,124
 
*      Common stock and capital surplus as of September 30, 2018 includes the 5% stock dividend distributed effective April 13, 2018.

See Notes to Consolidated Financial Statements

6


VIRGINIA NATIONAL BANKSHARES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(Unaudited)

For the nine months ended
      September 30, 2018       September 30, 2017
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $                  6,788     $                  5,400
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses 890 213
Net amortization and accretion of securities 209 327
Net losses on sales and calls of securities - 74
Net losses on sales of assets 33 -
Earnings on bank owned life insurance (333 ) (312 )
Amortization of intangible assets 83 87
Depreciation and other amortization 849 858
Stock option expense 41 8
Net change in:
Accrued interest receivable and other assets 297 18
Accrued interest payable and other liabilities 38 (205 )
Net cash provided by operating activities 8,895 6,468
 
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of available for sale securities - (45,290 )
Net decrease (increase) in restricted investments 176 (1,000 )
Proceeds from maturities, calls and principal payments of available for sale securities 3,837 7,212
Proceeds from sales of available for sale securities - 24,022
Net increase in organic loans (604 ) (9,109 )
Net decrease (increase) in purchased loans 1,806 (9,857 )
Cash payment for wealth management book of business (100 ) (300 )
Purchase of bank premises and equipment (731 ) (249 )
Net cash provided by (used in) investing activities 4,384 (34,571 )
 
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in demand deposits, NOW accounts, and money market accounts (22,417 ) (16,404 )
Net increase (decrease) in certificates of deposit and other time deposits 17,957 (977 )
Net decrease in repurchase agreements (11,899 ) (7,699 )
Net (decrease) increase in other short term borrowings (5,000 ) 25,000
Proceeds from stock options exercised 268 981
Cash dividends paid (1,703 ) (1,000 )
Net cash used in financing activities (22,794 ) (99 )
NET DECREASE IN CASH AND CASH EQUIVALENTS $ (9,515 )   $ (28,202 )
 
CASH AND CASH EQUIVALENTS:
Beginning of period $ 18,277 $ 38,500
End of period $ 8,762 $ 10,298
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash payments for:
Interest $ 1,800     $ 899
Taxes $ 1,990     $ 2,900
   
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES  
Unrealized (loss) gain on available for sale securities $ (1,355 )   $ 732

See Notes to Consolidated Financial Statements

7


VIRGINIA NATIONAL BANKSHARES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

September 30, 2018

Note 1. Significant Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of Virginia National Bankshares Corporation (the “Company”), and its subsidiary Virginia National Bank (the “Bank”). Effective July 1, 2018, VNBTrust, National Association (“VNBTrust”), formerly a subsidiary of the Bank, was merged into Virginia National Bank, and the Bank continues to offer investment management, wealth advisory and trust and estate administration services under the name of VNB Wealth Management, also referred to herein as “VNB Wealth.” All references herein to VNB Wealth Management or VNB Wealth refer to VNBTrust for periods prior to July 1, 2018. All significant intercompany balances and transactions have been eliminated in consolidation.

The unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information. Accordingly, the unaudited consolidated financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included.

The preparation of financial statements in conformity with GAAP and the reporting guidelines prescribed by regulatory authorities requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses (including impaired loans), other-than-temporary impairment of securities, intangible assets, and fair value measurements. Operating results for the three-month and nine-month periods ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018.

The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2017. If needed, certain previously reported amounts have been reclassified to conform to current period presentation. No such reclassifications were significant.

Recent Accounting Pronouncements

Leases In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The FASB made subsequent amendments to Topic 842 in July 2018 through ASU 2018-10 (“Codification Improvements to Topic 842, Leases.”) and ASU 2018-11 (“Leases (Topic 842): Targeted Improvements.”) Among these amendments is the provision in ASU 2018-11 that provides entities with an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new leases standard will continue to be in accordance with current GAAP (Topic 840, Leases). The Company is currently assessing the impact that ASU 2016-02 (as amended) will have on its consolidated financial statements and has gathered the data necessary to analyze the impact of the adoption of this standard on the balance sheet and income statement, including evaluating leases and contracts which are covered and calculating the impact on its assets and liabilities. The Company does not expect the amendment to have a material impact on its net income but does anticipate an increase in assets and liabilities due to the recognition of the required right-of-use asset and corresponding liability for all lease obligations that are currently classified as operating leases, primarily real estate leases for office space, as well as additional disclosure on all our lease obligations.

8


Financial Instruments – Credit Losses In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements. Early in 2017, the Company formed a cross-functional steering committee, including some members of senior management, to provide governance and guidance over the project plan. The steering committee meets regularly to address the compliance requirements, data requirements and sources, and analysis efforts that are required to adopt these new requirements. In addition to attending seminars and webinars on this topic with regulators and other experts, the committee is working closely with the Company’s vendor to gather additional loan data which is anticipated to be needed for this calculation and is exploring potential solutions with other vendors. The extent of the change is indeterminable at this time as it will be dependent upon portfolio composition and credit quality at the adoption date, as well as economic conditions and forecasts at that time. Upon adoption, the impact to the allowance for credit losses (currently allowance for loan losses) will have an offsetting one-time cumulative-effect adjustment to retained earnings.

Goodwill Impairment Testing In January 2017, the FASB issued ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Public business entities that are SEC filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.

Premium Amortization on Purchased Callable Debt Securities In March 2017, the FASB issued ASU 2017-08, “Receivables – Nonrefundable Fees and Other Costs (Subtopic 310-20), Premium Amortization on Purchased Callable Debt Securities.” The amendments in this ASU shorten the amortization period for certain callable debt securities purchased at a premium. Upon adoption of the standard, premiums on these qualifying callable debt securities will be amortized to the earliest call date. Discounts on purchased debt securities will continue to be accreted to maturity. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. Upon transition, entities should apply the guidance on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and provide the disclosures required for a change in accounting principle. The Company does not expect the adoption of ASU 2017-08 to have a material impact on its consolidated financial statements.

Derivatives and Hedging - Targeted Improvements to Accounting for Hedging Activities In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The amendments in this ASU modify the designation and measurement guidance for hedge accounting as well as provide for increased transparency regarding the presentation of economic results on both the financial statements and related footnotes. Certain aspects of hedge effectiveness assessments will also be simplified upon implementation of this update. The amendments are effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted, including adoption in any interim period. The Company does not expect the adoption of ASU 2017-12 to have a material impact on its consolidated financial statements.

Stock Compensation - Improvements to Nonemployee Share-Based Payment Accounting In June 2018, the FASB issued ASU 2018-07, “Compensation – Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting.” The amendments expand the scope of Topic 718 to include share-based payments issued to non-employees for goods or services, which were previously excluded. The amendments will align the accounting for share-based payments to nonemployees and employees more similarly. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-07 to have a material impact on its consolidated financial statements.

Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement.” The amendments modify the disclosure requirements in Topic 820 to add disclosures regarding changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty. Certain disclosure requirements in Topic 820 are also removed or modified. The amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Certain of the amendments are to be applied prospectively while others are to be applied retrospectively. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-13 to have a material impact on its consolidated financial statements.

9


Note 2. Securities

The amortized cost and fair values of securities available for sale as of September 30, 2018 and December 31, 2017 were as follows (dollars in thousands):

September 30, 2018 Amortized Gross Unrealized Gross Unrealized Fair
      Cost       Gains       (Losses)       Value
U.S. Government agencies $      19,500 $      - $                (782 ) $      18,718
Mortgage-backed securities/CMOs 27,007 2 (1,132 ) 25,877
Municipal bonds 18,066 7 (568 ) 17,505
Total Securities Available for Sale $ 64,573 $ 9 $ (2,482 ) $ 62,100
 
December 31, 2017 Amortized Gross Unrealized Gross Unrealized Fair
Cost Gains (Losses) Value
U.S. Government agencies $ 19,500 $ - $ (538 ) $ 18,962
Mortgage-backed securities/CMOs 30,450 - (505 ) 29,945
Municipal bonds 18,668 68 (143 ) 18,593
Total Debt Securities 68,618 68 (1,186 ) 67,500
Marketable equity securities 1 - - 1
Total Securities Available for Sale $ 68,619 $ 68 $ (1,186 ) $ 67,501

As of September 30, 2018, there were $60.2 million, or 59 issues of individual securities, in a loss position. These securities have an unrealized loss of $2.5 million and consisted of 28 municipal bonds, 24 mortgage-backed/CMOs, and 7 agency bonds. The following table summarizes all securities with unrealized losses, segregated by length of time in a continuous unrealized loss position, at September 30, 2018 and December 31, 2017 (dollars in thousands):

September 30, 2018
Less than 12 Months 12 Months or more Total
Unrealized Unrealized       Unrealized
Fair Value Losses       Fair Value       Losses       Fair Value Losses
U.S. Government agencies $      - $          - $      18,718 $       (782 ) $      18,718 $       (782 )
Mortgage-backed/CMOs 4,910 (196 ) 20,542 (936 ) 25,452 (1,132 )
Municipal bonds 9,725 (309 ) 6,284 (259 ) 16,009 (568 )
$ 14,635 $ (505 ) $ 45,544 $ (1,977 ) $ 60,179 $ (2,482 )
 
December 31, 2017
Less than 12 Months 12 Months or more Total
Unrealized Unrealized Unrealized
      Fair Value       Losses Fair Value Losses Fair Value Losses
U.S. Government agencies $ 7,390 $ (110 ) $ 11,572 $ (428 ) $ 18,962 $ (538 )
Mortgage-backed/CMOs 21,422 (260 ) 8,523 (245 ) 29,945 (505 )
Municipal bonds 10,389 (132 ) 504 (11 ) 10,893 (143 )
$ 39,201 $ (502 ) $ 20,599 $ (684 ) $ 59,800 $ (1,186 )

The Company’s securities portfolio is primarily made up of fixed rate bonds, the prices of which move inversely with interest rates. Any unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date or repricing date or if market yields for such investments decline. At the end of any accounting period, the portfolio may have both unrealized gains and losses. Management does not believe any of the securities in an unrealized loss position are impaired due to credit quality. Accordingly, as of September 30, 2018, management believes the impairments detailed in the table above are temporary, and no impairment loss has been realized in the Company’s consolidated income statement.

10


An “other-than-temporary impairment” (“OTTI”) is considered to exist if either of the following conditions are met: it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis, or the Company does not expect to recover the security’s entire amortized cost basis (even if the Company does not intend to sell). In the event that a security would suffer impairment for a reason that was “other than temporary,” the Company would be expected to write down the security’s value to its new fair value, and the amount of the write down would be included in earnings as a realized loss. As of September 30, 2018, management has concluded that none of its investment securities have an OTTI based upon the information available. Additionally, management has the ability to hold any security with an unrealized loss until maturity or until such time as the value of the security has recovered from its unrealized loss position.

Securities having carrying values of $20.0 million at September 30, 2018 were pledged as collateral to secure public deposits and repurchase agreements. At December 31, 2017, securities having carrying values of $29.0 million were similarly pledged.

For the nine months ended September 30, 2018, there were no sales of securities. For the nine months ended September 30, 2017, proceeds from the sales of securities amounted to $24.0 million, and gross realized losses on these securities were $74 thousand.

Restricted securities are securities with limited marketability and consist of stock in the Federal Reserve Bank of Richmond (“FRB”), the Federal Home Loan Bank of Atlanta (“FHLB”), and CBB Financial Corporation (“CBBFC”), the holding company for Community Bankers Bank. These restricted securities, totaling $2.1 million and $2.3 million as of September 30, 2018 and December 31, 2017, respectively, are carried at cost.

11


Note 3. Loans

The composition of the loan portfolio by loan classification at September 30, 2018 and December 31, 2017 appears below (dollars in thousands).

September 30, December 31,
      2018       2017
Commercial
Commercial and industrial - organic $           48,315 $         45,254
Commercial and industrial - government guaranteed 28,766 22,946
Commercial and industrial - syndicated 12,498 13,165
Total commercial and industrial 89,579 81,365
Real estate construction and land
Residential construction 1,406 3,812
Commercial construction 6,422 13,365
Land and land development 10,953 9,681
Total construction and land 18,781 26,858
Real estate mortgages
1-4 family residential, first lien, investment 40,450 40,313
1-4 family residential, first lien, owner occupied 18,398 16,448
1-4 family residential, junior lien 3,315 2,965
Home equity lines of credit, first lien 8,084 9,238
Home equity lines of credit, junior lien 11,598 13,226
Farm 12,582 10,445
Multifamily 28,343 33,356
Commercial owner occupied 87,920 80,261
Commercial non-owner occupied 121,523 116,599
Total real estate mortgage 332,213 322,851
Consumer
Consumer revolving credit 22,813 24,030
Consumer all other credit 6,571 9,036
Student loans purchased 57,370 64,644
Total consumer 86,754 97,710
Total loans 527,327 528,784
Less: Allowance for loan losses (4,678 ) (4,043 )
Net loans $ 522,649 $ 524,741

The balances in the table above include unamortized premiums and net deferred loan costs and fees. As of September 30, 2018, and December 31, 2017, unamortized premiums on loans purchased were $2.3 million and $2.0 million, respectively. Net deferred loan costs (fees) totaled $107 thousand and $199 thousand as of September 30, 2018 and December 31, 2017, respectively.

Accounting guidance requires certain disclosures about investments in impaired loans, the allowance for loan losses and interest income recognized on impaired loans. A loan is considered impaired when it is probable that the Company will be unable to collect all principal and interest amounts when due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and current economic conditions.

12


Following is a breakdown by class of the loans classified as impaired loans as of September 30, 2018 and December 31, 2017. These loans are reported at their recorded investment, which is the carrying amount of the loan as reflected on the Company’s balance sheet, net of charge-offs and other amounts applied to reduce the net book balance. Average recorded investment in impaired loans is computed using an average of month-end balances for these loans for either the nine months ended September 30, 2018 or the twelve months ended December 31, 2017. Interest income recognized is for the nine months ended September 30, 2018 or the twelve months ended December 31, 2017. (Dollars below reported in thousands.)

September 30, 2018 Unpaid Average Interest
Recorded Principal Associated Recorded Income
      Investment       Balance       Allowance       Investment       Recognized
Impaired loans without a valuation allowance:
Land and land development $      35 $      92 $      - $      38 $      -
1-4 family residential mortgages, first lien, owner occupied 86 130 - 92 -
1-4 family residential mortgages, junior lien 128 128 289 14
Commercial non-owner occupied real estate 938 938 - 952 38
Total impaired loans without a valuation allowance 1,187 1,288 - 1,371 52
                               
Impaired loans with a valuation allowance
Student loans purchased 1,567 1,567 98 1,314 63
Total impaired loans with a valuation allowance 1,567 1,567 98 1,314 63
Total impaired loans $ 2,754 $ 2,855 $ 98 $ 2,685 $ 115
 
December 31, 2017 Unpaid Average Interest
Recorded Principal Associated Recorded Income
Investment Balance Allowance Investment Recognized
Impaired loans without a valuation allowance:
Land and land development $ 41 $ 94 $ - $ 46 $ -
1-4 family residential mortgages, first lien, owner occupied 99 137 - 107 -
1-4 family residential mortgages, junior lien 379 382 367 17
Commercial non-owner occupied real estate 972 972 - 992 48
Student loans purchased 1,083 1,083 - 959 64
Impaired loans with a valuation allowance - - - - -
Total impaired loans $ 2,574 $ 2,668 $ - $ 2,471 $ 129

Included in the impaired loans above are non-accrual loans. Generally, loans are placed on non-accrual when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Any unpaid interest previously accrued on those loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other non-accrual loans is recognized only to the extent of interest payments received. The recorded investment in non-accrual loans is shown below by class (dollars in thousands):

      September 30, 2018       December 31, 2017
Land and land development $      35 $      41
1-4 family residential mortgages, first lien, owner occupied 86 99
1-4 family residential mortgages, junior lien - 37
Student loans purchased 445 -
Total nonaccrual loans $ 566 $ 177

Additionally, Troubled Debt Restructurings (“TDRs”) are considered impaired loans. TDRs occur when the Company agrees to modify the original terms of a loan by granting a concession that it would not otherwise consider due to the deterioration in the financial condition of the borrower. These concessions are done in an attempt to improve the paying capacity of the borrower, and in some cases to avoid foreclosure, and are made with the intent to restore the loan to a performing status once sufficient payment history can be demonstrated. These concessions could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions.

Based on regulatory guidance on Student Lending, the Company has classified 68 of its student loans purchased as TDRs for a total of $1.1 million as of September 30, 2018. These borrowers that should have been in repayment have requested and been granted payment extensions or reductions exceeding the maximum lifetime allowable payment forbearance of twelve months (36 months lifetime allowance for military service), as permitted under the regulatory guidance, and are therefore considered restructurings. Student loan borrowers are allowed in-school deferments, plus an automatic six-month grace period post in-school status, before repayment is scheduled to begin, and these deferments do not count toward the maximum allowable forbearance. Initially, all student loans were fully insured by a surety bond, and the Company did not expect to experience a loss on these loans. Based on the loss of insurance after July 27, 2018 due to the insolvency of the insurer, management has evaluated these loans individually for impairment and included any potential loss in the allowance for loan losses; interest continues to accrue on these TDRs during any deferment and forbearance periods.

13


The following provides a summary, by class, of TDRs that continue to accrue interest under the terms of the restructuring agreement, which are considered to be performing, and TDRs that have been placed in non-accrual status, which are considered to be nonperforming (dollars in thousands).

Troubled debt restructurings (TDRs) September 30, 2018 December 31, 2017
No. of Recorded No. of Recorded
      Loans       Investment       Loans       Investment
Performing TDRs
1-4 family residential mortgages, junior lien 1 $ 128 2 $ 342
Commercial non-owner occupied real estate 1 938 1 972
Student loans purchased 67 1,122 64 1,083
Total performing TDRs 69 $ 2,188 67 $ 2,397
                     
Nonperforming TDRs
Student loans purchased   1     3   -     -
Land and land development 1 $ 20 1 $ 24
Total nonperforming TDRs   2   $ 23   1   $ 24
Total TDRs 71 $ 2,211 68 $ 2,421

A summary of loans shown above that were modified under the terms of a TDR during the three and nine months ended September 30, 2018 and 2017 is shown below by class (dollars in thousands). The Post-Modification Recorded Balance reflects the period end balances, inclusive of any interest capitalized to principal, partial principal paydowns, and principal charge-offs since the modification date. Loans modified as TDRs that were fully paid down, charged-off, or foreclosed upon by period end are not reported.

For three months ended For three months ended
September 30, 2018 September 30, 2017
Pre- Post- Pre- Post-
Modification Modification Modification Modification
Number Recorded Recorded Number Recorded Recorded
   of Loans    Balance    Balance    of Loans    Balance    Balance
Student loans purchased 1 $ 15 $ 15 7 $ 42 $ 42
Total loans modified during the period 1 $ 15 $ 15 7 $ 42 $ 42
 
For nine months ended For nine months ended
September 30, 2018 September 30, 2017
Pre- Post- Pre- Post-
Modification Modification Modification Modification
Number Recorded Recorded Number Recorded Recorded
of Loans Balance Balance of Loans Balance Balance
Student loans purchased 8 $ 135 $ 135 16 $ 133 $ 133
Total loans modified during the period 8 $ 135 $ 135 16 $ 133 $ 133

There were no loans modified as TDRs that subsequently defaulted during the nine months ended September 30, 2018 or the twelve months ended December 31, 2017 that were modified as TDRs during the twelve months prior to default.

There were no loans secured by 1-4 family residential property that were in the process of foreclosure at either September 30, 2018 or December 31, 2017.

14


Note 4. Allowance for Loan Losses

The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s quarterly evaluation of the collectability of the loan portfolio, credit concentrations, historical loss experience, specific impaired loans, and economic conditions. To determine the total allowance for loan losses, the Company estimates the reserves needed for each segment of the portfolio, including loans analyzed individually and loans analyzed on a pooled basis. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.

For purposes of determining the allowance for loan losses, the Company has segmented certain loans in the portfolio by product type. Within these segments, the Company has sub-segmented its portfolio by classes within the segments, based on the associated risks within these classes.

Loan Classes by Segments

Commercial loan segment:
Commercial and industrial - organic
Commercial and industrial - government guaranteed
Commercial and industrial - syndicated
 
Real estate construction and land loan segment:
Residential construction
Commercial construction
Land and land development
 
Real estate mortgage loan segment:
1-4 family residential, first lien, investment
1-4 family residential, first lien, owner occupied
1-4 family residential, junior lien
Home equity lines of credit, first lien
Home equity lines of credit, junior lien
Farm
Multifamily
Commercial owner occupied
Commercial non-owner occupied
 
Consumer loan segment:
Consumer revolving credit
Consumer all other credit
Student loans purchased

Management utilizes a loss migration model for determining the quantitative risk assigned to unimpaired loans in order to capture historical loss information at the loan level, track loss migration through risk grade deterioration, and increase efficiencies related to performing the calculations. The quantitative risk factor for each loan class primarily utilizes a migration analysis loss method based on loss history for the prior twelve quarters.

The migration analysis loss method is used for all loan classes except for the following:

Student loans purchased - On June 27, 2018, the Company was notified that ReliaMax Surety Company (“ReliaMax Surety”), the South Dakota insurance company which issued surety bonds for the student loan pool, was placed into liquidation due to insolvency. As such, a reserve was calculated beginning in the second quarter of 2018 using the insurance claim history on the portfolio to establish a historical charge-off rate. In addition qualitative factors were applied to the student loan pool and the calculated reserve is net of any deposit reserve accounts held at the Bank. For reporting periods prior to June 30, 2018, the Company did not charge off student loans as the insurance covered the past due loans, but the Company did apply qualitative factors to calculate a reserve on these loans, net of the deposit reserve accounts held by the Company for this group of loans.

   

Commercial and industrial syndicated loans - Prior to the quarter ended September 30, 2016, there was not an established loss history in the commercial and industrial syndicated loans. The S&P credit and recovery ratings on the credit facilities were utilized to calculate a three-year weighted average historical default rate. During the third quarter of 2016, there was a small loss in the commercial and industrial syndicated loans; therefore, the Company utilized a combination of the migration analysis loss method and the S&P credit and recovery ratings.

   

Commercial and industrial government guaranteed loans – These loans require no reserve as these are 100% guaranteed by either the Small Business Administration (“SBA”) or the United States Department of Agriculture (“USDA”).

15


Furthermore, a nominal loss reserve is applied to loans rated “Good” in an abundance of caution.

Under the migration analysis method, average loss rates are calculated at the risk grade and class levels by dividing the twelve-quarter average net charge-off amount by the twelve-quarter average loan balances. Qualitative factors are combined with these quantitative factors to arrive at the overall general allowances.

The Company’s internal creditworthiness grading system is based on experiences with similarly graded loans. The Company performs regular credit reviews of the loan portfolio to review the credit quality and adherence to its underwriting standards. Additionally, external reviews of a portion of the credits are conducted on a semi-annual basis.

Loans that trend upward on the risk ratings scale, toward more positive risk ratings, generally exhibit lower risk factor characteristics. Conversely, loans that migrate toward more negative ratings generally will result in a higher risk factor being applied to those related loan balances.

Risk Ratings and Historical Loss Factor Assigned

Excellent

A 0% historical loss factor applied, as these loans are secured by cash or fully guaranteed by a U.S. government agency and represent a minimal risk. The Company has never experienced a loss within this category.

Good

A 0% historical loss factor applied, as these loans represent a low risk and are secured by marketable collateral within margin. The Company has never experienced a loss within this category.

Pass

A historical loss factor for loans rated “Pass” is applied to current balances of like-rated loans, pooled by class. Loans with the following risk ratings are pooled by class and considered together as “Pass”:

Satisfactory – modest risk loans where the borrower has strong and liquid financial statements and more than adequate cash flow
Average – average risk loans where the borrower has reasonable debt service capacity
Marginal – acceptable risk loans where the borrower has acceptable financial statements but is leveraged

Watch

These loans have an acceptable risk but require more attention than normal servicing. A historical loss factor for loans rated “Watch” is applied to current balances of like-rated loans pooled by class.

Special Mention

These potential problem loans are currently protected but are potentially weak. A historical loss factor for loans rated “Special Mention” is applied to current balances of like-rated loans pooled by class.

Substandard

These problem loans are inadequately protected by the sound worth and paying capacity of the borrower and/or the value of any collateral pledged. These loans may be considered impaired and evaluated on an individual basis. Otherwise, a historical loss factor for loans rated “Substandard” is applied to current balances of all other “Substandard” loans pooled by class.

Doubtful

Loans with this rating have significant deterioration in the sound worth and paying capacity of the borrower and/or the value of any collateral pledged, making collection or liquidation of the loan in full highly questionable. These loans would be considered impaired and evaluated on an individual basis.

16


The following represents the loan portfolio designated by the internal risk ratings assigned to each credit as of September 30, 2018 and December 31, 2017 (dollars in thousands). There were no loans rated “Doubtful” as of either period.

                               Special      Sub-     
September 30, 2018 Excellent Good Pass Watch Mention standard TOTAL
Commercial
Commercial and industrial - organic $ 3,832 $ 22,751 $ 21,262 $ 198 $ 28 $ 244 $ 48,315
Commercial and industrial - government guaranteed 28,766 - - - - - 28,766
Commercial and industrial - syndicated - - 9,945 - - 2,553 12,498
Real estate construction
Residential construction - - 1,406 - - - 1,406
Commercial construction - - 6,422 - - - 6,422
Land and land development - - 9,921 512 - 520 10,953
Real estate mortgages
1-4 family residential, first lien, investment - - 37,361 2,695 118 276 40,450
1-4 family residential, first lien, owner occupied - - 17,151 1,093 12 142 18,398
1-4 family residential, junior lien - - 2,698 61 23 533 3,315
Home equity lines of credit, first lien - - 7,945 139 - - 8,084
Home equity lines of credit, junior lien - - 11,390 97 - 111 11,598
Farm - - 10,891 342 - 1,349 12,582
Multifamily - - 28,343 - - - 28,343
Commercial owner occupied - - 83,430 4,490 - - 87,920
Commercial non-owner occupied - - 118,986 1,542 - 995 121,523
Consumer
Consumer revolving credit 30 22,278 505 - - - 22,813
Consumer all other credit 231 5,745 565 - - 30 6,571
Student loans purchased - - 54,504 2,075 321 470 57,370
Total Loans $      32,859 $      50,774 $      422,725 $      13,244 $      502 $      7,223 $      527,327
 
Special Sub-
December 31, 2017 Excellent Good Pass Watch Mention standard TOTAL
Commercial
Commercial and industrial - organic $ 3,000 $ 23,937 $ 17,324 $ 13 $ 269 $ 711 $ 45,254
Commercial and industrial - government guaranteed 22,946 - - - - - 22,946
Commercial and industrial - syndicated - - 10,590 - - 2,575 13,165
Real estate construction
Residential construction - - 3,812 - - - 3,812
Commercial construction - - 13,365 - - - 13,365
Land and land development - - 9,137 3 - 541 9,681
Real estate mortgages
1-4 family residential, first lien, investment - - 38,003 1,875 - 435 40,313
1-4 family residential, first lien, owner occupied - - 15,465 260 - 723 16,448
1-4 family residential, junior lien - - 2,488 265 41 171 2,965
Home equity lines of credit, first lien - - 9,098 140 - - 9,238
Home equity lines of credit, junior lien - - 13,115 - - 111 13,226
Farm - - 9,065 - - 1,380 10,445
Multifamily - - 33,356 - - - 33,356
Commercial owner occupied - 669 79,137 455 - - 80,261
Commercial non-owner occupied - - 114,610 972 - 1,017 116,599
Consumer
Consumer revolving credit 6 22,977 1,045 1 1 - 24,030
Consumer all other credit 294 8,006 701 2 - 33 9,036
Student loans purchased - - 63,561 1,083 - - 64,644
Total Loans $ 26,246 $ 55,589 $ 433,872 $ 5,069 $ 311 $ 7,697 $ 528,784

17


In addition, the adequacy of the Company’s allowance for loan losses is evaluated through reference to eight qualitative factors, listed below and ranked in order of importance:

1)

Changes in national and local economic conditions, including the condition of various market segments;

2)

Changes in the value of underlying collateral;

3)

Changes in volume of classified assets, measured as a percentage of capital;

4)

Changes in volume of delinquent loans;

5)

The existence and effect of any concentrations of credit and changes in the level of such concentrations;

6)

Changes in lending policies and procedures, including underwriting standards;

7)

Changes in the experience, ability and depth of lending management and staff; and

8)

Changes in the level of policy exceptions.

It has been the Company’s experience that the first five factors drive losses to a much greater extent than the last three factors; therefore, the first five factors are weighted more heavily. Qualitative factors are not assessed against loans rated “Excellent” or “Good.”

For each segment and class of loans, management must exercise significant judgment to determine the estimation method that fits the credit risk characteristics of its various segments. Although this evaluation is inherently subjective, qualified management utilizes its significant knowledge and experience related to both the Company’s market and the history of the Company’s loan losses.

Impaired loans are individually evaluated and, if deemed appropriate, a specific allocation is made for these loans. In reviewing the loans classified as impaired loans totaling $2.8 million at September 30, 2018, specific valuation allowance was recognized 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 borrower. The $98 thousand in the allowance total shown below as individually evaluated for impairment was attributed to the impaired student loans which required an allowance as of September 30, 2018 due to the loss of the insurance on this portfolio as discussed previously.

18


A summary of the transactions in the Allowance for Loan Losses by loan portfolio segment for the nine months ended September 30, 2018 and the year ended December 31, 2017 appears below (dollars in thousands):

Allowance for Loan Losses Rollforward by Portfolio Segment
As of and for the period ended September 30, 2018
          Real Estate               
Commercial Construction Real Estate Consumer
Loans and Land Mortgages Loans Total
Allowance for Loan Losses:
Balance as of January 1, 2018 $ 885 $ 206 $ 2,730 $ 222 $ 4,043
Charge-offs - - - (316 ) (316 )
Recoveries 48 - 2 11 61
Provision for (recovery of) loan losses (53 ) (79 ) (144 ) 1,166 890
Ending Balance $ 880 $ 127 $ 2,588 $ 1,083 $ 4,678
 
Ending Balance:
Individually evaluated for impairment $ - $ - $ - $ 98 $ 98
Collectively evaluated for impairment 880 127 2,588 985 4,580
 
Loans:
Individually evaluated for impairment $ - $ 35 $ 1,152 $ 1,567 $ 2,754
Collectively evaluated for impairment 89,579 18,746 331,061 85,187 524,573
Ending Balance $        89,579 $         18,781 $     332,213 $     86,754 $     527,327
 
As of and for the year ended December 31, 2017
Real Estate
Commercial Construction Real Estate Consumer
Loans and Land Mortgages Loans Total
Allowance for Loan Losses:
Balance as of January 1, 2017 $ 824 $ 127 $ 2,506 $ 231 $ 3,688
Charge-offs (111 ) - - - (111 )
Recoveries 31 - 2 15 48
Provision for (recovery of) loan losses 141 79 222 (24 ) 418
Ending Balance $ 885 $ 206 $ 2,730 $ 222 $ 4,043
 
Ending Balance:
Individually evaluated for impairment $ - $ - $ - $ - $ -
Collectively evaluated for impairment 885 206 2,730 222 4,043
 
Loans:
Individually evaluated for impairment $ - $ 41 $ 1,450 $ 1,083 $ 2,574
Collectively evaluated for impairment 81,365 26,817 321,401 96,627 526,210
Ending Balance $ 81,365 $ 26,858 $ 322,851 $ 97,710 $ 528,784

As previously mentioned, one of the major factors that the Company uses in evaluating the adequacy of its allowance for loan losses is changes in the volume of delinquent loans. Management monitors payment activity on a regular basis. For all classes of loans, the Company considers the entire balance of the loan to be contractually delinquent if the minimum payment is not received by the due date. Interest and fees continue to accrue on past due loans until they are changed to non-accrual status.

19


The following tables show the aging of past due loans as of September 30, 2018 and December 31, 2017. (Dollars below reported in thousands.)

Past Due Aging as of 90 Days
September 30, 2018 30-59 60-89 90 Days or Past Due
Days Past Days Past More Past Total Past Total and Still
           Due      Due      Due       Due      Current      Loans      Accruing
Commercial loans
Commercial and industrial - organic $ - $ - $ - $ - $ 48,315 $ 48,315 $ -
Commercial and industrial - government guaranteed - - - - 28,766 28,766 -
Commercial and industrial - syndicated - - - - 12,498 12,498 -
Real estate construction and land
Residential construction - - - - 1,406 1,406 -
Commercial construction - - - - 6,422 6,422 -
Land and land development - - 16 16 10,937 10,953 16
Real estate mortgages
1-4 family residential, first lien, investment 86 - - 86 40,364 40,450 -
1-4 family residential, first lien, owner occupied - - - - 18,398 18,398 -
1-4 family residential, junior lien - - - - 3,315 3,315 -
Home equity lines of credit, first lien - - - - 8,084 8,084 -
Home equity lines of credit, junior lien - - - - 11,598 11,598 -
Farm - - - - 12,582 12,582 -
Multifamily - - - - 28,343 28,343 -
Commercial owner occupied - - - - 87,920 87,920 -
Commercial non-owner occupied 995 - - 995 120,528 121,523 -
Consumer loans
Consumer revolving credit - - - - 22,813 22,813 -
Consumer all other credit 1 - - 1 6,570 6,571 -
Student loans purchased 549 373 867 1,789 55,581 57,370 504
Total Loans $     1,631 $ 373 $ 883 $     2,887 $     524,440 $     527,327 $ 520
 
Past Due Aging as of 90 Days
December 31, 2017 30-59 60-89 90 Days or Past Due
Days Past Days Past More Past Total Past Total and Still
Due Due Due Due Current Loans Accruing
Commercial loans
Commercial and industrial - organic $ - $ - $ - $ - $ 45,254 $ 45,254 $ -
Commercial and industrial - government guaranteed - - - - 22,946 22,946 -
Commercial and industrial - syndicated - - - - 13,165 13,165 -
Real estate construction and land
Residential construction - - - - 3,812 3,812 -
Commercial construction - - - - 13,365 13,365 -
Land and land development 20 - - 20 9,661 9,681 -
Real estate mortgages
1-4 family residential, first lien, investment 118 - - 118 40,195 40,313 -
1-4 family residential, first lien, owner occupied 128 - 18 146 16,302 16,448 18
1-4 family residential, junior lien - - - - 2,965 2,965 -
Home equity lines of credit, first lien 100 - - 100 9,138 9,238 -
Home equity lines of credit, junior lien - - - - 13,226 13,226 -
Farm - - - - 10,445 10,445 -
Multifamily - - - - 33,356 33,356 -
Commercial owner occupied 11 - - 11 80,250 80,261 -
Commercial non-owner occupied 79 91 - 170 116,429 116,599 -
Consumer loans
Consumer revolving credit 1 - - 1 24,029 24,030 -
Consumer all other credit 71 - - 71 8,965 9,036 -
Student loans purchased 997 160 271 1,428 63,216 64,644 271
Total Loans $ 1,525 $ 251 $ 289 $ 2,065 $ 526,719 $ 528,784 $ 289

20


Note 5. Net Income Per Share

On March 16, 2018, the Board of Directors approved a stock dividend of five percent (5%) on the outstanding shares of common stock of the Company (or .05 share for each share outstanding) which was issued on April 13, 2018 to all shareholders of record as of the close of business on April 3, 2018 (the “5% Stock Dividend”). Shareholders received cash in lieu of any fractional shares that they otherwise would have been entitled to receive in connection with the stock dividend. The price paid for fractional shares was based on the volume-weighted average price of a share of common stock for the most recent three (3) days prior to the record date during which a trade of the Company’s stock occurred.

For the following table, share and per share data have been adjusted to reflect the 5% Stock Dividend. The table shows the weighted average number of shares used in computing net income per common share and the effect on the weighted average number of shares of diluted potential common stock for the three and nine months ended September 30, 2018 and 2017. Potential dilutive common stock equivalents have no effect on net income available to common shareholders. (Dollars below reported in thousands except per share data.)

Three Months Ended September 30, 2018 September 30, 2017
Weighted Per Weighted Per
            Average       Share             Average       Share
Net Income Shares Amount Net Income Shares Amount
Basic net income per share $      2,160 2,542,094 $      0.85 $      1,745 2,521,137 $      0.69
Effect of dilutive stock options - 19,544 (0.01 ) - 22,013 (0.01 )
Diluted net income per share $ 2,160 2,561,638 $ 0.84 $ 1,745 2,543,150 $ 0.68
 
Nine Months Ended September 30, 2018 September 30, 2017
Weighted Per Weighted Per
Average Share Average Share
Net Income Shares Amount Net Income Shares Amount
Basic net income per share $ 6,788 2,538,712 $ 2.67 $ 5,400 2,507,358 $ 2.15
Effect of dilutive stock options - 20,432 (0.02 ) - 22,531 (0.02 )
Diluted net income per share $ 6,788 2,559,144 $ 2.65 $ 5,400 2,529,889 $ 2.13

For the nine-month period ended September 30, 2018, there were 62,750 option shares considered anti-dilutive and excluded from this calculation. For the nine-month period ended September 30, 2017, option shares totaling 2,100, as adjusted, were considered anti-dilutive and were excluded from this calculation.

Note 6. Stock Incentive Plans

At the Annual Shareholders Meeting on May 21, 2014, shareholders approved the Virginia National Bankshares Corporation 2014 Stock Incentive Plan (“2014 Plan”). The 2014 Plan makes available up to 262,500 shares of the Company’s common stock, as adjusted by the 5% Stock Dividend, to be issued to plan participants. Similar to the Company’s 2003 Stock Incentive Plan (“2003 Plan”) and 2005 Stock Incentive Plan (“2005 Plan”), the 2014 Plan provides for granting of both incentive and nonqualified stock options, as well as restricted stock and other stock based awards. No new grants will be issued under the 2003 Plan or the 2005 Plan as these plans have expired.

For all of the Company’s stock incentive plans (the “Plans”), the option price of incentive stock options will not be less than the fair value of the stock at the time an option is granted. Nonqualified stock options may be granted at prices established by the Board of Directors, including prices less than the fair value on the date of grant. Outstanding stock options generally expire in ten years from the grant date. Stock options generally vest by the fourth or fifth anniversary of the date of the grant.

21


A summary of the shares issued and available under each of the Plans is shown below as of September 30, 2018. Share data and exercise price range per share have been adjusted to reflect the 5% Stock Dividend. Although the 2003 Plan and 2005 Plan have expired and no new grants will be issued under these plans, there were options issued before the plans expired which are still outstanding as shown below.

2003 Plan 2005 Plan 2014 Plan
Aggregate shares issuable       134,787       241,500       262,500  
Options issued, net of forfeited and expired options (113,457 ) (70,884 ) (64,850 )
Cancelled due to Plan expiration (21,330 ) (170,616 ) -
Remaining available for grant - - 197,650
  
Grants issued and outstanding:
Total vested and unvested shares 16,345 1,811 64,325
Fully vested shares 16,345 1,811 -
Exercise price range $      17.39 to $      11.18 to $      28.76 to
$ 17.39 $ 14.37 $ 44.75

The Company accounts for all of its stock incentive plans under recognition and measurement accounting principles which require that the compensation cost relating to stock-based payment transactions be recognized in the financial statements. Stock-based compensation arrangements include stock options and restricted stock. All stock-based payments to employees are required to be valued at a fair value on the date of grant and expensed based on that fair value over the applicable vesting period. For the nine months ended September 30, 2018 and 2017, the Company recognized $41 thousand and $8 thousand, respectively, in compensation expense for stock options. As of September 30, 2018, there was $429 thousand in unrecognized compensation expense remaining to be recognized in future reporting periods through 2023.

Stock Options

Changes in the stock options outstanding related to all of the Plans are summarized below. Share and per share data have been adjusted to reflect the 5% Stock Dividend. (Dollars in thousands except per share data):

September 30, 2018
Weighted Average Aggregate
      Number of Options       Exercise Price       Intrinsic Value
Outstanding at January 1, 2018 46,123 $                  19.96 $               793
Issued 62,750 44.34
Exercised (12,500 ) 21.39
Expired                 (13,892 ) 21.53
Outstanding at September 30, 2018 82,481 $ 38.02 $ 662
 
Options exercisable at September 30, 2018 18,155 $ 17.00 $ 527

22


The fair value of any grant is estimated at the grant date using the Black-Scholes pricing model. During 2017, a stock option grant for 2,100 shares, as adjusted to reflect the 5% Stock Dividend, was issued. During the first nine months of 2018, stock option grants for 62,750 shares were issued, and the fair value of each option granted was estimated based on the assumptions noted in the following table:

      For the nine months ended
September 30, 2018
Expected volatility1                             15.49 %
Expected dividends2 1.81 %
Expected term (in years)3 6.50
Risk-free rate4 2.85 %

1 Based on the monthly historical volatility of the Company’s stock price over the expected life of the options.
 

2 Calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant.
 

3 Based on the average of the contractual life and vesting period for the respective option.
 

4 Based upon an interpolated US Treasury yield curve interest rate that corresponds to the contractual life of the option, in effect at the time of the grant.

Summary information pertaining to options outstanding at September 30, 2018 is shown below. Share and per share data have been adjusted to reflect the 5% Stock Dividend.

Options Outstanding Options Exercisable
Weighted- Weighted- Weighted-
Number of Average Average Number of Average
Options Remaining Exercise Options Exercise
Exercise Price       Outstanding       Contractual Life       Price       Exercisable       Price
$11.18 to $20.00 18,156 0.8 Years $        17.00 18,156 $        17.00
$20.01 to $30.00 1,575 8.5 Years 28.76 0 -
$30.01 to $40.00 - - - 0 -
$40.01 to $44.75 62,750 9.6 Years 44.34 0 -
Total 82,481 7.7 Years $ 38.02 18,156 $ 17.00

Restricted Stock

There were no restricted stock grants outstanding throughout 2017 or as of September 30, 2018. No restricted stock grants were awarded during 2017 or the first nine months of 2018.

23


Note 7. Fair Value Measurements

Determination of Fair Value

The Company follows ASC 820, “Fair Value Measurements and Disclosures,” to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. This codification clarifies that 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).

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The following tables present the balances measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017 (dollars in thousands):

Fair Value Measurements at September 30, 2018 Using:
Quoted Prices in Significant
Active Markets Other Significant
for Identical Observable Unobservable
Assets Inputs Inputs
Description       Balance       (Level 1)       (Level 2)       (Level 3)
Assets:
U.S. Government agencies $      18,718 $                         - $                   18,718 $                    -
Mortgage-backed securities/CMOs 25,877 - 25,877 -
Municipal bonds 17,505 - 17,505 -
Total securities available for sale $ 62,100 $ - $ 62,100 $ -
 
  Fair Value Measurements at December 31, 2017 Using:
Quoted Prices in Significant
Active Markets Other Significant
for Identical Observable Unobservable
Assets Inputs Inputs
Description Balance (Level 1) (Level 2) (Level 3)
Assets:
U.S. Government agencies $ 18,962 $ - $ 18,962 $ -
Mortgage-backed securities/CMOs 29,945 - 29,945 -
Municipal bonds 18,593 - 18,593 -
Marketable equity securities 1 - 1 -
Total securities available for sale $ 67,501 $ - $ 67,501 $ -

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:

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. As of September 30, 2018 and December 31, 2017, the Company had no OREO property.

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 when due. 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).

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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 impaired loans of $2.8 million as of September 30, 2018 and $2.6 million as of December 31, 2017. None of the impaired loans as of December 31, 2017 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. The impaired loans as of September 30, 2018 requiring a valuation allowance are shown in the table below.

The following table presents the balances measured at fair value on a nonrecurring basis as of September 30, 2018 (dollars in thousands):

      Fair Value Measurements at September 30, 2018 Using:
Quoted Prices            
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
Description Balance (Level 1) (Level 2) (Level 3)
Assets:
Impaired loans
Student loans purchased 1,469 - - 1,469
Total impaired loans $      1,469 $      - $      - $      1,469

There were no balances measured at fair value on a nonrecurring basis at December 31, 2017.

ASC 825, “Financial Instruments,” requires disclosures about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

On January 1, 2018, the Company adopted ASU 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 makes targeted improvements to several areas of U.S. GAAP, including the disclosure of the fair value of financial instruments that are not measured at fair value on a recurring basis. In accordance with the prospective adoption of ASU No. 2016-01, the fair value of loans as of September 30, 2018 was measured using an exit price notion. The fair value of loans as of December 31, 2017 was measured using an entry price notion. The Company has historically estimated the fair value for loans reported at amortized cost on its balance sheet by examining the average rates per the terms of these loans, and comparing those average rates to the current rates offered by the Company (i.e., the entry price notion). Utilizing the exit price notion requires the Company to estimate fair value of these loans based on the price that would be received to sell these loans in an orderly transaction between market participants at the measurement date.

26


The carrying values and estimated fair values of the Company's financial instruments as of September 30, 2018 and December 31, 2017 are as follows (dollars in thousands):

Fair Value Measurement at September 30, 2018 using:
            Quoted Prices                  
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
Carrying value Level 1 Level 2 Level 3 Fair Value
Assets
Cash and cash equivalent $      8,762 $      8,762 $      - $      - $      8,762
Available for sale securities 62,100 - 62,100 - 62,100
Loans, net 522,649 - - 509,973 509,973
Bank owned life insurance 16,677 - 16,677 - 16,677
Accrued interest receivable 2,099 - 364 1,735 2,099
 
Liabilities
Demand deposits and interest-bearing transaction, money market, and savings accounts $ 411,312 $ - $ 411,312 $ - $ 411,312
Certificates of deposit 127,190 - 127,103 - 127,103
Repurchase agreements and other borrowings 17,193 - 17,193 - 17,193
Accrued interest payable 274 - 274 - 274

Fair Value Measurement at December 31, 2017 using:
            Quoted Prices                  
in Active Significant
Markets for Other Significant
Identical Observable Unobservable
Assets Inputs Inputs
Carrying value Level 1 Level 2 Level 3 Fair Value
Assets
Cash and cash equivalent $      18,277 $      18,277 $      - $      - $      18,277
Available for sale securities 67,501 - 67,501 - 67,501
Loans, net 524,741 - - 517,339 517,339
Bank owned life insurance 16,344 - 16,344 - 16,344
Accrued interest receivable 2,012 - 363 1,649 2,012
 
Liabilities
Demand deposits and interest-bearing transaction and money market accounts $ 433,729 $ - $ 433,729 $ - $ 433,729
Certificates of deposit 109,233 - 108,936 - 108,936
Repurchase agreements and other borrowings 34,092 - 34,092 - 34,092
Accrued interest payable 110 - 110 - 110

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. Consequently, the fair values of the Company’s financial instruments will fluctuate 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.

27


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.

Note 8. Other Comprehensive Income

A component of the Company’s other comprehensive income, in addition to net income from operations, is the recognition of the unrealized gains and losses on available for sale securities, net of income taxes. Reclassifications of realized gains and losses on available for sale securities are reported in the income statement as “Gains (losses) on sales and calls of securities” with the corresponding income tax effect reflected as a component of income tax expense. Amounts reclassified out of accumulated other comprehensive income are presented below for the three and nine months ended September 30, 2018 and 2017 (dollars in thousands):

Three Months Ended Nine Months Ended
September 30, 2018 September 30, 2017 September 30, 2018 September 30, 2017
Available for sale securities                         
Realized losses on sales of securities       $      - $                        (78 ) $ - $                        (74 )
Tax effect - 27 - 25
Realized losses, net of tax $      - $ (51 ) $ - $ (49 )

Note 9. Segment Reporting

Virginia National Bankshares Corporation has two reportable segments, the Bank and VNB Wealth. Effective July 1, 2018, VNBTrust merged into Virginia National Bank, which continues to offer the same services previously provided by VNBTrust.

The Company’s commercial banking segment involves making loans and generating deposits from individuals, businesses and charitable organizations. Loan fee income, service charges from deposit accounts, and other non-interest-related fees, such as fees for debit cards and ATM usage and fees for treasury management services, generate additional income for this segment.

The VNB Wealth segment includes (a) trust income from the investment management, wealth advisory and trust and estate services, comprised of both management fees and performance fees, (b) advisory and brokerage income from investment advisory, retail brokerage, annuity and insurance services offered under the name of VNB Investment Services, (c) income from the Company’s registered investment adviser, Masonry Capital Management, LLC, and (d) royalty income from the sale of Swift Run Capital Management, LLC in 2013. More information on royalty income and the related sale can be found under Summary of Significant Accounting Policies in Note 1 of the notes to consolidated financial statements, which is found in Item 8. Financial Statements and Supplementary Data, in the Company’s Form 10-K Report for December 31, 2017 (the “Company’s 2017 Form 10-K”).

A management fee for administrative and technology support services provided by the Bank is allocated to VNB Wealth. For both the nine months ended September 30, 2018 and 2017, management fees of $75 thousand were charged to VNB Wealth and eliminated in consolidated totals.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies provided earlier in this report. Each reportable segment is a strategic business unit that offers different products and services. They are managed separately, because each segment appeals to different markets and, accordingly, require different technology and marketing strategies.

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Segment information for the three and nine months ended September 30, 2018 and 2017 is shown in the following tables (dollars in thousands). Note that asset information is not reported below, as the assets previously allocated to VNB Wealth are reported at the Bank level subsequent to the merger of VNBTrust, National Association, into the Bank effective July 1, 2018; also, assets specifically allocated to the VNB Wealth lines of business are insignificant and are no longer provided to the chief operating decision maker.

Three months ended September 30, 2018       Bank       VNB Wealth       Consolidated
Net interest income $      5,791 $      - $      5,791
Provision for loan losses 285 - 285
Noninterest income 700 570 1,270
Noninterest expense 3,542 547 4,089
Income before income taxes 2,664 23 2,687
Provision for income taxes 522 5 527
Net income $ 2,142 $ 18 $ 2,160
 
Three months ended September 30, 2017 Bank VNB Wealth Consolidated
Net interest income $ 5,457 $ 26 $ 5,483
Provision for loan losses 168 - 168
Noninterest income 610 548 1,158
Noninterest expense 3,380 537 3,917
Income before income taxes 2,519 37 2,556
Provision for income taxes 798 13 811
Net income $ 1,721 $ 24 $ 1,745
 
Nine months ended September 30, 2018 Bank VNB Wealth Consolidated
Net interest income $ 17,106 $ 73 $ 17,179
Provision for loan losses 890 - 890
Noninterest income 2,046 2,245 4,291
Noninterest expense 10,547 1,586 12,133
Income before income taxes 7,715 732 8,447
Provision for income taxes 1,505 154 1,659
Net income $ 6,210 $ 578 $ 6,788
 
Nine months ended September 30, 2017 Bank VNB Wealth Consolidated
Net interest income $ 15,798 $ 66 $ 15,864
Provision for loan losses 213 - 213
Noninterest income 1,977 1,757 3,734
Noninterest expense 9,858 1,597 11,455
Income before income taxes 7,704 226 7,930
Provision for income taxes 2,452 78 2,530
Net income $ 5,252 $ 148 $ 5,400

29



ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with Virginia National Bankshares Corporation’s consolidated financial statements, and notes thereto, for the year ended December 31, 2017, included in the Company’s 2017 Form 10-K. All per share data has been adjusted to reflect the 5% Stock Dividend effective April 13, 2018 (the “5% Stock Dividend”). Operating results for the three and nine months ended September 30, 2018 are not necessarily indicative of the results for the year ending December 31, 2018 or any future period.

FORWARD-LOOKING STATEMENTS AND FACTORS THAT COULD AFFECT FUTURE RESULTS

Certain statements contained or incorporated by reference in this quarterly report on Form 10-Q, including but not limited to, statements concerning future results of operations or financial position, borrowing capacity and future liquidity, future investment results, future credit exposure, future loan losses and plans and objectives for future operations, change in laws and regulations applicable to the Company and its subsidiaries, adequacy of funding sources, actuarial expected benefit payment, valuation of foreclosed assets, regulatory requirements, economic environment and other statements contained herein regarding matters that are not historical facts, are “forward-looking statements” as defined in the Securities Exchange Act of 1934. Such statements are often characterized by use of qualified words such as “expect,” “believe,” “estimate,” “project,” “anticipate,” “intend,” “will,” “should” or words of similar meaning or other statements concerning the opinions or judgment of the Company and its management about future events. These statements are not historical facts but instead are subject to numerous assumptions, risks and uncertainties, and represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside our control. Any forward-looking statements made by the Company speak only as of the date on which such statements are made. Our actual results and financial position may differ materially from the anticipated results and financial condition indicated in or implied by these forward-looking statements. The Company makes no commitment to update or revise forward-looking statements in order to reflect new information or subsequent events or changes in expectations.

Factors that could cause our actual results to differ materially from those in the forward-looking statements include, but are not limited to, the following: inflation, interest rates, market and monetary fluctuations; geopolitical developments including acts of war and terrorism and their impact on economic conditions; the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board; changes, particularly declines, in economic and business conditions, both generally and in the local markets in which the Company operates; the financial condition of the Company’s borrowers; competitive pressures on loan and deposit pricing and demand; changes in technology and their impact on the marketing of new products and services and the acceptance of these products and services by new and existing customers; the willingness of customers to substitute competitors’ products and services for the Company’s products and services; the impact of changes in financial services laws and regulations (including laws concerning taxes, banking, securities and insurance); changes in accounting principles, policies and guidelines; the ability to retain key personnel; incorrect assumptions regarding the allowance for loan losses; risks and assumptions associated with mergers and acquisitions and other expansion activities; other risks and uncertainties described from time to time in press releases and other public filings; and the Company’s performance in managing the risks involved in any of the foregoing. The foregoing list of important factors is not exclusive, and the Company will not update any forward-looking statement, whether written or oral, that may be made from time to time.

APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The accounting and reporting policies followed by the Company conform, in all material respects, to GAAP and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Company bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.

The Company considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain, and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Company’s consolidated financial statements. The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations.

For additional information regarding critical accounting policies, refer to the Application of Critical Accounting Policies and Critical Accounting Estimates section under Item 7 in the Company’s 2017 Form 10-K. There have been no significant changes in the Company’s application of critical accounting policies since December 31, 2017.

30


FINANCIAL CONDITION

Total assets

The total assets of the Company as of September 30, 2018 were $626.8 million. This is a $17.1 million decrease from the $643.9 million total assets reported at December 31, 2017 and a $16.5 million increase from the $610.3 million reported at September 30, 2017. A $26.3 million increase in loans since September 30, 2017 was the major reason for the increase in assets year-over-year.

Federal funds sold

The Company had overnight federal funds sold of $1.1 million as of September 30, 2018, compared to $6.9 million as of December 31, 2017 and $3.2 million as of September 30, 2017. Any excess funds are sold on a daily basis in the federal funds market. The Company intends to maintain sufficient liquidity at all times to meet its funding commitments.

The Company continues to participate in the Federal Reserve Bank of Richmond’s Excess Balance Account (“EBA”). The EBA is a limited-purpose account at the Federal Reserve Bank for the maintenance of excess cash balances held by financial institutions. The EBA eliminates the potential of concentration risk that comes with depositing excess balances with one or multiple correspondent banks.

Securities

The Company’s investment securities portfolio as of September 30, 2018 totaled $64.2 million, a decrease of $5.6 million compared with the $69.8 million reported at December 31, 2017 and a decrease of $9.6 million from the $73.8 million reported at September 30, 2017. Management proactively manages the mix of earning assets and cost of funds to maximize the earning capacity of the Company. At September 30, 2018 and September 30, 2017, the investment securities holdings represented 10.2% and 12.1% of the Company’s total assets, respectively.

The Company’s investment securities portfolio included restricted securities totaling $2.1 million as of September 30, 2018 compared to $2.3 million as of December 31, 2017 and $2.7 million as of September 30, 2017. These securities represent stock in the Federal Reserve Bank of Richmond (“FRB-R”), the Federal Home Loan Bank of Atlanta (“FHLB-A”), and CBB Financial Corporation (“CBBFC”), the holding company for Community Bankers Bank. The level of FRB-R and FHLB-A stock that the Company is required to hold is determined in accordance with membership guidelines provided by the Federal Reserve Bank Board of Governors or the Federal Home Loan Bank of Atlanta. The decrease compared to September 30, 2017 was due to the decrease in the Company’s short-term borrowing initiated with the FHLB-A from the third quarter of 2017 to the third quarter of 2018. Stock ownership in the bank holding company for Community Bankers’ Bank provides the Bank with several benefits that are not available to non-shareholder correspondent banks. None of these restricted securities are traded on the open market and can only be redeemed by the respective issuer.

At September 30, 2018, the unrestricted securities portfolio totaled $62.1 million. The following table summarizes the Company's available for sale securities by type as of September 30, 2018, December 31, 2017, and September 30, 2017 (dollars in thousands):

September 30, 2018 December 31, 2017 September 30, 2017
            Percent             Percent             Percent
Balance of Total Balance of Total Balance of Total
U.S. Government agencies $      18,718 30.1 % $      18,962 28.1 % $      19,166 27.0 %
Mortgage-backed securities/CMOs 25,877 41.7 % 29,945 44.4 % 31,624 44.5 %
Municipal bonds 17,505 28.2 % 18,593 27.5 % 20,259 28.5 %
Marketable equity securities - 0.0 % 1 0.0 % - 0.0 %
     Total available for sale securities $ 62,100 100.0 % $ 67,501 100.0 % $ 71,049 100.0 %

The securities are held primarily for earnings, liquidity, and asset/liability management purposes and reviewed quarterly for possible other-than-temporary impairments. During this review, management analyzes the length of time the fair value has been below cost, the expectation for that security’s performance, the creditworthiness of the issuer, and the Company’s intent and ability to hold the security to recovery or maturity. These factors are analyzed for each individual security.

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Loan portfolio

A management objective is to grow loan balances while maintaining the asset quality of the loan portfolio. The Company seeks to achieve this objective by maintaining rigorous underwriting standards coupled with regular evaluation of the creditworthiness of, and the designation of lending limits for, each borrower. The portfolio strategies include seeking industry, loan size, and loan type diversification in order to minimize credit exposure and originating loans in markets with which the Company is familiar. The predominant market area for loans includes Charlottesville, Albemarle County, Orange County, Harrisonburg, Winchester, Frederick County and areas in the Commonwealth of Virginia that are within a 75 mile radius of any Virginia National Bank office.

As of September 30, 2018, total loans were $527.3 million, compared to $528.8 million as of December 31, 2017 and $501.0 million at September 30, 2017. Loans as a percentage of total assets at September 30, 2018 were 84.1%, compared to 82.1% as of September 30, 2017. Loans as a percentage of deposits at September 30, 2018 were 97.9%, compared to 98.8% as of September 30, 2017. This consistently high loan-to-deposit ratio is in line with our strategy to achieve an effective mix of earning assets and liabilities on our balance sheet.

The following table summarizes the Company's loan portfolio by type of loan as of September 30, 2018, December 31, 2017, and September 30, 2017 (dollars in thousands):

September 30, 2018 December 31, 2017 September 30, 2017
Percent Percent       Percent
      Balance       of Total       Balance       of Total       Balance       of Total
Commercial and industrial $      89,579 17.0 % $      81,365 15.4 % $      82,214 16.4 %
Real estate - commercial 250,368 47.5 % 230,216 43.5 % 217,599 43.4 %
Real estate - residential mortgage 81,845 15.5 % 92,635 17.5 % 92,470 18.5 %
Real estate - construction 18,781 3.5 % 26,858 5.1 % 25,147 5.0 %
Consumer loans 86,754 16.5 % 97,710 18.5 % 83,594 16.7 %
Total loans $ 527,327      100.0 % $ 528,784      100.0 % $ 501,024 100.0 %

Loan balances declined $1.5 million, or 0.3%, since December 31, 2017 yet expanded $26.3 million, or 5.2%, from September 30, 2017. Over the one-year period, the loan growth was comprised of $65.9 million in new funding from organic loan growth, which was offset by $46.8 million in payoffs and normal amortization, supplemented by $7.2 million in net growth in purchased loans. The purchase of loans is considered a secondary strategy, which allows the Company to supplement organic loan growth and enhance earnings. Purchased loans with balances outstanding of $98.6 million as of September 30, 2018 were comprised of:

Student loans totaling $57.4 million. The Company purchased two student loan packages in 2015 and a third in the fourth quarter of 2016. A fourth tranche was closed in December 2017 for an additional $15.0 million. At the time each of these four packages of student loans was acquired, the Company purchased a surety bond that fully insured this portion of the Company’s consumer portfolio. However, during June 2018, ReliaMax Surety Company (“ReliaMax Surety”), the South Dakota insurance company which issued the surety bonds, was placed into liquidation due to insolvency. Loss claims can be filed for loans in default as of July 27, 2018, and the Company anticipates payment on such claims. No surety claims may be filed for student loans in default after July 27, 2018 since the insurance terminated.
 
Loans guaranteed by a U.S. government agency (“government guaranteed”) totaling $28.8 million, inclusive of premium. During the fourth quarter of 2016, the Company began augmenting the commercial and industrial portfolio with government guaranteed loans which represent the portion of loans that are 100% guaranteed by either the United States Department of Agriculture (“USDA”) or the Small Business Administration (“SBA”); the originating institution holds the unguaranteed portion of each loan and services it. These government guaranteed portion of loans are typically purchased at a premium. In the event of early prepayment, the Company may need to write off any unamortized premium.
 
Syndicated loans totaling $12.4 million. Syndicated loans represent shared national credits in leveraged lending transactions and are included in the commercial and industrial portfolio. The Company has developed policies to limit overall credit exposure to the syndicated market, as well as limits by industry and amount per borrower.

Management will continue to evaluate loan purchase transactions as needed to supplement organic loan growth, as part of its strategy to strengthen earnings and attain an effective mix of earning assets.

32


Loan quality

Non-accrual loans totaled $566 thousand at September 30, 2018, compared to the $177 thousand and $186 thousand reported at December 31, 2017 and September 30, 2017, respectively. The balance of loans in non-accrual status increased as a result of $445 thousand in student loans classified as non-accrual during the second and third quarters of 2018 based on the loss of insurance on these loans. The Company will file claims with the liquidator of ReliaMax Surety, which issued surety bonds on the student loan portfolio, by December 31, 2018 for these non-accrual loans. Based on information released by the liquidator, the Company expects to collect the principal balances outstanding on such loans, which were 120 or more days past due as of July 27, 2018, together with interest outstanding as of that date. Student loans that have or will become 120 days or more past due after July 27, 2018 are classified as charge-offs. The Company has contracted with a third party to proactively manage the collections of past due student loans; this third party has extensive experience and specializes in this type of asset management.

At September 30, 2018, the Company had loans classified as impaired loans in the amount of $2.8 million, compared to $2.6 million and $2.5 million at December 31, 2017 and September 30, 2017, respectively. Based on regulatory guidance on Student Lending, the Company has classified 68 of its purchased student loans as TDRs for a total of $1.1 million as of September 30, 2018. These borrowers that should have been in repayment have requested and been granted payment extensions or reductions exceeding the maximum lifetime allowable payment forbearance of twelve months (36 months lifetime allowance for military service), as permitted under the regulatory guidance, and are therefore considered restructurings. Student loan borrowers are allowed in-school deferments, plus an automatic six-month grace period post in-school status, before repayment is scheduled to begin, and these deferments do not count toward the maximum allowable forbearance. Management has evaluated these loans individually for impairment and included any potential loss in the allowance for loan loss; interest continues to accrue on these TDRs during any deferment and forbearance periods.

Management identifies potential problem loans through its periodic loan review process and considers potential problem loans as those loans classified as special mention, substandard, or doubtful.

Allowance for loan losses

In general, the Company determines the adequacy of its allowance for loan losses by considering the risk classification and delinquency status of loans and other factors. Management may also establish specific allowances for loans which management believes require allowances greater than those allocated according to their risk classification. The purpose of the allowance is to provide for losses inherent in the loan portfolio. Since risks to the loan portfolio include general economic trends as well as conditions affecting individual borrowers, the allowance is an estimate. The Company is committed to determining, on an ongoing basis, the adequacy of its allowance for loan losses. The Company applies historical loss rates to various pools of loans based on risk rating classifications. In addition, the adequacy of the allowance is further evaluated by applying estimates of loss that could be attributable to any one of the following eight qualitative factors:

      1)       Changes in national and local economic conditions, including the condition of various market segments;
2) Changes in the value of underlying collateral;
3) Changes in volume of classified assets, measured as a percentage of capital;
4) Changes in volume of delinquent loans;
5) The existence and effect of any concentrations of credit and changes in the level of such concentrations;
6) Changes in lending policies and procedures, including underwriting standards;
7) Changes in the experience, ability and depth of lending management and staff; and
8) Changes in the level of policy exceptions.

As discussed earlier, the Company utilizes a loss migration model. Migration analysis uses loan level attributes to track the movement of loans through various risk classifications in order to estimate the percentage of losses likely in the portfolio.

The relationship of the allowance for loan losses to total loans at September 30, 2018, December 31, 2017, and September 30, 2017 appears below (dollars in thousands):

      September 30,       December 31,       September 30,
2018 2017 2017
Loans held for investment at period-end $      527,327 $      528,784 $      501,024
Allowance for loan losses $ 4,678 $ 4,043 $ 3,824
Allowance as a percent of period-end loans 0.89 % 0.76 % 0.76 %

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Provisions for loan losses totaling $890 thousand and $213 thousand were recorded in the first nine months of 2018 and 2017, respectively. The following is a summary of the changes in the allowance for loan losses for the nine months ended September 30, 2018 and September 30, 2017 (dollars in thousands):

      2018       2017
Allowance for loan losses, January 1 $      4,043 $      3,688
Charge-offs (316 ) (111 )
Recoveries 61 34
Provision for loan losses 890 213
Allowance for loan losses, September 30 $ 4,678 $ 3,824

For additional insight into management’s approach and methodology in estimating the allowance for loan losses, please refer to the earlier discussion of “Allowance for Loan Losses” in Note 4 of the Notes to Consolidated Financial Statements. In addition, Note 4 includes details regarding the rollforward of the allowance by loan portfolio segments. The rollforward tables indicate the activity for loans that are charged-off, amounts received from borrowers as recoveries of previously charged-off loan balances, and the allocation by loan portfolio segment of the provision made during the period. The events that can positively impact the amount of allowance in a given loan segment include any one or all of the following: the recovery of a previously charged-off loan balance; the decline in the amount of classified or delinquent loans in a loan segment from the previous period, which most commonly occurs when these loans are repaid or are foreclosed; or when there are improvements in the ratios used to estimate the probability of loan losses. Improvements to the ratios could include lower historical loss rates, improvements to any of the qualitative factors mentioned above, or reduced loss expectations for individually-classified loans.

Management reviews the Allowance for Loan Losses on a quarterly basis to ensure it is adequate based upon the calculated potential losses inherent in the portfolio. Management believes the allowance for loan losses was adequately provided for as of September 30, 2018.

Premises and equipment

The Company’s premises and equipment, net of depreciation, as of September 30, 2018 totaled $7.2 million compared to $7.4 million as of December 31, 2017 and September 30, 2017. Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed by the straight-line method based on the estimated useful lives of assets. Expenditures for repairs and maintenance are charged to expense as incurred. The costs of major renewals and betterments are capitalized and depreciated over their estimated useful lives. Upon disposition, assets and related accumulated depreciation are removed from the books, and any resulting gain or loss is charged to income.

As of September 30, 2018, the Company and its subsidiaries occupied five full-service banking facilities in the cities of Charlottesville and Winchester, as well as the county of Albemarle in Virginia. The Bank closed its Orange, Virginia office effective April 13, 2018; expanded messenger service continues to be available to the customers within and surrounding Orange, Virginia.

The multi-story office building at 404 People Place, Charlottesville, Virginia, located in Albemarle County, also serves as the Company’s corporate headquarters and operations center, as well as the principal offices of VNB Wealth.

Both the Arlington Boulevard facility in Charlottesville and the People Place facility also contain office space that is currently under lease to tenants.

Deposits

Depository accounts represent the Company’s primary source of funds and are comprised of demand deposits, interest-bearing checking, money market, and savings accounts as well as time deposits. These deposits have been provided predominantly by individuals, businesses and charitable organizations in the Charlottesville/Albemarle area, the Orange County area, and the Winchester area.

Total deposits as of September 30, 2018 were $538.5 million, down $4.5 million compared to the balances of $543.0 million at December 31, 2017, yet up $31.2 million compared to the $507.3 million total as of September 30, 2017.

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Deposit accounts
(dollars in thousands)       September 30, 2018       December 31, 2017       September 30, 2017
% of Total       % of Total             % of Total
Balance       Deposits Balance Deposits Balance Deposits
No cost and low cost deposits:
Noninterest demand deposits $      170,623 31.7 % $      193,081 35.6 % $      166,544       32.8 %
Interest checking accounts 87,418 16.2 % 102,583 18.9 % 98,528 19.4 %
Money market and savings deposit accounts 153,271 28.5 % 138,065 25.4 % 128,149 25.3 %
 
Total noninterest and low cost deposit accounts 411,312 76.4 % 433,729 79.9 % 393,221 77.5 %
 
Time deposit accounts:
Certificates of deposit 84,164 15.6 % 76,688 14.1 % 97,273 19.2 %
CDARS deposits 43,026 8.0 % 32,545 6.0 % 16,776 3.3 %
Total certificates of deposit and other time deposits 127,190 23.6 % 109,233 20.1 % 114,049 22.5 %
 
Total deposit account balances $ 538,502          100.0 % $ 542,962     100.0 % $ 507,270 100.0 %

Noninterest-bearing demand deposits on September 30, 2018 were $170.6 million, representing 31.7% of total deposits. Interest-bearing transaction, money market, and savings accounts totaled $240.7 million, and represented 44.7% of total deposits at September 30, 2018. Collectively, noninterest-bearing and interest-bearing transaction and money market accounts represented 76.4% of total deposit accounts at September 30, 2018. These account types are an excellent source of low-cost funding for the Company.

The remaining 23.6% of total deposits consisted of certificates of deposit and other time deposit accounts totaling $127.2 million at September 30, 2018. Included in this deposit total are Certificate of Deposit Account Registry Service CDs, known as CDARSTM, whereby depositors can obtain FDIC deposit insurance on account balances of up to $50 million. CDARS deposits totaled $43.0 million as of September 30, 2018; of which $27.7 million were reciprocal balances for the Bank’s customers and $15.3 million were brokered deposits.

The Company implemented insured cash sweep (“ICS”) deposit products during the quarter. ICS deposit balances of $5.9 million and $10.6 million are included in the interest checking accounts and the money market and savings deposit accounts balances, respectively, in the table above.

Repurchase agreements and other borrowings

Short-term borrowings, consisting primarily of repurchase agreements, Federal Home Loan Bank (FHLB) Advances, and federal funds purchased, are additional sources of funds for the Company. The level of these borrowings is determined by various factors, including customer demand and the Company's ability to earn a favorable spread on the funds obtained.

Repurchase agreements, also referred to as securities sold under agreement to repurchase, are available to non-individual accountholders on an overnight term through the Company’s investment sweep product. Under the agreements to repurchase, invested funds are fully collateralized by security instruments that are pledged on behalf of customers utilizing this product. Total balances in repurchase agreements as of September 30, 2018 were $7.2 million, compared to $19.1 million at December 31, 2017 and $12.0 million as of September 30, 2017. The decrease in the balances in repurchase agreements is the result of the migration of certain customer balances from repurchase agreements to the new ICS deposit products.

The Company has a collateral dependent line of credit with the FHLB of Atlanta. As of September 30, 2018, December 31, 2017 and September 30, 2017, the Company had outstanding balances of $10.0 million and $15.0 million and $25.0 million, respectively, from FHLB advances.

Additional borrowing arrangements maintained by the Bank include formal federal funds lines with four major regional correspondent banks. The Company no outstanding balances in overnight federal funds purchased as of September 30, 2018, December 31, 2017 or September 30, 2017.

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Shareholders' equity and regulatory capital ratios

The following table displays the changes in shareholders' equity for the Company from December 31, 2017 to September 30, 2018 (dollars in thousands):

Equity, December 31, 2017       $      65,105
Net income 6,788
Other comprehensive loss (1,070 )
Cash dividends declared (2,008 )
Stock options exercised 268
Equity increase due to expensing of stock options 41
Equity, September 30, 2018 $ 69,124

The Basel III regulatory capital rules effective January 1, 2015 required the Company and its subsidiaries to comply with the following new minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.50% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6% of risk-weighted assets (increased from the prior requirement of 4.00%); (iii) a total capital ratio of 8.00% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.00% of total assets (unchanged from the prior requirement). These were the initial capital requirements.

Beginning January 1, 2016 a capital conservation buffer requirement began to be phased in over a four-year period, beginning at 0.625% of risk-weighted assets and increasing annually to 2.50% at January 1, 2019. Therefore, for the calendar year 2018, this 1.875% buffer effectively results in the minimum (i) common equity Tier 1 capital ratio of 6.375% of risk-weighted assets; (ii) Tier 1 capital ratio of 7.875% of risk-weighted assets; and (iii) total capital ratio of 9.875% of risk-weighted assets. The minimum leverage ratio remains at 4.00%. For additional information regarding the new capital requirements, refer to the Supervision and Regulation section, under Item 1. Business, found in the Company’s Form 10-K Report for December 31, 2017.

Using the new capital requirements, the Company’s capital ratios remain well above the levels designated by bank regulators as "well capitalized" at September 30, 2018. Under the current risk-based capital guidelines of federal regulatory authorities, the Company’s common equity Tier 1 capital ratio and Tier 1 capital ratio are both at 13.37% of its risk-weighted assets and are well in excess of the minimum capital requirements of 6.50% and 8.00%, respectively. Additionally, the Company has a total capital ratio of 14.26% of its risk-weighted assets and leverage ratio of 10.93% of total assets, which are both well in excess of the minimum 10.00% and 5.00% level designated by bank regulators under “well capitalized” capital guidelines.

RESULTS OF OPERATIONS

Non-GAAP presentations

The Company, in referring to its net income and net interest income, is referring to income computed in accordance with GAAP, unless otherwise noted. Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations also refer to various calculations that are non-GAAP presentations. They include:

Fully taxable-equivalent (“FTE”) adjustments – Net interest margin and efficiency ratios are presented on an FTE basis, consistent with SEC guidance in Industry Guide 3 which states that tax exempt income may be calculated on a tax equivalent basis. This is a non-GAAP presentation. The FTE basis adjusts for the tax-exempt status of net interest income from certain investments using a federal tax rate of 21% for 2018 and 34% for 2017, where applicable, to increase tax-exempt interest income to a taxable-equivalent basis.
 
Net interest margin – Net interest margin (FTE) is calculated as net interest income, computed on an FTE basis, expressed as a percentage of average earning assets. The Company believes this measure to be the preferred industry measurement of net interest margin and that it enhances comparability of net interest margin among peers in the industry.
 
Efficiency ratio – One of the ratios the Company monitors in its evaluation of operations is the efficiency ratio, which measures the cost to produce one dollar of revenue. The Company computes its efficiency ratio (FTE) by dividing noninterest expense by the sum of net interest income (FTE) and noninterest income. A lower ratio is an indicator of increased operational efficiency. This non-GAAP metric is used to assist investors in understanding how management assesses its ability to generate revenues from its non-funding-related expense base, as well as to align presentation of this financial measure with peers in the industry. The Company believes this measure to be the preferred industry measurement of operational efficiency, which is consistent with Federal Deposit Insurance Corporation (“FDIC”) studies.

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Net interest income is discussed in Management’s Discussion and Analysis on a GAAP basis, unless noted as “FTE”; and the reconcilement below shows the fully taxable-equivalent adjustment to net interest income to aid the reader in understanding the computations of net interest margin and the efficiency ratio on a non-GAAP basis (dollars in thousands):

Reconcilement of Non-GAAP Measures: For the three months ended For the nine months ended
      September 30, 2018       September 30, 2017       September 30, 2018       September 30, 2017
Net interest income $                   5,791 $                  5,483 $                 17,179 $                 15,864
Fully taxable-equivalent adjustment 23 40 69 104
Net interest income (FTE) $ 5,814 $ 5,523 $ 17,248 $ 15,968
 
Efficiency ratio 57.9 % 59.0 % 56.5 % 58.4 %
Impact of FTE adjustment -0.2 % -0.4 % -0.2 % -0.3 %
Efficiency ratio (FTE) 57.7 % 58.6 % 56.3 % 58.1 %
 
Net interest margin 3.78 % 3.67 % 3.79 % 3.56 %
Fully tax-equivalent adjustment 0.02 % 0.03 % 0.02 % 0.02 %
Net interest margin (FTE) 3.80 % 3.70 % 3.81 % 3.58 %

Net income

Net income for the three months ended September 30, 2018 was $2.2 million, a 23.8% increase compared to the $1.7 million reported for the three months ended September 30, 2017. Net income per diluted share was $0.84 for the quarter ended September 30, 2018 compared to $0.68 per diluted share for the same quarter in the prior year, as adjusted to reflect the 5% Stock Dividend. The $415 thousand increase in net income for the third quarter of 2018, when compared to the same period of 2017, was primarily driven by a $308 thousand increase in net interest income, driven by increases in rate and volume of the loan portfolio, along with a $284 thousand decrease in the provision for income taxes. Partially offsetting these reductions to net income was an increase in noninterest expense of $172 thousand.

Net income for the first nine months of 2018 was $6.8 million, a 25.7% increase compared to the $5.4 million reported for the first nine months of 2017. Net income per diluted share was $2.65 for the first nine months of 2018 compared to $2.13 per diluted share for the first nine months of 2017, as adjusted to reflect the 5% Stock Dividend. The $1.4 million increase in net income during the first nine months of 2018, when compared to the same period of 2017, was driven by an increase in net interest income of $1.3 million, by increases in rate and volume of the loan portfolio, along with an increase in noninterest income of $557 thousand, and a decrease in the provision for income taxes of $871 thousand. Partially offsetting these improvements were increases of $677 thousand in the provision for loan losses and $678 thousand in noninterest expenses.

Net interest income

Net interest income (FTE) for the three months ended September 30, 2018 was $5.8 million, a 5.3% increase compared to net interest income of $5.5 million for the three months ended September 30, 2017. Net interest income was positively impacted by an increase in average gross loan balances of $35.9 million. In addition, these loans earned a yield that was 35 basis points higher in the third quarter of 2018 as compared to the third quarter of 2017, rising from 4.27% to 4.62% for the periods noted.

Net interest income (FTE) for the nine months ended September 30, 2018 was $17.2 million, an 8.0% increase compared to net interest income of $16.0 million for the nine months ended September 30, 2017. Net interest income was positively impacted by an increase in average gross loan balances of $39.9 million. In addition, these loans earned a yield that was 29 basis points higher in the first nine months of 2018 compared to the first nine months of 2017, rising from 4.22% to 4.51% for the periods noted.

Net interest margin (FTE) is the ratio of net interest income (FTE) to average earning assets for the period. The level of interest rates, together with the volume and mix of earning assets and interest-bearing liabilities, impact net interest income (FTE) and net interest margin (FTE). The net interest margin (FTE) of 3.80% for the quarter ended September 30, 2018 was ten basis points higher than the 3.70% for the quarter ended September 30, 2017. The net interest margin (FTE) of 3.81% for the nine months ended September 30, 2018 was 23 basis points higher than the 3.58% for the nine months ended September 30, 2017. Refer to the Reconcilement of Non-GAAP Measures table within the Non-GAAP presentations section for a reconcilement of GAAP to non-GAAP net interest margin.

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Total interest income (FTE) for the three months ended September 30, 2018 was $815 thousand higher than the same period in the prior year, aiding in the year-to-date increase in net interest income (FTE). The increased yield on loans was the major contributor to the increased interest income. This shift resulted in an earning asset yield, as computed on a tax-equivalent basis, of 4.35% on average earning asset balances of $607.7 million for the three months ended September 30, 2018. The earning asset yield, as computed on a tax-equivalent basis, was 3.92% on average earning asset balances of $591.9 million for the three months ended September 30, 2017.

Total interest income (FTE) for the nine months ended September 30, 2018 was $2.3 million higher than the same period in the prior year, contributing to the year-to-date increase in net interest income (FTE). The increased loan volume was the major contributor to the increased interest income. This shift resulted in an earning asset yield, as computed on a tax-equivalent basis, of 4.24% on average earning asset balances of $605.8 million for the nine months ended September 30, 2018. The earning asset yield, as computed on a tax-equivalent basis, was 3.79% on average earning asset balances of $596.2 million for the nine months ended September 30, 2017.

Partially offsetting the increased interest income was an increase in interest expense of $524 thousand for the three months ended September 30, 2018 compared to the same period in the prior year. Interest expense increased $1.0 million for the nine months ended September 30, 2018 compared to the same period in the prior year. Interest expense increased due to increased rates paid on deposits to be competitive in the market. Average balances of, and interest rates on, borrowed funds for the first three and nine months of 2018 also increased from the same periods in the prior year. Although interest expense as a percentage of average earning assets increased 23 basis points when comparing third quarter of 2018 to third quarter of 2017, and increased 22 basis points when comparing the first nine months of 2018 to the first nine months of 2017, the Company continues to benefit from its low cost of funds. A table showing the mix of no cost and low cost deposit accounts is shown under “Financial Condition - Deposits” earlier in this report.

The following tables detail the average balance sheet, including an analysis of net interest income (FTE) for earning assets and interest bearing liabilities, for the three and nine months ended September 30, 2018 and 2017. These tables also include a rate/volume analysis for these same periods (dollars in thousands).

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Consolidated Average Balance Sheet And Analysis of Net Interest Income

For the three months ended
September 30, 2018 September 30, 2017 Change in Interest Income/Expense
Interest Average Interest Average Total
Average Income/ Yield/ Average Income/ Yield/ Change Due to: 4 Increase/
(dollars in thousands)    Balance    Expense    Cost    Balance    Expense    Cost    Volume    Rate    (Decrease)
ASSETS
Interest Earning Assets:
Securities
Taxable Securities $      52,765 $      308       2.33 % $      71,208 $      351       1.97 % $      (101 ) $      58 $      (43 )
Tax Exempt Securities 1   13,195 108 3.27 % 13,557 118 3.48 % (3 ) (7 ) (10 )
Total Securities 1 65,960 416 2.52 % 84,765 469 2.21 % (104 ) 51 (53 )
Total Loans 532,876 6,201 4.62 % 496,983 5,348 4.27 % 401 452 853
Fed Funds Sold 8,904 46 2.05 % 9,698 30 1.23 % (3 ) 19 16
Other Interest Bearing Deposits - - - 462 1 0.86 % (1 ) - (1 )
Total Earning Assets 607,740 6,663 4.35 % 591,908 5,848 3.92 % 293 522 815
Less: Allowance for Loan Losses (4,702 ) (3,721 )
Total Non-Earning Assets 37,983 36,502
Total Assets