Fair Value

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

Level 1 – Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2 – Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 – Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

Investment Securities: The Company uses a third party service to estimate fair value on available for sale securities on a monthly basis. ASU 2016-01, which was adopted by the Company as of January 1, 2018, requires the use of exit price notion when measuring the fair value of financial instruments for disclosure purposes. The Company’s service provider is considered a leading evaluation pricing service for U.S. domestic fixed income securities and complies fully with ASU 2016-01’s exit pricing requirements. They subscribe to multiple third-party pricing vendors, and supplement that information with matrix pricing methods. The fair values for investment securities, which consist of equity securities that are recorded at fair market value to comply with ASU 2016-01, are determined by quoted market prices in active markets, if available (Level 1). The equity securities change in fair market value is recorded in the income statements. For securities where quoted prices are not available, fair values are calculated based on quoted prices for similar assets in active markets, quoted prices for similar assets in markets that are not active or inputs other than quoted prices, which provide a reasonable basis for fair value determination. Such inputs may include interest rates and yield curves, volatilities, prepayment speeds, credit risks and default rates. Inputs used are derived principally from observable market data (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). The fair values of Level 3 investment securities are determined by using unobservable inputs to measure fair value of assets for which there is little, if any market activity at the measurement date, using reasonable inputs and assumptions based on the best information at the time, to the extent that inputs are available without undue cost and effort. For the period ended September 30, 2018 the fair value of Level 3 investment securities was immaterial.

Derivative Instruments: The fair values of derivative instruments are based on valuation models using observable market data as of the measurement date (Level 2).

Impaired Loans: At the time loans are considered impaired, collateral dependent impaired loans are valued at the lower of cost or fair value and non-collateral dependent loans are valued based on discounted cash flows. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair values are commonly based on recent real estate appraisals. These appraisals may use a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial and commercial real estate properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Appraisal Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what adjustments should be made to appraisals to arrive at fair value.

Assets measured at fair value on a recurring basis are summarized below:

	Fair Value Measurements at September 30, 2018 Using:
(In Thousands of Dollars)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Investment securities available-for sale
U.S. Treasury and U.S. government sponsored entities	$	6,383	$	0	$	6,383	$	0
State and political subdivisions		201,275		0		201,275		0
Corporate bonds		1,183		0		1,183		0
Mortgage-backed securities-residential		147,427		0		147,421		6
Collateralized mortgage obligations		21,301		0		21,301		0
Small Business Administration		12,427		0		12,427		0
Equity securities		427		427		0		0
Other investments measured at net asset value		6,465	n/a		n/a		n/a
Total investment securities	$	396,888	$	427	$	389,990	$	6
Loan yield maintenance provisions	$	1,167	$	0	$	1,167	$	0
Financial Liabilities
Interest rate swaps	$	1,167	$	0	$	1,167	$	0

	Fair Value Measurements at December 31, 2017 Using:
(In Thousands of Dollars)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Investment securities available-for sale
U.S. Treasury and U.S. government sponsored entities	$	8,917	$	0	$	8,917	$	0
State and political subdivisions		191,003		0		191,003		0
Corporate bonds		1,234		0		1,234		0
Mortgage-backed securities-residential		160,450		0		160,442		8
Collateralized mortgage obligations		17,121		0		17,121		0
Small Business Administration		14,212		0		14,212		0
Equity securities		394		394		0		0
Other investments measured at net asset value		5,185	n/a		n/a		n/a
Total investment securities	$	398,516	$	394	$	392,929	$	8
Loan yield maintenance provisions	$	653	$	0	$	653	$	0
Financial Liabilities
Interest rate swaps	$	653	$	0	$	653	$	0

There were no significant transfers between Level 1 and Level 2 during the three and nine month periods ended September 30, 2018 and 2017. For additional information related to yield maintenance provisions and interest rate swaps see Interest – Rate Swaps note.

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3):

	Investment Securities Available-for-sale (Level 3)
	Three Months ended September 30,						Nine Months ended September 30,
(In Thousands of Dollars)	2018			2017			2018			2017
Beginning Balance	$	7		$	10		$	8		$	12
Transfers from level 2		0			0			0			0
Repayments, calls and maturities		(1	)		(1	)		(2	)		(3	)
Ending Balance	$	6		$	9		$	6		$	9

Assets measured at fair value on a non-recurring basis are summarized below:

	Fair Value Measurements at September 30, 2018 Using:
(In Thousands of Dollars)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
Impaired loans
Commercial real estate
Farmland	$	251	$	0	$	0	$	251
Commercial
Commercial and industrial		10		0		0		10
1–4 family residential		1,346		0		0		1,346
Consumer		15		0		0		15

	Fair Value Measurements at December 31, 2017 Using:
(In Thousands of Dollars)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Financial Assets
1–4 family residential	$	740	$	0	$	0	$	740
Consumer		2		0		0		2

Impaired loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $1.9 million with a valuation allowance of $267 thousand at September 30, 2018, resulting in $94 thousand and $222 thousand in additional provision for loan losses for the three and nine months period ending September 30, 2018. At December 31, 2017, impaired loans had a principal balance of $851 thousand, with a valuation allowance of $109 thousand. Loans measured at fair value at September 30, 2017 resulted in an additional provision for loan losses of $16 thousand and $173 thousand for the three and nine month period ending September 30, 2017. Excluded from the fair value of impaired loans, at September 30, 2018 and December 31, 2017, discussed above are $707 thousand and $763 thousand of loans classified as troubled debt restructurings and measured using the present value of cash flows, which is not considered an exit price.

Impaired commercial real estate loans, both owner-occupied and non-owner occupied are valued by independent external appraisals. These external appraisals are prepared using the sales comparison approach and income approach valuation techniques. Management makes subsequent unobservable adjustments to the impaired loan appraisals. Impaired loans other than commercial real estate and other real estate owned are not considered material.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at the periods ended September 30, 2018 and December 31, 2017:

September 30, 2018	Fair value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
Impaired loans
Commercial real estate	$	251	Sales Comparison	Adjustment for differences between comparable sales	(22.70%) - 16.16% 9.39%
Commercial		10	Sales Comparison	Adjustment for differences between comparable sales	(18.61%) - 28.25% (7.66%)
Residential		1,346	Sales comparison	Adjustment for differences between comparable sales	(15.76%) - 27.92% 3.03%
Consumer		15	Sales comparison	Adjustment for differences between comparable sales	(12.04%) - 12.04% 0.00%

December 31, 2017	Fair value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
Impaired loans
Residential	$	740	Sales comparison	Adjustment for differences between comparable sales	(15.67%) - 27.92% 0.53%
Consumer		2	Sales comparison	Adjustment for differences between comparable sales	(21.98%) - 21.98% (0.00%)

The carrying amounts and estimated fair values of financial instruments not previously disclosed at September 30, 2018 and December 31, 2017 are as follows:

			Fair Value Measurements at September 30, 2018 Using:
(In Thousands of Dollars)	Carrying Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	75,635	$	19,652	$	55,983	$	0	$	75,635
Restricted stock		11,647	n/a		n/a		n/a		n/a
Loans held for sale		1,428		0		1,471		0		1,471
Loans, net		1,678,155		0		0		1,630,224		1,630,224
Accrued interest receivable		7,377		0		2,321		5,056		7,377
Financial liabilities
Deposits		1,758,711		1,451,980		299,623		0		1,751,603
Short-term borrowings		264,059		0		264,059		0		264,059
Long-term borrowings		6,214		0		5,968		0		5,968
Accrued interest payable		898		69		829		0		898

			Fair Value Measurements at December 31, 2017 Using:
(In Thousands of Dollars)	Carrying Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	57,614	$	17,785	$	39,829	$	0	$	57,614
Restricted stock		10,491	n/a		n/a		n/a		n/a
Loans held for sale		272		0		283		0		283
Loans, net		1,565,066		0		0		1,569,381		1,569,381
Accrued interest receivable		6,669		0		2,255		4,414		6,669
Financial liabilities
Deposits		1,604,719		1,340,814		259,346		0		1,600,160
Short-term borrowings		289,565		0		289,565		0		289,565
Long-term borrowings		6,994		0		6,690		0		6,690
Accrued interest payable		633		46		587		0		633

The methods and assumptions used to estimate fair value, not previously described, are described as follows:

Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments approximate fair values and are classified as either Level 1 or Level 2. The Company has determined that cash on hand and non-interest bearing due from bank accounts are Level 1 whereas interest bearing federal funds sold and other are Level 2.

Restricted Stock: It is not practical to determine the fair value of restricted stock due to restrictions placed on its transferability.

Loans: Fair values of loans, excluding loans held for sale, are estimated as follows: Beginning March 31, 2018 the Company used a third party firm that uses cash flow analysis and current market interest rates along with adjustments for credit, liquidity and option risk to conform to the ASU 2016-01 exit price requirement. At December 31, 2017, management used the discounted cash flow analysis and interest rates being offered for loans with similar terms to borrowers of similar credit quality to estimate fair market value. Impaired loans are valued at the lower of cost or fair value as described previously.

Loans held for sale: The fair value of loans held for sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

Accrued Interest Receivable/Payable: The carrying amounts of accrued interest receivable and payable approximate fair value resulting in a Level 1, Level 2 or Level 3 classification. The classification is the result of the association with securities, loans and deposits.

Deposits: The fair values disclosed for demand deposits – interest and non-interest checking, passbook savings, and money market accounts – are, by definition, equal to the amount payable on demand at the reporting date resulting in a Level 1 classification. The carrying amounts of variable rate certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair value for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Short-term Borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

Long-term Borrowings: The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Off-balance Sheet Instruments: The fair value of commitments is not considered material.