Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding, net of deferred loan fees and costs. Interest income is accrued on the principal amount outstanding. Loan origination and commitment fees and related direct costs are deferred and amortized to income over the term of the respective loan and loan commitment period as a yield adjustment.

Loans held-for-sale consists of residential mortgage loans that are carried at the lower of aggregate cost or fair value. Net unrealized losses, if any, are recognized through a valuation allowance charged to income. Gains and losses on residential mortgages held-for-sale are included in non-interest income.

QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates. These loss rates are based on a three year history of charge-offs and are more heavily weighted for recent experience for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:

Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation.

An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent firm reviews risk assessment and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments using information available to them at the time of their examination.

Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the expressed purpose of conducting commercial real estate transactions.

Overdrafts are reclassified as loans and are included in consumer loans above and total loans on the balance sheet. At March 31, 2019 and December 31, 2018, overdrafts were approximately $114,000 and $183,000, respectively.

QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at March 31, 2019, there was a concentration of loans to lessors of residential buildings and dwellings of 15.6% of total loans and to lessors of nonresidential buildings of 18.6% of total loans, compared with 15.8% and 18.1% of total loans, respectively, at December 31, 2018. These concentrations were primarily within the commercial real estate categories.

The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.

Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale of or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.

Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.

The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.

The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.

The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.

The Company employs a ten-grade risk rating system related to the credit quality of commercial loans and loans to state and political subdivisions of which the first six categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.

The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to all loans in the portfolio at the time the loan is originated. Loans with risk ratings of one through five are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of six are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of seven through ten are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Bank’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.

The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of March 31, 2019 and December 31, 2018:

March 31, 2019	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	161,678	$	78	$	3,625	$	—	$	165,381
Construction		54,717		—		—		—		54,717
Secured by commercial real estate		302,758		1,245		9,433		—		313,436
Secured by residential real estate		70,548		—		1,663		—		72,211
State and political subdivisions		47,552		—		—		—		47,552
Total	$	637,253	$	1,323	$	14,721	$	—	$	653,297

December 31, 2018	Pass		Special mention		Substandard		Doubtful		Total
Commercial:
Commercial and industrial	$	155,219	$	82	$	7,151	$	—	$	162,452
Construction		50,135	—		—			—		50,135
Secured by commercial real estate		297,713		1,259		9,618		—		308,590
Secured by residential real estate		66,838		173		1,570		—		68,581
State and political subdivisions		43,737	—		—			—		43,737
Total	$	613,642	$	1,514	$	18,339	$	—	$	633,495

For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of March 31, 2019 and December 31, 2018:

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of March 31, 2019 and December 31, 2018:

March 31, 2019	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	725	$	349	$	1,280	$	2,354	$	163,027	$	165,381
Construction		—		—		—		—		54,717		54,717
Secured by commercial real estate		1,754		—		1,613		3,367		310,069		313,436
Secured by residential real estate		166		—		429		595		71,616		72,211
State and political subdivisions		—		—		—		—		47,552		47,552
Retail:
1-4 family residential mortgages		746		—		465		1,211		66,620		67,831
Home equity loans and lines		55		243		30		328		76,191		76,519
Consumer		72		31		—		103		6,558		6,661
Total	$	3,518	$	623	$	3,817	$	7,958	$	796,350	$	804,308

December 31, 2018	30-59 days past due		60-89 days past due		90 days or more past due		Total past due loans		Current		Total loans receivable
Commercial:
Commercial and industrial	$	94	$	141	$	1,372	$	1,607	$	160,845	$	162,452
Construction		—		—		—		—		50,135		50,135
Secured by commercial real estate		305		1,029		638		1,972		306,618		308,590
Secured by residential real estate		24		352		291		667		67,914		68,581
State and political subdivisions		—		—		—		—		43,737		43,737
Retail:
1-4 family residential mortgages		544		245		476		1,265		66,188		67,453
Home equity loans and lines		82		205		61		348		77,127		77,475
Consumer		23		35		24		82		6,703		6,785
Total	$	1,072	$	2,007	$	2,862	$	5,941	$	779,267	$	785,208

The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of March 31, 2019 and December 31, 2018:

March 31, 2019	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	3,430
Construction		—		—
Secured by commercial real estate		—		1,885
Secured by residential real estate		—		1,209
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		920
Home equity loans and lines		—		130
Consumer		—		132
Total	$	—	$	7,706

December 31, 2018	90 days or more past due (still accruing)		Non-accrual
Commercial:
Commercial and industrial	$	—	$	3,179
Construction		—		—
Secured by commercial real estate		—		1,965
Secured by residential real estate		—		1,102
State and political subdivisions		—		—
Retail:
1-4 family residential mortgages		—		940
Home equity loans and lines		—		166
Consumer		—		126
Total	$	—	$	7,478

Activity in the allowance for loan losses for the three months ended March 31, 2019 and 2018 are as follows:

Three months ended March 31, 2019	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	3,092	$	(16	)	$	—		$	7	$	3,083
Construction		551		51			—			—		602
Secured by commercial real estate		2,824		5			—			—		2,829
Secured by residential real estate		754		(1	)		(31	)		21		743
State and political subdivisions		153		37			—			—		190
Retail:
1-4 family residential mortgages		497		3			—			—		500
Home equity loans and lines		338		18			(16	)		1		341
Consumer		164		28			(35	)		9		166
Unallocated		461		100		N/A			N/A			561
Total	$	8,834	$	225		$	(82	)	$	38	$	9,015

Three months ended March 31, 2018	Balance, beginning of period		Provision for (credit to) loan losses			Charge-offs			Recoveries		Balance, end of period
Commercial:
Commercial and industrial	$	2,711	$	103		$	—		$	15	$	2,829
Construction		563		(6	)		—			—		557
Secured by commercial real estate		2,410		20			—			1		2,431
Secured by residential real estate		816		17			—			2		835
State and political subdivisions		114		7			—			—		121
Retail:
1-4 family residential mortgages		444		68			—			—		512
Home equity loans and lines		357		20			—			4		381
Consumer		57		18			(26	)		12		61
Unallocated		369		(59	)	N/A			N/A			310
Total	$	7,841	$	188		$	(26	)	$	34	$	8,037

As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential impaired loans. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial loans and loans to state and political subdivisions by using either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired or are classified as a troubled debt restructuring.

An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.

For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.

The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible. TDR loans that are in compliance with their modified terms and that yield a market rate may be removed from the TDR status after a period of performance.

Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $2,047,000 and $2,160,000 as of March 31, 2019 and December 31, 2018, respectively. Non-performing TDRs totaled $1,293,000 and $1,317,000 as of March 31, 2019 and December 31, 2018, respectively. All TDRs are included in impaired loans.

The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment.

There was one newly identified TDR during the three months ended March 31, 2019. The TDR concession involved lower monthly payments. As of March 31, 2019 and December 31, 2018, QNB had no commitments to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings. There were no net charge-offs during the three months ended March 31, 2019 and 2018, resulting from loans previously modified as TDRs.

The following tables present loans, by loan class, modified as TDRs during the three months ended March 31, 2019 and 2018. The pre-modification and post-modification outstanding recorded investments disclosed in the tables below, represent carrying amounts immediately prior to the modification and as of the period end indicated.

There were no loans modified as TDRs within 12 months prior to March 31, 2019 and 2018 for which there was a payment default (60 days or more past due) during the three months ended March 31, 2019 and 2018.

The Company has four consumer mortgage loans secured by residential real estate for which foreclosure proceedings are in process at March 31, 2019. The recorded investment is $616,000.

The following tables present the balance in the allowance for loan losses at March 31, 2019 and December 31, 2018 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:

	Allowance for Loan Losses						Loans Receivable
March 31, 2019	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	3,083	$	1,572	$	1,511	$	165,381	$	3,537	$	161,844
Construction		602		—		602		54,717		—		54,717
Secured by commercial real estate		2,829		62		2,767		313,436		5,941		307,495
Secured by residential real estate		743		75		668		72,211		1,833		70,378
State and political subdivisions		190		—		190		47,552		—		47,552
Retail:
1-4 family residential mortgages		500		—		500		67,831		1,247		66,584
Home equity loans and lines		341		—		341		76,519		149		76,370
Consumer		166		—		166		6,661		75		6,586
Unallocated		561	N/A		N/A		N/A		N/A		N/A
Total	$	9,015	$	1,709	$	6,745	$	804,308	$	12,782	$	791,526

	Allowance for Loan Losses						Loans Receivable
December 31, 2018	Balance		Balance related to loans individually evaluated for impairment		Balance related to loans collectively evaluated for impairment		Balance		Balance individually evaluated for impairment		Balance collectively evaluated for impairment
Commercial:
Commercial and industrial	$	3,092	$	1,461	$	1,631	$	162,452	$	7,128	$	155,324
Construction		551		—		551		50,135		—		50,135
Secured by commercial real estate		2,824		101		2,723		308,590		6,083		302,507
Secured by residential real estate		754		97		657		68,581		1,740		66,841
State and political subdivisions		153		—		153		43,737		—		43,737
Retail:
1-4 family residential mortgages		497		—		497		67,453		1,268		66,185
Home equity loans and lines		338		5		333		77,475		186		77,289
Consumer		164		—		164		6,785		77		6,708
Unallocated		461	N/A		N/A		N/A		N/A		N/A
Total	$	8,834	$	1,664	$	6,709	$	785,208	$	16,482	$	768,726

The following table summarize additional information, in regards to impaired loans by loan portfolio class, as of March 31, 2019 and December 31, 2018:

	March 31, 2019						December 31, 2018
	Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance		Recorded investment (after charge-offs)		Unpaid principal balance		Related allowance
With no specific allowance recorded:
Commercial:
Commercial and industrial	$	804	$	1,041			$	4,243	$	4,525
Construction		—		—				—		—
Secured by commercial real estate		4,928		5,530				5,012		5,577
Secured by residential real estate		1,550		1,728				1,023		1,140
Retail:
1-4 family residential mortgages		1,247		1,347				1,268		1,357
Home equity loans and lines		149		274				140		190
Consumer		75		83				77		84
Total	$	8,753	$	10,003			$	11,763	$	12,873

With an allowance recorded:
Commercial:
Commercial and industrial	$	2,733	$	4,015	$	1,572	$	2,885	$	4,128	$	1,461
Construction		—		—		—		—		—		—
Secured by commercial real estate		1,013		1,030		62		1,071		1,095		101
Secured by residential real estate		283		319		75		717		773		97
Retail:
1-4 family residential mortgages		—		—		—		—		—		—
Home equity loans and lines		—		—		—		46		46		5
Consumer		—		—		—		—		—		—
Total	$	4,029	$	5,364	$	1,709	$	4,719	$	6,042	$	1,664

Total:
Commercial:
Commercial and industrial	$	3,537	$	5,056	$	1,572	$	7,128	$	8,653	$	1,461
Construction		—		—		—		—		—		—
Secured by commercial real estate		5,941		6,560		62		6,083		6,672		101
Secured by residential real estate		1,833		2,047		75		1,740		1,913		97
Retail:
1-4 family residential mortgages		1,247		1,347		—		1,268		1,357		—
Home equity loans and lines		149		274		—		186		236		5
Consumer		75		83		—		77		84		—
Total	$	12,782	$	15,367	$	1,709	$	16,482	$	18,915	$	1,664

The following table presents additional information regarding the average recorded investment and interest income recognized on impaired loans:

Three Months Ended March 31,	2019				2018
	Average recorded investment		Interest income recognized		Average recorded investment		Interest income recognized
Commercial:
Commercial and industrial	$	4,298	$	3	$	6,635	$	64
Construction		—		—		—		—
Secured by commercial real estate		6,011		48		3,710		23
Secured by residential real estate		1,749		10		1,728		4
Retail:
1-4 family residential mortgages		1,257		3		1,212		3
Home equity loans and lines		176		—		193		—
Consumer		76		—		84		—
Total	$	13,567	$	64	$	13,562	$	94