Note 6: Allowance for Loan Losses

The allowance for loan losses (“ALL”) reflects management’s judgment of probable loan losses inherent in the loan portfolio at the balance sheet date. Management uses a disciplined process and methodology to establish the ALL each quarter. To determine the total ALL, the Company estimates the reserves needed for each homogenous segment and class of the loan portfolio, and for any loans analyzed individually for impairment. Depending on the nature of each segment and class, considerations include historical loss experience, adverse situations that may affect a borrower’s ability to repay, credit scores, past due history, estimated value of any underlying collateral, prevailing local and national economic conditions, and internal policies and procedures, including credit risk management and underwriting. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as conditions change.

The ALL consists of specific, general, and unallocated components. The specific component is determined by identifying impaired loans (as described below) then evaluating those meeting certain criteria to calculate the amount of impairment. Impaired loans measured for impairment generally include (1) any loan risk rated Special Mention or worse where the borrower has filed for bankruptcy; and (2) all loans risk rated Substandard or worse with balances of $400 thousand or more; and (3) all loans classified as a troubled debt restructuring (“TDR”). A specific allowance is held when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component of the ALL is the result of the collective evaluation of any loans not identified as impaired or evaluated as impaired and are grouped into segments and classes. Historical loss experience is calculated and applied to each segment or class, as well as adjustments for qualitative factors. Qualitative factors include changes in local and national economic indicators, such as unemployment rates, interest rates, gross domestic product growth, and real estate market trends; the level of past due and nonaccrual loans; risk ratings on individual loans; strength of credit policies and procedures; loan officer experience; borrower credit scores; and other intrinsic risks related to the types and geographic locations of loans. These qualitative adjustments reflect management’s judgment of risks inherent in the segments. An unallocated component is maintained, if needed, to cover uncertainties that could affect management’s estimate of probable losses. Changes in the allowance for loan losses and the related provision expense can materially affect net income.

Loans Evaluated for Impairment

The following table shows loans evaluated for impairment individually and collectively by segment as of the dates stated.

September 30, 2018	Mortgage Loans on Real Estate		Commercial and Industrial		Consumer		Total
Allowance for loan losses applicable to:
Loans individually evaluated for impairment	$	922	$	—	$	131	$	1,053
Loans collectively evaluated for impairment		3,485		1,130		1,619		6,234
Purchased credit-impaired loans		—		—		—		—
Total allowance on loan losses	$	4,407	$	1,130	$	1,750	$	7,287
Loan balances applicable to:
Loans individually evaluated for impairment	$	7,463	$	—	$	131	$	7,594
Loans collectively evaluated for impairment		669,459		144,118		27,732		841,309
Purchased credit-impaired loans		5,399		—		57		5,456
Total loans	$	682,321	$	144,118	$	27,920	$	854,359
December 31, 2017
Allowance for loan losses applicable to:
Loans individually evaluated for impairment	$	861	$	92	$	141	$	1,094
Loans collectively evaluated for impairment		3,003		786		2,887		6,676
Purchased credit-impaired loans		—		—		—		—
Total allowance on loan losses	$	3,864	$	878	$	3,028	$	7,770
Loan balances applicable to:
Loans individually evaluated for impairment	$	8,874	$	92	$	141	$	9,107
Loans collectively evaluated for impairment		595,007		114,001		42,356		751,364
Purchased credit-impaired loans		5,756		—		69		5,825
Total loans	$	609,637	$	114,093	$	42,566	$	766,296

The following tables show an analysis of the change in the ALL by segment for the periods presented.

	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer			Total
For the Three Months Ended September 30, 2018
Beginning Balance	$	4,244		$	944		$	1,925		$	7,113
Charge-offs		(54	)		—			(418	)		(472	)
Recoveries		60			—			77			137
Provision		157			186			166			509
Ending Balance	$	4,407		$	1,130		$	1,750		$	7,287

	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer			Total
For the Three Months Ended September 30, 2017
Beginning Balance	$	3,686		$	456		$	99		$	4,241
Charge-offs		(75	)		—			(366	)		(441	)
Recoveries		10			1			34			45
Provision		216			56			803			1,075
Ending Balance	$	3,837		$	513		$	570		$	4,920

	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer			Total
For the Nine Months Ended September 30, 2018
Beginning Balance	$	3,864		$	878		$	3,028		$	7,770
Charge-offs		(168	)		(116	)		(1,095	)		(1,379	)
Recoveries		103			1			311			415
Provision (recovery)		608			367			(494	)		481
Ending Balance	$	4,407		$	1,130		$	1,750		$	7,287

	Mortgage Loans on Real Estate			Commercial and Industrial			Consumer			Total
For the Nine Months Ended September 30, 2017
Beginning Balance	$	3,318		$	493		$	52		$	3,863
Charge-offs		(348	)		—			(567	)		(915	)
Recoveries		98			2			39			139
Provision		769			18			1,046			1,833
Ending Balance	$	3,837		$	513		$	570		$	4,920

Purchased Credit-Impaired Loans

The following table presents the changes in the accretable yield for PCI loans for the period presented.

	For the Nine Months Ended
	September 30, 2018
Balance as of December 31, 2017	$	1,087
Accretion of acquisition accounting adjustment		(261	)
Reclassifications from nonaccretable balance, net		(56	)
Other changes, net		343
Balance as of September 30, 2018	$	1,113

Internal Risk Rating Grades

All loans in the Company’s loan portfolio, with the exception of purchased consumer loans, are risk rated using loan risk grading software that employs a variety of algorithms based on detailed account characteristics to include borrower’s payment history on a total relationship basis as well as loan to value exposure. For non-homogenous loans, management reviews these resulting grade assignments and makes adjustments to the final grade where appropriate based on an assessment of additional external information that may affect a particular loan. For purchased consumer loans, a loan is rated “substandard” when it is 90 days or more past due; otherwise, the loan is graded “pass”.

Risk rating categories are as follows:

Pass – Borrower is strong or sound and collateral securing the loan, if any, is adequate.

Watch – Borrower exhibits some signs of financial stress but is generally believed to be a satisfactory customer and collateral, if any, may be in excess of 90% of the loan balance.

Special Mention – Adverse trends in the borrower’s financial position are evident and warrant management’s close attention. Any collateral may not be fully adequate to secure the loan balance.

Substandard – A loan in this category has a well-defined weakness in the primary repayment source that jeopardizes the timely collection of the debt. There is a distinct possibility that a loss may result if the weakness is not corrected.

Doubtful – Default has already occurred and it is likely that foreclosure or repossession procedures have begun or will begin in the near future. Weaknesses make collection or liquidation in full, based on currently existing information, highly questionable and improbable.

Loss – Uncollectible and of such little value that continuance as a bankable asset is not warranted.

The following tables show the risk rating of loans as of the dates stated.

September 30, 2018	Construction, Land and Land Development		Farmland		Commercial Mortgages (Non-Owner Occupied)		Commercial Mortgages (Owner Occupied)		Residential First Mortgages		Residential Revolving and Junior Mortgages		Commercial and Industrial		Consumer		Total Loans
Grade:
Pass	$	86,066	$	748	$	166,537	$	75,984	$	281,677	$	37,298	$	137,964	$	9,605	$	795,879
Watch		6,504		—		4,307		4,712		7,809		1,159		4,873		18,105		47,469
Special mention		127		—		—		551		2,048		—		—		133		2,859
Substandard		2,053		—		1,152		1,144		1,732		713		1,281		72		8,147
Doubtful		—		—		—		—		—		—		—		5		5
Total loans	$	94,750	$	748	$	171,996	$	82,391	$	293,266	$	39,170	$	144,118	$	27,920	$	854,359

December 31, 2017	Construction, Land and Land Development		Farmland		Commercial Mortgages (Non-Owner Occupied)		Commercial Mortgages (Owner Occupied)		Residential First Mortgages		Residential Revolving and Junior Mortgages		Commercial and Industrial		Consumer		Total Loans
Grade:
Pass	$	55,949	$	923	$	140,625	$	67,732	$	256,614	$	43,659	$	110,281	$	12,431	$	688,214
Watch		6,690		—		5,931		10,076		8,624		1,376		2,373		29,917		64,987
Special mention		172		—		—		—		205		—		1,347		—		1,724
Substandard		3,231		—		201		2,244		3,922		1,463		92		218		11,371
Doubtful		—		—		—		—		—		—		—		—		—
Total loans	$	66,042	$	923	$	146,757	$	80,052	$	269,365	$	46,498	$	114,093	$	42,566	$	766,296

Impaired Loans

The following table shows the Company’s recorded investment and the borrowers’ unpaid principal balances for impaired loans, excluding PCI loans, with the associated ALL amount, if applicable, as of the dates stated.

	As of September 30, 2018						As of December 31, 2017
	Recorded Investment		Borrowers’ Unpaid Principal Balance		Related Allowance		Recorded Investment		Borrowers’ Unpaid Principal Balance		Related Allowance
With no related allowance:
Construction, land and land development	$	92	$	163	$	—	$	900	$	1,378	$	—
Commercial mortgages (non-owner occupied)		—		—		—		—		—		—
Commercial mortgages (owner occupied)		1,026		1,026		—		1,721		1,971		—
Residential first mortgages		1,507		1,507		—		1,488		1,488		—
Residential revolving and junior mortgages		416		416		—		414		414		—
Commercial and industrial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
Total impaired loans with no related allowance		3,041		3,112		—		4,523		5,251		—
With an allowance recorded:
Construction, land and land development		523		523		290		550		621		137
Commercial mortgages (non-owner occupied)		443		443		18		—		—		—
Commercial mortgages (owner occupied)		931		931		156		547		586		195
Residential first mortgages		2,395		2,395		374		1,914		1,914		367
Residential revolving and junior mortgages		130		130		84		1,340		1,340		162
Commercial and industrial		—		—		—		92		92		92
Consumer		131		131		131		141		141		141
Total impaired loans with allowance recorded		4,553		4,553		1,053		4,584		4,694		1,094
Total impaired loans:
Construction, land and land development		615		686		290		1,450		1,999		137
Commercial mortgages (non-owner occupied)		443		443		18		—		—		—
Commercial mortgages (owner occupied)		1,957		1,957		156		2,268		2,557		195
Residential first mortgages		3,902		3,902		374		3,402		3,402		367
Residential revolving and junior mortgages		546		546		84		1,754		1,754		162
Commercial and industrial		—		—		—		92		92		92
Consumer		131		131		131		141		141		141
Total impaired loans	$	7,594	$	7,665	$	1,053	$	9,107	$	9,945	$	1,094

The following table shows the average recorded investment and interest income recognized for impaired loans, excluding PCI loans, for the periods presented.

	For the Three Months Ended								For the Nine Months Ended
	September 30, 2018				September 30, 2017				September 30, 2018				September 30, 2017
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
With no related allowance:
Construction, land and land development	$	93	$	—	$	367	$	—	$	147	$	1	$	385	$	—
Commercial mortgages (non-owner occupied)		—		—		248		4		—		—		248		11
Commercial mortgages (owner occupied)		1,013		8		1,030		5		985		29		1,102		16
Residential first mortgages		1,472		21		1,425		4		1,282		62		1,439		15
Residential revolving and junior mortgages		416		1		482		5		415		4		485		7
Commercial and industrial		—		—		—		—		—		—		—		—
Consumer		—		3		—		—		—		—		—		—
Total impaired loans with no allowance		2,994		33		3,552		18		2,829		96		3,659		49
With an allowance recorded:
Construction, land and land development		524		8		1,315		15		512		24		1,323		44
Commercial mortgages (non-owner occupied)		445		11		—		—		223		11		—		—
Commercial mortgages (owner occupied)		935		13		1,372		4		945		39		1,381		19
Residential first mortgages		2,394		32		1,928		23		2,277		94		1,937		71
Residential revolving and junior mortgages		130		2		1,389		11		125		7		1,345		38
Commercial and industrial		—		—		92		—		—		—		92		—
Consumer		—		—		—		—		—		8		—		—
Total impaired loans with allowance recorded		4,428		66		6,096		53		4,082		183		6,078		172
Total impaired loans:
Construction, land and land development		617		8		1,682		15		659		25		1,708		44
Commercial mortgages (non-owner occupied)		445		11		248		4		223		11		248		11
Commercial mortgages (owner occupied)		1,948		21		2,402		9		1,930		68		2,483		35
Residential first mortgages		3,866		53		3,353		27		3,559		156		3,376		86
Residential revolving and junior mortgages		546		3		1,871		16		540		11		1,830		45
Commercial and industrial		—		—		92		—		—		—		92		—
Consumer		—		3		—		—		—		8		—		—
Total impaired loans	$	7,422	$	99	$	9,648	$	71	$	6,911	$	279	$	9,737	$	221

The following table presents a reconciliation of nonaccrual loans to impaired loans as of the dates stated.

	September 30, 2018			December 31, 2017
Nonaccrual loans	$	4,204		$	6,496
Nonaccrual loans not individually evaluated for impairment		(2,196	)		(854	)
Nonaccrual impaired loans		2,008			5,642
TDRs on accrual		4,415			2,214
Other impaired loans on accrual		1,171			1,251
Total impaired loans	$	7,594		$	9,107

Troubled Debt Restructuring

For economic or legal reasons related to a borrower’s financial condition, management may grant a concession to a borrower that it would not otherwise consider. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal or an extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risks, the related loan is classified as a troubled debt restructuring. Management strives to identify borrowers in financial difficulty early and may work with them to modify their loan to more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance, and other actions intended to minimize the economic loss to the Company.

Loans modified as TDRs are considered impaired and are individually evaluated for impairment for the ALL. The following table presents, by segment, information related to loans modified as TDRs for the periods presented.

	For the Three Months Ended						For the Three Months Ended
	September 30, 2018						September 30, 2017
	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Residential first mortgages (1)		4	$	1,272	$	1,303		—	$	—	$	—

(1)

Modifications were an extension of the loan terms.

	For the Nine Months Ended						For the Nine Months Ended
	September 30, 2018						September 30, 2017
	Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Loans		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Residential first mortgages (1)		8	$	1,862	$	1,894		—	$	—	$	—

(1)

Modifications were an extension of the loan terms.

No loans designated as TDRs subsequently defaulted in the first nine months of 2018 or 2017.

The following table presents a roll forward of accruing and nonaccruing TDRs for the period presented.

	Accruing			Nonaccruing			Total
Balance as of December 31, 2017	$	1,452		$	2,612		$	4,064
Charge-offs		—			(92	)		(92	)
Payments and other adjustments		(64	)		65			1
New TDR designation		1,192			702			1,894
Release TDR designation		—			—			—
Transfer		1,835			(1,835	)		—
Balance as of September 30, 2018	$	4,415		$	1,452		$	5,867