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. This service provider is considered a leading evaluation pricing service for U.S. domestic fixed income securities. They subscribe to multiple third-party pricing vendors, and supplement that information with matrix pricing methods. The fair values for investment securities are determined by quoted market prices in active markets, if available (Level 1). 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 March 31, 2017 and for the year ended December 31, 2016, 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 March 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	$	5,422	$	0	$	5,422	$	0
State and political subdivisions		165,025		0		165,025		0
Corporate bonds		1,041		0		1,041		0
Mortgage-backed securities-residential		169,178		0		169,167		11
Collateralized mortgage obligations		19,811		0		19,811		0
Small Business Administration		16,241		0		16,241		0
Equity securities		354		354		0		0
Total investment securities	$	377,072	$	354	$	376,707	$	11
Loan yield maintenance provisions	$	629	$	0	$	629	$	0
Financial Liabilities
Interest rate swaps	$	629	$	0	$	629	$	0

	Fair Value Measurements at December 31, 2016 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	$	5,921	$	0	$	5,921	$	0
State and political subdivisions		155,303		0		155,303		0
Corporate bonds		1,339		0		1,339		0
Mortgage-backed securities-residential		169,682		0		169,670		12
Collateralized mortgage obligations		20,693		0		20,693		0
Small Business Administration		16,706		0		16,706		0
Equity securities		351		351		0		0
Total investment securities	$	369,995	$	351	$	369,632	$	12
Loan yield maintenance provisions	$	685	$	0	$	685	$	0
Financial Liabilities
Interest rate swaps	$	685	$	0	$	685	$	0

There were no significant transfers between Level 1 and Level 2 during the three month periods ended March 31, 2017 and 2016. 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):

	Three Months ended March 31,
(In Thousands of Dollars)	2017			2016
Beginning Balance	$	12		$	15
Total unrealized gains or losses:
Included in other comprehensive income		0			0
Repayments, calls and maturities		(1	)		(1	)
Ending Balance	$	11		$	14

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

	Fair Value Measurements at March 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
Impaired loans
Commercial real estate
Owner occupied	$	23	$	0	$	0	$	23
1–4 family residential		139		0		0		139
Consumer		3		0		0		3
Other real estate owned
1–4 family residential		16		0		0		16

	Fair Value Measurements at December 31, 2016 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
Owner occupied	$	23	$	0	$	0	$	23
Farmland		339		0		0		339
Commercial
Agricultural		113		0		0		113
1–4 family residential		77		0		0		77
Consumer		2		0		0		2
Other real estate owned
1–4 family residential		16		0		0		16

Impaired loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $188 thousand with a valuation allowance of $23 thousand at March 31, 2017, resulting in $4 thousand in additional provision for loan losses for the three month period. At December 31, 2016, impaired loans had a principal balance of $727 thousand, with a valuation allowance of $173 thousand. Loans measured at fair value at March 31, 2016 resulted in no additional provision for loan losses for the three month period ending March 31, 2016. Excluded from the fair value of impaired loans, at March 31, 2017 and December 31, 2016, discussed above are $2.0 million 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 March 31, 2017 and December 31, 2016:

March 31, 2017	Fair value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
Impaired loans
Commercial real estate	$	23	Sales Comparison	Adjustment for differences between comparable sales	(24.02%)
Residential		139	Sales comparison	Adjustment for differences between comparable sales	(12.97%) - 14.22% (3.38%)
Consumer		3	Sales comparison	Adjustment for differences between comparable sales	(15.97%) - 15.97% 0.00%
Other Real Estate owned residential		16	Sales comparison	Adjustment for differences between comparable sales	(10.36%) - 17.10% (1.90%)

December 31, 2016	Fair value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)
Impaired loans
Commercial real estate	$	23	Sales comparison	Adjustment for differences between comparable sales	(24.02%)
		339	Quoted price for loan relationship	Offer price	35.77%
Commercial		113	Quoted price for loan relationship	Offer price	34.98%
Residential		77	Sales comparison	Adjustment for differences between comparable sales	(12.97%) - 14.22% (3.38%)
Consumer		2	Sales comparison	Adjustment for differences between comparable sales	(20.00%) - 20.00% (0.00%)
Other Real Estate owned residential		16	Sales comparison	Adjustment for differences between comparable sales	(10.36%) - 17.10% (1.90%)

The carrying amounts and estimated fair values of financial instruments not previously disclosed at March 31, 2017 and December 31, 2016 are as follows:

			Fair Value Measurements at March 31, 2017 Using:
(In Thousands of Dollars)	Carrying Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	61,251	$	19,577	$	41,674	$	0	$	61,251
Restricted stock		9,974	n/a		n/a		n/a		n/a
Loans held for sale		1,098		0		1,128		0		1,128
Loans, net		1,450,142		0		0		1,445,211		1,445,211
Mortgage servicing rights		928		0		928		0		928
Accrued interest receivable		5,797		0		2,032		3,765		5,797
Financial liabilities
Deposits		1,540,220		1,306,295		230,755		0		1,537,050
Short-term borrowings		235,228		0		235,228		0		235,228
Long-term borrowings		9,841		0		9,798		0		9,798
Accrued interest payable		507		35		472		0		507

			Fair Value Measurements at December 31, 2016 Using:
(In Thousands of Dollars)	Carrying Amount		Level 1		Level 2		Level 3		Total
Financial assets
Cash and cash equivalents	$	41,778	$	19,678	$	22,100	$	0	$	41,778
Restricted stock		9,583	n/a		n/a		n/a		n/a
Loans held for sale		355		0		365		0		365
Loans, net		1,416,783		0		0		1,406,951		1,406,951
Mortgage servicing rights		854		0		854		0		854
Accrued interest receivable		5,504		0		1,924		3,580		5,504
Financial liabilities
Deposits		1,524,756		1,289,037		232,410		0		1,521,447
Short-term borrowings		198,460		0		198,460		0		198,460
Long-term borrowings		15,036		0		15,009		0		15,009
Accrued interest payable		507		35		472		0		507

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: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

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.

Loan servicing rights: Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model utilizes interest rate, prepayment speed and default rate assumptions that market participants would use in estimating future net servicing income (Level 2).

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.