Note 11. Fair Value Measurements

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurements and Disclosures” topics of FASB ASU 2010-06, FASB ASU 2011-04, and FASB ASU 2016-01, the fair value of a financial instrument is the price that would be received in the sale of an asset or transfer of a liability (an exit price) in the principal or most advantageous market for the asset or 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 estimate 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 the principal or most advantageous market 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 can be a reasonable point within a range that is most representative of fair value under current market conditions.

In estimating the fair value of assets and liabilities, the Company relies mainly on two sources. The first source is the Company’s bond accounting service provider, which uses a model to determine the fair value of securities. Securities are priced based on an evaluation of observable market data, including benchmark yield curves, reported trades, broker/dealer quotes, and issuer spreads. Pricing is also impacted by credit information about the issuer, perceived market movements, and current news events impacting the individual sectors. The second source is a third party vendor the Company utilizes to provide fair value exit pricing for loans and interest bearing deposits in accordance with guidance.

In accordance with ASC 820, “Fair Value Measurements and Disclosures,” the Company groups its financial assets and financial liabilities generally measured at fair value into 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.

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Level 1: Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.

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Level 2: Valuation is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on 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 for substantially the full term of the asset or liability.

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Level 3: Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires significant management judgment or estimation.

An instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS

Debt securities with readily determinable fair values that are classified as “available-for-sale” are recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. 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). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s available-for-sale securities are considered to be Level 2 securities.

The following tables present the balances of certain assets measured at fair value on a recurring basis as of the dates indicated:

			Fair Value Measurements at June 30, 2019 Using
(dollars in thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities
U.S. Treasury securities	$	12,480	$	-	$	12,480	$	-
Obligations of U.S. Government agencies		11,572		-		11,572		-
Obligations of state and political subdivisions		42,132		-		42,132		-
Mortgage-backed securities		72,173		-		72,173		-
Money market investments		3,484		-		3,484		-
Corporate bonds and other securities		3,612		-		3,612		-
Total available-for-sale securities	$	145,453	$	-	$	145,453	$	-

			Fair Value Measurements at December 31, 2018 Using
(dollars in thousands)	Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities
U.S. Treasury securities	$	12,328	$	-	$	12,328	$	-
Obligations of U.S. Government agencies		10,714		-		10,714		-
Obligations of state and political subdivisions		48,837		-		48,837		-
Mortgage-backed securities		71,191		-		71,191		-
Money market investments		1,897		-		1,897		-
Corporate bonds and other securities		3,280		-		3,280		-
Total available-for-sale securities	$	148,247	$	-	$	148,247	$	-

ASSETS MEASURED AT FAIR VALUE ON A NONRECURRING BASIS

Under certain circumstances, adjustments are made to the fair value for assets and liabilities although they are not measured at fair value on an ongoing basis.

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 all amounts when due from the borrower in accordance with the contractual terms of the loan agreement. The measurement of fair value and loss associated with impaired loans can be based on the observable market price of the loan, the fair value of the collateral securing the loan, or the present value of the loan’s expected future cash flows, discounted at the loan’s effective interest rate. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable, with the vast majority of the collateral in real estate.

The value of real estate collateral is determined utilizing an income, market, or cost valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company. In the case of loans with lower balances, the Company may obtain a real estate evaluation instead of an appraisal. Evaluations utilize many of the same techniques as appraisals, and are typically performed by independent appraisers. Once received, appraisals and evaluations are reviewed by trained staff independent of the lending function to verify consistency and reasonability. Appraisals and evaluations are based on significant unobservable inputs, including but not limited to: adjustments made to comparable properties, judgments about the condition of the subject property, the availability and suitability of comparable properties, capitalization rates, projected income of the subject or comparable properties, vacancy rates, projected depreciation rates, and the state of the local and regional economy. The Company may also elect to make additional reductions in the collateral value based on management’s best judgment, which represents another source of unobservable inputs. Because of the subjective nature of collateral valuation, impaired loans are considered Level 3.

Impaired loans may be secured by collateral other than real estate. 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 using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). If a loan is not collateral-dependent, its impairment may be measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate. Because the loan is discounted at its effective rate of interest, rather than at a market rate, the loan is not considered to be held at fair value and is not included in the tables below. Collateral-dependent 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 part of the provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned (OREO)

Loans are transferred to OREO when the collateral securing them is foreclosed on. The measurement of gain or loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. If there is a contract for the sale of a property, and management reasonably believes the transaction will be consummated in accordance with the terms of the contract, fair value is based on the sale price in that contract (Level 1). If management has recent information about the sale of identical properties, such as when selling multiple condominium units on the same property, the remaining units would be valued based on the observed market data (Level 2). Lacking either a contract or such recent data, management would obtain an appraisal or evaluation of the value of the collateral as discussed above under Impaired Loans (Level 3). After the asset has been booked, a new appraisal or evaluation is obtained when management has reason to believe the fair value of the property may have changed and no later than two years after the last appraisal or evaluation was received. Any fair value adjustments to OREO below the original book value are recorded in the period incurred and expensed against current earnings.

Loans Held For Sale

Loans held for sale are carried at the lower of cost or fair value. These loans currently consist of residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). Gains and losses on the sale of loans are reported on a separate line item on the Company’s Consolidated Statements of Income.

The following table presents the assets carried in the consolidated balance sheets for which a nonrecurring change in fair value has been recorded. Assets are shown by class of loan and by level in the fair value hierarchy, as of the dates indicated. Certain impaired loans are valued by the present value of the loan’s expected future cash flows, discounted at the loan’s effective interest rate rather than at a market rate. These loans are not carried in the consolidated balance sheets at fair value and, as such, are not included in the tables below.

			Carrying Value at June 30, 2019 Using
(dollars in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans
Mortgage loans on real estate:
Residential 1-4 family	$	45	$	-	$	-	$	45
Commercial		1,772		-		-		1,772
Construction		74		-		-		74
Total mortgage loans on real estate	$	1,891	$	-	$	-	$	1,891
Commercial loans		3		-		-		3
Total	$	1,894	$	-	$	-	$	1,894

Loans
Loans held for sale	$	754	$	-	$	754	$	-

			Carrying Value at December 31, 2018 Using
(dollars in thousands)	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans
Mortgage loans on real estate:
Residential 1-4 family	$	188	$	-	$	-	$	188
Construction		74		-		-		74
Equity lines of credit		229		-		-		229
Total mortgage loans on real estate		491		-		-		491
Total	$	491	$	-	$	-	$	491

Loans
Loans held for sale	$	479	$	-	$	479	$	-

Other real estate owned
Construction	$	83	$	-	$	-	$	83
Total	$	83	$	-	$	-	$	83

The following tables display quantitative information about Level 3 Fair Value Measurements as of the dates indicated:

			Quantitative Information About Level 3 Fair Value Measurements
(dollars in thousands)	Fair Value at June 30, 2019		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Impaired loans
Residential 1-4 family real estate	$	45	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%
Commercial real estate	$	1,772	Market comparables	Selling costs		6.00	%
				Liquidation discount		35.00	%
Construction	$	74	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%
Commercial loans	$	3	Market comparables	Selling costs		0.00% - 7.25% (6.04	%)
				Liquidation discount		0.00% - 4.00% (3.33	%)

			Quantitative Information About Level 3 Fair Value Measurements
(dollars in thousands)	Fair Value at December 31, 2018		Valuation Techniques	Unobservable Input	Range (Weighted Average)
Impaired loans
Residential 1-4 family real estate	$	188	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%
Construction	$	74	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%
Equity lines of credit	$	229	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%

Other real estate owned
Construction	$	83	Market comparables	Selling costs		7.25	%
				Liquidation discount		4.00	%

The estimated fair values, and related carrying or notional amounts, of the Company’s financial instruments as of the dates indicated are as follows:

			Fair Value Measurements at June 30, 2019 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Cash and cash equivalents	$	50,602	$	50,602	$	-	$	-
Securities available-for-sale		145,453		-		145,453		-
Restricted securities		3,479		-		3,479		-
Loans held for sale		754		-		754		-
Loans, net of allowances for loan losses		750,421		-		-		741,154
Bank owned life insurance		27,153		-		27,153		-
Accrued interest receivable		3,223		-		3,223		-

Liabilities
Deposits	$	847,784	$	-	$	851,342	$	-
Overnight repurchase agreements		18,011		-		18,011		-
Federal Home Loan Bank advances		50,000		-		50,347		-
Other borrowings		2,250		-		2,250		-
Accrued interest payable		651		-		651		-

			Fair Value Measurements at December 31, 2018 Using
(dollars in thousands)	Carrying Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets
Cash and cash equivalents	$	42,217	$	42,217	$	-	$	-
Securities available-for-sale		148,247		-		148,247		-
Restricted securities		3,853		-		3,853		-
Loans held for sale		479		-		479		-
Loans, net of allowances for loan losses		763,898		-		-		749,848
Bank owned life insurance		26,763		-		26,763		-
Accrued interest receivable		3,095		-		3,095		-

Liabilities
Deposits	$	843,144	$	-	$	843,818	$	-
Overnight repurchase agreements		25,775		-		25,775		-
Federal Home Loan Bank advances		60,000		-		59,975		-
Other borrowings		2,550		-		2,550		-
Accrued interest payable		594		-		594		-