Note

Nature of Business and Significant Accounting Policies

Basis of presentation

The acronyms and abbreviations identified below are used in the Notes to the Consolidated Financial Statements, as well as in the other sections of this Form

-K (including appendices). It

may

be helpful to refer back to this page as you read this report.

	Allowance: Allowance for estimated losses on loans/leases		HTM: Held to maturity
	AOCI: Accumulated other comprehensive income (loss)		Iowa Superintendent: Iowa Superintendent of Banking
	AFS: Available for sale		LCR: Liquidity Coverage Ratio
	ASC: Accounting Standards Codification		m2: m2 Lease Funds, LLC
	ASC 805: Business Combination Standard		MD&A: Management's Discussion & Analysis
	ASU: Accounting Standards Update		NIM: Net interest margin
	BHCA: Bank Holding Company Act of 1956		NPA: Nonperforming asset
	BOLI: Bank-owned life insurance		NPL: Nonperforming loan
	Caps: Interest rate cap derivatives		NSFR: Net Stable Funding Ratio
	CFPB: Bureau of Consumer Financial Protection		OREO: Other real estate owned
	Community National: Community National Bancorporation		OTTI: Other-than-temporary impairment
	CNB: Community National Bank		PCAOB: Public Company Accounting Oversight Board
	CRA: Community Reinvestment Act		PCI: Purchased credit impaired
	CRBT: Cedar Rapids Bank & Trust Company		Provision: Provision for loan/lease losses
	CRE: Commercial real estate		PUD LOC: Public Unit Deposit Letter of Credit
	CRE Guidance: Interagency Concentrations in Commercial Real Estate		QCBT: Quad City Bank & Trust Company
	Lending, Sound Risk Management Practices guidance		RB&T: Rockford Bank & Trust Company
	CSB: Community State Bank		ROAA: Return on Average Assets
	C&I: Commercial and industrial		ROACE: Return on Average Common Equity
	Dodd-Frank Act: Dodd-Frank Wall Street Reform and		ROAE: Return on Average Equity
	Consumer Protection Act		SBA: U.S. Small Business Administration
	IDFPR: Illinois Department of Financial & Professional Regulation		SBLF: Small Business Lending Fund
	DGCL: Delaware General Corporation Law		SEC: Securities and Exchange Commission
	DIF: Deposit Insurance Fund		SERPs: Supplemental Executive Retirement Plans
	EPS: Earnings per share		TA: Tangible assets
	Exchange Act: Securities Exchange Act of 1934, as amended		TCE: Tangible common equity
	FASB: Financial Accounting Standards Board		TDRs: Troubled debt restructurings
	FDIC: Federal Deposit Insurance Corporation		TEY: Tax equivalent yield
	Federal Reserve: Board of Governors of the Federal Reserve System		The Company: QCR Holdings, Inc.
	FHLB: Federal Home Loan Bank		Treasury: U.S. Department of the Treasury
	FICO: Financing Corporation		USA Patriot Act: Uniting and Strengthening America by
	FRB: Federal Reserve Bank of Chicago		Providing Appropriate Tools Required to Intercept and
	FTEs: Full-time equivalents		Obstruct Terrorism Act of 2001
	GAAP: Generally Accepted Accounting Principles		USDA: U.S. Department of Agriculture
	Goldman Sachs: Goldman Sachs and Company

Nature of business

QCR Holdings, Inc. is a bank holding company providing bank and bank-related services through its banking subsidiaries, QCBT, CRBT, CSB and RB&T. The Company also engages in direct financing lease contracts through its wholly-owned equity investment by QCBT in

m2,

headquartered in Milwaukee, Wisconsin.

Note

Nature of Business and Significant Accounting Policies (continued)

August

31,

2016,

the Company acquired Community State Bank in Ankeny, Iowa (Des Moines MSA). The financial results of CSB for the period since acquisition are included in this report. See Note

to the Consolidated Financial Statements for additional information.

QCBT is a commercial bank that serves the Iowa and Illinois Quad Cities and adjacent communities. CRBT is a commercial bank that serves Cedar Rapids, Iowa, and adjacent communities including Cedar Falls and Waterloo, Iowa. CSB is a commercial bank that serves Des Moines, Iowa, and adjacent communities. RB&T is a commercial bank that serves Rockford, Illinois, and adjacent communities.

QCBT, CRBT, and CSB are chartered and regulated by the state of Iowa, and RB&T is chartered and regulated by the state of Illinois. All

four

subsidiary banks are insured and subject to regulation by the FDIC. QCBT, CRBT and RB&T are members of and regulated by the Federal Reserve System. CSB has not yet become a member of the Federal Reserve, but plans to apply for membership in early

2017.

The remaining subsidiaries of the Company consist of

five

non-consolidated subsidiaries formed for the issuance of trust preferred securities. See Note

for a listing of these subsidiaries and additional information.

Significant accounting policies:

Accounting estimates

: The preparation of financial statements, in conformity with GAAP, requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance, OTTI of securities, and the fair value of financial instruments.

Principles of consolidation

: The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries, except those

six

subsidiaries formed for the issuance of trust preferred securities which do not meet the criteria for consolidation. See Note

for a detailed listing of these subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.

Note

Nature of Business and Significant Accounting Policies (continued)

Presentation of cash flows

: For purposes of reporting cash flows, cash and due from banks include cash on hand and noninterest bearing amounts due from banks. Cash flows from federal funds sold, interest bearing deposits at financial institutions, loans/leases, deposits, and short-term borrowings are treated as net increases or decreases.

Cash and due from banks

: The subsidiary banks are required by federal banking regulations to maintain certain cash and due from bank reserves. The reserve requirement was approximately

$42,233,000

and

$30,532,000

as of

December

31,

2016

and

2015,

respectively.

Investment securities

: Investment securities held to maturity are those debt securities that the Company has the ability and intent to hold until maturity regardless of changes in market conditions, liquidity needs, or changes in general economic conditions. Such securities are carried at cost adjusted for amortization of premiums and accretion of discounts. If the ability or intent to hold to maturity is not present for certain specified securities, such securities are considered AFS as the Company intends to hold them for an indefinite period of time but not necessarily to maturity. Any decision to sell a security classified as AFS would be based on various factors, including movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other factors. Securities AFS are carried at fair value. Unrealized gains or losses, net of taxes, are reported as increases or decreases in AOCI. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings.

All securities are evaluated to determine whether declines in fair value below their amortized cost are other-than-temporary.

In estimating OTTI losses on AFS debt securities, management considers a number of factors including, but not limited to,

(1)

the length of time and extent to which the fair value has been less than amortized cost,

(2)

the financial condition and near-term prospects of the issuer,

(3)

the current market conditions, and

(4)

the lack of intent of the Company to sell the security prior to recovery and whether it is not more-likely-than-not that it will be required to sell the security prior to recovery.

If the Company lacks the intent to sell the security, and it is not more-likely-than-not the entity will be required to sell the security before recovery of its amortized cost basis, the Company will recognize the credit component of an OTTI of a debt security in earnings and the remaining portion in other comprehensive income. For held to maturity debt securities, the amount of an OTTI recorded in other comprehensive income for the noncredit portion would be amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.

In estimating OTTI losses on AFS equity securities management considers factors

(1),

(2)

and

(3)

above as well as whether the Company lacks the intent to sell the security and the ability to hold the security until its recovery. If the Company (a) intends to sell an impaired equity security and does not expect the fair value of the security to fully recover before the expected time of sale, or (b) does not have the ability to hold the security until its recovery, the security is deemed other-than-temporarily impaired and the impairment is charged to earnings. The Company recognizes an impairment loss through earnings if based upon other factors the loss is deemed to be other-than-temporary even if the decision to sell has not been made.

Loans receivable, held for sale

: Residential real estate loans which are originated and intended for resale in the

secondary

market in the foreseeable future are classified as held for sale. These loans are carried at the lower of cost or estimated market value in the aggregate. As assets specifically acquired for resale, the origination of, disposition of, and gain/loss on these loans are classified as operating activities in the statement of cash flows.

Loans receivable, held for investment

: Loans that management has the intent and ability to hold for the foreseeable future, or until pay-off or maturity occurs, are classified as held for investment. These loans are stated at the amount of unpaid principal adjusted for charge-offs, the allowance, and any deferred fees and/or costs on originated loans. Interest is credited to earnings as earned based on the principal amount outstanding. Deferred direct loan origination fees and/or costs are amortized as an adjustment of the related loan’s yield. As assets held for and used in the production of services, the origination and collection of these loans are classified as investing activities in the statement of cash flows.

The Company discloses allowance for credit losses (also known allowance) and fair value by portfolio segment, and credit quality information, impaired financing receivables, nonaccrual status, and TDRs by class of financing receivable. A portfolio segment is the level at which the Company develops and documents a systematic methodology to determine its allowance for credit losses. A class of financing receivable is a further disaggregation of a portfolio segment based on risk characteristics and the Company’s method for monitoring and assessing credit risk. See the following information and Note

The Company’s portfolio segments are as follows:

●

C&I

●

CRE

●

Residential real estate

●

Installment and other consumer

Direct financing leases are considered a segment within the overall loan/lease portfolio.

The Company’s classes of loans receivable are as follows:

●

C&I

●

Owner-occupied CRE

●

Commercial construction, land development, and other land loans that are not owner-occupied CRE

●

Other non-owner-occupied CRE

●

Residential real estate

●

Installment and other consumer

Direct financing leases are considered a class of financing receivable within the overall loan/lease portfolio. The accounting policies for direct financing leases are disclosed below.

Generally, for all classes of loans receivable, loans are considered past due when contractual payments are delinquent for

days or greater.

For all classes of loans receivable, loans will generally be placed on nonaccrual status when the loan has become

days past due (unless the loan is well secured and in the process of collection); or if any of the following conditions exist:

●

It becomes evident that the borrower will not make payments, or will not or cannot meet the terms for renewal of a matured loan;

●

When full repayment of principal and interest is not expected;

●

When the loan is graded “doubtful”;

●

When the borrower files bankruptcy and an approved plan of reorganization or liquidation is not anticipated in the near future; or

●

When foreclosure action is initiated.

When a loan is placed on nonaccrual status, income recognition is ceased. Previously recorded but uncollected amounts of interest on nonaccrual loans are reversed at the time the loan is placed on nonaccrual status. Generally, cash collected on nonaccrual loans is applied to principal. Should full collection of principal be expected, cash collected on nonaccrual loans can be recognized as interest income.

For all classes of loans receivable, nonaccrual loans

may

be restored to accrual status provided the following criteria are met:

●

The loan is current, and all principal and interest amounts contractually due have been made;

●

All principal and interest amounts contractually due, including past due payments, are reasonably assured of repayment within a reasonable period; and

●

There is a period of minimum repayment performance, as follows, by the borrower in accordance with contractual terms:

Six months of repayment performance for contractual monthly payments, or

One year of repayment performance for contractual quarterly or semi-annual payments.

Direct finance leases receivable, held for investment

: The Company leases machinery and equipment to customers under leases that qualify as direct financing leases for financial reporting and as operating leases for income tax purposes. Under the direct financing method of accounting, the minimum lease payments to be received under the lease contract, together with the estimated unguaranteed residual values (approximately

25%

of the cost of the related equipment), are recorded as lease receivables when the lease is signed and the lease property delivered to the customer. The excess of the minimum lease payments and residual values over the cost of the equipment is recorded as unearned lease income. Unearned lease income is recognized over the term of the lease on a basis that results in an approximate level rate of return on the unrecovered lease investment.

Lease income is recognized on the interest method. Residual value is the estimated fair market value of the equipment on lease at lease termination. In estimating the equipment’s fair value at lease termination, the Company relies on historical experience by equipment type and manufacturer and, where available, valuations by independent appraisers, adjusted for known trends.

The Company’s estimates are reviewed continuously to ensure reasonableness; however, the amounts the Company will ultimately realize could differ from the estimated amounts. If the review results in a lower estimate than had been previously established, a determination is made as to whether the decline in estimated residual value is other-than-temporary. If the decline in estimated unguaranteed residual value is judged to be other-than-temporary, the accounting for the transaction is revised using the changed estimate. The resulting reduction in the investment is recognized as a loss in the period in which the estimate is changed. An upward adjustment of the estimated residual value is not recorded.

The policies for delinquency and nonaccrual for direct financing leases are materially consistent with those described above for all classes of loan receivables.

The Company defers and amortizes fees and certain incremental direct costs over the contractual term of the lease as an adjustment to the yield. These initial direct leasing costs generally approximate

5.5%

of the leased asset’s cost. The unamortized direct costs are recorded as a reduction of unearned lease income.

TDRs

: TDRs exist when the Company, for economic or legal reasons related to the borrower’s/lessee’s financial difficulties, grants a concession (either imposed by court order, law, or agreement between the borrower/lessee and the Company) to the borrower/lessee that it would not otherwise consider. The Company is attempting to maximize its recovery of the balances of the loans/leases through these various concessionary restructurings.

The following criteria, related to granting a concession, together or separately, create a TDR:

●

A modification of terms of a debt such as

one

or a combination of:

The reduction of the stated interest rate.

The extension of the maturity date or dates at a stated interest rate lower than the current market rate for the new debt with similar risk.

The reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement.

The reduction of accrued interest.

●

A transfer from the borrower/lessee to the Company of receivables from

third

parties, real estate, other assets, or an equity position in the borrower to fully or partially satisfy a loan.

●

The issuance or other granting of an equity position to the Company to fully or partially satisfy a debt unless the equity position is granted pursuant to existing terms for converting the debt into an equity position.

Allowance

For all portfolio segments, the allowance is established as losses are estimated to have occurred through a provision that is charged to earnings. Loan/lease losses, for all portfolio segments, are charged against the allowance when management believes the uncollectability of a loan/lease balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

For all portfolio segments, the allowance is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans/leases in light of historical experience, the nature and volume of the loan/lease portfolio, adverse situations that

may

affect the borrower’s/lessee’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

A discussion of the risk characteristics and the allowance by each portfolio segment follows:

For

C&I loans

, the Company focuses on small and mid-sized businesses with primary operations as wholesalers, manufacturers, building contractors, business services companies, other banks, and retailers. The Company provides a wide range of C&I loans, including lines of credit for working capital and operational purposes, and term loans for the acquisition of facilities, equipment and other purposes. Approval is generally based on the following factors:

●

Ability and stability of current management of the borrower;

●

Stable earnings with positive financial trends;

●

Sufficient cash flow to support debt repayment;

●

Earnings projections based on reasonable assumptions;

●

Financial strength of the industry and business; and

●

Value and marketability of collateral.

Collateral for C&I loans generally includes accounts receivable, inventory, equipment and real estate. The Company’s lending policy specifies approved collateral types and corresponding maximum advance percentages. The value of collateral pledged on loans must exceed the loan amount by a margin sufficient to absorb potential erosion of its value in the event of foreclosure and cover the loan amount plus costs incurred to convert it to cash.

The Company’s lending policy specifies maximum term limits for C&I loans. For term loans, the maximum term is generally

years. Generally, term loans range from

years. For lines of credit, the maximum term is typically

365

days.

In addition, the Company often takes personal guarantees or cosigners to help assure repayment. Loans

may

be made on an unsecured basis if warranted by the overall financial condition of the borrower.

CRE

loans

are subject to underwriting standards and processes similar to C&I loans, in addition to those standards and processes specific to real estate loans. Collateral for CRE loans generally includes the underlying real estate and improvements, and

may

include additional assets of the borrower. The Company’s lending policy specifies maximum loan-to-value limits based on the category of CRE (CRE loans on improved property, raw land, land development, and commercial construction). These limits are the same limits established by regulatory authorities.

The Company’s lending policy also includes guidelines for real estate appraisals, including minimum appraisal standards based on certain transactions. In addition, the Company often takes personal guarantees to help assure repayment.

In addition, management tracks the level of owner-occupied CRE loans versus non-owner occupied loans. Owner-occupied loans are generally considered to have less risk. As of

December

31,

2016

and

2015,

approximately

30%

and

35%,

respectively, of the CRE loan portfolio was owner-occupied.

The Company’s lending policy limits non-owner occupied CRE lending to

300%

of total risk-based capital, and limits construction, land development, and other land loans to

100%

of total risk-based capital. Exceeding these limits warrants the use of heightened risk management practices in accordance with regulatory guidelines. As of

December

31,

2016

and

2015,

QCBT, CRBT and RB&T were in compliance with these limits. Although the CSB’s loan portfolio has historically been real estate dominated and its real estate portfolio levels exceed these policy limits, it has established a Credit Risk Committee to routinely monitor its real estate loan portfolio. CSB’s real estate levels, while still elevated at

December

31,

2016,

have declined since

December

31,

2015.

In some instances for all loans/leases, it

may

be appropriate to originate or purchase loans/leases that are exceptions to the guidelines and limits established within the Company’s lending policy described above and below. In general, exceptions to the lending policy do not significantly deviate from the guidelines and limits established within the Company’s lending policy and, if there are exceptions, they are clearly noted as such and specifically identified in loan/lease approval documents.

For

C&I and CRE loans

, the allowance consists of specific and general components.

The specific component relates to loans that are classified as impaired, as defined below. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan.

For C&I loans and all classes of CRE 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 and 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 case-by-case basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

The general component consists of quantitative and qualitative factors and covers non-impaired loans. The quantitative factors are based on historical charge-off experience and expected loss given default derived from the Company’s internal risk rating process. See below for a detailed description of the Company’s internal risk rating scale. The qualitative factors are determined based on an assessment of internal and/or external influences on credit quality that are not fully reflected in the historical loss or risk rating data.

For C&I and CRE loans, the Company utilizes the following internal risk rating scale:

Highest Quality (Pass) – loans of the highest quality with no credit risk, including those fully secured by subsidiary bank certificates of deposit and U.S. government securities.

Superior Quality (Pass) – loans with very strong credit quality. Borrowers have exceptionally strong earnings, liquidity, capital, cash flow coverage, and management ability. Includes loans secured by high quality marketable securities, certificates of deposit from other institutions, and cash value of life insurance. Also includes loans supported by U.S. government, state, or municipal guarantees.

Satisfactory Quality (Pass)

–

loans with satisfactory credit quality. Established borrowers with satisfactory financial condition, including credit quality, earnings, liquidity, capital and cash flow coverage. Management is capable and experienced. Collateral coverage and guarantor support, if applicable, are more than adequate. Includes loans secured by personal assets and business assets, including equipment, accounts receivable, inventory, and real estate.

Fair Quality (Pass)

–

loans with moderate but still acceptable credit quality. The primary repayment source remains adequate; however, management’s ability to maintain consistent profitability is unproven or uncertain. Borrowers exhibit acceptable leverage and liquidity.

May

include new businesses with inexperienced management or unproven performance records in relation to peer, or borrowers operating in highly cyclical or declining industries.

Early Warning (Pass)

–

loans where the borrowers have generally performed as agreed, however unfavorable financial trends exist or are anticipated. Earnings

may

be erratic, with marginal cash flow or declining sales. Borrowers reflect leveraged financial condition and/or marginal liquidity. Management

may

be new and a track record of performance has yet to be developed. Financial information

may

be incomplete, and reliance on

secondary

repayment sources

may

be increasing.

Special Mention – loans where the borrowers exhibit credit weaknesses or unfavorable financial trends requiring close monitoring. Weaknesses and adverse trends are more pronounced than Early Warning loans, and if left uncorrected,

may

jeopardize repayment according to the contractual terms. Currently, no loss of principal or interest is expected. Borrowers in this category have deteriorated to the point that it would be difficult to refinance with another lender. Special Mention should be assigned to borrowers in turnaround situations. This rating is intended as a transitional rating, therefore, it is generally not assigned to a borrower for a period of more than

one

year.

Substandard

–

loans which are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if applicable. These loans have a well-defined weakness or weaknesses which jeopardize repayment according to the contractual terms. There is distinct loss potential if the weaknesses are not corrected. Includes loans with insufficient cash flow coverage which are collateral dependent, other real estate owned, and repossessed assets.

Doubtful

–

loans which have all the weaknesses inherent in a Substandard loan, with the added characteristic that existing weaknesses make full principal collection, on the basis of current facts, conditions and values, highly doubtful. The possibility of loss is extremely high, but because of pending factors, recognition of a loss is deferred until a more exact status can be determined. All doubtful loans will be placed on non-accrual, with all payments, including principal and interest, applied to principal reduction.

The Company has certain loans risk-rated

(substandard), which are not classified as impaired based on the facts of the credit. For these non-impaired and risk-rated

loans, the Company does not follow the same allowance methodology as it does for all other non-impaired, collectively evaluated loans. Rather, the Company performs a more detailed analysis including evaluation of the cash flow and collateral valuations. Based upon this evaluation, an estimate of the probable loss in this portfolio is collectively evaluated under ASC

450

20.

These non-impaired risk-rated

loans exist primarily in the C&I and CRE segments.

For term C&I and CRE loans or credit relationships with aggregate exposure greater than

$1,000,000,

a loan review is required within

months of the most recent credit review. The review is completed in enough detail to, at a minimum, validate the risk rating. Additionally, the review shall include an analysis of debt service requirements, covenant compliance, if applicable, and collateral adequacy. The frequency of the review is generally accelerated for loans with poor risk ratings.

The Company’s Loan Quality area performs a documentation review of a sampling of C&I and CRE loans, the primary purpose of which is to ensure the credit is properly documented and closed in accordance with approval authorities and conditions. A review is also performed by the Company’s Internal Audit Department of a sampling of C&I and CRE loans for proper documentation, according to an approved schedule. Validation of the risk rating is also part of Internal Audit’s review (performed by Internal Loan Review). Additionally, over the past several years, the Company has contracted an independent outside

third

party to review a sampling of C&I and CRE loans. Validation of the risk rating is part of this review as well.

The Company leases machinery and equipment to C&I customers under

direct financing leases

. All lease requests are subject to the credit requirements and criteria as set forth in the lending/leasing policy. In all cases, a formal independent credit analysis of the lessee is performed.

For direct financing leases, the allowance consists of specific and general components.

The specific component relates to leases that are classified as impaired, as defined for commercial loans above. For those leases that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired lease is lower than the carrying value of that lease.

The general component consists of quantitative and qualitative factors and covers nonimpaired leases. The quantitative factors are based on historical charge-off experience for the entire lease portfolio. The qualitative factors are determined based on an assessment of internal and/or external influences on credit quality that are not fully reflected in the historical loss data.

Generally, the Company’s

residential real estate loans

conform to the underwriting requirements of Freddie Mac and Fannie Mae to allow the subsidiary banks to resell loans in the

secondary

market. The subsidiary banks structure most loans that will not conform to those underwriting requirements as adjustable rate mortgages that mature or adjust in

one

five

years or fixed rate mortgages that mature in

years, and then retain these loans in their portfolios. Servicing rights are not presently retained on the loans sold in the

secondary

market. The Company’s lending policy establishes minimum appraisal and other credit guidelines.

The Company provides many types of

installment and other consumer loans

including motor vehicle, home improvement, home equity, signature loans and small personal credit lines. The Company’s lending policy addresses specific credit guidelines by consumer loan type.

For

residential real estate loans, and installment and other consumer loans

, these large groups of smaller balance homogenous loans are collectively evaluated for impairment. The Company applies a quantitative factor based on historical charge-off experience in total for each of these segments. Accordingly, the Company generally does not separately identify individual residential real estate loans, and/or installment or other consumer loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

TDRs are considered impaired loans/leases and are subject to the same allowance methodology as described above for impaired loans/leases by portfolio segment. Once a loan is classified as a TDR, it will remain a TDR until the loan is paid off, charged off, moved to OREO or restructured into a new note without a concession. TDR status

may

also be removed if the TDR was restructured in a prior calendar year, is current, accruing and shows sustained performance.

Credit related financial instruments

: In the ordinary course of business, the Company has entered into commitments to extend credit and standby letters of credit. Such financial instruments are recorded when they are funded.

Transfers of financial assets

: Transfers of financial assets are accounted for as sales only when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when:

(1)

the assets have been isolated from the Company,

(2)

the transferee obtains the right to pledge or exchange the assets it received, and no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a modest benefit to the transferor, and

(3)

the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets. In addition, for transfers of a portion of financial assets (for example, participations of loan receivables), the transfer must meet the definition of a “participating interest” in order to account for the transfer as a sale. Following are the characteristics of a “participating interest”:

●

Pro-rata ownership in an entire financial asset.

●

From the date of the transfer, all cash flows received from entire financial assets are divided proportionately among the participating interest holders in an amount equal to their share of ownership.

●

The rights of each participating interest holder have the same priority, and no participating interest holder’s interest is subordinated to the interest of another participating interest holder. That is, no participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder.

●

No party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset.

BOLI

: BOLI is carried at cash surrender value with increases/decreases reflected as income/expense in the statement of income.

Premises and equipment

: Premises and equipment are stated at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the assets.

Restricted investment securities

: Restricted investment securities represent FHLB and FRB common stock. The stock is carried at cost. These equity securities are “restricted” in that they can only be sold back to the respective institution or another member institution at par. Therefore, they are less liquid than other tradable equity securities. The Company views its investment in restricted stock as a long-term investment. Accordingly, when evaluating for impairment, the value is determined based on the ultimate recovery of the par value, rather than recognizing temporary declines in value. There have been no other-than-temporary write-downs recorded on these securities.

OREO

: Real estate acquired through, or in lieu of, loan foreclosures, is held for sale and initially recorded at fair value less costs to sell, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less costs to sell. Subsequent write-downs to fair value are charged to earnings.

Repossessed assets

: Equipment or other non-real estate property acquired through, or in lieu of foreclosure, is held for sale and initially recorded at fair value less costs to sell.

Goodwill

: The Company recorded goodwill totaling

$3,222,688

from QCBT’s purchase of

80%

August

2005.

The goodwill is not being amortized, but is evaluated at least annually for impairment. An impairment charge is recognized when the calculated fair value of the reporting unit, including goodwill, is less than its carrying amount. Based on the annual analysis completed as of

September

30,

2016,

the Company determined that the goodwill was not impaired. Goodwill totaling

$9,888,225

was also recognized as part of the acquisition of CSB in

2016.

See Note

to the Consolidated Financial Statements for additional information. This goodwill is not being amortized, and will be evaluated annually for impairment in future years.

Core deposit intangible

: The Company recorded a core deposit intangible from the acquisition of CNB. The core deposit intangible was the portion of the acquisition purchase price which represented the value assigned to the existing deposit base at acquisition. The Company also recorded a core deposit intangible from the acquisition of CSB. See Note

to the Consolidated Financial Statements for additional information. The core deposit intangibles have a finite life and are amortized over the estimated useful life of the deposits (estimated to be

ten

years).

Swap transactions

: The Company offers a loan swap program to certain commercial loan customers. Through this program, the Company originates a variable rate loan with the customer. The Company and the swap customer will then enter into a fixed interest rate swap. Lastly, an identical offsetting swap is entered into by the Company with a counterparty. These “back-to-back” swap arrangements are intended to offset each other and allow the Company to book a variable rate loan, while providing the customer with a contract for fixed interest payments. In these arrangements, the Company’s net cash flow is equal to the interest income received from the variable rate loan originated with the customer. These customer swaps are not designated as hedging instruments and are recorded at fair value in other assets and other liabilities. Additionally, the Company receives an upfront fee from the counterparty, dependent upon the pricing that is recognized upon receipt from the counterparty. Swap fee income totaled

$1.7

million,

$1.7

million and

$155

thousand for the years ending

December

31,

2016,

2015

and

2014,

respectively.

Derivatives and hedging activities

: The Company enters into derivative financial instruments as part of its strategy to manage its exposure to changes in interest rates.

Derivative instruments represent contracts between parties that result in

one

party delivering cash to the other party based on a notional amount and an underlying index (such as a rate, security price or price index) as specified in the contract. The amount of cash delivered from

one

party to the other is determined based on the interaction of the notional amount of the contract with the underlying index.

The derivative financial instruments currently used by the Company to manage its exposure to interest rate risk include:

(1)

interest rate lock commitments provided to customers to fund certain mortgage loans to be sold into the

secondary

market (although this type of derivative is negligible); and

(2)

interest rate caps to manage the interest rate risk of certain short-term fixed rate liabilities.

Interest rate caps are valued by the transaction counterparty on a monthly basis and corroborated by a

third

party annually. The company uses the hypothetical derivative method to assess and measure effectiveness in accordance with ASC

815,

Derivatives and Hedging.

Preferred stock

: The Company currently has

250,000

shares of preferred stock authorized, but

none

outstanding as of

December

31,

2016

and

2015.

Should the Company have preferred stock outstanding in the future, dividends declared on those shares would be deducted from net income to arrive at net income available to common stockholders. Net income available to common stockholders would then be used in the earnings per share computations.

Treasury stock

: Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price. When treasury stock is reissued, any difference between the sales proceeds, or fair value when issued for business combinations, and the cost is recognized as a charge or credit to additional paid-in capital. The Company’s treasury stock was retired in

2015.

Stock-based compensation plans:

The Company accounts for stock-based compensation with measurement of compensation cost for all stock-based awards at fair value on the grant date and recognition of compensation over the requisite service period for awards expected to vest.

As discussed in Note

15,

during the years ended

December

31,

2016,

2015,

and

2014,

the Company recognized stock-based compensation expense related to stock option and incentive plans, stock purchase plans, and restricted stock awards of

$947,174,

$941,469,

and

$891,619,

respectively. As required, management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

The Company uses the Black-Scholes option pricing model to estimate the fair value of stock option grants with the following assumptions for the indicated periods:

	2016			2015			2014
Dividend yield	.35%	to	.51%	.37%	to	.46%		.47%
Expected volatility	29.32%	to	29.37%	28.92%	to	29.32%	29.07%	to	29.18%
Risk-free interest rate	1.73%	to	2.18%	1.89%	to	2.37%	2.69%	to	2.82%
Expected life of option grants (years)		6			6			6
Weighted-average grant date fair value		$7.31			$5.11			$5.68

The Company also uses the Black-Scholes option pricing model to estimate the fair value of stock purchase grants with the following assumptions for the indicated periods:

	2016			2015			2014
Dividend yield	.33%	to	.59%	.37%	to	.45%	.46%	to	.47%
Expected volatility	12.70%	to	15.60%	8.81%	to	13.10%	16.96%	to	19.35%
Risk-free interest rate	.39%	to	.57%	.09%	to	.16%	.04%	to	.12%
Expected life of purchase grants (months)	3	to	6	3	to	6	3	to	6
Weighted-average grant date fair value		$3.28			$2.39			$2.37

The fair value is amortized on a straight-line basis over the vesting periods of the grants and will be adjusted for subsequent changes in estimated forfeitures. The expected dividend yield assumption is based on the Company's current expectations about its anticipated dividend policy. Expected volatility is based on historical volatility of the Company's common stock price. The risk-free interest rate for periods within the contractual life of the option or purchase is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life of the option and purchase grants is derived using the “simplified” method and represents the period of time that options and purchases are expected to be outstanding. Historical data is used to estimate forfeitures used in the model. Two separate groups of employees (employees subject to broad based grants, and executive employees and directors) are used.

As of

December

31,

2016,

there was

$828,178

of unrecognized compensation cost related to share based payments, which is expected to be recognized over a weighted average period of

2.07

years.

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company's common stock for the

587,961

options that were in-the-money at

December

31,

2016.

The aggregate intrinsic value at

December

31,

2016

was

$16.7

million on options outstanding and

$11.8

million on options exercisable. During the years ended

December

31,

2016,

2015

and

2014,

the aggregate intrinsic value of options exercised under the Company's stock option plans was

$1,525,902,

$480,354,

and

$173,105,

respectively, and determined as of the date of the option exercise.

Income taxes

: The Company files its tax return on a consolidated basis with its subsidiaries. The entities follow the direct reimbursement method of accounting for income taxes under which income taxes or credits which result from the inclusion of the subsidiaries in the consolidated tax return are paid to or received from the parent company.

Deferred income taxes are provided under the liability method whereby deferred tax assets are recognized for deductible temporary differences and net operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more likely than not recognition threshold are measured as the largest amount of tax benefit that is more than

percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statements of income.

Trust assets

: Trust assets held by the subsidiary banks in a fiduciary, agency, or custodial capacity for their customers, other than cash on deposit at the subsidiary banks, are not included in the accompanying consolidated financial statements since such items are not assets of the subsidiary banks.

Earnings per share

: See Note

for a complete description and calculation of basic and diluted earnings per share.

Reclassifications

: Certain amounts in the prior year financial statements have been reclassified, with no effect on net income, comprehensive income, or stockholders’ equity, to conform with the current period presentation.

New accounting pronouncements:

May

2014,

FASB issued ASU

2014

09,

Revenue from Contracts with Customers

. ASU

2014

implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU

2014

is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU

2014

was originally effective for the Company on

January

2017,

however, FASB issued ASU

2015

which defers the effective date in order to provide additional time for both public and private entities to evaluate the impact. ASU

2014

will now be effective for the Company on

January

2018.

ASU

2014

will not impact interest income recognition; however, it will require the Company to change how it recognizes certain recurring revenue streams within trust and investment management fees, however it is not expected to have a significant impact on the Company’s consolidated financial statements. The Company continues to evaluate the potential impact on other components of noninterest income. At adoption, the Company will adjust beginning retained earnings for the cumulative effect, if that adjustment is deemed material.

January

2016,

FASB issued ASU

2016

01,

Financial Instruments – Overall

. ASU

2016

makes targeted adjustments to GAAP by eliminating the available for sale classification for equity securities and requiring equity investments to be measured at fair value with changes in fair value recognized in net income. The standard also requires public business entities to use the exit price notion when measuring fair value of financial instruments for disclosure purposes. The standard clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. It also requires an entity to present separately (within other comprehensive income) the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments. Additionally, the standard eliminates the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet. ASU

2016

is effective for fiscal years beginning after

December

15,

2017,

including interim periods within those fiscal years. The Company is in the process of analyzing the impact of adoption.

February

2016,

the FASB issued ASU

2016

02,

Leases

. Under ASU

2016

02,

lessees will be required to recognize a lease liability measured on a discounted basis and a right-of-use asset for all leases (with the exception of short-term leases). Lessor accounting is largely unchanged under ASU

2016

02.

However, the definition of initial direct costs was updated to include only initial direct costs that are considered incremental. This change in definition will change the manner in which the Company recognizes the costs associated with originating leases. ASU

2016

is effective for fiscal years beginning after

December

15,

2018,

including interim periods within those fiscal years. Early adoption is permitted for all entities. The Company is in the process of analyzing the impact of adoption on the Company’s consolidated financial statements.

March

2016,

the FASB issued ASU

2016

09,

Compensation – Stock Compensation

. ASU

2016

aims to simplify the accounting for companies that issue share-based payment awards to their employees. Simplification includes the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows of share-based payment awards. ASU

2016

is effective for fiscal years beginning after

December

15,

2016,

including interim periods within those fiscal years and it is not expected to have a significant impact on the Company’s consolidated financial statements.

June

2016,

the FASB issued ASU

2016

13,

Financial Instruments – Credit Losses

. Under the standard, assets measured at amortized cost (including loans, leases and AFS securities) will be presented at the net amount expected to be collected. Rather than the “incurred” model that is currently being utilized, the standard will require the use of a forward-looking approach to recognizing all expected credit losses at the beginning of an asset’s life. For public companies, ASU

2016

is effective for fiscal years beginning after

December

15,

2019,

including interim periods within those fiscal years. Companies

may

choose to early adopt for fiscal years beginning after

December

15,

2018,

including interim periods within those fiscal years. The Company is in the process of analyzing the impact of adoption on the Company’s consolidated financial statements.