NOTE 8. FAIR VALUE DISCLOSURES

The Company meets the requirements for disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. 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 estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

Fair value measurements under GAAP defines fair value, describes a framework for measuring fair value and requires disclosures about fair value measurements by establishing a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to valuation techniques that employ unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability. Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded and the reliability and transparency of the assumptions used to determine fair value.

The three levels are defined as follows: Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active or by model-based techniques in which all significant inputs are observable in the market for the asset or liability, for substantially the full term of the financial instrument. Level 3 – the valuation methodology is derived from model-based techniques in which at least one significant input is unobservable to the fair value measurement and based on the Company’s own assumptions about market participants’ assumptions.

Following is a description of the valuation methodologies used for instruments measured on a recurring basis at estimated fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. 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. All of the Company’s securities are classified as available for sale.

The Company had no fair value liabilities measured on a recurring basis at June 30, 2014 and December 31, 2013. A summary of assets at June 30, 2014 and December 31, 2013, measured at estimated fair value on a recurring basis was as follows:


(Dollars in Thousands)	Level 1		Level 2		Level 3		Total Fair Value Measurements
June 30, 2014
Securities available for sale:
U.S. Government Agencies	$	0	$	24,408	$	0	$	24,408
U.S. Government Sponsored Enterprises (GSE)		0		1,464		0		1,464
States and political subdivisions		0		52,833		0		52,833
GSE residential mortgage-backed securities		0		157,345		0		157,345
GSE residential collateralized mortgage obligations (CMOs)		0		88,627		0		88,627
GSE commercial CMOs		0		65,215		0		65,215

Total debt securities		0		389,892		0		389,892
Equity securities - financial services		0		69		0		69

Total securities	$	0	$	389,961	$	0	$	389,961


	Level 1		Level 2		Level 3		Total Fair Value Measurements
December 31, 2013
Securities available for sale:
U.S. Government Agencies	$	0	$	25,451	$	0	$	25,451
U.S. Government Sponsored Enterprises (GSE)		0		13,714		0		13,714
States and political subdivisions		0		71,544		0		71,544
GSE residential mortgage-backed securities		0		198,619		0		198,619
GSE residential collateralized mortgage obligations (CMOs)		0		40,532		0		40,532
GSE commercial CMOs		0		57,014		0		57,014

Total debt securities		0		406,874		0		406,874
Equity securities - financial services		0		69		0		69

Total securities	$	0	$	406,943	$	0	$	406,943

Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the financial statements:

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. 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). Impaired loans with an allocation 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 provision for loan losses on the consolidated statements of income. Specific allocations to the allowance for loan losses or partial charge-offs were $5,923,000 and $3,238,000 at June 30, 2014 and December 31, 2013.

Foreclosed Real Estate

Other real estate property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, other real estate owned is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. Specific charges to value the real estate owned at the lower of cost or fair value on properties held at June 30, 2014 and December 31, 2013 were $420,000 and $411,000.

A summary of assets at June 30, 2014 and December 31, 2013 measured at fair value on a nonrecurring basis is as follows:


(Dollars in thousands)	Level 1		Level 2		Level 3		Total Fair Value Measurements
June 30, 2014
Impaired loans, net	$	0	$	0	$	8,485	$	8,485
Foreclosed real estate		0		0		825		825

December 31, 2013
Impaired loans, net	$	0	$	0	$	6,457	$	6,457
Foreclosed real estate		0		0		558		558

The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:

(Dollars in thousands)

Fair Value
Estimate

Valuation
Techniques

Unobservable Input

Range

June 30, 2014

Impaired loans

8,485

Appraisal of
collateral

Management adjustments on appraisals for property type and recent activity

0%-30% discount

Management adjustments for liquidation expenses

5%-10% discount

Foreclosed real estate

825

Appraisal of
collateral

Management adjustments on appraisals for property type and recent activity

0%-30% discount

Management adjustments for liquidation expenses

5%-25% discount

December 31, 2013

Impaired loans

6,457

Appraisal of
collateral

Management adjustments on appraisals for property type and recent activity

0%-30% discount

Management adjustments for liquidation expenses

5%-10% discount

Foreclosed real estate

558

Appraisal of
collateral

Management adjustments on appraisals for property type and recent activity

0%-30% discount

Management adjustments for liquidation expenses

5%-10% discount

Fair values of financial instruments

In addition to those disclosed above, the following methods and assumptions were used by the Company in estimating fair values of financial instruments as disclosed herein:

Cash and Due from Banks and Interest Bearing Deposits with Banks

The carrying amounts of cash and due from banks and interest bearing deposits with banks approximate their fair value.

Loans Held for Sale

Loans held for sale are carried at the lower of cost or fair value. These loans typically consist of one-to-four family 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.

Loans Receivable

For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered in the market for loans with similar terms to borrowers of similar credit quality.

Restricted Investment in Bank Stock

These investments are carried at cost. The Company is required to maintain minimum investment balances in these stocks, which are not actively traded and therefore have no readily determinable market value.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated based on a valuation model that calculates the present value of estimated future net servicing income.

Deposits

The fair values disclosed for demand deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The carrying amounts of variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposits and IRAs are estimated using a discounted cash flow calculation that applies interest rates currently being offered in the market to a schedule of aggregated expected maturities on time deposits.

Short-Term Borrowings

The carrying amounts of federal funds purchased, borrowings under Repurchase Agreements, and other short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Long-Term Debt

The fair value of the Company’s fixed rate long-term borrowings is estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar types of borrowing arrangements. The carrying amounts of variable-rate long-term borrowings approximate their fair values at the reporting date.

Accrued Interest

The carrying amounts of accrued interest receivable and payable approximate their fair values.

Off-Balance-Sheet Instruments

The Company generally does not charge commitment fees. Fees for standby letters of credit and other off-balance-sheet instruments are not significant.

The estimated fair values of the Company’s financial statements were as follows at June 30, 2014 and December 31, 2013:


(Dollars in thousands)	Carrying Amount		Fair Value		Level 1		Level 2		Level 3
June 30, 2014
Financial Assets
Cash and due from banks	$	13,423	$	13,423	$	13,423	$	0	$	0
Interest bearing deposits with banks		26,589		26,589		26,589		0		0
Restricted investments in bank stock		9,277		9,277		0		0		9,277
Securities available for sale		389,961		389,961		0		389,961		0
Loans held for sale		2,109		2,109		0		2,109		0
Loans, net of allowance for loan losses		658,429		668,110		0		0		668,110
Accrued interest receivable		2,955		2,955		0		0		2,955
Mortgage servicing rights		2,740		2,934		0		0		2,934
Financial Liabilities
Deposits		981,705		982,242		0		982,242		0
Short-term borrowings		53,920		53,920		0		53,920		0
Long-term debt		15,354		16,153		0		16,153		0
Accrued interest payable		298		298		0		298		0
Off-balance sheet instruments		0		0		0		0		0

December 31, 2013
Financial Assets
Cash and due from banks	$	12,995	$	12,995	$	12,995	$	0	$	0
Interest bearing deposits with banks		24,565		24,565		24,565		0		0
Restricted investments in bank stock		9,921		9,921		0		0		9,921
Securities available for sale		406,943		406,943		0		406,943		0
Loans held for sale		1,936		1,936		0		1,936		0
Loans, net of allowance for loan losses		650,072		655,122		0		0		655,122
Accrued interest receivable		3,400		3,400		0		0		3,400
Mortgage servicing rights		2,806		3,090		0		0		3,090
Financial Liabilities
Deposits		1,000,390		1,002,235		0		1,002,235		0
Short-term borrowings		59,032		59,032		0		59,032		0
Long-term debt		16,077		16,645		0		16,645		0
Accrued interest payable		333		333		0		333		0
Off-balance sheet instruments		0		0		0		0		0