EX-13 2 ex13.htm EXHIBIT 13
Exhibit 13
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Middlefield Banc Corp.
We have audited the accompanying consolidated balance sheet of Middlefield Bane Corp. and subsidiaries (the "Company") as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 2012. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Middlefield Banc Corp. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ending December 31, 2012, in conformity with U.S. generally accepted accounting principles.

/s/ S.R. Snodgrass A.C. |
S.R. Snodgrass A.C. |

Wexford, Pennsylvania
March 13, 2013
1

MIDDLEFIELD BANC CORP.
CONSOLIDATED BALANCE SHEET
(Dollar amounts in thousands)

|  | December 31, |
|  | 2012 |  |  | 2011 |
ASSETS |  |  |  |  |  |
Cash and due from banks |  | $ | 33,568 |  |  | $ | 15,730 |
Federal funds sold |  |  | 11,778 |  |  |  | 18,660 |
Cash and cash equivalents |  |  | 45,346 |  |  |  | 34,390 |
Investment securities available for sale, at fair value |  |  | 194,472 |  |  |  | 193,977 |
Loans |  |  | 408,433 |  |  |  | 401,880 |
Less allowance for loan losses |  |  | 7,779 |  |  |  | 6,819 |
Net loans |  |  | 400,654 |  |  |  | 395,061 |
Premises and equipment, net |  |  | 8,670 |  |  |  | 8,264 |
Goodwill |  |  | 4,559 |  |  |  | 4,559 |
Core deposit intangibles |  |  | 195 |  |  |  | 235 |
Bank-owned life insurance |  |  | 8,536 |  |  |  | 8,257 |
Accrued interest and other assets |  |  | 7,856 |  |  |  | 9,808 |
TOTAL ASSETS |  | $ | 670,288 |  |  | $ | 654,551 |
LIABILITIES |  |  |  |  |  |  |  |
Deposits: |  |  |  |  |  |  |  |
Noninterest-bearing demand |  | $ | 75,912 |  |  | $ | 63,348 |
Interest-bearing demand |  |  | 63,915 |  |  |  | 55,853 |
Money market |  |  | 81,349 |  |  |  | 75,621 |
Savings |  |  | 175,406 |  |  |  | 167,207 |
Time |  |  | 196,753 |  |  |  | 218,933 |
Total deposits |  |  | 593,335 |  |  |  | 580,962 |
Short-term borrowings |  |  | 6,538 |  |  |  | 7,392 |
Other borrowings |  |  | 12,970 |  |  |  | 16,831 |
Accrued interest and other liabilities |  |  | 2,008 |  |  |  | 2,113 |
TOTAL LIABILITIES |  |  | 614,851 |  |  |  | 607,298 |
STOCKHOLDERS' EQUITY |  |  |  |  |  |  |  |
Common stock, no par value; 10,000,000 shares authorized, 2,181,763 and 1,951,868 shares issued |  |  | 34,295 |  |  |  | 31,240 |
Retained earnings |  |  | 22,485 |  |  |  | 18,206 |
Accumulated other comprehensive income |  |  | 5,391 |  |  |  | 4,541 |
Treasury stock, at cost; 189,530 shares |  |  | (6,734 | ) |  |  | (6,734 | )
TOTAL STOCKHOLDERS' EQUITY |  |  | 55,437 |  |  |  | 47,253 |
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY |  | $ | 670,288 |  |  | $ | 654,551 |

See accompanying notes to the consolidated financial statements.
2

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF INCOME
(Dollar amounts in thousands, except per share data)

|  | Year Ended December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
INTEREST INCOME |  |  |  |  |  |  |  |  |
Interest and fees on loans |  | $ | 22,418 |  |  | $ | 21,854 |  |  | $ | 21,084 |
Interest-bearing deposits in other institutions |  |  | 26 |  |  |  | 14 |  |  |  | 15 |
Federal funds sold |  |  | 20 |  |  |  | 12 |  |  |  | 52 |
Investment securities: |  |  |  |  |  |  |  |  |  |  |  |
Taxable interest |  |  | 3,209 |  |  |  | 4,862 |  |  |  | 5,185 |
Tax-exempt interest |  |  | 2,976 |  |  |  | 2,883 |  |  |  | 2,650 |
Dividends on stock |  |  | 97 |  |  |  | 102 |  |  |  | 108 |
Total interest income |  |  | 28,746 |  |  |  | 29,727 |  |  |  | 29,094 |
INTEREST EXPENSE |  |  |  |  |  |  |  |  |  |  |  |
Deposits |  |  | 5,728 |  |  |  | 7,467 |  |  |  | 9,504 |
Short-term borrowings |  |  | 261 |  |  |  | 235 |  |  |  | 249 |
Other borrowings |  |  | 294 |  |  |  | 400 |  |  |  | 642 |
Trust preferred securities |  |  | 164 |  |  |  | 550 |  |  |  | 550 |
Total interest expense |  |  | 6,447 |  |  |  | 8,652 |  |  |  | 10,945 |
NET INTEREST INCOME |  |  | 22,299 |  |  |  | 21,075 |  |  |  | 18,149 |
Provision for loan losses |  |  | 2,168 |  |  |  | 3,085 |  |  |  | 3,580 |
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES |  |  | 20,131 |  |  |  | 17,990 |  |  |  | 14,569 |
NONINTEREST INCOME |  |  |  |  |  |  |  |  |  |  |  |
Service charges on deposit accounts |  |  | 1,765 |  |  |  | 1,512 |  |  |  | 1,784 |
Investment securities gains (losses), net |  |  | 610 |  |  |  | (173 | ) |  |  | 11 |
Earnings on bank-owned life insurance |  |  | 279 |  |  |  | 278 |  |  |  | 273 |
Gains on sale of loans |  |  | 85 |  |  |  | - |  |  |  | - |
Other income |  |  | 712 |  |  |  | 620 |  |  |  | 555 |
Total noninterest income |  |  | 3,451 |  |  |  | 2,237 |  |  |  | 2,623 |
NONINTEREST EXPENSE |  |  |  |  |  |  |  |  |  |  |  |
Salaries and employee benefits |  |  | 7,127 |  |  |  | 7,233 |  |  |  | 6,411 |
Occupancy expense |  |  | 959 |  |  |  | 953 |  |  |  | 946 |
Equipment expense |  |  | 759 |  |  |  | 556 |  |  |  | 626 |
Data processing costs |  |  | 772 |  |  |  | 693 |  |  |  | 743 |
Ohio state franchise tax |  |  | 590 |  |  |  | 461 |  |  |  | 348 |
Federal deposit insurance expense |  |  | 487 |  |  |  | 966 |  |  |  | 1,166 |
Professional fees |  |  | 948 |  |  |  | 800 |  |  |  | 678 |
Losses on other real estate owned |  |  | 258 |  |  |  | 497 |  |  |  | 783 |
Advertising expenses |  |  | 423 |  |  |  | 439 |  |  |  | 401 |
Other real estate expenses |  |  | 498 |  |  |  | 194 |  |  |  | 82 |
Other expense |  |  | 2,818 |  |  |  | 2,709 |  |  |  | 2,579 |
Total noninterest expense |  |  | 15,639 |  |  |  | 15,501 |  |  |  | 14,763 |
Income before income taxes |  |  | 7,943 |  |  |  | 4,726 |  |  |  | 2,429 |
Income taxes (benefit) |  |  | 1,662 |  |  |  | 596 |  |  |  | (88 | )
NET INCOME |  | $ | 6,281 |  |  | $ | 4,130 |  |  | $ | 2,517 |
EARNINGS PER SHARE |  |  |  |  |  |  |  |  |  |  |  |
Basic |  | $ | 3.29 |  |  | $ | 2.45 |  |  | $ | 1.60 |
Diluted |  |  | 3.28 |  |  |  | 2.45 |  |  |  | 1.60 |
DIVIDENDS DECLARED PER SHARE |  | $ | 1.04 |  |  | $ | 1.04 |  |  | $ | 1.04 |

See accompanying notes to the consolidated financial statements.
3

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(Dollar amounts in thousands)

|  | Year Ended December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
Net income |  | $ | 6,281 |  |  | $ | 4,130 |  |  | $ | 2,517 |
Other comprehensive income: |  |  |  |  |  |  |  |  |  |  |  |
Net unrealized holding gain (loss) on available for sale investment securities |  |  | 1,897 |  |  |  | 5,969 |  |  |  | (103 | )
Tax effect |  |  | (644 | ) |  |  | (2,029 | ) |  |  | 35 |
Reclassification adjustment for investment security (gains) losses included in net income |  |  | (610 | ) |  |  | 173 |  |  |  | (11 | )
Tax effect |  |  | 207 |  |  |  | (59 | ) |  |  | 4 |
Total other comprehensive income (loss) |  |  | 850 |  |  |  | 4,054 |  |  |  | (75 | )
Comprehensive income |  | $ | 7,131 |  |  | $ | 8,184 |  |  | $ | 2,442 |

See accompanying notes to the consolidated financial statements.
4

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(Dollar amounts in thousands, except dividend per share amount)

|  | Common Stock |  |  | Retained |  |  | Accumulated Other Comprehensive |  |  | Treasury |  |  | Total Stockholders' |
|  | Shares |  |  | Amount |  |  | Earnings |  |  | Income |  |  | Stock |  |  | Equity |
Balance, December 31, 2009 |  |  | 1,754,112 |  |  | $ | 27,919 |  |  | $ | 14,960 |  |  | $ | 562 |  |  | $ | (6,734 | ) |  | $ | 36,707 |
Net income |  |  |  |  |  |  |  |  |  |  | 2,517 |  |  |  |  |  |  |  |  |  |  |  | 2,517 |
Other comprehensive loss |  |  |  |  |  |  |  |  |  |  |  |  |  |  | (75 | ) |  |  |  |  |  |  | (75 | )
Dividend reinvestment and purchase plan |  |  | 26,441 |  |  |  | 510 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 510 |
Cash dividends ($1.04 per share) |  |  |  |  |  |  |  |  |  |  | (1,637 | ) |  |  |  |  |  |  |  |  |  |  | (1,637 | )
Balance, December 31, 2010 |  |  | 1,780,553 |  |  | $ | 28,429 |  |  | $ | 15,840 |  |  | $ | 487 |  |  | $ | (6,734 | ) |  | $ | 38,022 |
Net income |  |  |  |  |  |  |  |  |  |  | 4,130 |  |  |  |  |  |  |  |  |  |  |  | 4,130 |
Other comprehensive income |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 4,054 |  |  |  |  |  |  |  | 4,054 |
Stock-based compensation expense |  |  | 2,400 |  |  |  | 59 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 59 |
Common stock issuance |  |  | 138,150 |  |  |  | 2,210 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 2,210 |
Dividend reinvestment and purchase plan |  |  | 30,765 |  |  |  | 542 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 542 |
Cash dividends ($1.04 per share) |  |  |  |  |  |  |  |  |  |  | (1,764 | ) |  |  |  |  |  |  |  |  |  |  | (1,764 | )
Balance, December 31, 2011 |  |  | 1,951,868 |  |  | $ | 31,240 |  |  | $ | 18,206 |  |  | $ | 4,541 |  |  | $ | (6,734 | ) |  | $ | 47,253 |
Net income |  |  |  |  |  |  |  |  |  |  | 6,281 |  |  |  |  |  |  |  |  |  |  |  | 6,281 |
Other comprehensive income |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 850 |  |  |  |  |  |  |  | 850 |
Stock-based compensation expense |  |  | 1,722 |  |  |  | 32 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 32 |
Common stock issuance |  |  | 196,635 |  |  |  | 2,329 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 2,329 |
Dividend reinvestment and purchase plan |  |  | 31,538 |  |  |  | 694 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | 694 |
Cash dividends ($1.04 per share) |  |  |  |  |  |  |  |  |  |  | (2,002 | ) |  |  |  |  |  |  |  |  |  |  | (2,002 | )
Balance, December 31, 2012 |  |  | 2,181,763 |  |  | $ | 34,295 |  |  | $ | 22,485 |  |  | $ | 5,391 |  |  | $ | (6,734 | ) |  | $ | 55,437 |

See accompanying notes to the consolidated financial statements.
5

MIDDLEFIELD BANC CORP.
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollar amounts in thousands)

|  | Year Ended December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
OPERATING ACTIVITIES |  |  |  |  |  |  |  |  |
Net income |  | $ | 6,281 |  |  | $ | 4,130 |  |  | $ | 2,517 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |  |  |  |  |  |  |  |  |  |
Provision for loan losses |  |  | 2,168 |  |  |  | 3,085 |  |  |  | 3,580 |
Investment securities (gains) losses, net |  |  | (610 | ) |  |  | 173 |  |  |  | (11 | )
Depreciation and amortization |  |  | 929 |  |  |  | 731 |  |  |  | 740 |
Amortization of premium and discount on investment securities |  |  | 930 |  |  |  | 451 |  |  |  | 6 |
Amortization of deferred loan fees, net |  |  | (188 | ) |  |  | (170 | ) |  |  | (58 | )
Origination of loans held for sale |  |  | (1,084 | ) |  |  | - |  |  |  | - |
Proceeds from sale of loans held for sale |  |  | 1,169 |  |  |  | - |  |  |  | - |
Gains on sale of loans |  |  | (85 | ) |  |  | - |  |  |  | - |
Earnings on bank-owned life insurance |  |  | (279 | ) |  |  | (278 | ) |  |  | (273 | )
Deferred income taxes |  |  | 2 |  |  |  | (97 | ) |  |  | (777 | )
Stock-based compensation expense |  |  | 32 |  |  |  | 59 |  |  |  | - |
Loss on other real estate owned |  |  | 258 |  |  |  | 497 |  |  |  | 783 |
Decrease (increase) in accrued interest receivable |  |  | 71 |  |  |  | 25 |  |  |  | (847 | )
Decrease in accrued interest payable |  |  | (153 | ) |  |  | (145 | ) |  |  | (115 | )
Decrease in prepaid federal deposit insurance |  |  | 486 |  |  |  | 707 |  |  |  | 727 |
Other, net |  |  | 355 |  |  |  | (22 | ) |  |  | (538 | )
Net cash provided by operating activities |  |  | 10,282 |  |  |  | 9,146 |  |  |  | 5,734 |
INVESTING ACTIVITIES |  |  |  |  |  |  |  |  |  |  |  |
Investment securities available for sale: |  |  |  |  |  |  |  |  |  |  |  |
Proceeds from repayments and maturities |  |  | 50,919 |  |  |  | 69,264 |  |  |  | 42,815 |
Proceeds from sale of securities |  |  | 32,985 |  |  |  | 24,127 |  |  |  | 5,874 |
Purchases |  |  | (83,431 | ) |  |  | (80,078 | ) |  |  | (113,860 | )
Increase in loans, net |  |  | (8,435 | ) |  |  | (32,956 | ) |  |  | (22,992 | )
Proceeds from the sale of other real estate owned |  |  | 954 |  |  |  | 866 |  |  |  | 932 |
Purchase of premises and equipment |  |  | (997 | ) |  |  | (583 | ) |  |  | (327 | )
Net cash used for investing activities |  |  | (8,005 | ) |  |  | (19,360 | ) |  |  | (87,558 | )
FINANCING ACTIVITIES |  |  |  |  |  |  |  |  |  |  |  |
Net increase in deposits |  |  | 12,373 |  |  |  | 15,711 |  |  |  | 78,145 |
(Decrease) increase in short-term borrowings, net |  |  | (854 | ) |  |  | (240 | ) |  |  | 832 |
Repayment of other borrowings |  |  | (3,861 | ) |  |  | (2,490 | ) |  |  | (6,544 | )
Common stock issued |  |  | 2,329 |  |  |  | 2,210 |  |  |  | - |
Proceeds from dividend reinvestment and purchase plan |  |  | 694 |  |  |  | 542 |  |  |  | 510 |
Cash dividends |  |  | (2,002 | ) |  |  | (1,764 | ) |  |  | (1,637 | )
Net cash provided by financing activities |  |  | 8,679 |  |  |  | 13,969 |  |  |  | 71,306 |
Increase (decrease) in cash and cash equivalents |  |  | 10,956 |  |  |  | 3,755 |  |  |  | (10,518 | )
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR |  |  | 34,390 |  |  |  | 30,635 |  |  |  | 41,153 |
CASH AND CASH EQUIVALENTS AT END OF YEAR |  | $ | 45,346 |  |  | $ | 34,390 |  |  | $ | 30,635 |
SUPPLEMENTAL INFORMATION |  |  |  |  |  |  |  |  |  |  |  |
Cash paid during the year for: |  |  |  |  |  |  |  |  |  |  |  |
Interest on deposits and borrowings |  | $ | 6,600 |  |  | $ | 8,797 |  |  | $ | 11,060 |
Income taxes |  |  | 1,550 |  |  |  | 615 |  |  |  | 850 |
Non-cash investing transactions: |  |  |  |  |  |  |  |  |  |  |  |
Transfers from loans to other real estate owned |  | $ | 862 |  |  | $ | 1,257 |  |  | $ | 2,110 |
Loans to facilitate the sale of other real estate owned |  |  | - |  |  |  | - |  |  |  | 257 |

See accompanying notes to the consolidated financial statements.
6

MIDDLEFIELD BANC CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A summary of the significant accounting and reporting policies applied in the presentation of the accompanying financial statements follows:
Nature of Operations and Basis of Presentation
Middlefield Banc Corp. (the “Company”) is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (“MBC”). MBC is a state-chartered bank located in Ohio. On April 19, 2007, Middlefield Banc Corp. acquired Emerald Bank (“EB”), an Ohio-chartered commercial bank headquartered in Dublin, Ohio. On October 23, 2009, the Company established an asset resolution subsidiary named EMORECO, Inc. The Company and its subsidiaries derive substantially all of their income from banking and bank-related services, which includes interest earnings on residential real estate, commercial mortgage, commercial and consumer financings as well as interest earnings on investment securities and deposit services to its customers through ten locations. The Company is supervised by the Board of Governors of the Federal Reserve System, while MBC and EB are subject to regulation and supervision by the Federal Deposit Insurance Corporation and the Ohio Division of Financial Institutions.
The consolidated financial statements of the Company include its wholly owned subsidiaries, MBC, EB, and EMORECO, Inc. (the “Banks”). Significant intercompany items have been eliminated in preparing the consolidated financial statements.
The financial statements have been prepared in conformity with U.S. generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ significantly from those estimates.
Investment Securities
Investment securities are classified at the time of purchase, based on management’s intention and ability, as securities held to maturity or securities available for sale. Debt securities acquired with the intent and ability to hold to maturity are stated at cost adjusted for amortization of premium and accretion of discount, which are computed using a level yield method and recognized as adjustments of interest income. Certain other debt securities have been classified as available for sale to serve principally as a source of liquidity. Unrealized holding gains and losses for available-for-sale securities are reported as a separate component of stockholders’ equity, net of tax, until realized. Realized security gains and losses are computed using the specific identification method. Interest and dividends on investment securities are recognized as income when earned.
Common stock of the Federal Home Loan Bank (“FHLB”) represents ownership in an institution that is wholly owned by other financial institutions. This equity security is accounted for at cost and classified with other assets. While the FHLBs have been negatively impacted by economic conditions of the past several years, the FHLB of Cincinnati has reported profits for 2012 and 2011, remains in compliance with regulatory capital and liquidity requirements, and continues to pay dividends on the stock and make redemptions at the par value. With consideration given to these factors, management concluded that the stock was not impaired at December 31, 2012 or 2011.
Securities are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value is other than temporary. For debt securities, management considers whether the present value of cash flows expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the investor does not intend to sell the security, and it is more-likely-than-not that it will not be required to sell the security, before recovery of the security’s amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings.
7

Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff generally are reported at their outstanding unpaid principal balances net of the allowance for loan losses. Interest income is recognized as income when earned on the accrual method. The accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of interest is doubtful. Interest received on nonaccrual loans is recorded as income or applied against principal according to management’s judgment as to the collectability of such principal.
Loan origination fees and certain direct loan origination costs are being deferred and the net amount amortized as an adjustment of the related loan’s yield. Management is amortizing these amounts over the contractual life of the related loans.
Allowance for Loan Losses
The allowance for loan losses represents the amount which management estimates is adequate to provide for probable loan losses inherent in its loan portfolio. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance, and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses which is charged to operations. The provision is based on management’s periodic evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the various portfolio segments, past experience with losses, the impact of economic conditions on borrowers, and other relevant factors. The estimates used in determining the adequacy of the allowance for loan losses, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term.
A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the Company expects to collect all amounts due, including interest accrued, at the contractual interest rate for the period of delay. All loans identified as impaired are evaluated independently by management. The Company estimates credit losses on impaired loans based on the present value of expected cash flows or the fair value of the underlying collateral if the loan repayment is expected to come from the sale or operation of such collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until such time, an allowance for loan losses is maintained for estimated losses. Cash receipts on impaired loans are applied first to accrued interest receivable unless otherwise required by the loan terms, except when an impaired loan is also a nonaccrual loan, in which case the portion of the payment related to interest is recognized as income.
Mortgage loans secured by one-to-four family properties and all consumer loans are large groups of smaller-balance homogeneous loans and are measured for impairment collectively. Management determines the significance of payment delays on a case-by-case basis, taking into consideration all circumstances concerning the loan, the creditworthiness and payment history of the borrower, the length of the payment delay, and the amount of shortfall in relation to the principal and interest owed.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost net of accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets, which range from 3 to 20 years for furniture, fixtures, and equipment and 3 to 40 years for buildings and leasehold improvements. Expenditures for maintenance and repairs are charged against income as incurred. Costs of major additions and improvements are capitalized.
Goodwill
The Company accounts for goodwill using a two-step process for testing the impairment of goodwill on at least an annual basis. This approach could cause more volatility in the Company’s reported net income because impairment losses, in any, could occur irregularly and in varying amounts. No impairment of goodwill was recognized in any of the periods presented.
8

Intangible Assets
Intangible assets include core deposit intangibles, which are a measure of the value of consumer demand and savings deposits acquired in business combinations accounted for as purchases. The core deposit intangibles are being amortized to expense over a 10 year life on a straight-line basis. The recoverability of the carrying value of intangible assets is evaluated on an ongoing basis, and permanent declines in value, if any, are charged to expense.
Bank-Owned Life Insurance (“BOLI”)
The Company owns insurance on the lives of a certain group of key employees. The policies were purchased to help offset the increase in the costs of various fringe benefit plans including healthcare. The cash surrender value of these policies is included as an asset on the Consolidated Balance Sheet and any increases in the cash surrender value are recorded as noninterest income on the Consolidated Statement of Income. In the event of the death of an insured individual under these policies, the Company would receive a death benefit, which would be recorded as noninterest income.
Other Real Estate Owned
Real estate properties acquired through foreclosure are initially recorded at fair value at the date of foreclosure, establishing a new cost basis. After foreclosure, management periodically performs valuations and the real estate is carried at the lower of cost or fair value less estimated cost to sell. Revenue and expenses from operations of the properties, gains or losses on sales and additions to the valuation allowance are included in operating results.
Income Taxes
The Company and its subsidiaries file a consolidated federal income tax return. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Earnings Per Share
The Company provides dual presentation of basic and diluted earnings per share. Basic earnings per share are calculated utilizing net income as reported in the numerator and average shares outstanding in the denominator. The computation of diluted earnings per share differs in that the dilutive effects of any stock options, warrants, and convertible securities are adjusted in the denominator.
Stock-Based Compensation
The Company accounts for stock compensation based on the grant date fair value of all share-based payment awards that are expected to vest, including employee share options to be recognized as employee compensation expense over the requisite service period.
For purposes of computing results, the Company estimated the fair values of stock options using the Black-Scholes option-pricing model. The model requires the use of subjective assumptions that can materially affect fair value estimates. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. The fair value of each stock option granted was estimated using the following weighted-average assumptions:

Grant Year |  | Expected Dividend Yield |  |  | Risk-Free Interest Rate |  |  | Expected Volatility |  |  | Expected Life (in years) |
2011 |  |  | 5.82 | % |  |  | 3.00 | % |  |  | 21.78 |  |  |  | 9.96 |

During the years ended December 31, 2012, 2011, and 2010, the Company recorded $0, $16,000, and $0, of compensation cost related to vested stock options. As of December 31, 2012, there was no unrecognized compensation cost related to unvested stock options. The weighted-average fair value of the stock option granted for 2011 was $1.75.
The Company also issued 1,722 and 2,400 shares of restricted stock and recorded stock-based compensation expense of $32,000 and $43,000 in 2012 and 2011, respectively.
9

Cash Flow Information
The Company has defined cash and cash equivalents as those amounts included in the Consolidated Balance Sheet captions as “Cash and due from banks” and “Federal funds sold” with original maturities of less than 90 days.
Advertising Costs
Advertising costs are expensed as incurred. Advertising expenses amounted to $423,000, $439,000, and $401,000, for 2012, 2011, and 2010, respectively.
Reclassification of Comparative Amounts
Certain comparative amounts for prior years have been reclassified to conform to current-year presentations. Such reclassifications did not affect net income or retained earnings.
Recent Accounting Pronouncements
In September 2011, the FASB issued ASU 2011-08, Intangibles – Goodwill and Other Topics (Topic 350), Testing Goodwill for Impairment . The objective of this Update is to simplify how entities, both public and nonpublic, test goodwill for impairment. The amendments in the Update permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent. Under the amendments in this Update, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments in this Update apply to all entities, both public and nonpublic, that have goodwill reported in their financial statements and are effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued or, for nonpublic entities, have not yet been made available for issuance. This ASU did not have a significant impact on the Company’s financial statements.
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities . The amendments in this Update affect all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. This information will enable users of an entity's financial statements to evaluate the effect or potential effect of netting arrangements on an entity's financial position, including the effect or potential effect of rights of setoff associated with certain financial instruments and derivative instruments in the scope of this Update. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. This ASU is not expected to have a significant impact on the Company’s financial statements.
10

2. EARNINGS PER SHARE
There are no convertible securities that would affect the numerator in calculating basic and diluted earnings per share; therefore, net income as presented on the Consolidated Statement of Income will be used as the numerator. The following table sets forth the composition of the weighted-average common shares (denominator) used in the basic and diluted earnings per share computation for year-ended December 31.

|  | 2012 |  |  | 2011 |  |  | 2010 |
Weighted average common shares outstanding |  |  | 2,101,490 |  |  |  | 1,872,582 |  |  |  | 1,764,743 |
Average treasury stock shares |  |  | (189,530 | ) |  |  | (189,530 | ) |  |  | (189,530 | )
Weighted average common shares and common stock equivalents used to calculate basic earnings per share |  |  | 1,911,960 |  |  |  | 1,683,052 |  |  |  | 1,575,213 |
Additional common stock equivalents used to calculate diluted earnings per share |  |  | 4,972 |  |  |  | - |  |  |  | 608 |
Weighted average common shares and common stock equivalents used to calculate diluted earnings per share |  |  | 1,916,932 |  |  |  | 1,683,052 |  |  |  | 1,575,821 |

Options to purchase 79,693 shares of common stock at prices ranging from $17.55 to $40.24 were outstanding during the year ended December 31, 2012. Of those options, 8,875 were considered dilutive based on the average market price exceeding the strike price for the year ended December 31, 2012. In accordance with the subscription agreement entered into by an institutional investor, there was also an additional 12,419 shares, at $16 per share, considered dilutive for the year ended December 31, 2012. The remaining options had no dilutive effect on the earnings per share.
Options to purchase 88,774 shares of common stock at prices ranging from $17.55 to $40.24 were outstanding during the year ended December 31, 2011, but were not included in the computation of diluted earnings per share as they were anti-dilutive due to the strike price being greater than the average market price as of December 31, 2011.
Options to purchase 89,077 shares of common stock at prices ranging from $22.33 to $40.24 were outstanding during the year ended December 31, 2010. Of those options, 9,561 were considered dilutive based on the average market price exceeding the strike price for the year ended December 31, 2010.
11

3. INVESTMENT SECURITIES AVAILABLE FOR SALE
The amortized cost and fair values of securities available for sale are as follows:

|  | December 31, 2012 |
(Dollar amounts in thousands) |  | Amortized Cost |  |  | Gross Unrealized Gains |  |  | Gross Unrealized Losses |  |  | Fair Value |
U.S. government agency securities |  | $ | 24,485 |  |  | $ | 566 |  |  |  | (91 | ) |  | $ | 24,960 |
Obligations of states and political subdivisions: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  |  | 6,888 |  |  |  | 738 |  |  |  | - |  |  |  | 7,626 |
Tax-exempt |  |  | 80,391 |  |  |  | 4,683 |  |  |  | (104 | ) |  |  | 84,970 |
Mortgage-backed securities in government-sponsored entities |  |  | 69,238 |  |  |  | 1,929 |  |  |  | (65 | ) |  |  | 71,102 |
Private-label mortgage-backed securities |  |  | 4,553 |  |  |  | 511 |  |  |  | - |  |  |  | 5,064 |
Total debt securities |  |  | 185,555 |  |  |  | 8,427 |  |  |  | (260 | ) |  |  | 193,722 |
Equity securities in financial institutions |  |  | 750 |  |  |  | - |  |  |  | - |  |  |  | 750 |
Total |  | $ | 186,305 |  |  | $ | 8,427 |  |  | $ | (260 | ) |  | $ | 194,472 |

|  | December 31, 2011 |
|  | Amortized Cost |  |  | Gross Unrealized Gains |  |  | Gross Unrealized Losses |  |  | Fair Value |
U.S. government agency securities |  | $ | 31,520 |  |  | $ | 427 |  |  | $ | (14 | ) |  | $ | 31,933 |
Obligations of states and political subdivisions: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  |  | 8,207 |  |  |  | 766 |  |  |  | - |  |  |  | 8,973 |
Tax-exempt |  |  | 75,807 |  |  |  | 3,681 |  |  |  | (61 | ) |  |  | 79,427 |
Mortgage-backed securities in government-sponsored entities |  |  | 63,808 |  |  |  | 1,819 |  |  |  | (54 | ) |  |  | 65,573 |
Private-label mortgage-backed securities |  |  | 7,005 |  |  |  | 411 |  |  |  | (95 | ) |  |  | 7,321 |
Total debt securities |  |  | 186,347 |  |  |  | 7,104 |  |  |  | (224 | ) |  |  | 193,227 |
Equity securities in financial institutions |  |  | 750 |  |  |  | - |  |  |  | - |  |  |  | 750 |
Total |  | $ | 187,097 |  |  | $ | 7,104 |  |  | $ | (224 | ) |  | $ | 193,977 |

The amortized cost and fair value of debt securities at December 31, 2012, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

(Dollar amounts in thousands) |  | Amortized Cost |  |  | Fair Value |
Due in one year or less |  | $ | 2,179 |  |  | $ | 2,239 |
Due after one year through five years |  |  | 5,555 |  |  |  | 5,870 |
Due after five years through ten years |  |  | 22,310 |  |  |  | 23,240 |
Due after ten years |  |  | 155,511 |  |  |  | 162,373 |
Total |  | $ | 185,555 |  |  | $ | 193,722 |

Investment securities with an approximate carrying value of $62,518,000 and $53,724,000 at December 31, 2012 and 2011, respectively, were pledged to secure deposits and other purposes as required by law.
12

Proceeds from the sales of securities available-for-sale and the gross realized gains and losses for the year ended December, 31 are as follows:

|  | 2012 |  |  | 2011 |  |  | 2010 |
Proceeds from sales |  | $ | 32,985 |  |  |  | 24,127 |  |  |  | 5,874 |
Gross realized gains |  |  | 704 |  |  |  | 830 |  |  |  | 74 |
Gross realized losses |  |  | (94 | ) |  |  | (809 | ) |  |  | (29 | )
Impairment losses |  |  | - |  |  |  | (194 | ) |  |  | (34 | )

The following tables show the Company’s gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

|  | December 31, 2012 |
|  | Less than Twelve Months |  |  | Twelve Months or Greater |  |  | Total |
(Dollar amounts in thousands) |  | Fair Value |  |  | Gross Unrealized Losses |  |  | Fair Value |  |  | Gross Unrealized Losses |  |  | Fair Value |  |  | Gross Unrealized Losses |
U.S. government agency securities |  | $ | 9,938 |  |  | $ | (91 | ) |  | $ | - |  |  | $ | - |  |  | $ | 9,938 |  |  | $ | (91 | )
Obligations of states and political subdivisions |  |  | 9,240 |  |  |  | (104 | ) |  |  | - |  |  |  | - |  |  |  | 9,240 |  |  |  | (104 | )
Mortgage-backed securities in government-sponsored entities |  |  | 12,353 |  |  |  | (65 | ) |  |  | - |  |  |  | - |  |  |  | 12,353 |  |  |  | (65 | )
Total |  | $ | 31,531 |  |  | $ | (260 | ) |  | $ | - |  |  | $ | - |  |  | $ | 31,531 |  |  | $ | (260 | )

|  | December 31, 2011 |
|  | Less than Twelve Months |  |  | Twelve Months or Greater |  |  | Total |
|  | Fair Value |  |  | Gross Unrealized Losses |  |  | Fair Value |  |  | Gross Unrealized Losses |  |  | Fair Value |  |  | Gross Unrealized Losses |
U.S. government agency securities |  | $ | 1,986 |  |  | $ | (14 | ) |  | $ | - |  |  | $ | - |  |  | $ | 1,986 |  |  | $ | (14 | )
Obligations of states and political subdivisions |  |  | 2,707 |  |  |  | (40 | ) |  |  | 919 |  |  |  | (21 | ) |  |  | 3,626 |  |  |  | (61 | )
Mortgage-backed securities in government-sponsored entities |  |  | 8,992 |  |  |  | (54 | ) |  |  | - |  |  |  | - |  |  |  | 8,992 |  |  |  | (54 | )
Private-label mortgage-backed securities |  |  | 1,628 |  |  |  | (42 | ) |  |  | 398 |  |  |  | (53 | ) |  |  | 2,026 |  |  |  | (95 | )
Total |  | $ | 15,313 |  |  | $ | (150 | ) |  | $ | 1,317 |  |  | $ | (74 | ) |  | $ | 16,630 |  |  | $ | (224 | )

There were 34 securities that were considered temporarily impaired at December 31, 2012.
On a quarterly basis, the Company performs an assessment to determine whether there have been any events or economic circumstances indicating that a security with an unrealized loss has suffered other-than-temporary impairment (“OTTI”). A debt security is considered impaired if the fair value is less than its amortized cost basis at the reporting date. The accounting literature requires the Company to assess whether the unrealized loss is other-than-temporary.
OTTI losses are recognized in earnings when the Company has the intent to sell the debt security or it is more likely than not that it will be required to sell the debt security before recovery of its amortized cost basis. However, even if the Company does not expect to sell a debt security, it must evaluate expected cash flows to be received and determine if a credit loss has occurred.
An unrealized loss is generally deemed to be other than temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. As a result the credit loss component of an OTTI is recorded as a component of investment securities gains (losses) in the accompanying Consolidated Statement of Income, while the remaining portion of the impairment loss is recognized in other comprehensive income, provided the Company does not intend to sell the underlying debt security and it is “more likely than not” that the Company will not have to sell the debt security prior to recovery.
13

Debt securities issued by U.S. government agencies, U.S. government-sponsored enterprises, and state and political subdivisions accounted for more than 97.0 percent of the total available-for-sale portfolio as of December 31, 2012, and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government and the lack of significant unrealized loss positions within the obligations of state and political subdivisions security portfolio. The Company’s assessment was concentrated mainly on private-label collateralized mortgage obligations of approximately $4.6 million, for which the Company evaluates credit losses on a quarterly basis. Gross unrealized gains related to private-label collateralized mortgage obligations amounted to $511,000, with no associated gross unrealized loss. The Company considered the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

| · | The length of time and the extent to which the fair value has been less than the amortized cost basis.

| · | Changes in the near term prospects of the underlying collateral of a security such as changes in default rates, loss severity given default and significant changes in prepayment assumptions.

| · | The level of cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities.

| · | Any adverse change to the credit conditions and liquidity of the issuer, taking into consideration the latest information available about the overall financial condition of the issuer, credit ratings, recent legislation, and government actions affecting the issuer’s industry and actions taken by the issuer to deal with the present economic climate.

The Company determined equity securities in financial institutions to be other than temporarily impaired and recognized a loss of $194,000 in 2011. In 2010, investment in a private-label collateralized mortgage obligation was deemed impaired, resulting in a loss of $35,000. These amounts represent a before-tax, non-cash charge, and were recorded as reductions to noninterest income.
4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES
Major classifications of loans at December 31 are summarized as follows (in thousands):

|  | 2012 |  |  | 2011 |
Commercial and industrial |  | $ | 62,188 |  |  | $ | 59,185 |
Real estate - construction |  |  | 22,522 |  |  |  | 21,545 |
Real estate - mortgage: |  |  |  |  |  |  |  |
Residential |  |  | 203,872 |  |  |  | 208,139 |
Commercial |  |  | 115,734 |  |  |  | 108,502 |
Consumer installment |  |  | 4,117 |  |  |  | 4,509 |
|  |  | 408,433 |  |  |  | 401,880 |
Less allowance for loan losses |  |  | (7,779 | ) |  |  | (6,819 | )
Net loans |  | $ | 400,654 |  |  | $ | 395,061 |

The Company’s primary business activity is with customers located within its local trade area, eastern Geauga County, and contiguous counties to the north, east, and south. The Company also serves the central Ohio market with offices in Dublin and Westerville, Ohio. Commercial, residential, consumer, and agricultural loans are granted. Although the Company has a diversified loan portfolio at December 31, 2012 and 2011, loans outstanding to individuals and businesses are dependent upon the local economic conditions in its immediate trade area.
The following table summarizes the primary segments of the loan portfolio and the allowance for loan losses as of December 31, 2012 and 2011 (in thousands):
14

|  |  |  |  |  |  |  | Real Estate- Mortgage |  |  |  |  |  |  |
December 31, 2012 |  | Commercial and industrial |  |  | Real estate- construction |  |  | Residential |  |  | Commercial |  |  | Consumer installment |  |  | Total |
Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  | $ | 4,592 |  |  | $ | 3,993 |  |  | $ | 5,761 |  |  | $ | 6,914 |  |  | $ | 28 |  |  | $ | 21,288 |
Collectively evaluated for impairment |  |  | 57,596 |  |  |  | 18,529 |  |  |  | 198,111 |  |  |  | 108,820 |  |  |  | 4,089 |  |  |  | 387,145 |
Total loans |  | $ | 62,188 |  |  | $ | 22,522 |  |  | $ | 203,872 |  |  | $ | 115,734 |  |  | $ | 4,117 |  |  | $ | 408,433 |

|  |  |  |  |  |  |  | Real estate- Mortgage |  |  |  |  |  |  |
December 31, 2011 |  | Commercial and industrial |  |  | Real estate- construction |  |  | Residential |  |  | Commercial |  |  | Consumer installment |  |  | Total |
Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  | $ | 4,492 |  |  | $ | 867 |  |  | $ | 4,882 |  |  | $ | 6,491 |  |  | $ | - |  |  | $ | 16,732 |
Collectively evaluated for impairment |  |  | 54,693 |  |  |  | 20,678 |  |  |  | 203,257 |  |  |  | 102,011 |  |  |  | 4,509 |  |  |  | 385,148 |
Total loans |  | $ | 59,185 |  |  | $ | 21,545 |  |  | $ | 208,139 |  |  | $ | 108,502 |  |  | $ | 4,509 |  |  | $ | 401,880 |

|  |  |  |  |  |  |  | Real Estate- Mortgage |  |  |  |  |  |  |
December 31, 2012 |  | Commercial and industrial |  |  | Real estate- construction |  |  | Residential |  |  | Commercial |  |  | Consumer installment |  |  | Total |
Allowance for loan losses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Ending allowance balance attributable to loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  | $ | 1,189 |  |  | $ | 933 |  |  | $ | 600 |  |  | $ | 960 |  |  | $ | 6 |  |  | $ | 3,688 |
Collectively evaluated for impairment |  |  | 543 |  |  |  | 190 |  |  |  | 2,272 |  |  |  | 1,031 |  |  |  | 55 |  |  |  | 4,091 |
Total ending allowance balance |  | $ | 1,732 |  |  | $ | 1,123 |  |  | $ | 2,872 |  |  | $ | 1,991 |  |  | $ | 61 |  |  | $ | 7,779 |

|  |  |  |  |  |  |  | Real Estate- Mortgage |  |  |  |  |  |  |
December 31, 2011 |  | Commercial and industrial |  |  | Real estate- construction |  |  | Residential |  |  | Commercial |  |  | Consumer installment |  |  | Total |
Allowance for loan losses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Ending allowance balance attributable to loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  | $ | 595 |  |  | $ | 237 |  |  | $ | 685 |  |  | $ | 185 |  |  | $ | - |  |  | $ | 1,702 |
Collectively evaluated for impairment |  |  | 701 |  |  |  | 201 |  |  |  | 3,046 |  |  |  | 1,121 |  |  |  | 48 |  |  |  | 5,117 |
Total ending allowance balance |  | $ | 1,296 |  |  | $ | 438 |  |  | $ | 3,731 |  |  | $ | 1,306 |  |  | $ | 48 |  |  | $ | 6,819 |

The Company’s loan portfolio is segmented to a level that allows management to monitor risk and performance. The portfolio is segmented into Commercial and Industrial (“C & I”), Real Estate Construction, Real Estate – Mortgage, which is further segmented into Residential and Commercial real estate, and Consumer Installment Loans. The C&I loan segment consists of loans made for the purpose of financing the activities of commercial customers. The residential mortgage loan segment consists of loans made for the purpose of financing the activities of residential homeowners. The commercial mortgage loan segment consists of loans made for the purposed of financing the activities of commercial real estate owners and operators. The consumer loan segment consists primarily of installment loans and overdraft lines of credit connected with customer deposit accounts.
Management evaluates individual loans in all of the commercial segments for possible impairment if the loan is greater than $150,000 and if the loan is either in nonaccrual status or is risk-rated Substandard and is greater than 90 days past due. Loans are considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in evaluating impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. 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. The Company does not separately evaluate individual consumer and residential mortgage loans for impairment, unless such loans are part of a larger relationship that is impaired. All TDRs are evaluated for possible impairment, irrespective of risk rating or category.
Once the determination has been made that a loan is impaired, the determination of whether a specific allocation of the allowance is necessary is measured by comparing the recorded investment in the loan with the fair value of the loan using one of three methods: (a) the present value of expected future cash flows discounted at the loan’s effective interest rate; (b) the loan’s observable market price; or (c) the fair value of the collateral less selling costs. The method is selected on a loan-by-loan basis, with management primarily utilizing the fair value of collateral method. The evaluation of the need and amount of a specific allocation of the allowance and whether a loan can be removed from impairment status is made on a quarterly basis. The Company’s policy for recognizing interest income on impaired loans does not differ from its overall policy for interest recognition.
15

The following tables present impaired loans by class, segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary (in thousands):
December 31, 2012

Impaired Loans |
|  | Recorded Investment |  |  | Unpaid Principal Balance |  |  | Related Allowance |
With no related allowance recorded: |  |  |  |  |  |  |
Commercial and industrial |  | $ | 1,230 |  |  | $ | 1,229 |  |  | $ | - |
Real estate - construction |  |  | 308 |  |  |  | 308 |  |  |  | - |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 2,716 |  |  |  | 2,729 |  |  |  | - |
Commercial |  |  | 4,143 |  |  |  | 4,164 |  |  |  | - |
Consumer installment |  |  | 11 |  |  |  | 11 |  |  |  | - |
Total |  | $ | 8,408 |  |  | $ | 8,441 |  |  | $ | - |
With an allowance recorded: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 3,362 |  |  | $ | 3,367 |  |  | $ | 1,189 |
Real estate - construction |  |  | 3,685 |  |  |  | 3,685 |  |  |  | 933 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 3,045 |  |  |  | 3,054 |  |  |  | 600 |
Commercial |  |  | 2,771 |  |  |  | 2,776 |  |  |  | 960 |
Consumer installment |  |  | 17 |  |  |  | 17 |  |  |  | 6 |
Total |  | $ | 12,880 |  |  | $ | 12,899 |  |  | $ | 3,688 |
Total: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 4,592 |  |  | $ | 4,596 |  |  | $ | 1,189 |
Real estate - construction |  |  | 3,993 |  |  |  | 3,993 |  |  |  | 933 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 5,761 |  |  |  | 5,783 |  |  |  | 600 |
Commercial |  |  | 6,914 |  |  |  | 6,940 |  |  |  | 960 |
Consumer installment |  |  | 28 |  |  |  | 28 |  |  |  | 6 |
Total |  | $ | 21,288 |  |  | $ | 21,340 |  |  | $ | 3,688 |

16

December 31, 2011

Impaired Loans |
|  | Recorded Investment |  |  | Unpaid Principal Balance |  |  | Related Allowance |
With no related allowance recorded: |  |  |  |  |  |  |
Commercial and industrial |  | $ | 1,172 |  |  | $ | 1,172 |  |  | $ | - |
Real estate - construction |  |  | 4,250 |  |  |  | 4,250 |  |  |  | - |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 3,188 |  |  |  | 3,193 |  |  |  | - |
Commercial |  |  | 2,528 |  |  |  | 2,536 |  |  |  | - |
Consumer installment |  |  | 24 |  |  |  | 24 |  |  |  | - |
Total |  | $ | 11,162 |  |  | $ | 11,175 |  |  | $ | - |
With an allowance recorded: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 465 |  |  | $ | 465 |  |  | $ | 196 |
Real estate - construction |  |  | 271 |  |  |  | 271 |  |  |  | 125 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | - |  |  |  | - |  |  |  | - |
Commercial |  |  | 2,555 |  |  |  | 2,560 |  |  |  | 551 |
Total |  | $ | 3,291 |  |  | $ | 3,296 |  |  | $ | 872 |
Total: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 1,637 |  |  | $ | 1,637 |  |  | $ | 196 |
Real estate - construction |  |  | 4,521 |  |  |  | 4,521 |  |  |  | 125 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 3,188 |  |  |  | 3,193 |  |  |  | - |
Commercial |  |  | 5,083 |  |  |  | 5,096 |  |  |  | 551 |
Consumer installment |  |  | 24 |  |  |  | 24 |  |  |  | - |
Total |  | $ | 14,453 |  |  | $ | 14,471 |  |  | $ | 872 |

The table above includes troubled debt restructuring totaling $4.6 million and $10.0 million as of December 31, 2012 and 2011, respectively.

|  | As of December 31, 2012 |  |  | As of December 31, 2011 |  |  | As of December 31, 2010 |
|  | Average Recorded Investment |  |  | Interest Income Recognized |  |  | Average Recorded Investment |  |  | Interest Income Recognized |  |  | Average Recorded Investment |  |  | Interest Income Recognized |
Total: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 2,776 |  |  | $ | 348 |  |  | $ | 1,637 |  |  | $ | 58 |  |  | $ | 3,149 |  |  | $ | 13 |
Real estate - construction |  |  | 2,798 |  |  |  | 156 |  |  |  | 4,521 |  |  |  | 216 |  |  |  | 618 |  |  |  | 1 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 4,263 |  |  |  | 338 |  |  |  | 3,188 |  |  |  | 157 |  |  |  | 594 |  |  |  | - |
Commercial |  |  | 4,717 |  |  |  | 543 |  |  |  | 5,083 |  |  |  | 97 |  |  |  | 3,320 |  |  |  | 69 |
Consumer installment |  |  | 27 |  |  |  | 3 |  |  |  | 24 |  |  |  | 2 |  |  |  | - |  |  |  | - |

17

|  | Modifications As of December 31, 2012 |  |  |  |
|  |  |  |  |  |  |  | Pre-Modification |
|  | Number of Contracts |  |  | Outstanding |
Troubled Debt Restructurings |  | Rate Forgiveness |  |  | Other |  |  | Total |  |  | Recorded Investment |
Commercial and industrial |  |  | 1 |  |  |  | 12 |  |  |  | 13 |  |  | $ | 489 |
Real estate- construction: |  |  | - |  |  |  | - |  |  |  | - |  |  |  | - |
Real estate- mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 2 |  |  |  | 7 |  |  |  | 9 |  |  |  | 921 |
Commercial |  |  | - |  |  |  | 1 |  |  |  | 1 |  |  |  | 156 |
Consumer Installment |  |  | - |  |  |  | 2 |  |  |  | 2 |  |  |  | 11 |

Troubled Debt Restructurings subsequently defaulted |  | Number of Contracts |  |  | Recorded Investment |
Commercial and industrial |  |  | 6 |  |  | $ | 256 |
Real estate- construction: |  |  | 1 |  |  |  | 3,622 |
Real estate- mortgage: |  |  |  |  |  |  |  |
Residential |  |  | 2 |  |  |  | 89 |
Commercial |  |  | - |  |  |  | - |
Consumer Installment |  |  | 1 |  |  |  | 5 |

|  | Modifications As of December 31, 2011 |  |  |  |
|  |  |  |  | Pre-Modification |
|  | Number of Contracts |  |  | Outstanding |
Troubled Debt Restructurings |  | Rate Forgiveness |  |  | Other |  |  | Total |  |  | Recorded Investment |
Commercial and industrial |  |  | - |  |  |  | 8 |  |  |  | 8 |  |  | $ | 586 |
Real estate- construction: |  |  | - |  |  |  | 2 |  |  |  | 2 |  |  |  | 3,883 |
Real estate- mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | - |  |  |  | 10 |  |  |  | 10 |  |  |  | 1,639 |
Commercial |  |  | - |  |  |  | 2 |  |  |  | 2 |  |  |  | 1,625 |
Consumer Installment |  |  | - |  |  |  | 2 |  |  |  | 2 |  |  |  | 24 |

Troubled Debt Restructurings subsequently defaulted |  | Number of Contracts |  |  | Recorded Investment |
Commercial and industrial |  |  | 3 |  |  | $ | 134 |
Real estate- construction: |  |  | - |  |  |  | - |
Real estate- mortgage: |  |  |  |  |  |  |  |
Residential |  |  | - |  |  |  | - |
Commercial |  |  | - |  |  |  | - |
Consumer Installment |  |  | 2 |  |  |  | 28 |

18

|  | Modifications As of December 31, 2010 |  |  |  |
|  |  |  |  | Pre-Modification |
|  | Number of Contracts |  |  | Outstanding |
Troubled Debt Restructurings |  | Rate Forgiveness |  |  | Other |  |  | Total |  |  | Recorded Investment |
Commercial and industrial |  |  | - |  |  |  | 7 |  |  |  | 7 |  |  | $ | 668 |
Real estate- mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | - |  |  |  | 8 |  |  |  | 8 |  |  |  | 1,230 |
Commercial |  |  | - |  |  |  | 3 |  |  |  | 3 |  |  |  | 2,025 |
Consumer Installment |  |  | - |  |  |  | 3 |  |  |  | 3 |  |  |  | 43 |

Troubled Debt Restructurings subsequently defaulted |  | Number of Contracts |  |  | Recorded Investment |
Commercial and industrial |  |  | 2 |  |  | $ | 174 |
Real estate- mortgage: |  |  |  |  |  |  |  |
Residential |  |  | 3 |  |  |  | 203 |
Commercial |  |  | - |  |  |  | - |
Consumer Installment |  |  | - |  |  |  | - |

Management uses a nine-point internal risk-rating system to monitor the credit quality of the overall loan portfolio. The first five categories are considered not criticized and are aggregated as Pass-rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The Special Mention category includes assets that are currently protected but are potentially weak, resulting in an undue and unwarranted credit risk, but not to the point of justifying a Substandard classification. Loans in the Substandard category have well-defined weaknesses that jeopardize the liquidation of the debt and have a distinct possibility that some loss will be sustained if the weaknesses are not corrected. All loans greater than 90 days past due are considered Substandard. Any portion of a loan that has been charged off is placed in the Loss category.
To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay a loan as agreed, the Company has a structured loan-rating process with several layers of internal and external oversight. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as bankruptcy, repossession, or death, occurs to raise awareness of a possible credit event. The Company’s Commercial Loan Officers are responsible for the timely and accurate risk rating of the loans in their portfolios at origination and on an ongoing basis. The Credit Department performs an annual review of all commercial relationships $200,000 or greater. Confirmation of the appropriate risk grade is included in the review on an ongoing basis. The Company has an experienced Loan Review Department that continually reviews and assesses loans within the portfolio. The Company engages an external consultant to conduct loan reviews on a semiannual basis. Generally, the external consultant reviews commercial relationships greater than $250,000 and/or criticized relationships greater than $125,000. Detailed reviews, including plans for resolution, are performed on loans classified as Substandard on a quarterly basis. Loans in the Special Mention and Substandard categories that are collectively evaluated for impairment are given separate consideration in the determination of the allowance.
19

The following table presents the classes of the loan portfolio summarized by the aggregate Pass rating and the criticized categories of Special Mention, Substandard, and Doubtful within the internal risk rating system as of December 31, 2012 and 2011 (in thousands):

|  | Pass |  |  | Special Mention |  |  | Substandard |  |  | Doubtful |  |  | Total Loans |
December 31, 2012 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 59,390 |  |  | $ | 678 |  |  | $ | 2,061 |  |  | $ | 59 |  |  | $ | 62,188 |
Real estate - construction |  |  | 17,601 |  |  |  | - |  |  |  | 4,921 |  |  |  | - |  |  |  | 22,522 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 190,967 |  |  |  | 758 |  |  |  | 12,147 |  |  |  | - |  |  |  | 203,872 |
Commercial |  |  | 106,509 |  |  |  | 1,928 |  |  |  | 7,297 |  |  |  | - |  |  |  | 115,734 |
Consumer installment |  |  | 4,084 |  |  |  | - |  |  |  | 33 |  |  |  | - |  |  |  | 4,117 |
Total |  | $ | 378,551 |  |  | $ | 3,364 |  |  | $ | 26,459 |  |  | $ | 59 |  |  | $ | 408,433 |

December 31, 2011 |  | Pass |  |  | Special Mention |  |  | Substandard |  |  | Doubtful |  |  | Total Loans |
Commercial and industrial |  | $ | 53,645 |  |  | $ | 1,104 |  |  | $ | 4,363 |  |  | $ | 73 |  |  | $ | 59,185 |
Real estate - construction |  |  | 20,883 |  |  |  | - |  |  |  | 662 |  |  |  | - |  |  |  | 21,545 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 192,534 |  |  |  | 1,100 |  |  |  | 14,505 |  |  |  | - |  |  |  | 208,139 |
Commercial |  |  | 100,536 |  |  |  | 443 |  |  |  | 7,523 |  |  |  | - |  |  |  | 108,502 |
Consumer installment |  |  | 4,495 |  |  |  | 6 |  |  |  | 8 |  |  |  | - |  |  |  | 4,509 |
Total |  | $ | 372,093 |  |  | $ | 2,653 |  |  | $ | 27,061 |  |  | $ | 73 |  |  | $ | 401,880 |

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the aging categories of performing loans and nonaccrual loans as of December 31, 2012 and 2011 (in thousands):

|  |  |  |  | Still Accruing |  |  |  |  |  |  |
|  | Current |  |  | 30-59 Days Past Due |  |  | 60-89 Days Past Due |  |  | 90 Days+ Past Due |  |  | Total Past Due |  |  | Non- Accrual |  |  | Total Loans |
December 31, 2012 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 60,428 |  |  | $ | 441 |  |  | $ | 63 |  |  | $ | 348 |  |  | $ | 852 |  |  | $ | 908 |  |  | $ | 62,188 |
Real estate - construction |  |  | 22,158 |  |  |  | - |  |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 364 |  |  |  | 22,522 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 191,349 |  |  |  | 2,614 |  |  |  | 1,401 |  |  |  | 90 |  |  |  | 4,105 |  |  |  | 8,418 |  |  |  | 203,872 |
Commercial |  |  | 113,023 |  |  |  | 509 |  |  |  | 97 |  |  |  | - |  |  |  | 606 |  |  |  | 2,105 |  |  |  | 115,734 |
Consumer installment |  |  | 4,074 |  |  |  | 25 |  |  |  | - |  |  |  | - |  |  |  | 25 |  |  |  | 18 |  |  |  | 4,117 |
Total |  | $ | 391,032 |  |  | $ | 3,589 |  |  | $ | 1,561 |  |  | $ | 438 |  |  | $ | 5,588 |  |  | $ | 11,813 |  |  | $ | 408,433 |

|  |  |  |  | Still Accruing |  |  |  |  |  |  |
|  | Current |  |  | 30-59 Days Past Due |  |  | 60-89 Days Past Due |  |  | 90 Days+ Past Due |  |  | Total Past Due |  |  | Non- Accrual |  |  | Total Loans |
December 31, 2011 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 57,291 |  |  | $ | 258 |  |  | $ | 16 |  |  | $ | 44 |  |  | $ | 318 |  |  | $ | 1,576 |  |  | $ | 59,185 |
Real estate - construction |  |  | 20,862 |  |  |  | 20 |  |  |  | - |  |  |  | - |  |  |  | 20 |  |  |  | 663 |  |  |  | 21,545 |
Real estate - mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 193,732 |  |  |  | 2,624 |  |  |  | 863 |  |  |  | 275 |  |  |  | 3,762 |  |  |  | 10,645 |  |  |  | 208,139 |
Commercial |  |  | 104,086 |  |  |  | 83 |  |  |  | 412 |  |  |  | - |  |  |  | 495 |  |  |  | 3,921 |  |  |  | 108,502 |
Consumer installment |  |  | 4,408 |  |  |  | 60 |  |  |  | 41 |  |  |  | - |  |  |  | 101 |  |  |  | - |  |  |  | 4,509 |
Total |  | $ | 380,379 |  |  | $ | 3,045 |  |  | $ | 1,332 |  |  | $ | 319 |  |  | $ | 4,696 |  |  | $ | 16,805 |  |  | $ | 401,880 |

Interest income that would have been recorded had these loans not been placed on nonaccrual status was $756,000 in 2012; $859,000 in 2011; and $470,000 in 2010.
20

An allowance for loan losses (“ALL”) is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the risk characteristics and credit quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.
The Company’s methodology for determining the ALL is based on the requirements of ASC Section 310-10-35 for loans individually evaluated for impairment (discussed above) and ASC Subtopic 450-20 for loans collectively evaluated for impairment, as well as the Interagency Policy Statement on the Allowance for Loan and Lease Losses and other bank regulatory guidance. The total of the two components represents the Company’s ALL.
Loans that are collectively evaluated for impairment are analyzed, with general allowances being made as appropriate. For general allowances, historical loss trends are used in the estimation of losses in the current portfolio. These historical loss amounts are modified by other qualitative factors.
The classes described above, which are based on the purpose code assigned to each loan, provide the starting point for the ALL analysis. Management tracks the historical net charge-off activity at the purpose code level. A historical charge-off factor is calculated utilizing the last four consecutive quarters.
Management has identified a number of additional qualitative factors which it uses to supplement the historical charge-off factor, because these factors are likely to cause estimated credit losses associated with the existing loan pools to differ from historical loss experience. The additional factors that are evaluated quarterly and updated using information obtained from internal, regulatory, and governmental sources are: national and local economic trends and conditions; levels of and trends in delinquency rates and non-accrual loans; trends in volumes and terms of loans; effects of changes in lending policies; experience, ability, and depth of lending staff; value of underlying collateral; and concentrations of credit from a loan type, industry, and/or geographic standpoint.
Management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the ALL. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the ALL.
The following tables summarize the primary segments of the loan portfolio (in thousands):

|  | Commercial and industrial |  |  | Real estate- construction |  |  | Real estate- residential mortgage |  |  | Real estate- commercial mortgage |  |  | Consumer installment |  |  | Total |
ALL balance at December 31, 2011 |  | $ | 1,296 |  |  | $ | 438 |  |  | $ | 3,731 |  |  | $ | 1,306 |  |  | $ | 48 |  |  | $ | 6,819 |
Charge-offs |  |  | (230 | ) |  |  | (135 | ) |  |  | (785 | ) |  |  | (123 | ) |  |  | (64 | ) |  |  | (1,337 | )
Recoveries |  |  | 71 |  |  |  | - |  |  |  | 31 |  |  |  | - |  |  |  | 27 |  |  |  | 129 |
Provision |  |  | 595 |  |  |  | 820 |  |  |  | (105 | ) |  |  | 808 |  |  |  | 50 |  |  |  | 2,168 |
ALL balance at December 31, 2012 |  | $ | 1,732 |  |  | $ | 1,123 |  |  | $ | 2,872 |  |  | $ | 1,991 |  |  | $ | 61 |  |  | $ | 7,779 |

|  | Commercial and industrial |  |  | Real estate- construction |  |  | Real estate- residential mortgage |  |  | Real estate- commercial mortgage |  |  | Consumer installment |  |  | Total |
ALL balance at December 31, 2010 |  | $ | 1,234 |  |  | $ | 356 |  |  | $ | 3,392 |  |  | $ | 1,143 |  |  | $ | 96 |  |  | $ | 6,221 |
Charge-offs |  |  | (568 | ) |  |  | (6 | ) |  |  | (1,862 | ) |  |  | (265 | ) |  |  | (11 | ) |  |  | (2,712 | )
Recoveries |  |  | 76 |  |  |  | - |  |  |  | 122 |  |  |  | - |  |  |  | 27 |  |  |  | 225 |
Provision |  |  | 554 |  |  |  | 88 |  |  |  | 2,079 |  |  |  | 428 |  |  |  | (64 | ) |  |  | 3,085 |
ALL balance at December 31, 2011 |  | $ | 1,296 |  |  | $ | 438 |  |  | $ | 3,731 |  |  | $ | 1,306 |  |  | $ | 48 |  |  | $ | 6,819 |

|  | Commercial and industrial |  |  | Real estate- construction |  |  | Real estate- residential mortgage |  |  | Real estate- commercial mortgage |  |  | Consumer installment |  |  | Total |
ALL balance at December 31, 2009 |  | $ | 864 |  |  | $ | - |  |  | $ | 2,816 |  |  | $ | 1,198 |  |  | $ | 59 |  |  | $ | 4,937 |
Charge-offs |  |  | (450 | ) |  |  | - |  |  |  | (1,433 | ) |  |  | (428 | ) |  |  | (59 | ) |  |  | (2,370 | )
Recoveries |  |  | 40 |  |  |  | - |  |  |  | - |  |  |  | - |  |  |  | 34 |  |  |  | 74 |
Provision |  |  | 780 |  |  |  | 356 |  |  |  | 2,009 |  |  |  | 373 |  |  |  | 62 |  |  |  | 3,580 |
ALL balance at December 31, 2010 |  | $ | 1,234 |  |  | $ | 356 |  |  | $ | 3,392 |  |  | $ | 1,143 |  |  | $ | 96 |  |  | $ | 6,221 |

21

5. PREMISES AND EQUIPMENT
Major classifications of premises and equipment at December 31 are summarized as follows:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |
Land and land improvements |  | $ | 1,885 |  |  | $ | 1,898 |
Building and leasehold improvements |  |  | 9,427 |  |  |  | 9,131 |
Furniture, fixtures, and equipment |  |  | 3,665 |  |  |  | 2,952 |
|  |  | 14,977 |  |  |  | 13,981 |
Less accumulated depreciation and amortization |  |  | 6,307 |  |  |  | 5,717 |
Total |  | $ | 8,670 |  |  | $ | 8,264 |

Depreciation charged to operations was $591,000 in 2012, $499,000 in 2011, and $542,000 in 2010.
6. GOODWILL AND INTANGIBLE ASSETS
Goodwill totaled $4,559,000 at the years ended December 31, 2012, and 2011. Core deposit intangible gross carrying amount was $195,000 and $235,000 for the years ended December 31, 2012, and 2011. Core deposit accumulated amortization was $200,000 and $160,000 for the years ended December 31, 2012, and 2011.
Core deposit intangible assets are amortized on a straight-line basis over their estimated lives of ten years. Amortization expense totaled $40,000 in 2012, 2011, and 2010. The estimated aggregate future amortization expense for core deposit intangible assets as of December 31, 2012, is as follows (in thousands):

2013 |  | $ | 40,000 |
2014 |  |  | 40,000 |
2015 |  |  | 40,000 |
2016 |  |  | 40,000 |
Thereafter |  |  | 35,000 |
Total |  | $ | 195,000 |

7. OTHER ASSETS
The components of other assets at year ended December 31 are as follows:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |
FHLB stock |  | $ | 1,887 |  |  | $ | 1,887 |
Accrued interest on investment securities |  |  | 1,032 |  |  |  | 1,185 |
Accrued interest on loans |  |  | 1,132 |  |  |  | 1,049 |
Deferred tax asset, net |  |  | 181 |  |  |  | 621 |
Prepaid federal deposit insurance |  |  | 513 |  |  |  | 977 |
Other Real Estate Owned |  |  | 1,846 |  |  |  | 2,196 |
Other |  |  | 1,460 |  |  |  | 2,128 |
Total |  | $ | 8,051 |  |  | $ | 10,043 |

8. DEPOSITS
Time deposits at December 31, 2012, mature $98,028,000, $35,512,000, $41,164,000, $15,097,000, and $6,952,000 during 2013, 2014, 2015, 2016, and 2017, respectively.
22

Maturities on time deposits of $100,000 or more at December 31, 2012, are as follows:

(Dollar amounts in thousands) |  | Amount |  |  | Percent of Total |
Within three months |  | $ | 10,031 |  |  |  | 12.55 | %
Beyond three but within six months |  |  | 9,005 |  |  |  | 11.27 |
Beyond six but within twelve months |  |  | 18,234 |  |  |  | 22.82 |
Beyond one year |  |  | 42,648 |  |  |  | 53.36 |
Total |  | $ | 79,918 |  |  |  | 100.00 | %

The aggregate of all time deposit accounts of $100,000 or more amounted to $86,793,000 at December 31, 2011.
9. SHORT-TERM BORROWINGS
The year ended December 31 outstanding balances and related information of short-term borrowings, which includes securities sold under agreements to repurchase and short-term borrowings from other banks, are summarized as follows:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
Balance at year-end |  | $ | 6,538 |  |  | $ | 7,392 |  |  | $ | 7,632 |
Average balance outstanding |  |  | 7,005 |  |  |  | 7,276 |  |  |  | 7,320 |
Maximum month-end balance |  |  | 7,458 |  |  |  | 7,552 |  |  |  | 8,178 |
Weighted-average rate at year-end |  |  | 2.97 | % |  |  | 3.14 | % |  |  | 3.10 | %
Weighted-average rate during the year |  |  | 3.15 | % |  |  | 3.23 | % |  |  | 3.40 | %

Average balances outstanding during the year represent daily average balances, and average interest rates represent interest expense divided by the related average balance.
The Company maintains a $4,000,000 line of credit at an adjustable rate, currently 3.71 percent, and a $3,000,000 line of credit at an adjustable rate, currently at 4.00 percent. At December 31, 2012, 2011, and 2010, outstanding borrowings under these lines were $4,900,000, $5,700,000, and $5,700,000, respectively.
10. OTHER BORROWINGS
Other borrowings consist of advances from the FHLB and subordinated debt as follows:

(Dollar amounts in thousands) |  |  | Maturity range |  |  | Weighted- average |  |  | Stated interest rate range |  |  |  |  |  |  |
Description |  |  | from |  |  | to |  |  | interest rate |  |  | from |  |  | to |  |  | 2012 |  |  | 2011 |
Fixed rate amortizing |  |  | 01/23/13 |  |  | 09/04/28 |  |  |  | 3.99 | % |  |  | 2.70 | % |  |  | 4.48 | % |  | $ | 4,722 |  |  | $ | 6,576 |
Convertible |  |  | 10/09/12 |  |  | 10/09/12 |  |  |  | 4.14 |  |  |  | 4.14 |  |  |  | 4.14 |  |  |  | - |  |  |  | 2,007 |
Junior subordinated debt |  |  | 12/21/37 |  |  | 12/21/37 |  |  |  | 2.50 |  |  |  | 1.98 |  |  |  | 6.58 |  |  |  | 8,248 |  |  |  | 8,248 |
Total |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  | $ | 12,970 |  |  | $ | 16,831 |

23

The scheduled maturities of other borrowings are as follows:

(Dollar amounts in thousands) |  |  |  |  |  |
Year Ending December 31, |  | Amount |  |  | Average Rate |
2013 |  | $ | 1,362 |  |  |  | 3.95 | %
2014 |  |  | 984 |  |  |  | 3.99 |
2015 |  |  | 685 |  |  |  | 4.01 |
2016 |  |  | 502 |  |  |  | 4.00 |
2017 |  |  | 373 |  |  |  | 4.00 |
Beyond 2017 |  |  | 9,065 |  |  |  | 2.17 |
Total |  | $ | 12,970 |  |  |  | 2.63 | %

The Company entered into a ten-year “Convertible Select” fixed commitment advance arrangement with the FHLB. Rates may be reset at the FHLB’s discretion on a quarterly basis based on the three-month LIBOR rate. At each rate change, the Company may exercise a put option and satisfy the obligation without penalty.
Fixed rate amortizing advances from the FHLB require monthly principal and interest payments and an annual 20 percent pay-down of outstanding principal. Monthly principal and interest payments are adjusted after each 20 percent pay-down. Under the terms of a blanket agreement, FHLB borrowings are secured by certain qualifying assets of the Company which consist principally of first mortgage loans or mortgage-backed securities. Under this credit arrangement, the Company has a remaining borrowing capacity of approximately $68.9 million at December 31, 2012.
In December 2006, the Company formed a special purpose entity (“Entity”) to issue $8,000,000 of floating rate, obligated mandatorily redeemable securities, and $248,000 in common securities as part of a pooled offering. The rate adjusts quarterly, equal to LIBOR plus 1.67 percent. The Entity may redeem them, in whole or in part, at face value. The Company borrowed the proceeds of the issuance from the Entity in December 2006 in the form of an $8,248,000 note payable, which is included in the liabilities section of the Company’s Consolidated Balance Sheet.
11. OTHER LIABILITIES
The components of other liabilities are as follows (Dollar amounts in thousands):

|  | 2012 |  |  | 2011 |
Accrued interest payable |  | $ | 492 |  |  | $ | 645 |
Other |  |  | 1,516 |  |  |  | 1,468 |
Total |  | $ | 2,008 |  |  | $ | 2,113 |

12. INCOME TAXES
The provision (benefit) for federal income taxes consists of:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
Current payable |  | $ | 1,660 |  |  | $ | 693 |  |  | $ | 689 |
Deferred |  |  | 2 |  |  |  | (97 | ) |  |  | (777 | )
Total provision (benefit) |  | $ | 1,662 |  |  | $ | 596 |  |  | $ | (88 | )

24

The tax effects of deductible and taxable temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |
Deferred tax assets: |  |  |  |  |  |
Allowance for loan losses |  | $ | 2,645 |  |  | $ | 2,318 |
Supplemental retirement plan |  |  | 218 |  |  |  | 182 |
Alternative minimum tax credits |  |  | - |  |  |  | 551 |
Investment security basis adjustment |  |  | 66 |  |  |  | 66 |
Nonaccrual interest income |  |  | 508 |  |  |  | 298 |
Deferred origination fees, net |  |  | 189 |  |  |  | 105 |
OREO adjustments |  |  | 116 |  |  |  | - |
Net operating losses |  |  | 86 |  |  |  | 190 |
Other |  |  | 47 |  |  |  | 125 |
Gross deferred tax assets |  |  | 3,875 |  |  |  | 3,835 |
Deferred tax liabilities: |  |  |  |  |  |  |  |
Premises and equipment |  |  | 434 |  |  |  | 405 |
Net unrealized gain on securities |  |  | 2,777 |  |  |  | 2,339 |
FHLB stock dividends |  |  | 225 |  |  |  | 225 |
Intangibles |  |  | 256 |  |  |  | 208 |
Other |  |  | 2 |  |  |  | 37 |
Gross deferred tax liabilities |  |  | 3,694 |  |  |  | 3,214 |
Net deferred tax assets |  | $ | 181 |  |  | $ | 621 |

No valuation allowance was established at December 31, 2012 and 2011, in view of the Company’s ability to carry-back to taxes paid in previous years and certain tax strategies, coupled with the anticipated future taxable income as evidenced by the Company's earnings potential.
The reconciliation between the federal statutory rate and the Company’s effective consolidated income tax rate is as follows:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
|  | Amount |  |  | % of Pretax Income |  |  | Amount |  |  | % of Pretax Income |  |  | Amount |  |  | % of Pretax Income |
Provision at statutory rate |  | $ | 2,700 |  |  |  | 34.0 | % |  | $ | 1,606 |  |  |  | 34.0 | % |  | $ | 827 |  |  |  | 34.0 | %
Tax-free income |  |  | (1,095 | ) |  |  | -13.8 |  |  |  | (1,071 | ) |  |  | -22.7 |  |  |  | (993 | ) |  |  | -40.9 |
Nondeductible interest expense |  |  | 48 |  |  |  | 0.6 |  |  |  | 61 |  |  |  | 1.3 |  |  |  | 76 |  |  |  | 3.1 |
Other |  |  | 9 |  |  |  | 0.1 |  |  |  | - |  |  |  | 0.0 |  |  |  | 2 |  |  |  | 0.2 |
Actual tax expense and effective rate |  | $ | 1,662 |  |  |  | 20.9 | % |  | $ | 596 |  |  |  | 12.6 | % |  | $ | (88 | ) |  |  | (3.6 | ) %

There is a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority that would have full knowledge of all relevant information. A tax position that meets the more-likely-than-not recognition threshold is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Tax positions that previously failed to meet the more-likely-than-not recognition threshold should be recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not recognition threshold should be derecognized in the first subsequent financial reporting period in which that threshold is no longer met.
25

At December 31, 2012 and December 31, 2011, the Company had no unrecognized tax benefits. The Company does not expect the total amount of unrecognized tax benefits to significantly increase within the next 12 months. The Company recognizes interest and penalties on unrecognized tax benefits as a component of income tax expense.
The Company and the Banks are subject to U.S. federal income tax as well as an income tax in the state of Ohio, and the Banks are subject to a capital-based franchise tax in the state of Ohio. The Company and the Banks are no longer subject to examination by taxing authorities for years before December 31, 2009.
13. EMPLOYEE BENEFITS
Retirement Plan
The Banks maintain section 401(k) employee savings and investment plans for all full-time employees and officers of the Banks with more than one year of service. The Banks’ contributions to the plans are based on 50 percent matching of voluntary contributions up to 6 percent of compensation. An eligible employee can contribute up to 15 percent of salary. Employee contributions are vested at all times, and MBC contributions are fully vested after six years beginning at the second year in 20 percent increments. EB contributions are vested at 25 percent for less than a year of employment, 50 percent after one year, 75 percent after two years, and fully vested after three years. Contributions for 2012, 2011, and 2010 to these plans amounted to $125,000, $104,000, and $106,000, respectively.
Supplemental Retirement Plan
MBC maintains a Directors’ Retirement Plan to provide postretirement payments over a ten-year period to members of the Board of Directors who have completed five or more years of service. The plan requires payment of 25 percent of the final average annual board fees paid to a director in the three years preceding the director’s retirement.
The following table illustrates the components of the net periodic pension cost for the Directors’ Retirement Plan for the years ended:

|  | Projected Payments |
2013 |  | $ | 34,000 |
2014 |  |  | 34,000 |
2015 |  |  | 34,000 |
2016 |  |  | 29,000 |
2017 |  |  | 23,000 |
Thereafter |  |  | 41,000 |
Total |  | $ | 195,000 |

The retirement plan is available solely for nonemployee directors of The Middlefield Banking Company, but the bank has not entered into any additional retirement arrangements for nonemployee directors since 2001. Of the director participants, all but one have retired, but the ten-year benefit payments for the director who continues to serve began in 2010 because he attained the age 75 retirement age in that year.
Executive Deferred Compensation Plan
The Company maintains an Executive Deferred Compensation Plan (the “Plan”) to provide post-retirement payments to members of senior management. The Plan agreements are noncontributory, defined contribution arrangements that provide supplemental retirement income benefits to five officers, with contributions made solely by the Banks. During 2012, 2011, and 2010, the Company contributed $139,000, $91,000, and $92,000, respectively, to the Plan.
Stock Option and Restricted Stock Plan
The Company maintains a stock option and restricted stock plan (“the Plan”) for granting incentive stock options, nonqualified stock options, and restricted stock to key officers and employees and nonemployee directors of the Company. A total of 160,000 shares of authorized and unissued or issued common stock are reserved for issuance under the Plan, which expires ten years from the date of stockholder ratification. The per share exercise price of an option granted will not be less than the fair value of a share of common stock on the date the option is granted. No option shall become exercisable earlier than one year from the date the Plan was approved by the stockholders.
26

The following table presents share data related to the outstanding options:

|  | 2012 |  |  | Weighted- average Exercise Price |  |  | 2011 |  |  | Weighted- average Exercise Price |
Outstanding, January 1 |  |  | 88,774 |  |  | $ | 26.81 |  |  |  | 89,077 |  |  | $ | 27.87 |
Granted |  |  | - |  |  |  | - |  |  |  | 9,000 |  |  |  | 17.55 |
Forfeited |  |  | (9,081 | ) |  |  | 22.94 |  |  |  | (9,303 | ) |  |  | 28.03 |
Outstanding, December 31 |  |  | 79,693 |  |  | $ | 27.25 |  |  |  | 88,774 |  |  | $ | 26.81 |
Exercisable, December 31 |  |  | 79,693 |  |  | $ | 27.25 |  |  |  | 79,774 |  |  | $ | 27.85 |

27

Stock Option and Restricted Stock Plan (Continued)
The following table summarizes the characteristics of stock options at December 31, 2012:

|  |  |  |  | Outstanding |  |  | Exercisable |
Grant Date |  | Exercise Price |  |  | Shares |  |  | Contractual Average Life |  |  | Average Exercise Price |  |  | Shares |  |  | Average Exercise Price |
December 8, 2003 |  | $ | 24.29 |  |  |  | 18,112 |  |  |  | 0.94 |  |  | $ | 24.29 |  |  |  | 18,112 |  |  | $ | 24.29 |
May 12, 2004 |  |  | 27.35 |  |  |  | 907 |  |  |  | 1.33 |  |  |  | 27.35 |  |  |  | 907 |  |  |  | 27.35 |
December 13, 2004 |  |  | 30.45 |  |  |  | 11,223 |  |  |  | 1.95 |  |  |  | 30.45 |  |  |  | 11,223 |  |  |  | 30.45 |
December 14, 2005 |  |  | 36.73 |  |  |  | 7,163 |  |  |  | 2.95 |  |  |  | 36.73 |  |  |  | 7,163 |  |  |  | 36.73 |
December 10, 2006 |  |  | 40.24 |  |  |  | 3,150 |  |  |  | 3.95 |  |  |  | 40.24 |  |  |  | 3,150 |  |  |  | 40.24 |
April 19, 2007 |  |  | 37.33 |  |  |  | 3,639 |  |  |  | 4.31 |  |  |  | 37.33 |  |  |  | 3,639 |  |  |  | 37.73 |
May 16, 2007 |  |  | 37.48 |  |  |  | 1,337 |  |  |  | 4.41 |  |  |  | 37.48 |  |  |  | 1,337 |  |  |  | 37.48 |
December 10, 2007 |  |  | 37.00 |  |  |  | 2,450 |  |  |  | 4.95 |  |  |  | 37.00 |  |  |  | 2,450 |  |  |  | 37.00 |
January 2, 2008 |  |  | 36.25 |  |  |  | 1,337 |  |  |  | 5.12 |  |  |  | 36.25 |  |  |  | 1,337 |  |  |  | 36.25 |
November 10, 2008 |  |  | 23.00 |  |  |  | 21,500 |  |  |  | 5.95 |  |  |  | 23.00 |  |  |  | 21,500 |  |  |  | 23.00 |
May 9, 2011 |  |  | 17.55 |  |  |  | 8,875 |  |  |  | 8.41 |  |  |  | 17.55 |  |  |  | 8,875 |  |  |  | 17.55 |
|  |  |  |  |  |  | 79,693 |  |  |  |  |  |  |  |  |  |  |  | 79,693 |  |  |  |  |

For the years ended December 31, 2012, 2011, and 2010, the Company granted 1,722, 2,400, and 110 shares, respectively, of common stock under the Omnibus Equity Plan. The Company recognizes compensation expense in the amount of fair value of the common stock at the grant date and as an addition to stockholders’ equity.
14. COMMITMENTS
In the normal course of business, there are various outstanding commitments and certain contingent liabilities which are not reflected in the accompanying consolidated financial statements. These commitments and contingent liabilities represent financial instruments with off-balance sheet risk. The contract or notional amounts of those instruments reflect the extent of involvement in particular types of financial instruments which were composed of the following:

(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |
Commitments to extend credit |  | $ | 91,854 |  |  | $ | 81,402 |
Standby letters of credit |  |  | 281 |  |  |  | 639 |
Total |  | $ | 92,135 |  |  | $ | 82,041 |

These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheet. The Company’s exposure to credit loss, in the event of nonperformance by the other parties to the financial instruments, is represented by the contractual amounts as disclosed. The Company minimizes its exposure to credit loss under these commitments by subjecting them to credit approval and review procedures and collateral requirements as deemed necessary. Commitments generally have fixed expiration dates within one year of their origination.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Performance letters of credit represent conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These instruments are issued primarily to support bid or performance-related contracts. The coverage period for these instruments is typically a one-year period with an annual renewal option subject to prior approval by management. Fees earned from the issuance of these letters are recognized over the coverage period. For secured letters of credit, the collateral is typically bank deposit instruments or customer business assets.
28

Leasing Arrangements
The Company leases certain of its banking facilities under operating leases which contain certain renewal options. As of December 31, 2012, approximate future minimum rental payments, including the renewal options under these leases, are as follows (in thousands):

2013 |  | $ | 271 |
2014 |  | $ | 280 |
2015 |  | $ | 284 |
2016 |  | $ | 284 |
2017 |  | $ | 284 |
Thereafter |  | $ | 284 |

The above amounts represent minimum rentals not adjusted for possible future increases due to escalation provisions and assume that all renewal option periods will be exercised by the Company. Rent expense approximated $269,000, $248,000, and $234,000 for the years ended December 31, 2012, 2011, and 2010, respectively.
15. REGULATORY RESTRICTIONS
The Company is subject to the regulatory requirements of the Federal Reserve System as a multi-bank holding company. The affiliate banks are subject to regulations of the Federal Deposit Insurance Corporation (“FDIC”) and the State of Ohio, Division of Financial Institutions.
In February of 2011 Emerald Bank agreed with the FDIC and the Ohio Division of Financial Institutions that Emerald Bank will take specified actions to correct weaknesses in the bank’s condition and operations. The actions that Emerald Bank agreed to take include reducing the bank’s concentration of credit in non-owner occupied 1 - 4 family residential mortgage loans, reducing delinquent and classified loans, enhancing credit administration for non-owner occupied residential real estate, developing plans for the reduction of borrower indebtedness on classified and delinquent credits, implementing an earnings improvement plan, maintaining leverage capital of at least 9%, revising the bank’s methodology for calculating and determining the adequacy of the allowance for loan losses, and providing to the FDIC and the ODFI notice of proposed dividend payments at least 30 days in advance.
We have conducted an evaluation and reorganization of lending and credit administration personnel, retained collection and workout personnel, and sold $5.8 million of nonperforming assets EMORECO, Inc., Middlefield Banc Corp.’s nonbank-asset resolution subsidiary established in the fourth quarter of 2009. Middlefield Banc Corp. provided capital of $500,000 to Emerald Bank in 2010 and $1.5 million in 2011 so that Emerald Bank would achieve the elevated 9% leverage capital level. At December 31, 2012 Emerald Bank’s leverage ratio was 10.61%.
In addition to Emerald Bank maintaining leverage capital of at least 9%, The Middlefield Banking Company committed to the FDIC that The Middlefield Banking Company will maintain capital ratios at levels no lower than its June 30, 2010 ratios (i.e., no lower than 6.25% tier 1 leverage capital and 11.29% total risk-based capital), and Middlefield Banc Corp. committed to the Federal Reserve that Middlefield Banc Corp. will maintain tier 1 leverage capital of at least 7.25% and total risk-based capital of at least 12%, both at the level of the holding company and at the level of The Middlefield Banking Company, the lead bank.
Cash Requirements
The Cleveland district Federal Reserve Bank requires the Company to maintain certain average reserve balances. As of December 31, 2012 and 2011, the Company had required reserves of $7,063,000 and $5,419,000 comprising vault cash and a depository amount held with the Federal Reserve Bank.
Loans
Federal law prevents the Company from borrowing from the Banks unless the loans are secured by specific obligations. Further, such secured loans are limited in amount of 10 percent of the Banks’ common stock and capital surplus.
Dividends
MBC and EB are subject to dividend restrictions that generally limit the amount of dividends that can be paid by an Ohio state-chartered bank. Under the Ohio Banking Code, cash dividends may not exceed net profits as defined for that year combined with retained net profits for the two preceding years less any required transfers to surplus. Under this formula, for MBC, the amount available for payment of dividends for 2012 approximates $8,077,000 plus 2012 profits retained up to the date of the dividend declaration. For EB, there is no amount available for payment of dividends for 2012 until the net deficit for the two preceding years of $144,000 is overcome.
29

Potential Restrictions
On or about January 14, 2013 an investor to whom we sold a total of 196,635 shares in April of 2012, constituting 9.9% of our stock, obtained from the Ohio Division of Financial Institutions and the Federal Reserve Bank of Cleveland regulatory clearance to acquire up to 24.99% of our stock. The August 15, 2011 Stock Purchase Agreement, as amended, under which we sold shares to the investor provided for sale of up to 24.99% of our stock, subject to the investor obtaining regulatory clearance and subject to other conditions. Although we disclosed in a Form 8-K Current Report filed with the SEC on January 18, 2013 that sale of additional shares to the investor under the terms of the Stock Purchase Agreement will not occur, if the investor nevertheless acquires shares and increases his ownership to 10% or more of our common stock, whether acquiring the shares on the open market or from us, we will become subject to additional restrictions under the terms of the regulatory clearance issued to the investor by the Ohio Division of Financial Institutions. Specifically, for three years after the investor becomes an owner of 10% or more of our stock, we would have to obtain advance approval of the ODFI in order for The Middlefield Banking Company to pay a dividend to Middlefield Banc Corp., and for 12 months we would have to obtain advance written approval of the ODFI for any changes in the composition of Middlefield Banc Corp.’s board or executive management.
16. REGULATORY CAPITAL
Federal regulations require the Company and the Banks to maintain minimum amounts of capital. Specifically, each is required to maintain certain minimum dollar amounts and ratios of Total and Tier I capital to risk-weighted assets and of Tier I capital to average total assets.
In addition to the capital requirements, the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) established five capital categories ranging from “well capitalized” to “critically undercapitalized.” Should any institution fail to meet the requirements to be considered “adequately capitalized,” it would become subject to a series of increasingly restrictive regulatory actions.
As of December 31, 2012 and 2011, the FDIC categorized the Banks as well capitalized under the regulatory framework for prompt corrective action. To be classified as a well capitalized financial institution, Total risk-based, Tier 1 risk-based, and Tier 1 Leverage capital ratios must be at least 10 percent, 6 percent, and 5 percent, respectively.
The Company’s and its subsidiaries’ actual capital ratios are presented in the following table that shows that all regulatory capital requirements were met as of December 31, 2012.
30

(Dollar amounts in thousands) |  | Middlefield Banc Corp. December 31, 2012 |  |  | The Middlefield Banking Co. December 31, 2012 |  |  | Emerald Bank December 31, 2012 |
|  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |
Total Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Risk-weighted Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 57,784 |  |  |  | 13.86 | % |  | $ | 47,887 |  |  |  | 13.29 | % |  | $ | 8,440 |  |  |  | 15.45 | %
For Capital Adequacy Purposes |  |  | 33,344 |  |  |  | 8.00 |  |  |  | 28,822 |  |  |  | 8.00 |  |  |  | 4,370 |  |  |  | 8.00 |
To Be Well Capitalized |  |  | 41,680 |  |  |  | 10.00 |  |  |  | 36,027 |  |  |  | 10.00 |  |  |  | 5,463 |  |  |  | 10.00 |
Tier I Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Risk-weighted Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 52,543 |  |  |  | 12.61 | % |  | $ | 43,371 |  |  |  | 12.04 | % |  | $ | 7,737 |  |  |  | 14.16 | %
For Capital Adequacy Purposes |  |  | 16,672 |  |  |  | 4.00 |  |  |  | 14,411 |  |  |  | 4.00 |  |  |  | 2,185 |  |  |  | 4.00 |
To Be Well Capitalized |  |  | 25,008 |  |  |  | 6.00 |  |  |  | 21,616 |  |  |  | 6.00 |  |  |  | 3,278 |  |  |  | 6.00 |
Tier I Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Average Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 52,543 |  |  |  | 7.88 | % |  | $ | 43,371 |  |  |  | 7.32 | % |  | $ | 7,737 |  |  |  | 10.61 | %
For Capital Adequacy Purposes |  |  | 26,675 |  |  |  | 4.00 |  |  |  | 23,684 |  |  |  | 4.00 |  |  |  | 2,916 |  |  |  | 4.00 |
To Be Well Capitalized |  |  | 33,344 |  |  |  | 5.00 |  |  |  | 29,605 |  |  |  | 5.00 |  |  |  | 3,646 |  |  |  | 5.00 |

See Note 15 for additional information concerning regulatory capital requirements
31

The Company’s and its subsidiaries’ actual capital ratios are presented in the following table that shows that all regulatory capital requirements were met as of December 31, 2011.

|  | Middlefield Banc Corp. December 31, 2011 |  |  | The Middlefield Banking Co. December 31, 2011 |  |  | Emerald Bank December 31, 2011 |
|  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |
Total Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Risk-weighted Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 49,915 |  |  |  | 12.06 | % |  | $ | 42,185 |  |  |  | 11.75 | % |  | $ | 7,456 |  |  |  | 13.82 | %
For Capital Adequacy Purposes |  |  | 33,101 |  |  |  | 8.00 |  |  |  | 28,722 |  |  |  | 8.00 |  |  |  | 4,317 |  |  |  | 8.00 |
To Be Well Capitalized |  |  | 41,376 |  |  |  | 10.00 |  |  |  | 35,903 |  |  |  | 10.00 |  |  |  | 5,396 |  |  |  | 10.00 |
Tier I Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Risk-weighted Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 44,723 |  |  |  | 10.81 | % |  | $ | 37,697 |  |  |  | 10.50 | % |  | $ | 6,782 |  |  |  | 12.57 | %
For Capital Adequacy Purposes |  |  | 16,551 |  |  |  | 4.00 |  |  |  | 14,361 |  |  |  | 4.00 |  |  |  | 2,158 |  |  |  | 4.00 |
To Be Well Capitalized |  |  | 24,826 |  |  |  | 6.00 |  |  |  | 21,542 |  |  |  | 6.00 |  |  |  | 3,237 |  |  |  | 6.00 |
Tier I Capital |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
(to Average Assets) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Actual |  | $ | 44,723 |  |  |  | 7.13 | % |  | $ | 37,697 |  |  |  | 6.75 | % |  | $ | 6,782 |  |  |  | 9.92 | %
For Capital Adequacy Purposes |  |  | 25,079 |  |  |  | 4.00 |  |  |  | 22,325 |  |  |  | 4.00 |  |  |  | 2,734 |  |  |  | 4.00 |
To Be Well Capitalized |  |  | 31,349 |  |  |  | 5.00 |  |  |  | 27,906 |  |  |  | 5.00 |  |  |  | 3,417 |  |  |  | 5.00 |

17. FA IR VALUE DISCLOSURE MEASUREMENTS
The following disclosures show the hierarchal disclosure framework associated with the level of pricing observations utilized in measuring assets and liabilities at fair value. The three broad levels defined by U.S. generally accepted accounting principles are as follows:

| Level I: | Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

| Level II: | Pricing inputs are other than the quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities includes items for which quoted prices are available but traded less frequently and items that are fair-valued using other financial instruments, the parameters of which can be directly observed.

| Level III: | Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

This hierarchy requires the use of observable market data when available.
32

The following table presents the assets reported on the balance sheet at their fair value as of December 31, 2012 and 2011, by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

|  |  |  |  | December 31, 2012 |  |  |  |
(Dollar amounts in thousands) |  | Level I |  |  | Level II |  |  | Level III |  |  | Total |
Assets measured on a recurring basis: |  |  |  |  |  |  |  |  |  |  |  |
U.S. government agency securities |  | $ | - |  |  | $ | 24,960 |  |  | $ | - |  |  | $ | 24,960 |
Obligations of states and political subdivisions |  |  | - |  |  |  | 92,596 |  |  |  | - |  |  |  | 92,596 |
Mortgage-backed securities in government- sponsored entities |  |  | - |  |  |  | 71,102 |  |  |  | - |  |  |  | 71,102 |
Private-label mortgage-backed securities |  |  | - |  |  |  | 5,064 |  |  |  | - |  |  |  | 5,064 |
Total debt securities |  |  | - |  |  |  | 193,722 |  |  |  | - |  |  |  | 193,722 |
Equity securities in financial institutions |  |  | 5 |  |  |  | 745 |  |  |  | - |  |  |  | 750 |
Total |  | $ | 5 |  |  | $ | 194,467 |  |  | $ | - |  |  | $ | 194,472 |

|  |  |  |  |  | December 31, 2011 |  |  |  |  |
|  | Level I |  |  | Level II |  |  | Level III |  |  | Total |
Assets measured on a recurring basis: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
U.S. government agency securities |  | $ | - |  |  | $ | 31,933 |  |  | $ | - |  |  | $ | 31,933 |
Obligations of states and political subdivisions |  |  | - |  |  |  | 88,400 |  |  |  | - |  |  |  | 88,400 |
Mortgage-backed securities in government- sponsored entities |  |  | - |  |  |  | 65,573 |  |  |  | - |  |  |  | 65,573 |
Private-label mortgage-backed securities |  |  | - |  |  |  | 7,321 |  |  |  | - |  |  |  | 7,321 |
Total debt securities |  |  | - |  |  |  | 193,227 |  |  |  | - |  |  |  | 193,227 |
Equity securities in financial institutions |  |  | 5 |  |  |  | 745 |  |  |  | - |  |  |  | 750 |
Total |  | $ | 5 |  |  | $ | 193,972 |  |  | $ | - |  |  | $ | 193,977 |

Financial instruments are considered Level III when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. In addition to these unobservable inputs, the valuation models for Level III financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly. Level III financial instruments also include those for which the determination of fair value requires significant management judgment or estimation.
The following tables present the assets measured on a nonrecurring basis on the Consolidated Balance Sheet at their fair value by level within the fair value hierarchy. Impaired loans that are collateral-dependent are written down to fair value through the establishment of specific reserves. Techniques used to value the collateral that secure the impaired loan include: quoted market prices for identical assets classified as Level I inputs and observable inputs, employed by certified appraisers, for similar assets classified as Level II inputs. In cases where valuation techniques included inputs that are unobservable and are based on estimates and assumptions developed by management based on the best information available under each circumstance, the asset valuation is classified as Level III inputs.

|  |  |  |  | December 31, 2012 |  |  |  |
(Dollar amounts in thousands) |  | Level I |  |  | Level II |  |  | Level III |  |  | Total |
Assets measured on a non-recurring basis: |  |  |  |  |  |  |  |  |  |  |  |
Impaired loans |  | $ | - |  |  | $ | - |  |  | $ | 17,600 |  |  | $ | 17,600 |
Other real estate owned |  |  | - |  |  |  | - |  |  |  | 1,846 |  |  |  | 1,846 |

33

|  |  |  |  | December 31, 2011 |  |  |  |
|  | Level I |  |  | Level II |  |  | Level III |  |  | Total |
Assets measured on a non-recurring basis: |  |  |  |  |  |  |  |  |  |  |  |
Impaired loans |  | $ | - |  |  | $ | - |  |  | $ | 13,581 |  |  | $ | 13,581 |
Other real estate owned |  |  | - |  |  |  | - |  |  |  | 2,196 |  |  |  | 2,196 |

The following table presents additional quantitative information about assets measured at fair value on a non-recurring basis and for which the Company uses Level III inputs to determine fair value:

|  | Quantitative Information about Level III Fair Value Measurements |
(unaudited, in thousands) |  | Estimate |  |  | Valuation Techniquest |  |  | Unobservable Input |  |  | Range (Weighted Average) |
December 31, 2012 |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Impaired loans |  | $ | 17,600 |  |  | Appraisal of collateral (1) |  |  | Appraisal adjustments (2) |  |  | 20.0% | to | -68.0% | (-32.4%) |
|  |  |  |  |  |  |  |  | Liquidation expenses (2) |  |  | 0.3% | to | -45.8% | (-2.1%) |
Other real estate owned |  | $ | 1,846 |  |  | Appraisal of collateral (1), (3) |  |  |  |  |  |  |  |  |  |

| (1) | Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various level 3 inputs which are not identifiable.

| (2) | Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses. The range and weighted average of liquidation expenses and other appraisal adjustments are presented as a percent of the appraisal.

| (3) | Includes qualitative adjustments by management and estimated liquidation expenses.

The estimated fair value of the Company’s financial instruments is as follows:

|  | December 31, 2012 |
|  | Carrying Value |  |  | Level I |  |  | Level II |  |  | Level III |  |  | Total Fair Value |
|  | (in thousands) |
Financial assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Cash and cash equivalents |  | $ | 45,346 |  |  | $ | 45,346 |  |  | $ | - |  |  | $ | - |  |  | $ | 45,346 |
Investment securities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Available for sale |  |  | 194,472 |  |  |  | 5 |  |  |  | 194,467 |  |  |  | - |  |  |  | 194,472 |
Net loans |  |  | 400,654 |  |  |  | - |  |  |  | - |  |  |  | 390,206 |  |  |  | 390,206 |
Bank-owned life insurance |  |  | 8,536 |  |  |  | 8,536 |  |  |  | - |  |  |  | - |  |  |  | 8,536 |
Federal Home Loan Bank stock |  |  | 1,887 |  |  |  | 1,887 |  |  |  | - |  |  |  | - |  |  |  | 1,887 |
Accrued interest receivable |  |  | 2,163 |  |  |  | 2,163 |  |  |  | - |  |  |  | - |  |  |  | 2,163 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Deposits |  | $ | 593,335 |  |  | $ | 396,582 |  |  | $ | - |  |  | $ | 196,122 |  |  | $ | 592,704 |
Short-term borrowings |  |  | 6,538 |  |  |  | 6,538 |  |  |  | - |  |  |  | - |  |  |  | 6,538 |
Other borrowings |  |  | 12,970 |  |  |  | - |  |  |  | - |  |  |  | 13,337 |  |  |  | 13,337 |
Accrued interest payable |  |  | 492 |  |  |  | 492 |  |  |  | - |  |  |  | - |  |  |  | 492 |

34

|  | December 31, 2011 |
|  | Carrying Value |  |  | Level I |  |  | Level II |  |  | Level III |  |  | Total Fair Value |
|  | (in thousands) |
Financial assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Cash and cash equivalents |  | $ | 34,390 |  |  | $ | 34,390 |  |  | $ | - |  |  | $ | - |  |  | $ | 34,390 |
Investment securities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Available for sale |  |  | 193,977 |  |  |  | 5 |  |  |  | 193,972 |  |  |  | - |  |  |  | 193,977 |
Net loans |  |  | 395,061 |  |  |  | - |  |  |  | - |  |  |  | 382,542 |  |  |  | 382,542 |
Bank-owned life insurance |  |  | 8,257 |  |  |  | 8,257 |  |  |  | - |  |  |  | - |  |  |  | 8,257 |
Federal Home Loan Bank stock |  |  | 1,887 |  |  |  | 1,887 |  |  |  | - |  |  |  | - |  |  |  | 1,887 |
Accrued interest receivable |  |  | 2,234 |  |  |  | 2,234 |  |  |  | - |  |  |  | - |  |  |  | 2,234 |
Financial liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Deposits |  | $ | 580,962 |  |  | $ | 362,029 |  |  | $ | - |  |  | $ | 225,149 |  |  | $ | 587,178 |
Short-term borrowings |  |  | 7,392 |  |  |  | 7,392 |  |  |  | - |  |  |  | - |  |  |  | 7,392 |
Other borrowings |  |  | 16,831 |  |  |  | - |  |  |  | - |  |  |  | 17,327 |  |  |  | 17,327 |
Accrued interest payable |  |  | 645 |  |  |  | 645 |  |  |  | - |  |  |  | - |  |  |  | 645 |

Financial instruments are defined as cash, evidence of ownership interest in an entity, or a contract which creates an obligation or right to receive or deliver cash or another financial instrument from/to a second entity on potentially favorable or unfavorable terms.
Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing parties other than in a forced liquidation sale. If a quoted market price is available for a financial instrument, the estimated fair value would be calculated based upon the market price per trading unit of the instrument.
If no readily available market exists, the fair value estimates for financial instruments should be based upon management’s judgment regarding current economic conditions, interest rate risk, expected cash flows, future estimated losses, and other factors as determined through various option pricing formulas or simulation modeling. Since many of these assumptions result from judgments made by management based upon estimates which are inherently uncertain, the resulting estimated fair values may not be indicative of the amount realizable in the sale of a particular financial instrument. In addition, changes in assumptions on which the estimated fair values are based may have a significant impact on the resulting estimated fair values.
As certain assets such as deferred tax assets and premises and equipment are not considered financial instruments, the estimated fair value of financial instruments would not represent the full value of the Company.
The Company employed simulation modeling in determining the estimated fair value of financial instruments for which quoted market prices were not available based upon the following assumptions:
Cash and Cash Equivalents, Federal Home Loan Bank Stock, Accrued Interest Receivable, Accrued Interest Payable, and Short-Term Borrowings
The fair value is equal to the current carrying value.
Bank-Owned Life Insurance
The fair value is equal to the cash surrender value of the life insurance policies.
Investment Securities Available for Sale
The fair value of investment securities is equal to the available quoted market price. If no quoted market price is available, fair value is estimated using the quoted market price for similar securities. Fair value for certain private-label collateralized mortgage obligations were determined utilizing discounted cash flow models, due to the absence of a current market to provide reliable market quotes for the instruments.
35

Loans
The fair value is estimated by discounting future cash flows using current market inputs at which loans with similar terms and qualities would be made to borrowers of similar credit quality. Where quoted market prices were available, primarily for certain residential mortgage loans, such market rates were utilized as estimates for fair value.
Deposits and Other Borrowed Funds
The fair values of certificates of deposit and other borrowed funds are based on the discounted value of contractual cash flows. The discount rates are estimated using rates currently offered for similar instruments with similar remaining maturities. Demand, savings, and money market deposits are valued at the amount payable on demand as of year-end.
Commitments to Extend Credit
These financial instruments are generally not subject to sale, and estimated fair values are not readily available. The carrying value, represented by the net deferred fee arising from the unrecognized commitment or letter of credit, and the fair value, determined by discounting the remaining contractual fee over the term of the commitment using fees currently charged to enter into similar agreements with similar credit risk, are not considered material for disclosure. The contractual amounts of unfunded commitments and letters of credit are presented in Note 14.
18. COMMON STOCK OFFERING
In a private common stock offering that began in 2010, Middlefield Banc Corp. sold a total of 138,150 shares in 2011, followed by a sale of 93,050 shares on April 17, 2012 and a sale of 103,585 shares on April 30, 2012. The offering concluded on March 8, 2013 with a sale of 13,320 shares to an institutional investor, completing the sale to that investor under the terms of the subscription agreement it entered into in August of 2011. All sales in the offering occurred at $16 per share.
19. PARENT COMPANY
Following are condensed financial statements for the Company.
CONDENSED BALANCE SHEET

(Dollar amounts in thousands) |  | December 31, |
|  | 2012 |  |  | 2011 |
ASSETS |  |  |  |  |  |
Cash and due from banks |  | $ | 1,740 |  |  | $ | 710 |
Investment securities available for sale |  |  | 751 |  |  |  | 751 |
Investment in non-bank subsidiary |  |  | 2,664 |  |  |  | 2,944 |
Investment in subsidiary banks |  |  | 62,002 |  |  |  | 55,256 |
Other assets |  |  | 1,453 |  |  |  | 1,638 |
TOTAL ASSETS |  | $ | 68,610 |  |  | $ | 61,299 |
LIABILITIES |  |  |  |  |  |  |  |
Trust preferred securities |  | $ | 8,248 |  |  | $ | 8,248 |
Short-term borrowings |  |  | 4,896 |  |  |  | 5,700 |
Other liabilities |  |  | 29 |  |  |  | 98 |
TOTAL LIABILITIES |  |  | 13,173 |  |  |  | 14,046 |
STOCKHOLDERS' EQUITY |  |  | 55,437 |  |  |  | 47,253 |
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY |  | $ | 68,610 |  |  | $ | 61,299 |

36

CONDENSED STATEMENT OF INCOME

|  | Year Ended December 31, |
(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
INCOME |  |  |  |  |  |  |  |  |
Dividends from subsidiary bank |  | $ | 2,327 |  |  | $ | 2,403 |  |  | $ | 2,061 |
Interest income |  |  | - |  |  |  | - |  |  |  | 3 |
Other |  |  | 8 |  |  |  | (177 | ) |  |  | 17 |
Total income |  |  | 2,335 |  |  |  | 2,226 |  |  |  | 2,081 |
EXPENSES |  |  |  |  |  |  |  |  |  |  |  |
Interest expense |  |  | 417 |  |  |  | 772 |  |  |  | 773 |
Other |  |  | 594 |  |  |  | 370 |  |  |  | 270 |
Total expenses |  |  | 1,011 |  |  |  | 1,142 |  |  |  | 1,043 |
Income before income tax benefit |  |  | 1,324 |  |  |  | 1,084 |  |  |  | 1,038 |
Income tax benefit |  |  | (342 | ) |  |  | (449 | ) |  |  | (348 | )
Income before equity in undistributed net income of subsidiaries |  |  | 1,666 |  |  |  | 1,533 |  |  |  | 1,386 |
Equity in undistributed net income of subsidiaries |  |  | 4,615 |  |  |  | 2,597 |  |  |  | 1,131 |
NET INCOME |  | $ | 6,281 |  |  | $ | 4,130 |  |  | $ | 2,517 |
Comprehensive Income |  | $ | 7,131 |  |  | $ | 8,184 |  |  | $ | 2,442 |

37

20. PARENT COMPANY (continued)
CONDENSED STATEMENT OF CASH FLOWS

|  | Year Ended December 31, |  |  |  |
(Dollar amounts in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
OPERATING ACTIVITIES |  |  |  |  |  |  |  |  |
Net income |  | $ | 6,281 |  |  | $ | 4,130 |  |  | $ | 2,517 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |  |  |  |  |  |  |  |  |  |
Equity in undistributed net income of Middlefield Banking Company |  |  | (4,655 | ) |  |  | (3,422 | ) |  |  | (2,582 | )
Equity in undistributed net income of Emerald Bank |  |  | (240 | ) |  |  | 384 |  |  |  | 292 |
Equity in undistributed net income of EMORECO |  |  | 280 |  |  |  | 441 |  |  |  | 1,159 |
Stock-based compensation expense |  |  | 32 |  |  |  | 59 |  |  |  | - |
Investment securities losses, net |  |  | - |  |  |  | 179 |  |  |  | - |
Other |  |  | (885 | ) |  |  | (806 | ) |  |  | (602 | )
Net cash provided by operating activities |  |  | 813 |  |  |  | 965 |  |  |  | 784 |
INVESTING ACTIVITIES |  |  |  |  |  |  |  |  |  |  |  |
Investment in subsidiary bank |  |  | - |  |  |  | (1,500 | ) |  |  | (500 | )
Net cash used for investing activities |  |  | - |  |  |  | (1,500 | ) |  |  | (500 | )
FINANCING ACTIVITIES |  |  |  |  |  |  |  |  |  |  |  |
Net decrease in short-term borrowings |  |  | (804 | ) |  |  | - |  |  |  | - |
Common stock issued |  |  | 2,329 |  |  |  | 2,210 |  |  |  | - |
Proceeds from dividend reinvestment plan |  |  | 694 |  |  |  | 542 |  |  |  | 510 |
Cash dividends |  |  | (2,002 | ) |  |  | (1,764 | ) |  |  | (1,637 | )
Net cash provided by (used for) financing activities |  |  | 217 |  |  |  | 988 |  |  |  | (1,127 | )
Increase (decrease) in cash |  |  | 1,030 |  |  |  | 453 |  |  |  | (843 | )
CASH AT BEGINNING OF YEAR |  |  | 710 |  |  |  | 257 |  |  |  | 1,100 |
CASH AT END OF YEAR |  | $ | 1,740 |  |  | $ | 710 |  |  | $ | 257 |

38

21. SELECTED QUARTERLY FINANCIAL DATA (Unaudited)

(Dollar amounts in thousands) |  | Three Months Ended |
|  | March 31, 2012 |  |  | June 30, 2012 |  |  | September 30, 2012 |  |  | December 31, 2012 |
Total interest income |  | $ | 7,232 |  |  | $ | 7,223 |  |  | $ | 7,342 |  |  | $ | 6,949 |
Total interest expense |  |  | 1,686 |  |  |  | 1,646 |  |  |  | 1,602 |  |  |  | 1,513 |
Net interest income |  |  | 5,546 |  |  |  | 5,577 |  |  |  | 5,740 |  |  |  | 5,436 |
Provision for loan losses |  |  | 600 |  |  |  | 450 |  |  |  | 143 |  |  |  | 975 |
Net interest income after provision for loan losses |  |  | 4,946 |  |  |  | 5,127 |  |  |  | 5,597 |  |  |  | 4,461 |
Total noninterest income |  |  | 794 |  |  |  | 1,017 |  |  |  | 868 |  |  |  | 772 |
Total noninterest expense |  |  | 3,782 |  |  |  | 4,041 |  |  |  | 4,122 |  |  |  | 3,694 |
Income before income taxes |  |  | 1,958 |  |  |  | 2,103 |  |  |  | 2,343 |  |  |  | 1,539 |
Income taxes |  |  | 435 |  |  |  | 463 |  |  |  | 494 |  |  |  | 270 |
Net income |  | $ | 1,523 |  |  | $ | 1,640 |  |  | $ | 1,849 |  |  | $ | 1,269 |
Per share data: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Net income |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  | $ | 0.86 |  |  | $ | 0.85 |  |  | $ | 0.93 |  |  | $ | 0.65 |
Diluted |  |  | 0.86 |  |  |  | 0.85 |  |  |  | 0.93 |  |  |  | 0.64 |
Average shares outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  |  | 1,763,982 |  |  |  | 1,919,333 |  |  |  | 1,978,181 |  |  |  | 1,984,818 |
Diluted |  |  | 1,764,585 |  |  |  | 1,921,205 |  |  |  | 1,983,863 |  |  |  | 1,991,354 |

39

(Dollar amounts in thousands) |  | Three Months Ended |
|  | March 31, 2011 |  |  | June 30, 2011 |  |  | September 30, 2011 |  |  | December 31, 2011 |
Total interest income |  | $ | 7,359 |  |  | $ | 7,421 |  |  | $ | 7,528 |  |  | $ | 7,419 |
Total interest expense |  |  | 2,341 |  |  |  | 2,304 |  |  |  | 2,134 |  |  |  | 1,873 |
Net interest income |  |  | 5,018 |  |  |  | 5,117 |  |  |  | 5,394 |  |  |  | 5,546 |
Provision for loan losses |  |  | 865 |  |  |  | 700 |  |  |  | 920 |  |  |  | 600 |
Net interest income after provision for loan losses |  |  | 4,153 |  |  |  | 4,417 |  |  |  | 4,474 |  |  |  | 4,946 |
Total noninterest income |  |  | 699 |  |  |  | 594 |  |  |  | 686 |  |  |  | 258 |
Total noninterest expense |  |  | 3,705 |  |  |  | 4,292 |  |  |  | 3,906 |  |  |  | 3,598 |
Income before income taxes |  |  | 1,147 |  |  |  | 719 |  |  |  | 1,254 |  |  |  | 1,606 |
Income taxes |  |  | 145 |  |  |  | (1 | ) |  |  | 175 |  |  |  | 277 |
Net income |  | $ | 1,002 |  |  | $ | 720 |  |  | $ | 1,079 |  |  | $ | 1,329 |
Per share data: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Net income |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  | $ | 0.62 |  |  | $ | 0.44 |  |  | $ | 0.63 |  |  | $ | 0.76 |
Diluted |  |  | 0.62 |  |  |  | 0.44 |  |  |  | 0.63 |  |  |  | 0.76 |
Average shares outstanding: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Basic |  |  | 1,621,889 |  |  |  | 1,647,771 |  |  |  | 1,704,677 |  |  |  | 1,756,157 |
Diluted |  |  | 1,651,889 |  |  |  | 1,647,920 |  |  |  | 1,704,677 |  |  |  | 1,756,157 |

Management’s Discussion and Analysis of
Financial Condition and Results of Operations
Overview
The consolidated review and analysis of Middlefield Banc Corp. (“Company”) is intended to assist the reader in evaluating the performance of the Company for the years ended December 31, 2012, 2011, and 2010. This information should be read in conjunction with the consolidated financial statements and accompanying notes to the financial statements.
The Company is an Ohio corporation organized to become the holding company of The Middlefield Banking Company (“MBC”). MBC is a state-chartered bank located in Ohio. On April 19, 2007, the Company acquired Emerald Bank (“EB”), an Ohio-chartered commercial bank headquartered in Dublin, Ohio. On October 23, 2009, the Company established an asset resolution subsidiary named EMORECO, Inc. The Company and its two banking subsidiaries derive substantially all of their income from banking and bank-related services, which includes interest earnings on residential real estate, commercial mortgage, commercial and consumer financings as well as interest earnings on investment securities and deposit services to its customers through ten locations. The Company is supervised by the Board of Governors of the Federal Reserve System, while the Banks are subject to regulation and supervision by the Federal Deposit Insurance Corporation and the Ohio Division of Financial Institutions. MBC and EB are members of the Federal Home Loan Bank (FHLB) of Cincinnati, which is one of the twelve regional banks comprising the FHLB System.
This Management’s Discussion and Analysis section of the Annual Report contains forward-looking statements. Forward-looking statements are based upon a variety of estimates and assumptions. The estimates and assumptions involve judgments about a number of things, including future economic, competitive, and financial market conditions and future business decisions. These matters are inherently subject to significant business, economic, and competitive uncertainties, all of which are difficult to predict and many of which are beyond the Company's control. Although the Company believes its estimates and assumptions are reasonable, actual results could vary materially from those shown. Inclusion of forward-looking information does not constitute a representation by the Company or any other person that the indicated results will be achieved. Investors are cautioned not to place undue reliance on forward-looking information.
40

These forward-looking statements may involve significant risks and uncertainties. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from the results in these forward-looking statements.
Significant Factors Affecting Financial Results
Formation of asset resolution subsidiary. On October 23, 2009 the Company received from the Federal Reserve Bank of Cleveland approval to establish an asset resolution subsidiary. Organized as an Ohio corporation under the name EMORECO, Inc. and wholly owned by the Company, the purpose of the asset resolution subsidiary is to maintain, manage, and ultimately dispose of nonperforming loans and real estate acquired by subsidiary banks as the result of borrower default on real-estate-secured loans. At December 31, 2012, EMORECO’s assets consist of six nonperforming loans and eight OREO properties. EMORECO has paid approximately $5.8 million to Emerald Bank for the nonperforming loans and other real estate, using funds contributed by the Company, which were borrowed under lines of credit of the holding company. Federal law governing bank holding companies provides that a holding company subsidiary has limited real estate investment powers. EMORECO may only manage and maintain property and may not improve or develop property without advance approval of the Federal Reserve Bank.
Closer regulatory supervision of Emerald Bank. In February of 2011 Emerald Bank agreed with the FDIC and the Ohio Division of Financial Institutions that Emerald Bank will take specified actions to correct weaknesses in the bank’s condition and operations. The actions that Emerald Bank agreed to take include reducing the bank’s concentration of credit in non-owner occupied 1 - 4 family residential mortgage loans, reducing delinquent and classified loans, enhancing credit administration for non-owner occupied residential real estate, developing plans for the reduction of borrower indebtedness on classified and delinquent credits, implementing an earnings improvement plan, maintaining leverage capital of at least 9%, revising the bank’s methodology for calculating and determining the adequacy of the allowance for loan losses, and providing to the FDIC and the ODFI notice of proposed dividend payments at least 30 days in advance.
We have conducted an evaluation and reorganization of lending and credit administration personnel, retained collection and workout personnel, and sold $5.8 million of nonperforming assets EMORECO, Inc., Middlefield Banc Corp.’s nonbank-asset resolution subsidiary established in the fourth quarter of 2009. Middlefield Banc Corp. provided capital of $500,000 to Emerald Bank in 2010 and $1.50 million in 2011 so that Emerald Bank would achieve the elevated 9% leverage capital level. At December 31, 2012 Emerald Bank’s leverage ratio was 10.61%.
In addition to Emerald Bank maintaining leverage capital of at least 9%, The Middlefield Banking Company committed to the FDIC that The Middlefield Banking Company will maintain capital ratios at levels no lower than its June 30, 2010 ratios (i.e., no lower than 6.25% tier 1 leverage capital and 11.29% total risk-based capital), and Middlefield Banc Corp. committed to the Federal Reserve that Middlefield Banc Corp. will maintain tier 1 leverage capital of at least 7.25% and total risk-based capital of at least 12%, both at the level of the holding company and at the level of The Middlefield Banking Company, the lead bank.
Continued weakness in the local and regional economies. In 2012 the Company continued to be the impacted by the recession that began in late 2007, with sluggish local and regional economies, a depressed residential and commercial real estate market, and elevated unemployment levels. We currently anticipate that in the near term of the next year or two the economy of the markets in which we conduct business will remain sluggish at best. There is the potential for further deterioration in the residential and commercial real estate markets and in unemployment levels, but we currently are optimistic that within the next year or two these local and regional macro-economic factors could actually turn slightly positive. Nevertheless, we anticipate that prevailing interest rates will remain at historically low levels, with improvement in the level of nonperforming assets and classified assets lagging somewhat behind improvement in the local and regional economies. In the longer term of three to five years, we anticipate a more solid economy locally, regionally, and nationally, with interest rates finally increasing from their prolonged record-low levels.
Capital maintenance and enhancement is a priority. In January of 2011, the Company’s board established a goal to achieve Tier 1 leverage capital of 7.25% and total risk-based capital of 12.00%, both at the level of the Company and at MBC. The parent company board also affirmed the goal of restraining growth at the level of the subsidiary banks to promote achievement of these elevated capital level targets. The Company’s Tier 1 leverage capital was 7.88% as of December 31, 2012, with total risk-based capital of 13.86%. MBC’s Tier 1 leverage capital was 7.32% as of December 31, 2012, with total risk-based capital of 13.29%. In 2012 MBC restrained asset growth by reducing the rates paid on deposits, which also had the effect of enhancing our net interest margin. We also benefitted from stable income, saw a large increase in unrecognized gains on securities, and raised additional equity capital in a private offering. These led to increased equity capital, resulting in overall improvement to the regulatory capital ratios of MBC and the Company. The goal of the elevated capital levels is to account for the ongoing economic stress in the markets in which the Company and its subsidiary banks operate and to account for the levels of substandard and other nonperforming assets.
41

In a private common stock offering that began in 2010, Middlefield Banc Corp. sold a total of 138,150 shares in 2011, followed by a sale of 93,050 shares on April 17, 2012 and a sale of 103,585 shares on April 30, 2012. The offering concluded on March 8, 2013 with a sale of 13,320 shares to an institutional investor, completing the sale to that investor under the terms of the subscription agreement it entered into in August of 2011. All sales in the offering occurred at $16 per share. Although the private stock offering has ended, because of elevated regulatory capital requirements and increased levels of substandard and nonperforming assets we continue to monitor our capital closely and we continue to consider opportunities to enhance capital, whether by raising additional equity or otherwise.
On or about January 14, 2013 an investor to whom we sold a total of 196,635 shares in April of 2012, constituting 9.9% of our stock, obtained from the Ohio Division of Financial Institutions and the Federal Reserve Bank of Cleveland regulatory clearance to acquire up to 24.99% of our stock. The August 15, 2011 Stock Purchase Agreement, as amended, under which we sold shares to the investor provided for sale of up to 24.99% of our stock, subject to the investor obtaining regulatory clearance and subject to other conditions. Although we disclosed in a Form 8-K Current Report filed with the SEC on January 18, 2013 that sale of additional shares to the investor under the terms of the Stock Purchase Agreement will not occur, if the investor nevertheless acquires shares and increases his ownership to 10% or more of our common stock, whether acquiring the shares on the open market or from us, we will become subject to additional restrictions under the terms of the regulatory clearance issued to the investor by the Ohio Division of Financial Institutions. Specifically, for three years after the investor becomes an owner of 10% or more of our stock, we would have to obtain advance approval of the ODFI in order for The Middlefield Banking Company to pay a dividend to Middlefield Banc Corp., and for 12 months we would have to obtain advance written approval of the ODFI for any changes in the composition of Middlefield Banc Corp.’s board or executive management.
Longer-term prospects for growth. Capital enhancement and reduction of nonperforming assets are a higher priority than growth. The Company does not anticipate significant deposit growth, and the percentage of assets represented by the securities portfolio will continue to exceed historical levels until loan demand in the Company’s markets recovers. An increase in loan demand and in the availability of high-quality lending opportunities depends on improvement in a broad range of economic factors in the markets in which the Company operates, including employment levels and the condition of the residential and commercial real estate markets in northeastern Ohio and in central Ohio.
The financial crisis that began at the end of 2007 has had a profound impact on the banking industry. More than 450 banks and savings associations have failed. The FDIC’s list of problem institutions remains at an elevated level, with 694 problem institutions at the end of the third quarter of 2012. Nonperforming and classified assets held by the banking industry likewise remain at elevated levels. With continued economic stagnation, uncertainty about when the economy will fully recover and the strength of the recovery and the potential for other factors to have an adverse impact on the prospects for the banking industry, such as national and global economic and political factors, the bank regulatory agencies have insisted that banks increase the size of the buffer that protects a bank from unknown potential adverse events and circumstances: regulatory capital.
Under these conditions a bank’s prospects for growth by expansion or other form of acquisition are limited by the more immediate need for additional capital or by the bank’s obligation to ensure that expansion will not expose the bank to the risk of inadequate capital. In addition, the economic events of the last few years have very adversely affected bank valuations throughout the entire industry, with the entire industry burdened by excessive nonperforming and classified assets and the potential for still more growth in those asset classes. Much of the growth by acquisition or expansion that has occurred in the banking industry in recent years has consisted of FDIC-assisted acquisitions of failed institutions. We believe that as economic uncertainties are reduced, including uncertainty about whether the nonperforming and other classified assets will continue to grow or will instead finally be reduced to more historically normal levels, the opportunities for growth, including by acquisition of other institutions or by establishment or acquisition of branches, will increase significantly. We believe that until then most of the growth that will occur will consist of organic growth based on a bank’s existing profile.
At approximately 7,000, the total number of banks and savings associations as of the end of 2012 is less than half the number at the end of 1990, when the number exceeded 15,000. Nevertheless, a large percentage of the 7,000 institutions that remain are small, community-oriented institutions, although the share of total banking assets that they control continues to decline. As an increasing share of the banking universe is occupied by the largest institutions, and taking into account economic, demographic, and technological changes and a greatly expanding regulatory burden, the future of banking favors larger institutions. We believe these factors create a strong incentive for growth through industry consolidation, meaning acquisition of smaller institutions by larger institutions and mergers of smaller institutions as a defense to competitive pressure from larger institutions. We therefore believe that industry consolidation is likely to continue and that the pace of consolidation could actually accelerate.
42

The trend toward consolidation would be most advantageous for financial institution organizations that have a surplus of capital, a strategy for growth, a strong financial profile, and few if any regulatory supervisory concerns, the ingredients of prompt regulatory approval that could be a significant competitive advantage in the market for financial institution mergers and acquisitions. Our goal is to acquire that advantage; although we give no assurance that our efforts to do so will succeed. We are committing significant resources to eliminating weaknesses in the performance and condition of Emerald Bank and The Middlefield Banking Company, we have moved nonperforming and substandard assets from Emerald Bank to an asset resolution subsidiary, we have agreed to elevated capital requirements for both banks and for the holding company and we have taken steps to achieve those elevated capital levels, we continue to invest resources both to resolve existing nonperforming and substandard assets and to prevent growth in those asset classes, and we have raised additional holding company capital through a private equity offering.
Although we currently are not exploring acquisition opportunities and although it is unrealistic to expect that we will grow by acquisition within the next 12 months, beyond that immediate future we are seeking to make Middlefield Banc Corp. eligible to grow by acquisition if a suitable opportunity arises. We give no assurance that we will be eligible or that there will arise an opportunity we consider to be appropriate.
Critical Accounting Policies
Allowance for loan losses. Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The Company’s allowance for loan losses provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio.
Management uses historical information to assess the adequacy of the allowance for loan losses as well as the prevailing business environment, which is affected by changing economic conditions and various external factors and which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For a full discussion of the Company’s methodology of assessing the adequacy of the reserve for loan losses, refer to Note 1 of “Notes to Consolidated Financial Statements” of this Annual Report.
Valuation of Securities. Securities are classified as held-to-maturity or available-for-sale on the date of purchase. Only those securities classified as held-to-maturity are reported at amortized cost. Available-for-sale and trading securities are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income, net of related deferred income taxes, on the Consolidated Balance Sheet. The fair value of a security is determined based on quoted market prices. If quoted market prices are not available, fair value is determined based on quoted prices of similar instruments. Realized securities gains or losses are reported within noninterest income in the Consolidated Statement of Income. The cost of securities sold is based on the specific identification method.
Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. Investment securities are generally evaluated for OTTI under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320, Investments — Debt and Equity Securities. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, whether the market decline was affected by macroeconomic conditions and whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, the Company may consider whether the securities are issued by the federal government or its agencies, or U.S. government-sponsored enterprises, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income or loss. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
43

Debt securities issued by U.S. government agencies, U.S. government-sponsored enterprises, and state and political subdivisions accounted for more than 97.0 percent of the total available-for-sale portfolio as of December 31, 2012, and no credit losses are expected, given the explicit and implicit guarantees provided by the U.S. federal government and the lack of significant unrealized loss positions within the obligations of state and political subdivisions security portfolio. The Company considered the following factors in determining whether a credit loss exists and the period over which the debt security is expected to recover:

| · | The length of time and the extent to which the fair value has been less than the amortized cost basis.

| · | Changes in the near term prospects of the underlying collateral of a security such as changes in default rates, loss severity given default and significant changes in prepayment assumptions.

| · | The level of cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities.

| · | Any adverse change to the credit conditions and liquidity of the issuer, taking into consideration the latest information available about the overall financial condition of the issuer, credit ratings, recent legislation and government actions affecting the issuer’s industry and actions taken by the issuer to deal with the present economic climate.

The Company’s investment in one private-label collateralized mortgage obligation with a carrying value of $899,000 was impaired in 2011 as a result of the Company’s determination that declines in their fair value were other than temporary. As a result of this determination, the Company recognized a $35,000 before-tax, non-cash charge, which was recorded as a reduction to noninterest income.
Refer to Note 5 in the consolidated financial statements.
Income Taxes
The Company estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which the Company conducts business. On a quarterly basis, management assesses the reasonableness of its effective tax rate based upon its current estimate of the amount and components of net income, tax credits and the applicable statutory tax rates expected for the full year. The estimated income tax expense is recorded in the Consolidated Statement of Income.
Deferred income tax assets and liabilities are determined using the balance sheet method and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheet. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax basis of assets and liabilities and recognizes enacted changes in tax rates and laws. Deferred tax assets are recognized to the extent they exist and are subject to a valuation allowance based on management’s judgment that realization is more-likely-than-not.
Accrued taxes represent the net estimated amount due to taxing jurisdictions and are reported in accrued taxes, interest and expenses in the Consolidated Balance Sheet. The Company evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information and maintains tax accruals consistent with its evaluation of these relative risks and merits. Changes to the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by taxing authorities and changes to statutory, judicial and regulatory guidance that impact the relative risks of tax positions. These changes, when they occur, can affect deferred taxes and accrued taxes as well as the current period’s income tax expense and can be significant to the operating results of the Company.
Goodwill and Other Intangible Assets
Goodwill is the excess of the purchase price over the fair value of the assets acquired in connection with business acquisitions accounted for as purchases. Other intangible assets consist of branch acquisition core deposit premiums.
The Company must assess goodwill and other intangible assets each year for impairment. The gross carrying amount of goodwill and intangible assets is tested for impairment in the fourth quarter, after the annual forecasting process.
44

Management’s assessment of the carrying value of goodwill and intangible assets involves estimating cash flows for future periods. If the future cash flows were less than the recorded goodwill and other intangible assets balances, the Company would be required to take a charge against earnings to write down the assets to the lower value.
Fair Value of Financial Instruments
The disclosure of the fair value of financial instruments is based on available market prices or management’s estimates of the fair value of such instruments.
Management consults with a third party for available market prices as well as performs calculations of the present value of contractual cash flows discounted at current comparative market inputs. Prepayment estimates are utilized when appropriate.
Changes in Financial Condition
General The Company’s total assets increased $15.8 million or 2.4% to $670.3 million at December 31, 2012 from $654.6 million at December 31, 2011. The increase was due to an increase in cash and due from banks of $17.8 million and net loans receivable of $5.6 million, which was partially offset by a decrease in federal funds sold of $6.9 million.
The increase in the Company’s total assets reflects a related increase in total liabilities of $7.6 million or 1.2% to a total balance of $614.9 million at December 31, 2012 from $607.3 million at December 31, 2011. The Company also experienced an increase in total stockholders’ equity of $8.2 million.
The increase in total liabilities was primarily due to deposit growth for the year. Total deposits increased $12.4 million or 2.1% to $593.3 million at December 31, 2012 from $581.0 million as of December 31, 2011. The net increase in total stockholders’ equity can be attributed to increases in retained earnings of $4.3 million, or 23.5% and common stock of $3.1 million, or 9.8%.
Cash on hand and Federal funds sold Cash and due from banks, interest-earning deposits and federal funds sold represent cash and cash equivalents which increased $11.0 million or 31.9% to $45.3 million at December 31, 2012 from $34.4 million at December 31, 2011. Deposits from customers into savings and checking accounts, loan and security repayments and proceeds from borrowed funds typically increase these accounts. Decreases result from customer withdrawals, new loan originations, security purchases and repayments of borrowed funds. The net increase in 2012 can be attributed to an increase in due from banks of $17.9 million, or 113.4%.
Securities Management's objective in structuring the portfolio is to maintain a prudent level of liquidity while providing an acceptable rate of return without sacrificing asset quality. Maturing securities have historically provided sufficient liquidity. The balance of total securities increased $495,000, or .3%, as compared to 2011, with the ratio of securities to total assets decreasing to 29.0% at December 31, 2012, compared to 29.6% at December 31, 2011.
The Company continues to benefit from owning mortgage-backed securities, which totaled $76.2 million or 39.2% of the Company's total investment portfolio at December 31, 2012. The primary advantage of mortgage-backed securities has been the increased cash flows due to the more rapid (monthly) repayment of principal as compared to other types of investment securities, which deliver proceeds upon maturity or call date. The weighted average federal tax equivalent (FTE) yield on all debt securities at year-end 2012 was 4.21%, as compared to 4.72% at year-end 2011. While the Company's focus is to generate interest revenue primarily through loan growth, management will continue to invest excess funds in securities when opportunities arise.
The majority of all of the Company’s securities are valued based on prices compiled by third party vendors using observable market data. However, certain securities are less actively traded and do not always have quoted market prices. The determination of their fair value, therefore, requires judgment, as this determination may require benchmarking to similar instruments or analyzing default and recovery rates. Examples include certain collateralized mortgage and debt obligations and high-yield debt securities.
Loans receivable The loans receivable category consists primarily of single family mortgage loans used to purchase or refinance personal residences located within the Company’s market area and commercial real estate loans used to finance properties that are used in the borrowers’ businesses or to finance investor-owned rental properties and commercial loans to finance the business operations and to a lesser extent construction and consumer loans. Net loans receivable increased $5.6 million or 1.4% to $400.7 million at December 31, 2012 from $395.1 million at December 31, 2011. Included in this growth were increases in commercial real estate and commercial and industrial loans of $7.2 and $3.0 million, respectively. These increases were partially offset by a decrease of $4.3 million in residential real estate loans.
45

The product mix in the loan portfolio is commercial loans equaling 15.2%, construction loans 5.5%, residential real estate loans 49.9%, commercial real estate loans 28.3% and consumer loans 1.0% at December 31, 2012 compared with 14.7%, 5.5%, 51.7%, 27.0% and 1.1%, respectively, at December 31, 2011.
Loans contributed 78.0% of total interest income in 2012 and 73.5% in 2011. The loan portfolio yield of 5.51% in 2012 was 76 basis points greater than the average yield for total interest earning assets. Management recognizes that while the loan portfolio holds some of the Company’s highest yielding assets, it is inherently the most risky portfolio. Accordingly, management attempts to balance credit risk versus return with conservative credit standards. Management has developed and maintains comprehensive underwriting guidelines and a loan review function that monitors credits during and after the approval process. Because of the Company’s increased levels of nonperforming assets, management follows additional procedures to ensure MBC and EB obtain current borrower financial information annually throughout the life of the loan obligation.
To minimize risks associated with changes in the borrower’s future repayment capacity, the Company generally requires scheduled periodic principal and interest payments on all types of loans and normally requires collateral.
The Company will continue to monitor the size of its loan portfolio growth during 2013. The Company's lending markets remain challenging and have impacted loan growth due to suppressed levels of loan originations in previous years. The Company anticipates total loan growth to be marginal, with volume to continue at a flat to moderate pace throughout 2013. The Company remains committed to sound underwriting practices without sacrificing asset quality and avoiding exposure to unnecessary risk that could weaken the credit quality of the portfolio.
FHLB stock. FHLB stock remained unchanged at $1.9 million at December 31, 2012 when compared to the prior year.
Goodwill. Goodwill results from prior business acquisitions and represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed annually for impairment and any such impairment is recognized in the period identified by a charge to earnings. In assessing goodwill for impairment, management estimates the fair value of the Company’s banking subsidiary to which the goodwill relates. To arrive at fair value estimates management considers prices received upon sale of other banking institutions of similar size and with similar operating results. Purchase prices as a multiple of earnings, book value, tangible book value and deposits are considered and applied to the Company’s banking subsidiary. The process of evaluating goodwill for impairment requires management to make significant estimates and judgments. The use of different estimates, judgments or approaches to estimate fair value could result in a different conclusion regarding impairment of goodwill. Based on the analysis, management has determined that there is no goodwill impairment.
The Company annually uses the services of an independent third party that is regarded in the banking industry as an expert in valuing core deposits and monitoring the ongoing value of core deposit intangibles and goodwill on an annual basis. Goodwill balances were unchanged in 2012.
Bank owned life insurance. Bank owned life insurance (BOLI) is universal life insurance, purchased by the Company, on the lives of the Company’s officers. The beneficial aspects of these universal life insurance policies are tax-free earnings and a tax-free death benefit, which are realized by the Company as the owner of the policies. BOLI increased by $279,000 to $8.5 million as of December 31, 2012 from $8.3 million at the end of 2011 as a result of the earnings of the underlying insurance policies.
Deposits. Interest-earning assets are funded generally by both interest-bearing and noninterest-bearing core deposits. Deposits are influenced by changes in interest rates, economic conditions and competition from other banks. The Company considers various sources when evaluating funding needs, including but not limited to deposits, which represented 96.8% of the Company’s total funding sources at December 31, 2012. The deposit base consists of demand deposits, savings, money market accounts and time deposits. Total deposits increased $12.4 million or 2.1% to $593.3 million at December 31, 2012 from $581.0 million at December 31, 2011.
Time deposits, particularly certificates of deposit ("CD's"), remain the largest source of funding for the Company's earning assets, making up 33.2% of total deposits. During 2012, time deposits decreased $22.2 million, or 10.1%, from year-end 2011. This is primarily due to the historically low market interest rates on CD’s causing customers to seek greater return or additional liquidity in other instruments.
46

Offsetting the decrease in time deposits was an increase in the Company's demand deposit balances, which were up $20.6 million, or 17.3%, to finish at $139.8 million at year-end 2012 as compared to $119.2 million at year-end 2011. Also adding to the Company’s deposit growth for the year were increases in savings and money market accounts of $8.2 million and $5.7 million, or 4.9% and 7.6%, respectively. The Company will continue to experience increased competition for deposits in its market areas, which could challenge net growth in its deposit balances. The Company will continue to evaluate its deposit portfolio mix to properly employ both retail and wholesale funds to support earning assets and minimize interest costs.
Borrowed funds. The Company uses short and long-term borrowings as another source of funding to benefit asset growth and liquidity needs. These borrowings primarily include FHLB advances, junior subordinated debt, lines of credit from other banks and repurchase agreement borrowings. Borrowed funds decreased $4.7 million or 19.5% to $19.5 million at December 31, 2012 from $24.2 million at December 31, 2011. FHLB advances declined $3.9 million with short-term borrowings decreasing $854,000.
Stockholders’ equity. The Company maintains a capital level that exceeds regulatory requirements as a margin of safety for its depositors and shareholders. All of the capital ratios exceeded the regulatory well capitalized guidelines. Emerald Bank has agreed with the FDIC and the Ohio Division of Financial Institutions to maintain tier 1 leverage capital of at least 9%, The Middlefield Banking Company committed to the FDIC that The Middlefield Banking Company will maintain capital ratios at levels no lower than its June 30, 2010 ratios (i.e., no lower than 6.25% tier 1 leverage capital and 11.29% total risk-based capital), and Middlefield Banc Corp. committed to the Federal Reserve that Middlefield Banc Corp. will maintain tier 1 leverage capital of at least 7.25% and total risk-based capital of at least 12%, both at the level of the holding company and at the level of The Middlefield Banking Company, the lead bank. With improved earnings and with additional equity capital raised in 2011 and in 2012, we have achieved the enhanced capital goals. In a private common stock offering that began in 2010, we sold a total of 138,150 shares in 2011, followed by a sale of 93,050 shares on April 17, 2012 and a sale of 103,585 shares on April 30, 2012. The offering concluded on March 8, 2013 with a sale of 13,320 shares to an institutional investor, completing the sale to that investor under the terms of the subscription agreement it entered into in August of 2011. All sales in the offering occurred at $16 per share.
Stockholders’ equity totaled $55.4 million at December 31, 2012, compared to $47.3 million at December 31, 2011, which represents growth of 17.3%. Common stock increased $3.1 million or 9.8% to $34.3 million at December 31, 2012 from $31.2 million at December 31, 2011. The Company maintains a dividend reinvestment and stock purchase plan. The plan allows shareholders to purchase additional shares of Company stock. A benefit of the plan is to permit the shareholders to reinvest cash dividends as well as make supplemental purchases without the usual payment of brokerage commissions. During 2012, shareholders invested more than $692,000 through the dividend reinvestment and stock purchase plan. These proceeds resulted in the issuance of 31,537 new shares at an average price of $21.95.
Contributing to the equity growth was a $4.3 million increase in retained earnings resulting from net income, less cash dividends paid of $2.0 million, or $1.04 per share, year-to-date.
Average Balance Sheet and Yield/Rate Analysis. The following table sets forth, for the periods indicated, information concerning the total dollar amounts of interest income from interest-earning assets and the resultant average yields, the total dollar amounts of interest expense on interest-bearing liabilities and the resultant average costs, net interest income, interest rate spread and the net interest margin earned on average interest-earning assets. For purposes of this table, average balances are calculated using monthly averages and the average loan balances include non-accrual loans and exclude the allowance for loan losses, and interest income includes accretion of net deferred loan fees. Yields on tax-exempt securities (tax-exempt for federal income tax purposes) are shown on a fully tax equivalent basis utilizing a federal tax rate of 34%.
47

|  | For the Twelve Months Ended December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
|  | Average |  |  |  |  |  | Average |  |  | Average |  |  |  |  |  | Average |  |  | Average |  |  |  |  |  | Average |
(Dollars in thousands) |  | Balance |  |  | Interest |  |  | Yield/Cost |  |  | Balance |  |  | Interest |  |  | Yield/Cost |  |  | Balance |  |  | Interest |  |  | Yield/Cost |
Interest-earning assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Loans receivable |  | $ | 407,154 |  |  | $ | 22,418 |  |  |  | 5.51 | % |  | $ | 383,854 |  |  | $ | 21,854 |  |  |  | 5.69 | % |  | $ | 362,239 |  |  | $ | 21,084 |  |  |  | 5.82 | %
Investment securities (3) |  |  | 183,507 |  |  |  | 6,185 |  |  |  | 4.21 | % |  |  | 195,528 |  |  |  | 7,745 |  |  |  | 4.72 | % |  |  | 177,377 |  |  |  | 7,835 |  |  |  | 5.19 | %
Interest-bearing deposits with other banks |  |  | 46,306 |  |  |  | 143 |  |  |  | 0.31 | % |  |  | 39,162 |  |  |  | 128 |  |  |  | 0.33 | % |  |  | 32,466 |  |  |  | 175 |  |  |  | 0.54 | %
Total interest-earning assets |  |  | 636,967 |  |  |  | 28,746 |  |  |  | 4.75 | % |  |  | 618,544 |  |  |  | 29,727 |  |  |  | 5.05 | % |  |  | 572,082 |  |  |  | 29,094 |  |  |  | 5.32 | %
Noninterest-earning assets |  |  | 22,701 |  |  |  |  |  |  |  |  |  |  |  | 21,554 |  |  |  |  |  |  |  |  |  |  |  | 39,896 |  |  |  |  |  |  |  |  |
Total assets |  | $ | 659,668 |  |  |  |  |  |  |  |  |  |  | $ | 640,098 |  |  |  |  |  |  |  |  |  |  | $ | 611,978 |  |  |  |  |  |  |  |  |
Interest-bearing liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest-bearing demand deposits |  | $ | 69,041 |  |  |  | 251 |  |  |  | 0.36 | % |  | $ | 62,918 |  |  |  | 326 |  |  |  | 0.52 | % |  | $ | 43,714 |  |  |  | 394 |  |  |  | 0.90 | %
Money market deposits |  |  | 72,614 |  |  |  | 300 |  |  |  | 0.41 | % |  |  | 74,565 |  |  |  | 601 |  |  |  | 0.81 | % |  |  | 66,392 |  |  |  | 942 |  |  |  | 1.42 | %
Savings deposits |  |  | 171,712 |  |  |  | 655 |  |  |  | 0.38 | % |  |  | 159,479 |  |  |  | 1,185 |  |  |  | 0.74 | % |  |  | 130,107 |  |  |  | 1,616 |  |  |  | 1.24 | %
Certificates of deposit |  |  | 206,905 |  |  |  | 4,529 |  |  |  | 2.19 | % |  |  | 225,715 |  |  |  | 5,355 |  |  |  | 2.37 | % |  |  | 248,445 |  |  |  | 6,552 |  |  |  | 2.64 | %
Borrowings |  |  | 22,611 |  |  |  | 719 |  |  |  | 3.18 | % |  |  | 25,521 |  |  |  | 1,185 |  |  |  | 4.64 | % |  |  | 30,865 |  |  |  | 1,441 |  |  |  | 4.67 | %
Total interest-bearing liabilities |  |  | 542,883 |  |  |  | 6,454 |  |  |  | 1.19 | % |  |  | 548,198 |  |  |  | 8,653 |  |  |  | 1.58 | % |  |  | 519,522 |  |  |  | 10,945 |  |  |  | 2.11 | %
Noninterest-bearing liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Other liabilities |  |  | 64,355 |  |  |  |  |  |  |  |  |  |  |  | 51,556 |  |  |  |  |  |  |  |  |  |  |  | 53,350 |  |  |  |  |  |  |  |  |
Stockholders' equity |  |  | 52,430 |  |  |  |  |  |  |  |  |  |  |  | 40,344 |  |  |  |  |  |  |  |  |  |  |  | 39,105 |  |  |  |  |  |  |  |  |
Total liabilities and stockholders' equity |  | $ | 659,668 |  |  |  |  |  |  |  |  |  |  | $ | 640,098 |  |  |  |  |  |  |  |  |  |  | $ | 611,978 |  |  |  |  |  |  |  |  |
Net interest income |  |  |  |  |  | $ | 22,292 |  |  |  |  |  |  |  |  |  |  | $ | 21,074 |  |  |  |  |  |  |  |  |  |  | $ | 18,149 |  |  |  |  |
Interest rate spread (1) |  |  |  |  |  |  |  |  |  |  | 3.56 | % |  |  |  |  |  |  |  |  |  |  | 3.47 | % |  |  |  |  |  |  |  |  |  |  | 3.22 | %
Net interest margin (2) |  |  |  |  |  |  |  |  |  |  | 3.74 | % |  |  |  |  |  |  |  |  |  |  | 3.65 | % |  |  |  |  |  |  |  |  |  |  | 3.41 | %
Ratio of average interest-earning assets to average interest-bearing liabilities |  |  |  |  |  |  |  |  |  |  | 117.33 | % |  |  |  |  |  |  |  |  |  |  | 112.83 | % |  |  |  |  |  |  |  |  |  |  | 110.12 | %

(1) | Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities

(2) | Net interest margin represents net interest income as a percentage of average interest-earning assets.

(3) | Tax equivalent adjustments to interest income for tax-exempt securities was $1,533, $1,485, and $1,365 for 2012, 2011, and 2010, respectively.

INTEREST RATES AND INTEREST DIFFERENTIAL

|  | 2012 versus 2011 |  |  | 2011 versus 2010 |
|  | Increase (decrease) due to |  |  | Increase (decrease) due to |
(Dollars in thousands) |  | Volume |  |  | Rate |  |  | Total |  |  | Volume |  |  | Rate |  |  | Total |
Interest-earning assets: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Loans receivable |  | $ | 1,305 |  |  | $ | (741 | ) |  | $ | 564 |  |  | $ | 1,244 |  |  | $ | (474 | ) |  | $ | 770 |
Investment securities |  |  | (537 | ) |  |  | (1,023 | ) |  |  | (1,560 | ) |  |  | 899 |  |  |  | (989 | ) |  |  | (90 | )
Interest-bearing deposits with other banks |  |  | 23 |  |  |  | (8 | ) |  |  | 15 |  |  |  | 29 |  |  |  | (76 | ) |  |  | (47 | )
Total interest-earning assets |  |  | 791 |  |  |  | (1,772 | ) |  |  | (981 | ) |  |  | 2,172 |  |  |  | (1,539 | ) |  |  | 633 |
Interest-bearing liabilities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest-bearing demand deposits |  |  | 27 |  |  |  | (102 | ) |  |  | (75 | ) |  |  | 136 |  |  |  | (204 | ) |  |  | (68 | )
Money market deposits |  |  | (12 | ) |  |  | (290 | ) |  |  | (302 | ) |  |  | 91 |  |  |  | (431 | ) |  |  | (340 | )
Savings deposits |  |  | 69 |  |  |  | (599 | ) |  |  | (530 | ) |  |  | 292 |  |  |  | (722 | ) |  |  | (431 | )
Certificates of deposit |  |  | (429 | ) |  |  | (397 | ) |  |  | (826 | ) |  |  | (569 | ) |  |  | (627 | ) |  |  | (1,197 | )
Borrowings |  |  | (114 | ) |  |  | (352 | ) |  |  | (466 | ) |  |  | (249 | ) |  |  | (7 | ) |  |  | (256 | )
Total interest-bearing liabilities |  |  | (459 | ) |  |  | (1,740 | ) |  |  | (2,199 | ) |  |  | (299 | ) |  |  | (1,993 | ) |  |  | (2,292 | )
Net interest income |  | $ | 1,250 |  |  | $ | (32 | ) |  | $ | 1,218 |  |  | $ | 2,472 |  |  | $ | 453 |  |  | $ | 2,925 |

48

Changes in Results of Operations
2012 Results Compared to 2011 Results
General The Company posted net income of $6.3 million, compared to $4.1 million for the year ended December 31, 2011. On a per share basis, 2012 earnings were $3.28 per diluted share, representing an increase from the $2.45 per diluted share for the year ended December 31, 2011. The return on average equity for the year ended December 31, 2012, was 11.98% and the Company’s return on average assets was 0.95%. The $2.2 million or 52.1% improvement in net income between 2012 and 2011 can be attributed to a decrease in total interest expense of $2.2 million. This was partially offset by a decrease in total interest income of $981,000.
Net interest income Net interest income, which is the Company’s largest revenue source, is the difference between interest income on earning assets and interest expense paid on liabilities. Net interest income is affected by the changes in interest rates and the composition of interest-earning assets and interest-bearing liabilities. Net interest income increased by $1.2 million in 2012 to $22.3 million compared to $21.1 million for 2011. This increase is the net result of a $2.2 million decrease in interest expense which was partially offset by a decrease in interest income of $981,000. Interest-earning assets averaged $637.0 million during 2012 representing a $18.4 million or 3.0% increase since year-end 2011. The Company’s average interest-bearing liabilities decreased 5.5% from $548.2 million in 2011 to $542.9 million in 2012.
The profit margin, or spread, on invested funds is a key performance measure. The Company monitors two key performance indicators — net interest spread and net interest margin. The net interest spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. The net interest margin represents the overall profit margin: net interest income as a percentage of total interest-earning assets. This performance indicator gives effect to interest earned for all investable funds including the substantial volume of interest-free funds. For 2012 the net interest margin, measured on a fully taxable equivalent basis, increased to 3.74%, compared to 3.65% in 2011.
Interest income Interest income decreased $981,000 to $28.7 million for 2012 which is attributable to a $1.7 million decrease in taxable interest on investment securities. The change in interest income on securities was the result of a decrease in the average balance of investment securities and a lower yield on the portfolio. The average balance of investment securities decreased by $12.0 million or 6.2% to $183.5 million for the year ended December 31, 2012 as compared to $195.5 million for the year ended December 31, 2011. The investment security yield fell to 4.21% for 2012, from 4.72% in 2011.
Interest and fees on loans increased $564,000 to $22.4 million for 2012, compared to $21.9 million for 2011. This increase is attributable to the growth of the average balance of loans of $23.3 million to $407.2 million for the year ended December 31, 2012 as compared to $383.9 million for the year ended December 31, 2011 which was offset by a decline in the loan yield to 5.51% for 2012, compared to 5.69% for 2011.
Interest expense Interest expense decreased $2.2 million or 25.5% to $6.5 million for 2012, compared with $8.7 million for 2011. This change in interest expense can be attributed to a 39 basis point decline in the rate paid on these liabilities, as well as a decrease in the average balance of interest-bearing liabilities. For the year ended December 31, 2012 the average balance of interest-bearing liabilities decreased by $5.3 million to $542.9 million as compared to $548.2 million for the year ended December 31, 2011. Interest incurred on deposits declined by $1.8 million for the year from $7.5 million in 2011 to $5.7 million for year-end 2012. The change in deposit expense was due to a 33 basis point decline during the year and a decrease in the average balance of $2.4 million in 2012. Interest expense incurred on FHLB advances, repurchase agreements, junior subordinated debt and other borrowings declined $466,000 or 39.3% to $719,000 for 2012, compared to $1.2 million for 2011. The decline was compounded by a 146 basis point decrease in the rate paid on these borrowings during the year.
Loan Loss Provision The provision for loan losses is an operating expense recorded to maintain the related balance sheet allowance for loan losses at an amount considered adequate to cover probable losses incurred in the normal course of lending. The provision for loan losses for the year ended December 31, 2012 was $2.2 million compared to $3.1 million in 2011. The loan loss provision is based upon management's assessment of a variety of factors, including types and amounts of non-performing loans, historical loss experience, collectability of collateral values and guaranties, pending legal action for collection of loans and related guaranties, and current economic conditions. The loan loss provision reflects management's judgment of the current period cost-of-credit risk inherent in the loan portfolio. Although management believes the loan loss provision has been sufficient to maintain an adequate allowance for loan losses, actual loan losses could exceed the amounts that have been charged to operations.
49

The ratio of the allowance for loan losses to total loans increased to 1.90% of total loans at December 31, 2012 compared to the 1.70% at December 31, 2011. During the fourth quarter of 2009, the Company created a new entity, EMORECO, Inc., which is designed to aid in troubled asset resolution. Since its inception, EMORECO has purchased $5.8 million of non-performing assets from EB, $209,000 coming in 2012.
Non-interest income Non-interest income increased $1.2 million or 54.3% to $3.4 million for 2012 compared to $2.2 million for 2011. The increase is largely due to increases in investment security gains and service charges on deposit accounts of $783,000 and $253,000, respectively.
Non-interest expense Operating expenses increased $138,000, or .9% to $15.6 million for 2012 compared to $15.5 million for 2011. Equipment expense, professional fees, and Ohio franchise tax increased $203,000, $148,000, and $129,000, or 36.5%, 18.5%, and 28.0%, respectively. Other expenses increased to $3.7 million, up $397,000 or 11.9% compared to the 2011 balance of $3.3 million. Included in this amount are miscellaneous expenses related to other real estate owned which totaled $376,000. This increase of $226,000, a 150.6% increase over the prior year, stems largely from EMORECO activities relating to loans and OREO such as purchases from EB, write-downs, and OREO maintenance. FDIC insurance expense decreased $479,000, or 49.6%, as management continues to monitor the related accrual method. Losses on the sale of other real estate owned decreased $239,000 or 48.1% to $258,000 when compared to the prior year. This decrease reflects a normalizing of the Company’s sales of other real estate owned properties and the conservative approach in original valuation of these properties.
Provision for Income Taxes The provision for income taxes increased $1.1 million to $1.7 million for 2012, compared to a tax benefit of $596,000 in 2011. This increase was due to an increase in pretax income of $3.2 million during 2012. The Company’s effective federal income tax rate in 2012 was 20.9% compared to 12.6% in 2011.
Changes in Results of Operations
2011 Results Compared to 2010 Results
General The Company posted net income of $4.1 million, compared to $2.5 million for the year ended December 31, 2010. On a per share basis, 2011 earnings were $2.45 per diluted share, representing an increase from the $1.60 per diluted share for the year ended December 31, 2010. The return on average equity for the year ended December 31, 2011, was 10.24% and the Company’s return on average assets was 0.65%. The $1.6 million or 64.1% improvement in net income between 2011 and 2010 can be attributed to a decrease in total interest expense of $2.3 million.
Net interest income Net interest income, which is the Company’s largest revenue source, is the difference between interest income on earning assets and interest expense paid on liabilities. Net interest income is affected by the changes in interest rates and the composition of interest-earning assets and interest-bearing liabilities. Net interest income increased by $2.9 million in 2011 to $21.1 million compared to $18.1 million for 2010. This increase is the net result of a $2.3 million decrease in interest expense which was supported by an increase in interest income of $633,000. Interest-earning assets averaged $618.5 million during 2011 representing a $46.5 million or 8.1% increase since year-end 2010. The Company’s average interest-bearing liabilities increased 5.5% from $519.5 million in 2010 to $548.2 million in 2011.
The profit margin, or spread, on invested funds is a key performance measure. The Company monitors two key performance indicators—net interest spread and net interest margin. The net interest spread represents the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities. The net interest margin represents the overall profit margin: net interest income as a percentage of total interest-earning assets. This performance indicator gives effect to interest earned for all investable funds including the substantial volume of interest-free funds. For 2011 the net interest margin, measured on a fully taxable equivalent basis, increased to 3.65%, compared to 3.41% in 2010.
Interest income Interest income increased $633,000 to $29.7 million for 2011 which was partially attributed to a $770,000 increase in interest and fees on loans. The change in interest income on securities was the net result of an increase in the average balance of investment securities which was offset by a lower yield on the portfolio. The average balance of investment securities increased by $18.1 million or 10.2% to $195.5 million for the year ended December 31, 2011 as compared to $177.4 million for the year ended December 31, 2010. The additional interest income earned due to growth was offset by a decline in the investment security yield to 4.72% for 2011, compared to 5.19% for 2010.
Interest and fees on loans increased $770,000 to $21.9 million for 2011, compared to $21.1 million for 2010. This increase was primarily attributable to the growth of the average balance of loans of $21.6 million to $383.9 million for the year ended December 31, 2011 as compared to $362.2 million for the year ended December 31, 2010 which was offset by a decline in the loan yield to 5.69% for 2011, compared to 5.82% for 2010. This decline was due to the fact that a large percentage of the loan portfolio uses the prime rate as its index. Loans continued to reprice to the historically low 3.25% prime rate throughout 2011.
50

Interest expense Interest expense decreased $2.3 million or 21.0% to $8.7 million for 2011, compared with $10.9 million for 2010. This change in interest expense can be attributed to a 53 basis point decline in the rate paid on these liabilities, partially offset by an increase in the average balance of interest-bearing liabilities. For the year ended December 31, 2011 the average balance of interest-bearing liabilities grew by $28.7 million to $548.2 million as compared to $519.5 million for the year ended December 31, 2010. Interest incurred on deposits declined by $2.0 million for the year from $9.5 million in 2009 to $7.5 million for year-end 2011. The change in deposit expense was due to a 51 basis point decline during the year which was partially offset by an increase in the average balance of $34.0 million in 2011. Interest expense incurred on FHLB advances, repurchase agreements, junior subordinated debt and other borrowings declined $256,000 or 17.8% to $1.2 million for 2011, compared to $1.4 million for 2010. The decline was slightly more profound by a 3 basis point decrease in the rate paid on these borrowings during the year.
Loan Loss Provision —The provision for loan losses is an operating expense recorded to maintain the related balance sheet allowance for loan losses at an amount considered adequate to cover probable losses incurred in the normal course of lending. The provision for loan losses for the year ended December 31, 2011 was $3.1 million compared to $3.6 million in 2010. The loan loss provision is based upon management’s assessment of a variety of factors, including types and amounts of non-performing loans, historical loss experience, collectability of collateral values and guaranties, pending legal action for collection of loans and related guaranties, and current economic conditions. The loan loss provision reflects management’s judgment of the current period cost-of-credit risk inherent in the loan portfolio. Although management believes the loan loss provision has been sufficient to maintain an adequate allowance for loan losses, actual loan losses could exceed the amounts that have been charged to operations.
The ratio of the allowance for loan losses to total loans increased to 1.70% of total loans at December 31, 2011 compared to the 1.67% at December 31, 2010. During the fourth quarter of 2009, the Company created a new entity, EMORECO, Inc., which is designed to aid in troubled asset resolution. Since its inception, EMORECO has purchased $5.8 million of non-performing assets from EB, $957,000 coming in 2011.
Non-interest income Non-interest income decreased $386,000 or 14.7% to $2.2 million for 2011 compared to $2.6 million for 2010. The decrease is due to a reduction in service charges on deposit accounts of $272,000 and investment security losses of $194,000. The decline in service charges is the result of changes in federal regulations regarding the collection of overdraft fees while the security losses were mostly due to other than temporary impairment losses to equity securities. These were partially offset by increases in revenue from investment services of $41,000 and rental income from OREO owned of $34,000.
Non-interest expense Operating expenses increased $738,000, or 5.0% to $15.5 million for 2011 compared to $14.8 million for 2010. Expense increases in salaries and employee benefits of $822,000 were largely the result of the addition of employees due to the growth of the Company and increases in employees’ health benefits. Professional fees increased $122,000, or 18.0%, as management continues to explore avenues of decreased risk by leveraging outside resources. Additionally the Company recognized an increase in the Ohio state franchise tax of $113,000 when compared to 2010. Other expenses increased to $3.3 million, up $280,000 or 9.1% compared to the 2010 balance of $3.1 million. Included in this amount are expenses related to delinquent loans, foreclosures and OREO which totaled $596,000 an increase of $31,000 over the prior year which represents 11.1% of the increase. EMORECO had $123,000 in loan and OREO expenses in 2011. Based on the number of non-performing loans management believes that the higher than historic expenses related to asset quality will continue into 2012. Losses on the sale of OREO decreased $286,000 or 36.5% to $497,000 when compared to the prior year. This decrease reflects a normalizing of the Company’s sales of OREO properties and the conservative approach in original valuation of these properties. Included in this total is the Company’s non-bank asset resolution subsidiary, EMORECO, which had $455,000 in losses on the sale of OREO.
Provision for Income Taxes The provision for income taxes increased $684,000 to $596,000 for 2011, compared to a tax benefit of $88,000 in 2010. This increase was due to an increase in pretax income of $2.3 million during 2011. This increase was offset by the increase in non-taxable income from obligations of states and political subdivisions to $2.9 million, an increase of $233,000 when compared to 2010. The Company’s effective federal income tax rate in 2011 was 12.6% compared to (3.6%) in 2010.
51

Asset and Liability Management
The primary objective of the Company’s asset and liability management function is to maximize the Company’s net interest income while simultaneously maintaining an acceptable level of interest rate risk given the Company’s operating environment, capital and liquidity requirements, performance objectives and overall business focus. The principal determinant of the exposure of the Company’s earnings to interest rate risk is the timing difference between the re-pricing or maturity of interest-earning assets and the re-pricing or maturity of its interest-bearing liabilities. The Company’s asset and liability management policies are designed to decrease interest rate sensitivity primarily by shortening the maturities of interest-earning assets while at the same time extending the maturities of interest-bearing liabilities. The Board of Directors of the Company continues to believe in a strong asset/liability management process in order to insulate the Company from material and prolonged increases in interest rates. As a result of this policy, the Company emphasizes a larger, more diversified portfolio of residential mortgage loans in the form of mortgage-backed securities. Mortgage-backed securities generally increase the quality of the Company’s assets by virtue of the insurance or guarantees that back them, are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Company.
The Company’s Board of Directors has established an Asset and Liability Management Committee consisting of outside directors and senior management. This committee, which meets quarterly, generally monitors various asset and liability management policies and strategies.
Interest Rate Sensitivity Simulation Analysis
The Company utilizes income simulation modeling in measuring its interest rate risk and managing its interest rate sensitivity. The Asset and Liability Management Committee of the Company believes the various rate scenarios of the simulation modeling enables the Company to more accurately evaluate and manage the exposure of interest rate fluctuations on net interest income, the yield curve, various loan and mortgage-backed security prepayments, and deposit decay assumptions.
Earnings simulation modeling and assumptions about the timing and volatility of cash flows are critical in net portfolio equity valuation analysis. Particularly important are the assumptions driving mortgage prepayments and expected attrition of the core deposit portfolios. These assumptions are based on the Company’s historical experience and industry standards and are applied consistently across all rate risk measures.
The Company has established the following guidelines for assessing interest rate risk:
Net interest income simulation- Given a 200 basis point parallel gradual increase or decrease in market interest rates, net interest income may not change by more than 10% for a one-year period.
Portfolio equity simulation- Portfolio equity is the net present value of the Company’s existing assets and liabilities. Given a 200 basis point immediate and permanent increase or decrease in market interest rates, portfolio equity may not correspondingly decrease or increase by more than 20% of stockholders’ equity.
The following table presents the simulated impact of a 200 basis point upward or downward shift of market interest rates on net interest income, and the change in portfolio equity. This analysis was done assuming the interest-earning asset and interest-bearing liability levels at December 31, 2012 remained constant. The impact of the market rate movements was developed by simulating the effects of rates changing gradually over a one-year period from the December 31, 2012 levels for net interest income, and portfolio equity. The impact of market rate movements was developed by simulating the effects of an immediate and permanent change in rates at December 31, 2012 for portfolio equity:

|  | Increase 200 Basis Points |  |  | Decrease 200 Basis Points |
Net interest income - increase (decrease) |  |  | (0.28 | )% |  |  | 0.22 | %
Portfolio equity - increase (decrease) |  |  | (16.65 | )% |  |  | (5.80 | )%

52

Allowance for Loan Losses. The allowance for loan losses (ALL) represents the amount management estimates are adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. Accordingly, all loan losses are charged to the allowance, and all recoveries credited to it. The ALL is established through a provision for loan losses, which is charged to operations. The provision is based on management's periodic evaluation of the adequacy of the ALL, taking into account the overall risk characteristics of the various portfolio segments, the Company's loan loss experience, the impact of economic conditions on borrowers, and other relevant factors. The estimates used to determine the adequacy of the ALL, including the amounts and timing of future cash flows expected on impaired loans, are particularly susceptible to significant change in the near term. The total ALL is a combination of a specific allowance for identified problem loans and a general allowance for homogeneous loan pools.
In 2012, the combination of relative weakness in commercial real estate values and a sluggish economy continued to have an adverse impact on the financial condition of commercial borrowers. Management does see continuing signs that the local economic environment has stabilized and that certain industries, specifically timber and construction, within our defined market area have experienced some improvement. Though economic improvement is noted, it has not been for a period of time sufficient to warrant the medium-term outlook, as it relates to the ALL and the qualitative factors found therein.
The allowance for loan loss balance as of December 31, 2012 totaled $7.8 million representing a $960,000 increase from the end of 2011. For the year of 2012, the provision for loan losses was $2.2 million which represented a decrease of $917,000 from the $3.1 million provided during 2011. The provision for 2012 is reflective of the slightly positive trend in the decrease in non-performing loans. Asset quality is a high-priority in our overall business plan as it relates to long-term asset growth projections. During 2012, net charge-offs decreased by $1.3 million to $1.2 million compared to $2.5 million in 2011, signifying a favorable trend. Two key ratios to monitor asset quality performance are net charge-offs/average loans and the allowance for loan losses/non-performing loans. At year-end 2012, these ratios were .30% and 54.8%, respectively, compared to .65% and 27.8% in 2011.
The specific allowance incorporates the results of measuring impaired loans. The formula allowance is calculated by applying loss factors to outstanding loans by type, excluding loans for which a specific allowance has been determined. Loss factors are based on management's determination of the amounts necessary for concentrations and changes in mix and volume of the loan portfolio, and consideration of historical loss experience.
The non-specific allowance is determined based upon management's evaluation of existing economic and business conditions affecting the key lending areas of the Company and other conditions, such as new loan products, credit quality trends, collateral values, unique industry conditions within portfolio segments that existed as of the balance sheet date, and the impact of those conditions on the collectability of the loan portfolio. Management reviews these conditions quarterly. The non-specific allowance is subject to a higher degree of uncertainty because it considers risk factors that may not be reflected in the historical loss factors.
Although management uses the best information available to make the determination of the adequacy of the ALL at December 31, 2012, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making the initial determinations. A downturn in the local economy and employment could result in increased levels of non-performing assets and charge-offs, increased loan loss provisions, and reductions in income. Additionally, as an integral part of the examination process, bank regulatory agencies periodically review a Company's ALL. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.
53

The following table sets forth information concerning the Company's ALL at the dates and for the periods presented.

|  | For the Years Ended December 31, |
(Dollars in thousands) |  | 2012 |  |  | 2011 |  |  | 2010 |
Allowance balance at beginning of period |  | $ | 6,819 |  |  | $ | 6,221 |  |  | $ | 4,937 |
Loans charged off: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  |  | (230 | ) |  |  | (568 | ) |  |  | (450 | )
Real estate-construction |  |  | (135 | ) |  |  | (6 | ) |  |  | - |
Real estate-mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | (785 | ) |  |  | (1,862 | ) |  |  | (1,433 | )
Commercial |  |  | (123 | ) |  |  | (265 | ) |  |  | (428 | )
Consumer installment |  |  | (64 | ) |  |  | (11 | ) |  |  | (59 | )
Total loans charged off |  |  | (1,337 | ) |  |  | (2,712 | ) |  |  | (2,370 | )
Recoveries of loans previously charged-off: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  |  | 71 |  |  |  | 76 |  |  |  | 40 |
Real estate-construction |  |  | - |  |  |  | - |  |  |  | - |
Real estate-mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 31 |  |  |  | 122 |  |  |  | - |
Commercial |  |  | - |  |  |  | - |  |  |  | - |
Consumer installment |  |  | 27 |  |  |  | 27 |  |  |  | 34 |
Total recoveries |  |  | 129 |  |  |  | 225 |  |  |  | 74 |
Net loans charged off |  |  | (1,208 | ) |  |  | (2,487 | ) |  |  | (2,296 | )
Provision for loan losses |  |  | 2,168 |  |  |  | 3,085 |  |  |  | 3,580 |
Allowance balance at end of period |  | $ | 7,779 |  |  | $ | 6,819 |  |  | $ | 6,221 |
Loans outstanding: |  |  |  |  |  |  |  |  |  |  |  |
Average |  | $ | 407,154 |  |  | $ | 383,854 |  |  | $ | 362,239 |
End of period |  |  | 408,433 |  |  |  | 401,880 |  |  |  | 372,498 |
Ratio of allowance for loan losses to loans outstanding at end of period |  |  | 1.90 | % |  |  | 1.70 | % |  |  | 1.67 |
Net charge offs to average loans |  |  | (0.30 | ) |  |  | (0.65 | ) |  |  | (0.63 | )

54

The following table illustrates the allocation of the Company's allowance for probable loan losses for each category of loan for each reported period. The allocation of the allowance to each category is not necessarily indicative of future loss in a particular category and does not restrict our use of the allowance to absorb losses in other loan categories.

|  | At December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
|  | Amount |  |  | Percent of Loans in Each Category to Total Loans |  |  | Amount |  |  | Percent of Loans in Each Category to Total Loans |  |  | Amount |  |  | Percent of Loans in Each Category to Total Loans |
(Dollars in Thousands) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Type of Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 1,732 |  |  |  | 15.2 | % |  | $ | 1,296 |  |  |  | 14.7 | % |  | $ | 1,234 |  |  |  | 15.4 | %
Real estate construction |  |  | 1,123 |  |  |  | 5.5 |  |  |  | 438 |  |  |  | 5.4 |  |  |  | 356 |  |  |  | 4.3 |
Mortgage: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 2,872 |  |  |  | 49.9 |  |  |  | 3,731 |  |  |  | 51.8 |  |  |  | 3,392 |  |  |  | 56.4 |
Commercial |  |  | 1,991 |  |  |  | 28.3 |  |  |  | 1,306 |  |  |  | 27.0 |  |  |  | 1,143 |  |  |  | 22.6 |
Consumer installment |  |  | 61 |  |  |  | 1.0 |  |  |  | 48 |  |  |  | 1.1 |  |  |  | 96 |  |  |  | 1.3 |
Total |  | $ | 7,779 |  |  |  | 100.0 | % |  | $ | 6,819 |  |  |  | 100.0 | % |  | $ | 6,221 |  |  |  | 100.0 | %

Non-performing assets. Non-performing assets includes non-accrual loans, troubled debt restructurings (TDRs), loans 90 days or more past due, assets purchased by EMORECO from EB, OREO, and repossessed assets. A loan is classified as non-accrual when, in the opinion of management, there are serious doubts about collectability of interest and principal. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower’s financial condition is such that collection of principal and interest is doubtful. Payments received on nonaccrual loans are applied against principal according to management’s shadow accounting system.
TDRs are those loans which the Company, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the Company would not otherwise consider. The Company has 49 TDRs with a total balance of $4.7 million as of December 31, 2012 compared to 40 TDRs totaling $10.0 million as of December 31, 2011. Non-performing loans amounted to $14.2 million or 3.5% of total loans and $25.1 million or 6.3% of total loans at December 31, 2012 and December 31, 2011, respectively. Non-performing loans secured by real estate totaled $12.8 million as of December 31, 2012, a decrease of $10.0 million from $22.8 million at December 31, 2011. OREO is initially recorded at fair value and continually monitored for accurate valuation.
A major factor in determining the appropriateness of the ALL is the type of collateral which secures the loans. Of the total nonperforming loans at December 31, 2012, 90.2% were secured by real estate. Although this does not insure against all losses, the real estate provides substantial recovery, even in a distressed-sale and declining-value environment. In response to the poor economic conditions which have eroded the performance of the Company’s loan portfolio, additional resources have been allocated to the loan workout process. The Company’s objective is to work with the borrower to minimize the burden of the debt service and to minimize the future loss exposure to the Company.
55

The following table summarizes nonperforming assets by category.

|  |  |  |  | At December 31, |
|  | 2012 |  |  | 2011 |  |  | 2010 |
|  | (Dollars in Thousands) |
Loans accounted for on a nonaccrual basis: |  |  |  |  |  |  |  |  |
Commercial and industrial |  | $ | 560 |  |  | $ | 1,576 |  |  | $ | 2,540 |
Real estate-construction |  |  | 364 |  |  |  | 663 |  |  |  | 648 |
Real estate-mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 8,329 |  |  |  | 10,645 |  |  |  | 11,686 |
Commercial |  |  | 2,105 |  |  |  | 3,921 |  |  |  | 3,513 |
Consumer installment |  |  | 18 |  |  |  | - |  |  |  | 12 |
Total nonaccrual loans |  |  | 11,376 |  |  |  | 16,805 |  |  |  | 18,399 |
Troubled debt restructuring: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  |  | 503 |  |  |  | 778 |  |  |  | 619 |
Real estate-construction |  |  | - |  |  |  | 3,883 |  |  |  | - |
Real estate-mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 1,250 |  |  |  | 797 |  |  |  | 530 |
Commercial |  |  | 617 |  |  |  | 1,940 |  |  |  | 428 |
Consumer installment |  |  | 11 |  |  |  | 24 |  |  |  | 10 |
Total troubled debt restructuring |  |  | 2,381 |  |  |  | 7,422 |  |  |  | 1,587 |
Accruing loans which are contractually past due 90 days or more: |  |  |  |  |  |  |  |  |  |  |  |
Commercial and industrial |  |  | 348 |  |  |  | 44 |  |  |  | - |
Real estate-construction |  |  | - |  |  |  | - |  |  |  | - |
Real estate-mortgage: |  |  |  |  |  |  |  |  |  |  |  |
Residential |  |  | 89 |  |  |  | 275 |  |  |  | - |
Commercial |  |  | - |  |  |  | - |  |  |  | - |
Consumer installment |  |  | - |  |  |  | - |  |  |  | - |
Total accruing loans which are contractually past due 90 days or more |  |  | 437 |  |  |  | 319 |  |  |  | - |
Total non - performing loans |  |  | 14,194 |  |  |  | 24,546 |  |  |  | 19,986 |
Other real estate owned |  |  | 1,846 |  |  |  | 2,196 |  |  |  | 2,302 |
Total non-performing assets |  | $ | 16,040 |  |  | $ | 26,742 |  |  | $ | 22,288 |
Total non-performing loans to total loans |  |  | 3.48 | % |  |  | 6.11 | % |  |  | 5.37 | %
Total non-performing loans to total assets |  |  | 2.12 | % |  |  | 3.75 | % |  |  | 3.16 | %
Total non-performing assets to total assets |  |  | 2.39 | % |  |  | 4.09 | % |  |  | 3.53 | %

Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions, the borrower's financial condition is such that collection of interest is doubtful. Payments received on non-accrual loans are recorded as income or applied against principal according to management's judgment as to the collectability of principal.
A loan is considered impaired when it is probable the borrower will not repay the loan according to the original contractual terms of the loan agreement, including all troubled debt restructurings. Management has determined that first mortgage loans on one-to-four family properties and all consumer loans represent large groups of smaller-balance homogeneous loans that are to be collectively evaluated. Loans that experience insignificant payment delays, which are defined as 90 days or less, generally are not classified as impaired. A loan is not impaired during a period of delay in payment if the Company expects to collect all amounts due, including interest accrued at the contractual interest rate for the period of delay. Management evaluates all loans identified as impaired individually. The Company estimates credit losses on impaired loans based on the present value of expected cash flows, or the fair value of the underlying collateral if loan repayment is expected to come from the sale or operation of the collateral. Impaired loans, or portions thereof, are charged off when it is determined a realized loss has occurred. Until that time, an allowance for loan loss is maintained for estimated losses.
56

Interest income that would have been recorded had these loans not been placed on nonaccrual status was $756,000 in 2012; $859,000 in 2011; and $470,000 in 2010. Management is not aware of any trends or uncertainties related to any loans classified as doubtful or substandard that might have a material effect on earnings, liquidity, or capital resources.
Liquidity and Capital Resources
Liquidity. Liquidity management involves monitoring the ability to meet the cash flow needs of bank customers, such as borrowings or deposit withdrawals, as well as the Company’s own financial commitments. The principal sources of liquidity are net income, loan payments, maturing and principal reductions on securities and sales of securities available for sale, federal funds sold and cash and deposits with banks. Along with its liquid assets, the Company has additional sources of liquidity available to ensure adequate funds are available as needed. These include, but are not limited to, the purchase of federal funds, the ability to borrow funds under line of credit agreements with correspondent banks, a borrowing agreement with the Federal Home Loan Bank of Cincinnati, Ohio and the adjustment of interest rates to obtain deposits. Management believes the Company has the capital adequacy, profitability and reputation to meet the current and projected needs of its customers.
Liquidity is managed based on factors including core deposits as a percentage of total deposits, the level of funding source diversification, the allocation and amount of deposits among deposit types, the short-term funding sources used to fund assets, the amount of non-deposit funding used to fund assets, the availability of unused funding sources, off-balance sheet obligations, the availability of assets readily converted to cash without undue loss, the amount of cash and liquid securities we hold, and the re-pricing characteristics and maturities of our assets when compared to the re-pricing characteristics of our liabilities and other factors.
The Company's liquid assets consist of cash and cash equivalents, which include investments in very short-term investments (i.e., federal funds sold), and investment securities classified as available for sale. The level of these assets is dependent on the Company's operating, investing, and financing activities during any given period. At December 31, 2012, cash and cash equivalents totaled $45.3 million or 6.8% of total assets while investment securities classified as available for sale totaled $194.5 million or 29.0% of total assets. Management believes that the liquidity needs of the Company are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, FHLB advances, junior subordinated debt, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.
Operating activities provided net cash of $10.3 million, $9.1 million, and $5.7 million for 2012, 2011, and 2010, respectively, generated principally from net income of $6.3 million, $4.1 million, and $2.5 million in each of these respective periods.
Investing activities used $8.0 million which consisted primarily of investment activity and loan originations. The cash usages primarily consisted of investment purchases of $83.4 million and loan increases of $8.7 million. Partially offsetting the usage are proceeds from repayments and maturities and proceeds from sale of securities of $50.9 million and $33.0 million, respectively. For the same period ended 2011, investing activities used $19.4 million. These cash usages primarily consisted of loan increases of $33.0 million, as well as investment purchases of $80.1 million. Partially offsetting the usage of investment activities is $69.3 million of proceeds from investment security maturities and repayments. During the same period ended 2010, investing activities used $87.6 million in funds, principally for the net origination of loans and the purchase of investment securities of $23.0 million and $113.9 million, respectively.
Financing activities consist of the solicitation and repayment of customer deposits, borrowings and repayments, treasury stock activity, and the payment of dividends. During 2012, net cash provided by financing activities totaled $8.7 million, principally derived from an increase in deposit accounts of $12.4 million and offset by $3.9 million to repay FHLB borrowings. During 2011, net cash provided by financing activities totaled $14.0 million, principally derived from an increase in deposit accounts of $15.7 million and offset by $2.5 million to repay FHLB borrowings. During the same period ended 2010, net cash provided by financing activities totaled $71.3 million, principally derived from an increase in deposit accounts.
Liquidity may be adversely affected by many circumstances, including unexpected deposit outflows and increased draws on lines of credit. Management monitors projected liquidity needs and determines the desirable level based in part on the Company's commitment to make loans and management's assessment of the Company's ability to generate funds. The Company anticipates having sufficient liquidity to satisfy estimated short and long-term funding needs.
57

Capital Resources. The Company's primary source of capital is retained earnings. Historically, the Company has generated net retained income to support normal growth and expansion. Management has developed a capital planning policy to not only ensure regulatory compliance but capital adequacy for future expansion.
Market Price of and Dividends on the Registrant's Common Equity and Related Stockholder Matters
The Company had approximately 1,058 stockholders of record as of December 31, 2012. There is no established market for the Company’s common stock. The stock is traded very infrequently. Bid prices are quoted from time to time in the “pink sheets” under the symbol “MBCN.” The “pink sheets” is a quotation service for over-the-counter securities that is maintained by Pink OTC Markets Inc., a privately owned company. The following table shows the high and low bid prices of and cash dividends paid on the Company’s common stock in 2012 and 2011, adjusted for stock splits and stock dividends. This information does not reflect retail mark-up, markdown or commissions, and does not necessarily represent actual transactions.

|  | High Bid |  |  | Low Bid |  |  | Cash Dividends per share |
2012 |  |  |  |  |  |  |  |  |
First Quarter |  | $ | 21.25 |  |  | $ | 17.00 |  |  | $ | 0.26 |
Second Quarter |  | $ | 24.50 |  |  | $ | 21.25 |  |  | $ | 0.26 |
Third Quarter |  | $ | 25.00 |  |  | $ | 21.55 |  |  | $ | 0.26 |
Fourth Quarter |  | $ | 26.70 |  |  | $ | 22.25 |  |  | $ | 0.26 |
2011 |  |  |  |  |  |  |  |  |  |  |  |
First Quarter |  | $ | 19.00 |  |  | $ | 16.61 |  |  | $ | 0.26 |
Second Quarter |  | $ | 19.00 |  |  | $ | 17.00 |  |  | $ | 0.26 |
Third Quarter |  | $ | 18.37 |  |  | $ | 16.50 |  |  | $ | 0.26 |
Fourth Quarter |  | $ | 17.95 |  |  | $ | 16.15 |  |  | $ | 0.26 |

58

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a significant deficiency (as defined in Public Company Accounting Oversight Board Auditing Standard No. 5), or a combination of significant deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by management or employees in the normal course by management or employees in the normal course of performing their assigned functions.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2012, the Company’s internal control over financial reporting was effective.
This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
/s/ Thomas G. Caldwell
By: Thomas G. Caldwell
President and Chief Executive Officer
(Principal Executive Officer)
Date: March 13, 2013
/s/ Donald L. Stacy
By: Donald L. Stacy
Treasurer
(Principal Financial & Accounting Officer)
Date: March 13, 2013
59