NOTE 10. Fair Value Measurements

GAAP requires the Company to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

"Fair Value Measurements" defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

• Level 1 Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

• Level 2 Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

• Level 3 Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The following sections provide a description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy:

Securities Available for Sale: Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow. Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy.

Interest Rate Swap: The fair value is estimated by a third party using inputs that are observable or that can be corroborated by observable market data, and therefore, are classified within Level 2 of the valuation hierarchy.

The following table presents balances of financial assets and liabilities measured at fair value on a recurring basis at March 31, 2012 and December 31, 2011:


				Fair Value Measurements at March 31, 2012 Using
				Quoted Prices
				in Active		Significant
				Markets for		Other	Significant
		Balance as of		Identical		Observable	Unobservable
		March 31,		Assets		Inputs	Inputs
		2012		(Level 1)		(Level 2)	(Level 3)
				(in thousands)
Assets:
Securities available for sale
Obligations of U.S. government corporations and agencies	$	17,598	$	-	$	17,598	$	-
Mortgage-backed securities		32,546		-		32,546		-
Obligations of states and political subdivisions		44,800		-		44,800		-
Corporate securities		12,955		-		12,955		-
Equity securities:
Bank preferred stock		2,258		2,258		-		-
Total assets at fair value	$	110,157	$	2,258	$	107,899	$	-

Liabilities:
Interest rate swap		561		-		561		-
Total liabilities at fair value	$	561	$	-	$	561	$	-


				Fair Value Measurements at December 31, 2011 Using
				Quoted Prices
				in Active		Significant
				Markets for		Other		Significant
		Balance as of		Identical		Observable	Unobservable
		December 31,		Assets		Inputs		Inputs
		2011		(Level 1)		(Level 2)		(Level 3)
				(in thousands)
Assets:
Securities available for sale
Obligations of U.S. government corporations and agencies	$	18,533	$	-	$	18,533	$	-
Mortgage-backed securities		34,546		-		34,546		-
Obligations of states and political subdivisions		45,766		-		45,766		-
Corporate securities		13,043				13,043
Equity securities:
Bank preferred stock		2,246		2,246		-		-
Total assets at fair value	$	114,134	$	2,246	$	111,888	$	-


Liabilities:
Interest rate swap		580		-		580		-
Total liabilities at fair value	$	580	$	-	$	580	$	-

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

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

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. Level 2 impaired loan value is determined by utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business' financial statements if not considered significant using observable market data. Level 3 impaired loan values are determined using inventory and accounts receivables collateral and are based on financial statement balances or aging reports. If the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old or has been discounted based on management's historical knowledge, changes in market conditions from the time of valuation, and/or management's expertise and knowledge of the client and client's business, then the fair value is considered Level 3. Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other Real Estate Owned: Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lesser of the fair value of the property, less estimated selling costs or the loan balance outstanding at the date of foreclosure. Any write-downs based on the asset's fair value at the date of acquisition are charged to the allowance for loan losses. If there is a contract for the sale of a property, and management reasonably believes the contract will be executed, fair value is based on the sale price in that contract (Level 1). Lacking such a contract, the value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. After foreclosure, valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less cost to sell. Any subsequent valuation adjustments are applied to earnings in the consolidated statements of income. Impairment losses on property to be held and used are measured as the amount by which the carrying amount of a property exceeds its fair value. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost or fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of GAAP.

The following table displays quantitative information about Level 3 Fair Value Measurements for certain financial assets measured at fair value on a nonrecurring basis for March 31, 2012 (dollars in thousands):


	Quantitative information about Level 3 Fair Value Measurements for March 31, 2012
	Valuation Technique(s)	Unobservable Input		Range
Assets:
Impaired loans	Discounted appraised value		Selling cost	6% - 12%

Other real estate owned	Discounted appraised value		Selling cost	6% - 12%

The following table summarizes the Company's financial and nonfinancial assets that were measured at fair value on a nonrecurring basis at March 31, 2012 and December 31, 2011:


				Carrying value at March 31, 2012
		Balance as of		Identical		Observable	Unobservable
		March 31,		Assets		Inputs		Inputs
		2012		(Level 1)		(Level 2)		(Level 3)
				(in thousands)
Financial Assets:
Impaired loans	$	7,388	$	-	$	4,062	$	3,326

Nonfinancial Assets:
Other real estate owned		2,776		431		1,709		636


				Carrying value at December 31, 2011
				Quoted Prices
				in Active		Significant
				Markets for		Other		Significant
		Balance as of		Identical		Observable	Unobservable
		December 31,		Assets		Inputs		Inputs
		2011		(Level 1)		(Level 2)		(Level 3)
				(in thousands)
Financial Assets:
Impaired loans	$	6,804	$	-	$	3,379	$	3,425

Nonfinancial Assets:
Other real estate owned		2,378		-		1,742		636

The changes in Level 3 financial assets measured at estimated fair value on a nonrecurring basis during the period ended March 31, 2012 were as follows:


	Fair Value Measurements at March 31, 2012
	Impaired				Other Real
	Loans				Estate Owned
		(in thousands)
Balance - January 1, 2012	$	3,425		$	636
Sales proceeds		-			-
Valuation allowance		-			-
(Loss) on disposition		-			-
Transfers into Level 3		484			-
Transfers out of Level 3		(583	)		-
Total assets at fair value	$	3,326		$	636

GAAP defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than through a forced or liquidation sale for purposes of this disclosure. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. The following methods and assumptions were used to estimate the fair value of the Company's financial instruments:

Cash and short-term investments/accrued interest: The fair value was equal to the carrying amount.

Securities: The fair value, excluding restricted securities, was based on quoted market prices. The fair value of restricted securities approximated the carrying amount based on the redemption provisions of the issuers.

Loans: The fair value of variable rate loans, which reprice frequently and with no significant change in credit risk, was equal to the carrying amount. The fair value of all other loans was determined using discounted cash flow analysis. The discount rate was equal to the current interest rate on similar products.

Deposits and borrowings: The fair value of demand deposits, savings accounts, and certain money market deposits was equal to the carrying amount. The fair value of all other deposits and borrowings was determined using discounted cash flow analysis. The discount rate was equal to the current interest rate on similar products.

Off-balance-sheet financial instruments: The fair value of commitments to extend credit was estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the credit worthiness of the counterparties. The fair value of fixed rate loan commitments also considered the difference between current interest rates and the committed interest rates. The fair value of standby letters of credit was estimated using the fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations with the counterparties.

The carrying value and fair value of the Company's financial instruments at March 31, 2012 and December 31, 2011 were as follows:


				Fair Value Measurements at March 31, 2012 Using
				Quoted Prices
				in Active	Significant
				Markets for	Other		Significant
		Carrying Value		Identical	Observable		Unobservable			Fair Value
		as of		Assets	Inputs		Inputs			as of
		March 31, 2012		(Level 1)	(Level 2)		(Level 3)			March 31, 2012
					(in thousands)
Financial Assets:
Cash and short-term investments	$	11,218	$	11,218	$	-	$	-	$	11,218
Securities		110,157		2,258		107,899		-		110,157
Restricted Investments		3,520		-		3,520		-		3,520
Loans, net		407,535		-		417,467		7,388		424,855
Accrued interest receivable		2,044		-		2,044		-		2,044

Financial Liabilities:
Deposits	$	448,159	$	-	$	449,593	$	-	$	449,593
Federal funds purchased and securities sold under agreements to repurchase		10,000		-		10,278		-		10,278
Federal Home Loan Bank advances		32,250		-		34,753		-		34,753
Trust preferred capital notes		7,217		-		7,217		-		7,217
Accrued interest payable		298		-		298		-		298
Interest rate swap contract		561		-		561		-		561


			December 31, 2011
		Carrying Value	(in thousands)		Fair Value
		as of			as of
		December 31, 2011			December 31, 2011
Financial assets:
Cash and short-term investments	$	21,941		$	21,941
Securities		114,134			114,134
Restricted Investments		3,520			3,520
Loans, net		401,681			418,230
Accrued interest receivable		2,037			2,037


Financial liabilities:
Deposits	$	448,465		$	449,990
Federal funds purchased and securities sold under agreements to repurchase		10,000			10,350
Federal Home Loan Bank advances		42,250			44,833
Trust preferred capital notes		7,217			7,217
Accrued interest payable		336			336
Interest rate swap contract		580			580

The Company assumes interest rate risk (the risk that general interest rate levels will change) during its normal operations. As a result, the fair value of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities in order to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay their principal balance in a rising rate environment and more likely to do so in a falling rate environment. Conversely, depositors who are receiving fixed rate interest payments are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting the terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.