10-Q 1 d799636d10q.htm FORM 10-Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2014

or

¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 0-23976

(Exact name of registrant as specified in its charter)

Virginia |  | 54-1232965
(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
112 West King Street, Strasburg, Virginia |  | 22657
(Address of principal executive offices) |  | (Zip Code)

(540) 465-9121

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer |  | ¨ |  | Accelerated filer |  | ¨
Non-accelerated filer |  | ¨ (Do not check if a smaller reporting company) |  | Smaller reporting company |  | x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. As of November 14, 2014, 4,903,612 shares of common stock, par value $1.25 per share, of the registrant were outstanding.

##### Table of Contents

TABLE OF CONTENTS

|  |  |  | Page |
PART I – FINANCIAL INFORMATION |
Item 1. |  | Financial Statements |  |  |  |
|  | Consolidated Balance Sheets |  |  | 3 |
|  | Consolidated Statements of Income |  |  | 4 |
|  | Consolidated Statements of Comprehensive Income (Loss) |  |  | 8 |
|  | Consolidated Statements of Cash Flows |  |  | 10 |
|  | Consolidated Statements of Changes in Shareholders’ Equity |  |  | 12 |
|  | Notes to Consolidated Financial Statements |  |  | 13 |
Item 2. |  | Management’s Discussion and Analysis of Financial Condition and Results of Operations |  |  | 33 |
Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk |  |  | 48 |
Item 4. |  | Controls and Procedures |  |  | 48 |
PART II – OTHER INFORMATION |
Item 1. |  | Legal Proceedings |  |  | 49 |
Item 1A. |  | Risk Factors |  |  | 49 |
Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds |  |  | 49 |
Item 3. |  | Defaults Upon Senior Securities |  |  | 49 |
Item 4. |  | Mine Safety Disclosures |  |  | 49 |
Item 5. |  | Other Information |  |  | 49 |
Item 6. |  | Exhibits |  |  | 49 |

2

##### Table of Contents

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

FIRST NATIONAL CORPORATION

Consolidated Balance Sheets

(in thousands, except per share data)

|  | (unaudited) September 30, 2014 |  |  | December 31, 2013 |
Assets |  |  |  |  |  |  |  |
Cash and due from banks |  | $ | 6,862 |  |  | $ | 5,767 |
Interest-bearing deposits in banks |  |  | 3,885 |  |  |  | 25,741 |
Securities available for sale, at fair value |  |  | 104,710 |  |  |  | 103,301 |
Restricted securities, at cost |  |  | 1,636 |  |  |  | 1,804 |
Loans held for sale |  |  | 181 |  |  |  | — |
Loans, net of allowance for loan losses, 2014, $9,716; 2013, $10,644 |  |  | 364,974 |  |  |  | 346,449 |
Other real estate owned, net of valuation allowance, 2014, $456; 2013, $1,665 |  |  | 1,807 |  |  |  | 3,030 |
Premises and equipment, net |  |  | 16,175 |  |  |  | 16,642 |
Accrued interest receivable |  |  | 1,327 |  |  |  | 1,302 |
Bank owned life insurance |  |  | 11,244 |  |  |  | 10,978 |
Other assets |  |  | 6,609 |  |  |  | 7,876 |
Total assets |  | $ | 519,410 |  |  | $ | 522,890 |
Liabilities and Shareholders’ Equity |  |  |  |  |  |  |  |
Liabilities |  |  |  |  |  |  |  |
Deposits: |  |  |  |  |  |  |  |
Noninterest-bearing demand deposits |  | $ | 103,019 |  |  | $ | 92,901 |
Savings and interest-bearing demand deposits |  |  | 224,655 |  |  |  | 234,054 |
Time deposits |  |  | 111,245 |  |  |  | 123,756 |
Total deposits |  | $ | 438,919 |  |  | $ | 450,711 |
Federal funds purchased |  |  | 5,325 |  |  |  | — |
Other borrowings |  |  | 6,033 |  |  |  | 6,052 |
Trust preferred capital notes |  |  | 9,279 |  |  |  | 9,279 |
Accrued interest and other liabilities |  |  | 2,232 |  |  |  | 3,288 |
Total liabilities |  | $ | 461,788 |  |  | $ | 469,330 |
Shareholders’ Equity |  |  |  |  |  |  |  |
Preferred stock, $1,000 per share liquidation preference; authorized 1,000,000 shares; 14,595 shares issued and outstanding, net of discount |  | $ | 14,595 |  |  | $ | 14,564 |
Common stock, par value $1.25 per share; authorized 8,000,000 shares; issued and outstanding, 2014, 4,903,612 shares; 2013, 4,901,464 shares |  |  | 6,130 |  |  |  | 6,127 |
Surplus |  |  | 6,828 |  |  |  | 6,813 |
Retained earnings |  |  | 30,312 |  |  |  | 27,360 |
Accumulated other comprehensive loss, net |  |  | (243 | ) |  |  | (1,304 | )
Total shareholders’ equity |  | $ | 57,622 |  |  | $ | 53,560 |
Total liabilities and shareholders’ equity |  | $ | 519,410 |  |  | $ | 522,890 |

See Notes to Consolidated Financial Statements

3

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

Three months ended September 30, 2014 and 2013

(in thousands, except per share data)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Interest and Dividend Income |  |  |  |  |  |  |  |
Interest and fees on loans |  | $ | 4,536 |  |  | $ | 4,673 |
Interest on deposits in banks |  |  | 3 |  |  |  | 18 |
Interest and dividends on securities available for sale: |  |  |  |  |  |  |  |
Taxable interest |  |  | 536 |  |  |  | 498 |
Tax-exempt interest |  |  | 86 |  |  |  | 79 |
Dividends |  |  | 20 |  |  |  | 18 |
Total interest and dividend income |  | $ | 5,181 |  |  | $ | 5,286 |
Interest Expense |  |  |  |  |  |  |  |
Interest on deposits |  | $ | 343 |  |  | $ | 572 |
Interest on federal funds purchased |  |  | 2 |  |  |  | — |
Interest on trust preferred capital notes |  |  | 55 |  |  |  | 55 |
Interest on other borrowings |  |  | 30 |  |  |  | 30 |
Total interest expense |  | $ | 430 |  |  | $ | 657 |
Net interest income |  | $ | 4,751 |  |  | $ | 4,629 |
Provision for (recovery of) loan losses |  |  | (100 | ) |  |  | 275 |
Net interest income after provision for (recovery of) loan losses |  | $ | 4,851 |  |  | $ | 4,354 |
Noninterest Income |  |  |  |  |  |  |  |
Service charges on deposit accounts |  | $ | 655 |  |  | $ | 627 |
ATM and check card fees |  |  | 367 |  |  |  | 373 |
Wealth management fees |  |  | 494 |  |  |  | 406 |
Fees for other customer services |  |  | 94 |  |  |  | 86 |
Income from bank owned life insurance |  |  | 103 |  |  |  | 68 |
Net gains on sale of loans |  |  | — |  |  |  | 47 |
Net (losses) on sale of securities available for sale |  |  | (91 | ) |  |  | — |
Other operating income |  |  | 32 |  |  |  | 18 |
Total noninterest income |  | $ | 1,654 |  |  | $ | 1,625 |
Noninterest Expense |  |  |  |  |  |  |  |
Salaries and employee benefits |  | $ | 2,668 |  |  | $ | 2,411 |
Occupancy |  |  | 303 |  |  |  | 306 |
Equipment |  |  | 299 |  |  |  | 302 |
Marketing |  |  | 114 |  |  |  | 81 |
Stationery and supplies |  |  | 84 |  |  |  | 66 |
Legal and professional fees |  |  | 250 |  |  |  | 237 |
ATM and check card fees |  |  | 167 |  |  |  | 176 |
FDIC assessment |  |  | 90 |  |  |  | 189 |
Bank franchise tax |  |  | 106 |  |  |  | 71 |
Other real estate owned, net |  |  | (23 | ) |  |  | 252 |
Telecommunications |  |  | 75 |  |  |  | 72 |
Data processing |  |  | 129 |  |  |  | 99 |
Other operating expense |  |  | 491 |  |  |  | 386 |
Total noninterest expense |  | $ | 4,753 |  |  | $ | 4,648 |

4

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

(Continued)

Three months ended September 30, 2014 and 2013

(in thousands, except per share data)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Income before income taxes |  | $ | 1,752 |  |  | $ | 1,331 |
Income tax expense |  |  | 505 |  |  |  | 91 |
Net income |  | $ | 1,247 |  |  | $ | 1,240 |
Effective dividend and accretion on preferred stock |  |  | 329 |  |  |  | 229 |
Net income available to common shareholders |  | $ | 918 |  |  | $ | 1,011 |
Earnings per common share, basic and diluted |  | $ | 0.19 |  |  | $ | 0.21 |

See Notes to Consolidated Financial Statements

5

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

Nine months ended September 30, 2014 and 2013

(in thousands, except per share data)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Interest and Dividend Income |  |  |  |  |  |  |  |
Interest and fees on loans |  | $ | 13,154 |  |  | $ | 14,422 |
Interest on deposits in banks |  |  | 33 |  |  |  | 45 |
Interest and dividends on securities available for sale: |  |  |  |  |  |  |  |
Taxable interest |  |  | 1,660 |  |  |  | 1,313 |
Tax-exempt interest |  |  | 276 |  |  |  | 228 |
Dividends |  |  | 62 |  |  |  | 56 |
Total interest and dividend income |  | $ | 15,185 |  |  | $ | 16,064 |
Interest Expense |  |  |  |  |  |  |  |
Interest on deposits |  | $ | 1,115 |  |  | $ | 1,910 |
Interest on federal funds purchased |  |  | 2 |  |  |  | — |
Interest on trust preferred capital notes |  |  | 163 |  |  |  | 166 |
Interest on other borrowings |  |  | 89 |  |  |  | 89 |
Total interest expense |  | $ | 1,369 |  |  | $ | 2,165 |
Net interest income |  | $ | 13,816 |  |  | $ | 13,899 |
Provision for (recovery of) loan losses |  |  | (700 | ) |  |  | 2,525 |
Net interest income after provision for (recovery of) loan losses |  | $ | 14,516 |  |  | $ | 11,374 |
Noninterest Income |  |  |  |  |  |  |  |
Service charges on deposit accounts |  | $ | 1,928 |  |  | $ | 1,550 |
ATM and check card fees |  |  | 1,067 |  |  |  | 1,071 |
Wealth management fees |  |  | 1,450 |  |  |  | 1,233 |
Fees for other customer services |  |  | 307 |  |  |  | 302 |
Income from bank owned life insurance |  |  | 266 |  |  |  | 199 |
Net gains on sale of loans |  |  | — |  |  |  | 171 |
Net (losses) on sale of securities available for sale |  |  | (69 | ) |  |  | — |
Other operating income |  |  | 46 |  |  |  | 634 |
Total noninterest income |  | $ | 4,995 |  |  | $ | 5,160 |
Noninterest Expense |  |  |  |  |  |  |  |
Salaries and employee benefits |  | $ | 7,731 |  |  | $ | 7,488 |
Occupancy |  |  | 896 |  |  |  | 980 |
Equipment |  |  | 898 |  |  |  | 889 |
Marketing |  |  | 349 |  |  |  | 304 |
Stationery and supplies |  |  | 258 |  |  |  | 222 |
Legal and professional fees |  |  | 699 |  |  |  | 635 |
ATM and check card fees |  |  | 493 |  |  |  | 502 |
FDIC assessment |  |  | 384 |  |  |  | 710 |
Bank franchise tax |  |  | 305 |  |  |  | 209 |
Other real estate owned, net |  |  | (62 | ) |  |  | 735 |
Telecommunications |  |  | 219 |  |  |  | 212 |
Data processing |  |  | 378 |  |  |  | 277 |
Loss on disposal of premises and equipment |  |  | 2 |  |  |  | 3 |
Loss on land lease termination |  |  | — |  |  |  | 206 |
Other operating expense |  |  | 1,364 |  |  |  | 1,146 |
Total noninterest expense |  | $ | 13,914 |  |  | $ | 14,518 |

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

(Continued)

Nine months ended September 30, 2014 and 2013

(in thousands, except per share data)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Income before income taxes |  | $ | 5,597 |  |  | $ | 2,016 |
Income tax expense (benefit) |  |  | 1,662 |  |  |  | (468 | )
Net income |  | $ | 3,935 |  |  | $ | 2,484 |
Effective dividend and accretion on preferred stock |  |  | 810 |  |  |  | 684 |
Net income available to common shareholders |  | $ | 3,125 |  |  | $ | 1,800 |
Earnings per common share, basic and diluted |  | $ | 0.64 |  |  | $ | 0.37 |

See Notes to Consolidated Financial Statements

7

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FIRST NATIONAL CORPORATION

Consolidated Statements of Comprehensive Income

Three months ended September 30, 2014 and 2013

(in thousands)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Net income |  | $ | 1,247 |  |  | $ | 1,240 |
Other comprehensive income (loss), net of tax, |  |  |  |  |  |  |  |
Unrealized holding gains (losses) on available for sale securities, net of tax $51 and $0, respectively |  |  | 101 |  |  |  | (501 | )
Reclassification adjustment for losses included in net income, net of tax $31 and $0, respectively |  |  | 60 |  |  |  | — |
Total other comprehensive income (loss) |  |  | 161 |  |  |  | (501 | )
Total comprehensive income |  | $ | 1,408 |  |  | $ | 739 |

See Notes to Consolidated Financial Statements

8

##### Table of Contents

FIRST NATIONAL CORPORATION

Consolidated Statements of Comprehensive Income (Loss)

Nine months ended September 30, 2014 and 2013

(in thousands)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Net income |  | $ | 3,935 |  |  | $ | 2,484 |
Other comprehensive income (loss), net of tax, |  |  |  |  |  |  |  |
Unrealized holding gains (losses) on available for sale securities, net of tax $522 and $0, respectively |  |  | 1,016 |  |  |  | (3,194 | )
Reclassification adjustment for losses included in net income, net of tax $24 and $0, respectively |  |  | 45 |  |  |  | — |
Total other comprehensive income (loss) |  |  | 1,061 |  |  |  | (3,194 | )
Total comprehensive income (loss) |  | $ | 4,996 |  |  | $ | (710 | )

See Notes to Consolidated Financial Statements

9

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

Nine months ended September 30, 2014 and 2013

(in thousands)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Cash Flows from Operating Activities |  |  |  |  |  |  |  |
Net income |  | $ | 3,935 |  |  | $ | 2,484 |
Adjustments to reconcile net income to net cash provided by operating activities: |  |  |  |  |  |  |  |
Depreciation and amortization |  |  | 729 |  |  |  | 763 |
Origination of loans held for sale |  |  | (181 | ) |  |  | (2,567 | )
Proceeds from sale of loans held for sale |  |  | 1,450 |  |  |  | 3,241 |
Net gains on sales of loans held for sale |  |  | — |  |  |  | (171 | )
Provision for (recovery of) loan losses |  |  | (700 | ) |  |  | 2,525 |
Provision for other real estate owned |  |  | 93 |  |  |  | 660 |
Net losses on sale of securities available for sale Net gains on sale of other real estate owned |  |  | 69 (234 | ) |  |  | — (53 | )
Losses on disposal of premises and equipment |  |  | 2 |  |  |  | 3 |
Income from bank owned life insurance |  |  | (266 | ) |  |  | (199 | )
Accretion of discounts and amortization of premiums on securities, net |  |  | 490 |  |  |  | 709 |
Changes in assets and liabilities: |  |  |  |  |  |  |  |
(Increase) decrease in interest receivable |  |  | (25 | ) |  |  | 120 |
(Increase) decrease in other assets |  |  | 720 |  |  |  | (532 | )
Increase (decrease) in other liabilities |  |  | (1,056 | ) |  |  | 708 |
Net cash provided by operating activities |  | $ | 5,026 |  |  | $ | 7,691 |
Cash Flows from Investing Activities |  |  |  |  |  |  |  |
Proceeds from sales of securities available for sale |  | $ | 3,453 |  |  | $ | 1,850 |
Proceeds from maturities, calls, and principal payments of securities available for sale |  |  | 10,408 |  |  |  | 19,373 |
Purchase of securities available for sale |  |  | (14,219 | ) |  |  | (40,991 | )
Proceeds from redemption of restricted securities |  |  | 168 |  |  |  | 170 |
Purchase of premises and equipment |  |  | (264 | ) |  |  | (232 | )
Proceeds from sale of other real estate owned |  |  | 1,502 |  |  |  | 2,927 |
Net (increase) decrease in loans |  |  | (19,415 | ) |  |  | 12,294 |
Net cash used in investing activities |  | $ | (18,367 | ) |  | $ | (4,609 | )
Cash Flows from Financing Activities |  |  |  |  |  |  |  |
Net increase in demand deposits and savings accounts |  | $ | 719 |  |  | $ | 18,880 |
Net decrease in time deposits |  |  | (12,511 | ) |  |  | (14,534 | )
Principal payments on other borrowings |  |  | (19 | ) |  |  | (18 | )
Cash dividends paid on preferred stock |  |  | (707 | ) |  |  | (568 | )
Cash dividends paid on common stock, net of reinvestment |  |  | (227 | ) |  |  | — |
Increase in federal funds purchased |  |  | 5,325 |  |  |  | — |
Net cash provided by (used in) financing activities |  | $ | (7,420 | ) |  | $ | 3,760 |
Increase (decrease) in cash and cash equivalents |  | $ | (20,761 | ) |  | $ | 6,842 |
Cash and Cash Equivalents |  |  |  |  |  |  |  |
Beginning |  | $ | 31,508 |  |  | $ | 31,028 |
Ending |  | $ | 10,747 |  |  | $ | 37,870 |

See Notes to Consolidated Financial Statements

10

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

(Continued)

Nine months ended September 30, 2014 and 2013

(in thousands)

|  | (unaudited) September 30, 2014 |  |  | (unaudited) September 30, 2013 |
Supplemental Disclosures of Cash Flow Information |  |  |  |  |  |  |  |
Cash payments for: |  |  |  |  |  |  |  |
Interest |  | $ | 1,403 |  |  | $ | 2,219 |
Income Taxes |  | $ | 601 |  |  | $ | 310 |
Supplemental Disclosures of Noncash Investing and Financing Activities |  |  |  |  |  |  |  |
Unrealized gains (losses) on securities available for sale |  | $ | 1,607 |  |  | $ | (3,194 | )
Transfer from loans to loans held for sale |  | $ | 1,450 |  |  | $ | — |
Transfer from loans to other real estate owned |  | $ | 139 |  |  | $ | 748 |
Transfer from premises and equipment to other real estate owned |  | $ | — |  |  | $ | 641 |
Transfer from other assets to other real estate owned |  | $ | — |  |  | $ | 452 |
Issuance of common stock, dividend reinvestment plan |  | $ | 18 |  |  | $ | — |

See Notes to Consolidated Financial Statements

11

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FIRST NATIONAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity

Nine months ended September 30, 2014 and 2013

(in thousands)

(unaudited)

|  | Preferred Stock |  |  | Common Stock |  |  | Surplus |  |  | Retained Earnings |  |  | Accumulated Other Comprehensive Loss |  |  | Total |
Balance, December 31, 2012 |  | $ | 14,409 |  |  | $ | 6,127 |  |  | $ | 6,813 |  |  | $ | 18,399 |  |  | $ | (859 | ) |  | $ | 44,889 |
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 2,484 |  |  |  | — |  |  |  | 2,484 |
Other comprehensive loss |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (3,194 | ) |  |  | (3,194 | )
Cash dividends on preferred stock |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (568 | ) |  |  | — |  |  |  | (568 | )
Accretion of preferred stock discount |  |  | 116 |  |  |  | — |  |  |  | — |  |  |  | (116 | ) |  |  | — |  |  |  | — |
Balance, September 30, 2013 |  | $ | 14,525 |  |  | $ | 6,127 |  |  | $ | 6,813 |  |  | $ | 20,199 |  |  | $ | (4,053 | ) |  | $ | 43,611 |

|  | Preferred Stock |  |  | Common Stock |  |  | Surplus |  |  | Retained Earnings |  |  | Accumulated Other Comprehensive Income (Loss) |  |  | Total |
Balance, December 31, 2013 |  | $ | 14,564 |  |  | $ | 6,127 |  |  | $ | 6,813 |  |  | $ | 27,360 |  |  | $ | (1,304 | ) |  | $ | 53,560 |
Net income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 3,935 |  |  |  | — |  |  |  | 3,935 |
Other comprehensive income |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 1,061 |  |  |  | 1,061 |
Cash dividends on common stock ($0.025 per share) |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (245 | ) |  |  | — |  |  |  | (245 | )
Issuance of 2,148 shares common stock, dividend reinvestment plan |  |  | — |  |  |  | 3 |  |  |  | 15 |  |  |  | — |  |  |  | — |  |  |  | 18 |
Cash dividends on preferred stock |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (707 | ) |  |  | — |  |  |  | (707 | )
Accretion of preferred stock discount |  |  | 31 |  |  |  | — |  |  |  | — |  |  |  | (31 | ) |  |  | — |  |  |  | — |
Balance, September 30, 2014 |  | $ | 14,595 |  |  | $ | 6,130 |  |  | $ | 6,828 |  |  | $ | 30,312 |  |  | $ | (243 | ) |  | $ | 57,622 |

See Notes to Consolidated Financial Statements

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FIRST NATIONAL CORPORATION

Notes to Consolidated Financial Statements

(unaudited)

Note 1. General

The accompanying unaudited consolidated financial statements of First National Corporation (the Company) and its subsidiaries, including First Bank (the Bank), have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP. All significant intercompany balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments and reclassifications of a normal and recurring nature considered necessary to present fairly the financial positions at September 30, 2014 and December 31, 2013, the results of operations and comprehensive income (loss) for the three and nine months ended September 30, 2014 and 2013 and the cash flows and changes in shareholders’ equity for the nine months ended September 30, 2014 and 2013. The statements should be read in conjunction with the consolidated financial statements and related notes included in the Annual Report on Form 10-K for the year ended December 31, 2013. Operating results for the three and nine month periods ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014.

Recent Accounting Pronouncements

In January 2014, the FASB issued ASU 2014-01, “Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU permit reporting entities to make an accounting policy election to account for their investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. Under the proportional amortization method, an entity amortizes the initial cost of the investment in proportion to the tax credits and other tax benefits received and recognizes the net investment performance in the income statement as a component of income tax expense (benefit). The amendments in this ASU should be applied retrospectively to all periods presented. A reporting entity that uses the effective yield method to account for its investments in qualified affordable housing projects before the date of adoption may continue to apply the effective yield method for those preexisting investments. The amendments in this ASU are effective for public business entities for annual periods and interim reporting periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-01 to have an impact on its consolidated financial statements.

In January 2014, the FASB issued ASU 2014-04, “Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force).” The amendments in this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Company does not expect the adoption of ASU 2014-04 to have an impact on its consolidated financial statements.

13

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

In April 2014, the FASB issued ASU 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.” The amendments in this ASU change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization’s operations and financial results and include disposals of a major geographic area, a major line of business, or a major equity method investment. The new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. Additionally, the new guidance requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The amendments in the ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-08 to have a material impact on its consolidated financial statements.

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers: Topic 606”. This ASU applies to any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards. The guidance supersedes the revenue recognition requirements in Topic 605, “Revenue Recognition”, most industry-specific guidance, and some cost guidance included in Subtopic 605-35, “Revenue Recognition—Construction-Type and Production-Type Contracts”. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To be in alignment with the core principle, an entity must apply a five step process including: identification of the contract(s) with a customer, identification of performance obligations in the contract(s), determination of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue when (or as) the entity satisfies a performance obligation. Additionally, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer have also been amended to be consistent with the guidance on recognition and measurement. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted. The Company is currently assessing the impact that ASU 2014-09 will have on its consolidated financial statements.

In June 2014, the FASB issued ASU No. 2014-11, “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures”. This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014; however, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The Company does not expect the adoption of ASU 2014-11 to have an impact on its consolidated financial statements.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

In June 2014, the FASB issued ASU No. 2014-12, “Compensation – Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period”. The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation – Stock Compensation (Topic 718)”, should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Company is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern”. This update is intended to provide guidance about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period. If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect the adoption of ASU 2014-15 to have an impact on its consolidated financial statements.

Note 2. Securities

The Company invests in U.S. agency and mortgage-backed securities, obligations of state and political subdivisions and corporate equity securities. Amortized costs and fair values of securities available for sale at September 30, 2014 and December 31, 2013 were as follows (in thousands):

|  | September 30, 2014 |
|  | Amortized Cost |  |  | Gross Unrealized Gains |  |  | Gross Unrealized (Losses) |  |  | Fair Value |
U.S. agency and mortgage-backed securities |  | $ | 83,746 |  |  | $ | 882 |  |  | $ | (1,248 | ) |  | $ | 83,380 |
Obligations of states and political subdivisions |  |  | 21,068 |  |  |  | 429 |  |  |  | (172 | ) |  |  | 21,325 |
Corporate equity securities |  |  | 1 |  |  |  | 4 |  |  |  | — |  |  |  | 5 |
|  | $ | 104,815 |  |  | $ | 1,315 |  |  | $ | (1,420 | ) |  | $ | 104,710 |

|  | December 31, 2013 |
|  | Amortized Cost |  |  | Gross Unrealized Gains |  |  | Gross Unrealized (Losses) |  |  | Fair Value |
U.S. agency and mortgage-backed securities |  | $ | 86,365 |  |  | $ | 670 |  |  | $ | (2,138 | ) |  | $ | 84,897 |
Obligations of states and political subdivisions |  |  | 18,647 |  |  |  | 350 |  |  |  | (598 | ) |  |  | 18,399 |
Corporate equity securities |  |  | 1 |  |  |  | 4 |  |  |  | — |  |  |  | 5 |
|  | $ | 105,013 |  |  | $ | 1,024 |  |  | $ | (2,736 | ) |  | $ | 103,301 |

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

At September 30, 2014 and December 31, 2013, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):

|  | September 30, 2014 |
|  | Less than 12 months |  |  | 12 months or more |  |  | Total |
|  | Fair Value |  |  | Unrealized (Loss) |  |  | Fair Value |  |  | Unrealized (Loss) |  |  | Fair Value |  |  | Unrealized (Loss) |
U.S. agency and mortgage-backed securities |  | $ | 15,817 |  |  | $ | (205 | ) |  | $ | 33,557 |  |  | $ | (1,043 | ) |  | $ | 49,374 |  |  | $ | (1,248 | )
Obligations of states and political subdivisions |  |  | 1,632 |  |  |  | (5 | ) |  |  | 6,143 |  |  |  | (167 | ) |  |  | 7,775 |  |  |  | (172 | )
|  | $ | 17,449 |  |  | $ | (210 | ) |  | $ | 39,700 |  |  | $ | (1,210 | ) |  | $ | 57,149 |  |  | $ | (1,420 | )

|  | December 31, 2013 |
|  | Less than 12 months |  |  | 12 months or more |  |  | Total |
|  | Fair Value |  |  | Unrealized (Loss) |  |  | Fair Value |  |  | Unrealized (Loss) |  |  | Fair Value |  |  | Unrealized (Loss) |
U.S. agency and mortgage-backed securities |  | $ | 49,810 |  |  | $ | (1,755 | ) |  | $ | 10,180 |  |  | $ | (383 | ) |  | $ | 59,990 |  |  | $ | (2,138 | )
Obligations of states and political subdivisions |  |  | 7,165 |  |  |  | (422 | ) |  |  | 2,663 |  |  |  | (176 | ) |  |  | 9,828 |  |  |  | (598 | )
|  | $ | 56,975 |  |  | $ | (2,177 | ) |  | $ | 12,843 |  |  | $ | (559 | ) |  | $ | 69,818 |  |  | $ | (2,736 | )

The tables above provide information about securities that have been in an unrealized loss position for less than twelve consecutive months and securities that have been in an unrealized loss position for twelve consecutive months or more. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Impairment is considered to be other-than-temporary if the Company (1) intends to sell the security, (2) more likely than not will be required to sell the security before recovering its cost, or (3) does not expect to recover the security’s entire amortized cost basis. Presently, the Company does not intend to sell any of these securities, does not expect to be required to sell these securities, and expects to recover the entire amortized cost of all the securities.

At September 30, 2014, there were thirty-four U.S. agency and mortgage-backed securities and sixteen obligations of state and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio is considered investment grade. The weighted-average re-pricing term of the portfolio was 4.0 years at September 30, 2014. At December 31, 2013, there were forty U.S. agency and mortgage-backed securities and twenty-one obligations of states and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio was considered investment grade at December 31, 2013. The weighted-average re-pricing term of the portfolio was 4.5 years at December 31, 2013. The unrealized losses at September 30, 2014 in the U.S. agency and mortgage-backed securities portfolio and the obligation of states and political subdivisions portfolio were related to changes in market interest rates and not credit concerns of the issuers.

Federal Home Loan Bank, Federal Reserve Bank and Community Bankers’ Bank stock are generally viewed as long-term investments and as restricted securities, which are carried at cost, because there is a minimal market for the stock. Therefore, when evaluating restricted securities for impairment, their value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider these investments to be other-than-temporarily impaired at September 30, 2014, and no impairment has been recognized. Restricted securities are not part of the available for sale securities portfolio.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

The composition of restricted securities at September 30, 2014 and December 31, 2013 was as follows (in thousands):

|  | September 30, 2014 |  |  | December 31, 2013 |
Federal Home Loan Bank stock |  | $ | 740 |  |  | $ | 908 |
Federal Reserve Bank stock |  |  | 846 |  |  |  | 846 |
Community Bankers’ Bank stock |  |  | 50 |  |  |  | 50 |
|  | $ | 1,636 |  |  | $ | 1,804 |

Note 3. Loans

Loans at September 30, 2014 and December 31, 2013 are summarized as follows (in thousands):

|  | September 30, 2014 |  |  | December 31, 2013 |
Real estate loans: |  |  |  |  |  |  |  |
Construction and land development |  | $ | 29,862 |  |  | $ | 34,060 |
Secured by 1-4 family residential |  |  | 155,298 |  |  |  | 141,961 |
Other real estate loans |  |  | 154,769 |  |  |  | 145,968 |
Commercial and industrial loans |  |  | 22,943 |  |  |  | 22,803 |
Consumer and other loans |  |  | 11,818 |  |  |  | 12,301 |
Total loans |  | $ | 374,690 |  |  | $ | 357,093 |
Allowance for loan losses |  |  | (9,716 | ) |  |  | (10,644 | )
Loans, net |  | $ | 364,974 |  |  | $ | 346,449 |

Net deferred loan fees included in the above loan categories were $123 thousand and $18 thousand at September 30, 2014 and December 31, 2013, respectively. Consumer and other loans included $248 thousand and $279 thousand of demand deposit overdrafts at September 30, 2014 and December 31, 2013, respectively.

Risk characteristics of each loan portfolio class that are considered by the Company include:

| • |  | 1-4 family residential mortgage loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.

| • |  | Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project.

| • |  | Other real estate loans and commercial and industrial loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability.

| • |  | Consumer and other loans carry risk associated with the continued credit-worthiness of the borrower and the value of the collateral, i.e. rapidly depreciating assets such as automobiles, or lack thereof. Consumer loans are likely to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy, or other changes in circumstances.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

The following table provides a summary of loan classes and an aging of past due loans as of September 30, 2014 and December 31, 2013 (in thousands):

|  | September 30, 2014 |
|  | 30-59 Days Past Due |  |  | 60-89 Days Past Due |  |  | > 90 Days Past Due |  |  | Total Past Due |  |  | Current |  |  | Total Loans |  |  | Non-accrual Loans |  |  | 90 Days or More Past Due and Accruing |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 1,296 |  |  | $ | 72 |  |  | $ | 932 |  |  | $ | 2,300 |  |  | $ | 27,562 |  |  | $ | 29,862 |  |  | $ | 2,656 |  |  | $ | 165 |
1-4 family residential |  |  | 646 |  |  |  | 287 |  |  |  | 977 |  |  |  | 1,910 |  |  |  | 153,388 |  |  |  | 155,298 |  |  |  | 1,357 |  |  |  | 402 |
Other real estate loans |  |  | 1,604 |  |  |  | 71 |  |  |  | 3,082 |  |  |  | 4,757 |  |  |  | 150,012 |  |  |  | 154,769 |  |  |  | 4,529 |  |  |  | 1,581 |
Commercial and industrial |  |  | 77 |  |  |  | — |  |  |  | 13 |  |  |  | 90 |  |  |  | 22,853 |  |  |  | 22,943 |  |  |  | 131 |  |  |  | — |
Consumer and other loans |  |  | 31 |  |  |  | — |  |  |  | — |  |  |  | 31 |  |  |  | 11,787 |  |  |  | 11,818 |  |  |  | — |  |  |  | — |
Total |  | $ | 3,654 |  |  | $ | 430 |  |  | $ | 5,004 |  |  | $ | 9,088 |  |  | $ | 365,602 |  |  | $ | 374,690 |  |  | $ | 8,673 |  |  | $ | 2,148 |

|  | December 31, 2013 |
|  | 30-59 Days Past Due |  |  | 60-89 Days Past Due |  |  | > 90 Days Past Due |  |  | Total Past Due |  |  | Current |  |  | Total Loans |  |  | Non-accrual Loans |  |  | 90 Days or More Past Due and Accruing |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 161 |  |  | $ | 2,852 |  |  | $ | 3,339 |  |  | $ | 6,352 |  |  | $ | 27,708 |  |  | $ | 34,060 |  |  | $ | 5,811 |  |  | $ | — |
1-4 family residential |  |  | 1,561 |  |  |  | 316 |  |  |  | 136 |  |  |  | 2,013 |  |  |  | 139,948 |  |  |  | 141,961 |  |  |  | 953 |  |  |  | 27 |
Other real estate loans |  |  | 1,077 |  |  |  | 1,636 |  |  |  | 74 |  |  |  | 2,787 |  |  |  | 143,181 |  |  |  | 145,968 |  |  |  | 4,756 |  |  |  | — |
Commercial and industrial |  |  | 165 |  |  |  | — |  |  |  | 22 |  |  |  | 187 |  |  |  | 22,616 |  |  |  | 22,803 |  |  |  | 144 |  |  |  | 22 |
Consumer and other loans |  |  | 41 |  |  |  | 5 |  |  |  | — |  |  |  | 46 |  |  |  | 12,255 |  |  |  | 12,301 |  |  |  | 14 |  |  |  | — |
Total |  | $ | 3,005 |  |  | $ | 4,809 |  |  | $ | 3,571 |  |  | $ | 11,385 |  |  | $ | 345,708 |  |  | $ | 357,093 |  |  | $ | 11,678 |  |  | $ | 49 |

Credit Quality Indicators

As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to the risk grading of specified classes of loans. The Company utilizes a risk grading matrix to assign a rating to each of its loans. The loan ratings are summarized into the following categories: pass, special mention, substandard, doubtful and loss. Pass rated loans include all risk rated credits other than those included in special mention, substandard or doubtful. Loans classified as loss are charged-off. Loan officers assign risk grades to loans at origination and as renewals arise. The Bank’s Credit Administration department reviews risk grades for accuracy on a quarterly basis and as credit issues arise. In addition, a certain amount of loans are reviewed each year through the Company’s internal and external loan review process. A description of the general characteristics of the loan grading categories is as follows:

Pass – Loans classified as pass exhibit acceptable operating trends, balance sheet trends, and liquidity. Sufficient cash flow exists to service the loan. All obligations have been paid by the borrower as agreed.

Special Mention – Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or the Bank’s credit position at some future date.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Substandard – Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful – Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. The Company considers all doubtful loans to be impaired and places the loan on non-accrual status.

Loss – Loans classified as loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted.

The following tables provide an analysis of the credit risk profile of each loan class as of September 30, 2014 and December 31, 2013 (in thousands):

|  | September 30, 2014 |
|  | Pass |  |  | Special Mention |  |  | Substandard |  |  | Doubtful |  |  | Total |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 20,448 |  |  | $ | 3,032 |  |  | $ | 6,382 |  |  | $ | — |  |  | $ | 29,862 |
Secured by 1-4 family residential |  |  | 142,694 |  |  |  | 5,657 |  |  |  | 6,947 |  |  |  | — |  |  |  | 155,298 |
Other real estate loans |  |  | 130,111 |  |  |  | 9,524 |  |  |  | 15,134 |  |  |  | — |  |  |  | 154,769 |
Commercial and industrial |  |  | 22,446 |  |  |  | 198 |  |  |  | 299 |  |  |  | — |  |  |  | 22,943 |
Consumer and other loans |  |  | 11,818 |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 11,818 |
Total |  | $ | 327,517 |  |  | $ | 18,411 |  |  | $ | 28,762 |  |  | $ | — |  |  | $ | 374,690 |

|  | December 31, 2013 |
|  | Pass |  |  | Special Mention |  |  | Substandard |  |  | Doubtful |  |  | Total |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 19,724 |  |  | $ | 3,500 |  |  | $ | 10,836 |  |  | $ | — |  |  | $ | 34,060 |
Secured by 1-4 family residential |  |  | 130,048 |  |  |  | 5,378 |  |  |  | 6,535 |  |  |  | — |  |  |  | 141,961 |
Other real estate loans |  |  | 118,663 |  |  |  | 10,227 |  |  |  | 17,078 |  |  |  | — |  |  |  | 145,968 |
Commercial and industrial |  |  | 21,563 |  |  |  | 555 |  |  |  | 685 |  |  |  | — |  |  |  | 22,803 |
Consumer and other loans |  |  | 12,287 |  |  |  | — |  |  |  | 14 |  |  |  | — |  |  |  | 12,301 |
Total |  | $ | 302,285 |  |  | $ | 19,660 |  |  | $ | 35,148 |  |  | $ | — |  |  | $ | 357,093 |

Note 4. Allowance for Loan Losses

Transactions in the allowance for loan losses for the nine months ended September 30, 2014 and 2013 and for the year ended December 31, 2013 were as follows (in thousands):

|  | September 30, 2014 |  |  | December 31, 2013 |  |  | September 30, 2013 |
Balance at beginning of year |  | $ | 10,644 |  |  | $ | 13,075 |  |  | $ | 13,075 |
Provision charged to (recovery from) operating expense |  |  | (700 | ) |  |  | (425 | ) |  |  | 2,525 |
Loan recoveries |  |  | 619 |  |  |  | 2,486 |  |  |  | 575 |
Loan charge-offs |  |  | (847 | ) |  |  | (4,492 | ) |  |  | (4,300 | )
Balance at end of period |  | $ | 9,716 |  |  | $ | 10,644 |  |  | $ | 11,875 |

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

The following tables present, as of September 30, 2014, December 31, 2013 and September 30, 2013, the total allowance for loan losses, the allowance by impairment methodology and loans by impairment methodology (in thousands):

|  | September 30, 2014 |
|  | Construction and Land Development |  |  | Secured by 1-4 Family Residential |  |  | Other Real Estate |  |  | Commercial and Industrial |  |  | Consumer and Other Loans |  |  | Total |
Allowance for loan losses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Beginning Balance, December 31, 2013 |  | $ | 2,710 |  |  | $ | 2,975 |  |  | $ | 4,418 |  |  | $ | 442 |  |  | $ | 99 |  |  | $ | 10,644 |
Charge-offs |  |  | (91 | ) |  |  | (259 | ) |  |  | (203 | ) |  |  | (43 | ) |  |  | (251 | ) |  |  | (847 | )
Recoveries |  |  | 79 |  |  |  | 10 |  |  |  | 340 |  |  |  | 16 |  |  |  | 174 |  |  |  | 619 |
Provision for (recovery of) loan losses |  |  | (832 | ) |  |  | 185 |  |  |  | (131 | ) |  |  | (58 | ) |  |  | 136 |  |  |  | (700 | )
Ending Balance, September 30, 2014 |  | $ | 1,866 |  |  | $ | 2,911 |  |  | $ | 4,424 |  |  | $ | 357 |  |  | $ | 158 |  |  | $ | 9,716 |
Ending Balance: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  |  | 626 |  |  |  | 133 |  |  |  | 914 |  |  |  | 36 |  |  |  | — |  |  |  | 1,709 |
Collectively evaluated for impairment |  |  | 1,240 |  |  |  | 2,778 |  |  |  | 3,510 |  |  |  | 321 |  |  |  | 158 |  |  |  | 8,007 |
Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Ending Balance |  |  | 29,862 |  |  |  | 155,298 |  |  |  | 154,769 |  |  |  | 22,943 |  |  |  | 11,818 |  |  |  | 374,690 |
Individually evaluated for impairment |  |  | 3,382 |  |  |  | 3,436 |  |  |  | 9,899 |  |  |  | 126 |  |  |  | — |  |  |  | 16,843 |
Collectively evaluated for impairment |  |  | 26,480 |  |  |  | 151,862 |  |  |  | 144,870 |  |  |  | 22,817 |  |  |  | 11,818 |  |  |  | 357,847 |

|  | December 31, 2013 |
|  | Construction and Land Development |  |  | Secured by 1-4 Family Residential |  |  | Other Real Estate |  |  | Commercial and Industrial |  |  | Consumer and Other Loans |  |  | Total |
Allowance for loan losses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Beginning Balance, December 31, 2012 |  | $ | 2,481 |  |  | $ | 3,712 |  |  | $ | 6,163 |  |  | $ | 608 |  |  | $ | 111 |  |  | $ | 13,075 |
Charge-offs |  |  | (2,962 | ) |  |  | (260 | ) |  |  | (1,070 | ) |  |  | (37 | ) |  |  | (163 | ) |  |  | (4,492 | )
Recoveries |  |  | — |  |  |  | 823 |  |  |  | 1,304 |  |  |  | 179 |  |  |  | 180 |  |  |  | 2,486 |
Provision for (recovery of) loan losses |  |  | 3,191 |  |  |  | (1,300 | ) |  |  | (1,979 | ) |  |  | (308 | ) |  |  | (29 | ) |  |  | (425 | )
Ending Balance, December 31, 2013 |  | $ | 2,710 |  |  | $ | 2,975 |  |  | $ | 4,418 |  |  | $ | 442 |  |  | $ | 99 |  |  | $ | 10,644 |
Ending Balance: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  |  | 882 |  |  |  | 190 |  |  |  | 263 |  |  |  | 44 |  |  |  | — |  |  |  | 1,379 |
Collectively evaluated for impairment |  |  | 1,828 |  |  |  | 2,785 |  |  |  | 4,155 |  |  |  | 398 |  |  |  | 99 |  |  |  | 9,265 |
Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Ending Balance |  |  | 34,060 |  |  |  | 141,961 |  |  |  | 145,968 |  |  |  | 22,803 |  |  |  | 12,301 |  |  |  | 357,093 |
Individually evaluated for impairment |  |  | 6,862 |  |  |  | 3,431 |  |  |  | 11,143 |  |  |  | 258 |  |  |  | — |  |  |  | 21,694 |
Collectively evaluated for impairment |  |  | 27,198 |  |  |  | 138,530 |  |  |  | 134,825 |  |  |  | 22,545 |  |  |  | 12,301 |  |  |  | 335,399 |

20

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

|  | September 30, 2013 |
|  | Construction and Land Development |  |  | Secured by 1-4 Family Residential |  |  | Other Real Estate |  |  | Commercial and Industrial |  |  | Consumer and Other Loans |  |  | Total |
Allowance for loan losses: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Beginning Balance, December 31, 2012 |  | $ | 2,481 |  |  | $ | 3,712 |  |  | $ | 6,163 |  |  | $ | 608 |  |  | $ | 111 |  |  | $ | 13,075 |
Charge-offs |  |  | (2,923 | ) |  |  | (260 | ) |  |  | (976 | ) |  |  | (31 | ) |  |  | (110 | ) |  |  | (4,300 | )
Recoveries |  |  | — |  |  |  | 47 |  |  |  | 214 |  |  |  | 177 |  |  |  | 137 |  |  |  | 575 |
Provision for (recovery of) loan losses |  |  | 3,385 |  |  |  | (332 | ) |  |  | (89 | ) |  |  | (359 | ) |  |  | (80 | ) |  |  | 2,525 |
Ending Balance, September 30, 2013 |  | $ | 2,943 |  |  | $ | 3,167 |  |  | $ | 5,312 |  |  | $ | 395 |  |  | $ | 58 |  |  | $ | 11,875 |
Ending Balance: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Individually evaluated for impairment |  |  | 743 |  |  |  | 81 |  |  |  | 201 |  |  |  | 56 |  |  |  | — |  |  |  | 1,081 |
Collectively evaluated for impairment |  |  | 2,200 |  |  |  | 3,086 |  |  |  | 5,111 |  |  |  | 339 |  |  |  | 58 |  |  |  | 10,794 |
Loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Ending Balance |  |  | 34,404 |  |  |  | 142,446 |  |  |  | 156,691 |  |  |  | 21,316 |  |  |  | 11,970 |  |  |  | 366,827 |
Individually evaluated for impairment |  |  | 7,217 |  |  |  | 3,439 |  |  |  | 6,690 |  |  |  | 244 |  |  |  | — |  |  |  | 17,590 |
Collectively evaluated for impairment |  |  | 27,187 |  |  |  | 139,007 |  |  |  | 150,001 |  |  |  | 21,072 |  |  |  | 11,970 |  |  |  | 349,237 |

Impaired loans and the related allowance at September 30, 2014, December 31, 2013 and September 30, 2013, were as follows (in thousands):

|  | September 30, 2014 |
|  | Unpaid Principal Balance |  |  | Recorded Investment with No Allowance |  |  | Recorded Investment with Allowance |  |  | Total Recorded Investment |  |  | Related Allowance |  |  | Average Recorded Investment |  |  | Interest Income Recognized |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 3,588 |  |  | $ | 2,129 |  |  | $ | 1,253 |  |  | $ | 3,382 |  |  | $ | 626 |  |  | $ | 6,289 |  |  | $ | 34 |
Secured by 1-4 family |  |  | 4,384 |  |  |  | 2,686 |  |  |  | 750 |  |  |  | 3,436 |  |  |  | 133 |  |  |  | 3,200 |  |  |  | 108 |
Other real estate loans |  |  | 10,453 |  |  |  | 7,499 |  |  |  | 2,400 |  |  |  | 9,899 |  |  |  | 914 |  |  |  | 10,635 |  |  |  | 188 |
Commercial and industrial |  |  | 131 |  |  |  | 8 |  |  |  | 118 |  |  |  | 126 |  |  |  | 36 |  |  |  | 171 |  |  |  | 1 |
Consumer and other loans |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Total |  | $ | 18,556 |  |  | $ | 12,322 |  |  | $ | 4,521 |  |  | $ | 16,843 |  |  | $ | 1,709 |  |  | $ | 20,295 |  |  | $ | 331 |

21

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

|  | December 31, 2013 |
|  | Unpaid Principal Balance |  |  | Recorded Investment with No Allowance |  |  | Recorded Investment with Allowance |  |  | Total Recorded Investment |  |  | Related Allowance |  |  | Average Recorded Investment |  |  | Interest Income Recognized |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 9,086 |  |  | $ | 4,259 |  |  | $ | 2,603 |  |  | $ | 6,862 |  |  | $ | 882 |  |  | $ | 5,397 |  |  | $ | 204 |
Secured by 1-4 family |  |  | 4,341 |  |  |  | 2,515 |  |  |  | 916 |  |  |  | 3,431 |  |  |  | 190 |  |  |  | 2,864 |  |  |  | 146 |
Other real estate loans |  |  | 12,385 |  |  |  | 9,455 |  |  |  | 1,688 |  |  |  | 11,143 |  |  |  | 263 |  |  |  | 7,079 |  |  |  | 441 |
Commercial and industrial |  |  | 260 |  |  |  | 114 |  |  |  | 144 |  |  |  | 258 |  |  |  | 44 |  |  |  | 669 |  |  |  | 14 |
Consumer and other loans |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Total |  | $ | 26,072 |  |  | $ | 16,343 |  |  | $ | 5,351 |  |  | $ | 21,694 |  |  | $ | 1,379 |  |  | $ | 16,009 |  |  | $ | 805 |

|  | September 30, 2013 |
|  | Unpaid Principal Balance |  |  | Recorded Investment with No Allowance |  |  | Recorded Investment with Allowance |  |  | Total Recorded Investment |  |  | Related Allowance |  |  | Average Recorded Investment |  |  | Interest Income Recognized |
Real estate loans: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Construction and land development |  | $ | 9,441 |  |  | $ | 5,406 |  |  | $ | 1,811 |  |  | $ | 7,217 |  |  | $ | 743 |  |  | $ | 4,469 |  |  | $ | 217 |
Secured by 1-4 family |  |  | 4,339 |  |  |  | 2,533 |  |  |  | 906 |  |  |  | 3,439 |  |  |  | 81 |  |  |  | 2,673 |  |  |  | 105 |
Other real estate loans |  |  | 7,855 |  |  |  | 4,883 |  |  |  | 1,807 |  |  |  | 6,690 |  |  |  | 201 |  |  |  | 6,817 |  |  |  | 197 |
Commercial and industrial |  |  | 245 |  |  |  | 16 |  |  |  | 228 |  |  |  | 244 |  |  |  | 56 |  |  |  | 795 |  |  |  | 9 |
Consumer and other loans |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |  |  |  | — |
Total |  | $ | 21,880 |  |  | $ | 12,838 |  |  | $ | 4,752 |  |  | $ | 17,590 |  |  | $ | 1,081 |  |  | $ | 14,754 |  |  | $ | 528 |

The “Recorded Investment” amounts in the table above represent the outstanding principal balance on each loan represented in the table. The “Unpaid Principal Balance” represents the outstanding principal balance on each loan represented in the table plus any amounts that have been charged off on each loan and/or payments that have been applied towards principal on non-accrual loans.

As of September 30, 2014, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $1.9 million. At September 30, 2014, $796 thousand of the loans classified as TDRs were performing under the restructured terms and were not considered non-performing assets. There were $1.9 million in TDRs at December 31, 2013, $829 thousand of which were performing under the restructured terms. Modified terms under TDRs may include rate reductions, extension of terms that are considered to be below market, conversion to interest only, and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. There was one new other real estate loan modified under a TDR during the nine month period ended September 30, 2014. The recorded investment for this loan prior to the modification totaled $283 thousand and the recorded investment after the modification totaled $344 thousand. There were no loans modified under TDRs during the three month period ended September 30, 2014 and the three and nine month periods ended September 30, 2013.

For the three and nine months ended September 30, 2014 and 2013, there were no troubled debt restructurings that subsequently defaulted within twelve months of the loan modification. Management defines default as over ninety days past due or charged-off during the twelve month period subsequent to the modification.

22

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Note 5. Other Real Estate Owned (OREO)

At September 30, 2014 and December 31, 2013, OREO totaled $1.8 million and $3.0 million, respectively. OREO is primarily comprised of residential lots, raw land, non-residential properties and residential properties, and are located primarily in the Commonwealth of Virginia. Changes in the balance for OREO are as follows (in thousands):

|  | For the nine months ended September 30, 2014 |  |  | For the year ended December 31, 2013 |
Balance at the beginning of year, gross |  | $ | 4,695 |  |  | $ | 7,764 |
Transfers in |  |  | 139 |  |  |  | 2,036 |
Charge-offs |  |  | (1,302 | ) |  |  | (1,564 | )
Sales proceeds |  |  | (1,502 | ) |  |  | (3,618 | )
Gain on disposition |  |  | 234 |  |  |  | 80 |
Depreciation |  |  | (1 | ) |  |  | (3 | )
Balance at the end of period, gross |  | $ | 2,263 |  |  | $ | 4,695 |
Less: valuation allowance |  |  | (456 | ) |  |  | (1,665 | )
Balance at the end of period, net |  | $ | 1,807 |  |  | $ | 3,030 |

Changes in the valuation allowance are as follows (in thousands):

|  | For the nine months ended |  |  | For the year ended |
|  | September 30, 2014 |  |  | September 30, 2013 |  |  | December 31, 2013 |
Balance at beginning of year |  | $ | 1,665 |  |  | $ | 2,174 |  |  | $ | 2,174 |
Provision for losses |  |  | 93 |  |  |  | 660 |  |  |  | 1,055 |
Transfers in |  |  | — |  |  |  | 63 |  |  |  | — |
Charge-offs, net |  |  | (1,302 | ) |  |  | (1,332 | ) |  |  | (1,564 | )
Balance at end of period |  | $ | 456 |  |  | $ | 1,565 |  |  | $ | 1,665 |

Net expenses applicable to OREO, other than the provision for losses, were $79 thousand and $128 thousand for the nine months ended September 30, 2014 and 2013, respectively and $150 thousand for the year ended December 31, 2013.

Note 6. Other Borrowings

The Bank had unused lines of credit totaling $98.0 million and $108.4 million available with non-affiliated banks at September 30, 2014 and December 31, 2013, respectively. This amount primarily consists of a blanket floating lien agreement with the Federal Home Loan Bank of Atlanta (FHLB) under which the Bank can borrow up to 19% of its total assets. The unused line of credit with FHLB totaled $62.6 million at September 30, 2014.

At September 30, 2014 and December 31, 2013, the Bank had borrowings from the FHLB system totaling $6.0 million which mature through December 28, 2018. The interest rate on these notes payable ranged from 1.78% to 2.04% and the weighted average rate was 1.91%. The Bank also had a letter of credit from the FHLB totaling $30.0 million and $25.0 million at September 30, 2014 and December 31, 2013, respectively. The Bank had collateral pledged on the borrowings and the letter of credit at September 30, 2014 and December 31, 2013 including real estate loans totaling $96.2 million and $78.6 million, respectively, and Federal Home Loan Bank stock with a book value of $740 thousand and $908 thousand, respectively.

At September 30, 2014 and December 31, 2013, the Bank had a note payable totaling $33 and $52 thousand, respectively, secured by a deed of trust, which requires monthly payments of $2 thousand and matures January 3, 2016. The fixed interest rate on this loan is 4.00%.

23

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Note 7. Capital Requirements

A comparison of the capital of the Company and the Bank at September 30, 2014 and December 31, 2013 with the minimum regulatory guidelines were as follows (dollars in thousands):

|  | Actual |  |  | Minimum Capital Requirement |  |  | Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions |
|  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |  |  | Amount |  |  | Ratio |
September 30, 2014: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total Capital (to Risk Weighted Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 71,084 |  |  |  | 18.92 | % |  | $ | 30,063 |  |  |  | 8.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 66,445 |  |  |  | 17.71 | % |  | $ | 30,014 |  |  |  | 8.00 | % |  | $ | 37,517 |  |  |  | 10.00 | %
Tier 1 Capital (to Risk Weighted Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 66,325 |  |  |  | 17.65 | % |  | $ | 15,032 |  |  |  | 4.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 61,693 |  |  |  | 16.44 | % |  | $ | 15,007 |  |  |  | 4.00 | % |  | $ | 22,510 |  |  |  | 6.00 | %
Tier 1 Capital (to Average Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 66,325 |  |  |  | 12.74 | % |  | $ | 20,832 |  |  |  | 4.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 61,693 |  |  |  | 11.85 | % |  | $ | 20,817 |  |  |  | 4.00 | % |  | $ | 26,021 |  |  |  | 5.00 | %
December 31, 2013: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Total Capital (to Risk Weighted Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 66,437 |  |  |  | 18.21 | % |  | $ | 29,193 |  |  |  | 8.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 60,578 |  |  |  | 16.62 | % |  | $ | 29,160 |  |  |  | 8.00 | % |  | $ | 36,450 |  |  |  | 10.00 | %
Tier 1 Capital (to Risk Weighted Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 61,800 |  |  |  | 16.94 | % |  | $ | 14,597 |  |  |  | 4.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 55,947 |  |  |  | 15.35 | % |  | $ | 14,580 |  |  |  | 4.00 | % |  | $ | 21,870 |  |  |  | 6.00 | %
Tier 1 Capital (to Average Assets): |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Consolidated |  | $ | 61,800 |  |  |  | 11.75 | % |  | $ | 21,047 |  |  |  | 4.00 | % |  |  | N/A |  |  |  | N/A |
First Bank |  | $ | 55,947 |  |  |  | 10.68 | % |  | $ | 20,948 |  |  |  | 4.00 | % |  | $ | 26,184 |  |  |  | 5.00 | %

Note 8. Trust Preferred Capital Notes

On June 8, 2004, First National (VA) Statutory Trust II (Trust II), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities. On June 17, 2004, $5.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at September 30, 2014 and December 31, 2013 was 2.83% and 2.84%, respectively. The securities have a mandatory redemption date of June 17, 2034, and were subject to varying call provisions that began September 17, 2009. The principal asset of Trust II is $5.2 million of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company. The Company is current on its interest payments on the trust preferred securities.

On July 24, 2006, First National (VA) Statutory Trust III (Trust III), a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable capital securities. On July 31, 2006, $4.0 million of trust preferred securities were issued through a pooled underwriting. The securities have a LIBOR-indexed floating rate of interest. The interest rate at September 30, 2014 and December 31, 2013 was 1.83% and 1.85%, respectively. The securities have a mandatory redemption date of October 1, 2036, and were subject to varying call provisions that began October 1, 2011. The principal asset of Trust III is $4.1 million of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company. The Company is current on its interest payments on the trust preferred securities.

24

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

While these securities are debt obligations of the Company, they are included in capital for regulatory capital ratio calculations. Under present regulations, the trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. At September 30, 2014 and December 31, 2013, the total amount of trust preferred securities issued by the Trusts was included in the Company’s Tier 1 capital.

Note 9. Benefit Plans

The Bank has a noncontributory, defined benefit pension plan for all full-time employees over 21 years of age with at least one year of credited service and hired prior to May 1, 2011. Effective May 1, 2011, the plan was frozen to new participants. Only individuals employed on or before April 30, 2011 are eligible to become participants in the plan upon satisfaction of the eligibility requirements. Benefits are generally based upon years of service and average compensation for the five highest-paid consecutive years of service. The Bank’s funding practice has been to make at least the minimum required annual contribution permitted by the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended.

Components of the net periodic benefit cost of the plan for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands):

|  | For the three months ended September 30, |  |  | For the nine months ended September 30, |
|  | 2014 |  |  | 2013 |  |  | 2014 |  |  | 2013 |
Service cost |  | $ | 86 |  |  | $ | 118 |  |  | $ | 260 |  |  | $ | 352 |
Interest cost |  |  | 67 |  |  |  | 70 |  |  |  | 201 |  |  |  | 210 |
Expected return on plan assets |  |  | (78 | ) |  |  | (76 | ) |  |  | (236 | ) |  |  | (227 | )
Amortization of net loss |  |  | — |  |  |  | 27 |  |  |  | — |  |  |  | 82 |
Net periodic benefit cost |  | $ | 75 |  |  | $ | 139 |  |  | $ | 225 |  |  | $ | 417 |

The Company previously disclosed in its consolidated financial statements in its Annual Report on Form 10-K for the year ended December 31, 2013, that it expected to make no contribution to its pension plan during the year ended December 31, 2014. There was no minimum annual contribution required.

In addition to the defined benefit pension plan, the Company maintains a 401(k) plan and an employee stock ownership plan (ESOP) for eligible employees. See Note 11 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 for additional information about the Company’s benefit plans.

Note 10. Earnings per Common Share

Basic earnings per common share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. There are no potential common shares that would have a dilutive effect. The average number of common shares outstanding used to calculate basic and diluted earnings per common share were 4,902,716 and 4,901,464 for the three months ended September 30, 2014 and 2013, respectively, and 4,901,931 and 4,901,464 for the nine months ended September 30, 2014 and 2013 respectively.

25

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Note 11. Fair Value Measurements

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the “Fair Value Measurement and Disclosures” topic of FASB ASC, the fair value of an instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various 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 fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its assets and liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Level 1 – |  | Valuation is based on quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities generally include debt and equity securities that are traded in an active exchange market. Valuations are obtained from readily available pricing sources for market transactions involving identical assets or liabilities.
Level 2 – |  | Valuation is based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. The valuation may be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
Level 3 – |  | Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which determination of fair value requires a significant management judgment or estimation.

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

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

Securities available for sale

Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2).

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

The following tables present the balances of assets measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013 (in thousands).

|  |  |  |  | Fair Value Measurements at September 30, 2014 |
Description |  | Balance as of September 30, 2014 |  |  | Quoted Prices in Active Markets for Identical Assets (Level 1) |  |  | Significant Other Observable Inputs (Level 2) |  |  | Significant Unobservable Inputs (Level 3) |
Securities available for sale |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
U.S. agency and mortgage-backed securities |  | $ | 83,380 |  |  | $ | — |  |  | $ | 83,380 |  |  | $ | — |
Obligations of states and political subdivisions |  |  | 21,325 |  |  |  | — |  |  |  | 21,325 |  |  |  | — |
Corporate equity securities |  |  | 5 |  |  |  | 5 |  |  |  | — |  |  |  | — |
|  | $ | 104,710 |  |  | $ | 5 |  |  | $ | 104,705 |  |  | $ | — |

|  |  |  |  | Fair Value Measurements at December 31, 2013 |
Description |  | Balance as of December 31, 2013 |  |  | Quoted Prices in Active Markets for Identical Assets (Level 1) |  |  | Significant Other Observable Inputs (Level 2) |  |  | Significant Unobservable Inputs (Level 3) |
Securities available for sale |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
U.S. agency and mortgage-backed securities |  | $ | 84,897 |  |  | $ | — |  |  | $ | 84,897 |  |  | $ | — |
Obligations of states and political subdivisions |  |  | 18,399 |  |  |  | — |  |  |  | 18,399 |  |  |  | — |
Corporate equity securities |  |  | 5 |  |  |  | 5 |  |  |  | — |  |  |  | — |
|  | $ | 103,301 |  |  | $ | 5 |  |  | $ | 103,296 |  |  | $ | — |

Certain 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.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

The following describes the valuation techniques used by the Company to measure certain 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 agreements will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price of the loan, or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2) within the last twelve months. However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (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

Loans are transferred to other real estate owned when the collateral securing them is foreclosed on or acquired through a deed in lieu of foreclosure. The measurement of loss associated with other real estate owned is based on the appraisal documents and assessed the same way as impaired loans described above.

The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis during the periods (dollars in thousands):

|  |  |  |  | Fair Value Measurements at September 30, 2014 |
Description |  | Balance as of September 30, 2014 |  |  | Quoted Prices in Active Markets for Identical Assets (Level 1) |  |  | Significant Other Observable Inputs (Level 2) |  |  | Significant Unobservable Inputs (Level 3) |
Impaired loans, net |  | $ | 2,812 |  |  | $ | — |  |  | $ | — |  |  | $ | 2,812 |
Other real estate owned, net |  |  | 1,807 |  |  |  | — |  |  |  | — |  |  |  | 1,807 |

|  |  |  |  | Fair Value Measurements at December 31, 2013 |
Description |  | Balance as of December 31, 2013 |  |  | Quoted Prices in Active Markets for Identical Assets (Level 1) |  |  | Significant Other Observable Inputs (Level 2) |  |  | Significant Unobservable Inputs (Level 3) |
Impaired loans, net |  | $ | 3,972 |  |  | $ | — |  |  | $ | — |  |  | $ | 3,972 |
Other real estate owned, net |  |  | 3,030 |  |  |  | — |  |  |  | — |  |  |  | 3,030 |

28

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

|  | Quantitative information about Level 3 Fair Value Measurements for September 30, 2014 |
|  | Fair Value |  |  | Valuation Technique |  | Unobservable Input |  | Range (Weighted- Average) |
Impaired loans, net |  | $ | 2,812 |  |  | Property appraisals |  | Selling cost |  |  | 10 | %
Other real estate owned, net |  | $ | 1,807 |  |  | Property appraisals |  | Selling cost |  |  | 7 | %

Accounting guidance requires disclosure of the fair value of financial assets and financial liabilities, including those financial assets and financial liabilities that are not measured and reported at fair value on a recurring basis or non-recurring basis. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed above. The methodologies for other financial assets and financial liabilities are discussed below:

Cash and Cash Equivalents and Federal Funds Sold

The carrying amounts of cash and short-term instruments approximate fair values.

Restricted Securities

The carrying value of restricted securities approximates fair value based on redemption.

Loans

For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for all other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for non-performing loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Deposit Liabilities

The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Accrued Interest

The carrying amounts of accrued interest approximate fair value.

Borrowings and Federal Funds Purchased

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

29

##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Bank Owned Life Insurance

The carrying amounts of bank owned life insurance approximate fair value.

Commitments and Unfunded Credits

The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The fair value of stand-by letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At September 30, 2014 and December 31, 2013, fair value of loan commitments and standby letters of credit was immaterial.

The carrying values and estimated fair values of the Company’s financial instruments at September 30, 2014 and December 31, 2013 are as follows (in thousands):

|  | Fair Value Measurements at September 30, 2014 Using |
|  | Carrying Amount |  |  | Quoted Prices in Active Markets for Identical Assets Level 1 |  |  | Significant Other Observable Inputs Level 2 |  |  | Significant Unobservable Inputs Level 3 |  |  | Fair Value |
Financial Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Cash and short-term investments |  | $ | 10,747 |  |  | $ | 10,747 |  |  | $ | — |  |  | $ | — |  |  | $ | 10,747 |
Securities |  |  | 104,710 |  |  |  | 5 |  |  |  | 104,705 |  |  |  | — |  |  |  | 104,710 |
Restricted securities |  |  | 1,636 |  |  |  | — |  |  |  | 1,636 |  |  |  | — |  |  |  | 1,636 |
Loans held for sale |  |  | 181 |  |  |  | — |  |  |  | 181 |  |  |  | — |  |  |  | 181 |
Loans, net |  |  | 364,974 |  |  |  | — |  |  |  | — |  |  |  | 371,773 |  |  |  | 371,773 |
Bank owned life insurance |  |  | 11,244 |  |  |  | — |  |  |  | 11,244 |  |  |  | — |  |  |  | 11,244 |
Accrued interest receivable |  |  | 1,327 |  |  |  | — |  |  |  | 1,327 |  |  |  | — |  |  |  | 1,327 |
Financial Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Deposits |  | $ | 438,919 |  |  | $ | — |  |  | $ | 327,674 |  |  | $ | 111,148 |  |  | $ | 438,822 |
Federal funds purchased |  |  | 5,325 |  |  |  | — |  |  |  | 5,325 |  |  |  | — |  |  |  | 5,325 |
Other borrowings |  |  | 6,033 |  |  |  | — |  |  |  | — |  |  |  | 6,093 |  |  |  | 6,093 |
Trust preferred capital notes |  |  | 9,279 |  |  |  | — |  |  |  | — |  |  |  | 10,028 |  |  |  | 10,028 |
Accrued interest payable |  |  | 143 |  |  |  | — |  |  |  | 143 |  |  |  | — |  |  |  | 143 |

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

|  | Fair Value Measurements at December 31, 2013 Using |
|  | Carrying Amount |  |  | Quoted Prices in Active Markets for Identical Assets Level 1 |  |  | Significant Other Observable Inputs Level 2 |  |  | Significant Unobservable Inputs Level 3 |  |  | Fair Value |
Financial Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Cash and short-term investments |  | $ | 31,508 |  |  | $ | 31,508 |  |  | $ | — |  |  | $ | — |  |  | $ | 31,508 |
Securities |  |  | 103,301 |  |  |  | 5 |  |  |  | 103,296 |  |  |  | — |  |  |  | 103,301 |
Restricted securities |  |  | 1,804 |  |  |  | — |  |  |  | 1,804 |  |  |  | — |  |  |  | 1,804 |
Loans, net |  |  | 346,449 |  |  |  | — |  |  |  | — |  |  |  | 353,874 |  |  |  | 353,874 |
Bank owned life insurance |  |  | 10,978 |  |  |  | — |  |  |  | 10,978 |  |  |  | — |  |  |  | 10,978 |
Accrued interest receivable |  |  | 1,302 |  |  |  | — |  |  |  | 1,302 |  |  |  | — |  |  |  | 1,302 |
Financial Liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Deposits |  | $ | 450,711 |  |  | $ | — |  |  | $ | 326,955 |  |  | $ | 124,422 |  |  | $ | 451,377 |
Other borrowings |  |  | 6,052 |  |  |  | — |  |  |  | — |  |  |  | 6,095 |  |  |  | 6,095 |
Trust preferred capital notes |  |  | 9,279 |  |  |  | — |  |  |  | — |  |  |  | 9,399 |  |  |  | 9,399 |
Accrued interest payable |  |  | 177 |  |  |  | — |  |  |  | 177 |  |  |  | — |  |  |  | 177 |

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values 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 to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates 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 terms of new loans and deposits and by investing in securities with terms that mitigate the Company’s overall interest rate risk.

Note 12. Preferred Stock

The Company has (i) 13,900 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, with a par value of $1.25 per share and liquidation preference of $1,000 per share (the Preferred Stock) and (ii) 695 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series B, with a par value of $1.25 per share and liquidation preference of $1,000 per share (the Warrant Preferred Stock). The Preferred Stock paid cumulative dividends at a rate of 5% per annum until May 14, 2014, and thereafter at a rate of 9% per annum. The Warrant Preferred Stock pays cumulative dividends at a rate of 9% per annum from the date of issuance. The discount on the Preferred Stock was amortized over a five year period using the constant effective yield method.

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##### Table of Contents

Notes to Consolidated Financial Statements

(unaudited)

Note 13. Accumulated Other Comprehensive Loss

Changes in each component of accumulated other comprehensive loss were as follows (in thousands):

|  | Net Unrealized Gains (Losses) on Securities |  |  | Adjustments Related to Pension Benefits |  |  | Accumulated Other Comprehensive Loss |
Balance at December 31, 2012 |  | $ | 1,770 |  |  | $ | (2,629 | ) |  | $ | (859 | )
Unrealized holding losses (net of tax, $0) |  |  | (3,194 | ) |  |  | — |  |  |  | (3,194 | )
Change during period |  |  | (3,194 | ) |  |  | — |  |  |  | (3,194 | )
Balance at September 30, 2013 |  | $ | (1,424 | ) |  | $ | (2,629 | ) |  | $ | (4,053 | )
Balance at December 31, 2013 |  | $ | (1,129 | ) |  | $ | (175 | ) |  | $ | (1,304 | )
Unrealized holding gains (net of tax, $522) |  |  | 1,016 |  |  |  | — |  |  |  | 1,016 |
Reclassification adjustment (net of tax, ($24)) |  |  | 45 |  |  |  | — |  |  |  | 45 |
Change during period |  |  | 1,061 |  |  |  | — |  |  |  | 1,061 |
Balance at September 30, 2014 |  | $ | (68 | ) |  | $ | (175 | ) |  | $ | (243 | )

The following tables present information related to reclassifications from accumulated other comprehensive loss for the three and nine month periods ended September 30, 2014 and 2013 (in thousands):

Details About Accumulated Other Comprehensive Loss |  | Amount Reclassified from Accumulated Other Comprehensive Loss |  |  | Affected Line Item in the Consolidated Statements of Income
|  | For the three months ended September 30, |  |  |
|  | 2014 |  |  | 2013 |  |  |
Securities available for sale: |  |  |  |  |  |  |  |  |  |
Net securities losses reclassified into earnings |  | $ | 91 |  |  | $ | — |  |  | Net (losses) on sale of securities available for sale
Related income tax benefit |  |  | (31 | ) |  |  | — |  |  | Income tax expense
Total reclassifications |  | $ | 60 |  |  | $ | — |  |  | Net of tax

Details About Accumulated Other Comprehensive Loss |  | Amount Reclassified from Accumulated Other Comprehensive Loss |  |  | Affected Line Item in the Consolidated Statements of Income
|  | For the nine months ended September 30, |  |  |
|  | 2014 |  |  | 2013 |  |  |
Securities available for sale: |  |  |  |  |  |  |  |  |  |
Net securities losses reclassified into earnings |  | $ | 69 |  |  | $ | — |  |  | Net (losses) on sale of securities available for sale
Related income tax benefit |  |  | (24 | ) |  |  | — |  |  | Income tax expense
Total reclassifications |  | $ | 45 |  |  | $ | — |  |  | Net of tax

Note 14. Subsequent Event

On November 12, 2014, the Board of Directors of the Company declared a quarterly dividend of $0.025 per common share, which is payable on December 19, 2014 to shareholders of record as of December 5, 2014.

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##### Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Statement Regarding Forward-Looking Statements

The Company makes forward-looking statements in this Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include statements regarding profitability, liquidity, adequacy of capital, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

| • |  | adverse economic conditions in the market area and the impact on credit quality and risks inherent in the loan portfolio such as repayment risk and fluctuating collateral values;

| • |  | additional future losses if our levels of non-performing assets do not moderate and if the proceeds we receive upon liquidation of assets are less than the carrying value of such assets;

| • |  | further increases of non-performing assets may reduce interest income and increase net charge-offs, provision for loan losses, and operating expenses;

| • |  | the adequacy of the allowance for loan losses related to specific reserves on impaired loans, and changes in factors considered such as general economic and business conditions in the market area and overall asset quality;

| • |  | the adequacy of the valuation allowance for other real estate owned related to changes in economic conditions and local real estate activity;

| • |  | loss or retirement of key executives;

| • |  | the ability to compete effectively in the highly competitive banking industry;

| • |  | legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses that the Company is engaged in;

| • |  | the ability to implement various technologies into operations may impact the Company’s ability to operate profitably;

| • |  | the ability of the Company to implement its disaster recovery plan in the event of a natural or other disaster;

| • |  | losses that could arise from breaches in cyber-security;

| • |  | the ability to raise capital as needed;

| • |  | increases in FDIC insurance premiums could adversely affect the Company’s profitability;

| • |  | the ability to retain customers and secondary funding sources if the Bank’s reputation would become damaged;

| • |  | the reliance on secondary sources, such as Federal Home Loan Bank advances, sales of securities and loans, federal funds lines of credit from correspondent banks and out-of-market time deposits, to meet liquidity needs;

| • |  | changes in interest rates could have a negative impact on the Company’s net interest income and an unfavorable impact on the Bank’s customers’ ability to repay loans; and

| • |  | other factors identified in Item 1A. Risk Factors of the Company’s Form 10-K for the year ending December 31, 2013.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results. The following discussion and analysis of the financial condition at September 30, 2014 and results of operations of the Company for the three and nine month periods ended September 30, 2014 and 2013 should be read in conjunction with the consolidated financial statements and related notes included in Part I, Item 1, of this Form 10-Q and in Part II, Item 8, of the Form 10-K for the period ending December 31, 2013. The results of operations for the three and nine month periods ended September 30, 2014 may not be indicative of the results to be achieved for the year.

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##### Table of Contents

Executive Overview

The Company

First National Corporation (the Company) is the bank holding company of:

| • |  | First Bank (the Bank). The Bank owns:

| • |  | First Bank Financial Services, Inc.

| • |  | Shen-Valley Land Holdings, LLC

| • |  | First National (VA) Statutory Trust II (Trust II)

| • |  | First National (VA) Statutory Trust III (Trust III)

First Bank Financial Services, Inc. invests in entities that provide title insurance and investment services. Shen-Valley Land Holdings, LLC was formed to hold other real estate owned and future office sites. The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities.

Products, Services, Customers and Locations

The Bank’s primary market area is located within an hour commute of the Washington, D.C. Metropolitan Area. The Bank’s office locations are well-positioned in strong markets along the Interstate 81 and Interstate 66 corridors in the Shenandoah Valley region of Virginia. Within the market area, there are various types of industry including medical and professional services, manufacturing, retail, government contracting and higher education. Customers include individuals, small and medium-sized businesses, local governmental entities and non-profit organizations.

The Bank provides loan, deposit, wealth management and other products and services in the Shenandoah Valley region of Virginia. Loan products and services include personal loans, residential mortgages, home equity loans and commercial loans. Deposit products and services include checking, savings, NOW accounts, money market accounts, IRA accounts, certificates of deposit and cash management accounts. The Bank offers other services, including internet banking, mobile banking, remote deposit capture and other traditional banking services.

The Bank’s wealth management division offers estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, estate settlement, 401(k) and benefit plans. In addition, the division offers financial planning and brokerage services to individuals throughout the Bank’s market area.

The Bank launched a new mortgage division named “First Mortgage” during the second quarter of 2014. The mortgage division began originating residential mortgage loans to customers in the third quarter of 2014. The majority of loans originated in future periods are expected to be sold to investors in the secondary market. First Mortgage offers mortgage services to customers throughout the Shenandoah Valley of Virginia.

The Bank’s products and services are provided through 10 branch offices, 1 customer service center, 2 loan production offices, 25 ATMs and its website, www.fbvirginia.com. The loan production offices opened during 2014 in Staunton and Harrisonburg, Virginia. The Bank operates six of its offices under the “Financial Center” concept. A Financial Center offers all of the Bank’s financial services at one location. This concept allows loan, deposit, and wealth management personnel to be readily available to serve customers throughout the Bank’s market area. The location and general character of these properties is further described in Part I, Item 2 of Form 10-K for the year ended December 31, 2013.

Revenue Sources and Expense Factors

The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% to 75% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services and ATM and check card fees.

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##### Table of Contents

The provision for loan losses and noninterest expense are generally the two major expense categories. The provision is determined by factors that include net charge-offs, asset quality, economic conditions and loan growth. Changing economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs and ultimately the required provision for or recovery of loan losses. The largest component of noninterest expense for the nine month period ended September 30, 2014 was salaries and employee benefits, comprising 56% of noninterest expenses, followed by occupancy and equipment expense, comprising 13% of noninterest expenses.

Quarterly Performance

For the three months ended September 30, 2014, net income totaled $1.2 million, which was unchanged compared to the same period in 2013. After the effective dividend on preferred stock, net income available to common shareholders was $918 thousand, or $0.19 per basic and diluted share, compared to $1.0 million, or $0.21 per basic and diluted share, for the same period in 2013. Return on average assets and return on average equity were 0.95% and 8.64%, respectively, for the third quarter of 2014 compared to 0.92% and 11.44% for the same quarter in 2013.

Net interest income increased by $122 thousand to $4.8 million, compared to the third quarter in 2013. The net interest margin was 3.92% for the third quarter of 2014 compared to 3.68% for the same period in 2013. The Bank recorded a recovery of loan losses of $100 thousand during the third quarter, compared to a provision for loan losses of $275 thousand for the same quarter in 2013. Noninterest income increased $29 thousand, or 2%, to $1.7 million compared to $1.6 million for the same period one year ago. Noninterest expense increased $105 thousand, or 2%, to $4.8 million for the quarter compared to $4.6 million for the same period in 2013.

Year-to-Date Performance

Net income totaled $3.9 million for the nine months ended September 30, 2014 compared to $2.5 million for the same period in 2013. After the effective dividend on preferred stock, net income available to common shareholders was $3.1 million, or $0.64 per basic and diluted share, compared to $1.8 million, or $0.37 per basic and diluted share, for the same period in 2013. Return on average assets and return on average equity were 1.00% and 9.41%, respectively, for the nine months ended September 30, 2014 compared to 0.62% and 7.48% for the same period in 2013.

For the nine months ended September 30, 2014, net interest income decreased 1%, or $83 thousand, compared to the same period of 2013. The net interest margin was 3.82% for the nine months ended September 30, 2014 compared to 3.73% for the same period in 2013. The Bank recorded a recovery of loan losses of $700 thousand, compared to a provision for loan losses of $2.5 million for the same period one year ago. Noninterest income decreased $165 thousand, or 3%, to $5.0 million compared to $5.2 million when comparing the two periods primarily because the Company recorded a $543 thousand one-time gain on termination of a post-retirement obligation for directors during the same period of 2013. Noninterest income, excluding the one-time gain on termination of a post-retirement obligation for directors, increased 8%, or $378 thousand, compared to the same period one year ago. Noninterest expense decreased $604 thousand, or 4%, to $13.9 million compared to $14.5 million for the same period in 2013.

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Non-GAAP Financial Measures

This report refers to the efficiency ratio, which is computed by dividing noninterest expense, excluding OREO income/(expense), securities losses, loss on disposal of premises and equipment, and loss on land lease termination, by the sum of net interest income on a tax-equivalent basis and noninterest income, excluding the gain on termination of postretirement benefit obligation. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with U.S. generally accepted accounting principles (GAAP) and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands).

|  | Efficiency Ratio |
|  | For the three months ended |  |  | For the nine months ended |
|  | September 30, 2014 |  |  | September 30, 2013 |  |  | September 30, 2014 |  |  | September 30, 2013 |
Noninterest expense |  | $ | 4,753 |  |  | $ | 4,648 |  |  | $ | 13,914 |  |  | $ | 14,518 |
Add/(Subtract): other real estate owned income / (expense), net |  |  | 23 |  |  |  | (252 | ) |  |  | 62 |  |  |  | (735 | )
Subtract: losses on premises and equipment, net |  |  | — |  |  |  | — |  |  |  | (2 | ) |  |  | (3 | )
Subtract: loss on land lease termination |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (206 | )
|  | $ | 4,776 |  |  | $ | 4,396 |  |  | $ | 13,974 |  |  | $ | 13,574 |
Tax-equivalent net interest income |  | $ | 4,822 |  |  | $ | 4,691 |  |  | $ | 14,041 |  |  | $ | 14,076 |
Noninterest income |  |  | 1,654 |  |  |  | 1,625 |  |  |  | 4,995 |  |  |  | 5,160 |
Add: securities losses, net |  |  | 91 |  |  |  | — |  |  |  | 69 |  |  |  | — |
Subtract: gain on termination of postretirement benefit obligation |  |  | — |  |  |  | — |  |  |  | — |  |  |  | (543 | )
|  | $ | 6,567 |  |  | $ | 6,316 |  |  | $ | 19,105 |  |  | $ | 18,693 |
Efficiency ratio |  |  | 72.74 | % |  |  | 69.60 | % |  |  | 73.15 | % |  |  | 72.62 | %

This report also refers to net interest margin, which is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit for each of 2014 and 2013 is 34%. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands).

|  | Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income |
|  | For the three months ended |  |  | For the nine months ended |
|  | September 30, 2014 |  |  | September 30, 2013 |  |  | September 30, 2014 |  |  | September 30, 2013 |
GAAP measures: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest income - loans |  | $ | 4,536 |  |  | $ | 4,673 |  |  | $ | 13,154 |  |  | $ | 14,422 |
Interest income - investments and other |  |  | 645 |  |  |  | 613 |  |  |  | 2,031 |  |  |  | 1,642 |
Interest expense - deposits |  |  | (343 | ) |  |  | (572 | ) |  |  | (1,115 | ) |  |  | (1,910 | )
Interest expense - other borrowings |  |  | (30 | ) |  |  | (30 | ) |  |  | (89 | ) |  |  | (89 | )
Interest expense - trust preferred capital notes |  |  | (55 | ) |  |  | (55 | ) |  |  | (163 | ) |  |  | (166 | )
Interest expense - other |  |  | (2 | ) |  |  | — |  |  |  | (2 | ) |  |  | — |
Total net interest income |  | $ | 4,751 |  |  | $ | 4,629 |  |  | $ | 13,816 |  |  | $ | 13,899 |
Non-GAAP measures: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Tax benefit realized on non-taxable interest income - loans |  | $ | 27 |  |  | $ | 23 |  |  | $ | 83 |  |  | $ | 60 |
Tax benefit realized on non-taxable interest income - municipal securities |  |  | 44 |  |  |  | 39 |  |  |  | 142 |  |  |  | 117 |
Total tax benefit realized on non-taxable interest income |  | $ | 71 |  |  | $ | 62 |  |  | $ | 225 |  |  | $ | 177 |
Total tax-equivalent net interest income |  | $ | 4,822 |  |  | $ | 4,691 |  |  | $ | 14,041 |  |  | $ | 14,076 |

Critical Accounting Policies

General

The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the

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financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Bank uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.

Presented below is a discussion of those accounting policies that management believes are the most important (“Critical Accounting Policies”) to the portrayal and understanding of the Company’s financial condition and results of operations. The Critical Accounting Policies require management’s most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management determines that the loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance. For further information about the Company’s loans and the allowance for loan losses, see Notes 3 and 4 in this Form 10-Q.

The allowance for loan losses is evaluated on a quarterly basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The Bank performs regular credit reviews of the loan portfolio to review credit quality and adherence to underwriting standards. The credit reviews consist of reviews by its internal credit administration department and reviews performed by an independent third party. Upon origination, each loan is assigned a risk rating ranging from one to nine, with loans closer to one having less risk. This risk rating scale is our primary credit quality indicator. The Bank has various committees that review and ensure that the allowance for loans losses methodology is in accordance with GAAP and loss factors used appropriately reflect the risk characteristics of the loan portfolio.

The allowance represents an amount that, in management’s judgment, will be adequate to absorb any losses on existing loans that may become uncollectible. Management’s judgment in determining the level of the allowance is based on evaluations of the collectability of loans while taking into consideration such factors as trends in delinquencies and charge-offs, changes in the nature and volume of the loan portfolio, current economic conditions that may affect a borrower’s ability to repay and the value of the collateral, overall portfolio quality and review of specific potential losses. The evaluation also considers the following risk characteristics of each loan portfolio class:

| • |  | 1-4 family residential mortgage loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.

| • |  | Real estate construction and land development loans carry risks that the project may not be finished according to schedule, the project may not be finished according to budget and the value of the collateral may, at any point in time, be less than the principal amount of the loan. Construction loans also bear the risk that the general contractor, who may or may not be a loan customer, may be unable to finish the construction project as planned because of financial pressure or other factors unrelated to the project.

| • |  | Other real estate loans and commercial and industrial loans carry risks associated with the successful operation of a business or a real estate project, in addition to other risks associated with the ownership of real estate, because repayment of these loans may be dependent upon the profitability and cash flows of the business or project. In addition, there is risk associated with the value of collateral other than real estate which may depreciate over time and cannot be appraised with as much reliability.

| • |  | Consumer and other loans carry risk associated with the continued credit-worthiness of the borrower and the value of the collateral, i.e. rapidly depreciating assets such as automobiles, or lack thereof. Consumer loans are likely to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy, or other changes in circumstances.

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, collateral value or observable market price of the

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impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.

The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses see Note 4 to the Consolidated Financial Statements.

Other Real Estate Owned (OREO)

Other real estate owned (OREO) consists of properties obtained through a foreclosure proceeding or through an in-substance foreclosure in satisfaction of loans and properties originally acquired for branch expansion but no longer intended to be used for that purpose. OREO is reported at the lower of cost or fair value less costs to sell, determined on the basis of current appraisals, comparable sales, and other estimates of fair value obtained principally from independent sources, adjusted for estimated selling costs. Management also considers other factors or recent developments, such as changes in absorption rates or market conditions from the time of valuation and anticipated sales values considering management’s plans for disposition, which could result in adjustments to the collateral value estimates indicated in the appraisals. Significant judgments and complex estimates are required in estimating the fair value of other real estate, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. In response to market conditions and other economic factors, management may utilize liquidation sales as part of its distressed asset disposition strategy. As a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other real estate. Management reviews the value of other real estate each quarter and adjusts the values as appropriate. Revenue and expenses from operations and changes in the valuation allowance are included in other real estate owned expenses.

Lending Policies

General

In an effort to manage risk, the Bank’s loan policy gives loan amount approval limits to individual loan officers based on their position within the Bank and level of experience. The Management Loan Committee can approve new loans up to their authority. The Board Loan Committee approves all loans which exceed the authority of the Management Loan Committee. The full Board of Directors must approve loans which exceed the authority of the Board Loan Committee, up to the Bank’s legal lending limit. The Board Loan Committee currently consists of five directors, four of which are non-management directors. The Board Loan Committee approves the Bank’s Loan Policy and reviews the loan watch list, concentrations of credit and other risk management reports. The Board Loan Committee meets on a monthly basis and the Chairman of the Committee then reports to the Board of Directors.

Residential loan originations are primarily generated by Bank loan officer solicitations, referrals by real estate professionals and customers. Commercial real estate loan originations are obtained through direct solicitation and additional business from existing customers. All completed loan applications are reviewed by the Bank’s loan officers. As part of the application process, information is obtained concerning the income, financial condition, employment and credit history of the applicant. Loan quality is analyzed based on the Bank’s experience and credit underwriting guidelines depending on the type of loan involved. Real estate collateral is valued by independent appraisers who have been pre-approved by the Board Loan Committee.

As part of the ongoing monitoring of the credit quality of the Company’s loan portfolio, certain appraisals are analyzed by management or by an outsourced appraisal review specialist throughout the year in order to ensure standards of quality are met. The Company also obtains an independent review of loans within the portfolio on an annual basis to analyze loan risk ratings and validate specific reserves on impaired loans.

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In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At September 30, 2014, commitments to extend credit, stand-by letters of credit and rate lock commitments totaled $65.3 million.

Construction and Land Development Lending

The Bank makes local construction loans, including residential and land acquisition and development loans. These loans are secured by the property under construction and the underlying land for which the loan was obtained. The majority of these loans have an average life of approximately one year and re-price monthly as key rates change. Construction lending entails significant additional risks, compared with residential mortgage lending. Construction loans sometimes involve larger loan balances concentrated with single borrowers or groups of related borrowers. Another risk involved in construction lending is the fact that loan funds are advanced upon the security of the land or property under construction, which value is estimated based on the completion of construction. Thus, there is risk associated with failure to complete construction and potential cost overruns. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the appraised value, in addition to analyzing the creditworthiness of its borrowers. The Bank typically obtains a first lien on the property as security for its construction loans, typically requires personal guarantees from the borrower’s principal owners, and typically monitors the progress of the construction project during the draw period.

1-4 Family Residential Real Estate Lending

1-4 family residential lending activity may be generated by Bank loan officer solicitations, referrals by real estate professionals and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. Residential mortgage loans generally are made on the basis of the borrower’s ability to make payments from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In addition to the Bank’s underwriting standards, loan quality may be analyzed based on guidelines issued by a secondary market investor. The valuation of residential collateral is generally provided by independent fee appraisers who have been approved by the Board Loan Committee. In addition to originating fixed rate mortgage loans with the intent to sell to correspondent lenders or broker to wholesale lenders, the Bank originates balloon and other mortgage loans for the portfolio. Depending on the financial goals of the Company, the Bank occasionally originates and retains these loans.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, hotels, small shopping centers, farms and churches. Commercial real estate loan originations are obtained through direct solicitation of customers and potential customers. The valuation of commercial real estate collateral is provided by independent appraisers who have been approved by the Board Loan Committee. Commercial real estate lending entails significant additional risk, compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation. The Bank typically requires personal guarantees of the borrowers’ principal owners and considers the valuation of the real estate collateral.

Commercial and Industrial Lending

Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much reliability as residential real estate. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers.

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Consumer Lending

The Bank offers various secured and unsecured consumer loans, including unsecured personal loans and lines of credit, automobile loans, deposit account loans and installment and demand loans. Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured, such as lines of credit, or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on a proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and additionally from any verifiable secondary income. Although creditworthiness of the applicant is of primary consideration, the underwriting process also includes an analysis of the value of the collateral in relation to the proposed loan amount.

Results of Operations

General

Net interest income represents the primary source of earnings for the Company. Net interest income equals the amount by which interest income on interest-earning assets, predominantly loans and securities, exceeds interest expense on interest-bearing liabilities, including deposits, other borrowings and trust preferred securities. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, are the components that impact the level of net interest income. The net interest margin is calculated by dividing tax-equivalent net interest income by average earning assets. The provision for loan losses, noninterest income, noninterest expense and income tax expense are the other components that determine net income. Noninterest income and expense primarily consists of income from service charges on deposit accounts; revenue from wealth management services; ATM and check card income; revenue from other customer services; income from bank owned life insurance; general and administrative expenses and other real estate owned expenses.

Net Interest Income

Net interest income totaled $4.8 million for the third quarter of 2014, which was a $122 thousand increase when compared to the same period a year ago. The net interest margin increased to 3.92% from 3.68% and average earning assets were $18.3 million lower when comparing the periods. Interest-earning asset yields increased 8 basis points while the cost of funds decreased 16 basis points, which resulted in a higher net interest margin for the third quarter of 2014 compared to the same quarter in 2013. Interest-earning asset yields increased from higher yields earned on securities along with higher balances of securities when comparing to the same period in 2013. The cost of funds decreased primarily from lower yields on time deposits and lower balances of time deposits when comparing the periods.

For the nine months ended September 30, 2014, net interest income totaled $13.8 million, which was a 1% decrease when compared to the same period a year ago. The net interest margin increased to 3.82% from 3.73% and average earning assets were $13.4 million lower when comparing the periods. Interest-earning asset yields decreased 11 basis points while the cost of funds decreased 21 basis points. Interest-earning asset yields decreased from lower yields earned on loans, as well as higher balances of securities and lower balances of loans, when comparing to the same period in 2013. Although interest-earning asset yields fell during the period, decreases in the cost of funds exceeded the decrease in the yields on interest-earning assets, which resulted in a higher net interest margin for the 2014 period compared to the 2013 period.

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The following tables show interest income on earning assets and related average yields as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated (dollars in thousands):

Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis) |
|  | For the three months ended |
|  | September 30, 2014 |  |  | September 30, 2013 |
|  | Average Balance |  |  | Interest Income/ Expense |  |  | Yield/ Rate |  |  | Average Balance |  |  | Interest Income/ Expense |  |  | Yield/ Rate |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  | $ | 95,373 |  |  | $ | 536 |  |  |  | 2.23 | % |  | $ | 95,075 |  |  | $ | 498 |  |  |  | 2.08 | %
Tax-exempt (1) |  |  | 11,945 |  |  |  | 131 |  |  |  | 4.32 | % |  |  | 8,401 |  |  |  | 119 |  |  |  | 5.60 | %
Restricted |  |  | 1,636 |  |  |  | 20 |  |  |  | 4.75 | % |  |  | 1,804 |  |  |  | 18 |  |  |  | 4.05 | %
Total securities |  | $ | 108,954 |  |  | $ | 687 |  |  |  | 2.50 | % |  | $ | 105,280 |  |  | $ | 635 |  |  |  | 2.39 | %
Loans: (2) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  | $ | 364,769 |  |  | $ | 4,485 |  |  |  | 4.88 | % |  | $ | 369,677 |  |  | $ | 4,630 |  |  |  | 4.97 | %
Tax-exempt (1) |  |  | 6,960 |  |  |  | 76 |  |  |  | 4.35 | % |  |  | 5,802 |  |  |  | 66 |  |  |  | 4.55 | %
Total loans |  | $ | 371,729 |  |  | $ | 4,561 |  |  |  | 4.87 | % |  | $ | 375,479 |  |  | $ | 4,696 |  |  |  | 4.96 | %
Federal funds sold |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 4 |  |  |  | — |  |  |  | — |
Interest-bearing deposits with other institutions |  |  | 6,858 |  |  |  | 4 |  |  |  | 0.21 | % |  |  | 25,124 |  |  |  | 17 |  |  |  | 0.27 | %
Total earning assets |  | $ | 487,541 |  |  | $ | 5,252 |  |  |  | 4.27 | % |  | $ | 505,887 |  |  | $ | 5,348 |  |  |  | 4.19 | %
Less: allowance for loan losses |  |  | (10,001 | ) |  |  |  |  |  |  |  |  |  |  | (13,050 | ) |  |  |  |  |  |  |  |
Total non-earning assets |  |  | 44,082 |  |  |  |  |  |  |  |  |  |  |  | 43,048 |  |  |  |  |  |  |  |  |
Total assets |  | $ | 521,622 |  |  |  |  |  |  |  |  |  |  | $ | 535,885 |  |  |  |  |  |  |  |  |
Liabilities and Shareholders’ Equity |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest bearing deposits: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Checking |  | $ | 108,908 |  |  | $ | 41 |  |  |  | 0.15 | % |  | $ | 114,969 |  |  | $ | 70 |  |  |  | 0.24 | %
Regular savings |  |  | 101,533 |  |  |  | 22 |  |  |  | 0.09 | % |  |  | 98,967 |  |  |  | 35 |  |  |  | 0.14 | %
Money market accounts |  |  | 18,760 |  |  |  | 5 |  |  |  | 0.10 | % |  |  | 17,720 |  |  |  | 5 |  |  |  | 0.12 | %
Time deposits: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
$100,000 and over |  |  | 47,304 |  |  |  | 142 |  |  |  | 1.19 | % |  |  | 62,258 |  |  |  | 228 |  |  |  | 1.45 | %
Under $100,000 |  |  | 61,057 |  |  |  | 126 |  |  |  | 0.81 | % |  |  | 76,232 |  |  |  | 219 |  |  |  | 1.14 | %
Brokered |  |  | 4,977 |  |  |  | 7 |  |  |  | 0.55 | % |  |  | 10,441 |  |  |  | 15 |  |  |  | 0.58 | %
Total interest-bearing deposits |  | $ | 342,539 |  |  | $ | 343 |  |  |  | 0.40 | % |  | $ | 380,587 |  |  | $ | 572 |  |  |  | 0.60 | %
Federal funds purchased |  |  | 1,059 |  |  |  | 2 |  |  |  | 0.90 | % |  |  | 1 |  |  |  | — |  |  |  | — |
Trust preferred capital notes |  |  | 9,279 |  |  |  | 55 |  |  |  | 2.35 | % |  |  | 9,279 |  |  |  | 55 |  |  |  | 2.39 | %
Other borrowings |  |  | 6,036 |  |  |  | 30 |  |  |  | 1.95 | % |  |  | 6,061 |  |  |  | 30 |  |  |  | 1.96 | %
Total interest-bearing liabilities |  | $ | 358,913 |  |  | $ | 430 |  |  |  | 0.47 | % |  | $ | 395,928 |  |  | $ | 657 |  |  |  | 0.66 | %
Non-interest bearing liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Demand deposits |  |  | 103,352 |  |  |  |  |  |  |  |  |  |  |  | 92,071 |  |  |  |  |  |  |  |  |
Other liabilities |  |  | 2,140 |  |  |  |  |  |  |  |  |  |  |  | 4,885 |  |  |  |  |  |  |  |  |
Total liabilities |  | $ | 464,405 |  |  |  |  |  |  |  |  |  |  | $ | 492,884 |  |  |  |  |  |  |  |  |
Shareholders’ equity |  |  | 57,217 |  |  |  |  |  |  |  |  |  |  |  | 43,001 |  |  |  |  |  |  |  |  |
Total liabilities and Shareholders’ equity |  | $ | 521,622 |  |  |  |  |  |  |  |  |  |  | $ | 535,885 |  |  |  |  |  |  |  |  |
Net interest income |  |  |  |  |  | $ | 4,822 |  |  |  |  |  |  |  |  |  |  | $ | 4,691 |  |  |  |  |
Interest rate spread |  |  |  |  |  |  |  |  |  |  | 3.80 | % |  |  |  |  |  |  |  |  |  |  | 3.53 | %
Cost of funds |  |  |  |  |  |  |  |  |  |  | 0.37 | % |  |  |  |  |  |  |  |  |  |  | 0.53 | %
Interest expense as a percent of average earning assets |  |  |  |  |  |  |  |  |  |  | 0.35 | % |  |  |  |  |  |  |  |  |  |  | 0.52 | %
Net interest margin |  |  |  |  |  |  |  |  |  |  | 3.92 | % |  |  |  |  |  |  |  |  |  |  | 3.68 | %

(1) | Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 34%. The tax-equivalent adjustment was $71 thousand and $62 thousand for the three months ended September 30, 2014 and 2013, respectively.

(2) | Loans placed on a non-accrual status are reflected in the balances.

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Average Balances, Income and Expenses, Yields and Rates (Taxable Equivalent Basis) |
|  | For the nine months ended |
|  | September 30, 2014 |  |  | September 30, 2013 |
|  | Average Balance |  |  | Interest Income/ Expense |  |  | Yield/ Rate |  |  | Average Balance |  |  | Interest Income/ Expense |  |  | Yield/ Rate |
Assets |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Securities: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  | $ | 96,497 |  |  | $ | 1,660 |  |  |  | 2.30 | % |  | $ | 89,677 |  |  | $ | 1,313 |  |  |  | 1.96 | %
Tax-exempt (1) |  |  | 12,096 |  |  |  | 418 |  |  |  | 4.62 | % |  |  | 7,696 |  |  |  | 345 |  |  |  | 5.99 | %
Restricted |  |  | 1,686 |  |  |  | 62 |  |  |  | 4.89 | % |  |  | 1,856 |  |  |  | 56 |  |  |  | 4.04 | %
Total securities |  | $ | 110,279 |  |  | $ | 2,140 |  |  |  | 2.59 | % |  | $ | 99,229 |  |  | $ | 1,714 |  |  |  | 2.31 | %
Loans: (2) |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Taxable |  | $ | 354,712 |  |  | $ | 12,994 |  |  |  | 4.90 | % |  | $ | 376,332 |  |  | $ | 14,305 |  |  |  | 5.08 | %
Tax-exempt (1) |  |  | 7,315 |  |  |  | 243 |  |  |  | 4.44 | % |  |  | 5,068 |  |  |  | 177 |  |  |  | 4.67 | %
Total loans |  | $ | 362,027 |  |  | $ | 13,237 |  |  |  | 4.89 | % |  | $ | 381,400 |  |  | $ | 14,482 |  |  |  | 5.08 | %
Federal funds sold |  |  | — |  |  |  | — |  |  |  | — |  |  |  | 2 |  |  |  | — |  |  |  | — |
Interest-bearing deposits with other institutions |  |  | 19,137 |  |  |  | 33 |  |  |  | 0.23 | % |  |  | 24,166 |  |  |  | 45 |  |  |  | 0.25 | %
Total earning assets |  | $ | 491,443 |  |  | $ | 15,410 |  |  |  | 4.19 | % |  | $ | 504,797 |  |  | $ | 16,241 |  |  |  | 4.30 | %
Less: allowance for loan losses |  |  | (10,376 | ) |  |  |  |  |  |  |  |  |  |  | (13,181 | ) |  |  |  |  |  |  |  |
Total non-earning assets |  |  | 44,981 |  |  |  |  |  |  |  |  |  |  |  | 43,642 |  |  |  |  |  |  |  |  |
Total assets |  | $ | 526,048 |  |  |  |  |  |  |  |  |  |  | $ | 535,258 |  |  |  |  |  |  |  |  |
Liabilities and Shareholders’ Equity |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Interest bearing deposits: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Checking |  | $ | 114,144 |  |  | $ | 131 |  |  |  | 0.15 | % |  | $ | 111,588 |  |  | $ | 236 |  |  |  | 0.28 | %
Regular savings |  |  | 101,777 |  |  |  | 66 |  |  |  | 0.09 | % |  |  | 99,847 |  |  |  | 122 |  |  |  | 0.16 | %
Money market accounts |  |  | 19,190 |  |  |  | 16 |  |  |  | 0.11 | % |  |  | 16,220 |  |  |  | 15 |  |  |  | 0.13 | %
Time deposits: |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
$100,000 and over |  |  | 48,514 |  |  |  | 456 |  |  |  | 1.26 | % |  |  | 63,449 |  |  |  | 738 |  |  |  | 1.56 | %
Under $100,000 |  |  | 64,178 |  |  |  | 423 |  |  |  | 0.88 | % |  |  | 79,182 |  |  |  | 749 |  |  |  | 1.26 | %
Brokered |  |  | 4,914 |  |  |  | 23 |  |  |  | 0.62 | % |  |  | 10,196 |  |  |  | 50 |  |  |  | 0.66 | %
Total interest-bearing deposits |  | $ | 352,717 |  |  | $ | 1,115 |  |  |  | 0.42 | % |  | $ | 380,482 |  |  | $ | 1,910 |  |  |  | 0.67 | %
Federal funds purchased |  |  | 358 |  |  |  | 2 |  |  |  | 0.90 | % |  |  | 1 |  |  |  | — |  |  |  | — |
Trust preferred capital notes |  |  | 9,279 |  |  |  | 163 |  |  |  | 2.35 | % |  |  | 9,279 |  |  |  | 166 |  |  |  | 2.40 | %
Other borrowings |  |  | 6,043 |  |  |  | 89 |  |  |  | 1.96 | % |  |  | 6,067 |  |  |  | 89 |  |  |  | 1.96 | %
Total interest-bearing liabilities |  | $ | 368,397 |  |  | $ | 1,369 |  |  |  | 0.50 | % |  | $ | 395,829 |  |  | $ | 2,165 |  |  |  | 0.73 | %
Non-interest bearing liabilities |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |
Demand deposits |  |  | 99,326 |  |  |  |  |  |  |  |  |  |  |  | 90,237 |  |  |  |  |  |  |  |  |
Other liabilities |  |  | 2,444 |  |  |  |  |  |  |  |  |  |  |  | 4,778 |  |  |  |  |  |  |  |  |
Total liabilities |  | $ | 470,167 |  |  |  |  |  |  |  |  |  |  | $ | 490,844 |  |  |  |  |  |  |  |  |
Shareholders’ equity |  |  | 55,881 |  |  |  |  |  |  |  |  |  |  |  | 44,414 |  |  |  |  |  |  |  |  |
Total liabilities and Shareholders’ equity |  | $ | 526,048 |  |  |  |  |  |  |  |  |  |  | $ | 535,258 |  |  |  |  |  |  |  |  |
Net interest income |  |  |  |  |  | $ | 14,041 |  |  |  |  |  |  |  |  |  |  | $ | 14,076 |  |  |  |  |
Interest rate spread |  |  |  |  |  |  |  |  |  |  | 3.69 | % |  |  |  |  |  |  |  |  |  |  | 3.57 | %
Cost of funds |  |  |  |  |  |  |  |  |  |  | 0.39 | % |  |  |  |  |  |  |  |  |  |  | 0.60 | %
Interest expense as a percent of average earning assets |  |  |  |  |  |  |  |  |  |  | 0.37 | % |  |  |  |  |  |  |  |  |  |  | 0.57 | %
Net interest margin |  |  |  |  |  |  |  |  |  |  | 3.82 | % |  |  |  |  |  |  |  |  |  |  | 3.73 | %

(1) | Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 34%. The tax-equivalent adjustment was $225 thousand and $177 thousand for the nine months ended September 30, 2014 and 2013, respectively.

(2) | Loans placed on a non-accrual status are reflected in the balances.

Provision for Loan Losses

The Bank recorded recovery of loan losses of $100 thousand during the third quarter, which resulted in a total allowance for loan losses of $9.7 million or 2.59% of total loans at September 30, 2014. This compared to a provision for loan losses of $275 thousand and an allowance for loan losses of $11.9 million, or 3.24% of total loans, at the end of the same quarter in 2013. The recovery of loan losses during the third quarter of 2014 was primarily a result of a decrease in the specific allocation from the improvement and resolution of certain impaired loans during the quarter. Net charge-offs totaled $190 thousand for the third quarter of 2014 compared to $878 thousand of net charge-offs for the same period in 2013.

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For the nine months ended September 30, 2014, recovery of loan losses totaled $700 thousand, compared to provision for loan losses of $2.5 million for the same period in 2013. The recovery of loan losses in 2014 was primarily the result of the improvement in the historical loss component of the calculation for allowance for loan losses offset by increases in specific reserves of $330 thousand from December 31, 2013. In 2013, the provision for loan losses resulted from net charge-offs and their impact on the historical loss component of the allowance for loan losses. Net charge-offs totaled $228 thousand for the nine months ended September 30, 2014 compared to $3.7 million for the same period in 2013.

Noninterest Income

Noninterest income increased $29 thousand, or 2%, to $1.7 million for the third quarter compared to $1.6 million for the same period one year ago. Revenue from wealth management fees increased by $88 thousand, or 22% and income from bank owned life insurance increased by $35 thousand, or 51%, comparing the third quarter to the same period one year ago. The increase in wealth management fees resulted primarily from higher balances of assets under management during the third quarter of 2014, compared to the same period one year ago. These increases were partially offset by $91 thousand of net losses on sale of securities available for sale.

For the nine months ended September 30, 2014, noninterest income decreased $165 thousand, or 3%, to $5.0 million compared to $5.2 million for the same period one year ago. The decrease in noninterest income was primarily the result of a one-time gain of $543 thousand recorded on termination of a post-retirement obligation for directors, included in other operating income, during the same period of 2013. Noninterest income, excluding the one-time gain on termination of a post-retirement obligation for directors, increased 8%, or $378 thousand, compared to the same period one year ago. Revenue from service charges on deposit accounts increased by $378 thousand, or 24%, revenue from wealth management fees increased by $217 thousand, or 18%, and income from bank owned life insurance increased by $67 thousand, or 34%, when comparing the periods. Revenue from service charges on deposit accounts increased primarily from increased checking account activity compared to the same period one year ago.

Noninterest Expense

Noninterest expense increased $105 thousand, or 2%, to $4.8 million for the quarter compared to $4.6 million for the same quarter of 2013. The increase in noninterest expense was primarily due to a $257 thousand, or 11% increase in expenses related to salaries and employee benefits and a $105 thousand, or 27% increase in other operating expense, when comparing the periods. Increases in salaries and employee benefits were impacted by the launch of First Mortgage, a new division of the Bank that began operations in May, along with the addition of a chief credit officer and three experienced commercial lenders. Increases in other operating expenses were primarily attributable to recruiting expenses pertaining to the new hires and additional expenses relating to the launch of the new mortgage division. These increases were partially offset by a $275 thousand decrease in expenses related to other real estate owned and a $99 thousand, or 52% decrease in FDIC assessment expenses, compared to the same period one year ago.

For the nine months ended September 30, 2014, noninterest expense decreased $604 thousand, or 4%, to $13.9 million compared to $14.5 million for the same period in the prior year. Expenses related to other real estate owned decreased $797 thousand, FDIC assessment expenses decreased $326 thousand, or 46%, and occupancy expenses decreased $84 thousand, or 9%, compared to the same period one year ago. Decreases in expenses related to other real estate owned resulted primarily from decreased write-downs in the carrying value of OREO property when comparing the periods. FDIC assessment expense decreased primarily as a result of an adjustment to the prepaid FDIC assessment balance during the first nine months of 2013. During the first nine months of 2014, the Company did not record a loss on land lease termination compared to a $206 thousand loss in 2013 that resulted from the Company’s decision to terminate a land lease for branch expansion. Occupancy expenses decreased, when comparing the periods, primarily because of the decrease in lease payments associated with the terminated land lease. These decreases were partially offset by increases in other operating expenses of $218 thousand, or 19%, increases of $101 thousand, or 36%, in data processing expenses, and increases of $96 thousand, or 46%, in bank franchise tax. Other operating expenses increased primarily from a new feature provided to checking account customers and additional loan expenses associated with the growth of the loan portfolio. Increases in data processing were primarily attributable to the shift in customer behavior from traditional to electronic services. Bank franchise tax increased because of higher levels of capital when comparing the periods.

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Income Taxes

The Company’s income tax provision differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the three and nine month periods ended September 30, 2014 and 2013. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income. A more detailed discussion of the Company’s tax calculation is contained in Note 10 of the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Financial Condition

General

Assets totaled $519.4 million at September 30, 2014 compared to $522.9 million at December 31, 2013. Assets under management of the wealth management division of the Bank increased by $20.9 million, or 7%, to $305.6 million at September 30, 2014 compared to $284.7 million at December 31, 2013. Assets managed by the wealth management division are not reflected on the Company’s consolidated balance sheet.

Loans

Loans, net of the allowance for loan losses, increased $18.5 million or 5% to $365.0 million at September 30, 2014, compared to $346.5 million at December 31, 2013. Although the Company believes loan demand remained relatively low in its market area, loan origination amounts increased during the first nine months of 2014.

The Company, through its banking subsidiary, grants mortgage, commercial and consumer loans to customers. The Bank segments its loan portfolio into real estate loans, commercial and industrial loans, and consumer and other loans. Real estate loans are further divided into the following classes: Construction and Land Development; 1-4 Family Residential; and Other Real Estate Loans. Descriptions of the Company’s loan classes are as follows:

Real Estate Loans – Construction and Land Development: The Company originates construction loans for the acquisition and development of land and construction of condominiums, townhomes, and one-to-four family residences.

Real Estate Loans – 1-4 Family: This class of loans includes loans secured by one-to-four family homes. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Real Estate Loans – Other: This loan class consists primarily of loans secured by various types of commercial real estate typically in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, hotels, small shopping centers, farms and churches.

Commercial and Industrial Loans: Commercial loans are typically secured with non-real estate commercial property. The Company makes commercial loans primarily to businesses located within its market area.

Consumer and Other Loans: Consumer loans include all loans made to individuals for consumer or personal purposes. They include new and used automobile loans, unsecured loans and lines of credit.

A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the Shenandoah Valley region of Virginia. The ability of the Bank’s debtors to honor their contracts may be impacted by the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses and any deferred fees or costs on originated loans. Interest income is accrued and credited to income based on the unpaid principal balance. Loan origination fees, net of certain origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. Loans greater than 90 days past due and still accruing increased to $2.1 million at September 30, 2014,

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compared to $49 thousand at December 31, 2014. The increase was primarily attributable to one loan relationship that is expected to return to current status during the fourth quarter of 2014. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Any unsecured loan that is deemed uncollectible is charged-off in full. Any secured loan that is considered by management to be uncollectible is partially charged-off and carried at the fair value of the collateral less estimated selling costs. This charge-off policy applies to all loan segments.

Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value (net of selling costs), and the probability of collecting scheduled principal and interest payments when due. Additionally, management generally evaluates substandard and doubtful loans greater than $250 thousand for impairment. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value of the collateral, net of selling costs, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company typically does not separately identify individual consumer, residential and certain small commercial loans that are less than $250 thousand for impairment disclosures, except for troubled debt restructurings (TDRs) as noted below. The recorded investment in impaired loans totaled $16.8 million and $21.7 million at September 30, 2014 and December 31, 2013, respectively.

Troubled Debt Restructurings (TDR)

In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above. There were $1.9 million in loans classified as TDRs as of September 30, 2014 and December 31, 2013.

Asset Quality

Management classifies as non-performing assets non-accrual loans and other real estate owned (OREO). OREO represents real property taken by the Bank when its customers do not meet the contractual obligation of their loans, either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank had $1.8 million and $3.0 million in OREO, net of the valuation allowance, at September 30, 2014 and December 31, 2013, respectively. The valuation allowance for other real estate owned totaled $456 thousand and $1.7 million at September 30, 2014 and December 31, 2013, respectively.

Non-performing assets were $10.5 million at September 30, 2014 and $14.7 million at December 31, 2013, representing 2.02% and 2.81% of total assets, respectively. Non-performing assets included $8.7 million in non-accrual loans and $1.8 million in OREO, net of the valuation allowance at September 30, 2014. This compares to $11.7 million in non-accrual loans and $3.0 million in OREO, net of the valuation allowance at December 31, 2013.

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The levels of non-performing assets at September 30, 2014 and December 31, 2013 were primarily attributable to weak local economic conditions that negatively impacted the ability of certain borrowers to service debt. Borrowers that have not been able to meet their debt requirements are primarily business customers involved in real estate development and commercial and residential real estate. At September 30, 2014, 43% of non-performing assets related to commercial real estate loans, 40% related to construction and land development loans, 13% related to residential real estate loans, 3% related to properties originally acquired for branch expansion no longer intended to be used for that purpose and 1% related to commercial and industrial loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $20.1 million and $23.5 million at September 30, 2014 and December 31, 2013, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing our customers’ ability to meet their debt requirements.

The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s current estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $9.7 million at September 30, 2014 and $10.6 million at December 31, 2013, representing 2.59% and 2.98% of total loans, respectively. The decrease in the allowance was primarily a result of a decrease in the general allocation from an improvement in the historical loss experience in excess of the increase in specific reserves required on impaired loans. Recoveries of loan losses of $832 thousand, $131 thousand, and $58 thousand were experienced in the Construction and Land Development, Other Real Estate, and Commercial and Industrial loan classes, respectively, during the nine month period ended September 30, 2014. The recoveries of loan losses in the Construction and Land Development and Commercial and Industrial loan classes were primarily attributable to decreases in the specific reserve and decreases in the general allocation from improvements in the historical loss experience. The recovery of loan losses in the Other Real Estate loan class resulted from a decrease in the general allocation from an improvement in the historical loss experience that exceeded the increase in the specific reserve.

Impaired loans totaled $16.8 million and $21.7 million at September 30, 2014 and December 31, 2013, respectively. The related allowance for loan losses provided for these loans totaled $1.7 million and $1.4 million at September 30, 2014 and December 31, 2013, respectively. The average recorded investment in impaired loans during the nine months ended September 30, 2014 and the year ended December 31, 2013 was $20.3 million and $16.0 million, respectively. Included in the impaired loans total at September 30, 2014 are loans classified as TDRs totaling $1.9 million. These loans represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of September 30, 2014, $796 thousand of these TDRs were performing under the restructured terms and were not considered non-performing assets.

Management believes, based upon its review and analysis, that the Bank has sufficient reserves to cover losses inherent within the loan portfolio. For each period presented, the provision for loan losses charged to expense was based on management’s judgment after taking into consideration all factors connected with the collectability of the existing portfolio. Management considers economic conditions, historical loss factors, past due percentages, internally generated loan quality reports and other relevant factors when evaluating the loan portfolio. There can be no assurance, however, that an additional provision for loan losses will not be required in the future, including as a result of changes in the economic assumptions underlying management’s estimates and judgments, adverse developments in the economy, on a national basis or in the Company’s market area, or changes in the circumstances of particular borrowers. For further discussion regarding the allowance for loan losses, see “Critical Accounting Policies”.

Securities

Securities at September 30, 2014 totaled $104.7 million, an increase of $1.4 million or 1% from $103.3 million at December 31, 2013. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions and corporate equity securities. As of September 30, 2014, neither the Company nor the Bank held any derivative financial instruments in its respective investment security portfolios. Gross unrealized gains in the securities portfolio totaled $1.3 million and $1.0 million at September 30, 2014 and December 31, 2013, respectively. Gross unrealized losses totaled $1.4 million and $2.7 million at September 30, 2014 and December 31, 2013, respectively. Investments in an unrealized loss position were considered temporarily impaired at September 30, 2014 and December 31, 2013. The change in the unrealized gains and losses of investment securities from December 31, 2013 to September 30, 2014 was related to changes in market interest rates.

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Deposits

Deposits totaled $438.9 million at September 30, 2014, a decrease of $11.8 million or 3% from $450.7 million at December 31, 2013. Non-interest bearing demand deposits increased $10.1 million or 11% to $103.0 million during the first nine months of 2014 from $92.9 million at December 31, 2013. Savings and interest-bearing demand deposits decreased $9.4 million or 4% to $224.7 million at September 30, 2014 compared to $234.1 million at December 31, 2013. Time deposits, which include brokered deposits, decreased $12.5 million or 10% during the first nine months of 2014 to $111.2 million compared to $123.8 million at December 31, 2013.

Liquidity

Liquidity represents the ability to meet present and future financial obligations through either the sale or maturity of existing assets or with borrowings from correspondent banks or other deposit markets. The Company classifies cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, investment securities and loans maturing within one year as liquid assets. As part of the Bank’s liquidity risk management, stress tests and cash flow modeling are performed quarterly.

As a result of the Bank’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Bank maintains overall liquidity sufficient to satisfy its depositors’ requirements and to meet its customers’ borrowing needs.

At September 30, 2014, cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, securities and loans maturing within one year totaled $79.5 million. At September 30, 2014, 18% or $68.8 million of the loan portfolio would mature within one year. Non-deposit sources of available funds totaled $98.0 million at September 30, 2014, which included $62.6 million available from FHLB, $31.7 million of unsecured federal funds lines of credit with other correspondent banks and $3.7 million available through the Federal Reserve Discount Window.

Capital Resources

The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to the size, composition, and quality of the Company’s asset and liability levels and consistent with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and absorb potential losses.

The Board of Governors of the Federal Reserve System has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.00%, of which at least 4.00% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. The Company had a ratio of total capital to risk-weighted assets of 18.92% at September 30, 2014 and a ratio of Tier 1 capital to risk-weighted assets of 17.65%. The Bank had a ratio of total capital to risk-weighted assets of 17.71% and a ratio of Tier 1 capital to risk-weighted assets of 16.44% at September 30, 2014. All of these exceed the capital requirements adopted by the federal regulatory agencies.

Under present regulations, trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. At September 30, 2014 and December 31, 2013, the total amount of trust preferred securities issued by the Trusts was included in the Company’s Tier 1 capital. The Company is current on the interest payments on its trust preferred capital notes.

In July 2013, the Federal Reserve Board released its final rules which will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. The new rules are effective January 1, 2015. Under the final rule, minimum requirements will increase for both the quality and quantity of capital held by banking organizations. In this respect, the final rule implements strict eligibility criteria for regulatory capital instruments and improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. Consistent with the international Basel framework, the rule includes a new minimum ratio of Common Equity Tier 1 Capital to Risk-Weighted Assets of 4.5% and a Common Equity Tier 1 Capital conservation buffer of 2.5% of risk-weighted assets. The conservation buffer will be phased in from 2016 through 2019. The rule also, among other things, raises the minimum ratio of Tier 1 Capital to Risk-Weighted Assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations.

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We have evaluated the impact of the Basel III final rule on the Company’s and the Bank’s regulatory capital ratios, and currently anticipate that capital ratios, on a Basel III basis, will be sufficient to meet the well capitalized minimum capital requirements.

The Company’s Preferred Stock includes Series A Preferred Stock which paid a dividend of 5% per annum until May 14, 2014 and 9% thereafter, and Series B Preferred Stock which pays a dividend of 9% per annum. The Company is current on its dividend payments on each series of preferred stock.

On November 12, 2014, the Board of Directors of First National Corporation declared a quarterly dividend of $0.025 per common share, which is payable on December 19, 2014 to shareholders of record as of December 5, 2014.

Contractual Obligations

There have been no material changes outside the ordinary course of business to the contractual obligations disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

Off-Balance Sheet Arrangements

The Company, through the Bank, is a party to credit related financial instruments with risk not reflected in the consolidated financial statements in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.

Commitments to extend credit, which amounted to $58.3 million at September 30, 2014, and $59.1 million at December 31, 2013, are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management’s credit evaluation of the customer.

Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are collateralized as deemed necessary and might not be drawn upon to the total extent to which the Bank is committed.

Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. At September 30, 2014 and December 31, 2013, the Bank had $6.1 million and $7.6 million in outstanding standby letters of credit, respectively.

Item 3. | Quantitative and Qualitative Disclosures About Market Risk

Not required.

Item 4. | Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to provide assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods required by the SEC and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. An evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of September 30, 2014 was carried out under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Based on and as of the date of such evaluation, the aforementioned officers concluded that the Company’s disclosure controls and procedures were effective.

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The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. | Legal Proceedings

There are no material pending legal proceedings, other than ordinary routine litigation incidental to the Company’s business, to which the Company is a party or to which the property of the Company is subject.

Item 1A. | Risk Factors

There were no material changes to the Company’s risk factors as disclosed in its Annual Report on Form 10-K for the year ended December 31, 2013.

Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. | Defaults upon Senior Securities

None

Item 4. | Mine Safety Disclosures

None

Item 5. | Other Information

None

Item 6. | Exhibits

The following documents are attached hereto as Exhibits:

3.1 |  | By-laws of First National Corporation (as restated in electronic format as of August 13, 2014), attached as Exhibit 3.1 to the Current Report on Form 8-K filed August 19, 2014 and incorporated by reference herein.
31.1 |  | Certification of Chief Executive Officer, Section 302 Certification
31.2 |  | Certification of Chief Financial Officer, Section 302 Certification
32.1 |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
32.2 |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
101 |  | The following materials from First National Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2014 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

FIRST NATIONAL CORPORATION |  |  |  |
(Registrant) |  |  |  |
/s/ Scott C. Harvard |  |  |  | November 14, 2014
Scott C. Harvard |  |  |  | Date
President and Chief Executive Officer |  |  |  |
/s/ M. Shane Bell |  |  |  | November 14, 2014
M. Shane Bell |  |  |  | Date
Executive Vice President and Chief Financial Officer |  |  |  |

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EXHIBIT INDEX

Number |  | Document
3.1 |  | By-laws of First National Corporation (as restated in electronic format as of August 13, 2014), attached as Exhibit 3.1 to the Current Report on Form 8-K filed August 19, 2014 and incorporated by reference herein.
31.1 |  | Certification of Chief Executive Officer, Section 302 Certification
31.2 |  | Certification of Chief Financial Officer, Section 302 Certification
32.1 |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
32.2 |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350
101 |  | The following materials from First National Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2014 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Income, (iii) Consolidated Statements of Comprehensive Income (iv) Consolidated Statements of Cash Flows, (v) Consolidated Statements of Shareholders’ Equity, and (vi) Notes to Consolidated Financial Statements.

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