Note 5 – Fair Value Measurements

Determination of Fair Value

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 Measurements and Disclosures topic of FASB ASC, the fair value of a financial 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 financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The 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 financial assets and financial 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 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.

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

Securities available-for-sale

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

The following table summarizes the Company's financial assets that were measured at fair value on a recurring basis during the period (in thousands):


			Carrying Value at June 30, 2012

			Quoted Prices		Significant
			in Active		Other		Significant
		Balance as of	Markets for		Observable		Unobservable
		June 30,	Identical Assets		Inputs		Inputs
Description		2012	(Level 1)		(Level 2)		(Level 3)
US agency obligations	$	27,566	$	-	$	27,566	$	-
Mortgage-backed securities		2,799		-		2,799		-
Municipals		22,611		-		22,611		-
Other (corporates)		2,698		-		2,698		-

Total available-for-sale securities	$	55,674	$	-	$	55,674	$	-


			Carrying Value at December 31, 2011

			Quoted Prices		Significant
			in Active		Other		Significant
		Balance as of	Markets for		Observable		Unobservable
		December 31,	Identical Assets		Inputs		Inputs
Description		2011	(Level 1)		(Level 2)		(Level 3)
US agency obligations	$	25,485	$	-	$	25,485	$	-
Mortgage-backed securities		3,939		-		3,939		-
Municipals		18,914		-		18,914		-

Total available-for-sale securities	$	48,338	$	-	$	48,338	$	-

Impaired loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over one year old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business' financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). 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

Certain assets such as other real estate owned (OREO) are measured at fair value less cost to sell. We believe that the fair value component in its valuation follows the provisions of ASC 820.

Real estate acquired through foreclosure is transferred to OREO. The measurement of loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. The value of OREO collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate is over one year old, then the fair value is considered Level 3. Any fair value adjustments are recorded in the period incurred and expensed against current earnings.

The following table summarizes the Company's impaired loans and OREO measured at fair value on a nonrecurring basis during the period (in thousands).


			Carrying Value at June 30, 2012
Description		Balance as of June 30, 2012	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans*	$	6,322	$-	$	3,151	$	3,171

Other real estate
owned	$	2,263	$-	$	2,263	$	-

* Includes loans charged down during the quarter to the net realizable value of the collateral.


			Carrying Value at December 31, 2011
Description		Balance as of December 31, 2011	Quoted Prices in Active Markets for Identical Assets (Level 1)	Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Impaired loans*	$	10,655	$-	$	2,710	$	7,945

Other real estate	$	3,253	$-	$	3,253	$	-
owned

* Includes loans charged down during the quarter to the net realizable value of the collateral.

The following table sets forth information regarding the quantitative inputs used to value assets classified as Level 3:


		Quantitative information about Level 3 Fair Value Measurements for June 30, 2012
			(dollars in thousands)
		Fair Value	Valuation Technique(s)	Unobservable Input	Range (Weighted Average)
Assets
			Discounted appraised
Impaired loans	$	3,171	value	Selling cost	5% - 10% (6%)
				Discount for lack of
				marketability and age
				of appraisal	0% - 25% (15%)

The following table summarizes activity at the Level 3 valuation for the first six months of 2012:


Six months ended June 30, 2012
(dollars in thousands)
Balance as of December 31, 2011	$	7,945
Transfers to Level 3		514
Changes in loan balances due to payments		(17	)
Loans no longer considered impaired or transferred to Level 2*		(5,271	)
Ending balance as of June 30, 2012	$	3,171

Financial Instruments

Cash, cash equivalents and Federal Funds sold

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

Securities

Fair values of securities, excluding Federal Reserve Bank stock, Federal Home Loan Bank stock, and Community Bankers' Bank stock are based on quoted market prices.

Loans

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain fixed rate loans are based on quoted market prices of similar loans adjusted for differences in loan characteristics. Fair values for other loans such as commercial real estate and commercial and industrial 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 of nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

Bank Owned Life Insurance (BOLI)

The carrying amount approximates fair value.

Deposits

Fair values disclosed for demand deposits (e.g., interest and noninterest checking, savings, and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed rate certificates of deposit are estimated using discounted cash flow analyses that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

FHLB borrowings

The fair value of FHLB borrowings is estimated using discounted cash flow analysis based on the rates currently offered for borrowings of similar remaining maturities and collateral requirements.

Short-term borrowings

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate fair value.

Capital notes

Fair values of capital notes are based on market prices for debt securities having similar maturity and interest rate characteristics.

Accrued interest

The carrying amounts of accrued interest approximate fair value.

Off-balance sheet credit-related instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. Fair value of off-balance sheet credit-related instruments were deemed to be immaterial at June 30, 2012 and December 31, 2011 and therefore are not included in the table below.

The estimated fair values, and related carrying or notional amounts, of Financial's financial instruments are as follows (in thousands):


				Fair Value Measurements at June 30, 2012 using
				Quoted Prices		Significant
				in Active		Other	Significant
				Markets for		Observable	Unobservable
		Carrying		Identical Assets		Inputs	Inputs
Assets		Amounts		(Level 1)		(Level 2)	(Level 3)			Balance
Cash and due from
banks	$	18,924	$	18,924	$	-	$	-	$	18,924
Federal funds sold		8,362		8,362		-		-		8,362
Securities
Available-for-sale		55,674		-		55,674		-		55,674
Held-to-maturity		3,087		-		3,437		-		3,437
Loans, net		319,216		-		326,005		3,171		329,176
Loans held for sale		1,164		-		1,164		-		1,164
Interest receivable		1,502		-		1,502		-		1,502
BOLI		8,773		-		8,773		-		8,773

Liabilities
Deposits	$	384,589	$	-	$	386,397	$	-	$	386,397
FHLB borrowings		10,000		-		9,774		-		9,774
Capital notes		9,627		-		9,409		-		9,409
Interest payable		107		-		107		-		107


				Fair Value Measurements at December 31, 2011 using
				Quoted Prices		Significant
				in Active		Other	Significant
				Markets for		Observable	Unobservable
		Carrying		Identical Assets		Inputs	Inputs
Assets		Amounts		(Level 1)		(Level 2)	(Level 3)			Balance
Cash and due from
banks	$	17,678	$	17,678	$	-	$	-	$	17,678
Federal funds sold		5,662		5,662		-		-		5,662
Securities
Available-for-sale		48,338		-		48,338		-		48,338
Held-to-maturity		8,133		-		8,533		-		8,533
Loans, net		318,754		-		320,658		7,945		328,603
Loans held for sale		434		-		434		-		434
Interest receivable		1,583		-		1,583		-		1,583
BOLI		8,609		-		8,609		-		8,609

Liabilities
Deposits	$	374,234	$	-	$	375,544	$	-	$	375,544
FHLB borrowings		10,000		-		9,752		-		9,752
Repurchase
agreements		8,379		-		8,392		-		8,392
Capital notes		7,000		-		6,826		-		6,826
Interest payable		111		-		111		-		111

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Bank's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment, and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing on-balance-sheet and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets that are not considered financial assets include deferred income taxes and bank premises and equipment; a significant liability that is not considered a financial liability is accrued post-retirement benefits. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

Financial 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 Financial's financial instruments will change when interest rate levels change, and that change may be either favorable or unfavorable to the Bank. 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 Bank's overall interest rate risk.