Note 5 - Loans and allowance for loan losses

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 collateral, overall portfolio quality and review of specific potential losses. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

Management has an established methodology used to determine the adequacy of the allowance for loan losses that assesses the risks and losses inherent in the loan portfolio. For purposes of determining the allowance for loan losses, the Bank has segmented certain loans in the portfolio by product type. Within these segments, the Bank has sub-segmented its portfolio by classes within the segments, based on the associated risks within these classes. The classifications set forth below do not correspond directly to the classifications set forth in the call report (Form FFIEC 041). Management has determined that the classifications set forth below are more appropriate for use in identifying and managing risk in the loan portfolio.


Loan Segments:	Loan Classes:
Commercial	Commercial and industrial loans
Commercial real estate	Commercial mortgages – owner occupied Commercial mortgages – non-owner occupied Commercial construction
Consumer	Consumer unsecured Consumer secured
Residential	Residential mortgages Residential consumer construction

Note 5 - Loans and allowance for loan losses (continued)

The evaluation also considers the following risk characteristics of each loan segment:

Commercial loans carry risks associated with the successful operation of a business because the 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 precision.

Commercial real estate loans carry risks associated with a real estate project and other risks associated with the ownership of real estate. In addition, for real estate construction loans there is a risk that the project will not be finished according to schedule, the project will 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 unrelated to the project.

Consumer loans carry risks associated with the continued credit-worthiness of the borrower and the value of the collateral (e.g., rapidly-depreciating assets such as automobiles), or lack thereof. Consumer loans are more likely than real estate loans to be immediately adversely affected by job loss, divorce, illness or personal bankruptcy. Unsecured consumer loans carry additional risks associated with the continued credit-worthiness of borrowers who may be unable to meet payment obligations.

Residential mortgage and construction loans carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral. Equity lines of credit carry risks associated with the continued credit-worthiness of the borrower and changes in the value of the collateral.

The Bank’s internal risk rating system is in place to grade commercial and commercial real estate loans. Category ratings are reviewed periodically by lenders and the credit review area of the Bank based on the borrower’s individual situation. Additionally, internal and external monitoring and review of credits are conducted on an annual basis.

Below is a summary and definition of the Bank’s risk rating categories:


RATING 1	Excellent
RATING 2	Above Average
RATING 3	Satisfactory
RATING 4	Acceptable / Low Satisfactory
RATING 5	Monitor
RATING 6	Special Mention
RATING 7	Substandard
RATING 8	Doubtful
RATING 9	Loss

Based on the above criteria, we segregate loans into the above categories for special mention, substandard, doubtful and loss from non-classified, or pass rated, loans. We review the characteristics of each rating at least annually, generally during the first quarter. The characteristics of these ratings are as follows:

Note 5 - Loans and allowance for loan losses (continued)

“Pass.” These are loans having risk ratings of 1 through 4. Pass loans are to persons or business entities with an acceptable financial condition, appropriate collateral margins, appropriate cash flow to service the existing loan, and an appropriate leverage ratio. The borrower has paid all obligations as agreed and it is expected that this type of payment history will continue. When necessary, acceptable personal guarantors support the loan.

“Monitor.” These are loans having a risk rating of 5. Monitor loans have currently acceptable risk but may have the potential for a specific defined weakness in the borrower’s operations and the borrower’s ability to generate positive cash flow on a sustained basis. The borrower’s recent payment history may currently or in the future be characterized by late payments. The Bank’s risk exposure is mitigated by collateral supporting the loan. The collateral is considered to be well-margined, well maintained, accessible and readily marketable.

“Special Mention.” These are loans having a risk rating of 6. Special Mention loans have weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. These loans do warrant more than routine monitoring due to a weakness caused by adverse events.

“Substandard.” These are loans having a risk rating of 7. Substandard loans are considered to have specific and well-defined weaknesses that jeopardize the viability of the Bank’s credit extension. The payment history for the loan has been inconsistent and the expected or projected primary repayment source may be inadequate to service the loan. The estimated net liquidation value of the collateral pledged and/or ability of the personal guarantor(s) to pay the loan may not adequately protect the Bank. There is a distinct possibility that the Bank will sustain some loss if the deficiencies associated with the loan are not corrected in the near term. A substandard loan would not automatically meet our definition of impaired unless the loan is significantly past due and the borrower’s performance and financial condition provide evidence that it is probable that the Bank will be unable to collect all amounts due.

“Doubtful.” These are loans having a risk rating of 8. Doubtful rated loans have all the weaknesses inherent in a loan that is classified substandard but 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 possibility of loss is high.

“Loss.” These are loans having a risk rating of 9. Loss rated loans are not considered collectible under normal circumstances and there is no realistic expectation for any future payment on the loan. Loss rated loans are fully charged off.

Note 5 - Loans and allowance for loan losses (continued)

The Bank grants primarily commercial, real estate, and installment loans to customers throughout its market area, which consists primarily of Region 2000 which includes the counties of Amherst, Appomattox, Bedford and Campbell and the cities of Bedford and Lynchburg, Virginia. The real estate portfolio can be affected by the condition of the local real estate market. The commercial and installment loan portfolio can be affected by the local economic conditions.

A summary of loans, net is as follows:



	December 31,
	2015	2014

Commercial	$76,773	$63,259
Commercial real estate	217,125	207,262
Consumer	81,531	76,380
Residential	59,699	52,462

Total loans (1)	435,128	399,363

Less allowance for loan losses	4,683	4,790

Net loans	$430,445	$394,573

(1)

Includes net deferred loan costs of $263 and $330, respectively.

The amount of overdrafts reclassified as loans was $17 and $12 as of December 31, 2015 and 2014, respectively.

The Company’s officers, directors and their related interests have various types of loan relationships with the Bank. The total outstanding balances of these related party loans at December 31, 2015 and 2014 were $16,068 and $17,339 respectively. During 2015, new loans and advances amounted to $2,252 and repayments amounted to $3,523. It should be noted that the beginning balance as of December 31, 2014 was adjusted upward to account for the existing loan relationships maintained by the related interests of a new director appointed during 2015.

Note 5 - Loans and allowance for loan losses (continued)

The following tables set forth information regarding impaired and non-accrual loans as of December 31, 2015 and 2014:



Loans on Non-Accrual Status


	As of December 31,
	2015	2014
Commercial	$483	$1,965
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	799	212
Commercial Mortgages-Non-Owner Occupied	514	70
Commercial Construction	367	460
Consumer
Consumer Unsecured	31	-
Consumer Secured	269	20
Residential:
Residential Mortgages	695	689
Residential Consumer Construction	248	90

Totals	$3,406	$3,506

Note 5 - Loans and allowance for loan losses (continued)


		Impaired Loans
		As of and for the Year Ended December 31, 2015
			Unpaid		Average	Interest
		Recorded	Principal	Related	Recorded	Income
2015		Investment	Balance	Allowance	Investment	Recognized
With No Related Allowance Recorded:
	Commercial	$ -	$ -	$ -	$ 1,009	$ -
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	3,082	3,100	-	2,959	174
	Commercial Mortgage Non-Owner Occupied	177	177	-	628	12
	Commercial Construction	27	514	-	244	-
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	20	20	-	21	1
	Residential
	Residential Mortgages	1,997	2,027	-	1,466	86
	Residential Consumer Construction	171	176	-	86	4

With an Allowance Recorded:
	Commercial	$ 1,180	$ 1,256	$ 6100	$ 1,293	$ 38
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	877	883	163	865	35
	Commercial Mortgage Non-Owner Occupied	672	738	175	399	38
	Commercial Construction	340	700	75	170	-
	Consumer
	Consumer Unsecured	31	32	31	16	1
	Consumer Secured	190	193	153	155	10
	Residential
	Residential Mortgages	650	800	87	740	42
	Residential Consumer Construction	-	-	-	-	-

Totals:
	Commercial	$ 1,180	$ 1,256	$ 610	$ 2,302	$ 38
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	3,959	3,983	163	3,824	209
	Commercial Mortgage Non-Owner Occupied	849	915	175	1,027	50
	Commercial Construction	367	1,214	75	414	-
	Consumer
	Consumer Unsecured	31	32	31	16	1
	Consumer Secured	210	213	153	176	11
	Residential
	Residential Mortgages	2,647	2,827	87	2,206	128
	Residential Consumer Construction	171	176	-	86	4
		$ 9,414	$ 10,616	$ 1,294	$ 10,051	$ 441

Note 5 - Loans and allowance for loan losses (continued)


		Impaired Loans
		As of and for the Year Ended December 31, 2014
2014		Recorded Investment	Unpaid Principal Balance	Related Allowance	Average Recorded Investment	Interest Income Recognized
With No Related Allowance Recorded:
	Commercial	$2,017	$2,280	$ -	$2,641	$63
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	2,835	2,835	-	1,687	152
	Commercial Mortgage Non-Owner Occupied	1,078	1,128	-	1,041	75
	Commercial Construction	460	1,194	-	606	-
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	21	21	-	21	1
	Residential
	Residential Mortgages	934	1,058	-	702	58
	Residential Consumer Construction	-	-	-	-	-

With An Allowance Recorded:
	Commercial	$1,406	$1,861	$713	$990	$29
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	852	1,029	63	1,636	36
	Commercial Mortgage Non-Owner Occupied	126	126	32	173	7
	Commercial Construction	-	-	-	-	-
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	119	119	119	80	7
	Residential
	Residential Mortgages	829	968	131	1,257	52
	Residential Consumer Construction	-	-	-	-	-

Totals:
	Commercial	$3,423	$4,141	$713	$3,631	$92
	Commercial Real Estate
	Commercial Mortgages-Owner Occupied	3,687	3,864	63	3,323	188
	Commercial Mortgage Non-Owner Occupied	1,204	1,254	32	1,214	82
	Commercial Construction	460	1,194	-	606	-
	Consumer
	Consumer Unsecured	-	-	-	-	-
	Consumer Secured	140	140	119	101	8
	Residential
	Residential Mortgages	1,763	2,026	131	1,959	110
	Residential Consumer Construction	-	-	-	-	-
		$10,677	$12,619	$1,058	$10,834	$480

Note 5 - Loans and allowance for loan losses (continued)

Changes in Allowance Methodology

Beginning with the quarter ended December 31, 2014, the Company changed its methodology for determining the historical loss portion of general reserves assigned to unimpaired credits. In prior periods, a rolling three year historical “look-back” period was utilized in the determination of historical loss rates to apply to the segments of the loan portfolio in the determination of general reserves. At December 31, 2014, the Company changed this period to a four year rolling historical “look-back” period.

The Company believes the expanded four year “look-back” period is more indicative of the losses and risks inherent in the portfolio, given the ongoing economic cycle and as the Bank expands into new markets.

The following table represents the effect on the loan loss provision for the year ended December 31, 2014 as a result of the change in allowance methodology from that used in prior periods.


Portfolio Segment:	Calculated Provision Based on Current Methodology	Calculated Provision Based on Prior Methodology	Difference
Commercial	$334	$234	$100
Commercial Real Estate	(260)	(1,006)	746
Consumer	(83)	(259)	176
Residential	64	41	23
Total	$55	$(990)	$1,045

Note 5 - Loans and allowance for loan losses (continued)

The following tables set forth the allowance for loan losses activity for the years ended December 31, 2015 and 2014:

Allowance for Loan Losses and Recorded Investment in Loans

For the Year Ended December 31, 2015


		Commercial
2015	Commercial	Real Estate	Consumer	Residential	Total

Allowance for Loan Losses:

Beginning Balance	$1,235	$2,194	$812	$549	$4,790
Charge-offs	(294)	(64)	(257)	-	(615)
Recoveries	14	122	54	36	226
Provision	240	(501)	464	79	282
Ending Balance	$1,195	$1,751	$1,073	$664	$4,683

Ending Balance: Individually evaluated for impairment	$610	$413	$184	$87	$1,294

Ending Balance: Collectively evaluated for impairment	585	1,338	889	577	3,389


Totals:	$1,195	$1,751	$1,073	$664	$4,683

Loans:

Ending Balance: Individually evaluated for impairment	$1,180	$5,175	$241	$2,818	$9,414

Ending Balance: Collectively evaluated for impairment	75,593	211,950	81,290	56,881	425,714

Totals:	$76,773	$217,125	$81,531	$59,699	$435,128

Note 5 - Loans and allowance for loan losses (continued)

Allowance for Loan Losses and Recorded Investment in Loans

For the Year Ended December 31, 2014


		Commercial
2014	Commercial	Real Estate	Consumer	Residential	Total

Allowance for Loan Losses:

Beginning Balance	$1,015	$2,631	$935	$605	$5,186
Charge-offs	(165)	(187)	(79)	(120)	(551)
Recoveries	51	10	39	-	100
Provision	334	(260)	(83)	64	55
Ending Balance	$1,235	$2,194	$812	$549	$4,790

Ending Balance: Individually evaluated for impairment	$713	$95	$119	$131	$1,058

Ending Balance: Collectively evaluated for impairment	522	2,099	693	418	3,732


Totals:	$1,235	$2,194	$812	$549	$4,790

Loans:

Ending Balance: Individually evaluated for impairment	$3,423	$5,351	$140	$1,763	$10,677

Ending Balance: Collectively evaluated for impairment	59,386	201,911	76,240	50,699	388,686

Totals:	$63,259	$207,262	$76,380	$52,462	$399,363

Note 5 - Loans and allowance for loan losses (continued)


Age Analysis of Past Due Loans as of December 31, 2015
2015	30-59 Days Past Due	60-89 Days Past Due	Greater than 90 Days	Total Past Due	Current	Total Loans	Recorded Investment > 90 Days & Accruing
Commercial	$ -	$244	$483	$727	$76,046	$76,773	$ -
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	425	571	426	1,422	75,549	76,971	-
Commercial Mortgages-Non-Owner Occupied	189	90	438	717	126,138	126,855	-
Commercial Construction	-	-	367	367	12,932	13,299	-
Consumer:
Consumer Unsecured	2	-	31	33	6,828	6,861	-
Consumer Secured	198	68	128	394	74,276	74,670	-
Residential:
Residential Mortgages	512	468	543	1,523	48,490	50,013	-
Residential Consumer Construction	-	-	248	248	9,438	9,686	-
Total	$1,326	$1,441	$2,664	$5,431	$429,697	$435,128	$ -


Age Analysis of Past Due Loans as of December 31, 2014
2014	30-59 Days Past Due	60-89 Days Past Due	Greater than 90 Days	Total Past Due	Current	Total Loans	Recorded Investment > 90 Days & Accruing
Commercial	$21	$80	$1,965	$2,066	$61,193	$63,259	$ -
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	192	-	212	404	77,304	77,708	-
Commercial Mortgages-Non-Owner Occupied	86	-	70	156	119,019	119,175	-
Commercial Construction	-	-	460	460	9,919	10,379	-
Consumer:
Consumer Unsecured	11	-	-	11	5,749	5,760	-
Consumer Secured	15	-	-	15	70,605	70,620	-
Residential:
Residential Mortgages	626	48	525	1,199	43,745	44,944	-
Residential Consumer Construction	29	-	-	29	7,489	7,518	-
Total	$980	$128	$3,232	$4,340	$395,023	$399,363	$ -

Note 5 - Loans and allowance for loan losses (continued)

Credit Quality Information - by Class

December 31, 2015

2015	Pass	Monitor	Special	Substandard	Doubtful	Totals
			Mention
Commercial	$73,831	$290	$1,457	$1,195	$ -	$76,773
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	68,813	1,353	2,801	4,004	-	76,971
Commercial Mortgages-Non-Owner Occupied	120,462	1,558	3,895	940	-	126,855
Commercial Construction	12,932	-	-	367	-	13,299
Consumer
Consumer Unsecured	6,830	-	-	31	-	6,861
Consumer Secured	73,825	276	50	519	-	74,670
Residential:
Residential Mortgages	47,180	-	-	2,833	-	50,013
Residential Consumer Construction	9,438	-	-	248	-	9,686

Totals	$413,311	$3,477	$8,203	$10,137	$ -	$435,128

Credit Quality Information - by Class

December 31, 2014

2014	Pass	Monitor	Special	Substandard	Doubtful	Totals
			Mention
Commercial	$58,745	$725	$224	$3,565	$ -	$63,259
Commercial Real Estate:
Commercial Mortgages-Owner Occupied	71,087	1,718	1,216	3,687	-	77,708
Commercial Mortgages-Non-Owner Occupied	112,560	1,586	3,971	1,058	-	119,175
Commercial Construction	9,919	-	-	460	-	10,379
Consumer
Consumer Unsecured	5,673	-	-	87	-	5,760
Consumer Secured	69,527	554	136	403	-	70,620
Residential:
Residential Mortgages	41,578	1,258	120	1,988	-	44,944
Residential Consumer Construction	7,428	-	-	90	-	7,518

Totals	$376,517	$5,841	$5,667	$11,338	$ -	$399,363

Note 5 - Loans and allowance for loan losses (continued)

Troubled Debt Restructurings (TDRs)

The following tables describe the loan modifications classified as TDRs during the twelve months ended December 31, 2015:

For the Twelve Months Ended December 31, 2015 (dollars in thousands)
Troubled Debt Restructurings During the Period	Number of Contracts	Pre-Modification Outstanding Recorded Investment	Post-Modification Outstanding Recorded Investment
Commercial	1	$21	$21
Commercial Real Estate	2	$456	$456

There were no loan modifications that would have been classified as Troubled Debt Restructurings (TDR) during the twelve months ended December 31, 2014.

The loans noted in the table above were modified during the periods to extend maturity only. These loans are factored into the determination of the allowance for loan losses as of the period indicated and are included in the Bank’s impaired loan analysis and individually evaluated for impairment.

At December 31, 2015 and December 31, 2014, the Bank had no outstanding commitments to disburse additional funds on loans classified as TDRs.

There were no loan modifications classified as TDRs within the last twelve months that defaulted (90 days past due) during the twelve months ended December 31, 2015 and 2014.