2.	SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The

consolidated financial statements include the accounts of Bancshares, the Bank and its wholly-owned subsidiaries (collectively, the “Company”) and

one

variable interest entity (“VIE”). All significant intercompany balances and transactions have been eliminated. The Company consolidates an entity if the Company has a controlling financial interest in the entity. VIEs are consolidated if the Company has the power to direct the significant economic activities of the VIE that impact financial performance and has the obligation to absorb losses or the right to receive benefits that could potentially be significant (i.e., the Company is the primary beneficiary). The assessment of whether or

not

the Company is the primary beneficiary of a VIE is performed on an ongoing basis. See Note

“Investment in Limited Partnership,” for further discussion of the consolidated VIE.

Use of Estimates

The accounting principles and reporting policies of the Company, and the methods of applying these principles, conform with accounting p

rinciples generally accepted in the United States of America (“U.S. GAAP”) and with general practices within the financial services industry. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated balance sheets and revenues and expenses for the period included in the consolidated statements of operations and of cash flows. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant changes in the near term relate to the accounting for the allowance for loan losses, the value of other real estate owned (“

OREO”) and certain collateral-dependent loans, and deferred tax asset valuation. In connection with the determination of the allowance for loan losses and OREO, management generally obtains independent appraisals for significant properties, evaluates the overall portfolio characteristics and delinquencies and monitors economic conditions.

A substantial portion of the Company

’s loans are secured by real estate in its primary market areas. Accordingly, the ultimate collectability of a substantial portion of the Company’s loan portfolio and the recovery of a portion of the carrying amount of foreclosed real estate are susceptible to changes in economic conditions in the Company’s primary market areas.

Cash and Cash Equivalents

For purpos

es of reporting cash flows, cash and cash equivalents include cash on hand, instruments with an original maturity of less than

days from issuance and amounts due from banks.

Supplemental disclosures of cash flow information and non-cash transactions related to cash flows for the years ended

December

31,

2017

and

2016

are as follows:

	2017		2016
	(Dollars in Thousands)
Cash paid during the period for:
Interest	$	2,566	$	2,210
Income taxes		127		105
Non-cash transactions:
Assets acquired in settlement of loans		773		1,289
Reissuance of treasury stock as compensation		350		53

Revenue Recognition

The main source of revenue for the Company is interest revenue, which is recognized on an accrual basis and calculated through the use of non-discretionary formulas based on written

contracts, such as loan agreements or securities contracts. Loan origination fees are amortized into interest income over the term of the loan. Other types of non-interest revenue, such as service charges on deposits, are accrued and recognized into income as services are provided and the amount of fees earned is reasonably determinable.

Reinsurance Activities

The Company assumes insurance risk related to credit life and credit accident and health insurance written by a non-affiliated insurance company for its customers that choose such coverage through a quota share reinsurance agreement. Assumed premiums on c

redit life insurance are deferred and earned over the period of insurance coverage using either a pro rata method or the effective yield method, depending on whether the amount of insurance coverage generally remains level or declines. Assumed premiums for accident and health policies are earned on an average of the pro rata and the effective yield methods.

Other liabilities include reserves for incurred but unpaid credit insurance claims for policies assumed under the quota share reinsurance agreement. Thes

e insurance liabilities are based on acceptable actuarial methods. Such liabilities are necessarily based on estimates, and, while management believes that the amount is adequate, the ultimate liability

may

be in excess of or less than the amounts provided. The methods for making such estimates and for establishing the resulting liabilities are continually reviewed, and any adjustments are reflected in earnings currently.

Investment Securities

Securities

may

be held in

one

three

portfolios: trading account secu

rities, securities held-to-maturity or securities available-for-sale. Trading account securities are carried at estimated fair value, with unrealized gains and losses included in operations. The Company held

trading account securities as of

December

31,

2017

2016.

Investment securities held-to-maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts. With regard to investment securities held-to-maturity, management has the intent and the Bank has the ability to hold such securities until maturity. Investment securities available-for-sale are carried at fair value, with any unrealized gains or losses excluded from operations and reflected, net of tax, as a separate component of shareholders’ equity in accumulated other comprehensive income or loss. Investment securities available-for-sale are so classified because management

may

decide to sell certain securities prior to maturity for liquidity, tax planning or other valid business purposes. When the fair value of a security falls below carrying value, an evaluation must be made to determine whether the unrealized loss is a temporary or other-than-temporary impairment. Impaired securities that are

not

deemed to be temporarily impaired are written down by a charge to operations to the extent that the impairment is related to credit losses. The amount of impairment related to other factors is recognized in other comprehensive income or loss. The Company uses a systematic methodology to evaluate potential impairment of its investments that considers, among other things, the magnitude and duration of the decline in fair value, the financial health and business outlook of the issuer and the Company’s ability and intent to hold the investment until such time as the security recovers its fair value.

Interest earned on investment securities available-for-sale is included in interest income. Amortization of premiums and discounts on investment securities is determined by the interest method and included in interest income. Gains and l

osses on the sale of investment securities available-for-sale, computed principally on the specific identification method, are shown separately in non-interest income.

Derivatives and Hedging Activities

As part of the Company

’s overall interest rate risk management, the Company

may

use derivative instruments, which can include interest rate swaps, caps and floors.

Accounting Standards Codification (“ASC”) Topic

815,

Derivatives and Hedging,

requires all derivative instruments to be carried at fair value on the consolidated balance sheets. ASC Topic

815

provides special accounting provisions for derivative instruments that qualify for hedge accounting. To be eligible, the Company must specifically identify a derivative as a hedging instrument and identify the risk being hedged. The derivative instrument must be shown to meet specific requirements under ASC Topic

815.

Loans and Interest Income

Loans a

re reported at principal amounts outstanding, adjusted for unearned income, net deferred loan origination fees and costs, purchase premiums and discounts, write-downs and the allowance for loan losses. Loan origination fees, net of certain deferred origination costs, and purchase premiums and discounts are recognized as an adjustment to the yield of the related loans, on an effective yield basis.

Interest on all loans is accrued and credited to income based on the principal amount outstanding.

The accrual of in

terest on loans is discontinued when, in the opinion of management, there is an indication that the borrower

may

be unable to make payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed against current income unless the collateral for the loan is sufficient to cover the accrued interest. Interest received on non-accrual loans generally is either applied against principal or reported as interest income, according to management’s judgment as to the collectability of principal. The policy for interest recognition on impaired loans is consistent with the non-accrual interest recognition policy. Generally, loans are restored to accrual status when the obligation is brought current and the borrower has performed in accordance with the contractual terms for a reasonable period of time and the ultimate collectability of the total contractual principal and interest is

longer in doubt.

Allowance for Loan Losses

The allowance for loan losses is determined based on various compo

nents for individually impaired loans and for homogeneous pools of loans. The allowance for loan losses is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries by portfolio segment. The methodology for determining charge-offs is consistently applied to each segment. The allowance for loan losses is maintained at a level that, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, and changes in its risk profile, credit concentrations, historical trends and economic conditions. This evaluation also considers the balance of impaired loans. Losses on individually identified impaired loans are measured based on the present value of expected future cash flows, discounted at each loan’s original effective market interest rate. As a practical expedient, impairment

may

be measured based on the loan’s observable market price or the fair value of the collateral if the loan is collateral-dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through the provision added to the allowance for loan losses. One-to-

four

family residential mortgages and consumer installment loans are subjected to a collective evaluation for impairment, considering delinquency and repossession statistics, loss experience and other factors. Though management believes the allowance for loan losses to be adequate, ultimate losses

may

vary from estimates. However, estimates are reviewed periodically, and, as adjustments become necessary, they are reported in earnings during periods in which they become known.

Premises and Equipment

Premises and equipment are carried at cost less accumulated depreciation, and amortization is computed principally by the straight-line method over the estimated useful lives of the assets or the expected lea

se terms for leasehold improvements, whichever is shorter. Useful lives for all premises and equipment range from

three

forty

years.

Other Real Estate Owned (OREO)

Other real estate consists of properties acquired through a foreclosure proceeding or acceptance of a deed in lieu of foreclosure. These properties are carried at the lower of cost or fair value based on appraised value, less estimated selling costs. Loss

es arising from the acquisition of properties are charged against the allowance for loan losses. Gains or losses realized upon the sale of OREO and additional losses related to subsequent valuation adjustments are determined on a specific property basis and are included as a component of non-interest expense along with carrying costs.

Income Taxes

The Company accounts for income taxes on the accrua

l basis through the use of the asset and liability method. Under the asset and liability method, deferred taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the consolidated financial statement carrying amounts and the basis of existing assets and liabilities. Deferred tax assets are also recorded for any tax attributes, such as tax credit and net operating loss carryforwards. The net balance of deferred tax assets and liabilities is reported in other assets in the consolidated balance sheets. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. See “Income Taxes” included in Note

for a discussion of the impact of recent federal tax legislation.

The Company evaluates the r

ealization of deferred tax assets based on all positive and negative evidence available at the balance sheet date. Realization of deferred tax assets is based on the Company’s judgments about relevant factors affecting realization, including taxable income within any applicable carryback periods, future projected taxable income, reversal of taxable temporary differences and other tax planning strategies to maximize realization of deferred tax assets. A valuation allowance is recorded for any deferred tax assets that are

not

“more likely than

not”

to be realized.

A tax position is recognized as a benefit only if it is “

more likely than

not”

that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit for which there is a greater than

50%

likelihood that such amount would be realized upon examination. For tax positions

not

meeting the “more likely than

not”

test,

tax benefit is recorded. The Company recognizes interest expense, interest income and penalties related to unrecognized tax benefits within current income tax expense.

Treasury Stock

Treasury stock purchases and sales are accounted for using the cost method.

Advertising Costs

Advertising costs f

or promoting the Company are minimal and expensed as incurred.

Segment Reporting

Management has identified

two

reportable operating segments of Bancshares: the Bank and ALC. The reportable segments were determined based on the internal management

reporting system and comprise Bancshares’ and the Bank’s significant subsidiaries. Segment results include certain overhead allocations and intercompany transactions that were recorded at current market prices. All intercompany transactions were eliminated in the determination of consolidated balances.

Reclassification

Certain amounts in the prior period consolidated financial statements have been reclassified to conform to the

2017

presentation.

Net Income Per Share and Comprehensive Income

Basic net income per share is

computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Included in basic shares are certain shares that have been accrued as of the balance sheet date as deferred compensation for members of Bancshares’ Board of Directors. Diluted net income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period, adjusted for the effect of potentially dilutive stock awards outstanding during the period. The dilutive shares consist of nonqualified stock option grants issued to employees and members of Bancshares’ Board of Directors pursuant to Bancshares

’

2013

Incentive Plan (the

“2013

Incentive Plan”) previously approved by Bancshares’ shareholders. The following table reflects weighted average shares used to calculate basic and diluted net income per share for the years ended

December 31, 2017

and

2016.

	Year Ended December 31,
	2017		2016
Basic shares		6,173,450		6,149,192
Dilutive shares		318,001		272,550
Diluted shares		6,491,451		6,421,742

	Year Ended December 31,
	2017		2016
	(Dollars in Thousands, Except Per Share Data)
Net income	$	(411)	$	1,224
Basic net income per share	$	(0.07)	$	0.20
Diluted net income per share	$	(0.06)	$	0.19

February 12, 2018,

the Company granted awards of nonqualified stock options to purchase a total of

62,150

shares of common stock

and restricted stock awards with respect to

5,520

shares of common stock to certain management employees and members of the Board of Directors. The shares underlying these awards are dilutive; however, since they were granted subsequent to

December 31, 2017,

they are

not

included in dilutive shares in the table above.

Comprehensive income consists of net income, as well as unrealized holding gains and losses that arise during the period associated with the Company’s available-for-sale securities portfolio and the effective portion of cash flow hedge derivatives. In the calculation of comprehensive income, reclassification adjustments are made for gains or losses realized in the statement of operations associated with the sale of available-for-sale securities or changes in the fair value of cash flow derivatives.

Acc

ounting Policies Recently Adopted and Pending Accounting Pronouncements

Accounting Standards Update (“

ASU”)

2018

02,

“Income Statement

– Reporting Comprehensive Income (Topic

220

).”

Issued in

February 2018,

ASU

2018

allows reclassification from accumulated other comprehensive income to retained earnings the stranded tax effects resulting from the Tax Cuts and Jobs Act of

2017.

As permitted by the ASU, the Company early adopted the amendments in the ASU as of

December 31, 2017.

As a result of the early adoption, deferred taxes within accumulated other comprehensive income of

$136

thousand were reclassified to retained earnings.

ASU

2016

13,

"Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments.”

Issued in

June 2016,

ASU

2016

removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all current recognition thresholds and will require companies to recognize an allowance for lifetime expected credit losses. Credit losses will be immediately recognized through net income; the amount recognized will be based on the current estimate of contractual cash flows

not

expected to be collected over the financial asset’s contractual term. ASU

2016

also amends the credit loss measurement guidance for available-for-sale debt securities. For public business entities, ASU

2016

is effective for financial statements issued for fiscal years and for interim periods within those fiscal years beginning after

December 15, 2019.

Institutions will be required to apply the changes through a cumulative-effect adjustment to their retained earnings as of the beginning of the

first

reporting period in which the guidance is effective. Management is currently evaluating the impact that this ASU will have on the Company’s consolidated financial statements. The Company expects the allowance for credit losses to increase upon adoption, with a corresponding adjustment to retained earnings.

ASU

2016

09,

“

Compensation-Stock Compensation (Topic

718

)-Improvements to Employee Share-Based Payment Accounting.”

Issued in

March 2016,

ASU

2016

seeks to reduce complexity in accounting standards by simplifying several aspects of the accounting for share-based payment transactions, including (

) accounting for income taxes; (

) classification of excess tax benefits on the statement of cash flows; (

) forfeitures; (

) minimum statutory tax withholding requirements; (

) classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax withholding purposes; (

) the practical expedient for estimating the expected term; and (

) intrinsic value. ASU

2016

became effective for the Company on

January 1, 2017.

The adoption of ASU

2016

did

not

have a material impact on the Company’s consolidated financial statements.

ASU

2016

05,

“Derivatives and Hedging (Topic

815

): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships.”

Issued in

March 2016,

ASU

2016

clarifies that a change in the counterparty to a derivative instrument that has been designated as a hedging instrument under ASC Topic

815

does

not,

in and of itself, require de-designation of that hedging relationship, provided that all other hedge accounting criteria continue to be met. ASU

2016

became effective for the Company on

January 1, 2017.

The adoption of ASU

2016

did

not

have a material impact on the Company’s consolidated financial statements.

ASU

2016

02,

“Leases (Topic

842

).”

Issued in

February 2016,

ASU

2016

was issued by the FASB to increase transparency and comparability among organizations by recognizing lease assets and liabilities on the balance sheet and by disclosing key information about leasing arrangements. ASU

2016

will require organizations that lease assets (lessees) to recognize on the balance sheet the assets and liabilities for the rights and obligations created by the lease for all operating leases under current U.S. GAAP with a term of more than

months. The recognition, measurement and presentation of expenses and cash flows arising from a lease are

not

significantly changed under ASU

2016

02,

and there will continue to be differentiation between finance leases and operating leases. The accounting applied by the lessor in a lease transaction remains largely unchanged from previous U.S. GAAP. ASU

2016

is effective for fiscal years beginning after

December 15,

2018.

Management is currently evaluating the impact that this ASU will have on the Company’s consolidated financial statements.

ASU

2016

01,

“

Financial Instruments-Overall (Subtopic

825

): Recognition and Measurement of Financial Assets and Financial Liabilities (An Amendment of FASB ASC

825

).”

Issued in

January 2016,

ASU

2016

is intended to enhance the reporting model for financial instruments to provide users of financial statements with improved decision-making information. The amendments of ASU

2016

include: (

) requiring equity investments, except those accounted for under the equity method of accounting or those that result in the consolidation of an investee, to be measured at fair value, with changes in fair value recognized in net income; (

) requiring a qualitative assessment to identify impairment of equity investments without readily determinable fair values; and (

) clarifying that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. The amendments of ASU

2016

are effective for interim and annual periods beginning after

December 15, 2017.

Management has determined that the adoption of this ASU will

not

materiality impact the Company’s consolidated financial statements.

ASU

2014

09,

“

Revenue from Contracts with Customers (Topic

606

).”

Issued in

May 2014,

ASU

2014

will add

FASB ASC Topic

606,

Revenue from Contracts with Customers,

and will supersede revenue recognition requirements in

FASB ASC Topic

605,

Revenue Recognition,

and certain cost guidance in

FASB ASC Topic

605

35,

Revenue Recognition – Construction-Type and Production-Type Contracts.

ASU

2014

requires an entity to recognize revenue when (or as) an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled. Depending on whether certain criteria are met, revenue should be recognized either over time, in a manner that depicts the entity’s performance, or at a point in time, when control of the goods or services is transferred to the customer.

ASU

2015

14,

“Revenue from Contracts with Customers (Topic

606

)-Deferral of the Effective Date,

”

issued in

August 2015,

defers the effective date of ASU

2014

one

year. ASU

2015

provides that the amendments of ASU

2014

become effective for interim and annual periods beginning after

December 15, 2017.

Management is currently evaluating the impact that this ASU will have on the Company’s consolidated financial statements, as well as the most appropriate method of application. However, because this guidance does

not

apply to revenue associated with financial instruments, including loans and securities accounted for under other U.S. GAAP, the adoption of ASU

2014

not

expected to have a material impact on the Company’s consolidated financial statements. Further, management has determined that the adoption of this ASU for revenue streams reported within non-interest income that are within the scope of the accounting standard will

not

materially impact the Company’s consolidated financial statements.