The Consolidated Financial Statements and related footnotes of the Company are presented below followed by the financial statements of the Parent.
Notes to Consolidated Financial Statements
Note 1. Nature of Banking Activities and Significant Accounting Policies
First National Corporation (the Company) is the bank holding company of First Bank (the Bank). The Company also owns First National (VA) Statutory Trust II (Trust II), and First National (VA) Statutory Trust III (Trust III and, together with Trust II, the Trusts). The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities and are not included in the Company’s consolidated financial statements in accordance with authoritative accounting guidance because management has determined that the Trusts qualify as variable interest entities. The Bank owns First Bank Financial Services, Inc., which invests in entities that provide title insurance and investment services. The Bank owns Shen-Valley Land Holdings, LLC and ESF, LLC which were formed to hold other real estate owned and future office sites. First Bank also owns Bank of Fincastle Services, Inc. which owns an entity that provides mortgage services. The Bank offers loan, deposit, and wealth management products and services in the Shenandoah Valley, central regions of Virginia, Roanoke Valley, and the city of Richmond. Loan products and services include consumer loans, residential mortgages, home equity loans, and commercial loans. Deposit products and services include checking accounts, treasury management solutions, savings accounts, money market accounts, certificates of deposit, and individual retirement accounts. Wealth management services include estate planning, investment management of assets, trustee under an agreement, trustee under a will, individual retirement accounts, and estate settlement. The Bank offers other services, including internet banking, mobile banking, remote deposit capture, and other traditional banking services.
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to accepted practices within the banking industry.
Principles of Consolidation
The consolidated financial statements of First National Corporation include the accounts of all six companies. All material intercompany balances and transactions have been eliminated in consolidation, except for balances and transactions related to the Trusts. The subordinated debt of these Trusts is reflected as a liability of the Company.
Use of Estimates
In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that require the most subjective or complex judgments relate to the allowance for loan losses, loans acquired in a business combination, and goodwill.
Significant Group Concentrations of Credit Risk
Most of the Company’s activities are with customers located within the Shenandoah Valley, central regions of Virginia, and the Richmond and Roanoke market areas. The types of lending that the Company engages in are included in Note 3. The Company has a concentration of credit risk in commercial real estate, but does not have a significant concentration to any one customer or industry.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, the Company has defined cash equivalents as those amounts included in the balance sheet captions “Cash and due from banks” and “Interest-bearing deposits in banks.”
Securities
Investments in debt securities with readily determinable fair values are classified as either held to maturity (HTM), available for sale (AFS), or trading based on management’s intent. Currently, all of the Company’s debt securities are classified as either AFS or HTM. Equity investments in the FHLB, the Federal Reserve Bank of Richmond, and Community Bankers Bank are separately classified as restricted securities and are carried at cost. AFS securities are carried at estimated fair value with the corresponding unrealized gains and losses excluded from earnings and reported in other comprehensive income (loss), and HTM securities are carried at amortized cost. When an individual AFS security is sold, the Company releases the income tax effects associated with the AFS security from accumulated other comprehensive income (loss). Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Gains or losses on the sale of securities are recorded on the trade date using the amortized cost of the specific security sold.
Transfers of debt securities into the held to maturity classification from the available for sale classification are made at fair value on the date of transfer. The unrealized holding gain or loss on the date of the transfer is reported in accumulated other comprehensive loss and in the carrying value of the held to maturity securities. Such amounts are amortized over the remaining contractual lives of the securities. The net impact to income from the amortization and accretion of the unrealized loss at date of transfer is zero.
Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either the Company (1) intends to sell the security or (2) it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-than-likely that it will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income (loss).
Equity securities with readily determinable fair values are carried at fair value, with changes in fair value reported in net income. Any equity securities without readily determinable fair values are carried at cost, minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments. Restricted equity securities are carried at cost and are periodically evaluated for impairment based on the ultimate recovery of par value. The entirety of any impairment on equity securities is recognized in earnings.
The Company regularly reviews each security for other-than-temporary impairment based on criteria that include the extent to which cost exceeds market price, the duration of that market decline, the financial health of and specific prospects for the issuer, the best estimate of the present value of cash flows expected to be collected from debt securities, the Company’s intention with regard to holding the security to maturity, and the likelihood that the Company would be required to sell the security before recovery.
Loans Held for Sale
Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or estimated fair value. The Company, through its banking subsidiary, requires a firm purchase commitment from a permanent investor before loans held for sale can be closed, thus limiting interest rate risk. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.
The Bank enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 60 days. The Bank protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Bank commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. As a result, the Bank is not exposed to losses nor will it realize significant gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitments and the best efforts contracts is very high due to their similarity.
The market value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. The Bank determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments.
Loans
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 commercial buildings, 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, office and retail buildings, industrial and warehouse buildings, hotels, and religious facilities.
Commercial and Industrial Loans: Commercial loans may be unsecured or secured with non-real estate commercial property. The Company's banking subsidiary makes commercial loans to businesses located within its market area and also to businesses outside of its market area through loan participations with other financial institutions. Loans originated under the SBA's PPP are also included in this loan class.
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. The Company's banking subsidiary makes consumer loans to individuals located within its market area and also to individuals outside of its market through the purchase of loans from another financial institution.
A substantial portion of the loan portfolio is represented by residential and commercial loans secured by real estate throughout the Bank's market area. 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. Interest income includes amortization of purchase premiums and discounts, recognized evenly over the life of the loans.
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. 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. When a loan is returned to accrual status, interest income is recognized based on the new effective yield to maturity of the loan.
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.
Loans Acquired in a Business Combination
Acquired loans are classified as either (i) purchased credit-impaired (PCI) loans or (ii) purchased performing loans and are recorded at fair value on the date of acquisition. PCI loans are those for which there is evidence of credit deterioration since origination and for which it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. When determining fair value, PCI loans are aggregated into pools of loans based on common risk characteristics as of the date of acquisition such as loan type, date of origination, and evidence of credit quality deterioration such as internal risk grades and past due and nonaccrual status. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the “nonaccretable difference.” Any excess of cash flows expected at acquisition over the estimated fair value is referred to as the “accretable yield” and is recognized as interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows. There were no acquired loans classified as PCI in the acquisition of Fincastle and the SmartBank loan portfolio acquisition during the third quarter of 2021.
Purchased performing loans are those for which there is no evidence of credit deterioration and it is probable at the date of acquisition that the Company will collect all contractually required principal and interest payments. When determining fair value, purchased performing loans are evaluated individually on the date of the acquisition. Premiums or discounts recorded on the acquired loans are amortized or accreted into income evenly over the life of the loans through interest and fees on loans. The Company calculates required allowance for loan losses for each of the acquired loans quarterly. Provision for loan losses is recorded for the purchased performing loans for the amount of the required allowance for loan losses that exceeds any unaccreted discount. All loans acquired from Fincastle and SmartBank in the third quarter of 2021 were considered purchased performing loans.
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.
Troubled Debt Restructurings (TDR)
In situations where, for economic or legal reasons related to a borrower’s financial condition, management grants 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 $101 thousand and $1.6 million in loans classified as TDRs as of December 31, 2022 and 2021, respectively.
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.
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 Company 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 the Company's primary credit quality indicator. The Company 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 creditworthiness of the borrower and changes in the value of the collateral. |
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| • | 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. |
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| • | Other real estate 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. |
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| • | Commercial and industrial loans carry risks associated with the successful operation of a business because repayment of these loans may be dependent upon the profitability and cash flows of the business. 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. |
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| • | Consumer and other loans carry risk associated with the continued creditworthiness of the borrower and the value of the collateral, if any. These loans are typically either unsecured or secured by rapidly depreciating assets such as automobiles. They are also likely to be immediately and adversely affected by job loss, divorce, illness, personal bankruptcy, or other changes in circumstances. Consumer and other loans also include purchased consumer loans which could have been originated outside of the Company's market area. |
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, fair value of collateral less estimated costs to sell, or observable market price of the 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 typically 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.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Premises and equipment are depreciated over their estimated useful lives ranging from three years to forty years; leasehold improvements are amortized over the lives of the respective leases or the estimated useful life of the leasehold improvement, whichever is less. Software is amortized over its estimated useful life ranging from three to seven years. Depreciation and amortization are recorded on the straight-line method.
Costs of maintenance and repairs are charged to expense as incurred. Costs of replacing structural parts of major units are considered individually and are expensed or capitalized as the facts dictate. Gains and losses on routine dispositions are reflected in current operations.
Other Real Estate Owned
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 operations or expansion but no longer intended to be used for that purpose. OREO is initially recorded at fair value less estimated costs to sell to establish a new cost basis. OREO is subsequently 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 owned, 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 owned. Management reviews the value of other real estate owned each quarter, if any, and adjusts the values as appropriate. Revenue and expenses from operations and changes in the valuation allowance are included in other real estate owned expense.
Bank-Owned Life Insurance
The Company owns insurance on the lives of a certain group of key employees. The policies were purchased to help offset the increase in the costs of various fringe benefit plans, including healthcare. The cash surrender value of these policies is included as an asset on the consolidated balance sheets, and any increase in cash surrender value is recorded as income from bank owned life insurance on the consolidated statements of income. In the event of the death of an insured individual under these policies, the Company receives a death benefit which is also recorded as income from bank owned life insurance. The Company is exposed to credit risk to the extent an insurance company is unable to fulfill its financial obligations under a policy.
Goodwill and Other Intangible Assets
Goodwill arises from business combinations and is determined as the excess fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually or more frequently if events and circumstances exist that indicate that a goodwill impairment test should be performed. The Company has selected June 30 as the date to perform the annual impairment test. Intangible assets with finite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the balance sheet. The Company recorded goodwill as a result of the acquisition of the Bank of Fincastle and SmartBank in 2021.
Other intangible assets consist of core deposit intangible assets arising from whole bank and branch acquisitions and are amortized on an accelerated method over their estimated useful lives, which range from 6 to 10 years.
Derivative Financial Instruments
The Company recognizes derivative financial instruments at fair value as either an other asset or other liability in its Consolidated Balance Sheets. The Company’s derivative financial instruments are comprised of interest rate swaps that qualify and are designated as cash flow hedges on the Company’s junior subordinated debt. Gains or losses on the Company’s cash flow hedges are reported as a component of other comprehensive income, net of deferred income taxes, and reclassified into earnings in the same period(s) during which the hedged transactions affect earnings. The Company’s derivative financial instruments are described more fully in Note 24.
Stock Based Compensation
Compensation cost is recognized for restricted stock units and other stock awards issued to employees and directors based on the fair value of the awards at the date of grant. The market price of the Company’s common stock at the date of grant is used to estimate the fair value of restricted stock units and other stock awards.
Retirement Plans
Employee 401(k) and profit sharing plan expense is the amount of matching contributions and Bank discretionary matches.
Transfers of Financial Assets
Transfers of financial assets, including loan participations, are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before maturity.
Income Taxes
Deferred income tax assets and liabilities are determined using the asset and liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Deferred taxes are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying consolidated balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. There was no liability for unrecognized tax benefits recorded as of December 31, 2022 and 2021. Interest and penalties associated with unrecognized tax benefits, if any, are classified as additional income taxes in the consolidated statements of income.
Wealth Management Department
Securities and other property held by the wealth management department in a fiduciary or agency capacity are not assets of the Company and are not included in the accompanying consolidated financial statements.
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 reflect 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. Potential common shares that may be issued by the Company relate to restricted stock units and are determined using the treasury method. See Note 14 for further information regarding earnings per common share.
Advertising Costs
The Company follows the policy of charging the production costs of advertising to expense as incurred. Total advertising expense incurred for 2022 and 2021 was $455 thousand and $487 thousand, respectively.
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains, and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities and changes in fair values of cash flow hedges, are reported as a separate component of the equity section of the consolidated balance sheets, such items, along with net income, are components of comprehensive income (loss).
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the consolidated financial statements.
Business Combinations
On July 1, 2021, the Company completed the acquisition of The Bank of Fincastle (Fincastle) for an aggregate purchase price of $33.8 million of cash and stock. On September 30, 2021, the Bank acquired $82.0 million of loans and certain fixed assets from SmartBank related to their Richmond area branch. The Bank purchased the fixed assets for an amount equal to SmartBank’s book value. Additional information about these acquisitions is presented in Note 25.
Recent Accounting Pronouncements
In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”. The ASU, as amended, requires an entity to measure expected credit losses for financial assets carried at amortized cost based on historical experience, current conditions, and reasonable and supportable forecasts. Among other things, the ASU also amended the impairment model for available for sale securities and addressed purchased financial assets with deterioration. The Company adopted ASU 2016-13 as of January 1, 2023 in accordance with the required implementation date and recorded the impact of adoption to retained earnings of $1.6 million, which was net of deferred income taxes, as required by the standard. The adjustment recorded at adoption consisted of adjustments to the allowance for credit losses on loans and securities held to maturity, as well as an adjustment to the Company’s reserve for unfunded loan commitments. Subsequent to adoption, the Company will record adjustments to its allowances for credit losses and reserves for unfunded commitments through the provision for credit losses in the consolidated statements of income.
The Company is utilizing a third-party model to tabulate its estimate of current expected credit losses, using a discounted cash flow methodology. In accordance with ASC 326, the Company has segmented its loan portfolio based on similar risk characteristics which included commercial and industrial loans, commercial real estate loans, residential real estate loans, and consumer loans. The Company primarily utilizes historical losses from peer companies and economic projections for its reasonable and supportable forecasting of current expected credit losses. To further adjust the allowance for credit losses for expected losses not already included within the quantitative component of the calculation, the Company considers qualitative adjustment factors, which include changes in international, national, regional and local economic factors, changes in the nature and volume of the loan portfolio, changes in the volume and severity of past due loans, and changes in the value of underlying collateral for collateral dependent loans. The Company’s CECL implementation process was overseen by the CECL committee and included an assessment of data availability and gap analysis, data collection, consideration and analysis of multiple loss estimation methodologies, an assessment of relevant qualitative factors and correlation analysis of multiple potential loss drivers and their impact on the Company’s historical loss experience. During 2022, the Company calculated its current expected credit losses model in parallel to its incurred loss model in order to further refine the methodology and model. In addition, the Company engaged a third-party to perform a comprehensive model validation.
Effective November 25, 2019, the SEC adopted Staff Accounting Bulletin (SAB) 119. SAB 119 updated portions of SEC interpretative guidance to align with FASB ASC 326, “Financial Instruments – Credit Losses.” It covers topics including (1) measuring current expected credit losses; (2) development, governance, and documentation of a systematic methodology; (3) documenting the results of a systematic methodology; and (4) validating a systematic methodology.
In March 2020, the FASB issued ASU No. 2020-04, “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting” (ASU 2020-04). These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022. Subsequently, in January 2021, the FASB issued ASU No. 2021-01 “Reference Rate Reform (Topic 848): Scope” (ASU 2021-01). This ASU clarifies that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in Topic 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply ASU 2021-01 on contract modifications that change the interest rate used for margining, discounting, or contract price alignment retrospectively as of any date from the beginning of the interim period that includes March 12, 2020, or prospectively to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued. An entity may elect to apply ASU 2021-01 to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020. The Company has identified loans and other financial instruments that are directly or indirectly influenced by LIBOR and plans to modify these financial instruments prior to June 30, 2023. The Company does not expect the modification of the financial instruments to have a material impact on the Company's consolidated financial statements.
In December 2022, the FASB issued ASU 2022-06, “Reference Rate Reform (Topic 848): Deferral of the Sunset Date of Topic 848”. ASU 2022-06 extends the period of time preparers can utilize the reference rate reform relief guidance in Topic 848. The objective of the guidance in Topic 848 is to provide relief during the temporary transition period, so the FASB included a sunset provision within Topic 848 based on expectations of when the London Interbank Offered Rate (LIBOR) would cease being published. In 2021, the UK Financial Conduct Authority (FCA) delayed the intended cessation date of certain tenors of USD LIBOR to June 30, 2023. To ensure the relief in Topic 848 covers the period of time during which a significant number of modifications may take place, the ASU defers the sunset date of Topic 848 from December 31, 2022, to December 31, 2024, after which entities will no longer be permitted to apply the relief in Topic 848. The ASU is effective for all entities upon issuance. The Company is assessing ASU 2022-06 and its impact on the Company’s transition away from LIBOR for its loan and other financial instruments.
Note 2. Securities
The Company invests in U.S. Treasury securities, U.S. agency and mortgage-backed securities, obligations of states and political subdivisions, and corporate debt securities. Amortized costs and fair values of securities at December 31, 2022 and 2021 were as follows (in thousands):
| | 2022 | |
| | Amortized Cost | | | Gross Unrealized Gains | | | Gross Unrealized (Losses) | | | Fair Value | |
Securities available for sale: | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 12,469 | | | $ | — | | | $ | (1,239 | ) | | $ | 11,229 | |
U.S. agency and mortgage-backed securities | | | 109,971 | | | | 95 | | | | (13,149 | ) | | | 96,918 | |
Obligations of states and political subdivisions | | | 64,386 | | | | 4 | | | | (9,630 | ) | | | 54,760 | |
Total securities available for sale | | $ | 186,826 | | | $ | 99 | | | $ | (24,018 | ) | | $ | 162,907 | |
Securities held to maturity: | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 38,211 | | | $ | — | | | $ | (568 | ) | | $ | 37,643 | |
U.S. agency and mortgage-backed securities | | | 99,374 | | | | — | | | | (9,189 | ) | | | 90,185 | |
Obligations of states and political subdivisions | | | 12,573 | | | | — | | | | (1,252 | ) | | | 11,321 | |
Corporate debt securities | | | 3,000 | | | | — | | | | (352 | ) | | | 2,648 | |
Total securities held to maturity | | $ | 153,158 | | | $ | — | | | $ | (11,361 | ) | | $ | 141,797 | |
Total securities | | $ | 339,984 | | | $ | 99 | | | $ | (35,379 | ) | | $ | 304,704 | |
| | 2021 | |
| | Amortized Cost | | | Gross Unrealized Gains | | | Gross Unrealized (Losses) | | | Fair Value | |
Securities available for sale: | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 39,871 | | | $ | 37 | | | $ | (250 | ) | | $ | 39,658 | |
U.S. agency and mortgage-backed securities | | | 177,131 | | | | 1,085 | | | | (1,837 | ) | | | 176,379 | |
Obligations of states and political subdivisions | | | 71,037 | | | | 910 | | | | (509 | ) | | | 71,438 | |
Corporate debt securities | | | 2,019 | | | | 1 | | | | — | | | | 2,020 | |
Total securities available for sale | | $ | 290,058 | | | $ | 2,033 | | | $ | (2,596 | ) | | $ | 289,495 | |
Securities held to maturity: | | | | | | | | | | | | | | | | |
U.S. agency and mortgage-backed securities | | $ | 26,392 | | | $ | 124 | | | $ | (53 | ) | | $ | 26,463 | |
Obligations of states and political subdivisions | | | 7,049 | | | | 118 | | | | (13 | ) | | | 7,154 | |
Total securities held to maturity | | $ | 33,441 | | | $ | 242 | | | $ | (66 | ) | | $ | 33,617 | |
Total securities | | $ | 323,499 | | | $ | 2,275 | | | $ | (2,662 | ) | | $ | 323,112 | |
At December 31, 2022 and 2021, investments in an unrealized loss position that were temporarily impaired were as follows (in thousands):
| | 2022 | |
| | Less than 12 months | | | 12 months or more | | | Total | |
| | Fair Value | | | Unrealized (Loss) | | | Fair Value | | | Unrealized (Loss) | | | Fair Value | | | Unrealized (Loss) | |
Securities available for sale: | | | | | | | | | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 9,041 | | | $ | (932 | ) | | $ | 2,188 | | | $ | (307 | ) | | $ | 11,229 | | | $ | (1,239 | ) |
U.S. agency and mortgage-backed securities | | | 27,282 | | | | (1,945 | ) | | | 62,342 | | | | (11,204 | ) | | | 89,624 | | | | (13,149 | ) |
Obligations of states and political subdivisions | | | 24,689 | | | | (2,581 | ) | | | 26,362 | | | | (7,049 | ) | | | 51,051 | | | | (9,630 | ) |
Total securities available for sale | | $ | 61,012 | | | $ | (5,458 | ) | | $ | 90,892 | | | $ | (18,560 | ) | | $ | 151,904 | | | $ | (24,018 | ) |
Securities held to maturity: | | | | | | | | | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 19,302 | | | $ | (258 | ) | | $ | 18,342 | | | $ | (310 | ) | | $ | 37,644 | | | $ | (568 | ) |
U.S. agency and mortgage-backed securities | | | 58,019 | | | | (6,848 | ) | | | 32,167 | | | | (2,341 | ) | | | 90,186 | | | | (9,189 | ) |
Obligations of states and political subdivisions | | | 8,648 | | | | (1,008 | ) | | | 2,672 | | | | (244 | ) | | | 11,320 | | | | (1,252 | ) |
Corporate debt securities | | | 2,648 | | | | (352 | ) | | | — | | | | — | | | | 2,648 | | | | (352 | ) |
Total securities held to maturity | | $ | 88,617 | | | $ | (8,466 | ) | | $ | 53,181 | | | $ | (2,895 | ) | | $ | 141,798 | | | $ | (11,361 | ) |
Total securities | | $ | 149,629 | | | $ | (13,924 | ) | | $ | 144,073 | | | $ | (21,455 | ) | | $ | 293,702 | | | $ | (35,379 | ) |
| | 2021 | |
| | Less than 12 months | | | 12 months or more | | | Total | |
| | Fair Value | | | Unrealized (Loss) | | | Fair Value | | | Unrealized (Loss) | | | Fair Value | | | Unrealized (Loss) | |
Securities available for sale: | | | | | | | | | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 29,656 | | | $ | (250 | ) | | $ | — | | | $ | — | | | $ | 29,656 | | | $ | (250 | ) |
U.S. agency and mortgage-backed securities | | | 109,950 | | | | (1,335 | ) | | | 14,749 | | | | (502 | ) | | | 124,699 | | | | (1,837 | ) |
Obligations of states and political subdivisions | | | 34,611 | | | | (500 | ) | | | 1,009 | | | | (9 | ) | | | 35,620 | | | | (509 | ) |
Total securities available for sale | | $ | 174,217 | | | $ | (2,085 | ) | | $ | 15,758 | | | $ | (511 | ) | | $ | 189,975 | | | $ | (2,596 | ) |
Securities held to maturity: | | | | | | | | | | | | | | | | | | | | | | | | |
U.S. agency and mortgage-backed securities | | $ | 5,411 | | | $ | (53 | ) | | $ | — | | | $ | — | | | $ | 5,411 | | | $ | (53 | ) |
Obligations of states and political subdivisions | | | 999 | | | | (13 | ) | | | — | | | | — | | | | 999 | | | | (13 | ) |
Total securities held to maturity | | $ | 6,410 | | | $ | (66 | ) | | $ | — | | | $ | — | | | $ | 6,410 | | | $ | (66 | ) |
Total securities | | $ | 180,627 | | | $ | (2,151 | ) | | $ | 15,758 | | | $ | (511 | ) | | $ | 196,385 | | | $ | (2,662 | ) |
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 December 31, 2022, there were 11 out of 11 U.S. Treasury securities, 126 out of 143 U.S. agency and mortgage-backed securities, 107 out of 116 obligations of states and political subdivisions, and one of one corporate debt securities 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 6.5 years at December 31, 2022. At December 31, 2021, there were six out of eight U.S. Treasury securities, 58 out of 135 U.S. agency and mortgage-backed securities and 37 out of 118 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, 2021. The weighted- average re-pricing term of the portfolio was 5.2 years at December 31, 2021. The unrealized losses at December 31, 2022 in the U.S. Treasury securities portfolio, U.S. agency and mortgage-backed securities portfolio, obligations of states and political subdivisions portfolio, and corporate debt securities portfolio were related to changes in market interest rates and not credit concerns of the issuers.
The amortized cost and fair value of securities at December 31, 2022 by contractual maturity are shown below (in thousands). Expected maturities of mortgage-backed securities will differ from contractual maturities because borrowers may have the right to prepay obligations with or without call or prepayment penalties.
| | Available for Sale | | | Held to Maturity | |
| | Amortized Cost | | | Fair Value | | | Amortized Cost | | | Fair Value | |
Due within one year | | $ | — | | | $ | — | | | $ | 905 | | | $ | 902 | |
Due after one year through five years | | | 19,801 | | | | 18,483 | | | | 44,441 | | | | 43,455 | |
Due after five years through ten years | | | 39,909 | | | | 36,498 | | | | 27,016 | | | | 24,481 | |
Due after ten years | | | 127,116 | | | | 107,926 | | | | 80,796 | | | | 72,959 | |
| | $ | 186,826 | | | $ | 162,907 | | | $ | 153,158 | | | $ | 141,797 | |
Proceeds from maturities, calls, principal payments, and sales of securities available for sale during 2022 and 2021were $39.1 million and $54.6 million, respectively. Gross losses of $2.0 million were realized on calls and sales during 2022 Gross gains of $37 thousand were realized on calls and sales during 2021,
Proceeds from maturities, calls, and principal payments of securities held to maturity during 2022 and 2021 were $9.3 million and $4.7 million, respectively. There were no sales of securities from the held to maturity portfolio for the years ended December 31, 2022 or 2021. The Company did not realize any gross gains or gross losses on held to maturity securities during 2022 or 2021.
Securities having a fair value of $134.5 million and $83.8 million at December 31, 2022 and 2021 were pledged to secure public deposits and for other purposes required by law.
During the third quarter of 2022, management continued to contemplate the accounting treatment of the Company’s securities portfolio. Given the rapidly rising interest rates, the resulting effects on capital and to better reflect management’s intention to hold certain securities until maturity, management approved the transfer of a portion of the portfolio from the available for sale accounting treatment to the held to maturity accounting treatment. Available for sale securities with a book value of $82.2 million and an associated unrealized loss of $7.8 million were transferred to the held to maturity classification at the fair value of $74.4 million.
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 December 31, 2022, and no impairment has been recognized.
The composition of restricted securities at December 31, 2022 and 2021 was as follows (in thousands):
| | 2022 | | | 2021 | |
Federal Home Loan Bank stock | | $ | 796 | | | $ | 701 | |
Federal Reserve Bank stock | | | 980 | | | | 980 | |
Community Bankers’ Bank stock | | | 132 | | | | 132 | |
| | $ | 1,908 | | | $ | 1,813 | |
The Company also holds limited partnership investments in Small Business Investment Companies (SBICs), which are included in other assets in the Consolidated Balance Sheets. The limited partnership investments are measured as equity investments without readily determinable fair values at their cost, less any impairment. The amounts included in other assets for the limited partnership investments were $599 thousand and $504 thousand at December 31, 2022 and 2021, respectively.
Note 3. Loans
Loans at December 31, 2022 and 2021 are summarized as follows (in thousands):
| | 2022 | | | 2021 | |
Real estate loans: | | | | | | | | |
Construction and land development | | $ | 51,840 | | | $ | 55,721 | |
Secured by 1-4 family residential | | | 331,421 | | | | 291,990 | |
Other real estate | | | 418,456 | | | | 364,921 | |
Commercial and industrial loans | | | 111,225 | | | | 99,805 | |
Consumer and other loans | | | 7,581 | | | | 12,681 | |
Total loans | | $ | 920,523 | | | $ | 825,118 | |
Allowance for loan losses | | | (7,446 | ) | | | (5,710 | ) |
Loans, net | | $ | 913,077 | | | $ | 819,408 | |
Net deferred loan fees included in the above loan categories were $3.2 million and $3.9 million at December 31, 2022 and 2021, respectively. Consumer and other loans included $197 thousand and $175 thousand of demand deposit overdrafts at December 31, 2022 and 2021, respectively.
The following tables provide a summary of loan classes and an aging of past due loans as of December 31, 2022 and 2021 (in thousands):
| | December 31, 2022 | |
| | 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 | | $ | 115 | | | $ | 20 | | | $ | 1,045 | | | $ | 1,180 | | | $ | 50,660 | | | $ | 51,840 | | | $ | 1,045 | | | $ | — | |
1-4 family residential | | | 1,033 | | | | 60 | | | | 207 | | | | 1,300 | | | | 330,121 | | | | 331,421 | | | | 530 | | | | — | |
Other real estate | | | 109 | | | | — | | | | — | | | | 109 | | | | 418,347 | | | | 418,456 | | | | 13 | | | | — | |
Commercial and industrial | | | 31 | | | | 130 | | | | 1,085 | | | | 1,246 | | | | 109,979 | | | | 111,225 | | | | 1,085 | | | | — | |
Consumer and other loans | | | 26 | | | | 25 | | | | — | | | | 51 | | | | 7,530 | | | | 7,581 | | | | — | | | | — | |
Total | | $ | 1,314 | | | $ | 235 | | | $ | 2,337 | | | $ | 3,886 | | | $ | 916,637 | | | $ | 920,523 | | | $ | 2,673 | | | $ | — | |
| | December 31, 2021 | |
| | 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 | | $ | — | | | $ | 115 | | | $ | — | | | $ | 115 | | | $ | 55,606 | | | $ | 55,721 | | | $ | — | | | $ | — | |
1-4 family residential | | | 1,293 | | | | 100 | | | | 372 | | | | 1,765 | | | | 290,225 | | | | 291,990 | | | | 766 | | | | — | |
Other real estate | | | 186 | | | | — | | | | — | | | | 186 | | | | 364,735 | | | | 364,921 | | | | 29 | | | | — | |
Commercial and industrial | | | 1,474 | | | | — | | | | — | | | | 1,474 | | | | 98,331 | | | | 99,805 | | | | 1,509 | | | | — | |
Consumer and other loans | | | 56 | | | | 11 | | | | — | | | | 67 | | | | 12,614 | | | | 12,681 | | | | — | | | | — | |
Total | | $ | 3,009 | | | $ | 226 | | | $ | 372 | | | $ | 3,607 | | | $ | 821,511 | | | $ | 825,118 | | | $ | 2,304 | | | $ | — | |
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.
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 Bank 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 December 31, 2022 and 2021 (in thousands):
| | December 31, 2022 | |
| | Pass | | | Special Mention | | | Substandard | | | Doubtful | | | Total | |
Real estate loans: | | | | | | | | | | | | | | | | | | | | |
Construction and land development | | $ | 50,795 | | | $ | — | | | $ | 1,045 | | | $ | — | | | $ | 51,840 | |
Secured by 1-4 family residential | | | 330,590 | | | | — | | | | 831 | | | | — | | | | 331,421 | |
Other real estate | | | 416,559 | | | | 1,884 | | | | 13 | | | | — | | | | 418,456 | |
Commercial and industrial | | | 110,065 | | | | 75 | | | | 1,085 | | | | — | | | | 111,225 | |
Consumer and other loans | | | 7,581 | | | | — | | | | — | | | | — | | | | 7,581 | |
Total | | $ | 915,590 | | | $ | 1,959 | | | $ | 2,974 | | | $ | — | | | $ | 920,523 | |
| | December 31, 2021 | |
| | Pass | | | Special Mention | | | Substandard | | | Doubtful | | | Total | |
Real estate loans: | | | | | | | | | | | | | | | | | | | | |
Construction and land development | | $ | 55,721 | | | $ | — | | | $ | — | | | $ | — | | | $ | 55,721 | |
Secured by 1-4 family residential | | | 290,909 | | | | — | | | | 1,081 | | | | — | | | | 291,990 | |
Other real estate | | | 364,892 | | | | — | | | | 29 | | | | — | | | | 364,921 | |
Commercial and industrial | | | 97,215 | | | | 1,081 | | | | 1,509 | | | | — | | | | 99,805 | |
Consumer and other loans | | | 12,681 | | | | — | | | | — | | | | — | | | | 12,681 | |
Total | | $ | 821,418 | | | $ | 1,081 | | | $ | 2,619 | | | $ | — | | | $ | 825,118 | |
Loans acquired in business combinations are recorded in the Consolidated Balance Sheets at fair value at the acquisition date under the acquisition method of accounting. The outstanding principal balance and the carrying amount at December 31, 2022 and 2021 of loans acquired in business combinations were as follows:
| | Acquired Loans - Purchased Performing | |
(Dollars in thousands) | | 2022 | | | 2021 | |
Outstanding principal balance | | $ | 187,017 | | | $ | 216,706 | |
| | | | | | | | |
Carrying amount | | | | | | | | |
Real estate loans: | | | | | | | | |
Construction and land development | | $ | 9,823 | | | $ | 26,348 | |
Secured by 1-4 family residential | | | 42,915 | | | | 53,803 | |
Other real estate loans | | | 103,521 | | | | 90,908 | |
Commercial and industrial loans | | | 24,661 | | | | 36,968 | |
Consumer and other loans | | | 3,560 | | | | 5,012 | |
Total acquired loans | | $ | 184,480 | | | $ | 213,039 | |
Note 4. Allowance for Loan Losses
The following tables present, as of December 31, 2022 and 2021, the total allowance for loan losses, the allowance by impairment methodology, and loans by impairment methodology (in thousands).
| | December 31, 2022 | |
| | 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, 2021 | | $ | 345 | | | $ | 1,077 | | | $ | 3,230 | | | $ | 718 | | | $ | 340 | | | $ | 5,710 | |
Charge-offs | | | — | | | | (6 | ) | | | — | | | | (32 | ) | | | (491 | ) | | | (529 | ) |
Recoveries | | | 10 | | | | 19 | | | | 15 | | | | 145 | | | | 226 | | | | 415 | |
Provision for (recovery of) loan losses | | | 191 | | | | 18 | | | | 364 | | | | 1,043 | | | | 234 | | | | 1,850 | |
Ending Balance, December 31, 2022 | | $ | 546 | | | $ | 1,108 | | | $ | 3,609 | | | $ | 1,874 | | | $ | 309 | | | $ | 7,446 | |
Ending Balance: | | | | | | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | | | — | | | | — | | | | — | | | | 888 | | | | — | | | | 888 | |
Collectively evaluated for impairment | | | 546 | | | | 1,108 | | | | 3,609 | | | | 986 | | | | 309 | | | | 6,558 | |
Loans: | | | | | | | | | | | | | | | | | | | | | | | | |
Ending Balance | | | 51,840 | | | | 331,421 | | | | 418,456 | | | | 111,225 | | | | 7,581 | | | | 920,523 | |
Individually evaluated for impairment | | | 1,045 | | | | 530 | | | | 13 | | | | 1,085 | | | | — | | | | 2,673 | |
Collectively evaluated for impairment | | | 50,795 | | | | 330,891 | | | | 418,443 | | | | 110,140 | | | | 7,581 | | | | 917,850 | |
| | December 31, 2021 | |
| | 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, 2020 | | $ | 306 | | | $ | 1,022 | | | $ | 4,956 | | | $ | 784 | | | $ | 417 | | | $ | 7,485 | |
Charge-offs | | | — | | | | (15 | ) | | | (992 | ) | | | (6 | ) | | | (434 | ) | | | (1,447 | ) |
Recoveries | | | 6 | | | | 65 | | | | 3 | | | | 7 | | | | 241 | | | | 322 | |
Provision for (recovery of) loan losses | | | 33 | | | | 5 | | | | (737 | ) | | | (67 | ) | | | 116 | | | | (650 | ) |
Ending Balance, December 31, 2021 | | $ | 345 | | | $ | 1,077 | | | $ | 3,230 | | | $ | 718 | | | $ | 340 | | | $ | 5,710 | |
Ending Balance: | | | | | | | | | | | | | | | | | | | | | | | | |
Individually evaluated for impairment | | | — | | | | — | | | | — | | | | 55 | | | | — | | | | 55 | |
Collectively evaluated for impairment | | | 345 | | | | 1,077 | | | | 3,230 | | | | 663 | | | | 340 | | | | 5,655 | |
Loans: | | | | | | | | | | | | | | | | | | | | | | | | |
Ending Balance | | | 55,721 | | | | 291,990 | | | | 364,921 | | | | 99,805 | | | | 12,681 | | | | 825,118 | |
Individually evaluated for impairment | | | — | | | | 765 | | | | 30 | | | | 1,509 | | | | — | | | | 2,304 | |
Collectively evaluated for impairment | | | 55,721 | | | | 291,225 | | | | 364,891 | | | | 98,296 | | | | 12,681 | | | | 822,814 | |
Impaired loans and the related allowance at December 31, 2022 and 2021, were as follows (in thousands):
| | December 31, 2022 | |
| | 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 | | $ | 2,412 | | | $ | 1,045 | | | $ | — | | | $ | 1,045 | | | $ | — | | | $ | 30 | | | $ | 75 | |
Secured by 1-4 family residential | | | 680 | | | | 530 | | | | — | | | | 530 | | | | — | | | | 580 | | | | 11 | |
Other real estate loans | | | 26 | | | | 13 | | | | — | | | | 13 | | | | — | | | | 22 | | | | — | |
Commercial and industrial | | | 1,084 | | | | — | | | | 1,085 | | | | 1,085 | | | | 888 | | | | 650 | | | | 40 | |
Total | | $ | 4,202 | | | $ | 1,588 | | | $ | 1,085 | | | $ | 2,673 | | | $ | 888 | | | $ | 1,282 | | | $ | 126 | |
| | December 31, 2021 | |
| | 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 | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | 91 | | | $ | — | |
Secured by 1-4 family | | | 889 | | | | 765 | | | | — | | | | 765 | | | | — | | | | 429 | | | | 9 | |
Other real estate loans | | | 40 | | | | 30 | | | | — | | | | 30 | | | | — | | | | 2,384 | | | | — | |
Commercial and industrial | | | 1,673 | | | | — | | | | 1,509 | | | | 1,509 | | | | 55 | | | | 1,613 | | | | — | |
Total | | $ | 2,602 | | | $ | 795 | | | $ | 1,509 | | | $ | 2,304 | | | $ | 55 | | | $ | 4,517 | | | $ | 9 | |
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. Only loan classes with balances are included in the tables above.
As of December 31, 2022, loans classified as TDRs and included in impaired loans in the disclosure above totaled $101 thousand. At December 31, 2022, none of the loans classified as TDRs were performing under the restructured terms and all were considered non-performing assets. There were $1.6 million in TDRs at December 31, 2021, none 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 were no loans modified as TDRs during the year ended December 31, 2022. There was no specific reserve component of the allowance for loan losses relating to the TDRs described above at December 31, 2022. The TDRs described above increased the specific reserve component of the allowance for loan losses by $55 thousand at December 31, 2022.
During the fourth quarter of 2020, the Company modified terms of certain loans for customers that continued to be negatively impacted by the pandemic. The loan modifications lowered borrower loan payments by allowing interest only payments for periods ranging between 6 and 24 months. All loans that were modified resumed original contractual loan payments during the year ended December 31, 2022.
For the years ended December 31, 2022 and 2021, there were no TDRs that subsequently defaulted within twelve months of the loan modification. Management defines default as over 90 days past due or the foreclosure and repossession of the collateral or charge-off of the loan during the twelve month period subsequent to the modification.
There were no non-accrual loans excluded from impaired loan disclosure at December 31, 2022 and December 31, 2021. Had non-accrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income in the amount of $177 thousand and $155 thousand during the years ended December 31, 2022 and 2021, respectively.
Note 5. Other Real Estate Owned
Changes in the balance for OREO during the years ended December 31, 2022 and 2021 are as follows (in thousands):
| | 2022 | | | 2021 | |
Balance at the beginning of year, net | | $ | 1,848 | | | $ | — | |
Transfers from loans to other real estate owned | | | — | | | | 130 | |
Transfers from property and equipment to other real estate owned | | | 184 | | | | — | |
Acquired in merger | | | — | | | | 2,137 | |
Sales proceeds | | | (2,011 | ) | | | (288 | ) |
Gain on disposition | | | 176 | | | | 8 | |
Balance at the end of year, gross | | $ | 197 | | | $ | 1,987 | |
Less: valuation allowance | | | (13 | ) | | | (139 | ) |
Balance at the end of year, net | | $ | 184 | | | $ | 1,848 | |
There were no residential real estate properties included in the ending OREO balances at December 31, 2022 and 2021. The Bank did not have any consumer mortgage loans secured by residential real estate properties for which formal foreclosure proceedings were in process as of December 31, 2022.
The Company acquired $2.1 million of OREO in the acquisition of Fincastle including $1.8 million of real estate and buildings formerly used as bank premises by Fincastle during the year ended December 31, 2021. The Company did not place these properties into service as bank premises and has designated them as held for sale. Net expenses applicable to OREO, other than the valuation allowance and gain on disposition, were $52 and $34 thousand for the years ended December 31, 2022 and 2021, respectively.
Note 6. Premises and Equipment
Premises and equipment are summarized as follows at December 31, 2022 and 2021 (in thousands):
| | 2022 | | | 2021 | |
Land | | $ | 5,412 | | | $ | 5,486 | |
Buildings and leasehold improvements | | | 20,801 | | | | 22,158 | |
Furniture and equipment | | | 8,081 | | | | 8,814 | |
Construction in process | | | 8 | | | | — | |
| | $ | 34,302 | | | $ | 36,458 | |
Less accumulated depreciation | | | 12,426 | | | | 14,055 | |
Premises and equipment, net | | $ | 21,876 | | | $ | 22,403 | |
Depreciation expense included in operating expenses for 2022 and 2021 was $1.5 million and $1.4 million, respectively.
Note 7. Deposits
The aggregate amount of time deposits, in denominations of $250 thousand or more, was $18.8 million and $19.3 million at December 31, 2022 and 2021, respectively.
The Bank obtains certain deposits through the efforts of third-party brokers. At December 31, 2022 and 2021, brokered deposits totaled $556 thousand and $660 thousand, respectively, and were included in time deposits on the Company’s consolidated financial statements.
At December 31, 2022, the scheduled maturities of time deposits were as follows (in thousands):
2023 | | $ | 73,486 | |
2024 | | | 38,497 | |
2025 | | | 12,377 | |
2026 | | | 8,063 | |
2027 | | | 4,426 | |
Thereafter | | | — | |
| | $ | 136,849 | |
Note 8. Other Borrowings
The Company had an unsecured line of credit totaling $5.0 million with a non-affiliated bank at December 31, 2022. There were no borrowings outstanding on the line of credit at December 31, 2022. The interest rate on the line of credit floats at Wall Street Journal Prime Rate plus 0.25%, with a floor of 3.50%, and matures on March 25, 2026.
The Bank had unused lines of credit totaling $287.3 million and $240.4 million available with non-affiliated banks at December 31, 2022 and 2021, respectively. These available sources of credit included $188.8 million available from Federal Home Loan Bank of Atlanta (FHLB), $47.5 million available from the Federal Reserve Bank, and unsecured lines of credit with correspondent banks totaling $51.0 million. The Bank can borrow up to 19% of its total assets through the blanket floating lien agreement with the FHLB. The Bank had collateral pledged on the borrowing line at December 31, 2022 and 2021 including real estate loans totaling $286.6 million and $205.8 million, respectively, and FHLB stock with a book value of $796 thousand and $701 thousand, respectively. The Bank did not have borrowings under these lines of credit at December 31, 2022 and 2021.
Note 9. Subordinated Debt
On October 30, 2015, the Company entered into a Subordinated Loan Agreement (the Agreement) pursuant to which the Company issued an interest only subordinated term note due 2025 in the aggregate principal amount of $5.0 million. The note had a fixed interest rate of 6.75% per annum. Debt issuance costs related to the note were fully amortized at December 31, 2022. The note included a prepayment option beginning January 1, 2021 through the maturity date of October 1, 2025. The Company prepaid the note in full on January 1, 2022 without penalty.
On June 29, 2020, the Company issued an interest only subordinated term note due 2030 in the aggregate principal amount of $5.0 million. The note initially bears interest at a fixed rate of 5.50% per annum. Beginning July 1, 2025, the interest rate shall reset quarterly to an interest rate per annum equal to the current three-month Secured Overnight Financing Rate (SOFR), plus 510 basis points. Unamortized debt issuance costs related to the note were $5 and $7 thousand at December 31, 2022 and 2021. The note has a maturity date of July 1, 2030. Subject to regulatory approval, the Company may prepay the note, in part or in full, beginning on July 1, 2025 through maturity, at the Company's option, on any scheduled interest payment date. The note contains customary events of default such as the bankruptcy of the Company and the non-payment of principal or interest when due. The holder of the note may accelerate the repayment of the note only in the event of bankruptcy or similar proceedings and not for any other event of default. The note is an unsecured, subordinated obligation of the Company and it ranks junior in right of payment to the Company’s existing and future senior indebtedness and to the Company’s obligations to its general creditors. The note ranks equally with all other unsecured subordinated debt, except any which by its terms is expressly stated to be subordinated to the note. The note ranks senior to all current and future junior subordinated debt obligations, preferred stock, and common stock of the Company. The note is not convertible into common stock or preferred stock, and is not callable by the holder.
Note 10. Junior Subordinated Debt
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 December 31, 2022 and 2021 was 7.34% and 2.82%, 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 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 junior subordinated debt.
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 December 31, 2022 and 2021 was 5.34% and 1.81%, 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 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 junior subordinated debt.
Note 11. Income Taxes
The Company is subject to U.S. federal and Virginia income tax as well as bank franchise tax in the state of Virginia. With few exceptions, the Company is no longer subject to U.S. federal, state and local income tax examinations by tax authorities for years prior to 2019.
Net deferred tax assets consisted of the following components at December 31, 2022 and 2021 (in thousands):
| | 2022 | | | 2021 | |
Deferred Tax Assets | | | | | | | | |
Allowance for loan losses | | $ | 1,564 | | | $ | 1,199 | |
Acquisition accounting adjustments, net | | | 570 | | | | 822 | |
Post-retirement benefits | | | 188 | | | | 156 | |
Core deposit intangible | | | 270 | | | | 309 | |
Unvested stock-based compensation | | | 81 | | | | 45 | |
Reserve for letter of credit losses | | | 88 | | | | 66 | |
Limited partnership investments | | | 39 | | | | 8 | |
Lease liability | | | 113 | | | | 60 | |
Housing tax credit | | | — | | | | 24 | |
Unrealized loss on securities available for sale | | | 6,536 | | | | 118 | |
NOL carryover - acquired from Fincastle | | | 1,434 | | | | 1,548 | |
Loan origination fees, net | | | 176 | | | | 183 | |
| | $ | 11,059 | | | $ | 4,538 | |
Deferred Tax Liabilities | | | | | | | | |
Depreciation | | $ | 701 | | | $ | 750 | |
Right of use asset | | | 112 | | | | 61 | |
Housing equity fund | | | — | | | | 12 | |
Other real estate owned | | | 29 | | | | 158 | |
Cash flow hedges | | | 563 | | | | 198 | |
| | $ | 1,405 | | | $ | 1,179 | |
Net deferred tax assets | | $ | 9,654 | | | $ | 3,359 | |
The income tax expense for the years ended December 31, 2022 and 2021 consisted of the following (in thousands):
| | 2022 | | | 2021 | |
Current tax expense | | $ | 4,193 | | | $ | 4,268 | |
Deferred tax benefit | | | (241 | ) | | | (1,682 | ) |
| | $ | 3,952 | | | $ | 2,586 | |
The income tax expense differs from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2022 and 2021, due to the following (in thousands):
| | 2022 | | | 2021 | |
Computed tax expense at statutory federal rate | | $ | 4,357 | | | $ | 2,718 | |
Increase in income taxes resulting from: | | | | | | | | |
Merger expenses | | | — | | | | 165 | |
Other | | | 8 | | | | 28 | |
Decrease in income taxes resulting from: | | | | | | | | |
Tax-exempt interest and dividend income | | | (252 | ) | | | (214 | ) |
Income from bank owned life insurance | | | (161 | ) | | | (111 | ) |
| | $ | 3,952 | | | $ | 2,586 | |
Note 12. Funds Restrictions and Reserve Balance
Transfers of funds from the banking subsidiary to the parent company in the form of loans, advances, and cash dividends are restricted by federal and state regulatory authorities. At December 31, 2022, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent company, without prior regulatory approval, totaled $20.8 million. The amount of unrestricted funds is generally determined by subtracting the total dividend payments of the Bank from the Bank’s net income for that year, combined with the Bank’s retained net income for the preceding two years.
The Bank is typically required to maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. The Federal Reserve adopted a rule in March 2020 eliminating the reserve requirement. There were no required balances at December 31, 2022 or December 31, 2021
Note 13. Benefit Plans
401(k) Plan
The Company maintains a 401(k) plan (the Plan) for all eligible employees. Participating employees may elect to contribute up to the maximum percentage allowed by the Internal Revenue Service, as defined in the Plan. The Company makes matching contributions, on a dollar-for dollar basis, for the first one percent of an employee’s compensation contributed to the Plan and fifty cents for each dollar of the employee’s contribution between two percent and six percent. The Company also makes an additional contribution based on years of service to participants who have completed at least one thousand hours of service during the year and who are employed on the last day of the Plan Year. All employees who are age nineteen or older are eligible. Employee contributions vest immediately. Employer matching contributions vest after two Plan service years with the Company. The Company has the discretion to make a profit sharing contribution to the Plan each year based on overall performance, profitability, and other economic factors. For the years ended December 31, 2022 and 2021, expense attributable to the Plan amounted to $1.2 million and $965 thousand, respectively.
Supplemental Executive Retirement Plans
On March 15, 2019, the Company entered into supplemental executive retirement plans and participation agreements with three of its employees. The retirement benefits are fixed and provide for retirement benefits payable in 180 monthly installments. The contribution expense totaled $151 thousand and $264 thousand for the years ended December 31, 2022 and 2021, respectively, and was solely funded by the Company. The accrued supplemental executive retirement plan liability was $894 thousand and $745 thousand at December 31, 2022 and 2021, respectively.
Note 14. 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.
The following table presents the computation of basic and diluted earnings per share for the years ended December 31, 2022 and 2021 (dollars in thousands, except per share data):
| | 2022 | | | 2021 | |
(Numerator): | | | | | | | | |
Net income | | $ | 16,797 | | | $ | 10,359 | |
(Denominator): | | | | | | | | |
Weighted average shares outstanding – basic | | | 6,252,369 | | | | 5,550,589 | |
Potentially dilutive common shares – restricted stock units | | | 6,988 | | | | 8,492 | |
Weighted average shares outstanding – diluted | | | 6,259,357 | | | | 5,559,081 | |
Income per common share | | | | | | | | |
Basic | | $ | 2.69 | | | $ | 1.87 | |
Diluted | | $ | 2.68 | | | $ | 1.86 | |
Note 15. Commitments and Unfunded Credits
The Company, through its banking subsidiary, 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.
At December 31, 2022 and 2021, the following financial instruments were outstanding whose contract amounts represent credit risk (in thousands):
| | 2022 | | | 2021 | |
Commitments to extend credit and unfunded commitments under lines of credit | | $ | 158,297 | | | $ | 161,428 | |
Stand-by letters of credit | | | 17,950 | | | | 18,904 | |
Commitments to extend credit 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 may or may 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 December 31, 2022, the Bank had $998 thousand in locked-rate commitments to originate mortgage loans. There were no loans held for sale at December 31, 2022. Risks arise from the possible inability of counterparties to meet the terms of their contracts. The Bank does not expect any counterparty to fail to meet its obligations.
The Bank has cash accounts in other commercial banks. The amount on deposit at these banks at December 31, 2022 exceeded the insurance limits of the Federal Deposit Insurance Corporation by $1.8 million.
Note 16. Transactions with Related Parties
During the year, executive officers and directors (and their affiliates) were customers of and had transactions with the Company in the normal course of business. In management’s opinion, these transactions were made on substantially the same terms as those prevailing for other customers.
At December 31, 2022 and 2021, these loans totaled $1.1 million and $1.6 million, respectively. During 2022, total principal additions were $11 thousand and total principal payments were $530 thousand.
Deposits from related parties held by the Bank at December 31, 2022 and 2021 amounted to $27.5 million and $17.3 million, respectively.
Note 17. Lease Commitments
Lease liabilities represent the Company's obligation to make lease payments and are presented at each reporting date as the net present value of the remaining contractual cash flows. Cash flows are discounted at the Company's incremental borrowing rate in effect at the commencement date of the lease. Right-of-use assets represent the Company's right to use the underlying asset for the lease term and are calculated as the sum of the lease liability and, if applicable, prepaid rent, initial direct costs, and any incentives received from the lessor.
Lease payments
Lease payments for short-term leases are recognized as lease expense on a straight-line basis over the lease term, or for variable lease payments, in the period in which the obligation was incurred. Payments for leases with terms longer than twelve months are included in the determination of the lease liability. Payments may be fixed for the term of the lease or variable. If the lease agreement provides a known escalator, such as a specified percentage increase per year or a stated increase at a specified time, the variable payment is included in the cash flows used to determine the lease liability. If the variable payment is based upon an unknown escalator, such as the consumer price index at a future date, the increase is not included in the cash flows used to determine the lease liability. Three of the Company's leases provide known escalators that are included in the determination of the lease liability. The remaining leases do not have variable payments during the term of the lease.
Options to extend, residual value guarantees, and restrictions and covenants
Of the Company's eight leases, six leases offer the option to extend the lease. The calculation of the lease liability includes the additional time and lease payments for options which the Company is reasonably certain it will exercise. None of the Company's leases provide for residual value guarantees and none provide restrictions or covenants that would impact dividends or require incurring additional financial obligations.
The following table presents the operating lease right-of-use asset and operating lease liability as of December 31, 2022 and 2021 (in thousands):
| Classification in the Consolidated Balance Sheets | | 2022 | | | 2021 | |
Operating lease right-of-use asset | Other assets | | $ | 535 | | | $ | 290 | |
Operating lease liability | Accrued interest payable and other liabilities | | | 537 | | | | 284 | |
The following table presents the weighted average remaining operating lease term and the weighted average discount rate for operating leases as of December 31, 2022 and 2021:
| | 2022 | | | 2021 | |
Weighted average remaining lease term, in years | | | 2.5 | | | | 2.8 | |
Weighted average discount rate | | | 3.51 | % | | | 2.65 | % |
The following table presents the components of operating lease expense and supplemental cash flow information for the years ended December 31, 2022 and 2021 (in thousands):
| | 2022 | | | 2021 | |
Lease Expense | | | | | | | | |
Operating lease expense | | $ | 247 | | | $ | 154 | |
Short-term lease expense | | | 33 | | | | 14 | |
Total lease expense (1) | | $ | 280 | | | $ | 168 | |
| | | | | | | | |
Cash paid for amounts included in lease liability | | $ | 249 | | | $ | 156 | |
Right of use assets obtained in exchange for operating lease liabilities commencing during the period | | $ | 491 | | | $ | 92 | |
(1) | Included in occupancy expense in the Company's consolidated statements of income. |
The following table presents a maturity schedule of undiscounted cash flows that contribute to the operating lease liability as of December 31, 2022 (in thousands):
Twelve months ending December 31, 2023 | | $ | 239 | |
Twelve months ending December 31, 2024 | | | 215 | |
Twelve months ending December 31, 2025 | | | 92 | |
Twelve months ending December 31, 2026 | | | 13 | |
Twelve months ending December 31, 2027 | | | — | |
Total undiscounted cash flows | | $ | 559 | |
Less: discount | | | (22 | ) |
Operating lease liability | | $ | 537 | |
The contracts in which the Company is lessee are with parties external to the Company and not related parties.
Note 18. Dividend Reinvestment Plan
The Company has in effect a Dividend Reinvestment Plan (DRIP) which provides an automatic conversion of dividends into common stock for enrolled shareholders. The Company may issue common shares to the DRIP or purchase on the open market. Common shares are purchased at a price which is based on the average closing prices of the shares as quoted on the Nasdaq Capital Market stock exchange for the 10 business days immediately preceding the dividend payment date.
The Company issued 10,384 and 7,861 common shares to the DRIP during the years ended December 31, 2022 and 2021, respectively.
Note 19. 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 Measurement 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 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).
Derivative asset/liability - cash flow hedges
Cash flow hedges are recorded at fair value on a recurring basis. The fair value of the Company's cash flow hedges is determined by a third party vendor using the discounted cash flow method (Level 2).
The following tables present the balances of assets measured at fair value on a recurring basis as of December 31, 2022 and 2021 (in thousands).
| | | | | | Fair Value Measurements at December 31, 2022 | |
Description | | Balance as of December 31, 2022 | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | |
Assets: | | | | | | | | | | | | | | | | |
Securities available for sale | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 11,229 | | | $ | — | | | $ | 11,229 | | | $ | — | |
U.S. agency and mortgage-backed securities | | | 96,918 | | | | — | | | | 96,918 | | | | — | |
Obligations of states and political subdivisions | | | 54,760 | | | | — | | | | 54,760 | | | | — | |
Corporate debt securities | | | — | | | | — | | | | — | | | | — | |
Total securities available for sale | | $ | 162,907 | | | $ | — | | | $ | 162,907 | | | $ | — | |
Derivatives - cash flow hedges | | | 2,679 | | | | — | | | | 2,679 | | | | — | |
Total assets | | $ | 165,586 | | | $ | — | | | $ | 165,586 | | | $ | — | |
| | | | | | Fair Value Measurements at December 31, 2021 | |
Description | | Balance as of December 31, 2021 | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | |
Assets: | | | | | | | | | | | | | | | | |
Securities available for sale | | | | | | | | | | | | | | | | |
U.S. Treasury securities | | $ | 39,658 | | | $ | — | | | $ | 39,658 | | | $ | — | |
U.S. agency and mortgage-backed securities | | | 176,379 | | | | — | | | | 176,379 | | | | — | |
Obligations of states and political subdivisions | | | 71,438 | | | | — | | | | 71,438 | | | | — | |
Corporate debt securities | | | 2,020 | | | | — | | | | 2,020 | | | | — | |
Total securities available for sale | | $ | 289,495 | | | $ | — | | | $ | 289,495 | | | $ | — | |
Derivatives - cash flow hedges | | | 941 | | | | — | | | | 941 | | | | — | |
Total assets | | $ | 290,436 | | | $ | — | | | $ | 290,436 | | | $ | — | |
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.
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:
Loans held for sale
Loans held for sale are carried at the lower of cost or market value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the years ended December 31, 2022 and 2021.
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 less estimated costs to sell. 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.
The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis as of December 31, 2022 and 2021 (dollars in thousands).
| | | | | | Fair Value Measurements at December 31, 2022 | |
Description | | Balance as of December 31, 2022 | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs (Level 2) | | | Significant Unobservable Inputs (Level 3) | |
Other real estate owned | | $ | 184 | | | $ | — | | | $ | — | | | $ | 184 | |
Impaired loans, net | | $ | 197 | | | $ | — | | | $ | — | | | $ | 197 | |
| | | | | | Fair Value Measurements at December 31, 2021 | |
Description | | Balance as of December 31, 2021 | | | Quoted Prices in Active Markets for Identical Assets (Level 1) | | | Significant Other Observable Inputs(Level 2) | | | Significant Unobservable Inputs (Level 3) | |
Impaired loans, net | | $ | 1,454 | | | $ | — | | | $ | — | | | $ | 1,454 | |
| | Quantitative information about Level 3 Fair Value Measurements for December 31, 2022 | |
| | Fair Value | | Valuation Technique | | Unobservable Input | | Range (Weighted Average) (1) | |
Other real estate owned | | $ | 184 | | Property appraisals | | Selling cost | | | 10.00 | % |
Impaired loans, net | | | 197 | | Present value of cash flows | | Discount rate | | | 6.50 | % |
| | Quantitative information about Level 3 Fair Value Measurements for December 31, 2021 | |
| | Fair Value | | Valuation Technique | | Unobservable Input | | Range (Weighted Average) (1) | |
Impaired loans, net | | $ | 1,454 | | Present value of cash flows | | Discount rate | | | 6.50 | % |
(1) | Unobservable inputs were weighted by the relative fair value of the instruments. |
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 carrying values and estimated fair values of the Company’s financial instruments at December 31, 2022 and 2021 are as follows (in thousands):
| | | | | | Fair Value Measurements at December 31, 2022 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 | | $ | 66,914 | | | $ | 66,914 | | | $ | — | | | $ | — | | | $ | 66,914 | |
Securities available for sale | | | 162,907 | | | | — | | | | 162,907 | | | | — | | | | 162,907 | |
Securities held to maturity | | | 153,158 | | | | — | | | | 141,797 | | | | — | | | | 141,797 | |
Restricted securities | | | 1,908 | | | | — | | | | 1,908 | | | | — | | | | 1,908 | |
Loans, net | | | 913,077 | | | | — | | | | — | | | $ | 880,473 | | | | 880,473 | |
Bank owned life insurance | | | 24,531 | | | | — | | | | 24,531 | | | | — | | | | 24,531 | |
Accrued interest receivable | | | 4,543 | | | | — | | | | 4,543 | | | | — | | | | 4,543 | |
Derivatives - cash flow hedges | | | 2,679 | | | | — | | | | 2,679 | | | | — | | | | 2,679 | |
Financial Liabilities | | | | | | | | | | | | | | | | | | | | |
Deposits | | $ | 1,241,332 | | | $ | — | | | $ | 1,104,483 | | | $ | 131,304 | | | $ | 1,235,787 | |
Subordinated debt | | | 4,995 | | | | — | | | | — | | | | 5,267 | | | | 5,267 | |
Junior subordinated debt | | | 9,279 | | | | — | | | | — | | | | 6,067 | | | | 6,067 | |
Accrued interest payable | | | 163 | | | | — | | | | 163 | | | | — | | | | 163 | |
| | | | | | Fair Value Measurements at December 31, 2021 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 | | $ | 176,006 | | | $ | 176,006 | | | $ | — | | | $ | — | | | $ | 176,006 | |
Securities available for sale | | | 289,495 | | | | — | | | | 289,495 | | | | — | | | | 289,495 | |
Securities held to maturity | | | 33,441 | | | | — | | | | 33,617 | | | | — | | | | 33,617 | |
Restricted securities | | | 1,813 | | | | — | | | | 1,813 | | | | — | | | | 1,813 | |
Loans, net | | | 819,408 | | | | — | | | | — | | | | 827,248 | | | | 827,248 | |
Bank owned life insurance | | | 24,294 | | | | — | | | | 24,294 | | | | — | | | | 24,294 | |
Accrued interest receivable | | | 3,903 | | | | — | | | | 3,903 | | | | — | | | | 3,903 | |
Derivatives - cash flow hedges | | | 941 | | | | — | | | | 941 | | | | — | | | | 941 | |
Financial Liabilities | | | | | | | | | | | | | | | | | | | | |
Deposits | | $ | 1,248,752 | | | $ | — | | | $ | 1,103,186 | | | $ | 145,101 | | | $ | 1,248,287 | |
Subordinated debt | | | 9,993 | | | | — | | | | — | | | | 8,932 | | | | 8,932 | |
Junior subordinated debt | | | 9,279 | | | | — | | | | — | | | | 8,145 | | | | 8,145 | |
Accrued interest payable | | | 152 | | | | — | | | | 152 | | | | — | | | | 152 | |
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 20. Regulatory Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III rules) became effective January 1, 2015, with full compliance of all the requirements phased in over a multi-year schedule, and became fully phased in January 1, 2019. As part of the new requirements, the common equity Tier 1 capital ratio is calculated and utilized in the assessment of capital for all institutions. The final rules also established a “capital conservation buffer” above the new regulatory minimum capital requirements. The capital conservation buffer was phased-in over four years, which began on January 1, 2016 and was fully implemented on January 1, 2019.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total (as defined in the regulations), Tier 1 (as defined), and common equity Tier 1 capital (as defined) to risk-weighted assets (as defined), and of Tier 1 capital to average assets. Management believes, as of December 31, 2022 and December 31, 2021, that the Bank met all capital adequacy requirements to which it is subject.
As of December 31, 2022, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum risk-based capital and leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
A comparison of the capital of the Bank at December 31, 2022 and December 31, 2021 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 | |
December 31, 2022: | | | | | | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk-Weighted Assets) | | $ | 139,549 | | | | 14.60 | % | | $ | 76,462 | | | | 8.00 | % | | $ | 95,578 | | | | 10.00 | % |
Tier 1 Capital (to Risk-Weighted Assets) | | $ | 132,103 | | | | 13.82 | % | | $ | 57,347 | | | | 6.00 | % | | $ | 76,462 | | | | 8.00 | % |
Common Equity Tier 1 Capital (to Risk-Weighted Assets) | | $ | 132,103 | | | | 13.82 | % | | $ | 43,010 | | | | 4.50 | % | | $ | 62,126 | | | | 6.50 | % |
Tier 1 Capital (to Average Assets) | | $ | 132,103 | | | | 9.36 | % | | $ | 55,228 | | | | 4.00 | % | | $ | 69,035 | | | | 5.00 | % |
December 31, 2021: | | | | | | | | | | | | | | | | | | | | | | | | |
Total Capital (to Risk-Weighted Assets) | | $ | 125,934 | | | | 14.76 | % | | $ | 68,237 | | | | 8.00 | % | | $ | 85,296 | | | | 10.00 | % |
Tier 1 Capital (to Risk-Weighted Assets) | | $ | 120,224 | | | | 14.09 | % | | $ | 51,178 | | | | 6.00 | % | | $ | 68,237 | | | | 8.00 | % |
Common Equity Tier 1 Capital (to Risk-Weighted Assets) | | $ | 120,224 | | | | 14.09 | % | | $ | 38,383 | | | | 4.50 | % | | $ | 55,442 | | | | 6.50 | % |
Tier 1 Capital (to Average Assets) | | $ | 120,224 | | | | 8.82 | % | | $ | 54,497 | | | | 4.00 | % | | $ | 68,121 | | | | 5.00 | % |
In addition to the regulatory minimum risk-based capital amounts presented above, the Bank must maintain a capital conservation buffer as required by the Basel III final rules. Accordingly, the Bank was required to maintain a capital conservation buffer of 2.50% at December 31, 2022 and December 31, 2021, respectively. Under the final rules, an institution is subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. As of December 31, 2022 and December 31, 2021, the capital conservation buffer of the Bank was 6.60% and 6.76%, respectively.
Note 21. Accumulated Other Comprehensive Income (Loss)
Changes in each component of accumulated other comprehensive income (loss) were as follows (in thousands):
| | Net Unrealized Gains (Losses) on Securities | | | Change in Fair Value of Cash Flow Hedges | | | Accumulated Other Comprehensive Income (Loss) | |
Balance at December 31, 2020 | | $ | 3,058 | | | $ | 340 | | | $ | 3,398 | |
Unrealized holding losses (net of tax, ($923)) | | | (3,474 | ) | | | — | | | | (3,474 | ) |
Reclassification adjustment (net of tax, ($8)) | | | (29 | ) | | | — | | | | (29 | ) |
Change in fair value (net of tax, $107) | | | — | | | | 403 | | | | 403 | |
Change during period | | | (3,503 | ) | | | 403 | | | | (3,100 | ) |
Balance at December 31, 2021 | | $ | (445 | ) | | $ | 743 | | | $ | 298 | |
Unrealized holding losses (net of tax, ($5,327)) | | | (20,033 | ) | | | — | | | | (20,033 | ) |
Unrealized holding losses on securities transferred from available for sale to held to maturity (net of tax ($1,513)) | | | (5,692 | ) | | | — | | | | (5,692 | ) |
Reclassification adjustment (net of tax, $421) | | | 1,583 | | | | — | | | | 1,583 | |
Change in fair value (net of tax, $365) | | | — | | | | 1,373 | | | | 1,373 | |
Change during period | | | (24,142 | ) | | | 1,373 | | | | (22,769 | ) |
Balance at December 31, 2022 | | $ | (24,587 | ) | | $ | 2,116 | | | $ | (22,471 | ) |
The following table presents information related to reclassifications from accumulated other comprehensive income (loss) for the years ended December 31, 2022 and 2021 (in thousands):
Details About Accumulated Other Comprehensive Income (Loss) | | Amount Reclassified from Accumulated Other Comprehensive Income (Loss) | | Affected Line Item in the Consolidated Statements of Income |
| | For the year ended December 31, | | |
| | 2022 | | | 2021 | | |
Securities available for sale: | | | | | | | | | |
Net securities losses (gains) reclassified into earnings | | $ | 2,004 | | | $ | (37 | ) | Net (losses) gains on securities available for sale |
Related income tax (benefit) expense | | | (421 | ) | | | 8 | | Income tax expense |
Total reclassifications | | $ | 1,583 | | | $ | (29 | ) | Net of tax |
Note 22. Stock Compensation Plans
On May 13, 2014, the Company’s shareholders approved the First National Corporation 2014 Stock Incentive Plan, which makes available up to 240,000 shares of common stock for the granting of stock options, restricted stock awards, stock appreciation rights, and other stock-based awards. Awards are made at the discretion of the Board of Directors and compensation cost equal to the fair value of the award is recognized over the vesting period.
Stock Awards
Whenever the Company deems it appropriate to grant a stock award, the recipient receives a specified number of unrestricted shares of employer stock. Stock awards may be made by the Company at its discretion without cash consideration and may be granted as settlement of a performance-based compensation award.
During 2022, the Company granted and issued 7,500 shares of common stock to members of the Board of Directors for their dedicated service and support. Also during 2022, the Company issued 27,134 shares of common stock to employees. Compensation expense related to stock awards totaled $481 thousand and $127 thousand for the years ended December 31, 2022 and 2021, respectively.
Restricted Stock Units
Restricted stock units are an award of units that correspond in number and value to a specified number of shares of employer stock which the recipient receives according to a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with the employer for a particular length of time. Each restricted stock unit that vests entitles the recipient to receive one share of common stock on a specified issuance date.
On February 9, 2022, 10,110 restricted stock units were granted to employees with 3,375 units vesting immediately, 3,370 units vesting after one year, and 3,365 units vesting after two years. The recipients do not have any stockholder rights, including voting, dividend, or liquidation rights, with respect to the shares underlying awarded restricted stock units until vesting has occurred and the recipients become the record holder of those shares. The unvested restricted stock units will vest on the established schedule if the employees remain employed by the Company on future vesting dates.
A summary of the activity for the Company’s restricted stock units for the period indicated is presented in the following table:
| | 2022 | |
| | Shares | | | Weighted Average Grant Date Fair Value | |
Unvested, January 1, 2022 | | | 30,781 | | | $ | 19.79 | |
Granted | | | 10,110 | | | | 22.19 | |
Vested | | | (11,643 | ) | | | 20.58 | |
Forfeited | | | (67 | ) | | | — | |
Unvested, December 31, 2022 | | | 29,181 | | | $ | 20.31 | |
At December 31, 2022, based on restricted stock unit awards outstanding at that time, the total unrecognized pre-tax compensation expense related to unvested restricted stock unit awards was $310 thousand. This expense is expected to be recognized through 2026. Compensation expense related to restricted stock unit awards recognized for the years ended December 31, 2022 and 2021 totaled $304 thousand and $226 thousand, respectively.
Note 23. Revenue Recognition
Most revenue associated with financial instruments, including interest income, loan origination fees, and credit card fees, is outside the scope of ASC topic 606. Gains and losses on investment securities, derivatives, financial guarantees, and sales of financial instruments are similarly excluded from the scope. The guidance is applicable to noninterest revenue streams such as service charges on deposit accounts, ATM and check card fees, wealth management fees, and fees for other customer services. Certain other in-scope revenue, such as gains on OREO are recorded in non-interest expense. Noninterest revenue streams within the scope of Topic 606 are discussed below.
Service charges on deposit accounts
Service charges on deposit accounts consist of monthly service fees, overdraft and nonsufficient funds fees, and other deposit account related fees. The Company's performance obligation for monthly service fees is generally satisfied, and the related revenue recognized, over the period in which the service is provided. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers' accounts. Overdraft and nonsufficient funds fees and other deposit account related fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time.
ATM and check card fees
ATM fees are primarily generated when a Company cardholder uses a non-Company ATM or a non-Company cardholder uses a Company ATM. ATM fees are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Check card fees are primarily comprised of interchange fee income. Interchange fees are earned whenever the Company's debit cards are processed through card payment networks, such as Visa. The Company's performance obligation for interchange fee income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. In compliance with Topic 606, debit card fee income is presented net of associated expense.
Wealth management fees
Wealth management fees are primarily comprised of fees earned from the management and administration of trusts and other customer assets. The Company's performance obligation is generally satisfied over time and the resulting fees are primarily recognized monthly, based upon the month-end market value of the assets under management and the applicable fee rate. Payment is generally received a few days after month-end through a direct charge to customers' accounts. Estate management fees are based upon the size of the estate. Revenue for estate management fees are recorded periodically, according to a fee schedule, and are based on the services that have been provided.
Brokered mortgage fees
Brokered mortgage fees are comprised of loan fee income earned from generating loans in the secondary market. Brokered mortgage fee income is recognized at loan closing.
Fees for other customer services
Fees for other customer services include check ordering charges, merchant services income, safe deposit box rental fees, and other service charges. Check ordering charges are transactional based, and therefore, the Company's performance obligation is satisfied, and related revenue recognized, at a point in time. Merchant services income mainly represent fees charged to merchants to process their debit and credit card transactions. The Company's performance obligation for merchant services income is largely satisfied, and related revenue recognized, when the services are rendered or upon completion. Payment is typically received immediately or in the following month. Safe deposit box rental fees are charged to the customer on an annual basis and recognized upon receipt of payment. The Company determined that since rentals and renewals occur fairly consistently over time, revenue is recognized on a basis consistent with the duration of the performance obligation.
Gains and losses are recorded when control of the property transfers to the buyer, which generally occurs at the time of transfer of the deed. If the Company finances the sale of a foreclosed property to the buyer, we assess whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the foreclosed property is derecognized and the gain or loss on sale is recorded upon transfer of control of the property to the buyer. For the years ended December 31, 2022 and 2021 net gains/(losses) on sales of foreclosed properties was $176 and $8, respectively.
The following table presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the years ended December 31, 2022 and 2021 (in thousands):
| | 2022 | | | 2021 | |
Noninterest Income | | | | | | | | |
Service charges on deposit accounts | | $ | 2,677 | | | $ | 2,061 | |
ATM and check card fees | | | 3,300 | | | | 2,930 | |
Wealth management fees | | | 3,008 | | | | 2,712 | |
Brokered mortgage fees | | | 245 | | | | 539 | |
Fees for other customer services | | | 839 | | | | 777 | |
Noninterest income (in-scope of Topic 606) | | $ | 10,069 | | | $ | 9,019 | |
Noninterest income (out-of-scope of Topic 606) | | | 2,552 | | | | 1,168 | |
Total noninterest income | | $ | 12,621 | | | $ | 10,187 | |
Note 24. Derivative Financial Instruments
On April 21, 2020, the Company entered into two interest rate swap agreements related to its outstanding junior subordinated debt. One swap agreement was related to the Company’s junior subordinated debt with a redemption date of June 17, 2034, which became effective on March 17, 2020. The notional amount of the interest rate swap was $5.0 million and terminates on June 17, 2034. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.79% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date. The other swap agreement was related to the Company’s junior subordinated debt with a redemption date of October 1, 2036, which became effective on April 1, 2020. The notional amount of the interest rate swap was $4.0 million and terminates on October 1, 2036. Under the terms of the agreement, the Company pays interest quarterly at a fixed rate of 0.82% and receives interest quarterly at a variable rate of three-month LIBOR. The variable rate resets on each interest payment date.
The Company entered into interest rate swaps to reduce interest rate risk and to manage interest expense. By entering into these agreements, the Company converted variable rate debt into fixed rate debt. Alternatively, the Company may enter into interest rate swap agreements to convert fixed rate debt into variable rate debt. Interest differentials paid or received under interest rate swap agreements are reflected as adjustments to interest expense. The Company designated the interest rate swaps as hedging instruments in qualifying cash flow hedges, as discussed in Note 1 to the Consolidated Financial Statements. Changes in fair value of these designated hedging instruments is reported as a component of other comprehensive income. Interest rate swaps designated as cash flow hedges are expected to be highly effective in offsetting the effect of changes in interest rates on the amount of variable rate interest payments, and the Company assesses the effectiveness of each hedging relationship quarterly. If the Company determines that a cash flow hedge is no longer highly effective, future changes in the fair value of the hedging instrument would be reported as earnings. As of December 31, 2022, the Company has designated cash flow hedges to manage its exposure to variability in cash flows on certain variable rate borrowings for periods that end between June 2034 and October 2036. The notional amounts of the interest rate swaps were not exchanged and do not represent exposure to credit loss. In the event of default by a counterparty, the risk in these transactions is the cost of replacing the agreements at current market rates.
All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.
Unrealized gains or losses recorded in other comprehensive income related to cash flow hedges are reclassified into earnings in the same period(s) during which the hedged interest payments affect earnings. When a designated hedging instrument is terminated and the hedged interest payments remain probable of occurring, any remaining unrecognized gain or loss in other comprehensive income is reclassified into earnings in the period(s) during which the forecasted interest payments affect earnings. Amounts reclassified into earnings and interest receivable or payable under designated interest rate swaps are reported in interest expense. The Company does not expect any unrealized losses related to cash flow hedges to be reclassified into earnings in the next twelve months.
The following table summarizes key elements of the Company's derivative instruments at December 31, 2022 and 2021 (in thousands):
| | 2022 | |
| | Notional Amount | | | Assets | | | Liabilities | | | Collateral Pledged(1) | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
Interest rate swap contracts | | $ | 9,000 | | | $ | 2,679 | | | $ | — | | | $ | — | |
| | 2021 | |
| | Notional Amount | | | Assets | | | Liabilities | | | Collateral Pledged(1) | |
Cash Flow Hedges | | | | | | | | | | | | | | | | |
Interest rate swap contracts | | $ | 9,000 | | | $ | 941 | | | $ | — | | | $ | — | |
(1) | Collateral pledged may be comprised of cash or securities. |
Note 25. Acquisitions
Acquisition of the Bank of Fincastle
On July 1, 2021, the Company completed its acquisition of Fincastle for an aggregate purchase price of $33.8 million of cash and stock. The Company paid cash consideration of $6.8 million and issued 1,348,065 shares of its common stock to the shareholders of Fincastle. Upon completion of the transaction, Fincastle was merged with and into the Bank. At the time of closing of the acquisition, Fincastle had six retail bank offices operating in the greater Roanoke region of Virginia. The former Fincastle branches continued to operate as The Bank of Fincastle, a division of First Bank, until the systems were converted on October 16, 2021. As of June 30, 2021, Fincastle reported total assets of $267.9 million, total loans of $194.5 million and total deposits of $236.3 million. For the year ended December 31, 2021, the Company recorded merger related expenses of $3.4 million in connection with the acquisition of Fincastle. The Company estimates that it incurred aggregate costs related to the merger of $3.4 million, with $69 thousand of merger related expenses recorded in the first and second quarters of 2022.
Acquisition of SmartBank Loan Portfolio
On September 30, 2021, the Bank acquired $82.0 million of loans and certain fixed assets from SmartBank related to its Richmond area branch, located in Glen Allen, Virginia. the Bank paid cash consideration of $83.7 million for the loans and fixed assets. Additionally, an experienced team of bankers based out of the SmartBank location have transitioned to become employees of the Bank. The Bank did not assume any deposit liabilities from SmartBank in connection with the transaction, and SmartBank closed their branch operation on December 31, 2021. The Bank assumed the facility lease at the branch on December 31, 2021 and now operates a loan production office in the location of the former SmartBank branch. The Bank’s assumption of the lease and acquisition of the remaining branch assets was completed in the fourth quarter of 2021. The Company incurred $101 thousand of expenses related to the acquisition of loans and fixed assets during 2021. There were no acquisition related expenses relating to Smartbank during 2022.
The acquisitions were accounted for as business combinations under ASC 805, Business Combinations. Under acquisition accounting, assets acquired, and liabilities assumed are recorded at their acquisition date fair values, and any excess of the purchase price over the aggregate fair value of the net assets acquired is recognized as goodwill. Determining the fair value of assets and liabilities, particularly related to the loan portfolio, is inherently subjective and involves significant judgment regarding the methods and assumptions used to estimate fair value. During the measurement period, the acquirer shall adjust the amounts recognized at the acquisition date and may recognize additional assets or liabilities to reflect new information obtained from facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date. Measurement period adjustments are recognized in the reporting period in which they are determined. The measurement period may not exceed one year from the acquisition date.
The following table presents the total consideration paid by the Company in connection with the acquisition of Fincastle and the SmartBank loan portfolio, the fair values of the assets acquired and liabilities assumed, and the resulting goodwill. Amounts for the Fincastle acquisition are as of July 1, 2021. Amounts for SmartBank are as of September 30, 2021.
(Dollars in thousands) | | Bank of Fincastle | | | SmartBank | | | Total | |
Purchase price: | | | | | | | | | | | | |
Cash paid | | $ | 6,752 | | | $ | 83,745 | | | $ | 90,497 | |
Common stock issued | | | 27,069 | | | | - | | | | 27,069 | |
Total purchase price | | $ | 33,821 | | | $ | 83,745 | | | $ | 117,566 | |
| | | | | | | | | | | | |
Identifiable assets acquired: | | | | | | | | | | | | |
Cash and due from banks | | $ | 46,158 | | | $ | - | | | $ | 46,158 | |
Federal funds sold | | | 120 | | | | - | | | | 120 | |
Securities, AFS, at fair value | | | 12,112 | | | | - | | | | 12,112 | |
Restricted securities | | | 183 | | | | - | | | | 183 | |
Loans, net of ALLL | | | 194,617 | | | | 81,637 | | | | 276,254 | |
Bank premises and equipment | | | 3,471 | | | | 172 | | | | 3,643 | |
Accrued interest receivable | | | 1,588 | | | | 143 | | | | 1,731 | |
OREO | | | 2,137 | | | | - | | | | 2,137 | |
BOLI | | | 5,852 | | | | - | | | | 5,852 | |
Other assets | | | 4,259 | | | | - | | | | 4,259 | |
Total identifiable assets acquired | | $ | 270,497 | | | $ | 81,952 | | | $ | 352,449 | |
| | | | | | | | | | | | |
Identifiable liabilities assumed: | | | | | | | | | | | | |
Demand deposits & savings accounts | | $ | 184,535 | | | $ | - | | | $ | 184,535 | |
Time deposits | | | 52,246 | | | | - | | | | 52,246 | |
Accrued expenses and other liabilities | | | 1,132 | | | | - | | | | 1,132 | |
Total identifiable liabilities assumed | | $ | 237,913 | | | $ | - | | | $ | 237,913 | |
| | | | | | | | | | | | |
Net identifiable assets acquired at fair value | | $ | 32,584 | | | $ | 81,952 | | | $ | 114,536 | |
| | | | | | | | | | | | |
Goodwill resulting from acquisitions | | $ | 1,237 | | | $ | 1,793 | | | $ | 3,030 | |
The following table presents certain unaudited pro forma information as if the acquisition had taken place on January 1, 2020. These results combine the historical results of Fincastle and the Company for the period prior to the merger. While certain adjustments were made for estimated effects resulting from the application of the acquisition method, including certain fair value adjustments, this pro forma information is not indicative of what would have occurred had the acquisition actually taken place on January 1, 2020. Pro forma adjustments for the year ended December 31, 2021 and December 31, 2020 include the net impact of accretion of loan discounts related to market interest rates, amortization of premiums on deposits, amortization of intangible assets and related income taxes. Unaudited pro forma net income for the years ended December 31, 2021 and 2020 includes after tax merger related expenses of $3.4 million, or ($0.61) per share. These amounts include $629 thousand recorded by Fincastle prior to the merger, which was primarily related to fees paid for legal and financial advisors. Unaudited pro forma net income also includes provision for loan losses recorded by Fincastle for loans that were recorded by the Corporation at fair value upon acquisition and have no allowance for loan losses in the books of the Corporation. Additionally, the Company expects to achieve further operational cost savings and other efficiencies as a result of the acquisition which are not reflected in the unaudited pro forma amounts below.
| | Unaudited Pro Forma | | | Unaudited Pro Forma | |
| | Twelve Months Ended | | | Twelve Months Ended | |
(Dollars in thousands, except per share amounts) | | December 31, 2021 | | | December 31, 2020 | |
Total revenues (net interest income plus noninterest income) | | $ | 42,116 | | | $ | 43,234 | |
Net income | | $ | 9,826 | | | $ | 7,660 | |
Net income per share, basic | | $ | 1.77 | | | $ | 1.57 | |
Net income per share, diluted | | $ | 1.77 | | | $ | 1.57 | |
The revenue and earnings amounts specific to SmartBank since the acquisition date that are included in the consolidated results for 2021 and 2020 are not readily determinable. The disclosures of these amounts are impracticable due to the merging of certain processes and systems at the acquisition date. Merger related expenses associated with the acquisition of Fincastle and SmartBank combined totaled $3.5 million through December 31, 2021. These costs included the integration of systems and operations and legal and consulting expenses, which have been expensed as incurred. Additional merger related expenses of $69 thousand were incurred throughout the first and second quarters of 2022.
Note 27. Parent Company Only Financial Statements
FIRST NATIONAL CORPORATION
(Parent Company Only)
Balance Sheets
December 31, 2022 and 2021
(in thousands)
| | 2022 | | | 2021 | |
Assets | | | | | | | | |
Cash | | $ | 9,501 | | | $ | 7,303 | |
Investment in subsidiaries, at cost, plus undistributed net income | | | 110,682 | | | | 122,964 | |
Other assets | | | 3,024 | | | | 6,256 | |
Total assets | | $ | 123,207 | | | $ | 136,523 | |
Liabilities and Shareholders’ Equity | | | | | | | | |
Subordinated debt | | $ | 4,995 | | | $ | 9,993 | |
Junior subordinated debt | | | 9,279 | | | | 9,279 | |
Other liabilities | | | 573 | | | | 212 | |
Total liabilities | | $ | 14,847 | | | $ | 19,484 | |
Preferred stock | | $ | — | | | $ | — | |
Common stock | | | 7,831 | | | | 7,785 | |
Surplus | | | 32,716 | | | | 31,966 | |
Retained earnings | | | 90,284 | | | | 76,990 | |
Accumulated other comprehensive (loss) income, net | | | (22,471 | ) | | | 298 | |
Total shareholders’ equity | | $ | 108,360 | | | $ | 117,039 | |
Total liabilities and shareholders’ equity | | $ | 123,207 | | | $ | 136,523 | |
FIRST NATIONAL CORPORATION
(Parent Company Only)
Statements of Income
Years Ended December 31, 2022 and 2021
(in thousands)
| | 2022 | | | 2021 | |
Income | | | | | | | | |
Dividends from subsidiary | | $ | 6,000 | | | $ | 6,000 | |
Total income | | $ | 6,000 | | | $ | 6,000 | |
Expense | | | | | | | | |
Interest expense | | $ | 547 | | | $ | 889 | |
Supplies | | | 5 | | | | 56 | |
Legal and professional fees | | | 209 | | | | 107 | |
Data processing | | | 47 | | | | 29 | |
Management fee-subsidiary | | | 469 | | | | 305 | |
Other expense | | | 70 | | | | 104 | |
Total expense | | $ | 1,347 | | | $ | 1,490 | |
Income before allocated tax benefits and undistributed income of subsidiary | | $ | 4,653 | | | $ | 4,510 | |
Allocated income tax benefit | | | 283 | | | | 312 | |
Income before equity in undistributed income of subsidiary | | $ | 4,936 | | | $ | 4,822 | |
Equity in undistributed income of subsidiary | | | 11,861 | | | | 5,537 | |
Net income | | $ | 16,797 | | | $ | 10,359 | |
FIRST NATIONAL CORPORATION
(Parent Company Only)
Statements of Cash Flows
Years Ended December 31, 2022 and 2021
(in thousands)
| | 2022 | | | 2021 | |
Cash Flows from Operating Activities | | | | | | | | |
Net income | | $ | 16,797 | | | $ | 10,359 | |
Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | |
Equity in undistributed income of subsidiary | | | (11,861 | ) | | | (5,537 | ) |
Stock-based compensation | | | 785 | | | | 354 | |
Amortization of debt issuance costs | | | 2 | | | | 2 | |
Decrease (increase) in other assets | | | 4,969 | | | | (5,020 | ) |
(Decrease) increase in other liabilities | | | (3 | ) | | | 1 | |
Net cash provided by operating activities | | $ | 10,689 | | | $ | 159 | |
Cash Flows from Investing Activities | | | | | | | | |
Net cash paid in acquisition of The Bank of Fincastle | | $ | — | | | $ | (6,752 | ) |
Net cash used in investing activities | | $ | — | | | $ | (6,752 | ) |
Cash Flows from Financing Activities | | | | | | | | |
Redemption of subordinated debt, net of issuance costs | | $ | (5,000 | ) | | $ | — | |
Cash dividends paid on common stock, net of reinvestment | | | (3,308 | ) | | | (2,505 | ) |
Repurchase of common stock | | | (183 | ) | | | (39 | ) |
Net cash (used in) financing activities | | $ | (8,491 | ) | | $ | (2,544 | ) |
Increase (decrease) in cash and cash equivalents | | $ | 2,198 | | | $ | (9,137 | ) |
Cash and Cash Equivalents | | | | | | | | |
Beginning | | | 7,303 | | | | 16,440 | |
Ending | | $ | 9,501 | | | $ | 7,303 | |