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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2014

or

 

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

For the transition period from                      to                     

Commission file number 0-23976

 

 

 

(Exact name of registrant as specified in its charter)

 

 

 

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

Registrant’s telephone number, including area code: (540) 465-9121

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.25 par value

(Title of class)

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this Chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		¨		Smaller reporting company		x

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the closing sales price on June 30, 2014 was $27,643,395.

The number of outstanding shares of common stock as of March 20, 2015 was 4,909,714.

DOCUMENTS INCORPORATED BY REFERENCE

Proxy Statement for the 2015 Annual Meeting of Shareholders – Part III

 

 

 

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Table of Contents

TABLE OF CONTENTS

 

				Page
Part I
Item 1.		Business			3
Item 1A.		Risk Factors			10
Item 1B.		Unresolved Staff Comments			20
Item 2.		Properties			21
Item 3.		Legal Proceedings			22
Item 4.		Mine Safety Disclosures			22
Part II
Item 5.		Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			22
Item 6.		Selected Financial Data			23
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
Item 7A.		Quantitative and Qualitative Disclosures About Market Risk			44
Item 8.		Financial Statements and Supplementary Data			44
Item 9.		Changes in and Disagreements With Accountants on Accounting and Financial Disclosure			91
Item 9A.		Controls and Procedures			91
Item 9B.		Other Information			91
Part III
Item 10.		Directors, Executive Officers and Corporate Governance			91
Item 11.		Executive Compensation			91
Item 12.		Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			91
Item 13.		Certain Relationships and Related Transactions, and Director Independence			91
Item 14.		Principal Accounting Fees and Services			91
Part IV
Item 15.		Exhibits, Financial Statement Schedules			92

 

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Part I

Cautionary Statement Regarding Forward-Looking Statements

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

 

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conditions in the financial markets and economic conditions may adversely affect the Company’s business;

 

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the inability of the Company to successfully manage its growth or implement its growth strategy;

 

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difficulties in combining the operations of acquired bank branches or entities with the Company’s own operations;

 

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intense competition from other financial institutions both in making loans and attracting deposits;

 

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consumers may increasingly decide not to use the Bank to complete their financial transactions;

 

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limited availability of financing or inability to raise capital;

 

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exposure to operational, technological, and organizational risk;

 

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reliance on other companies to provide key components of their business infrastructure;

 

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the Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses;

 

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operational functions of business counterparties over which the Company may have limited or no control may experience disruptions;

 

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nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition;

 

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allowance for loan losses may prove to be insufficient to absorb losses in the loan portfolio;

 

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the concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets;

 

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legislative or regulatory changes or actions, or significant litigation;

 

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the limited trading market for the Company’s common stock; it may be difficult to sell shares;

 

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unexpected loss of management personnel;

 

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losses that could arise from breaches in cyber-security;

 

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

 

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

 

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

 

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other factors identified in Item 1A, “Risk Factors”, below.

Because of these and other uncertainties, actual future results may be materially different from the results indicated by these forward-looking statements. In addition, past results of operations do not necessarily indicate future results.

 

Item 1.

Business

General

First National Corporation (the Company) is a bank holding company incorporated under Virginia law on September 7, 1983. The Company owns all of the stock of its primary operating subsidiary, First Bank (the Bank), which is a commercial bank chartered under Virginia law. The Company’s subsidiaries are:

 

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First Bank (the Bank). The Bank owns:

 

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First Bank Financial Services, Inc.

 

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Shen-Valley Land Holdings, LLC

 

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

 

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

 

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

The Bank first opened for business on July 1, 1907 under the name The Peoples National Bank of Strasburg. On January 10, 1928, the Bank changed its name to The First National Bank of Strasburg. On April 12, 1994, the Bank received approval from the Federal Reserve Bank of Richmond (the Federal Reserve) and the Virginia State Corporation Commission’s Bureau of Financial Institutions to convert to a state chartered bank with membership in the Federal Reserve System. On June 1, 1994, the Bank consummated such conversion and changed its name to First Bank.

Access to Filings

The Company’s internet address is www.fbvirginia.com. The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to those reports, as filed with or furnished to the Securities and Exchange Commission (the SEC), are available free of charge at www.fbvirginia.com as soon as reasonably practicable after being filed with or furnished to the SEC. A copy of any of the Company’s filings will be sent, without charge, to any shareholder upon written request to: M. Shane Bell, Chief Financial Officer, at 112 West King Street, Strasburg, Virginia 22657.

Products and Services

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

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

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

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

The Bank’s products and services are provided through 10 branch offices, 1 customer service center, 2 loan production offices, 25 ATMs and its website, www.fbvirginia.com. Upon the completion of a pending branch acquisition scheduled to close in April 2015, the Bank expects to add four branch office locations in the Shenandoah Valley region of Virginia located in Woodstock, Staunton, Waynesboro and Elkton, and two branch offices in central Virginia located in Farmville and Dillwyn. After the transaction closes, the Bank expects to operate a total of 16 branch offices with approximately $750 million in total assets. The loan production offices were opened during 2014 and are located in Staunton and Harrisonburg, Virginia. The Bank operates six of its branch offices under the “Financial Center” concept. A Financial Center offers all of the Bank’s financial services at one location. This concept allows loan, deposit, and wealth management personnel to be readily available to serve customers throughout the Bank’s market area. For the location of each of these Financial Centers, see Item 2 of this Form 10-K.

Competition

The financial services industry remains highly competitive and is constantly evolving. The Company experiences strong competition in all aspects of its business. In its market areas, the Company competes with large national and regional financial institutions, credit unions, other independent community banks, as well as consumer finance companies, mortgage companies, loan production offices, mutual funds and life insurance companies. Competition has increasingly come from out-of-state

 

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banks through their acquisitions of Virginia-based banks. Competition for deposits and loans is affected by various factors including interest rates offered, the number and location of branches and types of products offered, and the reputation of the institution. Credit unions have been allowed to increasingly expand their membership definitions and, because they enjoy a favorable tax status, may be able to offer more attractive loan and deposit pricing.

The Company believes its competitive advantages include long-term customer relationships, local management and directors, a commitment to excellent customer service, dedicated and loyal employees, and the support of and involvement in the communities that the Company serves. The Company focuses on providing products and services to individuals, small to medium-sized businesses and local governmental entities within its communities. According to Federal Deposit Insurance Corporation (FDIC) deposit data as of June 30, 2014, the Bank was ranked first in Shenandoah County with $226.5 million in deposits, representing 30% of the total deposit market; third in Warren County with $50.2 million or 11% of the market; and fourth in Winchester and Frederick County with $179.1 million or 9% of the market. The Bank was ranked third overall in its market area with 14% of the total deposit market.

No material part of the business of the Company is dependent upon a single or a few customers, and the loss of any single customer would not have a materially adverse effect upon the business of the Company.

Employees

At December 31, 2014, the Company and the Bank employed a total of 156 full-time equivalent employees. The Company considers relations with its employees to be excellent.

SUPERVISION AND REGULATION

Bank holding companies and banks are extensively and increasingly regulated under both federal and state laws. The following description briefly addresses certain historic and current provisions of federal and state laws and certain regulations, proposed regulations, and the potential impacts on the Company and the Bank. To the extent statutory or regulatory provisions or proposals are described in this report, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

Regulatory Reform – The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacted in 2010, implemented and continues to implement significant changes to the regulation of the financial services industry, including provisions that, among other things:

 

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Centralize responsibility for consumer financial protection by creating a new agency within the Federal Reserve Board, the Consumer Financial Protection Bureau (CFPB), with broad rulemaking, supervisory and enforcement authority with respect to a wide range of consumer protection laws that generally apply to all banks and thrifts. Smaller financial institutions, including the Bank, continue to be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws.

 

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Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies.

 

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Require the FDIC to seek to make its capital requirements for banks countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction.

 

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Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital.

 

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Implement corporate governance revisions, including advisory votes on executive compensation by stockholders.

 

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Established extensive requirements applicable to mortgage lending, including detailed requirements concerning mortgage originator compensation and underwriting, high-cost mortgages, servicing, appraisals, counseling and other matters.

 

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Make permanent the $250,000 limit for federal deposit insurance.

 

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Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

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The Dodd-Frank Act amends the Bank Holding Company Act of 1956, as amended (the “BHCA”) to require the federal financial regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds). The statutory provision is commonly called the “Volcker Rule”. The Federal Reserve Board issued final rules implementing the Volcker Rule on December 10, 2013. The Volcker Rule became effective on July 21, 2012 and the final rules were effective April 1, 2014, but the Federal Reserve Board issued an order extending the period during which institutions have to conform their activities and investments to the requirements of the Volcker Rule to July 21, 2017. We do not currently anticipate that the Volcker Rule will have a material effect on the operations of the holding company or the Bank, as we generally do not engage in activities or hold investments impacted by the Volcker Rule.

Many aspects of the Dodd-Frank Act still remain subject to rulemaking by various regulatory agencies and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. The changes resulting from the Dodd-Frank Act may affect the profitability of business activities, require changes to certain business practices, impose more stringent capital requirements, liquidity and leverage ratio requirements, or otherwise adversely affect the business of the Company and the Bank. These changes may also require the Company to invest significant management attention and resources to evaluate and make necessary changes to comply with new statutory and regulatory requirements.

The Company

General. As a bank holding company registered under the BHCA, the Company is subject to supervision, regulation, and examination by the Federal Reserve. The Company is also registered under the bank holding company laws of Virginia and is subject to supervision, regulation, and examination by the Virginia State Corporation Commission (the “SCC”).

Permitted Activities. A bank holding company is limited to managing or controlling banks, furnishing services to or performing services for its subsidiaries, and engaging in other activities that the Federal Reserve determines by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity reasonably can be expected to produce benefits to the public that outweigh possible adverse effects. Possible benefits include greater convenience, increased competition, and gains in efficiency. Possible adverse effects include undue concentration of resources, decreased or unfair competition, conflicts of interest, and unsound banking practices. Despite prior approval, the Federal Reserve may order a bank holding company or its subsidiaries to terminate any activity or to terminate ownership or control of any subsidiary when the Federal Reserve has reasonable cause to believe that a serious risk to the financial safety, soundness or stability of any bank subsidiary of that bank holding company may result from such an activity.

Banking Acquisitions; Changes in Control. The BHCA requires, among other things, the prior approval of the Federal Reserve in any case where a bank holding company proposes to (i) acquire direct or indirect ownership or control of more than 5% of the outstanding voting stock of any bank or bank holding company (unless it already owns a majority of such voting shares), (ii) acquire all or substantially all of the assets of another bank or bank holding company, or (iii) merge or consolidate with any other bank holding company. In determining whether to approve a proposed bank acquisition, the Federal Reserve will consider, among other factors, the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institution’s performance under the Community Reinvestment Act of 1977 (the “CRA”).

Subject to certain exceptions, the BHCA and the Change in Bank Control Act, together with the applicable regulations, require Federal Reserve approval (or, depending on the circumstances, no notice of disapproval) prior to any person or company’s acquiring “control” of a bank or bank holding company. A conclusive presumption of control exists if an individual or company acquires the power, directly or indirectly, to direct the management or policies of an insured depository institution or to vote 25% or more of any class of voting securities of any insured depository institution. A rebuttable presumption of control exists if a person or company acquires 10% or more but less than 25% of any class of voting securities of an insured depository institution and either the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or no other person will own a greater percentage of that class of voting securities immediately after the acquisition. The Company’s common stock is registered under Section 12 of the Exchange Act.

Source of Strength. Federal Reserve policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement. The federal bank regulatory agencies must still issue regulations to implement the source of strength provisions of the Dodd-Frank Act. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when the Company may not be in a financial position to provide such resources. Any capital loans by a bank holding

 

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company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

Safety and Soundness. There are a number of obligations and restrictions imposed on bank holding companies and their subsidiary banks by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the Federal Deposit Insurance Corporation (“FDIC”) insurance fund in the event of a depository institution default. For example, under the Federal Deposit Insurance Company Improvement Act of 1991, to avoid receivership of an insured depository institution subsidiary, a bank holding company is required to guarantee the compliance of any subsidiary bank that may become “undercapitalized” with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency up to the lesser of (i) an amount equal to 5% of the institution’s total assets at the time the institution became undercapitalized, or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan.

Under the Federal Deposit Insurance Act (“FDIA”), the federal bank regulatory agencies have adopted guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines.

Capital Requirements. The Federal Reserve imposes certain capital requirements on bank holding companies under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are described below under “The Bank-Capital Requirements”. Subject to its capital requirements and certain other restrictions, the Company is able to borrow money to make a capital contribution to the Bank, and such loans may be repaid from dividends paid by the Bank to the Company.

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

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

Limits on Dividends and Other Payments. The Company is a legal entity, separate and distinct from its subsidiaries. A significant portion of the revenues of the Company result from dividends paid to it by the Bank. There are various legal limitations applicable to the payment of dividends by the Bank to the Company and to the payment of dividends by the Company to its shareholders. The Bank is subject to various statutory restrictions on its ability to pay dividends to the Company. Under the current supervisory practices of the Bank’s regulatory agencies, prior approval from those agencies is required if cash dividends declared in any given year exceed net income for that year, plus retained net profits of the two preceding years. The payment of dividends by the Bank or the Company may be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Bank or the Company from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of the Bank, or the Company, could be deemed to constitute such an unsafe or unsound practice.

The Company’s preferred stock is in a superior ownership position compared to common stock. Dividends must be paid to the preferred stock holder before they can be paid to the common shareholders. If the dividends on the Preferred Stock have not been paid for an aggregate of six (6) quarterly dividend periods or more, whether or not consecutive, the Company’s authorized number of directors will be automatically increased by two (2) and the holders of the Preferred Stock will have the right to elect those directors at the Company’s next annual meeting or at a special meeting called for that purpose; these two directors may be elected annually and may serve until all accrued and unpaid dividends for all past dividend periods have been declared and paid in full. The Company is current on all dividend payments on the Preferred Stock.

 

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The Bank

General. The Bank is supervised and regularly examined by the Federal Reserve and the SCC. The various laws and regulations administered by the regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt, and acquisition of financial institutions and other companies; they also affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted, and location of offices. Certain of these law and regulations are referenced above under “The Company.”

Capital Requirements. The Federal Reserve and the other federal banking agencies have issued risk-based and leverage capital guidelines applicable to U. S. banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of the Federal Reserve, the Company and the Bank are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0%. At least half of the total capital is required to be “Tier 1 capital,” which consists principally of common and certain qualifying preferred shareholders’ equity (including grandfathered trust preferred securities), less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company were 18.67% and 19.93%, respectively, as of December 31, 2014, thus exceeding the minimum requirements. The Tier 1 and total capital to risk-weighted asset ratios of the Bank were 17.88% and 19.14%, respectively, as of December 31, 2014, also exceeding the minimum requirements.

Each of the federal regulatory agencies has established a minimum leverage capital ratio of Tier 1 capital to average adjusted assets (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including having the highest regulatory examination rating and are not contemplating significant growth or expansion. As of December 31, 2014, the Tier 1 leverage ratios of the Company and the Bank were 13.47% and 12.90%, respectively, well above the minimum requirements. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets.

The Bank will also be subject to the new Basel III capital rules discussed above. We have evaluated the impact of the Basel III final rule on the Bank’s regulatory capital ratios and currently anticipate that its capital ratios will be sufficient to meet the well capitalized minimum capital requirements.

Deposit Insurance. Substantially all of the deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. On April 1, 2011, the deposit insurance assessment base changed from total deposits to average total assets minus average tangible equity, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Act.

The FDIA, as amended by the Federal Deposit Insurance Reform Act and the Dodd-Frank Act, requires the FDIC to set a ratio of deposit insurance reserves to estimated insured deposits of at least 1.35%. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating. On February 7, 2011, the FDIC introduced three possible adjustments to an institution’s initial base assessment rate: (i) a decrease of up to five basis points for long-term unsecured debt, including senior unsecured debt (other than debt guaranteed under the Temporary Liquidity Guarantee Program) and subordinated debt and, for small institutions, a portion of Tier 1 capital; (ii) an increase for holding long-term unsecured or subordinated debt issued by other insured depository institutions known as the Depository Institution Debt Adjustment or DIDA; and (iii) for non-Risk Category I institutions, an increase not to exceed 10 basis points for brokered deposits in excess of 10% of domestic deposits.

In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately one basis point of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.

Transactions with Affiliates. Pursuant to Sections 23A and 23B of the Federal Reserve Act and Regulation W, the authority of the Bank to engage in transactions with related parties or “affiliates” or to make loans to insiders is limited. Loan transactions with an affiliate generally must be collateralized and certain transactions between the Bank and its affiliates, including the sale of assets, the payment of money or the provision of services, must be on terms and conditions that are substantially the same, or at least as favorable to the Bank, as those prevailing for comparable nonaffiliated transactions. In addition, the Bank generally may not purchase securities issued or underwritten by affiliates.

 

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Loans to executive officers, directors or to any person who directly or indirectly, or acting through or in concert with one or more persons, owns, controls or has the power to vote more than 10% of any class of voting securities of a bank (a “10% Shareholder”), are subject to Sections 22(g) and 22(h) of the Federal Reserve Act and their corresponding regulations (Regulation O) and Section 13(k) of the Exchange Act relating to the prohibition on personal loans to executives (which exempts financial institutions in compliance with the insider lending restrictions of Section 22(h) of the Federal Reserve Act). Among other things, these loans must be made on terms substantially the same as those prevailing on transactions made to unaffiliated individuals and certain extensions of credit to those persons must first be approved in advance by a disinterested majority of the entire board of directors. Section 22(h) of the Federal Reserve Act prohibits loans to any of those individuals where the aggregate amount exceeds an amount equal to 15% of an institution’s unimpaired capital and surplus plus an additional 10% of unimpaired capital and surplus in the case of loans that are fully secured by readily marketable collateral, or when the aggregate amount on all of the extensions of credit outstanding to all of these persons would exceed the Bank’s unimpaired capital and unimpaired surplus. Section 22(g) of the Federal Reserve Act identifies limited circumstances in which the Bank is permitted to extend credit to executive officers.

Prompt Corrective Action. Immediately upon becoming “undercapitalized,” a depository institution becomes subject to the provisions of Section 38 of the FDIA, which: (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution’s assets; and (v) require prior approval of certain expansion proposals. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the DIF, subject in certain cases to specified procedures. These discretionary supervisory actions include: (i) requiring the institution to raise additional capital; (ii) restricting transactions with affiliates; (iii) requiring divestiture of the institution or the sale of the institution to a willing purchaser; and (iv) any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions. The Bank meets the definition of being “well capitalized” as of December 31, 2014.

Community Reinvestment Act. The Bank is subject to the requirements of the Community Reinvestment Act of 1977. The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low and moderate income neighborhoods. If the Bank receives a rating from the Federal Reserve of less than satisfactory under the CRA, restrictions on operating activities could be imposed.

Privacy Legislation. Several recent regulations issued by federal banking agencies also provide new protections against the transfer and use of customer information by financial institutions. A financial institution must provide to its customers information regarding its policies and procedures with respect to the handling of customers’ personal information. Each institution must conduct an internal risk assessment of its ability to protect customer information. These privacy provisions generally prohibit a financial institution from providing a customer’s personal financial information to unaffiliated parties without prior notice and approval from the customer.

USA Patriot Act of 2001. In October 2001, the USA Patriot Act of 2001 (“Patriot Act”) was enacted in response to the September 11, 2001 terrorist attacks. The Patriot Act is intended to strengthen U. S. law enforcement and the intelligence communities’ abilities to work cohesively to combat terrorism. The continuing impact on financial institutions of the Patriot Act and related regulations and policies is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities to identify persons who may be involved in terrorism or money laundering.

Consumer Laws and Regulations. The Bank is also subject to certain consumer laws and regulations issued thereunder that are designed to protect consumers in transactions with banks. These laws include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, Real Estate Settlement Procedures Act, Home Mortgage Disclosure Act, the Fair Credit Reporting Act, the Fair Housing Act and the Dodd-Frank Act, among others. The laws and related regulations mandate certain disclosure requirements and regulate the manner in which financial institutions transact business with customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing customer relations.

 

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Incentive Compensation. In June 2010, the federal banking agencies issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of financial institutions do not undermine the safety and soundness of such institutions by encouraging excessive risk-taking. The Interagency Guidance on Sound Incentive Compensation Policies, which covers all employees that have the ability to materially affect the risk profile of a financial institution, either individually or as part of a group, is based upon the key principles that a financial institution’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the institution’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the financial institution’s board of directors.

The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of financial institutions, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each financial institution based on the scope and complexity of the institution’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the institution’s supervisory ratings, which can affect the institution’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a financial institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the institution’s safety and soundness and the financial institution is not taking prompt and effective measures to correct the deficiencies. At December 31, 2014, the Company had not been made aware of any instances of non-compliance with the guidance.

Effect of Governmental Monetary Policies

The Company’s operations are affected not only by general economic conditions but also by the policies of various regulatory authorities. In particular, the Federal Reserve regulates money and credit conditions and interest rates to influence general economic conditions. These policies have a significant impact on overall growth and distribution of loans, investments and deposits; they affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks, including the Company, in the past and are expected to do so in the future.

 

Item 1A.

Risk Factors

An investment in the Company’s securities involves risks. In addition to the other information set forth in this report, investors in the Company’s securities should carefully consider the factors discussed below. These factors could materially and adversely affect the Company’s business, financial condition, liquidity, results of operations and capital position, and could cause the Company’s actual results to differ materially from its historical results or the results contemplated by the forward-looking statements contained in this report, in which case the trading price of the Company’s securities could decline.

Risks Related To The Company’s Business

The Company’s business may be adversely affected by conditions in the financial markets and economic conditions generally.

The community banking industry is directly affected by national, regional, and local economic conditions. The economies in the Company’s market areas continued to show improvement during 2014. Management allocates significant resources to mitigate and respond to risks associated with the current economic conditions, however, such conditions cannot be predicted or controlled. Therefore, such conditions, including a reduction in federal government spending, a flatter yield curve, and extended low interest rates, could adversely affect the credit quality of the Company’s loans, and/or the Company’s results of operations and financial condition. The Company’s financial performance is dependent on the business environment in the markets where the Company operates, in particular, the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services the Company offers. In addition, the Company holds securities which can be significantly affected by various factors including credit ratings assigned by third parties. An adverse credit rating in securities held by the Company could result in a reduction of the fair value of its securities portfolio and have an adverse impact on its financial condition. While general economic conditions in Virginia and the U.S. continued to improve in 2014, there can be no assurance that this improvement will continue.

 

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The inability of the Company to successfully manage its growth or implement its growth strategy may adversely affect the Company’s results of operations and financial conditions.

The Company may not be able to successfully implement its growth strategy if it is unable to expand market share in existing locations, identify attractive markets, locations, or opportunities to expand in the future. In addition, the ability to manage growth successfully depends on whether the Company can maintain adequate capital levels, maintain cost controls, effectively manage asset quality, and successfully integrate any expanded business divisions or acquired businesses into the organization.

As the Company continues to implement its growth strategy by opening new branches or acquiring branches or banks, it expects to incur increased personnel, occupancy, and other operating expenses. In the case of new branches, the Company must absorb those higher expenses while it begins to generate new deposits. In the case of acquired branches, the Company must absorb higher expenses while it begins deploying the newly assumed deposit liabilities. With either new branches opened or branches acquired, there would be a time lag involved in deploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, the Company’s plans to expand could depress earnings in the short run, even if it efficiently executes a branching strategy leading to long-term financial benefits.

Difficulties in combining the operations of acquired bank branches or entities with the Company’s own operations may prevent the Company from achieving the expected benefits from acquisitions.

The Company may not be able to achieve fully the strategic objectives and operating efficiencies expected in an acquisition. Inherent uncertainties exist in integrating the operations of an acquired entity. In addition, the markets and industries in which the Company and its potential acquisition targets operate are highly competitive. The Company may lose customers or the customers of acquired entities as a result of an acquisition; the Company may lose key personnel, either from the acquired entity or from itself; and the Company may not be able to control the incremental increase in noninterest expense arising from an acquisition in a manner that improves its overall operating efficiencies. These factors could contribute to the Company’s not achieving the expected benefits from its acquisitions within desired time frames, if at all. Future business acquisitions could be material to the Company and it may issue additional shares of common stock to support those acquisitions, which would dilute current shareholders’ ownership interests. Acquisitions also could require the Company to use substantial cash or other liquid assets or to incur debt; the Company could therefore become more susceptible to economic downturns and competitive pressures.

The Company faces substantial competition that could adversely affect the Company’s growth and/or operating results.

The Company operates in a competitive market for financial services and faces intense competition from other financial institutions both in making loans and attracting deposits which can greatly affect pricing for its products and services. The Company’s primary competitors include community, regional, and national banks as well as credit unions and mortgage companies. Many of these financial institutions have been in business for many years, are significantly larger, have established customer bases and have greater financial resources and higher lending limits. In addition, credit unions are exempt from corporate income taxes, providing a significant competitive pricing advantage. Accordingly, some of the Company’s competitors in its market have the ability to offer products and services that it is unable to offer or to offer at more competitive rates.

Consumers may increasingly decide not to use the Bank to complete their financial transactions, which would have a material adverse impact on the Company’s financial condition and operations.

Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

 

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The Company’s mortgage revenue is cyclical and is sensitive to the level of interest rates, changes in economic conditions, decreased economic activity, and slowdowns in the housing market, any of which could adversely impact the Company’s profits.

The success of the Bank’s mortgage division is dependent upon its ability to originate loans and sell them to investors. Loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions. Loan production levels may suffer if the Bank experiences a slowdown in the local housing market or tightening credit conditions. Any sustained period of decreased activity caused by fewer refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect the Bank’s mortgage originations and, consequently, could significantly reduce its income from mortgage activities. As a result, these conditions would also adversely affect the Company’s results of operations.

Deteriorating economic conditions may also cause home buyers to default on their mortgages. In certain cases where the Bank has originated loans and sold them to investors, the Bank may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on, or related to, their loan application, if appraisals for such properties have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor. Such repurchases or settlements would adversely affect the Company’s results of operations.

The carrying value of goodwill may be adversely affected.

When a Company completes an acquisition, often times, goodwill is recorded on the date of acquisition as an asset. Current accounting guidance requires goodwill to be tested for impairment; the Company would perform such impairment analysis at least annually. A significant adverse change in expected future cash flows or sustained adverse change in the Company’s common stock could require the asset to become impaired. If impaired, the Company would incur a charge to earnings that would have a significant impact on the results of operations.

The Company is subject to claims and litigation pertaining to fiduciary responsibility.

From time to time, customers make claims and take legal action pertaining to the performance of the Bank’s fiduciary responsibilities. Whether customer claims and legal action related to the performance of the Bank’s fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services, as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.

The Company depends on the accuracy and completeness of information about clients and counterparties, and its financial condition could be adversely affected if it relies on misleading information.

In deciding whether to extend credit or to enter into other transactions with clients and counterparties, the Company may rely on information furnished to it by or on behalf of clients and counterparties, including financial statements and other financial information, which the Company does not independently verify. The Company also may rely on representations of clients and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to clients, the Company may assume that a customer’s audited financial statements conform to GAAP and present fairly, in all material respects, the financial condition, results of operations, and cash flows of the customer. The Company’s financial condition and results of operations could be negatively impacted to the extent it relies on financial statements that do not comply with GAAP or are materially misleading.

The Company’s dependency on its management team and the unexpected loss of any of those personnel could adversely affect operations.

The Company has assembled an experienced management team and continues to build the depth of that team. Although management development plans are in place, the unexpected loss of key employees could have a material adverse effect on the Company’s business and may result in lower revenues or greater expenses.

 

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Failure to maintain effective systems of internal and disclosure controls could have a material adverse effect on the Company’s results of operation and financial condition.

Effective internal and disclosure controls are necessary for the Company to provide reliable financial reports and effectively prevent fraud, and to operate successfully as a public company. If the Company cannot provide reliable financial reports or prevent fraud, its reputation and operating results would be harmed. As part of the Company’s ongoing monitoring of internal controls, it may discover material weaknesses or significant deficiencies in its internal control that require remediation. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The Company continually works on improving its internal controls. However, the Company cannot be certain that these measures will ensure that it implements and maintains adequate controls over its financial processes and reporting. Any failure to maintain effective controls or to timely implement any necessary improvement of the Company’s internal and disclosure controls could, among other things, result in losses from fraud or error, harm the Company’s reputation, or cause investors to lose confidence in the Company’s reported financial information, all of which could have a material adverse effect on the Company’s results of operation and financial condition.

Negative public opinion could damage our reputation and adversely impact liquidity and profitability.

As a financial institution, the Company’s earnings, liquidity, and capital are subject to risks associated with negative public opinion of the Company and of the financial services industry as a whole. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, the failure of any product or service sold by us to meet our clients’ expectations or applicable regulatory requirements, corporate governance and acquisitions, or from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to keep, attract and/or retain customers and can expose us to litigation and regulatory action. Actual or alleged conduct by one of our businesses can result in negative public opinion about our other businesses. Negative public opinion could also affect our ability to borrow funds in the unsecured wholesale debt markets.

Changes in interest rates could adversely affect the Company’s income and cash flows.

The Company’s income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets, such as loans and investment securities, and the interest rates paid on interest-bearing liabilities, such as deposits and borrowings. These rates are highly sensitive to many factors beyond the Company’s control, including general economic conditions and the policies of the Federal Reserve and other governmental and regulatory agencies. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment of loans, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if the Company does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates. In addition, the Company’s ability to reflect such interest rate changes in pricing its products is influenced by competitive pressures. Fluctuations in these areas may adversely affect the Company and its shareholders. The Bank is often at a competitive disadvantage in managing its costs of funds compared to the large regional, super-regional, or national banks that have access to the national and international capital markets.

The Company generally seeks to maintain a neutral position in terms of the volume of assets and liabilities that mature or re-price during any period so that it may reasonably maintain its net interest margin; however, interest rate fluctuations, loan prepayments, loan production, deposit flows, and competitive pressures are constantly changing and influence the ability to maintain a neutral position. Generally, the Company’s earnings will be more sensitive to fluctuations in interest rates depending upon the variance in volume of assets and liabilities that mature and re-price in any period. The extent and duration of the sensitivity will depend on the cumulative variance over time, the velocity and direction of changes in interest rates, shape and slope of the yield curve, and whether the Company is more asset sensitive or liability sensitive. Accordingly, the Company may not be successful in maintaining a neutral position and, as a result, the Company’s net interest margin may be affected.

 

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Limited availability of financing or inability to raise capital could adversely impact the Company.

The amount, type, source, and cost of the Company’s funding and capital directly impacts the ability to grow assets. The ability to raise funds through deposits, borrowings and other sources, or raise capital could become more difficult, more expensive, or altogether unavailable. A number of factors could make such financing more difficult, more expensive or unavailable including: the financial condition of the Company at any given time; rate disruptions in the capital markets; the reputation for soundness and security of the financial services industry as a whole; and, competition for funding from other banks or similar financial service companies, some of which could be substantially larger or be more favorably rated.

The soundness of other financial institutions could adversely affect the Company.

The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Company or by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client. There is no assurance that any such losses would not materially and adversely affect the Company’s results of operations.

The Company’s exposure to operational, technological, and organizational risk may adversely affect the Company.

Similar to other financial institutions, the Company is exposed to many types of operational and technological risk, including reputation, legal, and compliance risk. The Company’s ability to grow and compete is dependent on its ability to build or acquire the necessary operational and technological infrastructure and to manage the cost of that infrastructure while it expands and integrates acquired businesses. Operational risk can manifest itself in many ways, such as errors related to failed or inadequate processes, faulty or disabled computer systems, occurrences of fraud by employees or persons outside of the Company, and exposure to external events. The Company is dependent on its operational infrastructure to help manage these risks. From time to time, it may need to change or upgrade its technology infrastructure. The Company may experience disruption, and it may face additional exposure to these risks during the course of making such changes. If the Company would acquire another financial institution or bank branch operations, it would face additional challenges when integrating different operational platforms. Such integration efforts may be more disruptive to the business and/or more costly than anticipated.

The Company and the Bank rely on other companies to provide key components of their business infrastructure.

Third parties provide key components of the Company’s (and the Bank’s) business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, internet connections, and network access. While the Company has selected these third party vendors carefully, it does not control their actions. Any problem caused by these third parties, including poor performance of services, failure to provide services, disruptions in communication services provided by a vendor and failure to handle current or higher volumes, could adversely affect the Company’s ability to deliver products and services to its customers and otherwise conduct its business, and may harm its reputation. Financial or operational difficulties of a third party vendor could also hurt the Company’s operations if those difficulties affect the vendor’s ability to serve the Company. Replacing these third party vendors could also create significant delay and expense. Accordingly, use of such third parties creates an unavoidable inherent risk to the Company’s business operations.

The operational functions of business counterparties over which the Company may have limited or no control may experience disruptions that could adversely impact the Company.

Multiple major U.S. retailers have recently experienced data systems incursions reportedly resulting in the thefts of credit and debit card information, online account information, and other financial data of the retailers’ customers. Retailer incursions affect cards issued and deposit accounts maintained by many banks, including the Bank. Although neither the Company’s nor the Bank’s systems are breached in retailer incursions, these events can cause the Bank to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Bank and its customers. In some cases, the Bank may be required to reimburse customers for the losses they incur. Other possible points of intrusion or disruption not within the Company’s nor the Bank’s control include internet service providers, electronic mail portal providers, social media portals, distant-server (“cloud”) service providers, electronic data security providers, telecommunications companies, and smart phone manufacturers.

 

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The Company’s operations may be adversely affected by cyber security risks.

In the ordinary course of business, the Company collects and stores sensitive data, including proprietary business information and personally identifiable information of its customers and employees in systems and on networks. The secure processing, maintenance, and use of this information is critical to operations and the Company’s business strategy. The Company has invested in accepted technologies, and continually reviews processes and practices that are designed to protect its networks, computers, and data from damage or unauthorized access. Despite these security measures, the Company’s computer systems and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance, or other disruptions. A breach of any kind could compromise systems and the information stored there could be accessed, damaged or disclosed. A breach in security could result in legal claims, regulatory penalties, disruption in operations, and damage to the Company’s reputation, which could adversely affect its business. Furthermore, as cyber threats continue to evolve and increase, the Company may be required to expend significant additional resources to modify or enhance its protective measures, or to investigate and remediate any identified information security vulnerabilities.

Nonperforming assets take significant time to resolve and adversely affect the Company’s results of operations and financial condition.

The Company’s nonperforming assets adversely affect its net income in various ways. The Company does not record interest income on nonaccrual loans, which adversely affects its income and increases loan administration costs. When the Company receives collateral through foreclosures and similar proceedings, it is required to mark the related loan to the then fair market value of the collateral less estimated selling costs, which may result in a loss. An increase in the level of nonperforming assets also increases the Company’s risk profile and may affect the capital levels that the Company believes are appropriate in light of such risks. The Company utilizes various techniques such as workouts, restructurings, and loan sales to manage problem assets. Increases in or negative adjustments in the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect the Company’s business, results of operations, and financial condition. In addition, the resolution of nonperforming assets requires significant commitments of time from management and staff, which can be detrimental to the performance of their other responsibilities, including origination of new loans. There can be no assurance that the Company will avoid further increases in nonperforming loans in the future.

The Bank’s allowance for loan losses may prove to be insufficient to absorb losses in its loan portfolio.

Like all financial institutions, the Bank maintains an allowance for loan losses to provide for loans that its borrowers may not repay in their entirety. The Bank believes that it maintains an allowance for loan losses at a level adequate to absorb probable losses inherent in the loan portfolio as of the corresponding balance sheet date and in compliance with applicable accounting and regulatory guidance. However, the allowance for loan losses may not be sufficient to cover actual loan losses and future provisions for loan losses could materially and adversely affect the Company’s operating results. Accounting measurements related to impairment and the allowance for loan losses require significant estimates that are subject to uncertainty and changes relating to new information and changing circumstances. The significant uncertainties surrounding the ability of the Bank’s borrowers to execute their business models successfully through changing economic environments, competitive challenges, and other factors complicate the Bank’s estimates of the risk of loss and amount of loss on any loan. Because of the degree of uncertainty and susceptibility of these factors to change, the actual losses may vary from current estimates. The Company expects fluctuations in the loan loss provisions due to the uncertain economic conditions.

The Company’s banking regulators, as an integral part of their examination process, periodically review the allowance for loan losses and may require the Bank to increase its allowance for loan losses by recognizing additional provisions for loan losses charged to expense, or to decrease the allowance for loan losses by recognizing loan charge-offs, net of recoveries. Any such required additional provisions for loan losses or charge-offs could have a material adverse effect on the Company’s financial condition and results of operations.

If the Bank’s valuation allowance on OREO becomes inadequate, results of operations may be adversely affected.

The Bank maintains a valuation allowance that it believes is a reasonable estimate of known losses in OREO. The Bank obtains appraisals on all OREO properties on an annual basis and adjusts the valuation allowance accordingly. The carrying value of OREO is susceptible to changes in economic and real estate market conditions. Although the Company believes the valuation allowance is a reasonable estimate of known losses, such losses and the adequacy of the allowance cannot be fully predicted. Excessive declines in market values could have a material impact on financial performance.

 

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The Bank’s concentration in loans secured by real estate may adversely affect earnings due to changes in the real estate markets.

The Bank offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer, and other loans. Many of the Bank’s loans are secured by real estate (both residential and commercial) in the Bank’s market areas. A major change in the real estate markets, resulting in deterioration in the value of this collateral, or in the local or national economy, could adversely affect borrowers’ ability to pay these loans, which in turn could negatively affect the Bank. Risks of loan defaults and foreclosures are unavoidable in the banking industry; the Bank tries to limit its exposure to these risks by monitoring extensions of credit carefully. The Bank cannot fully eliminate credit risk; thus, credit losses will occur in the future. Additionally, changes in the real estate market also affect the value of foreclosed assets, and therefore, additional losses may occur when management determines it is appropriate to sell the assets.

The Bank has a significant concentration of credit exposure in commercial real estate, and loans with this type of collateral are viewed as having more risk of default.

The Bank’s commercial real estate portfolio consists primarily of owner-operated properties and other commercial properties. These types of loans are generally viewed as having more risk of default than residential real estate loans. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. Cash flows may be affected significantly by general economic conditions, and a downturn in the local economy or in occupancy rates in the local economy where the property is located could increase the likelihood of default. Because the Bank’s loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in the percentage of non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on the Bank’s financial condition.

The Bank’s banking regulators generally give commercial real estate lending greater scrutiny and may require banks with higher levels of commercial real estate loans to implement improved underwriting, internal controls, risk management policies, and portfolio stress testing, as well as possibly higher levels of allowances for losses and capital levels as a result of commercial real estate lending growth and exposures, which could have a material adverse effect on the Bank’s results of operations.

The Bank’s loan portfolio contains construction and development loans, and a decline in real estate values and economic conditions would adversely affect the value of the collateral securing the loans and have an adverse effect on the Bank’s financial condition.

Although most of the Bank’s construction and development loans are secured by real estate, the Bank believes that, in the case of the majority of these loans, the real estate collateral by itself may not be a sufficient source for repayment of the loan if real estate values decline. If the Bank is required to liquidate the collateral securing a construction and development loan to satisfy the debt, its earnings and capital may be adversely affected. A period of reduced real estate values may continue for some time, resulting in potential adverse effects on the Bank’s earnings and capital.

The Company’s credit standards and its on-going credit assessment processes might not protect it from significant credit losses.

The Company assumes credit risk by virtue of making loans and extending loan commitments and letters of credit. The Company manages credit risk through a program of underwriting standards, the review of certain credit decisions and a continuous quality assessment process of credit already extended. The Company’s exposure to credit risk is managed through the use of consistent underwriting standards that emphasize local lending while avoiding highly leveraged transactions as well as excessive industry and other concentrations. The Company’s credit administration function employs risk management techniques to help ensure that problem loans are promptly identified. While these procedures are designed to provide the Company with the information needed to implement policy adjustments where necessary and to take appropriate corrective actions, there can be no assurance that such measures will be effective in avoiding undue credit risk.

 

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The Company’s focus on lending to small to mid-sized community-based businesses may increase its credit risk.

Most of the Company’s commercial business and commercial real estate loans are made to small business or middle market customers. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities and have a heightened vulnerability to economic conditions. If general economic conditions in the market areas in which the Company operates negatively impact this important customer sector, the Company’s results of operations and financial condition may be adversely affected. Moreover, a portion of these loans have been made by the Company in recent years and the borrowers may not have experienced a complete business or economic cycle. Any deterioration of the borrowers’ businesses may hinder their ability to repay their loans with the Company, which could have a material adverse effect on the Company’s financial condition and results of operations.

The Bank relies upon independent appraisals to determine the value of the real estate which secures a significant portion of its loans, and the values indicated by such appraisals may not be realizable if the Bank is forced to foreclose upon such loans.

A significant portion of the Bank’s loan portfolio consists of loans secured by real estate. The Bank relies upon independent appraisers to estimate the value of such real estate. Appraisals are only estimates of value and the independent appraisers may make mistakes of fact or judgment that adversely affect the reliability of their appraisals. In addition, events occurring after the initial appraisal may cause the value of the real estate to increase or decrease. As a result of any of these factors, the real estate securing some of the Bank’s loans may be more or less valuable than anticipated at the time the loans were made. If a default occurs on a loan secured by real estate that is less valuable than originally estimated, the Bank may not be able to recover the outstanding balance of the loan.

The Dodd-Frank Act substantially changes the regulation of the financial services industry and it could have a material adverse effect upon the Company.

The Dodd-Frank Act provides wide-ranging changes in the way banks and financial services firms generally are regulated and affect the way the Company and its customers and counterparties do business with each other. Among other things, it requires increased capital and regulatory oversight for banks and their holding companies, changes the deposit insurance assessment system, changes responsibilities among regulators, establishes the CFPB, and makes various changes in the securities laws and corporate governance that affect public companies, including the Company. The Dodd-Frank Act also requires numerous studies and regulations related to its implementation. The Company is continually evaluating the effects of the Dodd-Frank Act, together with implementing the regulations that have been proposed and adopted. The ultimate effects of the Dodd-Frank Act and the resulting rulemaking cannot be predicted at this time, but it has increased the Company’s operating and compliance costs in the short-term, and it could have a material adverse effect on the Company’s results of operation and financial condition.

The Company is subject to more stringent capital and liquidity requirements as a result of the Basel III regulatory capital reforms and the Dodd-Frank Act, the short-term and long-term impact of which is uncertain.

The Company and the Bank are each subject to capital adequacy guidelines and other regulatory requirements specifying minimum amounts and types of capital which each must maintain. From time to time, regulators implement changes to these regulatory capital adequacy guidelines. Under the Dodd-Frank Act, the federal banking agencies have established stricter capital requirements and leverage limits for banks and bank holding companies that are based on the Basel III regulatory capital reforms. These stricter capital requirements will be phased-in over a four-year period, which began on January 1, 2015, until they are fully-implemented on January 1, 2019. If the Company and the Bank fail to meet these minimum capital guidelines and/or other regulatory requirements, the Company’s financial condition would be materially and adversely affected.

Recent regulations issued by the CFPB could adversely impact the Company’s earnings.

The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. Pursuant to the Dodd-Frank Act, the CFPB issued a final rule effective January 10, 2014, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms, or to originate “qualified mortgages” that meet specific requirements with respect to terms, pricing, and fees. The rule also contains additional disclosure requirements at mortgage loan origination and in monthly statements. These requirements could limit the Company’s ability to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could adversely impact the Company’s profitability.

 

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Current and proposed regulation addressing consumer privacy and data use and security could increase the Company’s costs and impact its reputation.

The Company is subject to a number of laws concerning consumer privacy and data use and securities, including information safeguard rules under the Gramm-Leach-Bliley Act. These rules require that financial institutions develop, implement, and maintain a written, comprehensive information security program containing safeguards that are appropriate to the financial institution’s size and complexity, the nature and scope of the financial institution’s activities, and the sensitivity of any customer information at issue. The United States has experienced a heightened legislative and regulatory focus on privacy and data security, including requiring consumer notification in the event of a data breach. In addition, most states have enacted security breach legislation requiring varying levels of consumer notification in the event of certain types of security breaches. New regulations in these areas may increase compliance costs, which could negatively impact earnings. In addition, failure to comply with the privacy and data use and security laws and regulations to which the Company is subject, including by reason of inadvertent disclosure of confidential information, could result in fines, sanctions, penalties, or other adverse consequences and loss of consumer confidence, which could materially adversely affect our results of operations, overall business, and reputation.

Legislative or regulatory changes or actions, or significant litigation, could adversely affect the Company or the businesses in which the Company is engaged.

The Company is subject to extensive state and federal regulation, supervision, and legislation that govern almost all aspects of its operations. Laws and regulations change from time to time and are primarily intended for the protection of consumers, depositors, and the FDIC’s DIF. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively affect the Company or its ability to increase the value of its business. Such changes include higher capital requirements, and could include increased insurance premiums, increased compliance costs, reductions of noninterest income, and limitations on services that can be provided. Actions by regulatory agencies or significant litigation against the Company could cause it to devote significant time and resources to defend itself and may lead to liability or penalties that materially affect the Company and its shareholders. Future changes in the laws or regulations or their interpretations or enforcement could be materially adverse to the Company and its shareholders.

See the section of this report entitled “Supervision and Regulation” for additional information on the statutory and regulatory issues that affect the Company’s business.

Changes in accounting standards could impact reported earnings.

The authorities that promulgate accounting standards, including the Financial Accounting Standards Board (“FASB”), the United States Securities Exchange Commission (the “SEC”), and other regulatory authorities, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes are difficult to predict and can materially impact how the Company records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of financial statements for prior periods. Such changes could also require the Company to incur additional personnel or technology costs.

Risks Related To The Company’s Securities

The Company’s ability to pay dividends depends upon the results of operations of its Bank subsidiary.

The Company is a bank holding company that conducts substantially all of its operations through its subsidiary Bank. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal regulatory considerations and the receipt of dividends and other distributions from the Bank. There are various regulatory restrictions on the ability of the Bank to pay dividends or make other payments to the Company. Although the Company has historically paid a cash dividend to the holders of its common stock, holders of the common stock are not entitled to receive dividends, and regulatory or economic factors may cause the Company’s Board of Directors to consider, among other things, the reduction of dividends paid on the Company’s common stock.

 

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There is a limited trading market for the Company’s common stock; it may be difficult to sell shares.

The trading volume in the Company’s common stock has been relatively limited. Even if a more active market develops, there can be no assurance that a more active and liquid trading market for the common stock will exist in the future. Consequently, shareholders may not be able to sell a substantial number of shares for the same price at which shareholders could sell a smaller number of shares. In addition, the Company cannot predict the effect, if any, that future sales of its common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of the common stock. Sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, could cause the price of the Company’s common stock to decline, or reduce the Company’s ability to raise capital through future sales of common stock. The lack of liquidity of the investment in the common shares should be carefully considered when making an investment decision.

Future issuances of the Company’s common stock could adversely affect the market price of the common stock and could be dilutive.

The Company is not restricted from issuing additional authorized shares of common stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, shares of common stock. Issuances of a substantial number of shares of common stock, or the expectation that such issuances might occur, including in connection with acquisitions by the Company, could materially adversely affect the market price of the shares of common stock and could be dilutive to shareholders. Because the Company’s decision to issue common stock in the future will depend on market conditions and other factors, it cannot predict or estimate the amount, timing, or nature of possible future issuances of its common stock. Accordingly, the Company’s shareholders bear the risk that future issuances will reduce the market price of the common stock and dilute their stock holdings in the Company.

The current economic conditions may cause volatility in the Company’s common stock value.

In the current economic environment, the value of publicly traded stocks in the financial services sector has been volatile. However, even in a more stable economic environment the value of the Company’s common stock can be affected by a variety of factors such as expected results of operations, actual results of operations, actions taken by shareholders, news or expectations based on the performance of others in the financial services industry, and expected impacts of a changing regulatory environment. These factors not only impact the value of the Company’s common stock but could also affect the liquidity of the stock given the Company’s size, geographical footprint, and industry.

The Company’s preferred stock and trust preferred capital notes (commonly referred to as trust preferred securities) have a preference to our common stock, which may limit our ability to pay dividends on common stock in the future.

Our ability to pay dividends on common stock is also limited by contractual restrictions under its trust preferred securities and preferred stock. Interest must be paid on the trust preferred securities, and dividends must be paid on the preferred stock, before dividends may be paid to the common shareholders. The Company is current in its interest and dividend payments on the trust preferred securities and preferred stock; however, it has the right to defer distributions on these instruments, during which time no dividends may be paid on its common stock. If the Company does not have sufficient earnings in the future and begins to defer distributions on the trust preferred securities or preferred stock, it will be unable to pay dividends on its common stock until it becomes current on those distributions.

The Company’s governing documents and Virginia law contain anti-takeover provisions that could negatively affect its shareholders.

The Company’s Articles of Incorporation and the Virginia Stock Corporation Act contain certain provisions designed to enhance the ability of the Board of Directors to deal with attempts to acquire control of the Company. These provisions and the ability to set the voting rights, preferences, and other terms of any series of outstanding preferred stock and preferred stock that may be issued, may be deemed to have an anti-takeover effect and may discourage takeovers (which certain shareholders may deem to be in their best interest). To the extent that such takeover attempts are discouraged, temporary fluctuations in the market price of the Company’s common stock resulting from actual or rumored takeover attempts may be inhibited. These provisions also could discourage or make more difficult a merger, tender offer, or proxy contest, even though such transactions may be favorable to the interests of shareholders, and could potentially adversely affect the market price of the Company’s common stock.

 

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Recently enacted legislation could allow the Company to deregister under the Exchange Act, which would result in a reduction in the amount and frequency of publicly-available information about the Company.

The Jumpstart Our Business Startups Act (or “JOBS Act”) may allow the Company to terminate the registration of its common stock under the Exchange Act. If the Company determines to deregister its common stock under the Exchange Act, it would enable it to save significant expenses relating to its public disclosure and reporting requirements under the Exchange Act. However, a de-registration of common stock also would result in a reduction in the amount and frequency of publicly-available information about the Company and the Bank.

 

Item 1B.

Unresolved Staff Comments

Not applicable.

 

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Item 2.

Properties

The following describes the location and general character of the principal offices of the Company.

The Company owns the headquarters building located at 112 West King Street, in Strasburg, Virginia. This location also serves as the Bank’s Strasburg Financial Center, which primarily serves the banking needs of northern Shenandoah County customers. This three story building also houses administrative employees, including human resources and marketing. Loan and deposit operations, data processing and information technology employees are housed in the Operations Center. Financial accounting and additional administrative employees are housed in the Winchester Financial Center. Financial centers provide full service banking, including loan, deposit, wealth management services, while the bank branches primarily focus on depository and consumer lending functions. The Bank operates a Customer Service Center located within The Village at Orchard Ridge retirement community. The following table provides the name, location, year opened and type of the Company’s locations:

 

Name		Location		Year Opened		Type		Owned/Leased
Strasburg Financial Center		112 West King Street Strasburg, Virginia		1927		Financial Center		Owned
Front Royal Express		508 North Commerce Avenue Front Royal, Virginia		1985		Branch		Leased
Kernstown Express		3143 Valley Pike Winchester, Virginia		1994		Branch		Owned
South Woodstock		860 South Main Street Woodstock, Virginia		1995		Branch		Owned
North Woodstock		496 North Main Street Woodstock, Virginia		1999		Branch		Leased
Front Royal Financial Center		1717 Shenandoah Avenue Front Royal, Virginia		2002		Financial Center		Owned
Winchester Financial Center		1835 Valley Avenue Winchester, Virginia		2003		Financial Center		Owned
Mount Jackson Financial Center		5304 Main Street Mount Jackson, Virginia		2004		Financial Center		Owned
Sherando Financial Center		695 Fairfax Pike Stephens City, Virginia		2006		Financial Center		Owned
Winchester West Financial Center		208 Crock Wells Mill Drive Winchester, Virginia		2006		Financial Center		Owned
Operations Center		406 Borden Mowery Drive Strasburg, Virginia		2008		Operations Center		Owned
The Village at Orchard Ridge Customer Service Center		400 Clocktower Ridge Drive Winchester, Virginia		2013		Customer Service Center		Leased
Staunton Loan Production Office		1600 North Coalter Street, Suite 10 Staunton, Virginia		2014		Loan Production Office		Leased
Harrisonburg Loan Production Office		727-C East Market Street Harrisonburg, Virginia		2014		Loan Production Office		Leased

 

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Rental expense for the leased locations totaled $60 thousand for the year ended December 31, 2014. The initial term for the lease for the Front Royal Express property expired and the tenancy is considered to be month-to-month. The lease for the North Woodstock property expires on May 31, 2016, without a renewal option. The initial term for the lease for the Village at Orchard Ridge space expired but has an automatic renewal option every twelve months. The lease for the Staunton Loan Production Office property expires on March 31, 2019 with a renewal option through March 31, 2024. The lease for the Harrisonburg Loan Production Office property expires on December 31, 2015, without a renewal option. All of the Company’s properties are in good operating condition and are adequate for the Company’s present and future needs.

 

Item 3.

Legal Proceedings

There are no material pending legal proceedings to which the Company is a party or to which the property of the Company is subject.

 

Item 4.

Mine Safety Disclosures

None.

Part II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Prices and Dividends

Shares of the common stock of the Company are traded on the over-the-counter (OTC) market and quoted on the OTC Markets Group exchange under the symbol “FXNC.” As of March 20, 2015 the Company had 608 shareholders of record and approximately 576 additional beneficial owners of shares of common stock.

Following are the high and low prices of sales of common stock known to the Company, along with the dividends that were paid quarterly in 2013 and 2014 (per share).

 

		Market Prices and Dividends
		Sales Price ($)								Dividends ($)
		High				Low
2013:
1st quarter			7.00				5.00				0.00
2nd quarter			7.50				5.75				0.00
3rd quarter			7.00				4.55				0.00
4th quarter			5.85				4.55				0.00
2014:
1st quarter			7.80				5.65				0.00
2nd quarter			7.99				7.30				0.025
3rd quarter			8.90				7.35				0.025
4th quarter			8.65				7.85				0.025

Dividend Policy

A discussion of certain limitations on the ability of the Bank to pay dividends to the Company and the ability of the Company to pay dividends on its common and preferred stock, is set forth in Part I., Item 1 – Business, of this Form 10-K under the headings “Supervision and Regulation – Limits on Dividends and Other Payments” and Item 1A – Risk Factors, “The Company’s preferred stock and trust preferred capital notes (commonly referred to as trust preferred securities) are superior to our common stock, which may limit our ability to pay dividends on common stock in the future.”

In the second quarter of 2014, the Company resumed payment of dividends on its common stock. The Company’s future dividend policy is subject to the discretion of its Board of Directors and will depend upon a number of factors, including future earnings, financial condition, liquidity and capital requirements of both the Company and the Bank, applicable governmental regulations and policies and other factors deemed relevant by the Board of Directors.

 

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Stock Repurchases

The Company did not repurchase any shares of its common stock during 2014.

Item 6. Selected Financial Data

The following is selected financial data for the Company for the last five years. This information has been derived from audited financial information included in Item 8 of this Form 10-K (in thousands, except ratios and per share amounts).

 

		For the years ended December 31,
		2014				2013				2012				2011				2010
Results of Operations
Interest and dividend income		$	20,399			$	21,157			$	23,432			$	25,648			$	27,215
Interest expense			1,778				2,709				4,167				5,450				6,814
Net interest income			18,621				18,448				19,265				20,198				20,401
Provision for (recovery of) loan losses			(3,850	)			(425	)			3,555				12,380				11,731
Net interest income after provision for (recovery of) loan losses			22,471				18,873				15,710				7,818				8,670
Noninterest income			7,444				6,931				7,172				5,799				6,082
Noninterest expense			18,785				20,750				19,117				20,743				20,561
Income (loss) before income taxes			11,130				5,054				3,765				(7,126	)			(5,809	)
Income tax expense (benefit)			3,499				(4,820	)			965				3,835				(2,206	)
Net income (loss)			7,631				9,874				2,800				(10,961	)			(3,603	)
Effective dividend and accretion on preferred stock			1,138				913				904				894				887
Net income (loss) available to common shareholders		$	6,493			$	8,961			$	1,896			$	(11,855	)		$	(4,490	)
Key Performance Ratios
Return on average assets			1.45	%			1.85	%			0.53	%			(1.96	%)			(0.66	%)
Return on average equity			13.49	%			21.87	%			6.80	%			(22.46	%)			(6.52	%)
Net interest margin			3.86	%			3.72	%			3.89	%			3.98	%			4.07	%
Efficiency ratio(1)			74.03	%			74.86	%			70.07	%			69.66	%			66.77	%
Dividend payout			5.67	%			0.00	%			0.00	%			(5.30	%)			(36.64	%)
Equity to assets			11.50	%			10.24	%			8.43	%			6.88	%			8.90	%
Per Common Share Data
Net income (loss), basic and diluted		$	1.32			$	1.83			$	0.48			$	(4.01	)		$	(1.53	)
Cash dividends			0.075				0.00				0.00				0.20				0.56
Book value at period end			9.17				7.96				6.22				7.72				11.66
Financial Condition
Assets		$	518,165			$	522,890			$	532,697			$	539,064			$	544,629
Loans, net			371,692				346,449				370,519				379,503				418,994
Securities			83,292				103,301				89,456				91,665				60,420
Deposits			444,338				450,711				466,917				469,172				463,500
Shareholders’ equity			59,564				53,560				44,889				37,096				48,498
Average shares outstanding, diluted			4,902				4,901				3,945				2,953				2,940
Capital Ratios
Leverage			13.47	%			11.75	%			10.47	%			8.45	%			10.54	%
Risk-based capital ratios:
Tier 1 capital			18.67	%			16.94	%			14.07	%			11.24	%			12.91	%
Total capital			19.93	%			18.21	%			15.34	%			12.51	%			14.18	%

 

(1)

The efficiency ratio is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with U.S. generally accepted accounting principles (GAAP) and should not be construed as such. Management believes such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under generally accepted accounting principles, or “GAAP.” See “Non-GAAP Financial Measures” included in Item 7 of this Form 10-K.

 

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Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operation

The following discussion and analysis of the financial condition and results of operations of the Company for the years ended December 31, 2014, 2013 and 2012 should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements included in Item 8 of this Form 10-K.

Executive Overview

The Company

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

 

•

First Bank (the Bank). The Bank owns:

 

•

First Bank Financial Services, Inc.

 

•

Shen-Valley Land Holdings, LLC

 

•

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

 

•

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

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

Products, Services, Customers and Locations

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

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

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

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

The Bank’s products and services are provided through 10 branch offices, 1 customer service center, 2 loan production offices, 25 ATMs and its website, www.fbvirginia.com. Upon the completion of a pending branch acquisition scheduled to close in April 2015, the Bank expects to add four branch offices in the Shenandoah Valley region of Virginia located in Woodstock, Staunton, Waynesboro and Elkton, and two branch offices in central Virginia located in Farmville and Dillwyn. After the transaction closes, the Bank expects to operate a total of 16 branch offices with approximately $750 million in total assets. The loan production offices were opened during 2014 and are located in Staunton and Harrisonburg, Virginia. The Bank operates six of its offices under the “Financial Center” concept. A Financial Center offers all of the Bank’s financial services at one location. This concept allows loan, deposit, and wealth management personnel to be readily available to serve customers throughout the Bank’s market area. For the location of each of these Financial Centers, see Item 2 of this Form 10-K.

 

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Revenue Sources and Expense Factors

The primary source of revenue is from net interest income earned by the Bank. Net interest income is the difference between interest income and interest expense and typically represents between 70% and 80% of the Company’s total revenue. Interest income is determined by the amount of interest-earning assets outstanding during the period and the interest rates earned on those assets. The Bank’s interest expense is a function of the amount of interest-bearing liabilities outstanding during the period and the interest rates paid. In addition to net interest income, noninterest income is the other source of revenue for the Company. Noninterest income is derived primarily from service charges on deposits, fee income from wealth management services and ATM and check card fees.

The provision for loan losses and noninterest expense are the two major expense categories. The provision is determined by factors that include net charge-offs, asset quality, economic conditions and loan growth. Changing economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control have a direct correlation with asset quality, net charge-offs and ultimately the required provision for loan losses. The largest component of noninterest expense for the year ended December 31, 2014 was salaries and employee benefits, comprising 56% of noninterest expenses, followed by occupancy and equipment expense, comprising 13% of expenses.

Financial Performance

For the year ended December 31, 2014, net income totaled $7.6 million, compared to $9.9 million in 2013. The prior year net income included a $4.8 million favorable impact to the income tax provision from elimination of the valuation allowance on net deferred tax assets. After the effective dividend on preferred stock, net income available to common shareholders was $6.5 million, or $1.32 per basic and diluted share compared to $9.0 million, or $1.83 per basic and diluted share, for the same period in 2013. Return on average assets was 1.45% and return on average equity was 13.49% for the year ended December 31, 2014, compared to 1.85% and 21.87%, respectively, for the year ended December 31, 2013.

Net interest income increased 1%, or $173 thousand to $18.6 million for the year ended December 31, 2014, compared to $18.4 million for the prior year. The net interest margin was 3.86% compared to 3.72% for the same period in 2013. Noninterest income increased $513 thousand, or 7%, to $7.4 million compared to $6.9 million for 2013. Noninterest expense decreased 9.5%, or $2.0 million to $18.8 million for the year ended December 31, 2014 compared to $20.8 million for 2013.

Income before income taxes totaled $11.1 million and $5.1 million for the years ended December 31, 2014 and 2013, respectively. There were significant variances in certain income statement categories when comparing the two periods that may, or may not occur in future periods. These positive and (negative) variances are summarized as follows:

 

•

$3.4 million for the recovery of loan losses;

 

•

$1.3 million for other real estate owned expense;

 

•

$696 thousand for net gains on sale of securities;

 

•

($606) thousand for other operating income that included a $543 gain from termination of post-retirement benefits in 2013;

 

•

$599 thousand for net losses on disposal of premises and equipment;

 

•

$430 thousand for FDIC assessment expense; and

 

•

$263 thousand for loss on lease termination.

Income before income taxes, excluding these income statement categories, was unchanged at $6.8 million for the years ended December 31, 2014 and 2013.

 

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Non-GAAP Financial Measures

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

 

		Efficiency Ratio
		2014				2013
Noninterest expense		$	18,785			$	20,750
Add/(Subtract): other real estate owned income/(expense), net			213				(1,115	)
Subtract: losses on disposal of premises and equipment, net			(2	)			(601	)
Subtract: loss on land lease termination			—				(263	)
		$	18,996			$	18,771
Tax-equivalent net interest income		$	18,913			$	18,688
Noninterest income			7,444				6,931
Subtract: securities gains, net			(696	)			—
Subtract: gain on termination of postretirement benefit obligation			—				(543	)
		$	25,661			$	25,076
Efficiency ratio			74.03	%			74.86	%

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

 

		Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
		2014				2013
GAAP measures:
Interest income – loans		$	17,777			$	18,844
Interest income – investments and other			2,622				2,313
Interest expense – deposits			(1,442	)			(2,368	)
Interest expense – other borrowings			(115	)			(119	)
Interest expense – trust preferred capital notes			(218	)			(222	)
Interest expense – other			(3	)			—
Total net interest income		$	18,621			$	18,448
Non-GAAP measures:
Tax benefit realized on non-taxable interest income – loans		$	108			$	82
Tax benefit realized on non-taxable interest income – municipal securities			184				158
Total tax benefit realized on non-taxable interest income		$	292			$	240
Total tax-equivalent net interest income		$	18,913			$	18,688

Critical Accounting Policies

General

The Company’s consolidated financial statements and related notes are prepared in accordance with GAAP. The financial information contained within the statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Bank uses historical loss factors as one factor in determining the inherent loss that may be present in the loan portfolio. Actual losses could differ significantly from the historical factors used. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact transactions could change.

 

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

Allowance for Loan Losses

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

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, including 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 our 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.

 

•

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

 

•

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

 

•

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

 

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The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.

The general component covers loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors. The historical loss experience is calculated by loan type and uses an average loss rate during the preceding twelve quarters. The qualitative factors are assigned by management based on delinquencies and asset quality, national and local economic trends, effects of the changes in the value of underlying collateral, trends in volume and nature of loans, effects of changes in the lending policy, the experience and depth of management, concentrations of credit, quality of the loan review system and the effect of external factors such as competition and regulatory requirements. The factors assigned differ by loan type. The general allowance estimates losses whose impact on the portfolio has yet to be recognized by a specific allowance. Allowance factors and the overall size of the allowance may change from period to period based on management’s assessment of the above described factors and the relative weights given to each factor. For further information regarding the allowance for loan losses see Notes 1 and 4 to the Consolidated Financial Statements.

Other Real Estate Owned (OREO)

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

Lending Policies

General

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

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

 

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

In the normal course of business, the Bank makes various commitments and incurs certain contingent liabilities which are disclosed but not reflected in its financial statements, including commitments to extend credit. At December 31, 2014, commitments to extend credit, stand-by letters of credit and rate lock commitments totaled $70.9 million.

Construction and Land Development Lending

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

1-4 Family Residential Real Estate Lending

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

Commercial Real Estate Lending

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

Commercial and Industrial Lending

Commercial and industrial loans generally have a higher degree of risk than loans secured by real estate, but typically have higher yields. Commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot

 

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be appraised with as much reliability as residential real estate. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers.

Consumer Lending

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

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

Results of Operations

General

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

Net Interest Income

Net interest income totaled $18.6 million for the year ended December 31, 2014, which was a 1% increase when compared to $18.5 million for the same period in 2013. The net interest margin increased to 3.86% from 3.72% and average earning assets were $12.3 million lower when comparing the periods. The impact of the higher net interest margin on net interest income was partially offset by the impact of lower interest-earning assets. Interest-earning asset yields decreased 4 basis points while the cost of funds, including noninterest-bearing deposits, decreased 18 basis points. Interest-earning asset yields decreased from lower yields earned on loans, as well as higher balances of securities and lower balances of loans, when comparing to 2013. Although interest-earning asset yields fell during the period, decreases in the cost of funds exceeded the decrease in the yields on interest-earning assets, which resulted in a higher net interest margin for 2014 compared to the prior year.

The net interest margin was 3.86% in 2014, 3.72% in 2013 and 3.89% in 2012. Tax-equivalent interest income as a percent of average earning assets was 4.22% in 2014, 4.26% in 2013 and 4.72% in 2012. Interest expense as a percent of average earning assets was 0.36% in 2014, 0.54% in 2013 and 0.83% in 2012. The interest rate spread was 3.73% in 2014, 3.57% in 2013 and 3.68% in 2012.

 

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The following table provides information on average interest-earning assets and interest-bearing liabilities for the years ended December 31, 2014, 2013 and 2012, as well as amounts and rates of tax equivalent interest earned and interest paid (dollars in thousands). The volume and rate analysis table analyzes the changes in net interest income for the periods broken down by their rate and volume components (in thousands).

 

Average Balances, Income and Expense, Yields and Rates (Taxable Equivalent Basis)
		Years Ending December 31,
		2014												2013												2012
		Average Balance				Interest Income/ Expense				Yield/ Rate				Average Balance				Interest Income/ Expense				Yield/ Rate				Average Balance				Interest Income/ Expense				Yield/ Rate
Assets
Interest-bearing deposits in other banks		$	16,718			$	38				0.22	%		$	25,091			$	61				0.24	%		$	15,118			$	30				0.20	%
Securities:
Taxable			94,689				2,144				2.26	%			91,290				1,870				2.05	%			81,641				1,924				2.36	%
Tax-exempt (1)			11,963				542				4.53	%			7,949				465				5.85	%			8,702				496				5.70	%
Restricted			1,667				82				4.94	%			1,843				75				4.07	%			2,373				77				3.25	%
Total securities			108,319				2,768				2.56	%			101,082				2,410				2.38	%			92,716				2,497				2.69	%
Loans: (2)
Taxable			358,259				17,568				4.90	%			371,317				18,683				5.03	%			385,548				21,005				5.45	%
Tax-exempt (1)			7,176				317				4.41	%			5,244				243				4.64	%			1,348				86				6.39	%
Total loans			365,435				17,885				4.89	%			376,561				18,926				5.03	%			386,896				21,091				5.45	%
Federal funds sold			—				—				—				2				—				0.48	%			6,165				12				0.19	%
Total earning assets			490,472				20,691				4.22	%			502,736				21,397				4.26	%			500,895				23,630				4.72	%
Less: allowance for loan losses			(10,208	)											(13,091	)											(13,944	)
Total nonearning assets			44,764												44,079												40,305
Total assets		$	525,028											$	533,724											$	527,256
Liabilities and Shareholders’ Equity
Interest-bearing deposits:
Checking		$	112,972			$	172				0.15	%		$	111,341			$	289				0.26	%		$	89,778			$	549				0.61	%
Money market accounts			19,155				21				0.11	%			16,581				21				0.13	%			21,333				67				0.31	%
Savings accounts			101,793				89				0.09	%			99,670				150				0.15	%			96,187				448				0.47	%
Certificates of deposit:
Less than $100			62,623				540				0.86	%			77,399				922				1.19	%			87,469				1,316				1.50	%
Greater than $100			47,963				592				1.23	%			61,579				923				1.50	%			71,504				1,238				1.73	%
Brokered deposits			4,756				28				0.59	%			9,604				63				0.65	%			11,478				89				0.77	%
Total interest-bearing deposits			349,262				1,442				0.41	%			376,174				2,368				0.63	%			377,749				3,707				0.98	%
Federal funds purchased			357				3				0.87	%			2				—				0.70	%			3				—				0.67	%
Trust preferred capital notes			9,279				218				2.35	%			9,279				222				2.39	%			9,279				238				2.56	%
Other borrowings			5,891				115				1.95	%			6,064				119				1.96	%			12,208				222				1.82	%
Total interest-bearing liabilities			364,789				1,778				0.49	%			391,519				2,709				0.69	%			399,239				4,167				1.04	%
Noninterest-bearing liabilities
Demand deposits			101,209												92,339												81,832
Other liabilities			2,451												4,727												4,984
Total liabilities			468,449												488,585												486,055
Shareholders’ equity			56,579												45,139												41,201
Total liabilities and shareholders’ equity		$	525,028											$	533,724											$	527,256
Net interest income						$	18,913											$	18,688											$	19,463
Interest rate spread											3.73	%											3.57	%											3.68	%
Cost of funds											0.38	%											0.56	%											0.87	%
Interest expense as a percent of average earning assets											0.36	%											0.54	%											0.83	%
Net interest margin											3.86	%											3.72	%											3.89	%

 

(1)	Income and yields are reported on a taxable-equivalent basis assuming a federal tax rate of 34%. The tax-equivalent adjustment was $292 thousand, $240 thousand and $198 thousand for 2014, 2013 and 2012, respectively.

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

 

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		Volume and Rate
		Years Ending December 31,
		2014												2013
		Volume Effect				Rate Effect				Change in Income/ Expense				Volume Effect				Rate Effect				Change in Income/ Expense
Interest-bearing deposits in other banks		$	(19	)		$	(5	)		$	(24	)		$	24			$	7			$	31
Loans, taxable			(642	)			(472	)			(1,114	)			(752	)			(1,570	)			(2,322	)
Loans, tax-exempt			84				(11	)			73				174				(17	)			157
Securities, taxable			73				201				274				438				(492	)			(54	)
Securities, tax-exempt			140				(62	)			78				(11	)			(20	)			(31	)
Securities, restricted			(6	)			13				7				15				(17	)			(2	)
Federal funds sold			—				—				—				23				(35	)			(12	)
Total earning assets		$	(370	)		$	(336	)		$	(706	)		$	(89	)		$	(2,144	)		$	(2,233	)
Checking		$	4			$	(121	)		$	(117	)		$	187			$	(447	)		$	(260	)
Money market accounts			8				(8	)			—				(13	)			(33	)			(46	)
Savings accounts			3				(64	)			(61	)			17				(315	)			(298	)
Certificates of deposits:
Less than $100			(157	)			(227	)			(384	)			(141	)			(253	)			(394	)
Greater than $100			(182	)			(148	)			(330	)			(161	)			(154	)			(315	)
Brokered deposits			(29	)			(5	)			(34	)			(13	)			(13	)			(26	)
Federal funds purchased			3				—				3				—				—				—
Trust preferred capital notes			—				(4	)			(4	)			—				(16	)			(16	)
Other borrowings			(3	)			(1	)			(4	)			(122	)			19				(103	)
Total interest-bearing liabilities		$	(353	)		$	(578	)		$	(931	)		$	(246	)		$	(1,212	)		$	(1,458	)
Change in net interest income		$	(17	)		$	242			$	225			$	157			$	(932	)		$	(775	)

Provision for (Recovery of) Loan Losses

The provision for (or recovery of) loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for (or recovery of) loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio.

The recovery of loan losses totaled $3.9 million for 2014, which resulted in a total allowance for loan losses of $6.7 million or 1.77% of total loans at December 31, 2014. This compared to a recovery of loan losses of $425 thousand for 2013 and an allowance for loan losses of $10.6 million, or 2.98% of total loans, at the prior year end.

The recovery of loan losses recorded in 2014 resulted primarily from a $4.4 million decrease in the general reserve component of the allowance for loan losses, when comparing the allowance for loan losses at December 31, 2014 and 2013. The $4.4 million decrease was driven primarily by lower historical net charge-offs that accounted for $4.2 million of the decrease, along with changes in qualitative adjustment factors that accounted for $241 thousand of the decrease. The impact on the general reserve from historical net charge-offs was attributable to the significant decrease, or improvement, in net charge-offs experienced during the three year period ended December 31, 2014, compared to the three year period ended December 31, 2013. The primary reason for the improvement was a significant amount of net charge-offs experienced during 2011 were no longer included in the three year loss history that determines the required general reserve component of the allowance for loan loss estimate at December 31, 2014. The Company has consistently applied its allowance for loan loss methodology and regularly reviews the three year historical charge-off look back period to ensure it is indicative of the risk that remains in the loan portfolio. As evidenced in the changes in the allowance for loan losses table appearing in the Asset Quality section, loan losses experienced in 2011 were not repeated in 2012, 2013 or 2014 and Management has no reason to believe that net charge-offs of that magnitude will be experienced in 2015. The $4.4 million decrease in the general reserve component was partially offset by a $528 thousand increase in the specific reserve component.

 

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For the year ended December 31, 2013, the recovery of loan losses totaled $425 thousand compared to the provision for loan losses of $3.6 million for the year ended December 31, 2012. The decrease in the provision for loan losses during 2013 was attributable to two large loan recoveries, an improvement in historical loss experience and lower specific reserves on impaired loans when compared to the year ended December 31, 2012.

Noninterest Income

Noninterest income increased 7% to $7.4 million for the year ended December 31, 2014 from $6.9 million for the same period in 2013. Noninterest income, excluding $696 thousand of net gains on sale of securities in 2014 and a $543 thousand one-time gain on termination of a post-retirement benefit in 2013, increased 6% to $6.7 million compared to $6.4 million for the same period one year ago. Noninterest income was positively impacted by higher levels of service charges on deposits, which increased 17% or $368 thousand over the prior year, as well as wealth management fees, which increased 13% or $219 thousand over the prior year. Revenue from service charges on deposit accounts increased primarily from increased checking account activity and the increase in wealth management fees resulted primarily from higher balances of assets under management during 2014 compared to the same period one year ago.

In 2013, noninterest income decreased 3% to $6.9 million from $7.2 million for 2013, primarily from gains on sales of securities in 2012.

Noninterest Expense

Noninterest expense decreased 9% or $2.0 million to $18.8 million for the year ended December 31, 2014, compared to $20.8 million for the same period in 2013. Expenses related to other real estate owned decreased $1.3 million, FDIC assessment expenses decreased $430 thousand, net gains on the sale of property and equipment decreased $599 thousand, and the loss on lease termination decreased $263 thousand, compared to the same period one year ago. Decreases in expenses related to other real estate owned resulted primarily from lower write-downs in the carrying value of OREO property when comparing the periods. FDIC assessments were also lower in 2014 than in the prior year due to lower assessment levels. During 2014, the Company did not terminate leases resulting in losses on lease termination or net losses on disposal of property and equipment, compared to 2013 which included a loss on lease termination and net losses on disposal of property and equipment that totaled $263 thousand and $601 thousand, respectively. These prior year expenses were a result of the Company’s decision to terminate a land lease during that period.

The decreases in these noninterest expense categories were partially offset by increases in other operating expenses of 14% or $232 thousand, increases of 38% or $142 thousand in data processing expenses, and increases of 47% or $131 thousand in bank franchise tax. Other operating expenses increased primarily from a new feature provided to checking account customers, and also additional loan expenses associated with the growth of the loan portfolio. Increases in data processing expenses were primarily attributable to the shift in customer behavior from traditional to electronic services. Bank franchise tax increased because of higher levels of capital when comparing the periods.

Income Taxes

The Company’s income tax provision differed from the amount of income tax determined by applying the U.S. federal income tax rate to pretax income for the years ended December 31, 2014 and 2013. The difference was a result of net permanent tax deductions, primarily comprised of tax-exempt interest income and from the reversal of the full valuation allowance on the Company’s net deferred tax asset. As of December 31, 2013, the Company had reversed the full valuation allowance on its net deferred tax assets (DTAs). The realization of DTAs is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. In assessing the need for a valuation allowance, the Company considered all available evidence about the realization of DTAs, both positive and negative, that could be objectively verified.

Positive evidence considered included (1) a return to trailing three years of cumulative pre-tax income in 2013, (2) the Company’s recent history of quarterly pre-tax earnings, (3) expectations for sustained profitability with sufficient taxable income to fully utilize the remaining net deferred tax benefits and (4) significant reductions in the level of non-performing assets since their peak during 2011, which was the primary source of the losses generated in 2010 and 2011.

Negative evidence considered was (1) the uncertainty about the potential impact on future earnings from nonperforming assets along with (2) a pre-tax loss reported by the Company during one quarterly period over the previous two years. As the

 

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number of consecutive periods of profitability increased and the level of profits are indicative of on-going results, the weight of cumulative losses as negative evidence decreased. A reduction in the weight given to such losses is further validated given that the source of the losses was due to an elevated level of problem assets and related credit costs, which have since been significantly reduced.

After weighing both the positive and negative evidence, management determined that a valuation allowance on the net deferred tax asset was no longer warranted as of December 31, 2013. No conditions existed during 2014 that would have caused the Company to re-evaluate the need for a valuation allowance on net deferred tax assets. For a more detailed discussion of the Company’s tax calculation, see Note 10 to the consolidated financial statements, included in Item 8 of this Form 10-K.

Financial Condition

General

Total assets were $518.2 million at December 31, 2014 compared to $522.9 million at December 31, 2013. The Company’s wealth management group had assets under management of $313.3 million at December 31, 2014 compared to $284.7 million at December 31, 2013. Assets managed by the wealth management group are not reflected on the Company’s balance sheet.

Loans

The Bank is an active lender with a loan portfolio that includes commercial and residential real estate loans, commercial loans, consumer loans, construction and land development loans and home equity loans. The Bank’s lending activity is concentrated on individuals, small and medium-sized businesses and local governmental entities primarily in its market area. As a provider of community-oriented financial services, the Bank does not attempt to geographically diversify its loan portfolio by undertaking significant lending activity outside its market area.

Gross loan balances increased 6% or $21.3 million to $378.4 million at December 31, 2014, compared to $357.1 million at December 31, 2013. The increase in loan balances was primarily the result of a slight improvement in loan demand, efforts of employees, and less pay-offs on loans, including classified loans, compared to prior years.

The Bank’s loan portfolio is summarized in the table below for the periods indicated (dollars in thousands).

 

		Loan Portfolio
		At December 31,
		2014								2013								2012								2011								2010
Commercial, financial, and agricultural		$	21,166				5.59	%		$	22,803				6.39	%		$	23,071				6.01	%		$	29,446				7.50	%		$	39,796				9.15	%
Real estate – construction			29,475				7.79	%			34,060				9.54	%			43,524				11.35	%			48,363				12.33	%			52,591				12.09	%
Real estate – mortgage:
Residential (1-4 family)			163,727				43.27	%			141,961				39.76	%			134,964				35.18	%			122,339				31.17	%			121,506				27.93	%
Secured by farmland			1,129				0.30	%			1,264				0.35	%			5,795				1.51	%			6,161				1.57	%			6,207				1.43	%
Other real estate loans			150,673				39.82	%			144,704				40.52	%			168,425				43.91	%			174,980				44.59	%			201,164				46.24	%
Consumer			5,070				1.34	%			5,214				1.46	%			7,144				1.86	%			10,085				2.57	%			12,879				2.96	%
All other loans			7,170				1.89	%			7,087				1.98	%			671				0.18	%			1,066				0.27	%			887				0.20	%
Total loans		$	378,410				100	%		$	357,093				100	%		$	383,594				100	%		$	392,440				100	%		$	435,030				100	%
Less: allowance for loan losses			6,718								10,644								13,075								12,937								16,036
Loans, net of allowance for loan losses		$	371,692							$	346,449							$	370,519							$	379,503							$	418,994

There was no category of loans that exceeded 10% of outstanding loans at December 31, 2014 that were not disclosed in the above table.

 

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The following table sets forth the maturities of the loan portfolio at December 31, 2014 (in thousands):

 

		Remaining Maturities of Selected Loans
		At December 31, 2014
		Less than One Year				One to Five Years				Greater than Five Years				Total
Commercial, financial, and agricultural		$	9,213			$	10,452			$	1,501			$	21,166
Real estate construction and land development			17,922				10,703				850				29,475
Real estate – mortgage:
Residential (1-4 family)			23,861				74,998				64,868				163,727
Other real estate loans			19,786				83,969				48,047				151,802
Consumer and other loans			1,294				10,784				162				12,240
Total loans		$	72,076			$	190,906			$	115,428			$	378,410

 

For maturities over one year:
Fixed rates		$	237,111
Variable rates			69,223
		$	306,334

Asset Quality

Management classifies non-performing assets as non-accrual loans and other real estate owned (OREO). OREO represents real property taken by the Bank either through foreclosure or through a deed in lieu thereof from the borrower and properties originally acquired for branch expansion but no longer intended to be used for that purpose. OREO is recorded at the lower of cost or fair value, less estimated selling costs, and is marketed by the Bank through brokerage channels. The Bank’s OREO, net of valuation allowance, totaled $1.9 million at December 31, 2014 and $3.0 million at December 31, 2013. Non-performing assets were $9.9 million and $14.7 million at December 31, 2014 and 2013, representing 1.91% and 2.81% of total assets, respectively. Non-performing assets included $8.0 million in non-accrual loans and $1.9 million in OREO, net of the valuation allowance, at December 31, 2014. This compares to $11.7 million in non-accrual loans and $3.0 million in OREO, net of the valuation allowance at December 31, 2013.

The levels of non-performing assets at December 31, 2014 and December 31, 2013 were primarily attributable to the impact of local economic conditions in recent years that negatively impacted the ability of certain borrowers to service debt. Borrowers that have not been able to meet their debt requirements are primarily business customers involved in real estate development and commercial and residential rental real estate. At December 31, 2014, 41% related to commercial real estate loans, 34% of non-performing assets related to construction and land development loans, 14% related to residential real estate loans, 7% related to multi-family residential loans, 3% related to properties originally acquired for branch expansion no longer intended to be used for that purpose and 1% related to commercial and industrial loans. Non-performing assets could increase due to other loans identified by management as potential problem loans. Other potential problem loans are defined as performing loans that possess certain risks, including the borrower’s ability to pay and the collateral value securing the loan, that management has identified that may result in the loans not being repaid in accordance with their terms. Other potential problem loans totaled $15.8 million and $23.5 million at December 31, 2014 and December 31, 2013, respectively. The amount of other potential problem loans in future periods may be dependent on economic conditions and other factors influencing our customers’ ability to meet their debt requirements.

The allowance for loan losses represents management’s analysis of the existing loan portfolio and related credit risks. The provision for loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses reflective of the risks in the loan portfolio. The allowance for loan losses totaled $6.7 million at December 31, 2014 and $10.6 million at December 31, 2013, representing 1.77% and 2.98% of total loans, respectively. The primary reason for the decrease in the allowance for loan losses was a significant amount of net charge-offs experienced during 2011 were no longer included in the three year loss history that determines the required general reserve component of the allowance for loan loss estimate at December 31, 2014. After analyzing the composition of the loan portfolio, related credit risks, and improvements in asset quality during recent years, the Company determined that the three year loss period and the qualitative adjustment factors that established the general reserve component of the allowance for loan losses were appropriate at December 31, 2014. For further discussion regarding the decrease in the allowance for loan losses, see “Provision for (Recovery of) Loan Losses” above.

 

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Impaired loans totaled $13.9 million at December 31, 2014, compared to $21.7 million at December 31, 2013. The related allowance for loan losses provided for these loans totaled $1.9 million and $1.4 million at December 31, 2014 and 2013. The average recorded investment in impaired loans during 2014 and 2013 was $19.2 million and $16.0 million, respectively. Included in the impaired loans total are loans classified as troubled debt restructurings (TDRs) totaling $1.9 million at December 31, 2014 and 2013. These loans represent situations in which a modification to the contractual interest rate or repayment structure has been granted to address a financial hardship. As of December 31, 2014, $790 thousand of these TDRs were performing under the restructured terms and were not considered non-performing assets.

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

 

		Allowance for Loan Losses
		At December 31,
		2014				2013				2012				2011				2010
Balance, beginning of period		$	10,644			$	13,075			$	12,937			$	16,036			$	7,106
Loans charged-off:
Commercial, financial and agricultural			43				37				261				348				387
Real estate-construction and land development			91				2,962				431				2,983				1,225
Real estate-mortgage
Residential (1-4 family)			272				260				761				4,639				132
Non-farm, non-residential			203				1,070				2,154				7,551				978
Secured by farmland			—				—				—				—				—
Consumer			318				163				186				268				340
All other loans			—				—				—				—				—
Total loans charged off		$	927			$	4,492			$	3,793			$	15,789			$	3,062
Recoveries:
Commercial, financial and agricultural		$	18			$	179			$	35			$	3			$	1
Real estate-construction and land development			80				—				1				50				—
Real estate-mortgage
Residential (1-4 family)			15				823				68				6				8
Non-farm, non-residential			509				1,304				64				—				—
Secured by farmland			—				—				—				—				—
Consumer			229				180				208				251				252
All other loans			—				—				—				—				—
Total recoveries		$	851			$	2,486			$	376			$	310			$	261
Net charge-offs		$	76			$	2,006			$	3,417			$	15,479			$	2,801
Provision for (recovery of) loan losses			(3,850	)			(425	)			3,555				12,380				11,731
Balance, end of period		$	6,718			$	10,644			$	13,075			$	12,937			$	16,036
Ratio of net charge-offs during the period to average loans outstanding during the period			0.02	%			0.53	%			0.88	%			3.70	%			0.63	%

 

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The following table shows the balance and percentage of the Bank’s allowance for loan losses allocated to each major category of loans (dollars in thousands).

 

		Allocation of Allowance for Loan Losses
		At December 31,
		2014								2013								2012								2011								2010
Commercial, financial and agricultural		$	310				4.61	%		$	442				6.39	%		$	608				6.01	%		$	963				7.50	%		$	858				9.15	%
Real estate-construction and land development			1,403				20.89	%			2,710				9.54	%			2,481				11.35	%			2,843				12.33	%			4,050				12.09	%
Real estate-mortgage			4,862				72.37	%			7,393				80.63	%			9,875				80.60	%			8,958				77.33	%			10,868				75.60	%
Consumer			67				1.00	%			24				1.46	%			101				1.86	%			157				2.57	%			248				2.96	%
All other			76				1.13	%			75				1.98	%			10				0.18	%			15				0.27	%			12				0.20	%
		$	6,718				100.0	%		$	10,644				100.0	%		$	13,075				100.0	%		$	12,937				100.0	%		$	16,036				100.0	%

The following table provides information on the Bank’s non-performing assets at the dates indicated (dollars in thousands).

 

		Non-performing Assets
		At December 31,
		2014				2013				2012				2011				2010
Non-accrual loans		$	8,000			$	11,678			$	8,393			$	11,841			$	10,817
Other real estate owned			1,888				3,030				5,590				6,374				3,961
Total non-performing assets		$	9,888			$	14,708			$	13,983			$	18,215			$	14,778
Loans past due 90 days accruing interest			—				49				228				459				598
Total non-performing assets and past due loans		$	9,888			$	14,757			$	14,211			$	18,674			$	15,376
Troubled debt restructurings		$	1,918			$	1,941			$	6,326			$	11,385			$	14,428
Allowance for loan losses to period end loans			1.77	%			2.98	%			3.41	%			3.30	%			3.69	%
Non-performing assets to period end loans			2.61	%			4.12	%			3.65	%			4.64	%			3.40	%

Securities

Securities at December 31, 2014 totaled $83.2 million, a decrease of $20.0 million or 19%, from $103.3 million at the end of 2013. Investment securities are comprised of U.S. agency and mortgage-backed securities, obligations of state and political subdivisions and corporate equity securities. The decrease in the securities portfolio was related to higher loan demand in the Company’s market area during 2014 compared to recent years. As of December 31, 2014, neither the Company nor the Bank held any derivative financial instruments in their respective investment security portfolios. Gross unrealized gains in the securities portfolio totaled $704 thousand and $1.0 million at December 31, 2014 and 2013, respectively. Gross unrealized losses totaled $906 thousand and $2.7 million at December 31, 2014 and 2013, respectively. Investments in an unrealized loss position were considered temporarily impaired at December 31, 2014 and 2013.

 

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The following table summarizes the fair value of the Company’s securities portfolio on the dates indicated (in thousands).

 

		Securities Portfolio
		At December 31,
		2014				2013				2012
Securities, available for sale
U.S. agency and mortgage-backed securities		$	67,029			$	84,897			$	73,218
Obligations of state and political subdivisions			16,257				18,399				16,235
Other securities			6				5				3
Total securities		$	83,292			$	103,301			$	89,456

The following table shows the maturities of debt and equity securities at amortized cost and market value at December 31, 2014 and approximate weighted average yields of such securities (dollars in thousands). Yields on state and political subdivision securities are shown on a tax equivalent basis, assuming a 34% federal income tax rate. The Company attempts to maintain diversity in its portfolio and maintain credit quality and re-pricing terms that are consistent with its asset/liability management and investment practices and policies. For further information on securities available for sale, see Note 2 to the consolidated financial statements, included in Item 8 of this Form 10-K.

 

		Securities Portfolio Maturity Distribution/Yield Analysis
		At December 31, 2014
		Less than One Year				One to Five Years				Five to Ten Years				Greater than Ten Years and Equity Securities				Total
Available for sale securities:
U.S. agency and mortgage-backed securities
Amortized cost		$	—			$	4,096			$	11,888			$	51,478			$	67,462
Market value		$	—			$	4,041			$	11,773			$	51,215			$	67,029
Weighted average yield			0.00	%			1.36	%			1.71	%			1.96	%			1.88	%
Obligations of state and political subdivisions
Amortized cost		$	—			$	2,859			$	5,846			$	7,326			$	16,031
Market value		$	—			$	2,904			$	5,930			$	7,423			$	16,257
Weighted average yield			0.00	%			3.87	%			3.34	%			3.80	%			3.64	%
Equity securities
Amortized cost		$	—			$	—			$	—			$	1			$	1
Market value		$	—			$	—			$	—			$	6			$	6
Weighted average yield			0.00	%			0.00	%			0.00	%			1.65	%			1.65	%
Total portfolio
Amortized cost		$	—			$	6,955			$	17,734			$	58,805			$	83,494
Market value		$	—			$	6,945			$	17,703			$	58,644			$	83,292
Weighted average yield (1)			0.00	%			2.39	%			2.25	%			2.19	%			2.22	%

 

(1)	Yields on tax-exempt securities have been calculated on a tax-equivalent basis.

The above table was prepared using the contractual maturities for all securities with the exception of mortgage-backed securities (MBS) and collateralized mortgage obligations (CMO). Both MBS and CMO securities were recorded using the yield book prepayment model that incorporates four causes of prepayments including home sales, refinancing, defaults, and curtailments/full payoffs.

 

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Deposits

Deposits at December 31, 2014 totaled $444.3 million, a decrease of $6.4 million, from $450.7 million at December 31, 2013. Non-interest bearing demand deposits increased $12.1 million or 13% to $105.0 million during the year ended December 31, 2014 from $92.9 million at December 31, 2013. Savings and interest-bearing demand deposits increased $3.6 million or 2% to $237.6 million at December 31, 2014 compared to $234.1 million at December 31, 2013. Time deposits, which include brokered deposits, decreased $22.0 million or 18% during the year ended December 31, 2014 to $101.7 million compared to $123.8 million at December 31, 2013.

The following tables include a summary of average deposits and average rates paid and maturities of CD’s greater than $100,000 (dollars in thousands).

 

		Average Deposits and Rates Paid
		Year Ended December 31,
		2014								2013								2012
		Amount				Rate				Amount				Rate				Amount				Rate
Noninterest-bearing deposits		$	101,209				—			$	92,339				—			$	81,832				—
Interest-bearing deposits:
Interest checking		$	112,972				0.15	%		$	111,341				0.26	%		$	89,778				0.61	%
Money market			19,155				0.11	%			16,581				0.13	%			21,333				0.31	%
Savings			101,793				0.09	%			99,670				0.15	%			96,187				0.47	%
Time deposits:
Less than $100			62,623				0.86	%			77,399				1.19	%			87,469				1.50	%
Greater than $100			47,963				1.23	%			61,579				1.50	%			71,504				1.73	%
Brokered deposits			4,756				0.59	%			9,604				0.65	%			11,478				0.77	%
Total interest-bearing deposits		$	349,262				0.41	%		$	376,174				0.63	%		$	377,749				0.98	%
Total deposits		$	450,471							$	468,513							$	459,581

 

		Maturities of CD’s Greater than $100,000
		Less than Three Months				Three to Six Months				Six to Twelve Months				Greater than One Year				Total
At December 31, 2014		$	9,257			$	6,951			$	6,480			$	24,389			$	47,077

The table above includes brokered deposits greater than $100 thousand.

Liquidity

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

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

 

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At December 31, 2014, cash, interest-bearing and noninterest-bearing deposits with banks, federal funds sold, securities and loans maturing within one year totaled $96.9 million. At December 31, 2014, 19% or $72.1 million of the loan portfolio would mature within one year. Non-deposit sources of available funds totaled $88.7 million at December 31, 2014, which included $42.9 million available from Federal Home Loan Bank of Atlanta (FHLB), $41.9 million of unsecured federal funds lines of credit with other correspondent banks and $3.9 million available through the Federal Reserve Discount Window.

Trust Preferred Capital Notes

See Note 9 to the consolidated financial statements, included in Item 8 of this Form 10-K, for discussion of trust preferred capital notes.

Contractual Obligations

The impact that contractual obligations as of December 31, 2014 are expected to have on liquidity and cash flow in future periods is as follows (in thousands):

 

		Contractual Obligations
		Total				Less than one year				1-3 years				3-5 years				More than 5 years
Other borrowings		$	26			$	26			$	—			$	—			$	—
Operating leases			160				69				65				26				—
Total		$	186			$	95			$	65			$	26			$	—

The Company does not have any capital lease obligations or other purchase or long-term obligations.

Off-Balance Sheet Arrangements

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

At December 31, 2014 and 2013, the following financial instruments were outstanding whose contract amounts represent credit risk (in thousands):

 

		2014				2013
Commitments to extend credit and unfunded commitments under lines of credit		$	60,019			$	59,115
Stand-by letters of credit			9,763				7,610

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 usually do not contain a specified maturity date and may or may not be drawn upon to the total extent to which the Bank is committed.

 

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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. 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, 2014, the Bank had $1.1 million in locked-rate commitments to originate mortgage loans. 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.

Capital Resources

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

The Board of Governors of the Federal Reserve System has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.00%, of which at least 4.00% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain intangible items. Under present regulations, trust preferred securities may be included in Tier 1 capital for regulatory capital adequacy purposes as long as their amount does not exceed 25% of Tier 1 capital, including total trust preferred securities. The portion of the trust preferred securities not considered as Tier 1 capital, if any, may be included in Tier 2 capital. The Company had a ratio of risk-weighted assets to total capital of 19.93% at December 31, 2014 and a ratio of risk-weighted assets to Tier 1 capital of 18.67%. Both of these exceed both the minimum capital requirement and the minimum to be well capitalized under prompt corrective action provisions adopted by the federal regulatory agencies.

The following table summarizes the Company’s Tier 1 capital, Tier 2 capital, risk-weighted assets and capital ratios at December 31, 2014, 2013 and 2012 (dollars in thousands).

 

		Analysis of Capital At December 31,
		2014				2013				2012
Tier 1 capital:
Preferred stock		$	14,595			$	14,564			$	14,409
Common stock			6,131				6,127				6,127
Surplus			6,835				6,813				6,813
Retained earnings			33,557				27,360				18,399
Trust preferred capital notes			9,279				9,279				9,279
Disallowed deferred tax asset			—				(2,235	)			—
Intangible assets			(85	)			(108	)			(130	)
Total Tier 1 Capital		$	70,312			$	61,800			$	54,897
Tier 2 capital:
Allowance for loan losses			4,733				4,637				4,979
Total Risk-Based Capital		$	75,045			$	66,437			$	59,877
Risk-weighted assets		$	376,626			$	364,915			$	390,254
Capital ratios:
Total Risk-Based Capital Ratio			19.93	%			18.21	%			15.34	%
Tier 1 Risk-Based Capital Ratio			18.67	%			16.94	%			14.07	%
Tier 1 Capital to Average Assets			13.47	%			11.75	%			10.47	%

 

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

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

On June 29, 2012, the Company completed the sale of 1,945,815 shares of common stock in a rights offering and to certain standby investors. The Company’s existing shareholders exercised subscription rights to purchase 1,520,815 shares at a subscription price of $4.00 per share, and the standby investors purchased an additional 425,000 shares at the same price of $4.00 per share. In total, the Company raised proceeds of $7.6 million, net of offering costs.

Recent Accounting Pronouncements

See Note 1 to the consolidated financial statements, included in Item 8 of this Form 10-K, for discussion of recent accounting pronouncements.

 

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Quarterly Results

The table below lists the Company’s quarterly performance for the years ended December 31, 2014, 2013 and 2012 (in thousands, except per share data).

 

		2014
		Fourth				Third				Second				First				Total
Interest and dividend income		$	5,214			$	5,181			$	5,095			$	4,909			$	20,399
Interest expense			409				430				456				483				1,778
Net interest income			4,805				4,751				4,639				4,426				18,621
Recovery of loan losses			(3,150	)			(100	)			(400	)			(200	)			(3,850	)
Net interest income after recovery of loan losses			7,955				4,851				5,039				4,626				22,471
Noninterest income			2,449				1,654				1,725				1,616				7,444
Noninterest expense			4,871				4,753				4,548				4,613				18,785
Income before income taxes			5,533				1,752				2,216				1,629				11,130
Income tax expense			1,837				505				674				483				3,499
Net income		$	3,696			$	1,247			$	1,542			$	1,146			$	7,631
Net income available to common shareholders		$	3,368			$	918			$	1,281			$	926			$	6,493
Net income per share, basic and diluted		$	0.68			$	0.19			$	0.26			$	0.19			$	1.32

 

		2013
		Fourth				Third				Second				First				Total
Interest and dividend income		$	5,093			$	5,286			$	5,371			$	5,407			$	21,157
Interest expense			544				657				717				791				2,709
Net interest income			4,549				4,629				4,654				4,616				18,448
Provision for (recovery of) loan losses			(2,950	)			275				2,500				(250	)			(425	)
Net interest income after provision for (recovery of) loan losses			7,499				4,354				2,154				4,866				18,873
Noninterest income			1,771				1,625				2,034				1,501				6,931
Noninterest expense			6,232				4,648				4,757				5,113				20,750
Income (loss) before income taxes			3,038				1,331				(569	)			1,254				5,054
Income tax expense (benefit)			(4,352	)			91				(830	)			271				(4,820	)
Net income		$	7,390			$	1,240			$	261			$	983			$	9,874
Net income available to common shareholders		$	7,162			$	1,011			$	31			$	757			$	8,961
Net income per share, basic and diluted		$	1.46			$	0.21			$	0.01			$	0.15			$	1.83

 

		2012
		Fourth				Third				Second				First				Total
Interest and dividend income		$	5,573			$	5,771			$	5,880			$	6,208			$	23,432
Interest expense			919				1,035				1,085				1,128				4,167
Net interest income			4,654				4,736				4,795				5,080				19,265
Provision for loan losses			100				805				650				2,000				3,555
Net interest income after provision for loan losses			4,554				3,931				4,145				3,080				15,710
Noninterest income			1,589				1,609				1,462				2,514				7,174
Noninterest expense			5,124				4,657				4,434				4,904				19,119
Income before income taxes			1,019				883				1,173				690				3,765
Income tax expense			76				195				479				215				965
Net income			943				688				694				475				2,800
Net income available to common shareholders			716				462				467				251				1,896
Net income per share, basic and diluted		$	0.15			$	0.09			$	0.16			$	0.08			$	0.48

 

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Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

Not required.

 

Item 8.

Financial Statements and Supplementary Data

 

		Page
Management’s Report Regarding the Effectiveness of Internal Controls Over Financial Reporting			45
Report of Independent Registered Public Accounting Firm			46
Consolidated Balance Sheets			47
Consolidated Statements of Income			48
Consolidated Statements of Comprehensive Income			50
Consolidated Statements of Cash Flows			51
Consolidated Statements of Changes in Shareholders’ Equity			53
Notes to Consolidated Financial Statements			54

 

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To the Shareholders		March 27, 2015
First National Corporation
Strasburg, Virginia

MANAGEMENT’S REPORT REGARDING THE EFFECTIVENESS OF INTERNAL CONTROLS

OVER FINANCIAL REPORTING

The management of First National Corporation (the Company) is responsible for the preparation, integrity and fair presentation of the financial statements included in the annual report as of December 31, 2014. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management’s judgments and estimates concerning the effects of events and transactions that are accounted for or disclosed.

Management is also responsible for establishing and maintaining an effective internal control structure over financial reporting. The Company’s internal control over financial reporting includes those policies and procedures that pertain to the Company’s ability to record, process, summarize and report reliable financial data. The internal control system contains monitoring mechanisms, and appropriate actions are taken to correct identified deficiencies. Management believes that internal controls over financial reporting, which are subject to scrutiny by management and the Company’s internal auditor, support the integrity and reliability of the financial statements. Management recognizes that there are inherent limitations in the effectiveness of any internal control system, including the possibility of human error and the circumvention or overriding of internal controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. In addition, because of changes in conditions and circumstances, the effectiveness of internal control over financial reporting may vary over time.

In order to insure that the Company’s internal control structure over financial reporting is effective, management assessed these controls as they conformed to accounting principles generally accepted in the United States of America and related call report instructions as of December 31, 2014. This assessment was based on criteria for effective internal control over financial reporting as described in “Internal Control – Integrated Framework (2013)” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management believes that the Company maintained effective internal controls over financial reporting as of December 31, 2014. Management’s assessment did not determine any material weakness within the Company’s internal control structure. The Company’s annual report does not include an attestation report of the Company’s registered public accounting firm, Yount, Hyde & Barbour. P.C. (YHB), regarding internal control over financial reporting. Management’ report was not subject to attestation by YHB pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in its annual report.

The 2014 end of year financial statements have been audited by the independent accounting firm of Yount, Hyde & Barbour, P.C. (YHB). Personnel from YHB were given unrestricted access to all financial records and related data, including minutes of all meetings of the Board of Directors and Committees thereof.

Management believes that all representations made to the independent auditors were valid and appropriate. The resulting report from YHB accompanies the financial statements.

The Board of Directors of the Company, acting through its Audit Committee (the Committee), is responsible for the oversight of the Company’s accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent auditors and approves decisions regarding the appointment or removal of members of the internal audit function. The Committee meets periodically with management, the independent auditors, and the internal auditor to insure that they are carrying out their responsibilities. The Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting, and auditing procedures of the Company in addition to reviewing the Company’s financial reports. The independent auditors and the internal auditor have full and unlimited access to the Audit Committee, with or without the presence of the management of the Company, to discuss the adequacy of internal control over financial reporting, and any other matters which they believe should be brought to the attention of the Audit Committee.

 

/s/ Scott C. Harvard				/s/ M. Shane Bell
Scott C. Harvard				M. Shane Bell
President				Executive Vice President
Chief Executive Officer				Chief Financial Officer

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors

First National Corporation

Strasburg, Virginia

We have audited the accompanying consolidated balance sheets of First National Corporation and subsidiaries as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First National Corporation and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles.

 

/s/ Yount, Hyde & Barbour, P.C.

Winchester, Virginia

March 27, 2015

 

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FIRST NATIONAL CORPORATION

Consolidated Balance Sheets

December 31, 2014 and 2013

(in thousands, except share and per share data)

 

 

		2014				2013
Assets
Cash and due from banks		$	6,043			$	5,767
Interest-bearing deposits in banks			18,802				25,741
Securities available for sale, at fair value			83,292				103,301
Restricted securities, at cost			1,366				1,804
Loans held for sale			328				—
Loans, net of allowance for loan losses, 2014, $6,718, 2013, $10,644			371,692				346,449
Other real estate owned, net of valuation allowance, 2014, $375, 2013, $1,665			1,888				3,030
Premises and equipment, net			16,126				16,642
Accrued interest receivable			1,261				1,302
Bank owned life insurance			11,357				10,978
Other assets			6,010				7,876
Total assets		$	518,165			$	522,890
Liabilities & Shareholders’ Equity
Liabilities
Deposits:
Noninterest-bearing demand deposits		$	104,986			$	92,901
Savings and interest-bearing demand deposits			237,618				234,054
Time deposits			101,734				123,756
Total deposits		$	444,338			$	450,711
Federal funds purchased			52				—
Other borrowings			26				6,052
Trust preferred capital notes			9,279				9,279
Accrued interest payable and other liabilities			4,906				3,288
Total liabilities		$	458,601			$	469,330
Shareholders’ Equity
Preferred stock, $1,000 per share liquidation preference; authorized 1,000,000 shares; 14,595 shares issued and outstanding, net of discount		$	14,595			$	14,564
Common stock, par value $1.25 per share; authorized 8,000,000 shares; issued and outstanding, 2014, 4,904,577 shares, 2013, 4,901,464 shares			6,131				6,127
Surplus			6,835				6,813
Retained earnings			33,557				27,360
Accumulated other comprehensive loss, net			(1,554	)			(1,304	)
Total shareholders’ equity		$	59,564			$	53,560
Total liabilities and shareholders’ equity		$	518,165			$	522,890

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

Three Years Ended December 31, 2014

(in thousands, except per share data)

 

 

		2014				2013				2012
Interest and Dividend Income
Interest and fees on loans		$	17,777			$	18,844			$	21,062
Interest on federal funds sold			—				—				12
Interest on deposits in banks			38				61				30
Interest and dividends on securities available for sale:
Taxable interest			2,144				1,870				1,924
Tax-exempt interest			358				307				327
Dividends			82				75				77
Total interest and dividend income		$	20,399			$	21,157			$	23,432
Interest Expense
Interest on deposits		$	1,442			$	2,368			$	3,707
Interest on federal funds purchased			3				—				—
Interest on trust preferred capital notes			218				222				238
Interest on other borrowings			115				119				222
Total interest expense		$	1,778			$	2,709			$	4,167
Net interest income		$	18,621			$	18,448			$	19,265
Provision for (recovery of) loan losses			(3,850	)			(425	)			3,555
Net interest income after provision for (recovery of) loan losses		$	22,471			$	18,873			$	15,710
Noninterest Income
Service charges on deposit accounts		$	2,572			$	2,204			$	2,127
ATM and check card fees			1,419				1,425				1,481
Wealth management fees			1,915				1,696				1,450
Fees for other customer services			397				391				390
Income from bank owned life insurance			367				358				14
Net gains on sale of securities available for sale			696				—				1,285
Net gains on sale of loans			20				193				214
Gain on termination of postretirement benefit			—				543				—
Other operating income			58				121				211
Total noninterest income		$	7,444			$	6,931			$	7,172

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Income

(Continued)

Three years ended December 31, 2014

(in thousands, except per share data)

 

 

		2014				2013				2012
Noninterest Expense
Salaries and employee benefits		$	10,586			$	10,528			$	9,590
Occupancy			1,211				1,282				1,343
Equipment			1,191				1,208				1,208
Marketing			426				345				430
Stationery and supplies			333				288				308
Legal and professional fees			1,019				975				975
ATM and check card fees			661				668				649
FDIC assessment			454				884				709
Bank franchise tax			410				279				260
Telecommunications expense			300				283				245
Data processing expense			518				376				347
Other real estate owned (income) expense, net			(213	)			1,115				1,355
Net (gain) loss on disposal of premises and equipment			2				601				(2	)
Loss on lease termination			—				263				—
Other operating expense			1,887				1,655				1,700
Total noninterest expense		$	18,785			$	20,750			$	19,117
Income before income taxes		$	11,130			$	5,054			$	3,765
Income tax provision (benefit)			3,499				(4,820	)			965
Net income		$	7,631			$	9,874			$	2,800
Effective dividend and accretion on preferred stock			1,138				913				904
Net income available to common shareholders		$	6,493			$	8,961			$	1,896
Earnings per common share, basic and diluted		$	1.32			$	1.83			$	0.48

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Comprehensive Income

Three years ended December 31, 2014

(in thousands)

 

 

		2014				2013				2012
Net income		$	7,631			$	9,874			$	2,800
Other comprehensive loss, net of tax:
Unrealized holding gains (loss) on available for sale securities, net of tax $750, ($1,493) and $0, respectively			1,456				(2,899	)			(111	)
Reclassification adjustment for gains included in net income, net of tax ($236), $0 and $0, respectively			(460	)			—				(1,285	)
Pension liability adjustment, net of tax ($642), $1,264 and $0, respectively			(1,246	)			2,454				(454	)
Total other comprehensive loss			(250	)			(445	)			(1,850	)
Total comprehensive income		$	7,381			$	9,429			$	950

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

Three years ended December 31, 2014

(in thousands)

 

 

		2014				2013				2012
Cash Flows from Operating Activities
Net income		$	7,631			$	9,874			$	2,800
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			967				1,011				1,110
Origination of loans held for sale			(1,503	)			(2,567	)			(8,627	)
Proceeds from sale of loans held for sale			2,645				3,263				8,612
Net gains on sales of loans			(20	)			(193	)			(214	)
Provision for (recovery of) loan losses			(3,850	)			(425	)			3,555
Provision for other real estate owned			12				1,055				1,190
Net gains on sale of securities available for sale			(696	)			—				(1,285	)
Net gains on sale of other real estate owned			(307	)			(80	)			(278	)
Deferred gains recognized on other real estate owned			73				—				—
Income from bank owned life insurance			(367	)			(358	)			(14	)
Gain on termination of postretirement benefit			—				(543	)			—
Accretion of discounts and amortization of premiums on securities, net			655				859				885
Net (gain) loss on disposal of premises and equipment			2				601				(2	)
Deferred income tax expense (benefit)			1,971				(4,776	)			—
Changes in assets and liabilities:
Decrease in interest receivable			41				157				161
(Increase) decrease in other assets			(620	)			143				3,620
Increase in accrued expenses and other liabilities			372				660				705
Net cash provided by operating activities		$	7,006			$	8,681			$	12,218
Cash Flows from Investing Activities
Proceeds from sales of securities available for sale		$	21,342			$	1,850			$	26,158
Proceeds from redemption of restricted securities			438				170				831
Proceeds from maturities, calls, and principal payments of securities available for sale			14,439				22,037				29,121
Purchases of securities available for sale			(14,219	)			(42,073	)			(54,096	)
Purchases of restricted securities			—				—				(30	)
Purchase of premises and equipment			(475	)			(548	)			(553	)
Proceeds from sale of premises and equipment			22				2				2
Proceeds from sale of other real estate owned			1,502				3,618				5,438
Purchase of bank owned life insurance			(12	)			—				(9,000	)
Net (increase) decrease in loans			(22,982	)			23,731				(149	)
Net cash provided by (used in) investing activities		$	55			$	8,787			$	(2,278	)

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Cash Flows

(Continued)

Three years ended December 31, 2014

(in thousands)

 

 

		2014				2013				2012
Cash Flows from Financing Activities
Net increase in demand deposits and savings accounts		$	15,649			$	20,236			$	26,811
Net decrease in time deposits			(22,022	)			(36,442	)			(29,066	)
Increase in federal funds purchased			52				—				—
Proceeds from other borrowings			—				—				2
Principal payments on other borrowings			(6,026	)			(24	)			(13,026	)
Net proceeds from issuance of common stock			—				—				7,601
Cash dividends paid on common stock, net of reinvestment			(342	)			—				—
Cash dividends paid on preferred stock			(1,035	)			(758	)			(758	)
Net cash used in financing activities		$	(13,724	)		$	(16,988	)		$	(8,436	)
Increase (decrease) in cash and cash equivalents		$	(6,663	)		$	480			$	1,504
Cash and cash equivalents, beginning of year			31,508				31,028				29,524
Cash and cash equivalents, end of year		$	24,845			$	31,508			$	31,028
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest		$	1,820			$	2,818			$	4,247
Income taxes		$	601			$	310			$	1,010
Supplemental Disclosures of Noncash Transactions
Unrealized gains (losses) on securities available for sale		$	1,510			$	(3,482	)		$	1,396
Change in pension liability		$	1,888			$	(2,364	)		$	454
Transfer from loans to loans held for sale		$	1,450			$	—			$	—
Transfer from loans to other real estate owned		$	139			$	764			$	5,578
Transfer from premises and equipment to other real estate owned		$	—			$	881			$	—
Transfer from other assets to other real estate owned		$	—			$	391			$	—
Issuance of common stock dividend reinvestment plan		$	26			$	—			$	—

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity

Three years ended December 31, 2014

(in thousands, except share and per share data)

 

 

		Preferred     Stock				Common     Stock				Surplus				Retained     Earnings				Accumulated Other     Comprehensive     Income (Loss)				Total
Balance, December 31, 2011		$	14,263			$	3,695			$	1,644			$	16,503			$	991			$	37,096
Net loss			—				—				—				2,800				—				2,800
Other comprehensive loss			—				—				—				—				(1,850	)			(1,850	)
Issuance of common stock, net of offering costs (1,945,815 shares)			—				2,432				5,169				—				—				7,601
Cash dividends on preferred stock			—				—				—				(758	)			—				(758	)
Accretion of preferred stock discount			146				—				—				(146	)			—				—
Balance, December 31, 2012		$	14,409			$	6,127			$	6,813			$	18,399			$	(859	)		$	44,889

 

 

		Preferred     Stock				Common     Stock				Surplus				Retained     Earnings				Accumulated Other     Comprehensive     Loss				Total
Balance, December 31, 2012		$	14,409			$	6,127			$	6,813			$	18,399			$	(859	)		$	44,889
Net income			—				—				—				9,874				—				9,874
Other comprehensive loss			—				—				—				—				(445	)			(445	)
Cash dividends on preferred stock			—				—				—				(758	)			—				(758	)
Accretion of preferred stock discount			155				—				—				(155	)			—				—
Balance, December 31, 2013		$	14,564			$	6,127			$	6,813			$	27,360			$	(1,304	)		$	53,560

 

 

		Preferred     Stock				Common     Stock				Surplus				Retained     Earnings				Accumulated Other     Comprehensive     Loss				Total
Balance, December 31, 2013		$	14,564			$	6,127			$	6,813			$	27,360			$	(1,304	)		$	53,560
Net income			—				—				—				7,631				—				7,631
Other comprehensive loss			—				—				—				—				(250	)			(250	)
Cash dividends on common stock ($0.075 per share)			—				—				—				(368	)			—				(368	)
Issuance of 3,113 shares common stock, dividend reinvestment plan			—				4				22				—				—				26
Cash dividends on preferred stock			—				—				—				(1,035	)			—				(1,035	)
Accretion of preferred stock discount			31				—				—				(31	)			—				—
Balance, December 31, 2014		$	14,595			$	6,131			$	6,835			$	33,557			$	(1,554	)		$	59,564

See Notes to Consolidated Financial Statements

 

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FIRST NATIONAL CORPORATION

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), First National (VA) Statutory Trust II (Trust II) and First National (VA) Statutory Trust III (Trust III). The Trusts were formed for the purpose of issuing redeemable capital securities, commonly known as trust preferred securities. 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 which holds other real estate owned. The Bank provides loan, deposit, wealth management and other products and services in the Shenandoah Valley region of Virginia. Loan products and services include personal loans, residential mortgages, home equity loans and commercial loans. Deposit products and services include checking, savings, NOW accounts, money market accounts, IRA accounts, certificates of deposit and cash management accounts. The Bank offers other services, including internet banking, mobile banking, remote deposit capture and other traditional banking services.

The 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 are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, valuation of other real estate owned, pension obligations and other-than-temporary impairment of securities.

Significant Group Concentrations of Credit Risk

Most of the Company’s activities are with customers located within the Shenandoah Valley region of Virginia. The types of lending that the Company engages in are included in Note 3. The Company does not have a significant concentration to any one customer.

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, available for sale (AFS) or trading based on management’s intent. Currently, all of the Company’s debt securities are classified as AFS. 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. 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.

 

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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.

For equity securities carried at cost as restricted securities, impairment is considered to be other-than-temporary based on the Company’s ability and intent to hold the investment until a recovery of fair value. Other-than-temporary impairment of an equity security results in a write-down that must be included in income.

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 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.

 

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

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

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

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

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

A loan’s past due status is based on the contractual due date of the most delinquent payment due. Loans are generally placed on non-accrual status when the collection of principal or interest is 90 days or more past due, or earlier, if collection is uncertain based on an evaluation of the net realizable value of the collateral and the financial strength of the borrower. Loans greater than 90 days past due may remain on accrual status if management determines it has adequate collateral to cover the principal and interest. For those loans that are carried on non-accrual status, payments are first applied to principal outstanding. A loan may be returned to accrual status if the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms of the loan and there is reasonable assurance the borrower will continue to make payments as agreed. These policies are applied consistently across the loan portfolio.

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

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

Impaired Loans

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

 

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Troubled Debt Restructurings (TDR)

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

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 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:

 

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

 

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

 

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

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are classified as impaired, and is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of that loan. For collateral dependent loans, an updated appraisal is ordered if a current one is not on file. Appraisals are performed by independent third-party appraisers with relevant industry experience. Adjustments to the appraised value may be made based on recent sales of like properties or general market conditions among other considerations.

 

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

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 other income on the consolidated statements of operations. In the event of the death of an insured individual under these policies, the Company would receive a death benefit which would be recorded as other income.

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.

 

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Income Taxes

The Company accounts for income taxes in accordance with ASC Topic 740, “Income Taxes”. Under this guidance, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date. See Note 10 for details on the Company’s income taxes.

The Company regularly reviews the carrying amount of its net deferred tax assets to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of the Company’s net deferred tax assets will not be realized in future periods, a deferred tax valuation allowance would be established. Consideration is given to various positive and negative factors that could affect the realization of the deferred tax assets. In evaluating this available evidence, management considers, among other things, historical performance, expectations of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with utilization of operating loss and tax credit carry forwards not expiring, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. The Company’s evaluation is based on current tax laws as well as management’s expectations of future performance.

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 as of December 31, 2014 and 2013. Interest and penalties associated with unrecognized tax benefits, if any, are classified as additional income taxes in the consolidated statement of operations.

Wealth Management Division

Securities and other property held by the wealth management division 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 reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. There are no potential common shares that would have a dilutive effect. Shares not committed to be released under the Company’s leveraged Employee Stock Ownership Plan (ESOP) are not considered to be outstanding. See Note 12 for further information on the Company’s ESOP. The average number of common shares outstanding used to calculate basic and diluted earnings per common share were 4,902,389, 4,901,464 and 3,944,506 for the years ended December 31, 2014, 2013 and 2012, respectively.

Advertising Costs

The Company follows the policy of charging the production costs of advertising to expense as incurred. Total advertising expense incurred for 2014, 2013 and 2012 was $313 thousand, $269 thousand and $364 thousand, respectively.

 

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Comprehensive Income

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 pension liability adjustments, 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.

Recent Accounting Pronouncements

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

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

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

 

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

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

In June 2014, the FASB issued ASU No. 2014-12, “Compensation – Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period”. The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in “Compensation – Stock Compensation (Topic 718)”, should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Company does not expect the adoption of ASU 2014-12 to have an impact on its consolidated financial statements.

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

 

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In November 2014, the FASB issued ASU No. 2014-16, “Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity.” The amendments in this ASU do not change the current criteria in U.S. GAAP for determining when separation of certain embedded derivative features in a hybrid financial instrument is required. The amendments clarify how current U.S. GAAP should be interpreted in evaluating the economic characteristics and risks of a host contract in a hybrid financial instrument that is issued in the form of a share. Specifically, the amendments clarify that an entity should consider all relevant terms and features, including the embedded derivative feature being evaluated for bifurcation, in evaluating the nature of the host contract. Furthermore, the amendments clarify that no single term or feature would necessarily determine the economic characteristics and risks of the host contract. Rather, the nature of the host contract depends upon the economic characteristics and risks of the entire hybrid financial instrument. The amendments in this ASU also clarify that, in evaluating the nature of a host contract, an entity should assess the substance of the relevant terms and features (i.e., the relative strength of the debt-like or equity-like terms and features given the facts and circumstances) when considering how to weight those terms and features. The amendments in this ASU are effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption, including adoption in an interim period, is permitted. The Company does not expect the adoption of ASU 2014-16 to have an impact on its consolidated financial statements.

In November 2014, the FASB issued ASU No. 2014-17, “Business Combinations (Topic 805): Pushdown Accounting.” The amendments in this ASU provide an acquired entity with an option to apply pushdown accounting in its separate financial statements upon occurrence of an event in which an acquirer obtains control of the acquired entity. An acquired entity may elect the option to apply pushdown accounting in the reporting period in which the change-in-control event occurs. An acquired entity should determine whether to elect to apply pushdown accounting for each individual change-in-control event in which an acquirer obtains control of the acquired entity. If pushdown accounting is not applied in the reporting period in which the change-in-control event occurs, an acquired entity will have the option to elect to apply pushdown accounting in a subsequent reporting period to the acquired entity’s most recent change-in-control event. An election to apply pushdown accounting in a reporting period after the reporting period in which the change-in-control event occurred should be considered a change in accounting principle in accordance with Topic 250, Accounting Changes and Error Corrections. If pushdown accounting is applied to an individual change-in-control event, that election is irrevocable. The amendments in this ASU are effective on November 18, 2014. After the effective date, an acquired entity can make an election to apply the guidance to future change-in-control events or to its most recent change-in-control event. However, if the financial statements for the period in which the most recent change-in-control event occurred already have been issued or made available to be issued, the application of this guidance would be a change in accounting principle. The Company does not expect the adoption of ASU 2014-17 to have an impact on its consolidated financial statements.

In January 2015, the FASB issued ASU No. 2015-01, “Income Statement – Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items.” The amendments in this ASU eliminate from U.S. GAAP the concept of extraordinary items. Subtopic 225-20, Income Statement – Extraordinary and Unusual Items, required that an entity separately classify, present, and disclose extraordinary events and transactions. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. The entity also is required to disclose applicable income taxes and either present or disclose earnings-per-share data applicable to the extraordinary item. The amendments in this ASU are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company does not expect the adoption of ASU 2015-01 to have an impact on its consolidated financial statements.

 

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Note 2.

Securities

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

 

		2014
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized (Losses)				Fair Value
U.S. agency and mortgage-backed securities		$	67,462			$	374			$	(807	)		$	67,029
Obligations of states and political subdivisions			16,031				325				(99	)			16,257
Corporate equity securities			1				5				—				6
		$	83,494			$	704			$	(906	)		$	83,292

 

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

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

 

		2014
		Less than 12 months								12 months or more								Total
		Fair Value				Unrealized (Loss)				Fair Value				Unrealized (Loss)				Fair Value				Unrealized (Loss)
U.S. agency and mortgage-backed securities		$	8,677			$	(60	)		$	32,527			$	(747	)		$	41,204			$	(807	)
Obligations of states and political subdivisions			715				(1	)			2,841				(98	)			3,556				(99	)
		$	9,392			$	(61	)		$	35,368			$	(845	)		$	44,760			$	(906	)

 

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

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

 

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At December 31, 2014, there were twenty-nine U.S. agency and mortgage-backed securities and seven obligations of states and political subdivisions in an unrealized loss position. One hundred percent of the Company’s investment portfolio is considered investment grade. The weighted-average re-pricing term of the portfolio was 3.9 years at December 31, 2014. At December 31, 2013, there were forty U.S. agency and mortgage-backed securities and twenty-one obligations of states and political subdivisions in an unrealized loss position. The weighted-average re-pricing term of the portfolio was 4.5 years at December 31, 2013. The change in the unrealized gains and losses from December 31, 2013 to December 31, 2014 in the U.S. Agency and mortgage-backed securities portfolio and the obligation of states and political subdivisions portfolio was related to changes in market interest rates and not credit concerns of the issuers.

The amortized cost and fair value of securities available for sale at December 31, 2014 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. Corporate equity securities are not included in the maturity categories in the following maturity summary because they do not have a stated maturity date.

 

		Amortized Cost				Fair Value
Due within one year		$	—			$	—
Due after one year through five years			6,955				6,945
Due after five years through ten years			17,734				17,703
Due after ten years			58,804				58,638
Corporate equity securities			1				6
		$	83,494			$	83,292

Proceeds from sales, calls and maturities of securities available for sale during 2014, 2013 and 2012 were $22.3 million, $4.6 million and $36.3 million, respectively. Gross gains of $787 thousand and $1.3 million were realized on those sales during 2014 and 2012, respectively. There were no gross gains realized in 2013. Gross losses of $91 thousand were realized on those sales during 2014. There were no gross losses realized in 2013 and 2012.

Securities having a book value of $4.5 million and $3.1 million at December 31, 2014 and 2013 were pledged to secure public deposits and for other purposes required by law.

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, 2014, and no impairment has been recognized. Restricted securities are not part of the available for sale securities portfolio.

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

 

		December 31, 2014				December 31, 2013
Federal Home Loan Bank stock		$	470			$	908
Federal Reserve Bank stock			846				846
Community Bankers’ Bank stock			50				50
		$	1,366			$	1,804

 

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Note 3.

Loans

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

 

		2014				2013
Real estate loans:
Construction and land development		$	29,475			$	34,060
Secured by 1-4 family residential			163,727				141,961
Other real estate			151,802				145,968
Commercial and industrial loans			21,166				22,803
Consumer and other loans			12,240				12,301
Total loans		$	378,410			$	357,093
Allowance for loan losses			(6,718	)			(10,644	)
Loans, net		$	371,692			$	346,449

Net deferred loan costs included in the above loan categories were $130 thousand at December 31, 2014. Net deferred loan fees included in the above loan categories were $18 thousand at December 31, 2013. Consumer and other loans included $285 thousand and $279 thousand of demand deposit overdrafts at December 31, 2014 and 2013, respectively.

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

 

		December 31, 2014
		30-59 Days Past Due				60-89 Days Past Due				> 90 Days Past Due				Total Past Due				Current				Total Loans				Non- Accrual Loans				90 Days or More Past Due and Accruing
Real estate loans:
Construction and land development		$	2,441			$	71			$	—			$	2,512			$	26,963			$	29,475			$	1,787			$	—
1-4 family residential			504				323				754				1,581				162,146				163,727				1,342				—
Other real estate loans			554				800				2,519				3,873				147,929				151,802				4,756				—
Commercial and industrial			10				106				—				116				21,050				21,166				115				—
Consumer and other loans			14				—				—				14				12,226				12,240				—				—
Total		$	3,523			$	1,300			$	3,273			$	8,096			$	370,314			$	378,410			$	8,000			$	—

 

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

 

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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 institution will sustain some loss if the deficiencies are not corrected.

Doubtful – Loans classified as doubtful have all the weakness 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, 2014 and 2013 (in thousands):

 

		December 31, 2014
		Pass				Special Mention				Substandard				Doubtful				Total
Real estate loans:
Construction and land development		$	20,476			$	2,962			$	6,037			$	—			$	29,475
Secured by 1-4 family residential			152,004				5,058				6,665				—				163,727
Other real estate loans			126,211				14,776				10,815				—				151,802
Commercial and industrial			20,428				463				275				—				21,166
Consumer and other loans			12,240				—				—				—				12,240
Total		$	331,359			$	23,259			$	23,792			$	—			$	378,410

 

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

 

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Note 4.

Allowance for Loan Losses

Transactions in the allowance for loan losses for the years ended December 31, 2014, 2013 and 2012 were as follows (in thousands):

 

		2014				2013				2012
Balance at beginning of year		$	10,644			$	13,075			$	12,937
Provision for (recovery of) loan losses			(3,850	)			(425	)			3,555
Loan recoveries			851				2,486				376
Loan charge-offs			(927	)			(4,492	)			(3,793	)
Balance at end of year		$	6,718			$	10,644			$	13,075

The following tables present, as of December 31, 2014, 2013 and 2012, the total allowance for loan losses, the allowance by impairment methodology and loans by impairment methodology (in thousands).

 

		December 31, 2014
		Construction and Land Development				Secured by 1-4 Family Residential				Other Real Estate				Commercial and Industrial				Consumer and Other Loans				Total
Allowance for loan losses:
Beginning Balance, December 31, 2013		$	2,710			$	2,975			$	4,418			$	442			$	99			$	10,644
Charge-offs			(91	)			(272	)			(203	)			(43	)			(318	)			(927	)
Recoveries			80				15				509				18				229				851
Provision for (recovery of) loan losses			(1,296	)			(1,514	)			(1,066	)			(107	)			133				(3,850	)
Ending Balance, December 31, 2014		$	1,403			$	1,204			$	3,658			$	310			$	143			$	6,718
Ending Balance:
Individually evaluated for impairment			245				173				1,456				33				—				1,907
Collectively evaluated for impairment			1,158				1,031				2,202				277				143				4,811
Loans:
Ending Balance			29,475				163,727				151,802				21,166				12,240				378,410
Individually evaluated for impairment			3,205				3,414				7,183				120				—				13,922
Collectively evaluated for impairment			26,270				160,313				144,619				21,046				12,240				364,488

 

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

 

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		December 31, 2012
		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, 2011		$	2,843			$	3,766			$	5,192			$	963			$	173			$	12,937
Charge-offs			(431	)			(761	)			(2,154	)			(261	)			(186	)			(3,793	)
Recoveries			1				68				64				35				208				376
Provision for (recovery of) loan losses			68				639				3,061				(129	)			(84	)			3,555
Ending Balance, December 31, 2012		$	2,481			$	3,712			$	6,163			$	608			$	111			$	13,075
Ending Balance:
Individually evaluated for impairment			567				306				930				35				—				1,838
Collectively evaluated for impairment			1,914				3,406				5,233				573				111				11,237
Loans:
Ending Balance			43,524				134,964				174,220				23,071				7,815				383,594
Individually evaluated for impairment			2,516				3,776				10,528				160				—				16,980
Collectively evaluated for impairment			41,008				131,188				163,692				22,911				7,815				366,614

Impaired loans and the related allowance at December 31, 2014, 2013 and 2012, were as follows (in thousands):

 

		December 31, 2014
		Unpaid Principal Balance				Recorded Investment with No Allowance				Recorded Investment with Allowance				Total Recorded Investment				Related Allowance				Average Recorded Investment				Interest Income Recognized
Real estate loans:
Construction and land development		$	3,299			$	2,800			$	405			$	3,205			$	245			$	5,532			$	40
Secured by 1-4 family			4,327				2,526				888				3,414				173				3,433				138
Other real estate loans			7,623				3,708				3,475				7,183				1,456				10,115				206
Commercial and industrial			127				5				115				120				33				159				1
Consumer and other loans			—				—				—				—				—				—				—
Total		$	15,376			$	9,039			$	4,883			$	13,922			$	1,907			$	19,239			$	385

 

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

 

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		December 31, 2012
		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		$	2,947			$	622			$	1,894			$	2,516			$	567			$	5,691			$	99
Secured by 1-4 family			4,706				1,690				2,086				3,776				306				4,821				163
Other real estate loans			14,861				4,886				5,642				10,528				930				10,148				276
Commercial and industrial			161				—				160				160				35				330				10
Consumer and other loans			—				—				—				—				—				—				—
Total		$	22,675			$	7,198			$	9,782			$	16,980			$	1,838			$	20,990			$	548

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

As of December 31, 2014, loans classified as troubled debt restructurings (TDRs) and included in impaired loans in the disclosure above totaled $1.9 million. At December 31, 2014, $790 thousand of the loans classified as TDRs were performing under the restructured terms and were not considered non-performing assets. There were $1.9 million in TDRs at December 31, 2013, $829 thousand of which were performing under the restructured terms. Modified terms under TDRs may include rate reductions, extension of terms that are considered to be below market, conversion to interest only, and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. There was one new loan modified under a TDR during the year ended December 31, 2014. There were no loans modified under TDRs during the year ended December 31, 2013. The following table provides further information regarding loans modified under TDRs during the years ended December 31, 2014 and 2012 (dollars in thousands):

 

		For the year ended December 31, 2014												For the year ended December 31, 2012
		Number of Contracts				Pre- modification outstanding recorded investment				Post- modification outstanding recorded investment				Number of Contracts				Pre- modification outstanding recorded investment				Post- modification outstanding recorded investment
Real estate loans:
Construction			—			$	—			$	—				—			$	—			$	—
Secured by 1-4 family			—				—				—				1				183				183
Other real estate loans			1				283				344				1				2,426				2,426
Commercial and industrial			—				—				—				—				—				—
Consumer and other loans			—				—				—				—				—				—
Total			1			$	283			$	344				2			$	2,609			$	2,609

For the years ended December 31, 2014, 2013 and 2012, there were no troubled debt restructurings that subsequently defaulted within twelve months of the loan modification.

Management defines default as over ninety days past due or the foreclosure and repossession of the collateral and 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, 2014. Non-accrual loans excluded from impaired loan disclosure amounted to $14 thousand and $13 thousand at December 31, 2013 and 2012, respectively. Had non-accrual loans performed in accordance with their original contract terms, the Company would have recognized additional interest income in the amount of $423 thousand, $483 thousand and $510 thousand during the years ended December 31, 2014, 2013 and 2012, respectively.

 

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Note 5.

Other Real Estate Owned

At December 31, 2014 and 2013, other real estate owned (OREO) totaled $1.9 million and $3.0 million, respectively. OREO was primarily comprised of residential lots, raw land, non-residential properties and residential properties associated with commercial relationships, and are located primarily in the Commonwealth of Virginia. Changes in the balance for OREO are as follows (in thousands):

 

		2014				2013
Balance at the beginning of year, gross		$	4,695			$	7,764
Transfers in			139				2,036
Charge-offs			(1,302	)			(1,564	)
Sales proceeds			(1,502	)			(3,618	)
Gain on disposition			307				80
Deferred gain recognized			(73	)			—
Depreciation			(1	)			(3	)
Balance at the end of year, gross			2,263				4,695
Less: valuation allowance			(375	)			(1,665	)
Balance at the end of year, net		$	1,888			$	3,030

Changes in the allowance for OREO losses are as follows (in thousands):

 

		2014				2013				2012
Balance at beginning of year		$	1,665			$	2,174			$	2,792
Provision for losses			12				1,055				1,190
Charge-offs, net			(1,302	)			(1,564	)			(1,808	)
Balance at end of year		$	375			$	1,665			$	2,174

Net expenses applicable to OREO, other than the provision for losses, were $81 thousand, $150 thousand and $443 thousand for the years ended December 31, 2014, 2013, and 2012, respectively.

 

Note 6.

Premises and Equipment

Premises and equipment are summarized as follows at December 31, 2014 and 2013 (in thousands):

 

		2014				2013
Land		$	4,393			$	4,393
Buildings and leasehold improvements			15,041				15,030
Furniture and equipment			9,686				9,296
Construction in process			42				56
		$	29,162			$	28,775
Less accumulated depreciation			13,036				12,133
		$	16,126			$	16,642

Depreciation expense included in operating expenses for 2014, 2013 and 2012 was $967 thousand, $1.0 million and $1.1 million, respectively.

 

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Note 7.

Deposits

The aggregate amount of time deposits, in denominations of $250 thousand or more, was $11.4 million and $11.8 million at December 31, 2014 and 2013, respectively.

The Bank obtains certain deposits through the efforts of third-party brokers. At December 31, 2014 and 2013, brokered deposits totaled $1.9 million and $5.1 million, respectively, and were included in time deposits on the Company’s consolidated financial statements.

At December 31, 2014, the scheduled maturities of time deposits were as follows (in thousands):

 

2015		$	48,462
2016			25,453
2017			5,831
2018			11,841
2019			10,147
		$	101,734

 

Note 8.

Other Borrowings

The Bank had unused lines of credit totaling $121.1 million and $108.4 million available with non-affiliated banks at December 31, 2014 and 2013, respectively. These amounts primarily consist of a blanket floating lien agreement with the Federal Home Loan Bank of Atlanta in which the Bank can borrow up to 19% of its assets. The unused line of credit with FHLB totaled $75.3 million at December 31, 2014.

At December 31, 2014, the Bank did not have borrowings from the Federal Home Loan Bank (FHLB) system. At December 31, 2013, the Bank had borrowings from FHLB totaling $6.0 million. The Bank had a letter of credit from the FHLB totaling $23.0 million and $25.0 million at December 31, 2014 and 2013, respectively. The Bank had collateral pledged on the borrowing line and letter of credit at December 31, 2014 and 2013 including real estate loans totaling $101.9 million and $78.6 million, respectively, and Federal Home Loan Bank stock with a book value of $470 thousand and $1.0 million, respectively.

At December 31, 2014 and 2013, the Bank had a note payable totaling $26 thousand and $52 thousand, respectively, secured by a deed of trust, for land purchased to construct a banking office, which requires monthly payments of $2 thousand, and matures January 3, 2016. The fixed interest rate on this loan was 4.00%.

 

Note 9.

Trust Preferred Capital Notes

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

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, 2014 and 2013 was 1.84% and 1.85%, respectively. The securities have a mandatory redemption date of October 1, 2036, and were subject to varying call provisions beginning October 1, 2011. The principal asset of Trust III is $4.1 million of the Company’s junior subordinated debt securities with maturities and interest rates comparable to the trust preferred securities. The Trust’s obligations under the trust preferred securities are fully and unconditionally guaranteed by the Company.

 

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

 

Note 10.

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 2011.

Net deferred tax assets consisted of the following components at December 31, 2014 and 2013 (in thousands):

 

		2014				2013
Deferred Tax Assets
Allowance for loan losses		$	2,284			$	3,619
Allowance for other real estate owned			127				566
Unfunded pension liability			732				90
Split dollar liability			—				207
Gain on other real estate owned			639				769
Securities available for sale			71				584
Accrued pension			392				289
Loan origination costs, net			—				6
Other			13				10
		$	4,258			$	6,140
Deferred Tax Liabilities
Depreciation		$	604			$	685
Discount accretion			2				5
Loan origination fees, net			44				—
		$	650			$	690
Net deferred tax assets		$	3,608			$	5,450

As of December 31, 2013, the Company reversed the full valuation allowance on its net deferred tax assets (DTAs). The realization of DTAs is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. In assessing the need for a valuation allowance, the Company considered all available evidence about the realization of DTAs, both positive and negative, that could be objectively verified.

Positive evidence considered included (1) a return to trailing three years of cumulative pre-tax income in 2013, (2) the Company’s recent history of quarterly pre-tax earnings, (3) expectations for sustained profitability with sufficient taxable income to fully utilize the remaining net deferred tax benefits, and (4) significant reductions in the level of non-performing assets since their peak during 2011, which was the primary source of the losses generated in 2010 and 2011.

Negative evidence considered was (1) the uncertainty about the potential impact on earnings from nonperforming assets along with (2) a pre-tax loss reported by the Company during one quarterly period over the previous two years. As the number of consecutive periods of profitability increased and the level of profits are indicative of on-going results, the weight of cumulative losses as negative evidence decreased. A reduction in the weight given to such losses was further validated given that the source of the losses was an elevated level of problem assets and related credit costs, which had since been significantly reduced. After weighing both the positive and negative evidence, management determined that a valuation allowance on the net deferred tax asset was no longer warranted as of December 31, 2013.

 

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The provision (benefit) for income taxes for the years ended December 31, 2014, 2013 and 2012 consisted of the following (in thousands):

 

		2014				2013				2012
Current tax expense (benefit)		$	1,528			$	(44	)		$	965
Deferred tax expense (benefit)			1,971				(4,776	)			—
		$	3,499			$	(4,820	)		$	965

The income tax provision (benefit) 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, 2014, 2013 and 2012, due to the following (in thousands):

 

		2014				2013				2012
Computed tax expense at statutory federal rate		$	3,784			$	1,718			$	1,280
Decrease in income taxes from deferred tax valuation allowance			—				(6,275	)			(167	)
Decrease in income taxes resulting from:
Tax-exempt interest and dividend income			(189	)			(153	)			(125	)
Other			(96	)			(110	)			(23	)
		$	3,499			$	(4,820	)		$	965

 

Note 11.

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, 2014, the aggregate amount of unrestricted funds which could be transferred from the banking subsidiary to the parent company, without prior regulatory approval, totaled $20.5 million.

The Bank must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the years ended December 31, 2014 and 2013, the aggregate amounts of daily average required balances were approximately $613 thousand and $1.4 million, respectively.

 

Note 12.

Benefit Plans

Pension Plan

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

 

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The following tables provide a reconciliation of the changes in the plan benefit obligation and the fair value of assets for the periods ended December 31, 2014, 2013 and 2012 (in thousands).

 

		2014				2013				2012
Change in Benefit Obligation
Benefit obligation, beginning of year		$	5,501			$	7,244			$	5,995
Service cost			347				470				427
Interest cost			269				279				269
Actuarial (gain) loss			1,769				(1,327	)			725
Benefits paid			(157	)			(961	)			(172	)
Gain due to settlement			—				(204	)			—
Benefit obligation, end of year		$	7,729			$	5,501			$	7,244
Changes in Plan Assets
Fair value of plan assets, beginning of year		$	4,329			$	4,046			$	3,454
Actual return on plan assets			196				744				458
Employer contributions			—				500				306
Benefits paid			(157	)			(961	)			(172	)
Fair value of assets, end of year		$	4,368			$	4,329			$	4,046
Funded Status, end of year		$	(3,361	)		$	(1,172	)		$	(3,198	)
Amount Recognized in Other Liabilities		$	(3,361	)		$	(1,172	)		$	(3,198	)
Amounts Recognized in Accumulated Other Comprehensive Loss, net of tax
Net loss		$	2,153			$	265			$	2,629
Prior service cost			—				—				—
Deferred income tax benefit			(732	)			(90	)			—
Amount recognized		$	1,421			$	175			$	2,629
Weighted Average Assumptions Used to Determine Benefit Obligation
Discount rate used for disclosure			4.00	%			5.00	%			4.00	%
Expected return on plan assets			7.50	%			8.00	%			8.00	%
Rate of compensation increase			3.00	%			3.00	%			3.00	%

 

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		2014				2013				2012
Components of Net Periodic Benefit Cost
Service cost		$	347			$	470			$	427
Interest cost			269				279				269
Expected return on plan assets			(315	)			(303	)			(275	)
Amortization of prior service cost			—				—				2
Recognized net loss due to settlement			—				284				—
Recognized net actuarial loss			—				109				86
Net periodic benefit cost		$	301			$	839			$	509
Other Changes in Plan Assets and Benefit Obligations Recognized in Accumulated Other Comprehensive (Income) Loss
Net (gain) loss		$	1,888			$	(2,364	)		$	456
Amortization of prior service cost			—				—				(2	)
Total recognized in accumulated other comprehensive income (loss)		$	1,888			$	(2,364	)		$	454
Total Recognized in Net Periodic Benefit Cost and Accumulated Other Comprehensive Income (Loss)		$	2,189			$	(1,525	)		$	963
Weighted Average Assumptions Used to Determine Net Periodic Benefit Cost
Discount rate			5.00	%			4.00	%			4.50	%
Expected return on plan assets			7.50	%			8.00	%			8.00	%
Rate of compensation increase			3.00	%			3.00	%			3.00	%

The plan sponsor selects the expected long-term rate of return on assets assumption in consultation with their investment advisors and actuary. This rate is intended to reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience, which may not continue over the measurement period, with higher significance placed on current forecasts of future long-term economic conditions.

Because assets are held in a qualified trust, anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).

The process used to select the discount rate assumption takes into account the benefit cash flow and the segmented yields on high-quality corporate bonds that would be available to provide for the payment of the benefit cash flow. A single effective discount rate, rounded to the nearest .25%, is then established that produces an equivalent discounted present value.

The pension plan’s weighted-average asset allocations at the end of the plan year for 2014 and 2013, by asset category were as follows:

 

		2014				2013
Asset Category
Mutual funds – fixed income			39	%			39	%
Mutual funds – equity			61	%			61	%
Total			100	%			100	%

 

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The trust fund is sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 40% fixed income and 60% equities. The Investment Manager selects investment fund managers with demonstrated experience and expertise, and funds with demonstrated historical performance for the implementation of the plan’s investment strategy. The investment manager will consider both actively and passively managed investment strategies and will allocate funds across the asset classes to develop an efficient investment structure.

It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting fees, transaction costs and other administrative costs chargeable to the trust.

Following is a description of the valuation methodologies used for assets measured at fair value.

Fixed income and equity funds: Valued at the net asset value of shares held at year-end.

The pension financial instruments measured and reported at fair value are classified and disclosed in one of the following categories:

 

•

Level 1 Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

•

Level 2 Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

 

•

Level 3 Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The following tables set forth by level, within the fair value hierarchy, the Company’s pension plan assets at fair value as of December 31, 2014, 2013 and 2012 (in thousands):

 

		Fair Value Measurements at December 31, 2014
		Total				Level 1				Level 2				Level 3
Fixed income funds		$	1,711			$	1,711			$	—			$	—
Equity funds			2,657				2,657				—				—
Total		$	4,368			$	4,368			$	—			$	—

 

		Fair Value Measurements at December 31, 2013
		Total				Level 1				Level 2				Level 3
Fixed income funds		$	1,697			$	1,697			$	—			$	—
Equity funds			2,632				2,632				—				—
Total		$	4,329			$	4,329			$	—			$	—

 

		Fair Value Measurements at December 31, 2012
		Total				Level 1				Level 2				Level 3
Fixed income funds		$	1,023			$	1,023			$	—			$	—
Equity funds			3,023				3,023				—				—
Total		$	4,046			$	4,046			$	—			$	—

The Company did not make a cash contribution during the year ended December 31, 2014, and expects to make no contribution during the year ended December 31, 2015. The Company made cash contributions of $500 thousand and $306 thousand during the years ended December 31, 2013 and 2012, respectively. The accumulated benefit obligation for the defined benefit pension plan was $5.3 million, $3.8 million and $5.1 million at December 31, 2014, 2013 and 2012, respectively.

 

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Estimated future benefit payments, which reflect expected future service, as appropriate, were as follows at December 31, 2014 (in thousands):

 

2015		$	361
2016			312
2017			301
2018			24
2019			26
Years 2020-2024			2,569

401(k) Plan

The Company maintains a 401(k) 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 for eligible employees hired on or after May 1, 2011. This contribution is allocated based on years of service to participants who were hired on or after May 1, 2011 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. The amount that the Company matches is contributed for the benefit of the respective employee to the employee stock ownership plan (ESOP). 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, 2014, 2013 and 2012, expense attributable to the Plan amounted to $306 thousand, $249 thousand and $219 thousand, respectively.

Employee Stock Ownership Plan

On January 1, 2000, the Company established an employee stock ownership plan. The ESOP provides an opportunity for the Company to award shares of First National Corporation stock to employees at its discretion. Employees are eligible to participate in the ESOP effective immediately upon beginning service with the Company. Participants become 100% vested after two years of credited service. In addition to the 401(k) matching contributions made by the Company to the ESOP, the Board of Directors may make discretionary contributions, within certain limitations prescribed by federal tax regulations. There was no compensation expense for the ESOP for the years ended December 31, 2014, 2013 and 2012. Shares of the Company held by the ESOP at December 31, 2014, 2013 and 2012, were 173,823, 169,882 and 134,609, respectively.

Split Dollar Life Insurance Plan

On January 6, 1999, the Bank adopted a Director Split Dollar Life Insurance Plan. This Plan provided life insurance coverage to insurable outside directors of the Bank. The Bank owns the policies and is entitled to all values and proceeds. The Plan provided retirement benefits and the payment of benefits at the death of the insured director. The amount of benefits was determined by the performance of the policies over the director’s life.

Accounting guidance requires a company to recognize an obligation over the director’s service period based upon the substantive agreement with the director such as the promise to maintain a life insurance policy or provide a death benefit postretirement. The related effect on net income recognized during the year ended December 31, 2012 was a benefit of $21 thousand. In May 2013, the Bank terminated its Split Dollar Life Insurance Plan that provided life insurance coverage to insurable directors and recorded a gain of $543 thousand from the termination of the postretirement benefit liability.

 

Note 13.

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.

 

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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, 2014 and 2013, the following financial instruments were outstanding whose contract amounts represent credit risk (in thousands):

 

		2014				2013
Commitments to extend credit and unfunded commitments under lines of credit		$	60,019			$	59,115
Stand-by letters of credit			9,763				7,610

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 usually do not contain a specified maturity date and 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. 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, 2014, the Bank had $1.1 million in locked-rate commitments to originate mortgage loans and $328 thousand in loans held for sale. 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, 2014 exceeded the insurance limits of the Federal Deposit Insurance Corporation by $10 thousand.

 

Note 14.

Transactions with Related Parties

During the year, executive officers and directors (and companies controlled by them) 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, 2014 and 2013, these loans totaled $2.4 million and $2.1 million, respectively. During 2014, total principal additions were $496 thousand and total principal payments were $164 thousand.

Deposits from related parties held by the Bank at December 31, 2014 and 2013 amounted to $5.7 million and $5.1 million, respectively.

 

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Note 15.

Lease Commitments

The Company was obligated under noncancelable leases for banking premises. Total rental expense for operating leases for 2014, 2013 and 2012 was $99 thousand, $224 thousand and $244 thousand, respectively. Minimum rental commitments under noncancelable leases with terms in excess of one year as of December 31, 2014 were as follows (in thousands):

 

		Operating Leases
2015		$	69
2016			39
2017			26
2018			22
2019			4
Total minimum payments		$	160

 

Note 16.

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 Over-the-Counter Markets Group exchange for the 10 business days immediately preceding the dividend payment date.

The Company issued 3,113 common shares to the DRIP during the year ended December 31, 2014. No shares were issued to the DRIP during the years ended December 31, 2013 and 2012.

 

Note 17.

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.

 

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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.

 

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).

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

 

						Fair Value Measurements at December 31, 2014
Description		Balance as of December 31, 2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Securities available for sale
U.S. agency and mortgage-backed securities		$	67,029			$	—			$	67,029			$	—
Obligations of states and political subdivisions			16,257				—				16,257				—
Corporate equity securities			6				6				—				—
		$	83,292			$	6			$	83,286			$	—

 

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

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

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, 2014 and 2013.

Impaired Loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreements will not be collected. The measurement of loss associated with impaired loans can be based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the observable market price of the loan, or the fair value of the collateral. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company’s collateral is real estate. The value of real estate collateral is determined utilizing a market valuation approach based on an appraisal conducted by an independent, licensed appraiser using observable market data (Level 2) within the last twelve months. However, if the collateral is a house or building in the process of construction or if an appraisal of the property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then a Level 3 valuation is considered to measure the fair value. The value of business equipment is based upon an outside appraisal, of one year or less, if deemed significant, or the net book value on the applicable business’s financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

Other real estate owned

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

 

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The following tables summarize the Company’s assets that were measured at fair value on a nonrecurring basis as of December 31, 2014 and 2013 (dollars in thousands).

 

						Fair Value Measurements at December 31, 2014
Description		Balance as of December 31, 2014				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans, net		$	2,976			$	—			$	—			$	2,976
Other real estate owned, net			1,888				—				—				1,888

 

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

 

Quantitative information about Level 3 Fair Value Measurements for December 31, 2014

Fair Value

Valuation Technique

Unobservable Input

Range (Weighted- Average)

Impaired loans, net

$

2,976

Property appraisals

Selling cost

10

%

Other real estate owned, net

1,888

Property appraisals

Selling cost

7

%

Quantitative information about Level 3 Fair Value Measurements for December 31, 2013

Fair Value

Valuation Technique

Unobservable Input

Range (Weighted- Average)

Impaired loans, net

$

3,972

Property appraisals

Selling cost

10%

Discount for lack of marketability and age of appraisal

0%-41% (8%)

Other real estate owned, net

3,030

Property appraisals

Selling cost

7%

 

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

Cash and Cash Equivalents and Federal Funds Sold

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

Restricted Stock

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

Loans

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

Deposit Liabilities

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

Accrued Interest

Accrued interest receivable and payable were estimated to equal the carrying value due to the short-term nature of these financial instruments.

Borrowings and Federal Funds Purchased

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

Bank Owned Life Insurance

Bank owned life insurance represents insurance policies on officers, directors, and past directors of the Company. The cash values of these policies are estimates using information provided by insurance carriers. These policies are carried at their cash surrender value, which approximates the fair value.

Commitments and Unfunded Credits

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

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

 

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

 

		Fair Value Measurements at December 31, 2014 Using
		Carrying Amount				Quoted Prices in Active Markets for Identical Assets Level 1				Significant Other Observable Inputs Level 2				Significant Unobservable Inputs Level 3				Fair Value
Financial Assets
Cash and short-term investments		$	24,845			$	24,845			$	—			$	—			$	24,845
Securities			83,292				6				83,286				—				83,292
Restricted securities			1,366				—				1,366				—				1,366
Loans held for sale			328				—				328				—				328
Loans, net			371,692				—				—				378,930				378,930
Bank owned life insurance			11,357				—				11,357				—				11,357
Accrued interest receivable			1,261				—				1,261				—				1,261
Financial Liabilities
Deposits		$	444,338			$	—			$	342,604			$	101,606			$	444,210
Federal funds purchased			52				—				52				—				52
Other borrowings			26				—				—				26				26
Trust preferred capital notes			9,279				—				—				9,756				9,756
Accrued interest payable			135				—				135				—				135

 

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

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely,

 

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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 18.

Regulatory Matters

The Company (on a consolidated basis) and the Bank are 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 Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and 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.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total (as defined in the regulations) and 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, 2014 and 2013, that the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2014, 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 total risk-based, Tier 1 risk-based, and Tier 1 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.

The Company’s and the Bank’s actual capital amounts and ratios are also presented in the following table (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, 2014:
Total Capital (to Risk Weighted Assets):
Company		$	75,045				19.93	%		$	30,130				8.00	%			N/A				N/A
Bank		$	71,941				19.14	%		$	30,077				8.00	%		$	37,596				10.00	%
Tier 1 Capital (to Risk Weighted Assets):
Company		$	70,312				18.67	%		$	15,065				4.00	%			N/A				N/A
Bank		$	67,217				17.88	%		$	15,038				4.00	%		$	22,557				6.00	%
Tier 1 Capital (to Average Assets):
Company		$	70,312				13.47	%		$	20,872				4.00	%			N/A				N/A
Bank		$	67,217				12.90	%		$	20,841				4.00	%		$	26,051				5.00	%
December 31, 2013:
Total Capital (to Risk Weighted Assets):
Company		$	66,437				18.21	%		$	29,193				8.00	%			N/A				N/A
Bank		$	60,578				16.62	%		$	29,160				8.00	%		$	36,450				10.00	%
Tier 1 Capital (to Risk Weighted Assets):
Company		$	61,800				16.94	%		$	14,597				4.00	%			N/A				N/A
Bank		$	55,947				15.35	%		$	14,580				4.00	%		$	21,870				6.00	%
Tier 1 Capital (to Average Assets):
Company		$	61,800				11.75	%		$	21,047				4.00	%			N/A				N/A
Bank		$	55,947				10.68	%		$	20,948				4.00	%		$	26,184				5.00	%

 

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Note 19.

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				Adjustments Related to Pension Benefits				Accumulated Other Comprehensive Income (Loss)
Balance at December 31, 2011		$	3,166			$	(2,175	)		$	991
Unrealized holding losses (net of tax, $0)			(111	)			—				(111	)
Reclassification adjustment (net of tax, $0)			(1,285	)			—				(1,285	)
Pension liability adjustment (net of tax, $0)			—				(454	)			(454	)
Change during period			(1,396	)			(454	)			(1,850	)
Balance at December 31, 2012		$	1,770			$	(2,629	)		$	(859	)
Unrealized holding losses (net of tax, ($1,493))			(2,899	)			—				(2,899	)
Pension liability adjustment (net of tax, $1,264)			—				2,454				2,454
Change during period			(2,899	)			2,454				(445	)
Balance at December 31, 2013		$	(1,129	)		$	(175	)		$	(1,304	)
Unrealized holding gains (net of tax, $750)			1,456				—				1,456
Reclassification adjustment (net of tax, $236)			(460	)			—				(460	)
Pension liability adjustment (net of tax, ($642))			—				(1,246	)			(1,246	)
Change during period			996				(1,246	)			(250	)
Balance at December 31, 2014		$	(133	)		$	(1,421	)		$	(1,554	)

The following table presents information related to reclassifications from accumulated other comprehensive income (loss) for the years ended December 31, 2014, 2013 and 2012 (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 Operations
		For the year ended December 31,
		2014				2013				2012
Securities available for sale:
Net securities gains reclassified into earnings		$	(696	)		$	—			$	(1,285	)		Net gains on sale of securities available for sale
Related income tax expense			236				—				—			Income tax provision (benefit)
Total reclassifications		$	(460	)		$	—			$	(1,285	)		Net of tax

 

Note 20.

Preferred Stock

The Company has (i) 13,900 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, with a par value of $1.25 per share and liquidation preference of $1,000 per share (the Preferred Stock) and (ii) 695 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series B, with a par value of $1.25 per share and liquidation preference of $1,000 per share (the Warrant Preferred Stock). The Preferred Stock paid cumulative dividends at a rate of 5% per annum until May 14, 2014, and thereafter at a rate of 9% per annum. The Warrant Preferred Stock pays cumulative dividends at a rate of 9% per annum from the date of issuance. The discount on the Preferred Stock was fully amortized over a five year period through March 12, 2014, using the constant effective yield method.

 

Note 21.

Rights Offering of Common Stock

On June 29, 2012, the Company completed the sale of 1,945,815 shares of common stock in a rights offering and to certain standby investors. The Company’s existing shareholders exercised subscription rights to purchase 1,520,815 shares at a subscription price of $4.00 per share, and the standby investors purchased an additional 425,000 shares at the same price of $4.00 per share. In total, the Company raised proceeds of $7.6 million, net of offering costs.

 

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Note 22.

Acquisition

On November 18, 2014, the Bank entered into a Purchase and Assumption Agreement (the “Agreement”) with Bank of America, National Association to acquire branch banking operations of six locations in Virginia. Subject to the satisfaction of customary closing conditions, the Bank expects the transaction to close in the second quarter of 2015. After the transaction closes, the Bank expects its assets to total approximately $750 million. The Agreement includes the acquisition of approximately $308 million of deposits and $1.7 million of premises and equipment. The Bank agreed to pay a 2.25% premium on total deposits on the closing date.

 

Note 23.

Subsequent Events

On February 11, 2015, the Board of Directors of the Company declared a quarterly cash dividend of $0.025 per common share, which is payable on March 20, 2015 to shareholders of record as of March 6, 2015.

 

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Note 24.

Parent Company Only Financial Statements

FIRST NATIONAL CORPORATION

(Parent Company Only)

Balance Sheets

December 31, 2014 and 2013

(in thousands)

 

 

		2014				2013
Assets
Cash		$	2,421			$	5,395
Investment in subsidiaries, at cost, plus undistributed net income			65,744				56,982
Other assets			685				470
Total assets		$	68,850			$	62,847
Liabilities and Shareholders’ Equity
Trust preferred capital notes		$	9,279			$	9,279
Other liabilities			7				8
Total liabilities		$	9,286			$	9,287
Preferred stock		$	14,595			$	14,564
Common stock			6,131				6,127
Surplus			6,835				6,813
Retained earnings			33,557				27,360
Accumulated other comprehensive loss, net			(1,554	)			(1,304	)
Total shareholders’ equity		$	59,564			$	53,560
Total liabilities and shareholders’ equity		$	68,850			$	62,847

 

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FIRST NATIONAL CORPORATION

(Parent Company Only)

Statements of Income

Three Years Ended December 31, 2014

(in thousands)

 

 

		2014				2013				2012
Income
Dividends from subsidiary		$	—			$	—			$	500
Gain on sale of securities available for sale			—				—				139
Other income			26				51				41
		$	26			$	51			$	680
Expense
Interest expense		$	218			$	222			$	237
Stationery and supplies			18				17				1
Legal and professional fees			37				40				—
Data processing			67				53				—
Management fee-subsidiary			251				95				—
Other expense			13				51				6
Total expense		$	604			$	478			$	244
Income (loss) before allocated tax benefits and undistributed income of subsidiary		$	(578	)		$	(427	)		$	436
Allocated income tax benefit			197				145				22
Income (loss) before equity in undistributed income of subsidiary		$	(381	)		$	(282	)		$	458
Equity in undistributed income of subsidiary			8,012				10,156				2,342
Net income		$	7,631			$	9,874			$	2,800
Effective dividend and accretion on preferred stock			1,138				913				904
Net income available to common shareholders		$	6,493			$	8,961			$	1,896

 

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FIRST NATIONAL CORPORATION

(Parent Company Only)

Statements of Cash Flows

Three Years Ended December 31, 2014

(in thousands)

 

 

		2014				2013				2012
Cash Flows from Operating Activities
Net income		$	7,631			$	9,874			$	2,800
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Equity in undistributed income of subsidiary			(8,012	)			(10,156	)			(2,342	)
Gain on sale of securities available for sale			—				—				(139	)
(Increase) decrease in other assets			(216	)			29				(42	)
Decrease in other liabilities			—				—				(2	)
Net cash provided by (used in) operating activities		$	(597	)		$	(253	)		$	275
Cash Flows from Investing Activities
Proceeds from sale of securities available for sale		$	—			$	—			$	164
Distribution of capital to subsidiary			(1,000	)			—				(1,000	)
Net cash used in investing activities		$	(1,000	)		$	—			$	(836	)
Cash Flows from Financing Activities
Cash dividends paid on common stock, net of reinvestment		$	(342	)		$	—			$	—
Cash dividends paid on preferred stock			(1,035	)			(758	)			(758	)
Net proceeds from issuance of common stock			—				—				7,601
Net cash provided by (used in) financing activities		$	(1,377	)		$	(758	)		$	6,843
Increase (decrease) in cash and cash equivalents		$	(2,974	)		$	(1,011	)		$	6,282
Cash and Cash Equivalents
Beginning			5,395				6,406				124
Ending		$	2,421			$	5,395			$	6,406

 

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Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

 

Item 9A.

Controls and Procedures

The Company’s management has evaluated, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of disclosure controls and procedures as of December 31, 2014 pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the Exchange Act). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2014, the disclosure controls and procedures are effective in ensuring that the information required to be disclosed in Exchange Act reports is (1) recorded, processed, summarized and reported in a timely manner and (2) accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Refer to Item 8 of this report for the “Management’s Report on the Effectiveness of Internal Controls over Financial Reporting.”

There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of it that occurred during the Company’s last fiscal quarter that materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

 

Item 9B.

Other Information

None.

PART III

 

Item 10.

Directors, Executive Officers and Corporate Governance

Information required by this Item is set forth under the headings “Election of Directors – Nominees,” “Executive Officers Who Are Not Directors,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Code of Conduct and Ethics,” “Committees” and “Director Selection Process” in the Company’s Proxy Statement for the 2015 Annual Meeting of Shareholders (the “Proxy Statement”), which information is incorporated herein by reference.

 

Item 11.

Executive Compensation

Information required by this Item is set forth under the headings “Executive Compensation” and “Director Compensation” in the Proxy Statement, which information is incorporated herein by reference.

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information required by this Item is set forth under the heading “Stock Ownership of Directors and Executive Officers” and “Stock Ownership of Certain Beneficial Owners” in the Proxy Statement, which information is incorporated herein by reference.

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

Information required by this Item is set forth under the headings “Certain Relationships and Related Party Transactions” and “Director Independence” in the Proxy Statement, which information is incorporated herein by reference.

 

Item 14.

Principal Accounting Fees and Services

Information required by this Item is set forth under the headings “Auditor Fees and Services” and “Policy for Approval of Audit and Permitted Non-Audit Services” in the Proxy Statement, which information is incorporated herein by reference.

 

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PART IV

 

Item 15.

Exhibits, Financial Statement Schedules

 

(a)	(1)    The response to this portion of Item 15 is included in Item 8 above.

 

(2)

The response to this portion of Item 15 is included in Item 8 above.

 

(3)

The following documents are attached hereto or incorporated herein by reference to Exhibits:

 

2.1		Purchase and Assumption Agreement, dated as of November 18, 2014, between Bank of America, National Association and First Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on November 19, 2014).
3.1		Amended and Restated Articles of Incorporation, as amended and restated on March 3, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Form 10-K for the year ended December 31, 2008).
3.2		Articles of Amendment to the Articles of Incorporation (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
3.3		By-laws of First National Corporation (as restated in electronic format as of August 13, 2014), attached as Exhibit 3.1 to the Current Report on Form 8-K filed August 19, 2014 and incorporated by reference herein.
4.1		Specimen of Common Stock Certificate (incorporated herein by reference to Exhibit 1 to the Company’s Form 10 filed with SEC on May 2, 1994).
4.2		Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
4.3		Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series B (incorporated herein by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
10.1		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and Dennis A. Dysart (incorporated by reference to Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended September 30, 2007).
10.2		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and M. Shane Bell (incorporated by reference to Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended June 30, 2007).
10.3		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and Marshall J. Beverley, Jr. (incorporated by reference to Exhibit 10.3 to the Company’s Form 10-Q for the quarter ended June 30, 2007).
10.4		Amendment to Employment Agreement between the Company and Dennis A. Dysart and M. Shane Bell (incorporated by reference to Exhibit 10.6 to the Company’s Form 10-K for the year ended December 31, 2008).
10.5		Amendment to Employment Agreement between the Company and Marshall J. Beverley, Jr. (incorporated by reference to Exhibit 10.7 to the Company’s Form 10-K for the year ended December 31, 2008).
10.8		Employment Agreement between the Company and Scott C. Harvard (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on May 22, 2014).
10.9		Executive Incentive Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed with the SEC on March 19, 2013).

 

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10.10		2014 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 to the Company’s Registration Statement on Form S-8, filed February 11, 2015).
14.1		Code of Conduct and Ethics (incorporated herein by reference to Exhibit 14.1 to the Company’s Current Report on Form 8-K, filed on April 11, 2008).
21.1		Subsidiaries of the Company.
23.1		Consent of Yount, Hyde & Barbour, P.C.
31.1		Certification of Chief Executive Officer, Section 302 Certification.
31.2		Certification of Chief Financial Officer, Section 302 Certification.
32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350.
32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.
101		The following materials from First National Corporation’s Annual Report on Form 10-K for the year ended December 31, 2014 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, (iv) Consolidated Statements of Changes in Shareholders’ Equity, and (v) Notes to Consolidated Financial Statements.

 

(b)

Exhibits

See Item 15(a)(3) above.

 

(c)

Financial Statement Schedules

See Item 15(a)(2) above.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

FIRST NATIONAL CORPORATION
By:		/s/ Scott C. Harvard
President and Chief Executive Officer
(on behalf of the registrant and as principal executive officer)
Date:		March 27, 2015

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

/s/ Scott C. Harvard				Date:		March 27, 2015
President & Chief Executive Officer Director (principal executive officer)
/s/ M. Shane Bell				Date:		March 27, 2015
Executive Vice President & Chief Financial Officer (principal financial officer and principal accounting officer)
/s/ Douglas C. Arthur				Date:		March 27, 2015
Chairman of the Board of Directors
/s/ John K. Marlow				Date:		March 27, 2015
Vice Chairman of the Board of Directors
/s/ Emily Marlow Beck				Date:		March 27, 2015
Director
/s/ Elizabeth H. Cottrell				Date:		March 27, 2015
Director
/s/ Dr. James A. Davis				Date:		March 27, 2015
Director
/s/ Dr. Miles K. Davis				Date:		March 27, 2015
Director
/s/ Christopher E. French				Date:		March 27, 2015
Director
/s/ W. Michael Funk				Date:		March 27, 2015
Director
/s/ Gerald F. Smith, Jr.				Date:		March 27, 2015
Director
/s/ James R. Wilkins, III				Date:		March 27, 2015
Director

 

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EXHIBIT INDEX

 

Number		Document
2.1		Purchase and Assumption Agreement, dated as of November 18, 2014, between Bank of America, National Association and First Bank (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed with the SEC on November 19, 2014).
3.1		Amended and Restated Articles of Incorporation, as amended and restated on March 3, 2009 (incorporated herein by reference to Exhibit 3.1 to the Company’s Form 10-K for the year ended December 31, 2008).
3.2		Articles of Amendment to the Articles of Incorporation (incorporated herein by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
3.3		By-laws of First National Corporation (as restated in electronic format as of August 13, 2014), attached as Exhibit 3.1 to the Current Report on Form 8-K filed August 19, 2014 and incorporated by reference herein.
4.1		Specimen of Common Stock Certificate (incorporated herein by reference to Exhibit 1 to the Company’s Form 10 filed with SEC on May 2, 1994).
4.2		Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated herein by reference to Exhibit 4.1 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
4.3		Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series B (incorporated herein by reference to Exhibit 4.3 to the Company’s Current Report on Form 8-K filed with the SEC on March 17, 2009).
10.1		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and Dennis A. Dysart (incorporated by reference to Exhibit 10.1 to the Company’s Form 10-Q for the quarter ended September 30, 2007).
10.2		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and M. Shane Bell (incorporated by reference to Exhibit 10.2 to the Company’s Form 10-Q for the quarter ended June 30, 2007).
10.3		Amended and Restated Employment Agreement, dated as of June 1, 2007, between the Company and Marshall J. Beverley, Jr. (incorporated by reference to Exhibit 10.3 to the Company’s Form 10-Q for the quarter ended June 30, 2007).
10.4		Amendment to Employment Agreement between the Company and Dennis A. Dysart and M. Shane Bell (incorporated by reference to Exhibit 10.6 to the Company’s Form 10-K for the year ended December 31, 2008).
10.5		Amendment to Employment Agreement between the Company and Marshall J. Beverley, Jr. (incorporated by reference to Exhibit 10.7 to the Company’s Form 10-K for the year ended December 31, 2008).
10.8		Employment Agreement between the Company and Scott C. Harvard (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed with the SEC on May 22, 2014).
10.9		Executive Incentive Plan (incorporated herein by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed with the SEC on March 19, 2013).
10.10		2014 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 to the Company’s Registration Statement on Form S-8, filed February 11, 2015).
14.1		Code of Conduct and Ethics (incorporated herein by reference to Exhibit 14.1 to the Company’s Current Report on Form 8-K, filed on April 11, 2008).
21.1		Subsidiaries of the Company.

 

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23.1		Consent of Yount, Hyde & Barbour, P.C.
31.1		Certification of Chief Executive Officer, Section 302 Certification.
31.2		Certification of Chief Financial Officer, Section 302 Certification.
32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350.
32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.
101		The following materials from First National Corporation’s Annual Report on Form 10-K for the year ended December 31, 2014 formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Cash Flows, (iv) Consolidated Statements of Changes in Shareholders’ Equity, and (v) Notes to Consolidated Financial Statements.

 

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