BOTJ 10-Q Quarter ended Sept. 30, 2019

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

For the Quarterly Period Ended September 30, 2019

BANK OF THE JAMES FINANCIAL GROUP, INC.

(Exact Name of Registrant as Specified in Its Charter)

Virginia		001-35402		20-0500300
(State or other jurisdiction of incorporation or organization)		(Commission file number)		(I.R.S. Employer Identification No.)
828 Main Street, Lynchburg, VA				24504
(Address of principal executive offices)				(Zip Code)

(434) 846-2000

(Registrant’s telephone number, including area code)

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    Yes  ☒    No  ☐

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

Large accelerated filer		☐		Accelerated filer		☐
Non-accelerated filer		☒		Smaller reporting company		☒
Emerging growth company		☐

Securities registered or to be registered pursuant to Section 12(b) of the Act

Title of each class		Trading Symbol(s)		Name of each exchange on which registered
Common Stock, 2.14 per share par value		BOTJ		The NASDAQ Stock Market LLC

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 4,372,436 shares of Common Stock, par value $2.14 per share, were outstanding at November 8, 2019.

Table of Contents

PART I – FINANCIAL INFORMATION			1
Item 1. Consolidated Financial Statements			1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			37
Item 3. Quantitative and Qualitative Disclosures About Market Risk			56
Item 4. Controls and Procedures			56
PART II – OTHER INFORMATION			57
Item 1. Legal Proceedings			57
Item 1A. Risk Factors			57
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			57
Item 3. Defaults Upon Senior Securities			57
Item 4. Mine Safety Disclosures			57
Item 5. Other Information			58
Item 6. Exhibits			58
SIGNATURES			59

PART I – FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Balance Sheets

(dollar amounts in thousands, except per share amounts) (2019 unaudited)

		September 30,				December 31,
		2019				2018
Assets
Cash and due from banks		$	27,315			$	26,725
Federal funds sold			22,141				23,600
Total cash and cash equivalents			49,456				50,325
Securities held-to-maturity (fair value of $3,938 in 2019 and $3,515 in 2018)			3,690				3,700
Securities available-for-sale, at fair value			54,400				52,727
Restricted stock, at cost			1,506				1,462
Loans, net of allowance for loan losses of $4,773 in 2019 and $4,581 in 2018			551,005				530,016
Loans held for sale			5,630				1,670
Premises and equipment, net			16,578				13,426
Interest receivable			1,755				1,742
Cash value - bank owned life insurance			13,606				13,359
Other real estate owned			2,242				2,430
Income taxes receivable			83				1,102
Deferred tax asset, net			1,085				1,755
Other assets			7,078				1,183
Total assets		$	708,114			$	674,897
Liabilities and Stockholders’ Equity
Deposits
Noninterest bearing demand		$	90,426			$	91,356
NOW, money market and savings			350,885				331,298
Time			191,722				189,389
Total deposits			633,033				612,043
Capital notes			5,000				5,000
Interest payable			167				127
Other liabilities			8,875				2,584
Total liabilities		$	647,075			$	619,754
Commitments and Contingencies
Stockholders’ equity
Preferred stock; authorized 1,000,000 shares; none issued and outstanding		$	—			$	—
Common stock $2.14 par value; authorized 10,000,000 shares; issued and outstanding 4,378,436 as of September 30, 2019 and December 31, 2018			9,370				9,370
Additional paid-in-capital			31,575				31,495
Retained earnings			19,817				16,521
Accumulated other comprehensive income (loss)			277				(2,243	)
Total stockholders’ equity		$	61,039			$	55,143
Total liabilities and stockholders’ equity		$	708,114			$	674,897

1

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Income

(dollar amounts in thousands, except per share amounts) (unaudited)

		For the Three Months Ended								For the Nine Months Ended
		September 30,								September 30,
		2019				2018				2019				2018
Interest Income
Loans		$	7,080			$	6,460			$	20,550			$	18,329
Securities
US Government and agency obligations			176				187				545				571
Mortgage backed securities			54				62				171				196
Municipals - taxable			77				81				237				243
Municipals - tax exempt			—				2				2				5
Dividends			9				9				60				40
Other (Corporates)			23				23				70				70
Interest bearing deposits			88				60				253				151
Federal Funds sold			89				96				332				255
Total interest income			7,596				6,980				22,220				19,860
Interest Expense
Deposits
NOW, money market savings			414				261				1,082				684
Time Deposits			926				679				2,500				1,885
FHLB borrowings			—				—				—				17
Finance leases			41				—				41				—
Capital notes			50				50				150				150
Total interest expense			1,431				990				3,773				2,736
Net interest income			6,165				5,990				18,447				17,124
Provision for loan losses			108				190				434				527
Net interest income after			6,057				5,800				18,013				16,597
Noninterest income
Gain on sales of loans held for sale			1,337				767				3,103				2,260
Service charges, fees and commissions			448				446				1,348				1,375
Increase in cash value of life insurance			81				86				248				256
Other			4				20				49				55
Gain on sales and calls of securities, net			291				—				291				—
Total noninterest income			2,161				1,319				5,039				3,946
Noninterest expenses
Salaries and employee benefits			3,356				2,853				9,437				8,398
Occupancy			414				388				1,252				1,143
Equipment			527				414				1,521				1,191
Supplies			163				124				467				413
Professional, data processing, and other outside expense			887				761				2,561				2,413
Marketing			228				165				649				492
Credit expense			195				140				478				377
Other real estate expenses			200				110				340				236
FDIC insurance expense			87				99				275				299
Other			316				310				967				805
Total noninterest expenses			6,373				5,364				17,947				15,767
Income before income taxes			1,845				1,755				5,105				4,776
Income tax expense			371				351				1,020				949
Net Income		$	1,474			$	1,404			$	4,085			$	3,827
Weighted average shares outstanding - basic			4,378,436				4,378,436				4,378,436				4,378,436
Weighted average shares outstanding - diluted			4,385,331				4,378,436				4,383,128				4,378,466
Earnings per common share - basic		$	0.34			$	0.32			$	0.93			$	0.87
Earnings per common share - diluted		$	0.34			$	0.32			$	0.93			$	0.87

2

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(dollar amounts in thousands) (unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2019				2018				2019				2018
Net Income		$	1,474			$	1,404			$	4,085			$	3,827
Other comprehensive income (loss):
Unrealized gains (losses) on securities available-for-sale			990				(693	)			3,481				(2,009	)
Tax effect			(208	)			144				(731	)			421
Reclassification adjustment for gains included in net income (1)			(291	)			—				(291	)			—
Tax effect (2)			61				—				61				—
Other comprehensive income (loss), net of tax			552				(549	)			2,520				(1,588	)
Comprehensive income		$	2,026			$	855			$	6,605			$	2,239

3

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30, 2019 and 2018

(dollar amounts in thousands) (unaudited)

		For the Nine Months Ended September 30,
		2019				2018
Cash flows from operating activities
Net Income		$	4,085			$	3,827
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			983				679
Stock based compensation expense			80				—
Net amortization and accretion of premiums and discounts on securities			298				312
(Gain) on sales of available-for-sale securities			(291	)			—
(Gain) on sales of loans held for sale			(3,103	)			(2,260	)
Proceeds from sales of loans held for sale			114,119				89,949
Origination of loans held for sale			(114,976	)			(87,592	)
Provision for loan losses			434				527
Loss on sale of other real estate owned			13				39
Impairment of other real estate owned			286				160
(Increase) in cash value of life insurance			(248	)			(256	)
(Increase) in interest receivable			(13	)			(163	)
Decrease (increase) in other assets			234				(79	)
Decrease in income taxes receivable			1,019				51
Increase in interest payable			40				20
(Decrease) increase in other liabilities			(1	)			671
Net cash provided by operating activities		$	2,959			$	5,885
Cash flows from investing activities
Proceeds from calls of securities held-to-maturity		$	—			$	2,000
Purchases of securities available-for-sale			(6,369	)			(998	)
Proceeds from maturities, calls and paydowns of securities available-for-sale			1,462				1,666
Proceeds from sale of securities available-for-sale			6,427				—
(Purchase) redemption of Federal Home Loan Bank stock			(44	)			43
Proceeds from sale of other real estate owned			349				846
Origination of loans, net of principal collected			(21,883	)			(34,459	)
Purchases of premises and equipment			(3,890	)			(704	)
Net cash (used in) investing activities		$	(23,948	)		$	(31,606	)

4

See accompanying notes to these consolidated financial statements

		2019				2018
Cash flows from financing activities
Net increase in deposits		$	20,990			$	39,954
Principal payments on finance lease obligations			(81	)			—
Dividends paid to common stockholders			(789	)			(787	)
Net cash provided by financing activities		$	20,120			$	39,167
(Decrease) increase in cash and cash equivalents			(869	)			13,446
Cash and cash equivalents at beginning of period		$	50,325			$	37,018
Cash and cash equivalents at end of period		$	49,456			$	50,464
Non cash transactions
Transfer of loans to other real estate owned		$	460			$	850
Fair value adjustment for securities available-for-sale			3,190				(2,009	)
Lease liabilities arising from right-of-use assets			6,373				—
Cash transactions
Cash paid for interest		$	3,733			$	2,716
Cash paid for income taxes			—				975

5

See accompanying notes to these consolidated financial statements

Bank of the James Financial Group, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

For the Three and Nine Months Ended September 30, 2019 and 2018

(dollars in thousands, except per share amounts) (unaudited)

																		Accumulated
										Additional								Other
		Shares				Common				Paid-in				Retained				Comprehensive
		Outstanding				Stock				Capital				Earnings				(Loss)				Total
Balance at December 31, 2017			4,378,436			$	9,370			$	31,495			$	12,269			$	(1,469	)		$	51,665
Net Income			—				—				—				1,123				—				1,123
Dividends paid on common stock ($0.06 per share)			—				—				—				(263	)			—				(263	)
Other comprehensive loss			—				—				—				—				(850	)			(850	)
Balance at March 31, 2018			4,378,436			$	9,370			$	31,495			$	13,129			$	(2,319	)		$	51,675
Net Income			—				—				—				1,300				—				1,300
Dividends paid on common stock ($0.06 per share)			—				—				—				(262	)			—				(262	)
Other comprehensive loss			—				—				—				—				(189	)			(189	)
Balance at June 30, 2018			4,378,436			$	9,370			$	31,495			$	14,167			$	(2,508	)		$	52,524
Net Income			—				—				—				1,404				—				1,404
Dividends paid on common stock ($0.06 per share)			—				—				—				(262	)							(262	)
Other comprehensive loss			—				—				—				—				(549	)			(549	)
Balance at September 30, 2018			4,378,436			$	9,370			$	31,495			$	15,309			$	(3,057	)		$	53,117

6

See accompanying notes to these consolidated financial statements

																		Accumulated
										Additional								Other
		Shares				Common				Paid-in				Retained				Comprehensive
		Outstanding				Stock				Capital				Earnings				Income (Loss)				Total
Balance at December 31, 2018			4,378,436			$	9,370			$	31,495			$	16,521			$	(2,243	)		$	55,143
Net Income			—				—				—				1,234				—				1,234
Dividends paid on common stock ($0.06 per share)			—				—				—				(263	)			—				(263	)
Stock-based compensation expense			—				—				27				—				—				27
Other comprehensive income			—				—				—				—				1,036				1,036
Balance at March 31, 2019			4,378,436			$	9,370			$	31,522			$	17,492			$	(1,207	)		$	57,177
Net Income			—				—				—				1,377				—				1,377
Dividends paid on common stock ($0.06 per share)			—				—				—				(263	)			—				(263	)
Stock-based compensation expense			—				—				26				—				—				26
Other comprehensive income			—				—				—				—				932				932
Balance at June 30, 2019			4,378,436			$	9,370			$	31,548			$	18,606			$	(275	)		$	59,249
Net Income			—				—				—				1,474				—				1,474
Dividends paid on common stock ($0.06 per share)			—				—				—				(263	)			—				(263	)
Stock-based compensation expense			—				—				27				—				—				27
Other comprehensive income			—				—				—				—				552				552
Balance at September 30, 2019			4,378,436			$	9,370			$	31,575			$	19,817			$	277			$	61,039

7

See accompanying notes to these consolidated financial statements

Notes to Consolidated Financial Statements

Note 1 – Basis of Presentation

The unaudited consolidated financial statements have been prepared by Bank of the James Financial Group, Inc. (“Financial” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. In management’s opinion the accompanying financial statements, which unless otherwise noted are unaudited, reflect all adjustments, consisting solely of normal recurring accruals, necessary for a fair presentation of the financial information as of September 30, 2019 and for the three and nine months ended September 30, 2019 and 2018 in conformity with accounting principles generally accepted in the United States of America. Additional information concerning the organization and business of Financial, accounting policies followed, and other related information is contained in Financial’s Annual Report on Form 10-K for the year ended December 31, 2018. These financial statements should be read in conjunction with the audited consolidated financial statements and footnotes for the year ended December 31, 2018 included in Financial’s Annual Report on Form 10-K. Results for the three and nine month periods ended September 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019.

Certain immaterial reclassifications have been made to prior period balances to conform to the current period presentation. Reclassifications had no effect on prior year net income or stockholders’ equity.

The Company’s primary market area consists of the area commonly referred to as Region 2000 which encompasses the seven jurisdictions of the Town of Altavista, Amherst County, Appomattox County, the Town of Bedford, Bedford County, Campbell County, and the City of Lynchburg. Recently, the Company has expanded into Charlottesville, Roanoke, Blacksburg, Harrisonburg, and Lexington.

Financial’s critical accounting policies include the evaluation of the allowance for loan losses which is based on management’s estimate of an amount that is adequate to absorb probable losses inherent in the loan portfolio of Bank of the James (the “Bank”), Financial’s wholly-owned subsidiary. The allowance for loan losses is established through a provision for loan losses based on available information including the composition of the loan portfolio, historical loan losses, specific impaired loans, availability and quality of collateral, age of the various portfolios, changes in local economic conditions, and loan performance and quality of the portfolio. Different assumptions used in evaluating the adequacy of the Bank’s allowance for loan losses could result in material changes in Financial’s financial condition and results of operations. The Bank’s policy with respect to the methodology for determining the allowance for loan losses involves a higher degree of complexity and requires management to make subjective judgments that often require assumptions or estimates about uncertain matters. This critical policy and its assumptions are periodically reviewed with the Board of Directors.

Financial also considers valuation of other real estate owned (OREO) a critical accounting policy. OREO consists of properties acquired through foreclosure or deed in lieu of foreclosure. These properties are carried at fair value less estimated costs to sell at the date of foreclosure. Losses from the acquisition of property in full or partial satisfaction of loans are charged against the allowance for loan losses. Subsequent write-downs, if any, are charged against expense. Gains and losses on the sales of foreclosed properties are included in determining net income in the year of the sale. Operating costs after acquisition are expensed.

8

Note 2 – Use of Estimates

The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Note 3 – Earnings Per Common Share (EPS)

The following is a summary of the earnings per share calculation for the three and nine months ended September 30, 2019 and 2018.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2019				2018				2019				2018
Net income		$	1,474,000			$	1,404,000			$	4,085,000			$	3,827,000
Weighted average number of shares			4,378,436				4,378,436				4,378,436				4,378,436
Restricted stock units/stock options affect of incremental shares			6,895				—				4,692				30
Weighted average diluted shares			4,385,331				4,378,436				4,383,128				4,378,466
Basic EPS (weighted avg shares)		$	0.34			$	0.32			$	0.93			$	0.87
Diluted EPS (Including incremental shares)		$	0.34			$	0.32			$	0.93			$	0.87

No restricted stock units or stock options were excluded in calculating diluted earnings per share for any of the periods presented.

Note 4 – Stock Based Compensation

Accounting standards require companies to recognize the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock, based on the fair value of those awards at the date of grant.

9

Note 4 – Stock Based Compensation (continued)

At December 31, 2018, there were no stock-based compensation awards outstanding that were issued under the Company’s 1999 Stock Option Plan. The final stock-based compensation issued under this plan consisting solely of employee stock options which expired during the second quarter of 2018.

At the annual meeting of shareholders held on May 15, 2018, the shareholders approved the Bank of the James Financial Group, Inc. 2018 Equity Incentive Plan (the “2018 Incentive Plan”). The 2018 Incentive Plan permits the issuance of up to 250,000 shares of common stock for awards to key employees of the Company and its subsidiaries in the form of stock options, restricted stock, restricted stock units, stock awards and performance units.

On January 2, 2019, the Company granted its first block of equity compensation under the 2018 Incentive Plan consisting of 24,500 restricted stock units. The recipients of restricted stock units do not receive shares of the Company’s stock immediately, but instead receive shares upon satisfying the requisite service period specified by the terms and conditions of the grant. Additionally, the recipients of restricted stock units do not enjoy the rights of holder of the Company’s common stock until the units have vested and as such, they do not have voting rights or rights to nonforfeitable dividends. The related compensation expense is based on the grant date fair value of the Company’s stock of $13.00 per share. Shares vest over 3 years in thirds with the first one-third vesting one year from the grant date. The total expense recognized for the three and nine months ended September 30, 2019, in connection with the restricted stock unit awards was approximately $27,000 and $80,000, respectively. There were no forfeitures during the three and nine month periods ending September 30, 2019.

At September 30, 2019, the unrecognized stock-based compensation expense related to unvested restricted stock awards amounted to approximately $239,000. The unrecognized expense will be recognized ratably over the remaining vesting period of 2.25 years. The Company accounts for forfeitures as they occur.

Note 5 – Fair Value Measurements

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the Fair Value Measurements and Disclosures topic of FASB ASC, the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market and 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 the principal or most advantageous market and in an orderly transaction (that is, not a forced

10

Note 5 – Fair Value Measurements (continued)

liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

In accordance with this guidance, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

•

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

•

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

•

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

Fair Value on a Recurring Basis

Securities Available-for-Sale

Fair values of securities available-for sale are based on quoted prices available in an active market. If quoted prices are available, these securities are classified within Level 1 of the valuation hierarchy. Level 1 securities would include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flow.

Level 2 securities would include U.S. agency securities, mortgage-backed agency securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Currently, all of the Company’s securities are considered to be Level 2 securities.

The following table summarizes the Company’s financial assets that were measured at fair value on a recurring basis during the period.

11

Note 5 – Fair Value Measurements (continued)

						Carrying Value at September 30, 2019 (in thousands)
Description		Balance as of September 30, 2019				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US Treasuries		$	1,980			$	—			$	1,980			$	—
US agency obligations			26,235				—				26,235				—
Mortgage-backed securities			10,808				—				10,808				—
Municipals			11,304				—				11,304				—
Corporates			4,073				—				4,073				—
Total available-for-sale securities		$	54,400			$	—			$	54,400			$	—
						Carrying Value at December 31, 2018 (in thousands)
Description		Balance as of December 31, 2018				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
US Treasuries		$	1,845			$				$	1,845			$
US agency obligations			23,267				—				23,267				—
Mortgage-backed securities			11,876				—				11,876				—
Municipals			12,009				—				12,009				—
Corporates			3,730				—				3,730				—
Total available-for-sale securities		$	52,727			$	—			$	52,727			$	—

Fair Value on a Non-recurring Basis

Impaired loans

Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected when due. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2). However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputs, the value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income.

12

Note 5 – Fair Value Measurements (continued)

Loans held for sale

Loans held for sale are carried at cost which approximates estimated fair 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 fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the period ended September 30, 2019. Gains and losses on the sale of loans are recorded within gains on sales of loans held for sale, net on the Consolidated Statements of Income.

Other real estate owned

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

Real estate acquired through foreclosure is transferred to OREO. The measurement of loss associated with OREO is based on the fair value of the collateral compared to the unpaid loan balance and anticipated costs to sell the property. The value of OREO property is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Bank using observable market data (Level 2).

Any fair value adjustments are recorded in the period incurred and expensed against current earnings. However, in situations where the collateral is a house or building in the process of construction, the appraisal is more than 12 months old, management has determined the fair value of the collateral is further impaired below the appraised value, or the appraisal is not based solely on market comparables adjusted for observable inputs, the value is considered Level 3.

13

Note 5 – Fair Value Measurements (continued)

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

						Carrying Value at September 30, 2019
Description		Balance as of September 30, 2019				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans*		$	1,010			$	—			$	—			$	1,010
Other real estate owned			2,242				—				—				2,242

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

						Carrying Value at December 31, 2018
Description		Balance as of December 31, 2018				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Impaired loans*		$	1,587			$	—			$	—			$	1,587
Other real estate owned			2,430				—				—				2,430

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

14

Note 5 – Fair Value Measurements (continued)

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

Quantitative information about Level 3 Fair Value Measurements for September 30, 2019 (dollars in thousands)

Fair Value

Valuation Technique(s)

Unobservable Input

Range (Weighted Average)

Assets

Impaired loans

$

1,010

Discounted appraised value

Selling cost

0% - 10% (8%)

Discount for lack of marketability and age of appraisal

0% - 20% (6%)

OREO

2,242

Discounted appraised value

Selling cost

0% - 10% (6%)

Discount for lack of marketability and age of appraisal

0% - 25% (15%)

Quantitative information about Level 3 Fair Value Measurements for December 31,  2018 (dollars in thousands)

Fair Value

Valuation Technique(s)

Unobservable Input

Range (Weighted Average)

Assets

Impaired loans

$

1,587

Discounted appraised value

Selling cost

0% - 10% (8%)

Discount for lack of marketability and age of appraisal

0% - 20% (6%)

OREO

2,430

Discounted appraised value

Selling cost

0% - 10% (6%)

Discount for lack of marketability and age of appraisal

0% - 25% (15%)

Financial Instruments

FASB ASC 825, Financial Instruments, requires disclosure about fair value of financial instruments, including those financial assets and financial liabilities that are not required to be measured and reported at fair value on a recurring or nonrecurring basis. ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company. The carrying amounts and estimated fair values of the Company’s financial instruments are presented in the following tables whether or not recognized on the Consolidated Balance Sheets at fair value.

15

Note 5 – Fair Value Measurements (continued)

The estimated fair values, and related carrying or notional amounts, of Financial’s financial instruments and their placement in the fair value hierarchy at September 30, 2019 and December 31, 2018 was as follows (in thousands):

						Fair Value Measurements at September 30, 2019 using
						Quoted Prices				Significant
						in Active				Other				Significant
						Markets for				Observable				Unobservable
		Carrying				Identical Assets				Inputs				Inputs
		Amounts				(Level 1)				(Level 2)				(Level 3)				Balance
Assets
Cash and due from banks		$	27,315			$	27,315			$	—			$	—			$	27,315
Fed funds sold			22,141				22,141				—				—				22,141
Securities
Available-for-sale			54,400				—				54,400				—				54,400
Held-to-maturity			3,690				—				3,938				—				3,938
Restricted stock			1,506								1,506				—				1,506
Loans, net (1)			551,005				—				—				551,540				551,540
Loans held for sale			5,630				—				5,630				—				5,630
Interest receivable			1,755				—				1,755				—				1,755
BOLI			13,606				—				13,606				—				13,606
Liabilities
Deposits		$	633,033			$	—			$	634,750			$	—			$	634,750
Capital notes			5,000				—				4,773				—				4,773
Interest payable			167				—				167				—				167
						Fair Value Measurements at December 31, 2018 using
						Quoted Prices				Significant
						in Active				Other				Significant
						Markets for				Observable				Unobservable
		Carrying				Identical Assets				Inputs				Inputs
		Amounts				(Level 1)				(Level 2)				(Level 3)				Balance
Assets
Cash and due from banks		$	26,725			$	26,725			$	—			$	—			$	26,725
Fed funds sold			23,600				23,600												23,600
Securities
Available-for-sale			52,727				—				52,727				—				52,727
Held-to-maturity			3,700				—				3,515				—				3,515
Restricted stock			1,462				—				1,462								1,462
Loans, net (1)			530,016				—				—				522,782				522,782
Loans held for sale			1,670				—				1,670				—				1,670
Interest receivable			1,742				—				1,742				—				1,742
BOLI			13,359				—				13,359				—				13,359
Liabilities
Deposits		$	612,043			$	—			$	612,532			$	—			$	612,532
Capital notes			5,000				—				4,710								4,710
Interest payable			127				—				127				—				127

(1)	Carrying amount is net of unearned income and the Allowance.

16