UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2014.

o 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:  0-12820

AMERICAN NATIONAL BANKSHARES INC.
(Exact name of registrant as specified in its charter)

VIRGINIA
 
54-1284688
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
 
 
628 Main Street
 
 
Danville, Virginia
 
24541
(Address of principal executive offices)
 
(Zip Code)

(434) 792-5111
(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
x
No
o
 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, 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.

Yes
x
No
o
 

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.

Large accelerated filer  o
Accelerated filer  x
Non-accelerated filer  o (Do not check if a smaller reporting company)
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes
o
No
x
 

At November 6, 2014, the Company had 7,846,454 shares of Common Stock outstanding, $1 par value.



AMERICAN NATIONAL BANKSHARES INC.

Index
 
 
Page
 
 
 
 
Part I.
FINANCIAL INFORMATION
 
 
 
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
Part II.
OTHER INFORMATION
 
 
 
 
 
 
Item 1.
Legal Proceedings
44
 
 
 
 
 
Item 1A.
Risk Factors
44
 
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
44
 
 
 
 
 
Item 3.
Defaults Upon Senior Securities
44
 
 
 
 
 
Item 4.
Mine Safety Disclosures
44
 
 
 
 
 
Item 5.
Other Information
44
 
 
 
 
 
Item 6.
Exhibits
44
 
 
 
 
SIGNATURES
45

2

PART I.   FINANCIAL INFORMATION
ITEM 1.  FINANCIAL STATEMENTS                                                                                                                                

American National Bankshares Inc. and Subsidiaries
 
Consolidated Balance Sheets
 
(Dollars in thousands, except share data)
 
 
Assets
 
(Unaudited)
September 30, 2014
   
(Audited)
December 31, 2013
 
Cash and due from banks
 
$
22,699
   
$
19,808
 
Interest-bearing deposits in other banks
   
58,278
     
47,873
 
 
               
Securities available for sale, at fair value
   
328,534
     
346,124
 
Restricted stock, at cost
   
4,529
     
4,889
 
Loans held for sale
   
811
     
2,760
 
 
               
Loans, net of unearned income
   
816,588
     
794,671
 
Less allowance for loan losses
   
(12,620
)
   
(12,600
)
Net loans
   
803,968
     
782,071
 
 
               
Premises and equipment, net
   
23,085
     
23,674
 
Other real estate owned, net
   
2,364
     
3,422
 
Goodwill
   
39,043
     
39,043
 
Core deposit intangibles, net
   
2,271
     
3,159
 
Bank owned life insurance
   
15,044
     
14,746
 
Accrued interest receivable and other assets
   
18,531
     
19,943
 
Total assets
 
$
1,319,157
   
$
1,307,512
 
 
               
Liabilities
               
Liabilities:
               
Demand deposits -- noninterest bearing
 
$
244,469
   
$
229,347
 
Demand deposits -- interest bearing
   
185,982
     
167,736
 
Money market deposits
   
173,192
     
185,270
 
Savings deposits
   
88,226
     
85,724
 
Time deposits
   
359,191
     
389,598
 
Total deposits
   
1,051,060
     
1,057,675
 
 
               
 
               
Customer repurchase agreements
   
51,945
     
39,478
 
Long-term borrowings
   
9,930
     
9,951
 
Trust preferred capital notes
   
27,495
     
27,419
 
Accrued interest payable and other liabilities
   
5,562
     
5,438
 
Total liabilities
   
1,145,992
     
1,139,961
 
 
               
Shareholders' equity
               
Preferred stock, $5 par, 2,000,000 shares authorized, none outstanding
   
-
     
-
 
Common stock, $1 par, 20,000,000 shares authorized, 7,843,454 shares outstanding at September 30, 2014 and 7,890,697 shares outstanding at December 31, 2013
   
7,843
     
7,891
 
Capital in excess of par value
   
57,087
     
58,050
 
Retained earnings
   
103,515
     
99,090
 
Accumulated other comprehensive income, net
   
4,720
     
2,520
 
Total shareholders' equity
   
173,165
     
167,551
 
Total liabilities and shareholders' equity
 
$
1,319,157
   
$
1,307,512
 

The accompanying notes are an integral part of the consolidated financial statements.

3

 
American National Bankshares Inc. and Subsidiaries
 
Consolidated Statements of Income
 
(Dollars in thousands, except share and per share data) (Unaudited)
 
 
 
 
Three Months Ended
September 30,
 
 
 
2014
   
2013
 
Interest and Dividend Income:
 
   
 
Interest and fees on loans
 
$
9,864
   
$
11,100
 
Interest and dividends on securities:
               
Taxable
   
918
     
845
 
Tax-exempt
   
966
     
1,056
 
Dividends
   
72
     
67
 
Other interest income
   
32
     
38
 
Total interest and dividend income
   
11,852
     
13,106
 
 
               
Interest Expense:
               
Interest on deposits
   
1,120
     
1,338
 
Interest on short-term borrowings
   
4
     
3
 
Interest on long-term borrowings
   
82
     
82
 
Interest on trust preferred capital notes
   
186
     
190
 
Total interest expense
   
1,392
     
1,613
 
 
               
Net Interest Income
   
10,460
     
11,493
 
Provision for Loan Losses
   
-
     
-
 
 
               
Net Interest Income After Provision for Loan Losses
   
10,460
     
11,493
 
 
               
Noninterest Income:
               
Trust fees
   
992
     
1,077
 
Service charges on deposit accounts
   
441
     
452
 
Other fees and commissions
   
479
     
471
 
Mortgage banking income
   
342
     
464
 
Securities gains, net
   
315
     
4
 
Other
   
412
     
299
 
Total noninterest income
   
2,981
     
2,767
 
 
               
Noninterest Expense:
               
Salaries
   
3,714
     
3,610
 
Employee benefits
   
799
     
856
 
Occupancy and equipment
   
933
     
933
 
FDIC assessment
   
157
     
163
 
Bank franchise tax
   
216
     
187
 
Core deposit intangible amortization
   
227
     
330
 
Data processing
   
361
     
305
 
Software
   
248
     
198
 
Foreclosed real estate, net
   
141
     
245
 
Merger related expense
   
268
     
-
 
Other
   
1,763
     
1,628
 
Total noninterest expense
   
8,827
     
8,455
 
Income Before Income Taxes
   
4,614
     
5,805
 
Income Taxes
   
1,446
     
1,562
 
Net Income
 
$
3,168
   
$
4,243
 
 
               
Net Income Per Common Share:
               
Basic
 
$
0.40
   
$
0.54
 
Diluted
 
$
0.40
   
$
0.54
 
Average Common Shares Outstanding:
               
Basic
   
7,841,078
     
7,877,901
 
Diluted
   
7,851,735
     
7,892,015
 

The accompanying notes are an integral part of the consolidated financial statements.

4

American National Bankshares Inc. and Subsidiaries
 
Consolidated Statements of Income
 
(Dollars in thousands, except share and per share data) (Unaudited)
 
 
 
 
Nine Months Ended
September 30
 
 
 
2014
   
2013
 
Interest and Dividend Income:
 
   
 
Interest and fees on loans
 
$
29,398
   
$
33,853
 
Interest and dividends on securities:
               
Taxable
   
2,850
     
2,574
 
Tax-exempt
   
3,017
     
3,153
 
Dividends
   
221
     
176
 
Other interest income
   
100
     
106
 
Total interest and dividend income
   
35,586
     
39,862
 
 
               
Interest Expense:
               
Interest on deposits
   
3,510
     
4,143
 
Interest on short-term borrowings
   
8
     
38
 
Interest on long-term borrowings
   
243
     
246
 
Interest on trust preferred capital notes
   
555
     
567
 
Total interest expense
   
4,316
     
4,994
 
 
               
Net Interest Income
   
31,270
     
34,868
 
Provision for Loan Losses
   
150
     
294
 
 
               
Net Interest Income After Provision for Loan Losses
   
31,120
     
34,574
 
 
               
Noninterest Income:
               
Trust fees
   
3,131
     
2,609
 
Service charges on deposit accounts
   
1,285
     
1,290
 
Other fees and commissions
   
1,416
     
1,393
 
Mortgage banking income
   
880
     
1,713
 
Securities gains, net
   
504
     
203
 
Other
   
1,168
     
1,015
 
Total noninterest income
   
8,384
     
8,223
 
 
               
Noninterest Expense:
               
Salaries
   
10,890
     
10,552
 
Employee benefits
   
2,621
     
2,622
 
Occupancy and equipment
   
2,779
     
2,721
 
FDIC assessment
   
486
     
485
 
Bank franchise tax
   
669
     
559
 
Core deposit intangible amortization
   
888
     
1,171
 
Data processing
   
1,054
     
892
 
Software
   
745
     
659
 
Foreclosed real estate, net
   
148
     
681
 
Merger related expense
   
268
     
-
 
Other
   
5,067
     
4,859
 
Total noninterest expense
   
25,615
     
25,201
 
Income Before Income Taxes
   
13,889
     
17,596
 
Income Taxes
   
4,038
     
4,992
 
Net Income
 
$
9,851
   
$
12,604
 
 
               
Net Income Per Common Share:
               
Basic
 
$
1.25
   
$
1.60
 
Diluted
 
$
1.25
   
$
1.60
 
Average Common Shares Outstanding:
               
Basic
   
7,871,016
     
7,867,835
 
Diluted
   
7,881,441
     
7,878,961
 

The accompanying notes are an integral part of the consolidated financial statements.


5




American National Bankshares Inc. and Subsidiaries
 
Consolidated Statements of Comprehensive Income
 
(Dollars in thousands) (Unaudited)
 
 
 
 
Three Months Ended
September 30,
 
 
 
2014
   
2013
 
 
 
   
 
Net income
 
$
3,168
   
$
4,243
 
 
               
Other comprehensive income (loss):
               
 
               
Unrealized gains (losses) on securities available for sale
   
(343
)
   
193
 
Income tax (expense) benefit
   
121
     
(67
)
 
               
Reclassification adjustment for gains on securities
   
(315
)
   
(4
)
Income tax expense
   
110
     
1
 
 
               
Other comprehensive income (loss)
   
(427
)
   
123
 
 
               
Comprehensive income
 
$
2,741
   
$
4,366
 
 

 
 
 
Nine Months Ended
September 30,
 
 
 
2014
   
2013
 
 
 
   
 
Net income
 
$
9,851
   
$
12,604
 
 
               
Other comprehensive income (loss):
               
 
               
Unrealized gains (losses) on securities available for sale
   
3,888
     
(7,988
)
Income tax (expense) benefit
   
(1,360
)
   
2,796
 
 
               
Reclassification adjustment for gains on securities
   
(504
)
   
(203
)
Income tax expense
   
176
     
71
 
 
               
Other comprehensive income (loss)
   
2,200
     
(5,324
)
 
               
Comprehensive income
 
$
12,051
   
$
7,280
 

The accompanying notes are an integral part of the consolidated financial statements.


6

American National Bankshares Inc. and Subsidiaries
 
Consolidated Statements of Changes in Shareholders' Equity
 
Nine Months Ended September 30, 2014 and 2013
 
(Dollars in thousands except per share data) (Unaudited)
 
 
 
 
Common
Stock
   
Capital in
Excess of
Par Value
   
Retained
Earnings
   
Accumulated
Other
Comprehensive
Income
   
Total
Shareholders'
Equity
 
 
 
   
   
   
   
 
 
 
   
   
   
   
 
Balance, December 31, 2012
 
$
7,847
   
$
57,211
   
$
90,591
   
$
7,597
   
$
163,246
 
 
                                       
Net income
   
-
     
-
     
12,604
     
-
     
12,604
 
 
                                       
Other comprehensive loss
   
-
     
-
     
-
     
(5,324
)
   
(5,324
)
 
                                       
Stock options exercised
   
17
     
292
     
-
     
-
     
309
 
 
                                       
Equity based compensation
   
22
     
402
     
-
     
-
     
424
 
 
                                       
Cash dividends declared, $0.69 per share
   
-
     
-
     
(5,433
)
   
-
     
(5,433
)
 
                                       
Balance, September 30, 2013
 
$
7,886
   
$
57,905
   
$
97,762
   
$
2,273
   
$
165,826
 
 
                                       
Balance, December 31, 2013
 
$
7,891
   
$
58,050
   
$
99,090
   
$
2,520
   
$
167,551
 
 
                                       
Net income
   
-
     
-
     
9,851
     
-
     
9,851
 
 
                                       
Other comprehensive income
   
-
     
-
     
-
     
2,200
     
2,200
 
 
                                       
Stock repurchased and retired
   
(70
)
   
(1,438
)
   
-
     
-
     
(1,508
)
 
                                       
Equity based compensation
   
22
     
475
     
-
     
-
     
497
 
 
                                       
Cash dividends declared, $0.69 per share
   
-
     
-
     
(5,426
)
   
-
     
(5,426
)
 
                                       
Balance, September 30, 2014
 
$
7,843
   
$
57,087
   
$
103,515
   
$
4,720
   
$
173,165
 

The accompanying notes are an integral part of the consolidated financial statements.

7




American National Bankshares Inc. and Subsidiaries
 
Consolidated Statements of Cash Flows
 
Nine Months Ended September 30, 2014 and 2013
 
(Dollars in thousands) (Unaudited)
 
 
 
 
2014
   
2013
 
Cash Flows from Operating Activities:
 
   
 
Net income
 
$
9,851
   
$
12,604
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
   
150
     
294
 
Depreciation
   
1,274
     
1,284
 
Net accretion of acquisition accounting adjustments
   
(2,064
)
   
(5,809
)
Core deposit intangible amortization
   
888
     
1,171
 
Net amortization of securities
   
1,916
     
2,430
 
Net gain on sale or call of securities
   
(504
)
   
(203
)
Gain on sale of loans held for sale
   
(686
)
   
(1,466
)
Proceeds from sales of loans held for sale
   
40,813
     
78,936
 
Originations of loans held for sale
   
(38,178
)
   
(67,537
)
Net gain on foreclosed real estate
   
(100
)
   
(86
)
Valuation allowance on foreclosed real estate
   
46
     
327
 
Equity based compensation expense
   
497
     
424
 
Deferred income tax expense (benefit)
   
396
     
(1,388
)
Net change in interest receivable
   
(916
)
   
107
 
Net change in other assets
   
450
     
2,529
 
Net change in interest payable
   
(29
)
   
(100
)
Net change in other liabilities
   
153
     
537
 
Net cash provided by operating activities
   
13,957
     
24,054
 
 
               
Cash Flows from Investing Activities:
               
Proceeds from sales of securities available for sale
   
13,667
     
2,627
 
Proceeds from maturities, calls and paydowns of securities available for sale
   
52,901
     
41,961
 
Purchases of securities available for sale
   
(47,006
)
   
(67,378
)
Net change in restricted stock
   
360
     
402
 
Net increase in loans
   
(20,276
)
   
(5,943
)
Purchases of premises and equipment
   
(685
)
   
(723
)
Proceeds from sales of foreclosed real estate
   
1,498
     
3,286
 
Net cash provided by (used in) investing activities
   
459
     
(25,768
)
 
               
Cash Flows from Financing Activities:
               
Net change in demand, money market, and savings deposits
   
23,792
     
50,700
 
Net change in time deposits
   
(30,407
)
   
(7,006
)
Net change in customer repurchase agreements
   
12,467
     
(5,916
)
Net change in long-term borrowings
   
(38
)
   
(113
)
Common stock dividends paid
   
(5,426
)
   
(5,433
)
       Repurchase of stock
   
(1,508
)
   
-
 
       Proceeds from exercise of stock options
   
-
     
309
 
Net cash (used in) provided by financing activities
   
(1,120
)
   
32,541
 
 
               
Net Increase in Cash and Cash Equivalents
   
13,296
     
30,827
 
 
               
Cash and Cash Equivalents at Beginning of Period
   
67,681
     
47,442
 
 
               
Cash and Cash Equivalents at End of Period
 
$
80,977
   
$
78,269
 

The accompanying notes are an integral part of the consolidated financial statements.

8


AMERICAN NATIONAL BANKSHARES INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The consolidated financial statements include the accounts of American National Bankshares Inc. (the "Company") and its wholly owned subsidiary, American National Bank and Trust Company (the "Bank").  The Bank offers a wide variety of retail, commercial, secondary market mortgage lending, and trust and investment services which also include non-deposit products such as mutual funds and insurance policies.

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the 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, the valuation of foreclosed real estate, goodwill and intangible assets, the valuation of deferred tax assets, other-than-temporary impairments of securities, and acquired loans with specific credit-related deterioration.

All significant inter-company transactions and accounts are eliminated in consolidation, with the exception of the AMNB Trust and the MidCarolina Trusts, as detailed in Note 9.

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the results of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results that may occur for the year ending December 31, 2014.  Certain reclassifications have been made to prior period balances to conform to the current period presentation. These reclassifications did not have an impact on net income and were considered immaterial. These statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.

Note 2 – Recent Accounting Pronouncements


In January 2014, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("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 is currently assessing the impact that ASU 2014-01 will have 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 is currently assessing the impact that ASU 2014-04 will have 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.
9

In June 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 2014-10, "Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation". The amendments in this ASU remove all incremental financial reporting requirements from U.S. GAAP for development stage entities, including the removal of Topic 915, "Development Stage Entities", from the FASB Accounting Standards Codification. In addition, this ASU adds an example disclosure and removes an exception provided to development stage entities in Topic 810, "Consolidation", for determining whether an entity is a variable interest entity.  The presentation and disclosure requirements in Topic 915 will no longer be required for the first annual period beginning after December 15, 2014. The revised consolidation standards are effective for annual periods beginning after December 15, 2015.  Early adoption is permitted. The Company does not expect the adoption of ASU 2014-10 to have a material impact 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 is currently assessing the impact that ASU 2014-11 will have 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 is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.
In August 2014, the FASB issued ASU No. 2014-14, "Receivables – Troubled Debt Restructurings by Creditors (Subtopic 310-40): Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure".  The amendments in this ASU apply to creditors that hold government-guaranteed mortgage loans and is intended to eliminate the diversity in practice related to the classification of these guaranteed loans upon foreclosure.  The new guidance stipulates that a mortgage loan be derecognized and a separate other receivable be recognized upon foreclosure if (1) the loan has a government guarantee that is not separable from the loan prior to foreclosure, (2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under that claim, and (3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the other receivable should be measured on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2014. Entities may adopt the amendments on a prospective basis or modified retrospective basis as of the beginning of the annual period of adoption; however, the entity must apply the same method of transition as elected under ASU 2014-04. Early adoption is permitted provided the entity has already adopted ASU 2014-04.  The Company is currently assessing the impact that ASU 2014-14 will have 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 a material impact on its consolidated financial statements.

Note 3 – Securities

The amortized cost and estimated fair value of investments in debt and equity securities at September 30, 2014 and December 31, 2013 were as follows:

 
 
September 30, 2014
 
(in thousands)
 
Amortized
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Estimated
Fair Value
 
Securities available for sale:
 
   
   
   
 
Federal agencies and GSEs
 
$
69,911
   
$
177
   
$
145
   
$
69,943
 
Mortgage-backed and CMOs
   
59,916
     
1,197
     
241
     
60,872
 
State and municipal
   
180,340
     
7,985
     
128
     
188,197
 
Corporate
   
8,478
     
13
     
82
     
8,409
 
Equity securities
   
1,000
     
113
     
-
     
1,113
 
Total securities available for sale
 
$
319,645
   
$
9,485
   
$
596
   
$
328,534
 

10

 
 
December 31, 2013
 
(in thousands)
 
Amortized
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Estimated
Fair Value
 
Securities available for sale:
 
   
   
   
 
Federal agencies and GSEs
 
$
66,241
   
$
126
   
$
486
   
$
65,881
 
Mortgage-backed and CMOs
   
69,168
     
1,085
     
645
     
69,608
 
State and municipal
   
193,251
     
5,999
     
517
     
198,733
 
Corporate
   
10,959
     
4
     
164
     
10,799
 
Equity securities
   
1,000
     
103
     
-
     
1,103
 
Total securities available for sale
 
$
340,619
   
$
7,317
   
$
1,812
   
$
346,124
 

Restricted Stock

Due to restrictions placed upon the Bank's common stock investment in the Federal Reserve Bank of Richmond ("FRB") and Federal Home Loan Bank of Atlanta ("FHLB"), these securities have been classified as restricted equity securities and carried at cost.  The restricted securities are not subject to the investment security classification and are included as a separate line item on the Company's balance sheet.  The FRB requires the Bank to maintain stock with a par value equal to 6.0% of its common stock and paid-in surplus.  One-half of this amount is paid to the Federal Reserve Bank and the remaining half is subject to call when deemed necessary by the Board of Governors of the Federal Reserve System.  The FHLB requires the Bank to maintain stock in an amount equal to a specific percentage of the Bank's total assets and 4.5% of outstanding borrowings. The Bank also owns common stock in CBB Financial Corporation, a Community Bankers Bank located in Richmond, Virginia which provides services to community banks that was inherited from the merger with Community First Financial Corporation in 2006 and common stock in Danville Community Development Corporation, a corporation formed by local banks in the Danville, Virginia area that restores dilapidated properties for resale.  The cost of restricted stock at September 30, 2014 and December 31, 2013 were as follows:

(in thousands)
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
FRB stock
 
$
1,625
   
$
2,722
 
FHLB stock
   
2,737
     
2,000
 
CBB Financial Corporation stock
   
101
     
101
 
Danville Community Development Corporation stock
   
66
     
66
 
   Total restricted stock
 
$
4,529
   
$
4,889
 

Temporarily Impaired Securities

The following table shows estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2014.  The reference point for determining when securities are in an unrealized loss position is month-end.  Therefore, it is possible that a security's market value exceeded its amortized cost on other days during the past twelve-month period.


 
 
Total
   
Less than 12 Months
   
12 Months or More
 
(in thousands)
 
Estimated
Fair
Value
   
Unrealized
Loss
   
Estimated
Fair
Value
   
Unrealized
Loss
   
Estimated
Fair
Value
   
Unrealized
Loss
 
Federal agencies and GSEs
 
$
30,126
   
$
145
   
$
10,613
   
$
30
   
$
19,513
   
$
115
 
Mortgage-backed and CMOs
   
14,362
     
241
     
8,315
     
28
     
6,047
     
213
 
State and municipal
   
14,539
     
128
     
8,217
     
66
     
6,322
     
62
 
Corporate
   
5,039
     
82
     
2,285
     
11
     
2,754
     
71
 
Total
 
$
64,066
   
$
596
   
$
29,430
   
$
135
   
$
34,636
   
$
461
 

GSE debt securities: The unrealized losses on the Company's investment in 14 government sponsored entities ("GSE") were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2014.

Mortgage-backed securities and CMOs: The unrealized losses on the Company's investment in 14 GSE mortgage-backed securities and collateralized mortgage obligations ("CMOs") were caused by interest rate increases. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost basis of the Company's investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2014.

State and municipal securities:  The unrealized losses on 15 state and municipal securities were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2014.

Corporate securities:  The unrealized losses on five investments in corporate securities were caused by interest rate increases. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2014.

Restricted stock: When evaluating restricted stock for impairment, its value is based on the ultimate recoverablity of the par value rather than by recognizing temporary declines in value. The company does not consider restricted stock to be other-than-temoraily impaired at September 30, 2014, and no impairment has been recognized.

11


The table below shows gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position, at December 31, 2013.

 
 
Total
   
Less than 12 Months
   
12 Months or More
 
(in thousands)
 
Estimated
Fair
Value
   
Unrealized
Loss
   
Estimated
Fair
Value
   
Unrealized
Loss
   
Estimated
Fair
Value
   
Unrealized
Loss
 
Federal agencies and GSEs
 
$
41,586
   
$
486
   
$
41,586
   
$
486
   
$
-
   
$
-
 
Mortgage-backed and CMOs
   
23,916
     
645
     
19,042
     
577
     
4,874
     
68
 
State and municipal
   
33,192
     
517
     
29,732
     
462
     
3,460
     
55
 
Corporate
   
7,347
     
164
     
7,347
     
164
     
-
     
-
 
Total
 
$
106,041
   
$
1,812
   
$
97,707
   
$
1,689
   
$
8,334
   
$
123
 

Other-Than-Temporary-Impaired Securities

As of September 30, 2014 and December 31, 2013, there were no securities classified as having other-than-temporary impairment.

Note 4 - Loans

Segments

Loans, excluding loans held for sale, were comprised of the following:

(in thousands)
 
September 30, 2014
   
December 31, 2013
 
 
 
   
 
Commercial
 
$
126,437
   
$
122,553
 
Commercial real estate:
               
Construction and land development
   
47,060
     
41,822
 
Commercial real estate
   
371,743
     
364,616
 
Residential real estate:
               
Residential
   
175,091
     
171,917
 
Home equity
   
90,952
     
87,797
 
Consumer
   
5,305
     
5,966
 
Total loans
 
$
816,588
   
$
794,671
 

Acquired Loans

Interest income, including accretion, on loans acquired from MidCarolina Financial Corporation ("MidCarolina") in connection with the Company's acquisition of MidCarolina for the nine months ended September 30, 2014 was approximately $8.5 million. This included $2.2 million in accretion income of which $88,000 was related to loan payoffs and renewals and $290,000 related to recoveries of loans charged off prior to the merger. The outstanding principal balance and the carrying amount of these loans included in the consolidated balance sheets at September 30, 2014 and December 31, 2013 are as follows:

(in thousands)
 
September 30, 2014
   
December 31, 2013
 
Outstanding principal balance
 
$
92,092
   
$
134,099
 
Carrying amount
   
84,711
     
124,828
 

The outstanding principal balance and related carrying amount of acquired impaired loans, for which the Company applies Accounting Standards Codification ("ASC") 310-30, to account for interest earned, at September 30, 2014 and December 31, 2013 are as follows:

(in thousands)
 
September 30, 2014
   
December 31, 2013
 
Outstanding principal balance
 
$
18,780
   
$
21,014
 
Carrying amount
   
14,847
     
16,644
 

The following table presents changes in the accretable discount on acquired impaired loans, for which the Company applies ASC 310-30, for the nine months ended September 30, 2014. The accretion reflected below includes $88,000 related to loan payoffs.

(in thousands)
 
Accretable Discount
 
Balance at December 31, 2013
 
$
2,046
 
Accretion
   
(862
)
Reclassification from nonaccretable difference
   
443
 
Balance at September 30, 2014
 
$
1,627
 

12


Past Due Loans

The following table shows an analysis by portfolio segment of the Company's past due loans at September 30, 2014.

 
 
   
   
   
   
   
   
 
(in thousands)
 
30- 59 Days
Past Due
   
60-89 Days
Past Due
   
90 Days +
Past Due
and Still
Accruing
   
Non-
Accrual
Loans
   
Total
Past
Due
   
Current
   
Total
Loans
 
 
 
   
   
   
   
   
   
 
Commercial
 
$
-
   
$
-
   
$
-
   
$
2
   
$
2
   
$
126,435
   
$
126,437
 
Commercial real estate:
                                                       
Construction and land development
   
-
     
-
     
-
     
290
     
290
     
46,770
     
47,060
 
Commercial real estate
   
-
     
-
     
-
     
3,399
     
3,399
     
368,344
     
371,743
 
Residential:
                                                       
Residential
   
389
     
6
     
-
     
590
     
985
     
174,106
     
175,091
 
Home equity
   
205
     
-
     
-
     
211
     
416
     
90,536
     
90,952
 
Consumer
   
2
     
-
     
-
     
2
     
4
     
5,301
     
5,305
 
Total
 
$
596
   
$
6
   
$
-
   
$
4,494
   
$
5,096
   
$
811,492
   
$
816,588
 

The following table shows an analysis by portfolio segment of the Company's past due loans at December 31, 2013.

(in thousands)
 
30- 59 Days
Past Due
   
60-89 Days
Past Due
   
90 Days +
Past Due
and Still
Accruing
   
Non-
Accrual
Loans
   
Total
Past
Due
   
Current
   
Total
Loans
 
 
 
   
   
   
   
   
   
 
Commercial
 
$
27
   
$
-
   
$
-
   
$
11
   
$
38
   
$
122,515
   
$
122,553
 
Commercial real estate:
                                                       
Construction and land development
   
-
     
51
     
-
     
877
     
928
     
40,894
     
41,822
 
Commercial real estate
   
667
     
-
     
-
     
2,879
     
3,546
     
361,070
     
364,616
 
Residential:
                                                       
Residential
   
642
     
202
     
-
     
880
     
1,724
     
170,193
     
171,917
 
Home equity
   
109
     
18
     
-
     
424
     
551
     
87,246
     
87,797
 
Consumer
   
21
     
1
     
-
     
-
     
22
     
5,944
     
5,966
 
Total
 
$
1,466
   
$
272
   
$
-
   
$
5,071
   
$
6,809
   
$
787,862
   
$
794,671
 

13


Impaired Loans

The following table presents the Company's impaired loan balances by portfolio segment, excluding loans acquired with deteriorated credit quality, at September 30, 2014.

(in thousands)
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With no related allowance recorded:
 
   
   
   
   
 
Commercial
 
$
9
   
$
9
   
$
-
   
$
14
   
$
1
 
Commercial real estate:
                                       
Construction and land development
   
291
     
333
     
-
     
504
     
-
 
Commercial real estate
   
984
     
990
     
-
     
919
     
-
 
Residential:
                                       
Residential
   
511
     
523
     
-
     
768
     
-
 
Home equity
   
205
     
205
     
-
     
350
     
-
 
Consumer
   
2
     
2
     
-
     
3
     
-
 
 
 
$
2,002
   
$
2,062
   
$
-
   
$
2,558
   
$
1
 
With a related allowance recorded:
                                       
Commercial
   
-
     
-
     
-
     
-
     
-
 
Commercial real estate:
                                       
Construction and land development
   
582
     
582
     
11
     
597
     
25
 
Commercial real estate
   
2,202
     
2,229
     
631
     
2,219
     
13
 
Residential
                                       
Residential
   
4
     
4
     
1
     
4
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
16
     
16
     
3
     
17
     
1
 
 
 
$
2,804
   
$
2,831
   
$
646
   
$
2,837
   
$
39
 
Total:
                                       
Commercial
 
$
9
   
$
9
   
$
-
   
$
14
   
$
1
 
Commercial real estate:
                                       
Construction and land development
   
873
     
915
     
11
     
1,101
     
25
 
Commercial real estate
   
3,186
     
3,219
     
631
     
3,138
     
13
 
Residential:
                                       
Residential
   
515
     
527
     
1
     
772
     
-
 
Home equity
   
205
     
205
     
-
     
350
     
-
 
Consumer
   
18
     
18
     
3
     
20
     
1
 
 
 
$
4,806
   
$
4,893
   
$
646
   
$
5,395
   
$
40
 
14


The following table presents the Company's impaired loan balances by portfolio segment, excluding loans acquired with deteriorated credit quality, at December 31, 2013.

(in thousands)
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With no related allowance recorded:
 
   
   
   
   
 
Commercial
 
$
19
   
$
19
   
$
-
   
$
20
   
$
1
 
Commercial real estate:
                                       
Construction and land development
   
18
     
18
     
-
     
261
     
4
 
Commercial real estate
   
936
     
936
     
-
     
950
     
13
 
Residential:
                                       
Residential
   
880
     
888
     
-
     
1,200
     
11
 
Home equity
   
424
     
424
     
-
     
433
     
-
 
   Consumer
   
-
     
-
     
-
     
-
     
-
 
 
 
$
2,277
   
$
2,285
   
$
-
   
$
2,864
   
$
29
 
With a related allowance recorded:
                                       
Commercial
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 
Commercial real estate:
                                       
Construction and land development
   
1,468
     
1,507
     
68
     
1,551
     
33
 
Commercial real estate
   
2,266
     
2,264
     
488
     
1,198
     
7
 
Residential:
                                       
Residential
   
1,198
     
-
     
-
     
-
     
-
 
Home equity
   
-
     
-
     
-
     
-
     
-
 
   Consumer
   
18
     
18
     
3
     
19
     
1
 
 
 
$
3,752
   
$
3,789
   
$
559
   
$
2,768
   
$
41
 
Total:
                                       
Commercial
 
$
19
   
$
19
   
$
-
   
$
20
   
$
1
 
Commercial real estate:
                                       
Construction and land development
   
1,486
     
1,525
     
68
     
1,812
     
37
 
Commercial real estate
   
3,202
     
3,200
     
488
     
2,148
     
20
 
Residential:
                                       
Residential
   
880
     
888
     
-
     
1,200
     
11
 
Home equity
   
424
     
424
     
-
     
433
     
-
 
   Consumer
   
18
     
18
     
3
     
19
     
1
 
 
 
$
6,029
   
$
6,074
   
$
559
   
$
5,632
   
$
70
 


The following table shows the detail of loans modified as troubled debt restructurings ("TDRs")  during the nine months ended September 30, 2014 included in the impaired loan balances. There were no loans modified as TDRs for the three months ended September 30, 2014 and 2013 or the nine months ended September 30, 2013.


 
 
Loans Modified as a TDR for the
Nine Months Ended September 30, 2014
 
(dollars in thousands)
 
Number of
Contracts
   
Pre-Modification
Outstanding Recorded
Investment
   
Post-Modification
Outstanding Recorded
Investment
 
Commercial
   
-
   
$
-
   
$
-
 
Commercial real estate
   
1
     
182
     
179
 
   Construction and land development
   
-
     
-
     
-
 
   Home Equity
   
1
     
8
     
8
 
   Residential real estate
   
2
     
121
     
115
 
Consumer
   
-
     
-
     
-
 
Total
   
4
   
$
311
   
$
302
 

          During the three and nine months ended September 30, 2014 and 2013, the Company had no loans that subsequently defaulted within twelve months of modification.

15

Risk Grades

The following table shows the Company's loan portfolio broken down by internal risk grading as of September 30, 2014.

(in thousands)
Commercial and Consumer Credit Exposure
Credit Risk Profile by Internally Assigned Grade

 
 
Commercial
   
Commercial
Real Estate
Construction
   
Commercial
Real Estate
Other
   
Residential
   
Home
Equity
 
 
 
   
   
   
   
 
Pass
 
$
124,768
   
$
41,573
   
$
361,955
   
$
164,460
   
$
88,773
 
Special Mention
   
1,659
     
624
     
5,400
     
7,484
     
1,624
 
Substandard
   
10
     
4,863
     
4,388
     
3,147
     
555
 
Doubtful
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
126,437
   
$
47,060
   
$
371,743
   
$
175,091
   
$
90,952
 

Consumer Credit Exposure
Credit Risk Profile Based on Payment Activity

 
Consumer
 
 
 
Performing
 
$
5,303
 
Nonperforming
   
2
 
Total
 
$
5,305
 
16


The following table shows the Company's loan portfolio broken down by internal risk grading as of December 31, 2013.

(in thousands)
Commercial and Consumer Credit Exposure
Credit Risk Profile by Internally Assigned Grade

 
 
Commercial
   
Commercial
Real Estate
Construction
   
Commercial
Real Estate
Other
   
Residential
   
Home
Equity
 
 
 
   
   
   
   
 
Pass
 
$
121,033
   
$
35,563
   
$
351,801
   
$
158,478
   
$
85,163
 
Special Mention
   
1,500
     
1,005
     
6,795
     
8,242
     
1,650
 
Substandard
   
20
     
5,254
     
6,020
     
5,197
     
984
 
Doubtful
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
122,553
   
$
41,822
   
$
364,616
   
$
171,917
   
$
87,797
 

Consumer Credit Exposure
Credit Risk Profile Based on Payment Activity

 
 
Consumer
 
 
 
 
Performing
 
$
5,966
 
Nonperforming
   
-
 
Total
 
$
5,966
 

Loans classified in the Pass category typically are fundamentally sound and risk factors are reasonable and acceptable.

Loans classified in the Special Mention category typically have been criticized internally, by loan review or the loan officer, or by external regulators under the current credit policy regarding risk grades.

Loans classified in the Substandard category typically have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are typically characterized by the possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Loans classified in the Doubtful category typically have all the weaknesses inherent in loans classified as substandard, plus 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. However, these loans are not yet rated as loss because certain events may occur that may salvage the debt.

Consumer loans are classified as performing or nonperforming.  A loan is nonperforming when payments of interest and principal are past due 90 days or more, or payments are less than 90 days past due, but there are other good reasons to doubt that payment will be made in full.
17


Note 5 – Allowance for Loan Losses and Reserve for Unfunded Lending Commitments

Changes in the allowance for loan losses and the reserve for unfunded lending commitments as of the indicated dates and periods are presented below:

The reserve for unfunded loan commitments is included in other liabilities.
(in thousands)
 
Nine Months Ended
September 30, 2014
   
Year Ended
December 31, 2013
   
Nine Months Ended
September 30, 2013
 
 
 
   
   
 
Allowance for Loan Losses
 
   
   
 
Balance, beginning of period
 
$
12,600
   
$
12,118
   
$
12,118
 
Provision for loan losses
   
150
     
294
     
294
 
Charge-offs
   
(398
)
   
(837
)
   
(629
)
Recoveries
   
268
     
1,025
     
901
 
Balance, end of period
 
$
12,620
   
$
12,600
   
$
12,684
 
 
                       
Reserve for Unfunded Lending Commitments
                       
Balance, beginning of period
 
$
210
   
$
201
   
$
201
 
Provision for (recovery of) loan losses
   
(55
)
   
9
     
1
 
Charge-offs
   
-
     
-
     
-
 
Balance, end of period
 
$
155
   
$
210
   
$
202
 

The following table presents the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at September 30, 2014.

 
 
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Unallocated
   
Total
 
(in thousands)
 
   
   
   
   
   
 
Allowance for Loan Losses
 
   
   
   
   
   
 
Balance as of December 31, 2013
 
$
1,810
   
$
6,819
   
$
3,690
   
$
99
   
$
182
   
$
12,600
 
Charge-offs
   
(101
)
   
-
     
(240
)
   
(57
)
   
-
     
(398
)
Recoveries
   
42
     
51
     
113
     
62
     
-
     
268
 
Provision for loan losses
   
70
     
139
     
156
     
(33
)
   
(182
)
   
150
 
Balance as of September 30, 2014
 
$
1,821
   
$
7,009
   
$
3,719
   
$
71
   
$
-
   
$
12,620
 
 
                                               
Balance as of September 30, 2014:
                                               
 
                                               
Allowance for Loan Losses
                                               
Individually evaluated for impairment
 
$
-
   
$
642
   
$
1
   
$
3
   
$
-
   
$
646
 
Collectively evaluated for impairment
   
1,818
     
6,118
     
3,495
     
68
     
-
     
11,499
 
Loans acquired with deteriorated credit quality
   
3
     
249
     
223
     
-
     
-
     
475
 
Total
 
$
1,821
   
$
7,009
   
$
3,719
   
$
71
   
$
-
   
$
12,620
 
 
                                               
Loans
                                               
Individually evaluated for impairment
 
$
9
   
$
4,059
   
$
720
   
$
18
   
$
-
   
$
4,806
 
Collectively evaluated for impairment
   
126,386
     
405,601
     
259,661
     
5,287
     
-
     
796,935
 
Loans acquired with deteriorated credit quality
   
42
     
9,143
     
5,662
     
-
     
-
     
14,847
 
Total
 
$
126,437
   
$
418,803
   
$
266,043
   
$
5,305
   
$
-
   
$
816,588
 

The following table presents the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at December 31, 2013.

 
 
Commercial
   
Commercial
Real Estate
   
Residential
Real Estate
   
Consumer
   
Unallocated
   
Total
 
(in thousands)
 
   
   
   
   
   
 
Allowance for Loan Losses
 
   
   
   
   
   
 
Balance as of December 31, 2012
 
$
1,450
   
$
6,822
   
$
3,638
   
$
208
   
$
-
   
$
12,118
 
Charge-offs
   
(129
)
   
(164
)
   
(369
)
   
(175
)
   
-
     
(837
)
Recoveries
   
335
     
323
     
244
     
123
     
-
     
1,025
 
Provision for loan losses
   
154
     
(162
)
   
177
     
(57
)
   
182
     
294
 
Balance as of December 31, 2013
 
$
1,810
   
$
6,819
   
$
3,690
   
$
99
   
$
182
   
$
12,600
 
 
                                               
Balance as of December 31, 2013:
                                               
 
                                               
Allowance for Loan Losses
                                               
Individually evaluated for impairment
 
$
-
   
$
556
   
$
-
   
$
3
   
$
-
   
$
559
 
Collectively evaluated for impairment
   
1,810
     
6,039
     
3,483
     
96
     
182
     
11,610
 
Loans acquired with deteriorated credit quality
   
-
     
224
     
207
     
-
     
-
     
431
 
Total
 
$
1,810
   
$
6,819
   
$
3,690
   
$
99
   
$
182
   
$
12,600
 
 
                                               
Loans
                                               
Individually evaluated for impairment
 
$
19
   
$
4,688
   
$
1,304
   
$
18
   
$
-
   
$
6,029
 
Collectively evaluated for impairment
   
122,424
     
392,720
     
250,906
     
5,948
     
-
     
771,998
 
Loans acquired with deteriorated credit quality
   
110
     
9,030
     
7,504
     
-
     
-
     
16,644
 
Total
 
$
122,553
   
$
406,438
   
$
259,714
   
$
5,966
   
$
-
   
$
794,671
 

18


The allowance for loan losses is allocated to loan segments based upon historical loss factors, risk grades on individual loans, portfolio analyses of smaller balance, homogenous loans, and qualitative factors.  Qualitative factors include trends in delinquencies, nonaccrual loans, and loss rates; trends in volume and terms of loans, effects of changes in risk selection, underwriting standards, and lending policies; experience of lending officers and other lending staff; national, regional, and local economic trends and conditions; legal, regulatory and collateral factors; and concentrations of credit.

Note 6 – Goodwill and Other Intangible Assets

      The Company records as goodwill the excess of the purchase price over the fair value of the identifiable net assets acquired. Impairment testing is performed annually, as well as when an event triggering impairment may have occurred. The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment.  No indicators of impairment were identified as of June 30, 2014.
Core deposit intangibles resulting from the acquisition of Community First Financial Corporation ("Community First") in April 2006 were $3,112,000 and are being amortized over 99 months.  Core deposit intangibles resulting from the MidCarolina acquisition in July 2011 were $6,556,000 and are being amortized on an accelerated basis over 108 months.

The changes in the carrying amount of goodwill and intangibles for the nine months ended September 30, 2014, are as follows (in thousands):

 
 
Goodwill
   
Intangibles
 
Balance as of December 31, 2013
 
$
39,043
   
$
3,159
 
Additions
   
-
     
-
 
Amortization
   
-
     
(888
)
Impairment
   
-
     
-
 
Balance as of September 30, 2014
 
$
39,043
   
$
2,271
 

Note 7 – Short-term Borrowings

Short-term borrowings consist of customer repurchase agreements, overnight borrowings from the FHLB, and Federal Funds purchased.  Customer repurchase agreements are collateralized by securities of the U.S. Government or its agencies or GSEs.  They mature daily.  The interest rates may be changed at the discretion of the Company. The securities underlying these agreements remain under the Company's control.  Other short-term borrowings consist of overnight advances which contain floating interest rates that may change daily at the discretion of the FHLB.  Federal Funds purchased are unsecured overnight borrowings from other financial institutions.  Short-term borrowings consisted of the following at September 30, 2014 and December 31, 2013 (in thousands):

 
September 30, 2014
 
December 31, 2013
 
 
 
 
Customer repurchase agreements
 
$
51,945
   
$
39,478
 
 
 
$
51,945
   
$
39,478
 

Note 8 – Long-term Borrowings

Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans, second mortgage loans, home equity lines of credit, and commercial real estate loans.  In addition, the Company pledges as collateral its capital stock in the FHLB and deposits with the FHLB.  The Company has a line of credit with the FHLB equal to 30% of the Company's assets, subject to the amount of collateral pledged.  As of September 30, 2014, $395,857,000 in eligible collateral was pledged under the blanket floating lien agreement which covers both short-term and long-term borrowings.  Long-term borrowings consisted of the following fixed rate, long-term advances as of September 30, 2014 and December 31, 2013 (dollars in thousands):

September 30, 2014
 
December 31, 2013
 
Due by
Advance
Amount
   
Weighted
Average
Rate
 
Due by
Advance Amount
 
Weighted
Average
Rate
 
 
   
 
 
 
 
 
 
   
 
March 2014
 
$
38
     
3.78
%
November 2017
 
$
9,930
     
2.98
%
November 2017
   
9,913
     
2.98
 
 
 
$
9,930
     
2.98
%
 
 
$
9,951
     
3.01
%

The advance due in November 2017 is net of a valuation allowance of $70,000. The original valuation allowance recorded on July 1, 2011, was a result of the merger with MidCarolina. The adjustment to the face value will be amortized into interest expense over the life of the borrowing.

In the regular course of conducting its business, the Company takes deposits from political subdivisions of the states of Virginia and North Carolina. At September 30, 2014, the Bank's public deposits totaled $126,973,000.  The Company is required to provide collateral to secure the deposits that exceed the insurance coverage provided by the Federal Deposit Insurance Corporation. This collateral can be provided in the form of certain types of government or agency bonds or letters of credit from the FHLB. At September 30, 2014, the Company had $72,000,000 in letters of credit with the FHLB outstanding, as well as $111,237,000 in agency, state, and municipal securities to provide collateral for such deposits.

Note 9 – Trust Preferred Capital Notes

On April 7, 2006, AMNB Statutory Trust I (the "AMNB Trust I"), a Delaware statutory trust and a wholly owned subsidiary of the Company, issued $20,000,000 of preferred securities (the "Trust Preferred Securities") in a private placement pursuant to an applicable exemption from registration.  The Trust Preferred Securities mature on September 30, 2036, but may be redeemed at the Company's option (which option became effective beginning on September 30, 2011).  Initially, the securities required quarterly distributions by the AMNB Trust I to the holder of the Trust Preferred Securities at a fixed rate of 6.66%.  Effective September 30, 2011, the rate resets quarterly at the three-month LIBOR plus 1.35%.  Distributions are cumulative and will accrue from the date of original issuance, but may be deferred by the Company from time to time for up to 20 consecutive quarterly periods.  The Company has guaranteed the payment of all required distributions on the Trust Preferred Securities.

19

The proceeds of the Trust Preferred Securities received by the AMNB Trust, along with proceeds of $619,000 received by the trust from the issuance of common securities by the trust to the Company, were used to purchase $20,619,000 of the Company's junior subordinated debt securities (the "Trust Preferred Capital Notes"), issued pursuant to junior subordinated debentures entered into between the Company and Wilmington Trust Company, as trustee.  The proceeds of the Trust Preferred Capital Notes were used to fund the cash portion of the merger consideration to the former shareholders of Community First in connection with the Company's acquisition of that company, and for general corporate purposes.

On July 1, 2011, in connection with the MidCarolina merger, the Company assumed $8,764,000 in junior subordinated debentures to MidCarolina Trust I and MidCarolinia Trust II, two separate Delaware statutory trusts (the "MidCarolina Trusts"), to fully and unconditionally guarantee the preferred securities issued by the MidCarolina Trusts. These long-term obligations, which currently qualify as Tier 1 capital, constitute a full and unconditional guarantee by the Company of the MidCarolina Trusts' obligations. The MidCarolina Trusts are not consolidated in the Company's financial statements.

In accordance with FASB ASC 810-10-15-14, the Company did not eliminate through consolidation the Company's $619,000 equity investment in AMNB Trust I or the $264,000 equity investment in the MidCarolina Trusts.  Instead, the Company reflected this equity investment in the "Accrued interest receivable and other assets" line item in the consolidated balance sheets.

A description of the junior subordinated debt securities outstanding payable to the trusts is shown below:

 
 
Date
   
Interest
   
Maturity
   
(Amounts in thousands)
Principal Amount
 
Issuing Entity
 
Issued
   
Rate
   
Date
   
September 30, 2014
   
December 31, 2013
 
AMNB Trust I
   
04-07-06
   
Libor plus
     
06-30-36
   
$
20,619
   
$
20,619
 
 
           
1.35
%
                       
 
                                       
MidCarolina Tust I
   
10-29-02
   
Libor plus
     
11-07-32
     
4,140
     
4,098
 
 
           
3.45
%
                       
 
                                       
MidCarolina Trust II
   
12-03-03
   
Libor plus
     
10-07-33
     
2,736
     
2,702
 
 
           
2.95
%
                       
 
                                       
 
                         
$
27,495
   
$
27,419
 
 
The principal amounts reflected for the MidCarolina Trusts are net of valuation allowances of $1,015,000 and $872,000, respectively. The original valuation allowances of $1,197,000 and $1,021,000 were recorded as a result of the merger with MidCarolina on July 1, 2011, and are being amortized into interest expense over the remaining lives of the respective borrowings.

Note 10 – Stock Based Compensation

The Company's 2008 Stock Incentive Plan ("2008 Plan") was adopted by the Board of Directors of the Company on February 19, 2008, and approved by shareholders on April 22, 2008, at the Company's 2008 Annual Meeting of Shareholders.  The 2008 Plan provides for the granting of restricted stock awards and incentive and non-statutory options to employees and directors on a periodic basis, at the discretion of the Board of Directors or a Board designated committee.  The 2008 Plan authorizes the issuance of up to 500,000 shares of common stock. The 2008 Plan replaced the Company's stock option plan that was approved by the shareholders at the 1997 Annual Meeting. The prior stock option plan was terminated in 2006.

Stock Options

Accounting guidance requires that compensation cost relating to share-based payment transactions be recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued.

A summary of stock option transactions for the nine months ended September 30, 2014 is as follows:

 
 
Option
Shares
   
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual Term
Aggregate
Intrinsic
Value
($000)
 
 
 
   
 
 
 
Outstanding at December 31, 2013
   
176,747
   
$
24.39
 
 
 
Granted
   
-
     
-
 
 
 
Exercised
   
-
     
-
 
 
 
Forfeited
   
-
     
-
 
 
 
Expired
   
-
     
-
 
 
 
Outstanding at September 30, 2014
   
176,747
   
$
24.39
 
2.58 years                                   
 
$
238
 
Exercisable at September 30, 2014
   
176,747
   
$
24.39
 
2.58 years                                   
 
$
238
 

The fair value of options is estimated at the date of grant using the Black-Scholes option pricing model and expensed over the options' vesting period.  As of September 30, 2014, there was no unrecognized compensation expenses related to nonvested stock option grants.

Restricted Stock

The Company from time-to-time grants shares of restricted stock to key employees and non-employee directors.  These awards help align the interests of these employees and directors with the interests of the shareholders of the Company by providing economic value directly related to increases in the value of the Company's common stock.  The value of the stock awarded is established as the fair market value of the stock at the time of the grant.  The Company recognizes expense, equal to the total value of such awards, ratably over the vesting period of the stock grants. Restricted stock granted cliff vests over 24 to 36 months based on the term of the award.

20

Nonvested restricted stock activity for the nine months ended September 30, 2014 is summarized in the following table.

Restricted Stock
 
Shares
   
Weighted Average Grant Date Value
 
 
 
   
 
Nonvested at January 1, 2014
   
33,350
   
$
19.77
 
Granted
   
12,702
     
24.23
 
Vested
   
5,602
     
18.39
 
Forfeited
   
-
     
-
 
Nonvested at September 30, 2014
   
40,450
   
$
21.36
 

As of September 30, 2014 and December 31, 2013, there was  $377,000 and $337,000 in unrecognized compensation cost related to nonvested restricted stock granted under the 2008 Plan.  The weighted average period over which this cost is expected to be recognized is 1.27 years.   The share based compensation expense for nonvested restricted stock was $267,000 and $211,000 during the first nine months of 2014 and 2013, respectively.

Starting in 2010, the Company began offering its outside directors alternatives with respect to director compensation. The regular quarterly board retainer can be received in the form of either (i) $3,000 in cash or (ii) shares of immediately vested, but restricted stock with a market value of $4,688. Monthly meeting fees can also be received as $600 per meeting in cash or $750 in immediately vested, but restricted stock.  For 2014, all 13 outside directors have elected to receive stock in lieu of cash for either all or part of their quarterly retainer or meeting fees. Only outside directors receive board fees. The Company issued 10,239 and 7,217 shares and recognized share based compensation expense of $230,000 and $213,000 during the first nine months of 2014 and 2013, respectively.

Note 11 – Earnings Per Share

The following shows the weighted average number of shares used in computing earnings per common share and the effect on weighted average number of shares of potentially dilutive common stock.  Potentially dilutive common stock had no effect on income available to common shareholders.

 
Three Months Ended
 
 
 
September 30,
 
 
 
2014
   
2013
 
 
 
Shares
 
Per
Share
Amount
   
Shares
 
Per
Share
Amount
 
Basic
   
7,841,078
   
$
0.40
     
7,877,901
   
$
0.54
 
Effect of dilutive securities - stock options
   
10,657
     
-
     
14,114
     
-
 
Diluted
   
7,851,735
   
$
0.40
     
7,892,015
   
$
0.54
 

 
Nine Months Ended
 
 
 
September 30,
 
 
 
2014
   
2013
 
 
 
Shares
 
Per
Share
Amount
   
Shares
 
Per
Share
Amount
 
Basic
   
7,871,016
   
$
1.25
     
7,867,835
   
$
1.60
 
Effect of dilutive securities - stock options
   
10,425
     
-
     
11,126
     
-
 
Diluted
   
7,881,441
   
$
1.25
     
7,878,961
   
$
1.60
 

Stock options on common stock which were not included in computing diluted earnings per share for the nine month periods ended September 30, 2014 and 2013, because their effects were antidilutive, averaged 120,277 and 182,620 shares, respectively.

21

Note 12 – Employee Benefit Plans


The following information pertains to the Company's non-contributory defined benefit pension plan which was frozen in 2009.  If lump sum payments exceed the service cost plus interest cost, an additional settlement charge will apply.

 
Nine Months Ended
 
Components of Net Periodic Benefit Cost
(in thousands)
 
September 30,
 
 
 
2014
   
2013
 
Service cost
 
$
-
   
$
-
 
Interest cost
   
228
     
216
 
Expected return on plan assets
   
(351
)
   
(384
)
Recognized net actuarial loss
   
54
     
207
 
 
               
Net periodic (benefit) cost
 
$
(69
)
 
$
39
 


Note 13 – Segment and Related Information

The Company has two reportable segments, (i) community banking and  (ii) trust and investment services.

Community banking involves making loans to and generating deposits from individuals and businesses.  All assets and liabilities of the Company are allocated to community banking.  Investment income from securities is also allocated to the community banking segment.  Loan fee income, service charges from deposit accounts, and non-deposit fees such as automated teller machine fees and insurance commissions generate additional income for the community banking segment.

Trust and investment services include estate planning, trust account administration, investment management, and retail brokerage.  Investment management services include purchasing equity, fixed income, and mutual fund investments for customer accounts. The trust and investment services segment receives fees for investment and administrative services.

Amounts shown in the "Other" column includes activities of the Company which are primarily debt service on trust preferred securities and corporate items.  Intersegment eliminations primarily consist of the Company's investment in the Bank.
22


Segment information as of and for the three and nine months ended September 30, 2014 and 2013, is shown in the following table.

 
 
Three Months Ended September 30, 2014
 
(in thousands)
 
 
Community
Banking
   
Trust and
Investment
Services
   
Other
   
Intersegment
Eliminations
   
Total
 
Interest income
 
$
11,837
   
$
-
   
$
15
   
$
-
   
$
11,852
 
Interest expense
   
1,206
     
-
     
186
     
-
     
1,392
 
Noninterest income
   
1,800
     
1,177
     
4
     
-
     
2,981
 
Income (loss) before income taxes
   
4,205
     
633
     
(224
)
   
-
     
4,614
 
Net income (loss)
   
2,886
     
430
     
(148
)
   
-
     
3,168
 
Depreciation and amortization
   
641
     
3
     
-
     
-
     
644
 
Total assets
   
1,317,189
     
-
     
200,757
     
(198,789
)
   
1,319,157
 
Capital expenditures
   
419
     
-
     
-
     
-
     
419
 

 
 
Three Months Ended September 30, 2013
 
 
 
Community
Banking
   
Trust and
Investment
Services
   
Other
   
Intersegment
Eliminations
   
Total
 
Interest income
 
$
13,093
   
$
-
   
$
13
   
$
-
   
$
13,106
 
Interest expense
   
1,423
     
-
     
190
     
-
     
1,613
 
Noninterest income
   
1,567
     
1,195
     
5
     
-
     
2,767
 
Income (loss) before income taxes
   
5,150
     
849
     
(194
)
   
-
     
5,805
 
Net income (loss)
   
3,754
     
616
     
(127
)
   
-
     
4,243
 
Depreciation and amortization
   
757
     
3
     
-
     
-
     
760
 
Total assets
   
1,322,205
     
-
     
193,290
     
(191,310
)
   
1,324,185
 
Capital expenditures
   
139
     
4
     
-
     
-
     
143
 

 
 
Nine Months Ended September 30, 2014
 
(in thousands)
 
 
Community
Banking
   
Trust and
Investment
Services
   
Other
   
Intersegment
Eliminations
   
Total
 
Interest income
 
$
35,541
   
$
-
   
$
45
   
$
-
   
$
35,586
 
Interest expense
   
3,761
     
-
     
555
     
-
     
4,316
 
Noninterest income
   
4,770
     
3,600
     
14
     
-
     
8,384
 
Income (loss) before income taxes
   
12,355
     
2,284
     
(750
)
   
-
     
13,889
 
Net income (loss)
   
8,726
     
1,620
     
(495
)
   
-
     
9,851
 
Depreciation and amortization
   
2,154
     
8
     
-
     
-
     
2,162
 
Total assets
   
1,317,189
     
-
     
200,757
     
(198,789
)
   
1,319,157
 
Capital expenditures
   
685
     
-
     
-
     
-
     
685
 

 
 
Nine Months Ended September 30, 2013
 
(in thousands)
 
 
Community
Banking
   
Trust and
Investment
Services
   
Other
   
Intersegment
Eliminations
   
Total
 
Interest income
 
$
39,849
   
$
-
   
$
13
   
$
-
   
$
39,862
 
Interest expense
   
4,427
     
-
     
567
     
-
     
4,994
 
Noninterest income
   
5,253
     
2,955
     
15
     
-
     
8,223
 
Income (loss) before income taxes
   
16,479
     
1,827
     
(710
)
   
-
     
17,596
 
Net income (loss)
   
11,763
     
1,309
     
(468
)
   
-
     
12,604
 
Depreciation and amortization
   
2,444
     
11
     
-
     
-
     
2,455
 
Total assets
   
1,322,205
     
-
     
193,290
     
(191,310
)
   
1,324,185
 
Capital expenditures
   
719
     
4
     
-
     
-
     
723
 
 
Note 14 – Fair Value of Financial Instruments

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 820, "Fair Value Measurement and Disclosures", the fair value of an 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 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.

23

Fair Value Hierarchy

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

Level 1 – Valuation is based on quoted prices in active markets for identical assets and liabilities.

Level 2 – Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.

Level 3 – Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain assets and liabilities 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). If no observable market data is available, valuations are based upon third party model based techniques (Level 3).  FRB and FHLB stocks are carried at cost since no ready market exists and there is no quoted market value.  The Company is required to own stock in these entities as long as it is a member.  Therefore, they have been excluded from the following table.

The following table presents the balances of assets and liabilities measured at fair value on a recurring basis during the period (in thousands):

 
Fair Value Measurements at September 30, 2014 Using
 
 
Balance as of
September 30,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Description
2014
 
Level 1
 
Level 2
 
Level 3
 
Assets:
 
 
 
 
Securities available for sale:
 
 
 
 
Federal agencies and GSEs
 
$
69,943
   
$
-
   
$
69,943
   
$
-
 
Mortgage-backed and CMOs
   
60,872
     
-
     
60,872
     
-
 
State and municipal
   
188,197
     
-
     
188,197
     
-
 
Corporate
   
8,409
     
-
     
8,409
     
-
 
Equity
   
1,113
     
-
     
-
     
1,113
 
Total
 
$
328,534
   
$
-
   
$
327,421
   
$
1,113
 

 
Fair Value Measurements at December 31, 2013 Using
 
 
Balance as of
December 31,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Description
2013
 
Level 1
 
Level 2
 
Level 3
 
Assets:
 
 
 
 
Securities available for sale:
 
 
 
 
Federal agencies and GSEs
 
$
65,881
   
$
-
   
$
65,881
   
$
-
 
Mortgage-backed and CMOs
   
69,608
     
-
     
69,608
     
-
 
State and municipal
   
198,733
     
-
     
198,733
     
-
 
Corporate
   
10,799
     
-
     
10,799
     
-
 
Equity
   
1,103
     
-
     
-
     
1,103
 
Total
 
$
346,124
   
$
-
   
$
345,021
   
$
1,103
 
 
 

 
 
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
    
Total Realized / Unrealized Gains
(Losses) Included in
 
 
Balances as of January 1, 2014
Net Income
Other Comprehensive Income
Purchases, Sales, Issuances and Settlements, Net
Transfer In (Out) of Level 3
Balances as of September 30, 2014
Securities available for sale:
 
 
 
 
 
                
 
 
 
 
 
 
                   
Equity
$
1,103
$
  -
$
 10
$
-
$
  -
$
 $1,113

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:

24

Loans held for sale: Loans held for sale are carried at 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 any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the nine month period ended September 30, 2014 or the year ended December 31, 2013. Gains and losses on the sale of loans are recorded within income from mortgage banking on the Consolidated Statements of Income.

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.  In addition, the impairment of a loan may be measured using a present value of future cash flows analysis (Level 3). 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, of one year or less, conducted by an independent, licensed appraiser using observable market data (Level 2).  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:  Measurement for fair values for other real estate owned are the same as real estate collateral discussed with impaired loans.

The following table summarizes the Company's assets that were measured at fair value on a nonrecurring basis at the dates indicated (in thousands):

 
Fair Value Measurements at September 30, 2014 Using
 
 
Balance as of
September 30,,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Description
2014
 
Level 1
 
Level 2
 
Level 3
 
Assets:
 
 
 
 
Loans held for sale
 
$
811
   
$
-
   
$
811
   
$
-
 
Impaired loans, net of valuation allowance
   
2,158
     
-
     
-
     
2,158
 
Other real estate owned
   
2,364
     
-
     
-
     
2,364
 

 
Fair Value Measurements at December 31, 2013 Using
 
 
Balance as of
December 31,
 
Quoted Prices in Active Markets for Identical Assets
 
Significant Other Observable Inputs
 
Significant Unobservable Inputs
 
Description
2013
 
Level 1
 
Level 2
 
Level 3
 
Assets:
 
 
 
 
Loans held for sale
 
$
2,760
   
$
-
   
$
2,760
   
$
-
 
Impaired loans, net of valuation allowance
   
3,193
     
-
     
-
     
3,193
 
Other real estate owned
   
3,422
     
-
     
-
     
3,422
 


Quantitative Information About Level 3 Fair Value Measurements for September 30, 2014

Assets
 
Valuation Technique
 
Unobservable Input
 
Weighted
Rate
 
 
 
 
 
 
 
Securities available for sale
 
Third party model based techniques
 
Stock price in different rate environments
 
11%
 
 
 
 
 
 
 
Impaired loans
 
Discounted appraised value
 
Selling cost
 
6%
 
 
Discounted cash flows
 
Market rate for borrower (discount rate)
 
6%
 
 
 
 
 
 
 
Other real estate owned
 
Discounted appraised value
 
Discount for lack of marketability and age of appraisal
 
6%

25


      The carrying values and estimated fair values of the Company's financial instruments at September 30, 2014 are as follows (in thousands):

 
 
Fair Value Measurements at September 30, 2014 Using
 
 
 
   
Quoted Prices in Active Markets for Identical Assets
   
Significant Other Observable Inputs
   
Significant Unobservable Inputs
   
Fair Value
 
 
 
Carrying Value
   
Level 1
   
Level 2
   
Level 3
   
Balance
 
Financial Assets:
 
   
   
   
   
 
Cash and cash equivalents
 
$
80,977
   
$
-
   
$
80,977
   
$
-
   
$
80,977
 
Securities available for sale
   
328,534
     
-
     
327,421
     
1,113
     
328,534
 
Restricted stock
   
4,529
     
-
     
4,529
     
-
     
4,529
 
Loans held for sale
   
811
     
-
     
811
     
-
     
811
 
Loans, net of allowance
   
803,968
     
-
     
-
     
806,753
     
806,753
 
Bank owned life insurance
   
15,044
     
-
     
15,044
     
-
     
15,044
 
Accrued interest receivable
   
4,345
     
-
     
4,345
     
-
     
4,345
 
 
                                       
Financial Liabilities:
                                       
Deposits
 
$
1,051,060
   
$
-
   
$
691,869
   
$
361,059
   
$
1,052,928
 
Repurchase agreements
   
51,945
     
-
     
51,945
     
-
     
51,945
 
Other borrowings
   
9,930
     
-
     
-
     
10,447
     
10,447
 
Trust preferred capital notes
   
27,495
     
-
     
-
     
21,134
     
21,134
 
Accrued interest payable
   
581
     
-
     
581
     
-
     
581
 

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

 
 
Fair Value Measurements at December 31, 2013 Using
 
 
 
   
Quoted Prices in Active Markets for Identical Assets
   
Significant Other Observable Inputs
   
Significant Unobservable Inputs
   
Fair Value
 
 
 
Carrying Value
   
Level 1
   
Level 2
   
Level 3
   
Balance
 
Financial Assets:
 
   
   
   
   
 
Cash and cash equivalents
 
$
67,681
   
$
-
   
$
67,681
   
$
-
   
$
67,681
 
Securities available for sale
   
346,124
     
-
     
345,021
     
1,103
     
346,124
 
Restricted stock
   
4,889
     
-
     
4,889
     
-
     
4,889
 
Loans held for sale
   
2,760
     
-
     
2,760
     
-
     
2,760
 
Loans, net of allowance
   
782,071
     
-
     
-
     
783,825
     
783,825
 
Bank owned life insurance
   
14,746
     
-
     
14,746
     
-
     
14,746
 
Accrued interest receivable
   
4,741
     
-
     
4,741
     
-
     
4,741
 
 
                                       
Financial Liabilities:
                                       
Deposits
 
$
1,057,675
   
$
-
   
$
668,077
   
$
392,991
   
$
1,061,068
 
Repurchase agreements
   
39,478
     
-
     
39,478
     
-
     
39,478
 
Other borrowings
   
9,951
     
-
     
-
     
10,560
     
10,560
 
Trust preferred capital notes
   
27,419
     
-
     
-
     
18,162
     
18,162
 
Accrued interest payable
   
610
     
-
     
610
     
-
     
610
 

The following methods and assumptions were used by the Company in estimating fair value disclosures for financial instruments:

Cash and cash equivalents.  The carrying amount is a reasonable estimate of fair value.

Securities.  Fair values are based on quoted market prices or dealer quotes.

Loans held for sale.  The carrying amount is a reasonable estimate of fair value.

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

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

Accrued interest receivable.  The carrying amount is a reasonable estimate of fair value.

Deposits.  The fair value of demand deposits, savings deposits, and money market deposits equals the carrying value. The fair value of fixed-rate certificates of deposit is estimated by discounting the future cash flows using the current rates at which similar deposit instruments would be offered to depositors for the same remaining maturities.

Repurchase agreements.  The carrying amount is a reasonable estimate of fair value.

Other short-term borrowings.  The carrying amount is a reasonable estimate of fair value.

26

Other borrowings.  The fair values of other borrowings are estimated using discounted cash flow analyses based on the interest rates for similar types of borrowing arrangements.

Trust preferred capital notes.  Fair value is calculated by discounting the future cash flows using the estimated current interest rates at which similar securities would be issued.

Accrued interest payable.  The carrying amount is a reasonable estimate of fair value.

Off-balance sheet instruments.  The fair value of 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 September 30, 2014 and December 31, 2013, the fair value of off-balance sheet instruments was deemed immaterial, and therefore was not included in the previous table.

The Company assumes interest rate risk (the risk that interest rates will change) in its normal operations.  As a result, the fair values of the Company's financial instruments will change when interest rates change and that change may be either favorable or unfavorable to the Company.

Note 15 – Supplemental Cash Flow Information

 
 
Nine Months Ended
September 30,
 
 
 
2014
   
2013
 
Supplemental Schedule of Cash and Cash Equivalents:
 
   
 
Cash and due from banks
 
$
22,699
   
$
24,071
 
Interest-bearing deposits in other banks
   
58,278
     
54,198
 
 
               
      Cash and cash equivalents
 
$
80,977
   
$
78,269
 
 
               
Supplemental Disclosure of Cash Flow Information:
               
Cash paid for:
               
Interest on deposits and borrowed funds
 
$
4,345
   
$
5,094
 
Income taxes
   
3,211
     
4,275
 
Noncash investing and financing activities:
               
Transfer of loans to other real estate owned
   
386
     
1,549
 
Unrealized gains (losses) on securities available for sale
   
3,384
     
(8,191
)

Note 16 – Accumulated Other Comprehensive Income

Changes in each component of accumulated other comprehensive income ("AOCI") for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands):

For the Three Month Period
 
Net Unrealized Gains (Losses) on Securities
   
Adjustments Related to Pension Benefits
   
Accumulated Other Comprehensive Income
 
 
 
   
   
 
Balance at June 30, 2013
 
$
4,353
   
$
(2,203
)
 
$
2,150
 
 
                       
Net unrealized gains on securities available for sale, net of tax, $67
   
126
     
-
     
126
 
 
                       
Reclassification adjustment for gains on securities, net of tax, $(1)
   
(3
)
   
-
     
(3
)
 
                       
Balance at September 30, 2013
 
$
4,476
   
$
(2,203
)
 
$
2,273
 
 
                       
Balance at June 30, 2014
 
$
6,205
   
$
(1,058
)
 
$
5,147
 
 
                       
Net unrealized losses on securities available for sale,  net of tax, $(121)
   
(222
)
   
-
     
(222
)
 
                       
   Reclassification adjustment for gains on securities, net of tax, $(110)
   
(205
)
   
-
     
(205
)
 
                       
Balance at September 30, 2014
 
$
5,778
   
$
(1,058
)
 
$
4,720
 

27

For the Nine Month Period
 
Net Unrealized Gains (Losses) on Securities
   
Adjustments Related to Pension Benefits
   
Accumulated Other Comprehensive Income
 
 
 
   
   
 
Balance at December 31, 2012
 
$
9,800
   
$
(2,203
)
 
$
7,597
 
 
                       
Net unrealized losses on securities available for sale, net of tax, $(2,796)
   
(5,192
)
   
-
     
(5,192
)
 
                       
Reclassification adjustment for gains on securities, net of tax, $(71)
   
(132
)
   
-
     
(132
)
 
                       
Balance at September 30, 2013
 
$
4,476
   
$
(2,203
)
 
$
2,273
 
 
                       
Balance at December 31, 2013
 
$
3,578
   
$
(1,058
)
 
$
2,520
 
 
                       
Net unrealized gains on securities available for sale, net of tax, $1,360
   
2,528
     
-
     
2,528
 
 
                       
   Reclassification adjustment for gains on securities, net of tax, $(176)
   
(328
)
   
-
     
(328
)
 
                       
Balance at September 30, 2014
 
$
5,778
   
$
(1,058
)
 
$
4,720
 
 

 
Reclassifications Out of Accumulated Other Comprehensive Income
For the Three and Nine Month Periods Ended September 30, 2014
(in thousands)

For the Three Month Period Ended September 30, 2014
Amount
 
Affected Line Item in
 
Reclassified
 
the Statement of Where
Details about AOCI Components
from AOCI
 
Net Income is Presented
 
 
    
Available for sale securities:
 
   
Realized gain on sale of securities
 
$
315
 
Securities gains, net
 
   
(110
)
Income tax expense
Total reclassifications
 
$
205
 
Net of tax
 

 
For the Nine Month Period Ended September 30, 2014
Amount
 
Affected Line Item in
 
Reclassified
 
the Statement of Where
Details about AOCI Components
from AOCI
 
Net Income is Presented
 
 
    
Available for sale securities:
 
   
Realized gain on sale of securities
 
$
504
 
Securities gains, net
 
   
(176
)
Income tax expense
Total reclassifications
 
$
328
 
Net of tax

Note 16 – Proposed Merger

On August 25, 2014, the Company announced that it had entered into an Agreement and Plan of Reorganization, dated August 24, 2014, with MainStreet Bankshares, Inc. ("MainStreet"), pursuant to which it will acquire MainStreet in a business combination transaction.  MainStreet is headquartered in Martinsville, Virginia and the transaction will expand the Company's footprint into the Roanoke, Virginia metropolitan statistical area adding three branches in Franklin County.  The Company expects that it will have approximately $1.5 billion in assets upon completion of the merger.

Pursuant and subject to the terms of the merger agreement, as a result of the merger, the holders of shares of MainStreet common stock will receive 0.482 shares of the Company's common stock and $3.46 in cash for each share of MainStreet common stock held immediately prior to the effective date of the merger.

Subject to customary closing conditions, including regulatory and shareholder approvals, the Company expects the merger to close in early January 2015. Following completion of the merger, MainStreet's subsidiary bank, Franklin Community Bank, will be merged into American National Bank and Trust Company.

ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The purpose of this discussion is to focus on important factors affecting the financial condition and results of operations of the Company.  The discussion and analysis should be read in conjunction with the Consolidated Financial Statements.

Forward-Looking Statements

This report contains forward-looking statements with respect to the financial condition, results of operations and business of American National Bankshares Inc. (the "Company') and its wholly owned subsidiary, American National Bank and Trust Company (the "Bank").  These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of management of the Company and on information available to management at the time these statements and disclosures were prepared.  Forward-looking statements are subject to numerous assumptions, estimates, risks, and uncertainties that could cause actual conditions, events, or results to differ materially from those stated or implied by such forward-looking statements.
28

A variety of factors, some of which are discussed in more detail in Item 1A – Risk Factors of the Company's Annual Report on Form 10-K for the year ended December 31, 2013, may affect the operations, performance, business strategy, and results of the Company.  Those factors include but are not limited to the following:
·
Financial market volatility, including the level of interest rates could affect the values of financial instruments and the amount of net interest income earned;
·
General economic or business conditions, either nationally or in the market areas in which the Company does business, may be less favorable than expected, resulting in deteriorating credit quality, reduced demand for credit, or a weakened ability to generate deposits;
·
Competition among financial institutions may increase and competitors may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than the Company;
·
Businesses that the Company is engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards;
·
The ability to retain key personnel;
·
The failure of assumptions underlying the allowance for loan losses; and
·
Risks associated with mergers and other acquisitions and other expansion activities.

Reclassification

In certain circumstances, reclassifications have been made to prior period information to conform to the 2014 presentation.  These reclassifications did not have an impact on net income and were considered immaterial.

CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies followed by the Company conform with U.S. generally accepted accounting principles ("GAAP") and they conform to general practices within the banking industry.  The Company's critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses, (2) mergers and acquisitions, (3) acquired loans with specific credit-related deterioration and (4) goodwill impairment.  A summary of the Company's significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements contained in the Form 10-K for the year ended  December 31, 2013.

The financial information contained within the Company's financial 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 when earning income, recognizing an expense, recovering an asset, or relieving a liability.  In addition, GAAP itself may change from one previously acceptable method to another method.

Allowance for Loan Losses

The purpose of the allowance for loan losses ("ALLL") is to provide for probable losses in the loan portfolio.  The allowance is increased by the provision for loan losses and by recoveries of previously charged-off loans.  Loan charge-offs decrease the allowance.

The goal of the Company is to maintain an appropriate, systematic, and consistently applied process to determine the amounts of the ALLL and the provision for loan loss.

The Company uses certain practices to manage its credit risk.  These practices include (a) appropriate lending limits for loan officers, (b) a loan approval process, (c) careful underwriting of loan requests, including analysis of borrowers, cash flows, collateral, and market risks, (d) regular monitoring of the portfolio, including diversification by type and geography, (e) review of loans by the Loan Review department, which operates independently of loan production, (f) regular meetings of the Credit Committees to discuss portfolio and policy changes and make decisions on large or unusual loan requests, and (g) regular meetings of the Asset Quality Committee which reviews the status of individual loans.

Risk grades are assigned as part of the loan origination process. From time to time, risk grades may be modified as warranted by the facts and circumstances surrounding the credit.

Calculation and analysis of the ALLL is prepared quarterly by the Finance department.  The Company's Credit Committee, Audit Committee, and the Board of Directors review the allowance for adequacy.

The Company's ALLL has two basic components:  the formula allowance and the specific allowance.  Each of these components is determined based upon estimates and judgments.

The formula allowance uses historical loss experience as an indicator of future losses, along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries, trends in volume and terms of loans, effects of changes in underwriting standards, experience of lending staff, economic conditions, and portfolio concentrations. In the formula allowance for commercial and commercial real estate loans, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans.  The period-end balances for each loan risk-grade category are multiplied by the adjusted loss factor.  Allowance calculations for consumer loans are calculated based on historical losses for each product category without regard to risk grade as individual risk grades are not assigned to these credits. This loss rate is combined with qualitative factors resulting in an adjusted loss factor for each product category.

The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. These include:
 
·
The present value of expected future cash flows discounted at the loan's effective interest rate.  The effective interest rate on a loan is the rate of return implicit in the loan (that is, the contractual interest rate adjusted for any net deferred loan fees or costs and any premium or discount existing at the origination or acquisition of the loan);
·
The loan's observable market price; or
·
The fair value of the collateral, net of estimated selling expenses, if the loan is collateral dependent.
    The use of these computed values is inherently subjective and actual losses could be greater or less than the estimates.

No single statistic, formula, or measurement determines the adequacy of the allowance.  Management makes subjective and complex judgments about matters that are inherently uncertain, and different amounts would be reported under different conditions or using different assumptions.  For analytical purposes, management allocates a portion of the allowance to specific loan categories and specific loans.  However, the entire allowance is used to absorb credit losses inherent in the loan portfolio, including identified and unidentified losses.

The relationships and ratios used in calculating the allowance, including the qualitative factors, may change from period to period as facts and circumstances evolve.  Furthermore, management cannot provide assurance that in any particular period the Company will not have sizeable credit losses in relation to the amount reserved.  Management may find it necessary to significantly adjust the allowance, considering current factors at the time.
29

Mergers and Acquisitions
Business combinations are accounted for under the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions.
Acquisition-related costs are costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of costs to the Company include systems conversions, integration planning consultants and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP. These acquisition-related costs have been and will be included within the Consolidated Statements of Income classified within the noninterest expense caption.
Acquired Loans with Specific Credit-Related Deterioration
Acquired loans with specific credit deterioration are accounted for by the Company in accordance with FASB ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality. Certain acquired loans, those for which specific credit-related deterioration, since origination, is identified, are recorded at fair value reflecting the present value of the amounts expected to be collected. Income recognition on these loans is based on a reasonable expectation about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.

Goodwill Impairment

The Company records as goodwill the excess of purchase price over the fair value of the identifiable net assets acquired. Impairment testing is performed annually, as well as when an event triggering impairment may have occurred. The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment.  No indicators of impairment were identified as of June 30, 2014.

Non-GAAP Presentations

Non-GAAP presentations are provided because the Company believes these may be valuable to investors.  These include (1) the analysis of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets and (2) the impact to net interest income and pretax income from accretable and amortizable fair value adjustments attributable to the merger with MidCarolina Financial Corporation ("MidCarolina") in July 2011.

Internet Access to Corporate Documents

The Company provides access to its Securities and Exchange Commission ("SEC") filings through a link on the Investors Relations page of the Company's web site at www.amnb.com.  Reports available include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are filed electronically with the SEC.  The information on the Company's website is not incorporated into this report or any other filing the Company makes with the SEC.  The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

ANNOUNCED ACQUISITION

On August 25, 2014, the Company and MainStreet BankShares, Inc. ("MainStreet") (OTCBB: MREE) announced the signing of a definitive agreement that calls for MainStreet to merge with and into the Company in a transaction valued at approximately $24.2 million at the time of the announcement. The transaction will expand the Company's footprint into the Roanoke Metropolitan Statistical Area, adds three banking offices in the Franklin County and Smith Mountain Lake areas, and will result in the Company having assets of approximately $1.5 billion. Management expects the transaction to close in early January 2015, pending approval from MainStreet's shareholders and approval from banking regulators.

MainStreet is the holding company for Franklin Community Bank N. A. ("Franklin").  MainStreet has loans of $127 million, assets of $166 million, and deposits of $139 million as of June 30, 2014. Franklin provides banking services to its customers from three banking offices located in Rocky Mount, Hardy, and Union Hall, Virginia.
 
RESULTS OF OPERATIONS

Earnings Performance
 
Three months ended September 30, 2014 and 2013
 
For the quarter ended September 30, 2014, the Company reported net income of $3,168,000 compared to $4,243,000 for the comparable quarter in 2014. The $1,075,000 or 25.3% decrease in earnings was primarily due to the expected large reduction in accretion income of $1,127,000 from the mid-2011 merger with MidCarolina.
SUMMARY INCOME STATEMENT
 
(Dollars in thousands)
 
 
 
   
   
   
 
For the three months ended September 30,
 
2014
   
2013
   
$ Change
   
% Change
 
 
 
   
   
   
 
Interest income
 
$
11,852
   
$
13,106
   
$
(1,254
)
   
-9.6
%
Interest expense
   
(1,392
)
   
(1,613
)
   
221
     
-13.7
%
Net interest income
   
10,460
     
11,493
     
(1,033
)
   
-9.0
%
Provision for loan losses
   
-
     
-
     
-
     
-
%
Noninterest income
   
2,981
     
2,767
     
214
     
7.7
%
Noninterest expense
   
(8,827
)
   
(8,455
)
   
(372
)
   
4.4
%
Income tax expense
   
(1,446
)
   
(1,562
)
   
116
     
-7.4
%
 
                               
Net income
 
$
3,168
   
$
4,243
   
$
(1,075
)
   
-25.3
%

30


Nine months ended September 30, 2014 and 2013

For the nine month period ended September 30, 2014, the Company reported net income of $9,851,000 compared to $12,604,000 for the comparable period in 2013. The $2,753,000 or 21.8% decrease in earnings was primarily due to the expected large reduction in accretion income of $3,468,000 from the mid-2011 merger with MidCarolina.

SUMMARY INCOME STATEMENT
 
(Dollars in thousands)
 
 
 
   
   
   
 
For the nine months ended September 30,
 
2014
   
2013
   
$ Change
   
% Change
 
 
 
   
   
   
 
Interest income
 
$
35,586
   
$
39,862
   
$
(4,276
)
   
-10.7
%
Interest expense
   
(4,316
)
   
(4,994
)
   
678
     
-13.6
%
Net interest income
   
31,270
     
34,868
     
(3,598
)
   
-10.3
%
Provision for loan losses
   
(150
)
   
(294
)
   
144
     
-49.0
%
Noninterest income
   
8,384
     
8,223
     
161
     
2.0
%
Noninterest expense
   
(25,615
)
   
(25,201
)
   
(414
)
   
1.6
%
Income tax expense
   
(4,038
)
   
(4,992
)
   
954
     
-19.1
%
 
                               
Net income
 
$
9,851
   
$
12,604
   
$
(2,753
)
   
-21.8
%
 
                               


Net Interest Income

Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits and other funding sources.  Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income.  The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities.  A tax rate of 35% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis.  Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the average rate earned on earning assets and the average rate paid on interest-bearing liabilities.

Three months ended September 30, 2014 and 2013

Net interest income on a taxable equivalent basis decreased $1,097,000 or 9.1%, for the third quarter of 2014 compared to the same quarter of 2013.  This decline was mostly driven by lower amounts of accretion income and was partially mitigated by reduced cost of interest-bearing liabilities.

For the third quarter of 2014, the Company's yield on interest-earning assets was 4.14%, compared to 4.59% for the third quarter of 2013.  The cost of interest-bearing liabilities was 0.62% compared to 0.70%. The interest rate spread was 3.52% compared to 3.89%.  The net interest margin, on a fully taxable equivalent basis, was 3.68% compared to 4.06%, a reduction of thirty eight-basis points (0.38%).

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the three months ended September 30, 2014 and 2013.  Nonaccrual loans are included in average balances.  Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.

31

   
Net Interest Income Analysis
 
   
For the Three Months Ended September 30, 2014 and 2013
 
   
(in thousands, except rates)
 
 
 
   
   
   
   
   
 
 
 
   
   
Interest
   
   
 
 
 
Average Balance
   
Income/Expense
   
Yield/Rate
 
 
 
   
   
   
   
   
 
 
 
2014
   
2013
   
2014
   
2013
   
2014
   
2013
 
Loans:
 
   
   
   
   
   
 
Commercial
 
$
126,340
   
$
126,745
   
$
1,339
   
$
1,511
     
4.20
%
   
4.73
%
Real estate
   
686,682
     
663,539
     
8,451
     
9,517
     
4.92
     
5.74
 
Consumer
   
4,540
     
5,671
     
85
     
104
     
7.43
     
7.28
 
Total loans
   
817,562
     
795,955
     
9,875
     
11,132
     
4.83
     
5.59
 
 
                                               
Securities:
                                               
Federal agencies & GSEs
   
72,828
     
55,543
     
212
     
126
     
1.16
     
0.91
 
Mortgage-backed & CMOs
   
58,365
     
72,505
     
345
     
322
     
2.36
     
1.78
 
State and municipal
   
183,679
     
195,673
     
1,783
     
1,945
     
3.88
     
3.98
   
    Other
   
14,583
     
15,861
     
114
     
116
     
3.13
     
2.93
 
Total securities
   
329,455
     
339,582
     
2,454
     
2,509
     
2.98
     
2.96
 
 
                                               
Deposits in other banks
   
45,744
     
54,307
     
32
     
38
     
0.28
     
0.28
 
 
                                               
Total interest-earning assets
   
1,192,761
     
1,189,844
     
12,361
     
13,679
     
4.14
     
4.59
 
 
                                               
Non-earning assets
   
116,359
     
117,503
                                 
 
                                               
Total assets
 
$
1,309,120
   
$
1,307,347
                                 
 
                                               
Deposits:
                                               
Demand
 
$
189,208
   
$
163,825
     
15
     
25
     
0.03
     
0.06
 
Money market
   
167,777
     
184,428
     
51
     
83
     
0.12
     
0.18
 
Savings
   
88,456
     
84,390
     
10
     
17
     
0.04
     
0.08
 
    Time
   
360,826
     
401,662
     
1,044
     
1,213
     
1.15
     
1.20
 
Total deposits
   
806,267
     
834,305
     
1,120
     
1,338
     
0.55
     
0.64
 
 
                                               
Customer repurchase agreements
   
45,725
     
46,712
     
2
     
3
     
0.02
     
0.03
 
Other short-term borrowings
   
2,215
     
-
     
2
     
-
     
0.36
     
-
 
Long-term borrowings
   
37,406
     
37,388
     
268
     
272
     
2.87
     
2.91
 
Total interest-bearing
                                               
liabilities
   
891,613
     
918,405
     
1,392
     
1,613
     
0.62
     
0.70
 
 
                                               
Noninterest bearing demand deposits
   
238,646
     
218,819
                                 
Other liabilities
   
6,368
     
6,993
                                 
Shareholders' equity
   
172,493
     
163,130
                                 
Total liabilities and
                                               
shareholders' equity
 
$
1,309,120
   
$
1,307,347
                                 
 
                                               
Interest rate spread
                                   
3.52
%
   
3.89
%
Net interest margin
                                   
3.68
%
   
4.06
%
 
                                               
Net interest income (taxable equivalent basis)
             
10,969
     
12,066
                 
Less: Taxable equivalent adjustment
                   
509
     
573
                 
Net interest income
                 
$
10,460
   
$
11,493
                 

32


Changes in Net Interest Income (Rate/Volume Analysis)
 
(in thousands)
 
 
 
   
   
 
 
 
Three Months Ended September 30
 
 
 
2014 vs. 2013
 
 
 
Interest
   
Change
 
 
 
Increase
   
Attributable to
 
Interest income
 
(Decrease)
   
Rate
   
Volume
 
  Loans:
 
   
   
 
    Commercial
 
$
(172
)
 
$
(167
)
 
$
(5
)
    Real Estate
   
(1,066
)
   
(1,389
)
   
323
 
    Consumer
   
(19
)
   
2
     
(21
)
      Total loans
   
(1,257
)
   
(1,554
)
   
297
 
  Securities:
                       
    Federal agencies
   
86
     
41
     
45
 
    Mortgage-backed
   
23
     
94
     
(71
)
    State and municipal
   
(162
)
   
(45
)
   
(117
)
    Other securities
   
(2
)
   
8
     
(10
)
      Total securities
   
(55
)
   
98
     
(153
)
  Deposits in other banks
   
(6
)
   
-
     
(6
)
      Total interest income
   
(1,318
)
   
(1,456
)
   
138
 
 
                       
Interest expense
                       
  Deposits:
                       
    Demand
   
(10
)
   
(13
)
   
3
 
    Money market
   
(32
)
   
(25
)
   
(7
)
    Savings
   
(7
)
   
(8
)
   
1
 
    Time
   
(169
)
   
(49
)
   
(120
)
      Total deposits
   
(218
)
   
(95
)
   
(123
)
 
                       
  Customer repurchase agreements
   
(1
)
   
(1
)
   
-
 
  Other borrowings
   
(2
)
   
(18
)
   
16
 
      Total interest expense
   
(221
)
   
(114
)
   
(107
)
Net interest income
 
$
(1,097
)
 
$
(1,342
)
 
$
245
 
 
                       



Nine months ended September 30, 2014 and 2013

Net interest income on a taxable equivalent basis decreased $3,723,000 or 10.2%, for the nine months ended September 30, 2014 compared to the same period of 2013.  This decline was mostly driven by lower amounts of accretion income and was partially mitigated by reduced cost of interest bearing liabilities.

For the first nine months of 2014, the Company's yield on interest-earning assets was 4.18%, compared to 4.70% for the first nine months of 2013.  The cost of interest-bearing liabilities was 0.64% compared to 0.73%. The interest rate spread was 3.54% compared to 3.97%.  The net interest margin, on a fully taxable equivalent basis, was 3.69% compared to 4.14%, a reduction of forty-five basis points (0.45%).

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the nine months ended September 30, 2014 and 2013.  Nonaccrual loans are included in average balances.  Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.

33

   
Net Interest Income Analysis
 
   
For the Nine Months Ended September 30, 2014 and 2013
 
   
(in thousands, except rates)
 
 
 
   
   
   
   
   
 
 
 
   
   
Interest
   
   
 
 
 
Average Balance
   
Income/Expense
   
Yield/Rate
 
 
 
   
   
   
   
   
 
 
 
2014
   
2013
   
2014
   
2013
   
2014
   
2013
 
Loans:
 
   
   
   
   
   
 
Commercial
 
$
122,441
   
$
127,592
   
$
4,096
   
$
4,706
     
4.49
%
   
4.95
%
Real estate
   
673,745
     
660,698
     
25,072
     
28,927
     
4.96
     
5.84
 
Consumer
   
4,833
     
5,955
     
261
     
316
     
7.25
     
7.12
 
Total loans
   
801,019
     
794,245
     
29,429
     
33,949
     
4.90
     
5.70
 
 
                                               
Securities:
                                               
Federal agencies & GSEs
   
73,506
     
51,668
     
617
     
368
     
1.12
     
0.95
 
Mortgage-backed & CMOs
   
62,420
     
76,286
     
1,116
     
1,040
     
2.38
     
1.82
 
State and municipal
   
189,311
     
192,113
     
5,548
     
5,804
     
3.91
     
4.03
 
    Other
   
15,483
     
13,718
     
362
     
306
     
3.12
     
2.97
 
Total securities
   
340,720
     
333,785
     
7,643
     
7,518
     
2.99
     
3.00
 
 
                                               
Deposits in other banks
   
46,024
     
51,650
     
100
     
106
     
0.29
     
0.28
 
 
                                               
Total interest-earning assets
   
1,187,763
     
1,179,680
     
37,172
     
41,573
     
4.18
     
4.70
 
 
                                               
Non-earning assets
   
116,025
     
122,390
                                 
 
                                               
Total assets
 
$
1,303,788
   
$
1,302,070
                                 
 
                                               
Deposits:
                                               
Demand
 
$
181,040
   
$
160,858
     
56
     
85
     
0.04
     
0.07
 
Money market
   
177,279
     
175,486
     
176
     
254
     
0.13
     
0.19
 
Savings
   
88,286
     
83,859
     
35
     
54
     
0.05
     
0.09
 
    Time
   
372,253
     
408,826
     
3,243
     
3,750
     
1.17
     
1.23
 
Total deposits
   
818,858
     
829,029
     
3,510
     
4,143
     
0.58
     
0.67
 
 
                                               
Customer repurchase agreements
   
41,443
     
48,016
     
5
     
38
     
0.02
     
0.11
 
Other short-term borrowings
   
937
     
-
     
3
     
-
     
0.43
     
-
 
Long-term borrowings
   
37,385
     
37,393
     
798
     
813
     
2.85
     
2.90
 
Total interest-bearing
                                               
liabilities
   
898,623
     
914,438
     
4,316
     
4,994
     
0.64
     
0.73
 
 
                                               
Noninterest bearing demand deposits
   
227,786
     
216,594
                                 
Other liabilities
   
5,929
     
6,443
                                 
Shareholders' equity
   
171,450
     
164,595
                                 
Total liabilities and
                                               
shareholders' equity
 
$
1,303,788
   
$
1,302,070
                                 
 
                                               
Interest rate spread
                                   
3.54
%
   
3.97
%
Net interest margin
                                   
3.69
%
   
4.14
%
 
                                               
Net interest income (taxable equivalent basis)
             
32,856
     
36,579
                 
Less: Taxable equivalent adjustment
                   
1,586
     
1,711
                 
Net interest income
                 
$
31,270
   
$
34,868
                 

34


Changes in Net Interest Income (Rate/Volume Analysis)
 
(in thousands)
 
 
 
   
   
 
 
 
Nine Months Ended September 30
 
 
 
2014 vs. 2013
 
 
 
Interest
   
Change
 
 
 
Increase
   
Attributable to
 
Interest income
 
(Decrease)
   
Rate
   
Volume
 
  Loans:
 
   
   
 
    Commercial
 
$
(610
)
 
$
(425
)
 
$
(185
)
    Real Estate
   
(3,855
)
   
(4,416
)
   
561
 
    Consumer
   
(55
)
   
6
     
(61
)
      Total loans
   
(4,520
)
   
(4,835
)
   
315
 
  Securities:
                       
    Federal agencies
   
249
     
74
     
175
 
    Mortgage-backed
   
76
     
287
     
(211
)
    State and municipal
   
(256
)
   
(172
)
   
(84
)
    Other securities
   
56
     
15
     
41
 
      Total securities
   
125
     
204
     
(79
)
  Deposits in other banks
   
(6
)
   
6
     
(12
)
      Total interest income
   
(4,401
)
   
(4,625
)
   
224
 
 
                       
Interest expense
                       
  Deposits:
                       
    Demand
   
(29
)
   
(39
)
   
10
 
    Money market
   
(78
)
   
(81
)
   
3
 
    Savings
   
(19
)
   
(22
)
   
3
 
    Time
   
(507
)
   
(182
)
   
(325
)
      Total deposits
   
(633
)
   
(324
)
   
(309
)
 
                       
  Repurchase agreements
   
(33
)
   
(28
)
   
(5
)
  Other borrowings
   
(12
)
   
(32
)
   
20
 
      Total interest expense
   
(678
)
   
(384
)
   
(294
)
Net interest income
 
$
(3,723
)
 
$
(4,241
)
 
$
518
 
 
                       

Noninterest Income

All comparisons discussed below are between the third quarter of 2014 and the third quarter of 2013.

Noninterest income increased to $2,981,000 in 2014 from $2,767,000 in 2013, an increase of $214,000 or 7.7%.   The major factors impacting that change are discussed below.

Fees from the management of trusts, estates, and asset management accounts decreased to $992,000 in 2014 from $1,077,000 in 2013, a reduction of $85,000 or 7.9%.  A substantial portion of trust fees are earned based on account market values, so changes in the equity markets may have a large impact on income.

Service charges on deposit accounts were $441,000 in 2014 compared to $452,000 in 2013, a decrease of $11,000 or 2.4%.

Other fees and commissions were $479,000 in 2014 compared to $471,000 in 2013, an increase of $8,000 or 1.7%.

Mortgage banking income was $342,000 in 2014 compared to $464,000 in 2013, a decrease of $122,000 or 26.3%. Recent increases in mortgage interest rates have slowed demand for residential mortgage loans and have, accordingly, reduced volume and income. Secondary mortgage loan volume is down 23.6% for the quarter compared to the same quarter last year.

Securities gains were $315,000 in 2014 compared to $4,000 in 2013.  The Company sold bonds consistent with its ongoing asset liability strategic objectives. Most of these sales where from issuers within states where management had some credit or economic concerns.

       Other income was $412,000 in 2014 compared to $299,000 in 2013, an increase of $113,000 or 37.8%. The major drivers of this increase were brokerage income, which was up $66,000 from the prior year quarter, and income from an equity investment in a Small Business Investment Company ("SBIC"), which was up $63.000 over the comparable period.  Income from the SBIC investment is sporadic in nature.

Noninterest Expense

All comparisons discussed below are between the third quarter of 2014 and the third quarter of 2013.

Noninterest expense was $8,827,000 in 2014 compared to $8,455,000 in 2013, an increase of $372,000 or 4.4%.  The major factors impacting that change are discussed below.

Salaries were $3,714,000 in 2014 compared to $3,610,000 in 2013, an increase of $104,000 or 2.9%.

Employee benefits were $799,000 in 2014 compared to $856,000 in 2013, a decrease of $57,000 or 6.7%.

Occupancy and equipment expense was $933,000 in 2014 and 2013.

The Federal Deposit Insurance Corporation ("FDIC") assessment for deposit insurance was $157,000 in 2014 compared to $163,000 in 2013, a decrease of $6,000 or 3.7%.

35

Bank franchise tax expense was $216,000 in 2014 compared to $187,000 in 2013, an increase of $29,000 or 15.5% due primarily to an immaterial accrual adjustment. The bank franchise tax is computed based on the Bank's equity, net of some adjustments.

Core deposit intangible amortization was $227,000 in 2014 compared to $330,000 in 2013, a decrease of $103,000 or 31.2%. Core deposit amortization from the MidCarolina acquisition is computed on an accelerated basis and will continue to decrease year over year.

Data processing expense was $361,000 in 2014 compared to $305,000 in 2013, an increase of $56,000 or 18.4%.  The increase is related to increased utilization of the Company's new core information management system and adding new features, e.g. instant issue debit cards.

Software expense was $248,000 in 2014 compared to $198,000 in 2013, an increase of $50,000 or 25.3%.  This increase was primarily due to upgrades to the Company's data processing infrastructure.

Foreclosed real estate, net, was $141,000 for 2014 compared to $245,000 for 2013, a decrease of $104,000 or 42.4%.  This expense category is historically volatile period to period. The expense generally fluctuates with the level of foreclosed real estate, which has been declining. Other real estate owned at September 30, 2014, was $2,364,000, compared to $3,422,000 at December 31, 2013.

Merger related expenses were $268,000 in 2014 related to the pending, recently announced MainStreet BankShares, Inc. merger.  These expenses were almost entirely non-deductible for income tax purposes. There were no merger related expenses in 2013. Management expects to incur further merger related costs in the fourth quarter 2014 and the first quarter 2015.

Other expenses were $1,763,000 in 2014 compared to $1,628,000 in 2013, an increase of $135,000 or 8.3%.

 
Income Taxes

The effective tax rate for the third quarter of 2014 was 31.3% compared to 26.9% for 2013. The increase in the effective tax rate during the quarter was related mostly to non-deductible merger related costs and secondarily to federal and state tax accrual adjustments,

The effective tax rate is lower than the statutory rate of 35% due to income that is not taxable for Federal income tax purposes.  The primary non-taxable income is that of state and municipal securities and industrial revenue bonds and loans.

Fair Value Impact to Net Income

The following table presents the impact for the three month and nine month periods ended September 30, 2014 of the accretable and amortizable fair value adjustments attributable to the MidCarolina merger on July 1, 2011 on net interest income and pretax income:

 
 
 
   
September 30, 2014
   
 
(in thousands)
Income Statement Effect
 
Remaining Premium/ (Discount) Balance on December 31, 2013
   
For the three months ended
   
For the Nine months ended
   
Remaining Premium/ (Discount) Balance
   
 
 
 
 
   
   
   
   
 
Interest income/(expense):
 
 
   
   
   
   
 
Loans
Income
 
$
(5,010
)
 
$
409
   
$
1,295
   
$
(3,671
)
   
(1
)
Accretable portion of loans acquired with deteriorated credit quality
Income
   
(2,046
)
   
186
     
862
     
(1,627
)
   
(2
)
Time deposits - brokered
Income
   
-
     
-
     
-
     
-
         
FHLB advances
Expense
   
87
     
(6
)
   
(17
)
   
70
         
Trust preferred securities
Expense
   
1,964
     
(25
)
   
(76
)
   
1,888
         
Net Interest Income
 
           
564
     
2,064
                 
 
 
                                       
Non-interest (expense)
 
                                       
Amortization of core deposit intangible
Expense
 
$
2,969
     
(227
)
   
(698
)
 
$
2,271
         
Net non-interest expense
 
           
(227
)
   
(698
)
               
 
 
                                       
Change in pretax income
 
         
$
337
   
$
1,366
                 

36

The following table presents the impact for the three month and nine month periods ended September 30, 2013 of the accretable and amortizable fair value adjustments attributable to the MidCarolina merger on July 1, 2011 on net interest income and pretax income:



 
 
 
   
September 30, 2013
   
 
(in thousands)
Income Statement Effect
 
Remaining Premium/ (Discount) Balance on December 31, 2012
   
For the Three Months Ended
   
For the Nine Months Ended
   
Remaining Premium/ (Discount) Balance
   
 
 
 
 
   
   
   
   
 
Interest income/(expense):
 
 
   
   
   
   
 
Loans
Income
 
$
(9,631
)
 
$
1,231
   
$
3,912
   
$
(5,708
)
   
(1
)
Accretable portion of loans acquired with deteriorated credit quality
Income
   
(2,165
)
   
491
     
1,713
     
(1,843
)
   
(2
)
Time deposits - brokered
Income
   
(278
)
   
69
     
278
     
-
         
FHLB advances
Expense
   
109
     
(6
)
   
(17
)
   
92
         
Trust preferred securities
Expense
   
2,066
     
(26
)
   
(77
)
   
1,989
         
Net Interest Income
 
           
1,759
     
5,809
                 
 
 
                                       
Non-interest (expense)
 
                                       
Amortization of core deposit intangible
Expense
 
$
4,094
     
(237
)
   
(889
)
 
$
3,205
         
Net non-interest expense
 
           
(237
)
   
(889
)
               
 
 
                                       
Change in pretax income
 
         
$
1,522
   
$
4,920
                 
 
 
                                       
(1) - Remaining discount balance includes $11 in charge-offs against the mark
 
(2) - Remaining discount balance includes $1,391 in reclassifications from the non-accretable difference
 
 
 
                                       
 
Impact of Inflation and Changing Prices
 
The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories.  The most significant effect of inflation is on noninterest expense, which tends to rise during periods of inflation.  Changes in interest rates have a greater impact on a financial institution's profitability than do the effects of higher costs for goods and services.  Through its balance sheet management practices, the Company has the ability to react to those changes and measure and monitor its interest rate and liquidity risk.  During the reported periods, inflation and interest rates have been low.
CHANGES IN FINANCIAL POSITION


BALANCE SHEET ANALYSIS

Securities

The securities portfolio generates income, plays a major role in the management of interest rate sensitivity, provides a source of liquidity, is used to meet collateral requirements for public deposits, and facilitates commercial customers' repurchase agreements.  The portfolio consists primarily of high credit quality, very liquid securities.  Federal agency and U. S. government sponsored enterprises, mortgage-backed securities, state and municipal securities, and corporates comprise the portfolio.

The available for sale securities portfolio was $328,534,000 at September 30, 2014 compared to $346,124,000 at December 31, 2013, a decrease of $17,590,000 or 5.1%.  At September 30, 2014, the available for sale portfolio had an amortized cost of $319,645,000, resulting in a net unrealized gain of $8,889,000.  At December 31, 2013, the available for sale portfolio had an amortized cost of $340,619,000, resulting in a net unrealized gain of $5,505,000.

The Company is aware of the relatively low, acutely uncertain current interest rate environment and has elected to maintain an investment strategy of purchasing high quality taxable securities of relatively short duration and longer term high quality, tax exempt securities, whose market values are not as volatile in rising rate environments as similarly termed taxable investments. The Company manages its investment portfolio on an aggregate portfolio basis for purposes of monitoring average life and duration. Accordingly, some individual purchases may fall outside these overall guidelines. The Company will attempt to deploy its cash to the maximum extent practical and prudent, consistent with its liquidity and asset liability strategy.


Loans

The loan portfolio consists primarily of commercial and residential real estate loans, commercial loans to small and medium-sized businesses, construction and land development loans, and home equity loans.

Total loans were $816,588,000 at September 30, 2014, compared to $794,671,000 at December 31, 2013, an increase of $21,917,000 or 2.8%.

Loans held for sale totaled $811,000 at September 30, 2014 and $2,760,000 at December 31, 2013, a decrease of $1,949,000 or 70.6%. This decrease was directly related to changes in the residential mortgage loan market, driven by increases in mortgage rates.  Secondary mortgage loan volume was down 43.5% for the nine month period in 2014 compared to the same period last year.

Management of the loan portfolio is organized around segments. Each segment is comprised of various loan types that are reflective of operational and regulatory management and reporting requirements. The following table presents the Company's loan portfolio by segment as of September 30, 2014 and December 31, 2013.

37

 
 
September 30,
   
December 31,
 
(in thousands)
 
2014
   
2013
 
 
 
   
 
Commercial
 
$
126,437
   
$
122,553
 
Commercial real estate:
               
      Construction and land development
   
47,060
     
41,822
 
      Commercial real estate
   
371,743
     
364,616
 
Residential real estate:
               
      Residential
   
175,091
     
171,917
 
      Home equity
   
90,952
     
87,797
 
Consumer
   
5,305
     
5,966
 
      Total loans
 
$
816,588
   
$
794,671
 
 
Allowance for Loan Losses

The purpose of the ALLL is to provide for probable losses in the loan portfolio. The allowance is increased by the provision for loan losses and by recoveries of previously charged-off loans. Loan charge-offs decrease the allowance.

At September 30, 2014, the ALLL was $12,620,000 compared to $12,600,000 at December 31, 2013. The ALLL as a percentage of loans was 1.55% and 1.59%, respectively.  The gradual decrease in the allowance as a percentage of loans was driven by continued good loss history combined with improving qualitative risk factors, including strong asset quality metrics and some improvement in local and national economic factors.  During the first nine months of 2014, the allowance for loan losses increased by $20,000 or 0.2%, provision expense was charged $150,000, and the loan portfolio increased by $21,917,000 or 2.8%.

In an effort to better evaluate the adequacy of its ALLL, the Company computes its ASC 450 loan balance by reducing total loans by acquired loans and loans that were evaluated for impairment individually or smaller balance nonaccrual loans evaluated for impairment in homogeneous pools. It also adjusts its ASC 450 loan loss reserve balance total by removing allowances associated with these other pools of loans.

The general allowance, ASC 450 (FAS 5) reserves to ASC 450 loans, was 1.58% at September 30, 2014, compared to 1.75% at December 31, 2013. On a dollar basis, the reserve was $11,499,000 at September 30, 2014, compared to $11,610,000 at December 31, 2013. This segment of the allowance represents by far the largest portion of the loan portfolio and the largest aggregate risk. This reserve peaked at 1.98% in December 2012, shortly after the MidCarolina merger transaction. Management considers the methodical and gradual reduction of the level of this reserve directionally consistent with the inherent risk in the loan portfolio, as evidenced by all major asset quality metrics and some improvement in economic related qualitative factors.

The specific allowance, ASC 310-40 (FAS 114) reserves to ASC 310-40 loans, was 13.43% at September 30, 2014, compared to 9.27% at December 31, 2013. On a dollar basis, the reserve was $646,000 at September 30, 2014, compared to $559,000 at December 31, 2013. The modest increase in the dollar amount of the reserve was related to changes in characteristics of loans reviewed individually for impairment.

The specific allowance does not include reserves related to acquired loans with deteriorated credit quality. This reserve was $475,000 at September 30, 2014, compared to $431,000 at December 31, 2013. This is the only portion of the reserve related to acquired loans. Cash flow expectations for these loans are reviewed on a quarterly basis and unfavorable changes in those estimates relative to the initial estimates can result in the need for specific loan loss provision.

The following table presents the Company's loan loss and recovery experience for the periods indicated (in thousands).

Summary of Loan Loss Experience
 
(in thousands)
 
 
 
   
 
   
 
Nine Months Ended
   
Year Ended
 
   
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
 
 
   
 
Balance at beginning of period
 
$
12,600
   
$
12,118
 
 
               
Charge-offs:
               
Construction and land development
   
-
     
-
 
Commercial real estate
   
-
     
164
 
Residential real estate
   
104
     
213
 
Home equity
   
136
     
156
 
Total real estate
   
240
     
533
 
Commercial and industrial
   
101
     
129
 
Consumer
   
57
     
175
 
Total charge-offs
   
398
     
837
 
 
               
Recoveries:
               
Construction and land development
   
20
     
227
 
Commercial real estate
   
31
     
96
 
Residential real estate
   
52
     
179
 
Home equity
   
61
     
65
 
Total real estate
   
164
     
567
 
Commercial and industrial
   
42
     
335
 
Consumer
   
62
     
123
 
Total recoveries
   
268
     
1,025
 
 
               
Net charge-offs (recoveries)
   
130
     
(188
)
Provision for loan losses
   
150
     
294
 
Balance at end of period
 
$
12,620
   
$
12,600
 

38

Asset Quality Indicators

The following table provides qualitative indicators relevant to the Company's loan portfolio for the three month period and year indicated below.

Asset Quality Ratios
 
 
 
 
 
 
 
 
 
September 30,
 
 
December 31,
 
 
 
2014
 
 
2013
 
 
 
 
 
 
 
 
Allowance to loans
 
1.55
%
 
1.59
%
Net charge-offs (recoveries) to allowance (1)
 
1.37
 
 
(1.49)
 
Net charge-offs (recoveries) to average loans (1)
0.02
 
 
(0.02)
 
Nonperforming assets to total assets
 
0.52
 
 
0.65
 
Nonperforming loans to loans
 
0.55
 
 
0.64
 
Provision to net charge-offs (recoveries) (1)
 
115.38
 
 
(156.38)
 
Provision to average loans (1)
 
0.02
 
 
0.04
 
Allowance to nonperforming loans
 
280.82
 
 
248.47
 
 
 
 
 
 
 
 
(1) - annualized
 
 
 
 
 
 


Nonperforming Assets (Loans and Other Real Estate Owned)

Nonperforming loans include loans on which interest is no longer accrued and accruing loans that are contractually past due 90 days or more. Nonperforming loans include loans originated and loans acquired.

Nonperforming loans to total loans were 0.55% at September 30, 2014 and 0.64% at December 31, 2013.

Nonperforming assets include nonperforming loans and foreclosed real estate.  Nonperforming assets represented 0.52% of total assets at September 30, 2014, down from 0.65% at December 31, 2013.

In most cases, it is the policy of the Company that any loan that becomes 90 days past due will automatically be placed on nonaccrual loan status, accrued interest reversed out of income, and further interest accrual ceased. Any payments received on such loans will be credited to principal. In some cases a loan in process of renewal may become 90 days past due. In these instances the loan may still be accruing because of a delayed renewal process in which the customer has not been billed. Loans will only be restored to full accrual status after nine consecutive months of payments that were each less than 30 days delinquent.

The $4,494,000 in nonaccrual loans shown on the following table includes: $3,171,000 in impaired loans individually evaluated for impairment; $756,000 in nonaccrual loan pools of smaller balance, homogenous loans, which were collectively evaluated for impairment (based on their collateral position and an improving payment history that still warrants nonaccrual status under internal policy guidelines, these loans were considered to have no dollar impairment); and $567,000 in loans with deteriorated credit quality acquired from the MidCarolina 2011 merger.

The following table presents the Company's nonperforming assets.


Nonperforming Assets
 
(in thousands)
 
 
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
Nonaccrual loans:
 
   
 
  Real estate
 
$
4,490
   
$
5,060
 
  Commercial
   
2
     
11
 
  Consumer
   
2
     
-
 
    Total nonaccrual loans
   
4,494
     
5,071
 
 
               
Loans past due 90 days
               
  and accruing interest:
   
-
     
-
 
 
               
Total nonperforming loans
   
4,494
     
5,071
 
 
               
Foreclosed real estate
   
2,364
     
3,422
 
 
               
Total nonperforming assets
 
$
6,858
   
$
8,493
 

39

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 the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The following table shows loans that were considered impaired, exclusive of acquired impaired loans.

Impaired Loans
 
(in thousands)
 
 
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
 
 
   
 
Accruing
 
$
878
   
$
958
 
Nonaccruing
   
3,928
     
5,071
 
Total impaired loans
 
$
4,806
   
$
6,029
 
 
               

Included in the impaired loan totals were $2,308,000 in troubled debt restructured loans at September 30, 2014 and $2,100,000 at December 31, 2013.


Other Real Estate Owned (Foreclosed Assets)

Foreclosed assets were $2,364,000 and $3,422,000 as of September 30, 2014 and December 31, 2013, respectively. Foreclosed assets are initially recorded at fair value, less estimated costs to sell, at the date of foreclosure. Loan losses resulting from foreclosure are charged against the ALLL at that time. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of the new cost basis or fair value, less estimated costs to sell with any additional write-downs charged against earnings.   For significant assets, these valuations are typically outside annual appraisals.

The following table shows the Company's Other Real Estate Owned.

Other Real Estate Owned
 
(in thousands)
 
 
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
 
 
   
 
Construction and land development
 
$
1,647
   
$
1,683
 
1-4 family residential
   
556
     
1,400
 
Commercial real estate
   
161
     
339
 
 
 
$
2,364
   
$
3,422
 
 
               

Deposits

The Company's deposits consist primarily of checking, money market, savings, and consumer time deposits.  Total deposits were $1,051,060,000 at September 30, 2014 compared to $1,057,675,000 at December 31, 2013, a decrease of $6,615,000 or 0.6%. The decline in deposits is mostly related to lower levels of time deposits.  The Company will adjust its time deposit pricing strategy appropriately with current market conditions and the liquidity requirements for the Bank. The Company's primary focus on the liability side of the balance sheet is growing core deposits and their affiliated relationships. The challenge in this ongoing low rate environment is to fund the Bank in a cost effective and competitive manner. The Company's cost of deposits for the third quarter 2014 was 0.55%, down from 0.64% for the third quarter 2013.


Shareholders' Equity

The Company's capital management strategy is to be classified as "well capitalized" under regulatory capital ratios and provide as high as possible total return to shareholders.

Shareholders' equity was $173,165,000 at September 30, 2014 compared to $167,551,000 at December 31, 2013, an increase of $5,614,000 or 3.4%.

The Company paid cash dividends of $0.69 per share during the first nine months of 2014 while the aggregate basic and diluted earnings per share for the same period was $1.25 per share.

Banking regulators have defined minimum regulatory capital ratios that the Company and its banking subsidiary are required to maintain.  These ratios take into account risk factors identified by those regulatory authorities associated with the assets and off-balance sheet activities of financial institutions.  The guidelines require percentages, or "risk weights," be applied to those assets and off-balance sheet assets in relation to their perceived risk.  Under the guidelines, capital strength is measured in two tiers.  Tier 1 capital consists primarily of shareholders' equity and trust preferred capital notes, while Tier 2 capital consists of qualifying allowance for loan losses.  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 trust preferred securities), less certain intangibles and other adjustments.  The remainder, Tier 2 capital, consists of cumulative preferred stock, long-term perpetual preferred stock, a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance.  "Total" capital is the combination of Tier 1 and Tier 2 capital.  Another regulatory indicator of capital adequacy is the leverage ratio, which is computed by dividing Tier 2 capital by average quarterly assets less intangible assets.

40

The regulatory guidelines require that minimum total capital (Tier 1 plus Tier 2) of 8% be held against total risk-adjusted assets, at least half of which (4%) must be Tier 1 capital.  At September 30, 2014, the Company's Tier 1 and total capital ratios were 17.04% and 18.30%, respectively.  At December 31, 2013, these ratios were 16.88% and 18.14%, respectively.  The ratios for both periods were in excess of the regulatory requirements.  The Company's leverage ratio was 12.29% and 11.81% at September 30, 2014 and December 31, 2013, respectively.  The leverage ratio has a regulatory minimum of 4%, with most institutions required to maintain a ratio of 4-5%, depending upon risk profiles and other factors.

As mandated by bank regulations, the following five capital categories are identified for insured depository institutions:  "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized."  These regulations require the federal banking regulators to take prompt corrective action with respect to insured depository institutions that do not meet minimum capital requirements. Under the regulations, well capitalized institutions must have Tier 1 risk-based capital ratios of at least 6%, total risk-based capital ratios of at least 10%, and leverage ratios of at least 5%, and not be subject to capital directive orders. Management believes, as of September 30, 2014, that the Company met the requirements to be considered "well capitalized."

Stock Repurchase Program

In prior years the Company had, in the normal course of business, operated certain stock repurchase programs. On April 17, 2014, the Company filed a Form 8-K with the SEC to announce the approval by its Board of Directors of a stock repurchase program. The program authorizes the repurchase of up to 250,000 shares of the Company's common shares over a two year period. The share purchase limit is equal to approximately 3% of the 7.9 million shares then outstanding at the time the Board approved the program.

Between late April and late May, 2014, the plan repurchased 69,784 shares at an average cost of $21.45 per share, for a total cost of approximately $1.5 million. Repurchase transactions have been consistently executed at less than book value per common share.

In early June 2014, the Company elected to establish a 10b5-1 plan with Raymond James & Associates, Inc. ("Raymond James").  This plan operated until October 31, 2014. The plan authorized Raymond James to buy on behalf of the Company, even during closed window periods, subject to certain price and volume limitations. The maximum number of shares that could be purchased under the 10b5-1 plan was 50,000 shares.  Raymond James  purchased 400 shares under the 10b5-1 plan in October 2014.


Liquidity

Liquidity is the ability of the Company to convert assets into cash or cash equivalents without significant loss and to raise additional funds by increasing liabilities in a timely manner.  Liquidity management involves maintaining the Company's ability to meet the daily cash flow requirements of its customers, whether they are borrowers requiring funds or depositors desiring to withdraw funds.  Additionally, the Company requires cash for various operating needs including dividends to shareholders, the servicing of debt, and the payment of general corporate expenses.  The Company manages its exposure to fluctuations in interest rates through policies approved by the Asset Liability Committee ("ALCO") and Board of Directors, both of which receive periodic reports of the Company's interest rate risk and liquidity position.  The Company uses a computer simulation model to assist in the management of the future liquidity needs of the Company. 

Liquidity sources include on balance sheet and off balance sheet sources.

Balance sheet liquidity sources include cash, amounts due from banks, loan repayments, and increases in deposits. The Company also maintains a large, high quality, very liquid bond portfolio, which is generally 50% to 60% unpledged and would, accordingly, be available for sale if necessary.     

Off balance sheet sources include lines of credit from the Federal Home Loan Bank of Atlanta ("FHLB"), federal funds lines of credit, and access to the Federal Reserve Bank of Richmond's discount window. 

The Company has a line of credit with the FHLB, equal to 30% of the Bank's assets, subject to the amount of collateral pledged.  Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans and home equity lines of credit.  In addition, the Company pledges as collateral its capital stock in and deposits with the FHLB.  At September 30, 2014, principal advance obligations to the FHLB consisted of $9,930,000 in fixed-rate, long-term advances compared to $9,951,000 in fixed-rate advances at December 31, 2013.  The Company also had outstanding $72,700,000 in letters of credit at September 30, 2014 and at December 31, 2013. The letters of credit provide the Bank with alternate collateral for securing public entity deposits above FDIC insurance levels, thereby providing less need for collateral pledging from the securities portfolio.

Short-term borrowings are discussed in Note 7 and long-term borrowings are discussed in Note 8 in the Consolidated Financial Statements included in this report.

The Company has federal funds lines of credit established with two correspondent banks in the amounts of $15,000,000 and $10,000,000, and has access to the Federal Reserve Bank's discount window.  There were no amounts outstanding under these facilities at September 30, 2014.

The Company acquired a relationship with Promontory Network, the sponsoring entity for the Certificate of Deposit Account Registry Service® ("CDARS"). Through CDARS, the Company is able to provide deposit customers with access to aggregate FDIC insurance in amounts exceeding $250,000.  This gives the Company the ability, as and when needed, to attract and retain large deposits from insurance and other safety conscious customers.  CDARS are classified as brokered deposits, however they are generally derived from customers with whom the Company has or wishes to have a direct and ongoing relationship.  As a result, management considers these deposits functionally, though not technically, in the same category as core deposits. With CDARS, the Company has the option to keep deposits on balance sheet or sell them to other members of the network.   Additionally, subject to certain limits, the Bank can use CDARS to purchase cost-effective funding without collateralization and in lieu of generating funds through traditional brokered CDs or the FHLB.  In this manner, CDARS can provide the Company with another funding option. Thus, CDARS serves as a deposit-gathering tool and an additional liquidity management tool.  Deposits through the CDARS program as of September 30, 2014 and December, 31, 2013, were $23,397,000 and $22,375,000, respectively.

     Management believes that these sources provide sufficient and timely liquidity, both on and off balance sheet.

41


Off-Balance-Sheet Activities

The Company enters into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions.  Other than subsidiaries to issue trust preferred securities, the Company does not have any off-balance sheet subsidiaries.  Off-balance sheet transactions were as follows (in thousands):

 
 
September 30,
   
December 31,
 
 
 
2014
   
2013
 
 
 
   
 
Commitments to extend credit
 
$
180,034
   
$
179,272
 
Standby letters of credit
   
3,907
     
3,405
 
Mortgage loan rate-lock commitments
   
6,282
     
5,913
 
 
               



Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates or other termination clauses.  Since many of the commitments are expected to expire without being funded, the total commitment amounts do not necessarily represent future funding requirements.  Standby letters of credit are conditional commitments issued by the Company guaranteeing the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements.


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLSOURES ABOUT MARKET RISK


Market Risk Management


Effectively managing market risk is essential to achieving the Company's financial objectives.  Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices.  The Company is generally not subject to currency exchange risk or commodity price risk.  The Company's primary market risk exposure is interest rate risk; however, market risk also includes liquidity risk.  Both are discussed in the following sections.

Interest Rate Risk Management

Interest rate risk and its impact on net interest income is a primary market risk exposure.  The Company manages its exposure to fluctuations in interest rates through policies approved by its ALCO and Board of Directors, both of which receive and review periodic reports of the Company's interest rate risk position.
 The Company uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates.  Simulation takes into account current balance sheet volumes and the scheduled repricing dates instrument level optionality, and maturities of assets and liabilities.  It incorporates numerous assumptions including growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid.  Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered asset sensitive when its earning assets (loans and securities) reprice faster or to a greater extent than its liabilities (deposits and borrowings).  An asset sensitive balance sheet will produce relatively more net interest income when interest rates rise and less net interest income when they decline.  Based on the Company's simulation analysis, management believes the Company's interest sensitivity position at September 30, 2014 is asset sensitive.  Management has no expectation that market interest rates will materially decline in the near term, given the prevailing economy and apparent policy of the Board of Governors of the Federal Reserve System.

42

Earnings Simulation

The following tables shows the estimated impact of changes in interest rates on net interest income as of September 30, 2014 assuming instantaneous rate shocks, and consistent levels of assets and liabilities.  Net interest income for the following twelve months is projected to increase when interest rates are higher than current rates.

Estimated Changes in Net Interest Income
 
(dollars in thousands)
 
 
 
   
 
 
 
September 30, 2014
 
 
 
Change in Net Interest Income
 
 
 
   
 
Change in interest rates
 
Amount
   
Percent
 
 
 
   
 
Up 4.00%
 
$
6,935
     
16.7
%
Up 3.00%
   
5,182
     
12.5
%
Up 2.00%
   
3,412
     
8.2
%
Up 1.00%
   
1,606
     
3.9
%
Flat
   
-
     
-
 
Down 0.25%
   
(537
)
   
-1.3
%
Down 0.50%
   
(1,242
)
   
-3.0
%


Management cannot predict future interest rates or their exact effect on net interest income.  Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results.  Certain limitations are inherent in such computations.  Assets and liabilities may react differently than projected to changes in market interest rates.   The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates.  Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect the Company's interest rate sensitivity position.  Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

Economic Value Simulation

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.
The following table reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the period ended September 30, 2014 (dollars in thousands):

Estimated Changes in Economic Value of Equity
 
(dollars in thousands)
 
 
 
   
   
 
 
 
September 30, 2014
 
 
 
   
   
 
Change in interest rates
 
Amount
   
$ Change
   
% Change
 
 
 
   
   
 
Up 4.00%
 
$
223,029
   
$
28,283
     
14.5
%
Up 3.00%
   
218,409
     
23,663
     
12.2
%
Up 2.00%
   
212,300
     
17,554
     
9.0
%
Up 1.00%
   
204,044
     
9,298
     
4.8
%
Flat
   
194,746
     
-
     
-
 
Down 0.25%
   
191,344
     
(3,402
)
   
-1.7
%
Down 0.50%
   
186,910
     
(7,836
)
   
-4.0
%

     Increases in interest rates over the past two quarters have had a negative impact on the economic value of the Company's assets. However, this has been more than offset by the positive impact the rate increases have had on the economic value of the Company's liabilities.

     Due to the current low interest rate environment, no measurement was considered necessary for a further decline in interest rates.

     There have been no material changes to market risk as disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.  Refer to those disclosures for further information.

43


ITEM 4.  CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
The Company's management, including the Chief Executive Officer and Chief Financial Officer, evaluated the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of September 30, 2014. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms.  There were no significant changes in the Company's internal controls over financial reporting that occurred during the quarter ended September 30, 2014, that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting.
PART II. OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

The nature of the business of the Company ordinarily results in a certain amount of litigation. The Company is involved in various legal proceedings, all of which are considered incidental to the normal conduct of business. Management believes that these proceedings will not have a material adverse effect on the consolidated financial position or consolidated results of operations of the Company.

ITEM 1A.  RISK FACTORS

        There have been no material changes to the risk factors disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on March 12, 2014.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

       On April 17, 2014, the Company's Board of Directors authorized a share repurchase program of up to 250,000 shares of the Company's outstanding common stock for a period of two years.  Repurchases may be made through open market purchases or in privately negotiated transactions, and shares repurchased will be returned to the status of authorized and unissued shares of common stock.  The actual timing, number, and value of shares repurchased under the program will be determined by management.

The following schedule summarizes the Company's total monthly stock repurchase activity for the three months ended September 30, 2014:


Period Beginning on First Day of Month Ended
 
Total Number of Shares Purchased
   
Average Price Paid Per Share
   
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
   
Maximum Number of Shares that May Yet Be Purchased Under Plans or Programs
 
 
 
   
   
   
 
August
   
400
     
21.04
     
400
     
179,816
 
Total
   
400
   
$
21.04
     
400
         


ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

  None

ITEM 4.  MINE SAFETY DISCLOSURES

  Not applicable

ITEM 5.  OTHER INFORMATION

 (a)  Required 8-K disclosures
       None
 (b)  Changes in Nominating Process
       None

ITEM 6.  EXHIBITS

11.0 Refer to EPS calculation in the Notes to Financial Statements
31.1 Section 302 Certification of Jeffrey V. Haley, President and Chief Executive Officer
31.2 Section 302 Certification of William W. Traynham, Senior Vice President and Chief Financial Officer
32.1 Section 906 Certification of Jeffrey V. Haley, President and Chief Executive Officer
32.2 Section 906 Certification of William W. Traynham, Senior Vice President and Chief Financial Officer
101            Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of September 30, 2014, December 31, 2013 and September 30, 2013, (ii) the Consolidated Statements of Income for the three and nine months ended September 30, 2014 and September 30, 2013, (iii) the Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2014 and September 30, 2013, (iv) the Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2014 and September 30, 2013, (v) the Consolidated   Statements of Cash Flows for the nine months ended September 30, 2014 and September 30, 2013 and (vi) the Notes to the Consolidated Financial Statements (furnished herewith).

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SIGNATURES

Pursuant to the requirements 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.

AMERICAN NATIONAL BANKSHARES INC.

 
 
 
 
 
 
 
 
 
 
/s/ Jeffrey V. Haley
 
 
Jeffrey V. Haley
 
Date – November 10, 2014
President and Chief Executive Officer
 
 
 
 
 
/s/ William W. Traynham
 
 
William W. Traynham
 
 
Senior Vice President and
 
Date – November 10, 2014
Chief Financial Officer
 








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