Exhibit 13.1

ALARION FINANCIAL SERVICES, INC.

Holding Company for

Audited Consolidated Financial Statements

At December 31, 2010 and 2009 and For the Years Then Ended

(Together with Report of Independent Registered Public Accounting Firm)

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Alarion Financial Services, Inc.

Ocala, Florida:

We have audited the accompanying consolidated balance sheets of Alarion Financial Services, Inc. and Subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company at December 31, 2010 and 2009, and the results of its operations and its cash flows for years then ended, in conformity with U.S. generally accepted accounting principles.

HACKER, JOHNSON & SMITH PA

Tampa, Florida

March 30, 2011

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

($ in thousands, except per share amounts)

 

		At December 31,
		2010				2009
Assets
Cash and due from banks		$	3,127				3,993
Interest-bearing time deposits in banks			—				5,895
Interest-earning deposits			262				285
Federal funds sold			3,015				11,925
Cash and cash equivalents			6,404				22,098
Interest-bearing time deposits in banks			—				2,287
Securities available for sale			49,304				31,282
Loans, net of allowance for loan losses of $4,115 and $3,035			213,069				228,355
Loans held for sale			7,395				6,325
Accrued interest receivable			903				939
Premises and equipment, net			13,418				13,310
Other real estate owned, net			6,359				1,583
Federal Home Loan Bank stock, at cost			1,409				1,499
Deferred income taxes			3,347				1,156
Other assets			1,382				1,749
Total assets		$	302,990				310,583
Liabilities and Stockholders’ Equity
Liabilities:
Noninterest-bearing demand deposits			26,778				18,136
NOW, money-market and savings deposits			76,476				73,537
Time deposits less than $100,000			89,016				97,322
Time deposits greater than $100,000			59,074				60,994
Total deposits			251,344				249,989
Federal Home Loan Bank advances			21,000				21,000
Other borrowings			3,054				7,633
Accrued interest payable			436				640
Accrued expenses and other liabilities			522				615
Total liabilities			276,356				279,877
Commitments (Notes 4, 10 and 19)
Stockholders’ equity:
Preferred stock, $.01 par value; 1,000,000 shares authorized:
Preferred stock, Series A, $.01 par value; $1,000 liquidation value; 6,514 shares outstanding in 2010			—				—
Preferred stock, Series B, $.01 par value; $1,000 liquidation value; 326 shares outstanding in 2010			—				—
Additional paid-in capital, preferred			6,840				6,840
Preferred stock discount			(200	)			(265	)
Common stock, $.01 par value; 4,000,000 shares authorized, 2,653,208 shares issued and outstanding in 2010 and 2009			27				27
Additional paid-in capital, common			26,693				26,680
Accumulated deficit			(6,111	)			(2,531	)
Accumulated other comprehensive loss			(615	)			(45	)
Total stockholders’ equity			26,634				30,706
Total liabilities and stockholders’ equity		$	302,990				310,583

See Accompanying Notes to Consolidated Financial Statements.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(In thousands, except per share amounts)

 

		Year Ended December 31,
		2010				2009
Interest income:
Loans		$	12,668				12,921
Securities			1,240				844
Other			60				496
Total interest income			13,968				14,261
Interest expense:
Deposits			4,334				5,916
Borrowings			696				816
Total interest expense			5,030				6,732
Net interest income			8,938				7,529
Provision for loan losses			6,635				1,012
Net interest income after provision for loan losses			2,303				6,517
Noninterest income:
Deposit account fees			372				377
Net gain on sale of securities			478				227
Net gain on sales of loans held for sale			1,368				877
Other			262				41
Total noninterest income			2,480				1,522
Noninterest expenses:
Salaries and employee benefits			4,084				3,573
Occupancy and equipment			1,222				1,127
Data processing			606				584
Professional services			518				278
Advertising and promotion			175				142
Office supplies and printing			126				112
Impairment of Silverton Bank stock			—				625
Other real estate owned expense			1,366				132
FDIC assessment			485				498
Other			1,210				904
Total noninterest expenses			9,792				7,975
(Loss) earnings before income tax (benefit) expense			(5,009	)			64
Income tax (benefit) expense			(1,849	)			57
Net (loss) earnings			(3,160	)			7
Preferred stock dividend requirements and accretion of preferred stock to par			420				396
Loss available to common shareholders		$	(3,580	)			(389	)
Loss per common share – basic and diluted		$	(1.35	)			(0.15	)
Weighted-average number of common shares outstanding, basic and diluted			2,653,208				2,653,208
Dividends per common share			—				—

See Accompanying Notes to Consolidated Financial Statements.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

Years Ended December 31, 2010 and 2009

($ in thousands)

 

																																										Accumulated Other Comprehensive Income (Loss)				Total Stockholders’ Equity
		Preferred Stock																								Common Stock
		Series A								Series B								Additional Paid-in																Additional Paid-In				Accumulated
		Shares				Amount				Shares				Amount				Capital				Discount				Shares				Amount				Capital				Deficit
Balance at December 31, 2008			—			$	—				—			$	—				—				—				2,653,208			$	27				26,613				(2,142	)			138				24,636
Comprehensive loss:
Net earnings			—				—				—				—				—				—				—				—				—				7				—				7
Net change in unrealized gain on securities available for sale, net of taxes of $110			—				—				—				—				—				—				—				—				—				—				(183	)			(183	)
Comprehensive loss																																															(176	)
Share-based compensation			—				—				—				—				—				—				—				—				67				—				—				67
Proceeds from issuance of 6,514 shares of Series A preferred stock to U.S. Treasury			6,514				—				—				—				6,514				—				—				—				—				—				—				6,514
Preferred stock warrants exercised by U.S. Treasury			—				—				326				—				326				(326	)			—				—				—				—				—				—
Preferred stock dividend requirements and Series B preferred stock accretion			—				—				—				—				—				61				—				—				—				(396	)			—				(335	)
Balance at December 31, 2009			6,514			$	—				326			$	—				6,840				(265	)			2,653,208			$	27				26,680				(2,531	)			(45	)			30,706

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity, Continued

Years Ended December 31, 2010 and 2009

($ in thousands)

 

																																										Accumulated Other Comprehensive Income (Loss)				Total Stockholders’ Equity
		Preferred Stock																				Common Stock
		Series A								Series B								Additional Paid-in Capital																Additional Paid-In Capital				Accumulated Deficit
		Shares				Amount				Shares				Amount								Discount				Shares				Amount
Balance at December 31, 2009			6,514			$	—				326			$	—				6,840				(265	)			2,653,208			$	27				26,680				(2,531	)			(45	)			30,706
Comprehensive loss:
Net loss			—				—				—				—				—				—				—				—				—				(3,160	)			—				(3,160	)
Net change in unrealized gain on securities available for sale, net of taxes of $342			—				—				—				—				—				—				—				—				—				—				(570	)			(570	)
Comprehensive loss																																															(3,730	)
Share-based compensation			—				—				—				—				—				—				—				—				13				—				—				13
Preferred stock dividend requirements and Series B preferred stock accretion			—				—				—				—				—				65				—				—				—				(420	)			—				(355	)
Balance at December 31, 2010			6,514			$	—				326			$	—				6,840				(200	)			2,653,208			$	27				26,693				(6,111	)			(615	)			26,634

See Accompanying Notes to Consolidated Financial Statements.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In thousands)

 

		Year Ended December 31,
		2010				2009
Cash flows from operating activities:		$	(3,160	)			7
Net (loss) earnings
Adjustments to reconcile net (loss) earnings to net cash provided by (used in) operating activities:
Provision for loan losses			6,635				1,012
Share-based compensation			13				67
Depreciation and amortization			626				626
Gain on sale of loans held for sale			(1,368	)			(877	)
Loans originated for sale			(66,533	)			(61,438	)
Proceeds from loans sold			66,831				58,505
Deferred income tax (benefit) expense			(1,849	)			57
Net amortization of deferred loan fees and costs			97				54
Loss on sale of other real estate owned			29				12
Provision for other real estate owned losses			1,217				76
Net decrease in accrued interest payable			(204	)			(478	)
Net decrease (increase) in accrued interest receivable			36				(208	)
Net decrease (increase) in other assets			367				(1,491	)
Impairment of Silverton Bank stock			—				625
Net gain on sale of securities			(478	)			(227	)
Net (decrease) increase in accrued expenses and other liabilities			(93	)			228
Net amortization of premiums and discounts on securities available for sale			534				122
Net cash provided by (used in) operating activities			2,700				(3,328	)
Cash flows from investing activities:
Purchase of securities available for sale			(52,310	)			(31,296	)
Proceeds from principal repayments and maturities on securities available for sale			10,970				8,480
Proceeds from sale of securities available for sale			22,350				4,469
Net decrease in time deposits in banks			2,287				10,123
Net decrease (increase) in loans			2,346				(27,712	)
Purchase of premises and equipment			(734	)			(332	)
Proceeds from sale of other real estate owned			186				63
Purchase (redemption) of Federal Home Loan Bank stock			90				(143	)
Net cash used in investing activities			(14,815	)			(36,348	)
Cash flows from financing activities:
Net increase in deposits			1,355				47,075
Net (decrease) increase in other borrowings			(4,579	)			49
Net decrease in Federal Home Loan Bank advances			—				(1,000	)
Proceeds from preferred stock issued			—				6,514
Preferred stock dividend requirements and Series B stock accretion			(355	)			(335	)
Net cash (used in) provided by financing activities			(3,579	)			52,303
Net (decrease) increase in cash and cash equivalents			(15,694	)			12,627
Cash and cash equivalents at beginning of year			22,098				9,471
Cash and cash equivalents at end of year		$	6,404				22,098

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows, Continued

(In thousands)

 

		Year Ended December 31,
		2010				2009
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest		$	5,234				7,210
Income taxes		$	—				—
Noncash transactions:
Accumulated other comprehensive loss, net change in unrealized loss on securities available for sale, net of taxes		$	(570	)			(183	)
Transfer of loans to other real estate owned		$	6,397				1,147
Transfer of other real estate owned to loans		$	189				64

See Accompanying Notes to Consolidated Financial Statements.

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

At December 31, 2010 and 2009 and for the Years Then Ended

(1) Summary of Significant Accounting Policies

Organization. Alarion Financial Services, Inc. (the “Holding Company”) owns 100% of the outstanding common stock of Alarion Bank (the “Bank”) and North Central Florida Developers Corporation. The Holding Company’s primary activity is the operation of the Bank and North Central Florida Developers Corporation. The Bank is a state (Florida)-chartered commercial bank. The Bank offers a variety of banking and financial services to individual and corporate customers through its six banking offices located in Ocala, Gainesville and Alachua, Florida. The deposit accounts of the Bank are insured up to the applicable limits by the Federal Deposit Insurance Corporation. North Central Florida Developers Corporation holds loans or assets that might require a longer term hold to realize full economic value.

Basis of Presentation. The accompanying consolidated financial statements include the accounts of the Holding Company, the Bank and North Central Florida Developers Corporation (collectively, the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting practices of the Company conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The following summarizes the more significant of these polices and practices.

Use of Estimates. In preparing consolidated financial statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses and the valuation of deferred tax assets and other real estate owned.

Cash and Cash Equivalents. For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash and balances due from banks, interest-earning deposits (including time deposits with original maturities of ninety days or less) and federal funds sold, all of which mature within ninety days.

At December 31, 2010 and 2009, the Bank was not required by law or regulation to maintain cash reserves with the Federal Reserve Bank, in accounts with other banks or in the vault.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Securities. Securities may be classified as either trading, held to maturity or available for sale. Securities that are held principally for resale in the near term are considered trading securities and recorded at fair value with changes in fair value recorded in operations. Debt securities that the Company has the positive intent and ability to hold to maturity are classified as “held to maturity” and are reported at amortized cost. Available-for-sale securities consist of securities not classified as trading securities nor as held-to-maturity securities. Unrealized holding gains and losses, net of tax, on available-for-sale securities are excluded from operations and reported in accumulated other comprehensive income (loss). Gains and losses on the sale of available-for-sale securities are recorded on the trade date and are determined using the specific-identification method. Purchase premiums and discounts are recognized in interest-income using the interest method over the terms of the securities.

Loans. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs.

Loan origination fees are capitalized and certain direct origination costs are deferred. Both are recognized as an adjustment of the yield of the related loan.

For loans amortized at cost, interest income is accrued based on the unpaid principal balance.

The accrual of interest on loans is discontinued at the time the loan is ninety days delinquent unless the loan is well collateralized and in process of collection. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Past due status is based on contractual terms of the loan.

All interest accrued but not collected for loans that are placed on nonaccrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. There were no changes in the Company’s accounting policies or methodology during the year ended December 31, 2010.

Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to operations. Loan losses will be charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, will be credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Allowance for Loan Losses, Continued. The allowance consists of specific and general components. The specific component relates to loans that are considered impaired. For such loans, an allowance is established when the discounted cash flows or the collateral value of the impaired loan is lower than the carrying value of that loan.

For all loans the general component is based on historical loss experience and adjusted for the following qualitative factors: changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off and recovery practices not considered elsewhere in estimating credit losses; changes in international, national, regional, and local economic and business conditions that affect the collectability of the portfolio, including the condition of various market segments; changes in the nature and volume of the portfolio and in the terms of the loans; changes in the experience, ability, and depth of lending management and other relevant staff; changes in the volume and severity of past due loans, the volume of nonaccrual loans, and the volume and severity of adversely classified or graded loans; changes in the quality of the Company’s loan review system; changes in the value of the underlying collateral for collateral-dependent loans; the existence and effect of any concentrations of credit, and changes in the level of such concentrations; the effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the Company’s existing portfolio, and other trends or uncertainties that could affect management’s estimate of probable losses.

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. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Impairment is measured on a loan-by-loan basis for commercial, commercial real estate and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral-dependent.

Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual residential real estate, home equity or consumer loans for impairment disclosures.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Loans Held for Sale. The Company has a mortgage division within the Bank to originate and sell residential mortgage loans in the secondary market. Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate, determined by outstanding commitments from investors or current investors yield requirements. The Company enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate-lock commitments). Rate-lock commitments on mortgage loans that are intended to be sold are considered to be derivatives in accordance with GAAP. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of loans held for sale. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The effect was not material to the Company’s consolidated financial statements for the years ended December 31, 2010 or 2009.

Loan origination fees are deferred and direct loan origination costs are capitalized until the related loan is sold, at which time the net fees are included in the net gain on sale of loans held for sale in the consolidated statements of operations.

Premises and Equipment. Land is stated at cost. Other premises, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Interest costs are capitalized in connection with construction of new banking offices. Depreciation and amortization expense are computed using the straight-line method over the shorter of the estimated useful life of each type of asset or related lease term which includes certain renewal options.

Other Real Estate Owned. Other real estate owned represents assets acquired through foreclosure and is initially recorded at fair value less selling costs at the date of foreclosure, establishing a new cost basis. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of the new costs basis or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in operations.

Comprehensive (Loss) Income. GAAP requires that recognized revenue, expenses, gains and losses be included in net (loss) earnings. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the consolidated balance sheet, such items, along with net (loss) earnings, are components of comprehensive income (loss).

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Comprehensive (Loss) Income, Continued. The components of accumulated other comprehensive (loss) income and related tax effects are as follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Unrealized holding losses on available for sale securities		$	(434	)			(66	)
Reclassification adjustment for gains realized in operations			(478	)			(227	)
Net change in unrealized losses			(912	)			(293	)
Income tax effect			342				110
Net unrealized loss		$	(570	)			(183	)

The reclassification adjustment above relates to gains on investment securities that were realized and included in net earnings in 2010 that also had been included in other comprehensive loss as unrealized holding gains in the period in which they arose. These gains must be deducted through other comprehensive loss of the period in which they are included in net earnings to avoid including them in comprehensive loss twice.

Transfer of Financial Assets. Transfers of financial assets or a participating interest in an entire financial asset are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. A participating interest is a portion of an entire financial asset that (1) conveys proportionate ownership rights with equal priority to each participating interest holder (2) involves no recourse (other than standard representations and warranties) to, or subordination by, any participating interest holder, and (3) does not entitle any participating interest holder to receive cash before any other participating interest holder.

Income Taxes. There are two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Income Taxes, Continued. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more-likely-than-not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance if, based on the weight of evidence available, it is more likely than not that some portion or all of a deferred tax asset will not be realized.

On January 1, 2009, the Company adopted accounting guidance relating to accounting for uncertainty in income taxes, which sets out a consistent framework to determine the appropriate level of tax reserves to maintain for uncertain tax positions. As of December 31, 2010, management is not aware of any uncertain tax positions that would have a material effect on the Company’s financial statements.

The Company recognizes interest and penalties on income taxes as a component of income taxes.

The Holding Company, North Central Florida Developers Corporation and the Bank file consolidated income tax returns. Income taxes are allocated between the Holding Company and its subsidiaries as though separate income tax returns were filed.

Stock Compensation Plan. The Company has adopted the fair value recognition method and expenses the fair value of any stock options as they vest and in the accompanying consolidated statements of operations.

Loss Per Common Share. Loss per common share (“EPS”) has been computed on the basis of the weighted-average number of shares of common stock outstanding. Outstanding stock options and warrants were not considered dilutive securities for 2010 and 2009 due to the fact that there was a loss available to common shareholders.

Off-Balance-Sheet Instruments. In the ordinary course of business the Company has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, unused lines of credit and standby letters of credit. Such financial instruments are recorded in the consolidated financial statements when they are funded.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Fair Value Measurements. Fair value is the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The fair value hierarchy requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The hierarchy describes three levels of inputs that may be used to measure fair value:

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities that are not active. Such inputs may include interest rates and yield curves, volatilities, prepayment speeds, credit risks, and default rates.

Level 3: Unobservable inputs to measure fair value of assets and liabilities for which there is little, if any market activity at the measurement date, using reasonable inputs and assumptions based upon the best information at the time, to the extent that inputs are available without undue cost and effort.

The following describes valuation methodologies used for assets and liabilities measured at fair value:

Securities Available for Sale. Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, certain mortgage products and exchange-traded equities. If quoted market prices are not available, then fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Examples of such instruments, which would generally be classified within Level 2 of the valuation hierarchy, include certain collateralized mortgage and debt obligations and certain high-yield debt securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. Securities classified within Level 3 include certain residual interests in securitizations and other less liquid securities.

Impaired Loans. Estimates of fair value are determined based on a variety of information, including the use of available appraisals, estimates of market value by licensed appraisers or local real estate brokers and the knowledge and experience of the Company’s management related to values of properties in the Company’s market areas. Management takes into consideration the type, location and occupancy of the property as well as current economic conditions in the area the property is located in assessing estimates of fair value. Accordingly, fair value estimates for impaired loans is classified as Level 3.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Fair Value Measurements, Continued.

Other Real Estate Owned. Estimates of fair values are determined based on a variety of information, including the use of available appraisals, estimates of market value by licensed appraisers or local real estate brokers and the knowledge and experience of the Company’s management related to values of properties in the Company’s market areas. Management takes into consideration the type, location and occupancy of the property as well as current economic conditions in the area the property is located in assessing estimates of fair value. Accordingly, the fair values estimates for other real estate owned are classified as Level 3.

Fair Values of Financial Instruments. The following methods and assumptions were used by the Company in estimating fair values of financial instruments:

Cash and Cash Equivalents and Interest Bearing Time Deposits in Banks. The carrying amounts of these financial instruments approximate their fair value.

Securities Available for Sale. The fair value for securities available for sale are based on the framework for measuring fair value.

Loans. For variable-rate loans that reprice frequently and have no significant change in credit risk, fair values are based on carrying values. Fair values for certain fixed-rate residential mortgage, commercial real estate and commercial loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair value for impaired loans are based on the framework for measuring fair value.

Loans Held for Sale. Loans held for sale, which are composed of residential first mortgage loans, are reported at the lower of cost or fair value on an aggregate loan portfolio basis. Gains or losses realized on the sales of loans held for sale are recognized at the time of sale and are determined by the difference between the net sales proceeds and the carrying value of the loans sold including any deferred origination fees and costs. Net unrealized losses, if any, are recognized through a market adjustment by charges to operations. Transfers of loans held for sale to the portfolio require a market value adjustment to be recognized in operations if the fair market value is less than the carrying value at the date of transfer.

Federal Home Loan Bank Stock. Fair value of the Company’s investment in Federal Home Loan Bank stock is based on its redemption value, which is its cost of $100 per share.

Deposits. The fair values disclosed for demand, NOW, money-market and savings deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). Fair values for fixed-rate time deposits are estimated using a discounted cash flow calculation that applies interest rates currently being offered on time deposits to a schedule of aggregated expected monthly maturities of time deposits.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(1) Summary of Significant Accounting Policies, Continued

 

Fair Values of Financial Instruments, Continued.

Other Borrowings. The carrying amounts of other borrowings approximates their fair value.

Federal Home Loan Bank Advances. Fair value of the advances from the Federal Home Loan Bank are estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rate for similar types of borrowings.

Accrued Interest. The carrying amounts of accrued interest approximate their fair values.

Off-Balance-Sheet Financial Instruments. Fair values for off-balance-sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Recent Pronouncements. In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements (Topic 820), which amends the guidance for fair value measurements and disclosures. The guidance in ASU 2010-06 requires a reporting entity to disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and to describe the reasons for the transfers. Furthermore, ASU 2010-06 requires a reporting entity to present separately information about purchases, sales, issuances, and settlements in the reconciliation for fair value measurements using significant unobservable inputs; clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value; and amends guidance on employers’ disclosures about postretirement benefit plan assets to require that disclosures be provided by classes of assets instead of by major categories of assets. The ASU was effective for interim and annual reporting periods beginning January 1, 2010, except for the disclosures about purchases, sales, issuances, and settlements in the rollforward of activity in Level 3 fair value measurements. Those disclosures were effective January 1, 2011 and for interim periods thereafter. In the period of initial adoption, entities will not be required to provide the amended disclosures for any previous periods presented for comparative purposes. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In July 2010, the FASB issued ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The new disclosures will require significantly more information about credit quality in a financial institution’s loan portfolio. This statement addresses only disclosures and does not change recognition or measurement of the allowance. For public entities, the disclosures as of the end of a reporting period was effective for interim and annual reporting periods ending on December 31, 2010. The disclosures about activity that occurs during a reporting period was effective for interim and annual reporting periods beginning on or after January 1, 2011. The adoption of the ASU did not have a material impact on the Company’s consolidated financial statements.

Reclassifications. Certain amounts in the 2009 financial statements have been reclassified to conform with the 2010 presentation.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(2) Securities Available for Sale

 

Securities available for sale have been classified according to management’s intent. The carrying amount and fair value of securities available for sale are as follows (in thousands):

 

		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Approximate Fair Value
At December 31, 2010-
Mortgage-backed securities		$	50,288				77				(1,061	)			49,304
At December 31, 2009:
U.S. Government agency securities			1,029				—				(24	)			1,005
Mortgage-backed securities			30,325				150				(198	)			30,277
		$	31,354				150				(222	)			31,282

Securities sold are as follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Gross proceeds		$	22,350				4,469
Gross gains			478				227
Gross losses			—				—
Total		$	478				227

Securities with gross unrealized losses at December 31, 2010, aggregated by investment category and length of time that individual securities have been in a continuous loss position, are as follows (in thousands):

 

Less Than Twelve Months

Over Twelve Months

Gross Unrealized Losses

Fair Value

Gross Unrealized Losses

Fair Value

Securities Available for Sale-

Mortgage-backed securities

$

1,061

44,778

—

—

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(2) Securities Available for Sale, Continued

 

The unrealized losses on twenty-three securities available for sale were caused by market conditions. It is expected that the securities would not be settled at a price less than the par value of the investments. Because the decline in fair value is attributable to changes in market conditions and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.

At December 31, 2010 and 2009, securities with a carrying value of approximately $10.5 million and $18.2 million, respectively, were pledged for other borrowings and public funds.

(3) Loans

The components of loans are as follows (in thousands):

 

		At December 31,
		2010				2009
Real estate loans:
Office/retail		$	43,687				41,832
Multi-family			9,518				9,886
Land			23,345				31,550
Line of credit			9,088				11,419
Other			54,953				49,503
Residential			32,667				30,033
Construction			4,819				15,400
Home equity			10,676				10,904
Commercial			20,587				22,406
Consumer			7,471				8,070
Total loans			216,811				231,003
Allowance for loan losses			(4,115	)			(3,035	)
Net deferred loan costs			373				387
Loans, net		$	213,069				228,355

The Company grants the majority of its loans to borrowers throughout Alachua and Marion Counties, Florida. Although the Company has a diversified loan portfolio, a significant portion of its borrowers’ ability to honor their contracts is dependent upon the economy in Alachua and Marion Counties, Florida. The Company does have eight acquisition and development loans, generally with original terms of three years or less, aggregating $9.5 million at December 31, 2010 and nine acquisition and development loans aggregating $12.8 million at December 31, 2009, for which the primary source of repayment is the sale of the related collateral or the conversion of the existing debt into debt at another financial institution. The majority of these loans are located in Alachua County.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(3) Loans, Continued

 

With the uncertain real estate market in Alachua and Marion Counties, in the short-term, obtaining refinancing or sale of the collateral may be difficult or impossible under terms acceptable to the borrower. It is likely many of these loans will be extended and may be modified to provide additional interest only periods. Management is closely monitoring these loans and believes the loan loss allowance at December 31, 2010 was adequate.

An analysis of the change in the allowance for loan losses follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Beginning balance		$	3,035				2,714
Provision for loan losses			6,635				1,012
Recoveries			261				1
Charge-offs			(5,816	)			(692	)
Ending balance		$	4,115				3,035

The following summarizes the loan credit quality at December 31, 2010 (in thousands):

 

		Office/ Retail				Multi- Family				Land				LOC				Other				Residential Real Estate				Construction				HELOC				Commercial				Consumer				Total
Credit Risk Profile by Internally Assigned Grade:
Grade:
Pass		$	38,560				9,518				13,812				5,365				49,605				30,908				3,895				10,627				18,450				6,769				187,509
Special mention			408				—				1,371				2,010				3,278				594				—				49				897				352				8,959
Substandard			4,719				—				8,162				1,713				2,070				1,165				924				—				1,240				350				20,343
Doubtful			—				—				—				—				—				—				—				—				—				—				—
Loss			—				—				—				—				—				—				—				—				—				—				—
Total		$	43,687				9,518				23,345				9,088				54,953				32,667				4,819				10,676				20,587				7,471				216,811

Internally assigned loan grades are defined as follows:

Pass – A Pass loan’s primary source of loan repayment is satisfactory, with secondary sources very likely to be realized if necessary.

Special Mention – A Special Mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in the deterioration of the repayment prospects for the asset or the Company’s credit position at some future date. Special Mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(3) Loans, Continued

 

Substandard – A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful – A loan classified Doubtful has all the weaknesses inherent in one classified Substandard with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss – A loan classified Loss is considered uncollectible and of such little value that continuance as a bankable asset is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.

Age analysis of past-due loans is as follows (in thousands):

 

		Accruing Loans
		30-59 Days Past Due				60-89 Days Past Due				Greater Than 90 Days Past Due				Total Past Due				Current				Nonaccrual Loans				Total Loans
At December 31, 2010:
Real estate loans:
Office/retail		$	392				2,620				—				3,012				40,206				469				43,687
Multi-family			—				—				—				—				9,518				—				9,518
Land			3,109				5				—				3,114				17,533				2,698				23,345
Line of credit			—				—				—				—				9,088				—				9,088
Other			—				—				—				—				53,417				1,536				54,953
Residential			496				358				—				854				31,031				782				32,667
Construction			—				—				—				—				4,819				—				4,819
Home equity			—				—				—				—				10,676				—				10,676
Commercial			91				—				—				91				20,338				158				20,587
Consumer			144				194				—				338				6,944				189				7,471
Total		$	4,232				3,177				—				7,409				203,570				5,832				216,811
December 31, 2009 comparative totals		$	392				435				—				827				227,334				2,892				231,003

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(3) Loans, Continued

 

The following summarizes the amount of impaired loans (in thousands):

 

		With No Related Allowance Recorded												With an Allowance Recorded												Total
		Recorded Investment				Unpaid Principal Balance				Related Allowance				Recorded Investment				Unpaid Principal Balance				Related Allowance				Recorded Investment				Unpaid Principal Balance				Related Allowance
December 31, 2010:
Real estate loans:
Office/retail		$	—				—				—				2,858				3,681				667				2,858				3,681				667
Multi-family			—				—				—				—				—				—				—				—				—
Land			4,625				5,936				—				3,200				3,652				337				7,825				9,588				337
Line of credit			—				—				—				912				1,388				476				912				1,388				476
Other			1,228				1,228				—				116				377				192				1,344				1,605				192
Residential			621				707				—				127				161				34				748				868				34
Construction			923				923				—				—				—				—				923				923				—
Home equity			—				—				—				—				—				—				—				—				—
Commercial			—				—				—				164				240				76				164				240				76
Consumer			92				146				—				116				260				145				208				406				145
		$	7,489				8,940				—				7,493				9,759				1,927				14,982				18,699				1,927

The following is a summary of information regarding nonaccrual and impaired loans at December 31, 2009 (in thousands):

 

Nonaccrual loans		$	2,842
Accruing loans past due ninety days or more		$	—
Collateral-dependent loans identified as impaired:
Gross loans with no related allowance for losses			1,932
Gross loans with related allowance for losses recorded			1,667
Less allowances on these loans			(246	)
Net loans with related allowance			1,421
Net investment in collateral-dependent impaired loans			3,353
Noncollateral-dependent loans identified as impaired:
Gross loans with no related allowance for losses			1,034
Gross loans with related allowance for losses recorded			2,094
Less allowance on these loans			(513	)
Net loans with related allowance			1,581
Net investment in noncollateral-dependent impaired loans			2,615
Net investment in impaired loans		$	5,968

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(3) Loans, Continued

 

The average net investment in impaired loans and interest income recognized and received on impaired loans are as follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Interest income recognized on impaired loans		$	271				155
Interest income received on impaired loans		$	271				155
Average net recorded investment in impaired loans		$	17,624				4,115

(4) Premises and Equipment

A summary of premises and equipment follows (in thousands):

 

		At December 31,
		2010				2009
Land		$	3,938				3,492
Buildings			7,776				7,770
Leasehold improvements			637				634
Furniture, fixtures and equipment			3,309				3,203
Construction in process			217				45
Total, at cost			15,877				15,144
Less accumulated depreciation and amortization			(2,459	)			(1,834	)
Premises and equipment, net		$	13,418				13,310

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(4) Premises and Equipment, Continued

 

The Company leases its Ocala corporate headquarters under an operating lease. This lease is for a term of five years, contains an escalation clause, requires monthly lease payments and common area maintenance charges with options to renew through 2025. Rent expense under this operating lease during the years ended December 31, 2010 and 2009 was $91,000 and $80,000, respectively. The Company offsets occupancy expense with sub-leases on various suites in the building. This provided rental income, net of operating expenses, for 2010 and 2009 of $0 and $4,000 respectively. The future minimum lease payments, which include certain renewal options, as of December 31, 2010 are as follows (in thousands):

 

Year Ending December 31,		Expense				Income
2011		$	95				75
2012			100				14
2013			100				—
2014			100				—
2015			17				—
2016 and thereafter			—				—
		$	412				89

(5) Other Real Estate Owned

Other real estate owned are presented net of an allowance for losses. An analysis of the allowance for losses on foreclosed assets is as follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Balance, beginning of year		$	76				—
Provision for losses			1,217				76
Charge-offs			(186	)			—
Balance, end of year		$	1,107				76

Expenses applicable to other real estate owned follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Loss on sale of other real estate owned		$	29				12
Provision for other real estate owned losses			1,217				76
Operating expenses, net of rental income			120				44
		$	1,366				132

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(6) Deposits

 

A schedule of maturities of time deposits at December 31, 2010 follows (in thousands):

 

Year Ending December 31,		Amount
2011		$	98,563
2012			35,404
2013			6,635
2014			3,305
2015			4,183
		$	148,090

(7) Other Borrowings

The Company enters into repurchase agreements with customers that sweep funds from deposit accounts into investment accounts. These investment accounts are not federally insured and are treated as borrowings. These agreements require the Company to pledge securities as collateral for these borrowings. At December 31, 2010 and 2009, the outstanding balance of such borrowings totaled approximately $3.1 million and $7.6 million, respectively, and the Company pledged securities with a carrying value of approximately $4.8 million and $10.5 million, respectively, as collateral for these agreements.

The Company had $4 million and $7 million under an unsecured credit facility with a correspondent bank at December 31, 2010 and 2009, respectively. The Company also had an additional $3 million under a secured credit facility with a correspondent bank at December 31, 2010. There were no amounts outstanding in connection with this agreement at December 31, 2010 and 2009.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(8) Federal Home Loan Bank Advances

 

The maturity and interest rate of the Federal Home Loan Bank (“FHLB”) advances are as follows ($ in thousands):

 

										At December 31,
Advance Type		Maturity				Interest Rate				2010				2009
Fixed			2010				2.86	%		$	—				2,000
Fixed			2010				3.54	%			—				2,000
Fixed			2011				0.76	%			1,000				1,000
Fixed			2011				0.83	%			1,000				—
Fixed			2011				0.98	%			1,000				—
Fixed			2011				1.04	%			1,000				1,000
Fixed			2012				1.14	%			1,000				—
Fixed			2011				1.23	%			2,000				2,000
Fixed			2012				1.33	%			1,000				—
Convertible			2016				4.47	%			5,000				5,000
Convertible			2016				4.71	%			3,000				3,000
Convertible			2017				4.22	%			5,000				5,000
										$	21,000				21,000

The Company has entered into a collateral agreement with the FHLB which consists of a blanket floating lien on the entire loan portfolio and the pledge of all the Company’s FHLB stock. One advance with a 2016 maturity date and interest rate of 4.47% has a call feature benefiting the issuer with a call date of February 23, 2011. The advance with a 2017 maturity date has a call feature benefiting the issuer with a call date of February 18, 2011. The Company may owe a fee in the event of full or partial repayment of advances prior to maturity.

(9) Income Taxes

Allocation of the Federal and state income taxes (benefit) is as follows (in thousands):

 

		Year Ended December 31,
		2010				2009
Deferred:
Federal		$	(1,579	)			49
State			(270	)			8
Income taxes (benefit)		$	(1,849	)			57

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(9) Income Taxes, Continued

The reasons for the differences between the statutory Federal income tax rate and the effective tax rate are summarized as follows ($ in thousands):

 

		Year Ended December 31,
		2010								2009
		Amount				% of Pretax Loss				Amount				% of Pretax Earnings
Income taxes (benefit) at statutory rate		$	(1,703	)			(34.0	)%		$	22				34.0	%
Increase (decrease) resulting from:
State taxes, net of Federal tax benefit			(178	)			(3.6	)			5				7.8
Share-based compensation			4				.1				23				35.9
Other			28				.6				7				11.4
Income taxes (benefit)		$	(1,849	)			(36.9	)%		$	57				89.1	%

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below (in thousands).

 

		At December 31,
		2010				2009
Deferred tax assets:
Allowance for loan losses		$	1,014				1,044
Net operating loss carryforwards			2,025				694
Foreclosed property expenses			464				50
Organizational and start-up costs			144				160
Unrealized loss on securities available for sale			369				27
Impaired loan interest			143				14
Other			40				48
Deferred tax assets			4,199				2,037
Deferred tax liabilities:
Premises and equipment			(472	)			(484	)
Deferred loan costs			(311	)			(337	)
Prepaid expenses			(69	)			(60	)
Deferred tax liabilities			(852	)			(881	)
Net deferred tax asset		$	3,347				1,156

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(9) Income Taxes, Continued

 

At December 31, 2010, the Company has approximately $5.4 million of net operating loss carryforwards available to offset future taxable income. These carryforwards will begin to expire in 2025.

The Company files income tax returns in the U.S. federal jurisdiction, and the State of Florida. The Company is no longer subject to the U.S. federal or state and local income tax examinations by tax authorities for years before 2007.

(10) Off-Balance-Sheet Financial Instruments

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments are commitments to extend credit, unused lines of credit and standby letters of credit and may involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheet. The contract amounts of these instruments reflect the extent of involvement the Company has in these financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, unused lines of credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments as it does for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Company upon extension of credit is based on management’s credit evaluation of the counterparty.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. These letters of credit are primarily issued to support third-party borrowing arrangements and generally have expiration dates within one year of issuance. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. At December 31, 2010, the Company held collateral supporting substantially all of these commitments and management does not anticipate any potential losses if these letters of credit are funded.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(10) Off-Balance-Sheet Financial Instruments, Continued

 

Standby letters of credit and commitments to extend credit typically result in loans with a market interest rate when funded. A summary of the amounts of the Company’s financial instruments with off-balance-sheet risk at December 31, 2010 follows (in thousands):

 

		Contract Amount
Commitments to extend credit		$	464
Unused lines of credit		$	17,630
Standby letters of credit		$	159

(11) Significant Group Concentrations of Credit Risk

The Company grants the majority of its loans to borrowers throughout the northeast Florida area, including Marion and Alachua counties. Although the Company has a diversified loan portfolio, a significant portion of its borrowers’ ability to honor their contracts is dependent upon the economy of this area. The Company does not have any significant concentrations to any one industry or customer.

(12) Stock Option Plan

The Company adopted a stock option plan for its employees and directors (the “Plan”). Fifteen percent of the total amount of shares outstanding, up to 450,000 shares (currently 397,981 shares), have been reserved under the Plan. Stock options are granted at an exercise price equal to or greater than the fair market value of the common stock on the date of grant. Options granted to directors vest immediately and for employees, the options primarily vest over two years starting with the date of grant and ending on the second anniversary thereof. At December 31, 2010, 128,262 options remain available for granting. A summary of stock option transactions under the Plan for the years ended December 31, 2010 and 2009 follows:

 

		Number of Options				Weighted Average Exercise Price				Weighted Average Remaining Contractual Term				Aggregate Intrinsic Value
Options outstanding at December 31, 2008			261,970			$	10.14
Options forfeited			(10,501	)			10.16
Options granted			24,600				10.00
Options outstanding at December 31, 2009			276,069				10.13
Options forfeited			(29,866	)			10.21
Options outstanding at December 31, 2010			246,203			$	10.12				5.86 years			$	—
Options exercisable at December 31, 2010			239,962			$	10.12				5.80 years			$	—

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(12) Stock Option Plan, Continued

 

No options have been granted during 2010. The fair value of each option granted in 2009 were estimated on the date of the grant using the Black-Scholes option-pricing model with the following assumptions:

 

Risk-free interest rate			1.46	%
Dividend yield			—	%
Expected stock volatility			10.00	%
Expected life in years			5.50
Per share grant-date fair value of options issued during the year		$	1.29

The Company examined its historical pattern of option exercises in an effort to determine if there were any pattern based on certain employee populations. From this analysis, the Company could not identify any patterns in the exercise of options. As such, the Company used the guidance in Staff Accounting Bulletin No. 107 issued by the Securities and Exchange Commission to determine the estimated life of options. Expected volatility is based on historical volatility of similar size financial institutions. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield assumption is based on the Company’s history and expectation of dividend payments.

There were no options exercised during the years ended December 31, 2010 and 2009. At December 31, 2010 there was approximately $1,000 of total unrecognized compensation expense related to the nonvested share-based compensation arrangements granted under the plans. The cost is expected to be recognized over a weighted-average period of one month. The total fair value of shares vesting and recognized as compensation expense was approximately $13,000 for the year ended December 31, 2010 and $67,000 in 2009. There was no associated income tax benefit recognized in 2010 or 2009.

(13) Employee Benefit Plan

The Company has a 401(k) profit sharing plan available to all employees electing to participate after meeting certain length-of-service requirements. The Company contributed $83,000 to the plan in 2010, and $83,000 in 2009.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(14) Related Party Transactions

 

The Company enters into transactions during the ordinary course of business with officers and directors of the Company and entities in which they hold a significant financial interest. The following summarizes these transactions (in thousands):

 

		At December 31,
		2010				2009
Loan balances at end of year		$	12,487				11,497
Deposits held from related parties-Balance at end of year		$	7,251				5,673

(15) Stockholders’ Equity and Dividend Restrictions

On January 23, 2009, the U.S. Treasury Department (the “Treasury”) purchased $6.5 million of the Company’s senior preferred stock as part of the US Treasury’s Capital Purchase Program. While the preferred shares are outstanding, the Company will pay the Treasury a five percent dividend on the senior preferred shares for the first five years following the investment, and a nine percent dividend thereafter. The Treasury also received warrants to purchase an additional $325,700 of the Company’s senior preferred stock at an exercise price of $0.01. The Treasury exercised these warrants on January 23, 2009. The senior preferred shares issued upon exercise of the warrants pay dividends at an annual rate of nine percent. While the senior preferred shares are outstanding, the Company must comply with restrictions on executive compensation and limitations on dividends and stock repurchases. The Company can repay the Treasury under the conditions established in the purchase agreements, and the Treasury can sell their investment to third parties.

The Company is limited in the amount of dividends it may pay by the amount of dividends the Bank may pay to the Holding Company. The Bank is limited in the amount of cash dividends that may be paid by Florida law. The amount of cash dividends that may be paid is based on the Bank’s net earnings of the current year combined with the Bank’s retained earnings of the preceding two years, as defined by state banking regulations. However, for any dividend declaration, the Bank must consider additional factors such as the amount of current period net earnings, liquidity, asset quality, capital adequacy and economic conditions. It is likely that these factors would further limit the amount of dividends which the Bank could declare. In addition, bank regulators have the authority to prohibit banks from paying dividends if they deem such payment to be an unsafe or unsound practice.

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(16) Regulatory Matters

 

The Bank is subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and percents (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2010, that the Bank meets all capital adequacy requirements to which it is subject.

As of December 31, 2010, the Bank is categorized as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage percents as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and percents are also presented in the table ($ in thousands):

 

		Actual								For Capital Adequacy Purposes								For Well Capitalized Purposes
		Amount				Percent				Amount				Percent				Amount				Percent
As of December 31, 2010:
Total Capital (to Risk- Weighted Assets)		$	26,170				11.47	%		$	18,253				8.00	%		$	22,816				10.00	%
Tier I Capital (to Risk- Weighted Assets)			23,303				10.22				9,121				4.00				13,681				6.00
Tier I Capital (to Average Assets)			23,303				7.62				12,233				4.00				15,291				5.00
As of December 31, 2009:
Total Capital (to Risk- Weighted Assets)			28,332				11.49				19,726				8.00				24,658				10.00
Tier I Capital (to Risk- Weighted Assets)			25,297				10.26				9,862				4.00				14,794				6.00
Tier I Capital (to Average Assets)			25,297				8.37				12,089				4.00				15,112				5.00

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(17) Fair Value of Financial Instruments

 

The estimated fair values of the Company’s financial instruments are as follows (in thousands):

 

		At December 31,
		2010								2009
		Carrying Amount				Fair Value				Carrying Amount				Fair Value
Financial assets:
Cash and cash equivalents		$	6,404				6,404				22,098				22,098
Interest bearing time deposits in banks			—				—				2,287				2,287
Securities available for sale			49,304				49,304				31,282				31,282
Loans, net			213,069				214,080				228,355				231,074
Loans held for sale			7,395				7,395				6,325				6,325
Accrued interest receivable			903				903				939				939
Federal Home Loan Bank stock			1,409				1,409				1,499				1,499
Financial liabilities:
Deposits			251,344				253,656				249,989				253,975
Federal Home Loan Bank advances			21,000				19,404				21,000				19,788
Other borrowings			3,054				3,054				7,633				7,633
Accrued interest payable			436				436				640				640
Off-balance-sheet financial instruments			—				—				—				—

(18) Fair Value Measurements

Available-for-sale securities, measured at fair value on a recurring basis are summarized below (in thousands):

 

		Fair     Value				Fair Value Measurements Using
						Quoted Prices In Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
At December 31, 2010-
Mortgage-backed securities		$	49,304				—				49,304				—
At December 31, 2009:
U.S. Government agency securities			1,005				—				1,005				—
Mortgage-backed securities			30,277				—				30,277				—
		$	31,282				—				31,282				—

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(18) Fair Value Measurements, Continued

 

Impaired collateral-dependent loans are carried at fair value when the current collateral value is lower than the carrying value of the loan. Those impaired collateral-dependent loans which are measured at fair value or a nonrecurring basis are as follows (in thousands):

 

		Fair   Value(1)				Level 1				Level 2				Level 3				Total   Losses				Losses Recorded During the Year
At December 31, 2010:
Office/retail		$	2,858				—				—				2,858				822				667
Multi-family			—				—				—				—				—				—
Land			4,691				—				—				4,691				1,763				1,763
LOC			912				—				—				912				477				477
Other			116				—				—				116				261				192
Residential real estate			218				—				—				218				120				120
Construction			—				—				—				—				—				—
HELOC			—				—				—				—				—				—
Commercial			164				—				—				164				76				76
Consumer			130				—				—				130				198				198
Total		$	9,088				—				—				9,088				3,717				3,493
At December 31, 2009:
Commercial real estate			597				—				—				597				226				226
Other			824				—				—				824				20				12
Total		$	1,421				—				—				1,421				246				238

 

(1)	In addition, loans with a carrying value of $5,894,000 and $1,932,000 at December 31, 2010 and 2009, respectively, were measured for impairment using Level 3 inputs and had a fair value in excess of carrying value.

Other real estate owned is recorded at the lower of cost or fair value less estimated costs to sell. Other real estate owned which is measured at fair value on a nonrecurring basis is as follows (in thousands):

 

		At Year End																Total Losses				Losses Recorded During the Year
		Fair Value				Level 1				Level 2				Level 3
At December 31, 2010		$	6,359				—				—				6,359				1,134				1,107
At December 31, 2009		$	1,583				—				—				1,583				76				76

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(19) Legal Contingencies

 

Various legal claims arise from time to time in the normal course of business which, in the opinion of management, will not have a material effect on the Company’s financial statements.

(20) Holding Company Only Financial Information

The Holding Company’s unconsolidated financial information is as follows (in thousands):

 

Condensed Balance Sheets
		At December 31,
		2010				2009
Assets
Cash		$	895				3,332
Investment in subsidiaries			25,653				27,302
Other assets			164				122
Total assets		$	26,712				30,756
Liabilities and Stockholders’ Equity
Other liabilities			78				50
Stockholders’ equity			26,634				30,706
Total liabilities and stockholders’ equity		$	26,712				30,756
Condensed Statements of Operations
		Year Ended December 31,
		2010				2009
Revenues		$	9				19
Operating expenses, net of income tax benefit			90				118
Net loss before loss (earnings) of subsidiaries			(81	)			(99	)
(Loss) earnings of subsidiaries			(3,079	)			106
Net (loss) earnings		$	(3,160	)			7

 

(continued)

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ALARION FINANCIAL SERVICES, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements, Continued

 

(20) Holding Company Only Financial Information, Continued

 

 

Condensed Statements of Cash Flows
		Year Ended December 31,
		2010				2009
Cash flows from operating activities:
Net (loss) earnings		$	(3,160	)			7
Adjustment to reconcile net (loss) earnings to net cash used in operating activities:
Share-based compensation			13				67
Equity in loss (earnings) of subsidiaries			3,079				(106	)
Increase in other assets			(42	)			(18	)
Increase in other liabilities			28				39
Net cash used in operating activities			(82	)			(11	)
Cash flows from investing activity-			(2,000	)			(4,001	)
Investment in subsidiaries
Cash flows from financing activities:
Proceeds from preferred stock issued			—				6,514
Preferred stock dividend requirements and Series B stock accretion			(355	)			(335	)
Net cash provided by financing activities			(355	)			6,179
Net (decrease) increase in cash			(2,437	)			2,167
Cash at beginning of the year			3,332				1,165
Cash at end of year		$	895				3,332
Supplemental disclosure of cash flow information:
Noncash transaction-
Accumulated other comprehensive loss, net change in unrealized loss on securities available for sale of subsidiary, net of taxes		$	(570	)			(183	)