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EX-32.1 - SECTION 350 CERTIFICATIONS - CITIZENS FINANCIAL SERVICES INCcertification.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm

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 March 31, 2017
Or

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

For the transition period from_____________________ to ___________________

Commission file number 0‑13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)

                    PENNSYLVANIA                                         23‑2265045
(State or other jurisdiction of incorporation or organization)                  (I.R.S. Employer Identification No.)

15 South Main Street
Mansfield, Pennsylvania 16933
(Address of principal executive offices)(Zip Code)

Registrant's telephone number, including area code: (570) 662‑2121

N/A
(Former Name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __X__ No_____

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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 (or for such shorter period that the registrant was required to submit and post such files).  Yes __X__ No_____

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

Large accelerated filer                                                                                    ____                                                      Accelerated filer  _X__

Non-accelerated filer                                                                      ____                                                      Smaller reporting company                                                                                    ____
(Do not check if a smaller reporting company)                                                                                                                                                            Emerging growth company  ____

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

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

The number of outstanding shares of the Registrant's Common Stock, as of May 2, 2017, was 3,320,366.


Citizens Financial Services, Inc.
Form 10-Q

INDEX

   
PAGE
Part I
FINANCIAL INFORMATION
 
Item 1.
Financial Statements (unaudited):
 
 
Consolidated Balance Sheet as of March 31,2017 and December 31, 2016
1
 
Consolidated Statement of Income for the Three Months Ended March 31, 2017 and 2016
2
 
Consolidated Statement of Comprehensive Income for the Three Months ended March 31, 2017 and 2016
3
 
Consolidated Statement of Cash Flows for the Three Months ended March 31, 2017 and 2016
4
 
Notes to Consolidated Financial Statements
5-32
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
33-51
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
52
Item 4.
Controls and Procedures
52
     
Part II
OTHER INFORMATION
 
Item 1.
Legal Proceedings
52
Item 1A.
Risk Factors
52
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
53
Item 3.
Defaults Upon Senior Securities
53
Item 4.
Mine Safety Disclosures
53
Item 5.
Other Information
53
Item 6.
Exhibits
53-54
 
Signatures
55

 

 
CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED BALANCE SHEET
           
(UNAUDITED)
           
 
           
 
 
March 31
   
December 31
 
(in thousands except share data)
 
2017
   
2016
 
ASSETS:
           
Cash and due from banks:
           
  Noninterest-bearing
 
$
13,587
   
$
16,854
 
  Interest-bearing
   
1,210
     
900
 
Total cash and cash equivalents
   
14,797
     
17,754
 
Interest bearing time deposits with other banks
   
6,708
     
6,955
 
Available-for-sale securities
   
281,773
     
314,017
 
Loans held for sale
   
1,581
     
1,827
 
                 
Loans (net of allowance for loan losses:
               
  2017, $9,405 and 2016, $8,886)
   
835,902
     
790,725
 
                 
Premises and equipment
   
16,949
     
17,030
 
Accrued interest receivable
   
3,618
     
4,089
 
Goodwill
   
21,089
     
21,089
 
Bank owned life insurance
   
26,389
     
26,223
 
Other intangibles
   
2,012
     
2,096
 
Receivable for settlement of security sales
   
1,297
     
7,759
 
Other assets
   
12,409
     
13,454
 
 
               
TOTAL ASSETS
 
$
1,224,524
   
$
1,223,018
 
 
               
LIABILITIES:
               
Deposits:
               
  Noninterest-bearing
 
$
157,426
   
$
147,425
 
  Interest-bearing
   
880,183
     
858,078
 
Total deposits
   
1,037,609
     
1,005,503
 
Borrowed funds
   
46,836
     
79,662
 
Accrued interest payable
   
612
     
720
 
Other liabilities
   
14,511
     
13,865
 
TOTAL LIABILITIES
   
1,099,568
     
1,099,750
 
STOCKHOLDERS' EQUITY:
               
Preferred Stock
               
  $1.00 par value; authorized 3,000,000 shares March 31, 2017 and December 31, 2016;
               
   none issued in 2017 or 2016
   
-
     
-
 
Common stock
               
  $1.00 par value; authorized 15,000,000 shares;  issued 3,704,375 at March 31, 2017 and
               
   December 31, 2016
   
3,704
     
3,704
 
Additional paid-in capital
   
42,256
     
42,250
 
Retained earnings
   
93,172
     
91,278
 
Accumulated other comprehensive loss
   
(1,421
)
   
(1,392
)
Treasury stock, at cost:  388,190 shares at March 31, 2017
               
  and 384,671 shares at December 31, 2016
   
(12,755
)
   
(12,572
)
TOTAL STOCKHOLDERS' EQUITY
   
124,956
     
123,268
 
TOTAL LIABILITIES AND
               
   STOCKHOLDERS' EQUITY
 
$
1,224,524
   
$
1,223,018
 
 
               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
         

1

CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED STATEMENT OF INCOME
           
(UNAUDITED)
           
 
 
Three Months Ended
 
   
March 31,
 
(in thousands, except share and per share data)
 
2017
   
2016
 
INTEREST INCOME:
           
Interest and fees on loans
 
$
9,717
   
$
8,596
 
Interest-bearing deposits with banks
   
35
     
71
 
Investment securities:
               
    Taxable
   
804
     
944
 
    Nontaxable
   
668
     
771
 
    Dividends
   
76
     
80
 
TOTAL INTEREST INCOME
   
11,300
     
10,462
 
INTEREST EXPENSE:
               
Deposits
   
1,045
     
1,074
 
Borrowed funds
   
258
     
183
 
TOTAL INTEREST EXPENSE
   
1,303
     
1,257
 
NET INTEREST INCOME
   
9,997
     
9,205
 
Provision for loan losses
   
615
     
135
 
NET INTEREST INCOME AFTER
               
    PROVISION FOR LOAN LOSSES
   
9,382
     
9,070
 
NON-INTEREST INCOME:
               
Service charges
   
1,058
     
1,102
 
Trust
   
221
     
196
 
Brokerage and insurance
   
191
     
209
 
Gains on loans sold
   
101
     
46
 
Investment securities gains, net
   
172
     
27
 
Earnings on bank owned life insurance
   
166
     
170
 
Other
   
126
     
166
 
TOTAL NON-INTEREST INCOME
   
2,035
     
1,916
 
NON-INTEREST EXPENSES:
               
Salaries and employee benefits
   
4,319
     
3,882
 
Occupancy
   
527
     
445
 
Furniture and equipment
   
139
     
157
 
Professional fees
   
310
     
287
 
FDIC insurance
   
105
     
157
 
Pennsylvania shares tax
   
281
     
150
 
Amortization of intangibles
   
76
     
82
 
ORE expenses
   
90
     
92
 
Other
   
1,344
     
1,660
 
TOTAL NON-INTEREST EXPENSES
   
7,191
     
6,912
 
Income before provision for income taxes
   
4,226
     
4,074
 
Provision for income taxes
   
923
     
791
 
NET INCOME
 
$
3,303
   
$
3,283
 
                 
PER COMMON SHARE DATA:
               
Net Income - Basic
 
$
1.00
   
$
0.98
 
Net Income - Diluted
 
$
1.00
   
$
0.98
 
Cash Dividends Paid
 
$
0.425
   
$
0.411
 
 
               
Number of shares used in computation - basic
   
3,313,616
     
3,356,573
 
Number of shares used in computation - diluted
   
3,313,636
     
3,356,573
 
 
               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 

2


CITIZENS FINANCIAL SERVICES, INC.
                       
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
                       
(UNAUDITED)
                       
 
 
Three Months Ended
 
 
 
March 31,
 
(in thousands)
       
2017
         
2016
 
Net income
       
$
3,303
         
$
3,283
 
Other comprehensive income (loss):
                           
      Change in unrealized gains on available for sale securities
   
70
             
1,694
         
      Income tax effect
   
(24
)
           
(577
)
       
      Change in unrecognized pension cost
   
60
             
61
         
      Income tax effect
   
(21
)
           
(21
)
       
      Less:  Reclassification adjustment for investment security gains included in net income
   
(172
)
           
(27
)
       
      Income tax effect
   
58
             
9
         
Other comprehensive income (loss), net of tax
           
(29
)
           
1,139
 
Comprehensive income
         
$
3,274
           
$
4,422
 
 
                               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
                 

3

CITIZENS FINANCIAL SERVICES, INC.
           
CONSOLIDATED STATEMENT OF CASH FLOWS
           
(UNAUDITED)
 
Three Months Ended
 
 
 
March 31,
 
(in thousands)
 
2017
   
2016
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
  Net income
 
$
3,303
   
$
3,283
 
  Adjustments to reconcile net income to net
               
   cash provided by operating activities:
               
    Provision for loan losses
   
615
     
135
 
    Depreciation and amortization
   
108
     
76
 
    Amortization and accretion of investment securities
   
382
     
567
 
    Deferred income taxes
   
(174
)
   
(115
)
    Investment securities gains, net
   
(172
)
   
(27
)
    Earnings on bank owned life insurance
   
(166
)
   
(170
)
    Originations of loans held for sale
   
(4,727
)
   
(3,913
)
    Proceeds from sales of loans held for sale
   
5,075
     
3,005
 
    Realized gains on loans sold
   
(101
)
   
(46
)
    Decrease in accrued interest receivable
   
471
     
115
 
    Decrease in accrued interest payable
   
(108
)
   
(74
)
    Other, net
   
1,801
     
(467
)
      Net cash provided by operating activities
   
6,307
     
2,369
 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
  Available-for-sale securities:
               
    Proceeds from sales
   
18,766
     
5,020
 
    Proceeds from maturity and principal repayments
   
29,858
     
9,757
 
    Purchase of securities
   
(11,039
)
   
(25,840
)
  Purchase of interest bearing time deposits with other banks
   
(746
)
   
-
 
  Proceeds from redemption of regulatory stock
   
2,617
     
112
 
  Purchase of regulatory stock
   
(1,288
)
   
-
 
  Net increase in loans
   
(45,880
)
   
(4,454
)
  Purchase of premises and equipment
   
(113
)
   
(166
)
  Proceeds from sale of interest bearing time deposits with other banks
   
750
     
-
 
  Proceeds from sale of foreclosed assets held for sale
   
125
     
289
 
      Net cash used in investing activities
   
(6,950
)
   
(15,282
)
CASH FLOWS FROM FINANCING ACTIVITIES:
               
  Net increase in deposits
   
32,106
     
29,780
 
  Proceeds from long-term borrowings
   
2
     
2
 
  Net increase in short-term borrowed funds
   
(32,828
)
   
(1,637
)
  Purchase of treasury and restricted stock
   
(396
)
   
(860
)
  Dividends paid
   
(1,198
)
   
(1,377
)
      Net cash (used) provided by financing activities
   
(2,314
)
   
25,908
 
          Net (decrease) increase in cash and cash equivalents
   
(2,957
)
   
12,995
 
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
17,754
     
24,384
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
14,797
   
$
37,379
 
 
               
Supplemental Disclosures of Cash Flow Information:
               
    Interest paid
 
$
1,411
   
$
1,331
 
    Income taxes paid
 
$
-
   
$
450
 
    Loans transferred to foreclosed property
 
$
307
   
$
64
 
    Investments and time deposits sold and not settled
 
$
1,297
   
$
-
 
 
               
The accompanying notes are an integral part of these unaudited consolidated financial statements.
 

4

 CITIZENS FINANCIAL SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1 - Basis of Presentation

Citizens Financial Services, Inc. (individually and collectively with its direct and indirect subsidiaries, the "Company") is a Pennsylvania corporation and the holding company of its wholly owned subsidiary, First Citizens Community Bank (the "Bank"), and of the Bank's wholly owned subsidiary, First Citizens Insurance Agency, Inc. ("First Citizens Insurance").

The accompanying consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission ("SEC") and in conformity with U.S. generally accepted accounting principles.  Because this report is based on an interim period, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted.  Certain of the prior year amounts have been reclassified to conform with the current year presentation.  Such reclassifications had no effect on net income or stockholders' equity.  All material inter‑company balances and transactions have been eliminated in consolidation.

In the opinion of management of the Company, the accompanying interim financial statements at March 31, 2017 and for the periods ended March 31, 2017 and 2016 include all adjustments, consisting of only normal recurring adjustments, necessary for a fair presentation of the financial condition and the results of operations for the periods. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. The financial performance reported for the Company for the three month period ended March 31, 2017 is not necessarily indicative of the results to be expected for the full year.  This information should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2016.

Note 2 - Earnings per Share

The following table sets forth the computation of earnings per share. Earnings per share calculations give retroactive effect to stock dividends declared by the Company.

   
Three months ended
 
   
March 31,
 
   
2017
   
2016
 
Net income applicable to common stock
 
$
3,303,000
   
$
3,283,000
 
 
               
Basic earnings per share computation
               
Weighted average common shares outstanding
   
3,313,616
     
3,356,573
 
Earnings per share - basic
 
$
1.00
   
$
0.98
 
 
               
Diluted earnings per share computation
               
Weighted average common shares outstanding for basic earnings per share
   
3,313,616
     
3,356,573
 
Add: Dilutive effects of restricted stock
   
20
     
-
 
Weighted average common shares outstanding for dilutive earnings per share
   
3,313,636
     
3,356,573
 
Earnings per share - diluted
 
$
1.00
   
$
0.98
 

For the three months ended March 31, 2017 and 2016, there were 2,087 and 5,325 shares, respectively, related to the restricted stock plan that were excluded from the diluted earnings per share calculations since they were anti-dilutive. These anti-dilutive shares had per share prices ranging from $49.87-$53.15 for the three month period ended March 31, 2017 and per share prices ranging from $46.69-$53.15 for the three month period ended March 31, 2016.

5

Note 3 - Income Tax Expense

Income tax expense is less than the amount calculated using the statutory tax rate, primarily as a result of tax-exempt income earned from state and municipal securities and loans and investments in affordable housing tax credits.

Investments in Qualified Affordable Housing Projects

As of March 31, 2017 and December 31, 2016, the Company was invested in four partnerships that provide affordable housing. The balance of the investments, which is included within other assets in the Consolidated Balance Sheet, was $660,000 and $700,000 as of March 31, 2017 and December 31, 2016, respectively. Investments purchased prior to January 1, 2015, are accounted for utilizing the effective yield method. As of March 31, 2017, the Company had $811,000 of tax credits remaining that will be recognized over 5.75 years. Tax credits of $35,000 and $50,000 were recognized as a reduction of tax expense during the three months ended March 31, 2017 and 2016, respectively. Amortization of the investment included in other expenses on the Consolidated Statement of Income was $40,000 and $65,000 during the three months ended March 31, 2017 and 2016, respectively.

Note 4 – Investments

The amortized cost, gross unrealized gains and losses, and fair value of investment securities at March 31, 2017 and December 31, 2016 were as follows (in thousands):

         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
March 31, 2017
 
Cost
   
Gains
   
Losses
   
Value
 
Available-for-sale securities:
                       
  U.S. agency securities
 
$
147,624
   
$
297
   
$
(263
)
 
$
147,658
 
  Obligations of state and
                               
    political subdivisions
   
87,082
     
1,500
     
(339
)
   
88,243
 
  Corporate obligations
   
3,000
     
95
     
-
     
3,095
 
  Mortgage-backed securities in
                               
    government sponsored entities
   
41,292
     
82
     
(256
)
   
41,118
 
  Equity securities in financial
                               
     institutions
   
899
     
760
     
-
     
1,659
 
Total available-for-sale securities
 
$
279,897
   
$
2,734
   
$
(858
)
 
$
281,773
 
                                 
December 31, 2016
                               
Available-for-sale securities:
                               
  U.S. agency securities
 
$
170,276
   
$
407
   
$
(269
)
 
$
170,414
 
  U.S. treasury securities
   
2,999
     
1
     
-
     
3,000
 
  Obligations of state and
                               
    political subdivisions
   
95,956
     
1,463
     
(493
)
   
96,926
 
  Corporate obligations
   
3,000
     
50
     
-
     
3,050
 
  Mortgage-backed securities in
                               
    government sponsored entities
   
37,987
     
88
     
(347
)
   
37,728
 
  Equity securities in financial institutions
   
1,821
     
1,078
     
-
     
2,899
 
Total available-for-sale securities
 
$
312,039
   
$
3,087
   
$
(1,109
)
 
$
314,017
 

The following table shows the Company's gross unrealized losses and fair value of the Company's investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time, which individual securities have been in a continuous unrealized loss position, at March 31, 2017 and December 31, 2016 (in thousands). As of March 31, 2017, the Company owned 80 securities whose fair value was less than their cost basis.

6


 
   
Less than Twelve Months
   
Twelve Months or Greater
   
Total
 
         
Gross
         
Gross
         
Gross
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
 March 31, 2017
 
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
U.S. agency securities
 
$
61,938
   
$
(263
)
 
$
-
   
$
-
   
$
61,938
   
$
(263
)
Obligations of state and
                                               
    political subdivisions
   
18,733
     
(279
)
   
2,117
     
(60
)
   
20,850
     
(339
)
Mortgage-backed securities in
                                               
   government sponsored entities
   
23,028
     
(221
)
   
3,159
     
(35
)
   
26,187
     
(256
)
    Total securities
 
$
103,699
   
$
(763
)
 
$
5,276
   
$
(95
)
 
$
108,975
   
$
(858
)
                                                 
December 31, 2016
                                               
U.S. agency securities
 
$
50,947
   
$
(269
)
 
$
-
   
$
-
   
$
50,947
   
$
(269
)
Obligations of states and
                                               
     political subdivisions
   
28,398
     
(472
)
   
767
     
(21
)
   
29,165
     
(493
)
Mortgage-backed securities in
                                               
   government sponsored entities
   
26,717
     
(330
)
   
753
     
(17
)
   
27,470
     
(347
)
    Total securities
 
$
106,062
   
$
(1,071
)
 
$
1,520
   
$
(38
)
 
$
107,582
   
$
(1,109
)

As of March 31, 2017 and December 31, 2016, the Company's investment securities portfolio contained unrealized losses on agency securities issued or backed by the full faith and credit of the United States government or are generally viewed as having the implied guarantee of the U.S. government, obligations of states and political subdivisions and mortgage backed securities issued by government sponsored entities. For fixed maturity investments management considers whether the present value of cash flows expected to be collected are less than the security's amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company's intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, if the Company does not intend to sell the security, and it is more likely than not that it will not be required to sell the security before recovery of the security's amortized cost basis, the charge to earnings is limited to the amount of credit loss. Any remaining difference between fair value and amortized cost (the difference defined as the non-credit portion) is recognized in other comprehensive income, net of applicable taxes. Otherwise, the entire difference between fair value and amortized cost is charged to earnings. For equity securities where the fair value has been significantly below cost for one year, the Company's policy is to recognize an impairment loss unless sufficient evidence is available that the decline is not other than temporary and a recovery period can be predicted.  The Company has concluded that any impairment of its investment securities portfolio outlined in the above table is not other than temporary and is the result of interest rate changes, sector credit rating changes, or issuer-specific rating changes that are not expected to result in the non-collection of principal and interest during the period.

Proceeds from sales of securities available-for-sale for the three months ended March 31, 2017 and 2016 were $18,766,000 and $5,020,000, respectively. The gross gains and losses were as follows (in thousands):

   
Three Months Ended
 
   
March 31,
 
 
 
2017
   
2016
 
Gross gains
 
$
172
   
$
27
 
Gross losses
   
-
     
-
 
Net gains
 
$
172
   
$
27
 

Investment securities with an approximate carrying value of $206.5 million and $206.3 million at March 31, 2017 and December 31, 2016, respectively, were pledged to secure public funds and certain other deposits.

7

Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.   The amortized cost and fair value of debt securities (excludes equity securities) at March 31, 2017, by contractual maturity, are shown below (in thousands):

   
Amortized
       
 
 
Cost
   
Fair Value
 
Available-for-sale debt securities:
           
  Due in one year or less
 
$
36,081
   
$
36,288
 
  Due after one year through five years
   
141,531
     
142,341
 
  Due after five years through ten years
   
38,172
     
38,283
 
  Due after ten years
   
63,214
     
63,202
 
Total
 
$
278,998
   
$
280,114
 

Note 5 – Loans

The Company grants loans primarily to customers throughout north central, central and south central Pennsylvania and the southern tier of New York.  Although the Company had a diversified loan portfolio at March 31, 2017 and December 31, 2016, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio and how those segments are analyzed within the allowance for loan losses as of March 31, 2017 and December 31, 2016 (in thousands):

March 31, 2017
 
Total Loans
   
Individually evaluated for impairment
   
Loans acquired with deteriorated credit quality
   
Collectively evaluated for impairment
 
Real estate loans:
                       
     Residential
 
$
203,817
   
$
945
   
$
35
   
$
202,837
 
     Commercial
   
267,097
     
6,347
     
1,965
     
258,785
 
     Agricultural
   
156,299
     
3,476
     
737
     
152,086
 
     Construction
   
26,118
     
-
           
26,118
 
Consumer
   
10,508
     
2
     
1
     
10,505
 
Other commercial loans
   
59,800
     
5,281
     
863
     
53,656
 
Other agricultural loans
   
24,227
     
1,612
           
22,615
 
State and political subdivision loans
   
97,441
     
-
           
97,441
 
Total
   
845,307
     
17,663
     
3,601
     
824,043
 
Allowance for loan losses
   
9,405
     
404
     
-
     
9,001
 
Net loans
 
$
835,902
   
$
17,259
   
$
3,601
   
$
815,042
 
 
                               
December 31, 2016
                               
Real estate loans:
                               
     Residential
 
$
207,423
   
$
957
   
$
35
   
$
206,431
 
     Commercial
   
252,577
     
5,742
     
1,969
     
244,866
 
     Agricultural
   
123,624
     
3,346
     
738
     
119,540
 
     Construction
   
25,441
     
-
     
-
     
25,441
 
Consumer
   
11,005
     
-
     
4
     
11,001
 
Other commercial loans
   
58,639
     
5,994
     
621
     
52,024
 
Other agricultural loans
   
23,388
     
1,654
     
-
     
21,734
 
State and political subdivision loans
   
97,514
     
-
     
-
     
97,514
 
Total
   
799,611
     
17,693
     
3,367
     
778,551
 
Allowance for loan losses
   
8,886
     
487
     
-
     
8,399
 
Net loans
 
$
790,725
   
$
17,206
   
$
3,367
   
$
770,152
 

Purchased loans acquired in The First National Bank of Fredericksburg (FNB) acquisition were recorded at fair value on their purchase date without a carryover of the related allowance for loan losses.

8

Upon acquisition, the Company evaluated whether an acquired loan was within the scope of ASC 310-30, Receivables-Loans and Debt Securities Acquired with Deteriorated Credit Quality. Purchased credit-impaired ("PCI") loans are loans that have evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments. Based upon management's review, there were no material increases or decreases in the expected cash flows of these loans between December 11, 2015 (the "acquisition date") and March 31, 2017. The fair value of PCI loans, on the acquisition date, was determined, primarily based on the fair value of the loans' collateral. The carrying value of PCI loans was $3,601,000 and $3,367,000 at March 31, 2017 and December 31, 2016, respectively.

The carrying value of the PCI loans was determined by projected discounted contractual cash flows.

Changes in the accretable yield for PCI loans were as follows for the three months ended March 31, 2017 and 2016, respectively (in thousands):

 
 
March 31, 2017
   
March 31, 2016
 
Balance at beginning of period
 
$
389
   
$
637
 
Accretion
   
(114
)
   
(86
)
Balance at end of period
 
$
275
   
$
551
 

The following table presents additional information regarding loans acquired with specific evidence of deterioration in credit quality under ASC 310-30 (in thousands):

   
March 31, 2017
   
December 31, 2016
 
Outstanding balance
 
$
6,688
   
$
6,487
 
Carrying amount
   
3,601
     
3,367
 

The segments of the Company's loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consist primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equity loans are consumer purpose installment loans or lines of credit with terms of 15 years or less secured by a mortgage which is often a second lien on residential real estate. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by assets other than real estate and overdraft lines of credit are typically secured by customer deposit accounts. Other commercial loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivision loans are loans to state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.

Management considers other commercial loans, other agricultural loans, state and political subdivision loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer's results of operations and cash flows or if the loan is modified in a troubled debt restructuring. In addition, certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships that are determined to be impaired may also be classified as impaired. Impaired loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allocation of the allowance for loan losses or a charge-off to the allowance for loan losses.

The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, excluding PCI loans, with the associated allowance amount, if applicable (in thousands):
 
9


 
       
Recorded
   
Recorded
             
 
 
Unpaid
   
Investment
   
Investment
   
Total
       
 
 
Principal
   
With No
   
With
   
Recorded
   
Related
 
March 31, 2017
 
Balance
   
Allowance
   
Allowance
   
Investment
   
Allowance
 
Real estate loans:
                             
     Mortgages
 
$
949
   
$
568
   
$
322
   
$
890
   
$
28
 
     Home Equity
   
55
     
-
     
55
     
55
     
10
 
     Commercial
   
8,628
     
5,937
     
410
     
6,347
     
47
 
     Agricultural
   
3,487
     
2,146
     
1,330
     
3,476
     
103
 
     Construction
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
2
     
-
     
2
     
2
     
2
 
Other commercial loans
   
5,797
     
4,806
     
475
     
5,281
     
195
 
Other agricultural loans
   
1,612
     
1,593
     
19
     
1,612
     
19
 
State and political
                                       
   subdivision loans
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
20,530
   
$
15,050
   
$
2,613
   
$
17,663
   
$
404
 
 
                                       
December 31, 2016
                                       
Real estate loans:
                         
 
 
         
     Mortgages
 
$
953
   
$
570
   
$
330
     $
900
   
$
22
 
     Home Equity
   
57
     
-
     
57
     
57
     
10
 
     Commercial
   
7,958
     
5,697
     
45
     
5,742
     
45
 
     Agricultural
   
3,347
     
2,000
     
1,347
     
3,347
     
54
 
     Construction
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other commercial loans
   
6,159
     
5,135
     
859
     
5,994
     
326
 
Other agricultural loans
   
1,653
     
1,629
     
24
     
1,653
     
30
 
State and political
                                       
   subdivision loans
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
20,127
   
$
15,031
   
$
2,662
   
$
17,693
   
$
487
 

The following tables includes the average balance of impaired financing receivables by class and the income recognized on these receivables for the three month periods ended March 31, 2017 and 2016(in thousands):

 
 
For the Three Months Ended
 
 
 
March 31, 2017
   
March 31, 2016
 
 
             
Interest
               
Interest
 
 
 
Average
   
Interest
   
Income
   
Average
   
Interest
   
Income
 
 
 
Recorded
   
Income
   
Recognized
   
Recorded
   
Income
   
Recognized
 
 
 
Investment
   
Recognized
   
Cash Basis
   
Investment
   
Recognized
   
Cash Basis
 
Real estate loans:
                                   
     Mortgages
 
$
894
   
$
3
   
$
-
   
$
391
   
$
4
   
$
-
 
     Home Equity
   
56
     
1
     
-
     
60
     
1
     
-
 
     Commercial
   
5,793
     
24
     
3
     
6,179
     
26
     
-
 
     Agricultural
   
3,382
     
31
     
-
     
165
     
2
     
-
 
     Construction
   
-
     
-
     
-
     
-
     
-
     
-
 
Consumer
   
1
     
-
     
-
     
-
     
-
     
-
 
Other commercial loans
   
5,597
     
40
     
10
     
5,952
     
66
     
1
 
Other agricultural loans
   
1,627
     
23
     
-
     
105
     
1
     
-
 
State and political
                                               
   subdivision loans
   
-
     
-
     
-
     
-
     
-
     
-
 
Total
 
$
17,350
   
$
122
   
$
13
   
$
12,852
   
$
100
   
$
1
 

10


Credit Quality Information

For commercial real estate, agricultural real estate, construction, other commercial, other agricultural and state and political subdivision loans, management uses a nine grade internal risk rating system to monitor credit quality. The first five categories are considered not criticized and are aggregated as "Pass" rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:
·
Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.
·
Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.
·
Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
·
Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.
·
Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay the loan as agreed, the Company's loan rating process includes several layers of internal and external oversight. The Company's loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management.  All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Company engages an external consultant on at least an annual basis to 1) review a minimum of 55% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated for over $1.0 million in the last year, 3) review a majority of borrowers with commitments greater than or equal to $1.0 million,  4) review selected loan relationships over $750,000 which are over 30 days past due or classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.

The following tables represent credit exposures by internally assigned grades as of March 31, 2017 and December 31, 2016 (in thousands):

March 31, 2017
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Ending Balance
 
Real estate loans:
                                   
     Commercial
 
$
240,229
   
$
14,732
   
$
12,136
   
$
-
   
$
-
   
$
267,097
 
     Agricultural
   
143,715
     
7,835
     
4,749
     
-
     
-
     
156,299
 
     Construction
   
26,118
     
-
     
-
     
-
     
-
     
26,118
 
Other commercial loans
   
53,657
     
1,560
     
4,498
     
85
     
-
     
59,800
 
Other agricultural loans
   
21,218
     
1,300
     
1,709
     
-
     
-
     
24,227
 
State and political
                                               
   subdivision loans
   
83,548
     
13,095
     
798
     
-
     
-
     
97,441
 
Total
 
$
568,485
   
$
38,522
   
$
23,890
   
$
85
   
$
-
   
$
630,982
 

11

 
December 31, 2016
 
Pass
   
Special Mention
   
Substandard
   
Doubtful
   
Loss
   
Ending Balance
 
Real estate loans:
                                   
     Commercial
 
$
225,185
   
$
14,045
   
$
13,347
   
$
-
   
$
-
   
$
252,577
 
     Agricultural
   
110,785
     
8,231
     
4,608
     
-
     
-
     
123,624
 
     Construction
   
25,441
     
-
     
-
     
-
     
-
     
25,441
 
Other commercial loans
   
51,396
     
2,049
     
5,105
     
89
     
-
     
58,639
 
Other agricultural loans
   
20,178
     
1,733
     
1,477
     
-
     
-
     
23,388
 
State and political
                                               
   subdivision loans
   
83,620
     
13,066
     
828
     
-
     
-
     
97,514
 
Total
 
$
516,605
   
$
39,124
   
$
25,365
   
$
89
   
$
-
   
$
581,183
 

For residential real estate mortgages, home equity and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below, and all loans past due 90 or more days and still accruing. The following table presents the recorded investment in those loan classes based on payment activity as of March 31, 2017 and December 31, 2016 (in thousands):

March 31, 2017
 
Performing
   
Non-performing
   
PCI
   
Total
 
Real estate loans:
                       
     Mortgages
 
$
145,446
   
$
1,539
   
$
35
   
$
147,020
 
     Home Equity
   
56,566
     
231
     
-
     
56,797
 
Consumer
   
10,395
     
112
     
1
     
10,508
 
Total
 
$
212,407
   
$
1,882
   
$
36
   
$
214,325
 
 
                               
December 31, 2016
                               
Real estate loans:
                               
     Mortgages
 
$
147,047
   
$
1,648
   
$
35
   
$
148,730
 
     Home Equity
   
58,438
     
255
     
-
   
$
58,693
 
Consumer
   
10,892
     
109
     
4
   
$
11,005
 
Total
 
$
216,377
   
$
2,012
   
$
39
   
$
218,428
 

Aging Analysis of Past Due Financing Receivables

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of March 31, 2017 and December 31, 2016 (in thousands):

12

 
 
                                     
Total
   
90 Days or
 
 
 
30-59 Days
   
60-89 Days
   
90 Days
   
Total Past
               
Financing
   
Greater and
 
March 31, 2017
 
Past Due
   
Past Due
   
Or Greater
   
Due
   
Current
   
PCI
   
Receivables
   
Accruing
 
Real estate loans:
                                               
     Mortgages
 
$
315
   
$
49
   
$
988
   
$
1,352
   
$
145,633
   
$
35
   
$
147,020
   
$
230
 
     Home Equity
   
156
     
85
     
188
     
429
     
56,368
     
-
     
56,797
     
146
 
     Commercial
   
301
     
645
     
3,973
     
4,919
     
260,213
     
1,965
     
267,097
     
58
 
     Agricultural
   
22
     
-
     
1,338
     
1,360
     
154,202
     
737
     
156,299
     
334
 
     Construction
   
-
     
-
     
-
     
-
     
26,118
     
-
     
26,118
     
-
 
Consumer
   
90
     
35
     
110
     
235
     
10,272
     
1
     
10,508
     
22
 
Other commercial loans
   
161
     
2
     
2,597
     
2,760
     
56,177
     
863
     
59,800
     
-
 
Other agricultural loans
   
774
     
-
     
225
     
999
     
23,228
     
-
     
24,227
     
225
 
State and political
                                                               
   subdivision loans
   
-
     
-
     
-
     
-
     
97,441
     
-
     
97,441
     
-
 
Total
 
$
1,819
   
$
816
   
$
9,419
   
$
12,054
   
$
829,652
   
$
3,601
   
$
845,307
   
$
1,015
 
 
                                                               
Loans considered non-accrual
 
$
77
   
$
10
   
$
8,404
   
$
8,491
   
$
1,991
   
$
-
   
$
10,482
         
Loans still accruing
   
1,742
     
806
     
1,015
     
3,563
     
827,661
     
3,601
     
834,825
         
Total
 
$
1,819
   
$
816
   
$
9,419
   
$
12,054
   
$
829,652
   
$
3,601
   
$
845,307
         
 
                                                               
December 31, 2016
                                                               
Real estate loans:
                                                               
     Mortgages
 
$
630
   
$
36
   
$
1,109
   
$
1,775
   
$
146,920
   
$
35
   
$
148,730
   
$
173
 
     Home Equity
   
384
     
49
     
209
     
642
     
58,051
     
-
     
58,693
     
160
 
     Commercial
   
1,757
     
58
     
4,302
     
6,117
     
244,491
     
1,969
     
252,577
     
-
 
     Agricultural
   
-
     
-
     
1,145
     
1,145
     
121,741
     
738
     
123,624
     
-
 
     Construction
   
-
     
-
     
-
     
-
     
25,441
     
-
     
25,441
     
-
 
Consumer
   
115
     
40
     
83
     
238
     
10,763
     
4
     
11,005
     
67
 
Other commercial loans
   
95
     
35
     
4,004
     
4,134
     
53,884
     
621
     
58,639
     
-
 
Other agricultural loans
   
43
     
34
     
5
     
82
     
23,306
     
-
     
23,388
     
5
 
State and political
                                                               
   subdivision loans
   
-
     
-
     
-
     
-
     
97,514
     
-
     
97,514
     
-
 
 
                                                               
Total
 
$
3,024
   
$
252
   
$
10,857
   
$
14,133
   
$
782,111
   
$
3,367
   
$
799,611
   
$
405