AMERICAN NATIONAL BANKSHARES INC. - FORM 10-Q

Attached files

file	filename
EX-32.2 - EXHIBIT 32.2 - AMERICAN NATIONAL BANKSHARES INC.	amnb-09302018xexhibit322.htm
EX-32.1 - EXHIBIT 32.1 - AMERICAN NATIONAL BANKSHARES INC.	amnb-09302018xexhibit321.htm
EX-31.2 - EXHIBIT 31.2 - AMERICAN NATIONAL BANKSHARES INC.	amnb-09302018xexhibit312.htm
EX-31.1 - EXHIBIT 31.1 - AMERICAN NATIONAL BANKSHARES INC.	amnb-09302018xexhibit311.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 September 30, 2018.



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO .

Commission file number: 0-12820

AMERICAN NATIONAL BANKSHARES INC.

(Exact name of registrant as specified in its charter)



VIRGINIA		54-1284688
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

628 Main Street
Danville, Virginia		24541
(Address of principal executive offices)		(Zip Code)

(434) 792-5111

(Registrant's telephone number, including area code)

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



Yes	x	No	o

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).



Yes	x	No	o

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 o	Accelerated filer x
Non-accelerated filer o	Smaller reporting company o
	Emerging growth company o

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	o	No	x

At October 26, 2018, the Company had 8,714,431 shares of Common Stock outstanding, $1 par value.

AMERICAN NATIONAL BANKSHARES INC.



Index			Page

Part I.		FINANCIAL INFORMATION

	Item 1.	Financial Statements

		Consolidated Balance Sheets as of September 30, 2018 (unaudited) and December 31, 2017	3

		Consolidated Statements of Income for the three and nine months ended September 30, 2018 and 2017 (unaudited)	4

		Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017 (unaudited)	6

		Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2018 and 2017 (unaudited)	7

		Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 (unaudited)	8

		Notes to Consolidated Financial Statements (unaudited)	9

	Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	36

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk	58

	Item 4.	Controls and Procedures	60

Part II.		OTHER INFORMATION

	Item 1.	Legal Proceedings	61

	Item 1A.	Risk Factors	61

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	63

	Item 3.	Defaults Upon Senior Securities	63

	Item 4.	Mine Safety Disclosures	63

	Item 5.	Other Information	63

	Item 6.	Exhibits	64

SIGNATURES			65

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS



American National Bankshares Inc.
Consolidated Balance Sheets
(Dollars in thousands, except per share data)
Assets	(Unaudited) September 30, 2018			(*) December 31, 2017
Cash and due from banks	$	32,688		$	28,594
Interest-bearing deposits in other banks	37,355			23,883

Equity securities, at fair value	2,087			—
Securities available for sale, at fair value	295,777			321,337
Restricted stock, at cost	5,239			6,110
Loans held for sale	1,934			1,639

Loans, net of unearned income	1,331,153			1,336,125
Less allowance for loan losses	(13,588		)	(13,603		)
Net loans	1,317,565			1,322,522

Premises and equipment, net	25,690			25,901
Other real estate owned, net of valuation allowance of $113 in 2018 and $147 in 2017	916			1,225
Goodwill	43,872			43,872
Core deposit intangibles, net	981			1,191
Bank owned life insurance	18,785			18,460
Accrued interest receivable and other assets	23,602			21,344
Total assets	$	1,806,491		$	1,816,078

Liabilities
Demand deposits -- noninterest bearing	$	420,486		$	394,344
Demand deposits -- interest bearing	230,984			226,914
Money market deposits	362,575			403,024
Savings deposits	135,702			126,786
Time deposits	373,360			383,658
Total deposits	1,523,107			1,534,726

Short-term borrowings:
Customer repurchase agreements	29,104			10,726
Other short-term borrowings	—			24,000
Junior subordinated debt	27,902			27,826
Accrued interest payable and other liabilities	10,312			10,083
Total liabilities	1,590,425			1,607,361

Shareholders' equity
Preferred stock, $5 par, 2,000,000 shares authorized, none outstanding	—			—
Common stock, $1 par, 20,000,000 shares authorized, 8,714,431 shares outstanding at September 30, 2018 and 8,650,547 shares outstanding at December 31, 2017	8,661			8,604
Capital in excess of par value	77,842			76,179
Retained earnings	138,715			127,010
Accumulated other comprehensive loss, net	(9,152		)	(3,076		)
Total shareholders' equity	216,066			208,717
Total liabilities and shareholders' equity	$	1,806,491		$	1,816,078

(*) - Derived from audited consolidated financial statements.

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



American National Bankshares Inc.
Consolidated Statements of Income
(Dollars in thousands, except per share data) (Unaudited)
	Three Months Ended September 30,					Nine Months Ended September 30,
	2018			2017		2018			2017
Interest and Dividend Income:
Interest and fees on loans	$	15,062		$	14,394	$	44,485		$	40,850
Interest and dividends on securities:
Taxable	1,568			1,108		4,432			3,395
Tax-exempt	362			460		1,204			1,604
Dividends	82			77		240			240
Other interest income	143			235		516			469
Total interest and dividend income	17,217			16,274		50,877			46,558
Interest Expense:
Interest on deposits	2,048			1,529		5,746			4,081
Interest on short-term borrowings	29			52		41			94
Interest on long-term borrowings	—			82		—			243
Interest on junior subordinated debt	389			273		1,008			756
Total interest expense	2,466			1,936		6,795			5,174
Net Interest Income	14,751			14,338		44,082			41,384
Provision for (recovery of) Loan Losses	(23		)	440		(97		)	1,090
Net Interest Income After Provision for Loan Losses	14,774			13,898		44,179			40,294
Noninterest Income:
Trust fees	1,001			1,098		2,875			2,918
Service charges on deposit accounts	605			622		1,809			1,818
Other fees and commissions	656			618		1,977			1,852
Mortgage banking income	551			612		1,492			1,603
Securities gains (losses), net	(17		)	—		393			590
Brokerage fees	172			219		603			603
Income from Small Business Investment Companies	150			86		476			118
Gains on premises and equipment, net	63			337		66			337
Other	199			212		585			584
Total noninterest income	3,380			3,804		10,276			10,423
Noninterest Expense:
Salaries	5,285			5,072		15,377			14,604
Employee benefits	1,036			1,048		3,322			3,229
Occupancy and equipment	1,069			1,151		3,297			3,367
FDIC assessment	134			138		412			401
Bank franchise tax	291			276		863			795
Core deposit intangible amortization	56			80		210			448
Data processing	420			475		1,309			1,464
Software	307			303		966			853
Other real estate owned, net	46			62		101			173
Other	2,260			2,105		6,751			6,528
Total noninterest expense	10,904			10,710		32,608			31,862
Income Before Income Taxes	7,250			6,992		21,847			18,855
Income Taxes	1,465			2,205		4,270			5,726
Net Income	$	5,785		$	4,787	$	17,577		$	13,129



Net Income Per Common Share:
Basic	$	0.66	$	0.55	$	2.02	$	1.52
Diluted	$	0.66	$	0.55	$	2.02	$	1.52
Average Common Shares Outstanding:
Basic	8,712,443		8,644,310		8,691,423		8,639,433
Diluted	8,718,918		8,663,246		8,703,662		8,657,891

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



American National Bankshares Inc.
Consolidated Statements of Comprehensive Income
(Dollars in thousands) (Unaudited)
	Three Months Ended September 30,
	2018			2017
Net income	$	5,785		$	4,787

Other comprehensive income (loss):

Unrealized gains (losses) on securities available for sale	(1,965		)	296
Tax effect	440			(104		)

Reclassification adjustment for gains on sales of securities	(73		)	—
Tax effect	16			—

Unrealized gains on cash flow hedges	438			—
Tax effect	(98		)	—

Other comprehensive income (loss)	(1,242		)	192

Comprehensive income	$	4,543		$	4,979

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



American National Bankshares Inc.
Consolidated Statements of Comprehensive Income
(Dollars in thousands) (Unaudited)
	Nine Months Ended September 30,
	2018			2017
Net income	$	17,577		$	13,129

Other comprehensive income (loss):

Unrealized gains (losses) on securities available for sale	(7,145		)	2,186
Tax effect	1,626			(765		)

Reclassification adjustment for gains on sales of securities	(81		)	(590		)
Tax effect	18			207

Unrealized gains on cash flow hedges	201			—
Tax effect	(45		)	—

Other comprehensive income (loss)	(5,426		)	1,038

Comprehensive income	$	12,151		$	14,167

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



American National Bankshares Inc.
Consolidated Statements of Changes in Shareholders' Equity
Nine Months Ended September 30, 2018 and 2017
(Dollars in thousands, except per share data) (Unaudited)
	Common Stock		Capital in Excess of Par Value			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Shareholders' Equity
Balance, December 31, 2016	$	8,578	$	75,076		$	119,600		$	(1,874	)	$	201,380

Net income	—		—			13,129			—			13,129

Other comprehensive income	—		—			—			1,038			1,038

Stock options exercised (4,950 shares)	5		109			—			—			114

Vesting of restricted stock (7,086 shares)	7		(7		)	—			—			—

Equity based compensation (24,344 shares)	10		765			—			—			775

Cash dividends paid, $0.72 per share	—		—			(6,222		)	—			(6,222		)

Balance, September 30, 2017	$	8,600	$	75,943		$	126,507		$	(836	)	$	210,214

Balance, December 31, 2017	$	8,604	$	76,179		$	127,010		$	(3,076	)	$	208,717

Net income	—		—			17,577			—			17,577

Other comprehensive loss	—		—			—			(5,426		)	(5,426		)

Reclassification for ASU 2016-01 adoption	—		—			650			(650		)	—

Stock options exercised (35,310 shares)	35		826			—			—			861

Vesting of restricted stock (10,718 shares)	11		(11		)	—			—			—

Equity based compensation (28,574 shares)	11		848			—			—			859

Cash dividends paid, $0.75 per share	—		—			(6,522		)	—			(6,522		)

Balance, September 30, 2018	$	8,661	$	77,842		$	138,715		$	(9,152	)	$	216,066

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



American National Bankshares Inc.
Consolidated Statements of Cash Flows
(Dollars in thousands) (Unaudited)
	Nine Months Ended September 30,
	2018			2017
Cash Flows from Operating Activities:
Net income	$	17,577		$	13,129
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for (recovery of) loan losses	(97		)	1,090
Depreciation	1,366			1,394
Net accretion of acquisition accounting adjustments	(1,002		)	(1,586		)
Core deposit intangible amortization	210			448
Net amortization of securities	1,262			1,417
Net gain on sale or call of securities available for sale	(81		)	(590		)
Net unrealized holding gains on equity securities	(312		)	—
Gain on sale of loans held for sale	(1,492		)	(1,274		)
Proceeds from sales of loans held for sale	61,772			67,511
Originations of loans held for sale	(60,575		)	(63,627		)
Net (gain) loss on other real estate owned	5			(13		)
Valuation allowance on other real estate owned	28			86
Net gain on sale of premises and equipment	(66		)	(337		)
Equity based compensation expense	859			775
Earnings on bank owned life insurance	(325		)	(328		)
Deferred income tax expense	203			792
Net change in interest receivable	(1		)	299
Net change in other assets	(660		)	(749		)
Net change in interest payable	93			39
Net change in other liabilities	136			(701		)
Net cash provided by operating activities	18,900			17,775

Cash Flows from Investing Activities:
Proceeds from sales of equity securities	431			—
Proceeds from sales of securities available for sale	57,607			55,403
Proceeds from maturities, calls and paydowns of securities available for sale	23,561			39,441
Purchases of securities available for sale	(66,221		)	(19,778		)
Net change in restricted stock	871			715
Net (increase) decrease in loans	5,600			(129,920		)
Proceeds from sale of premises and equipment	233			647
Purchases of premises and equipment	(1,322		)	(2,188		)
Proceeds from sales of other real estate owned	808			387
Net cash provided by (used in) investing activities	21,568			(55,293		)

Cash Flows from Financing Activities:
Net change in demand, money market, and savings deposits	(1,321		)	96,371
Net change in time deposits	(10,298		)	13,194
Net change in customer repurchase agreements	18,378			4,074
Net change in other short-term borrowings	(24,000		)	(20,000		)
Common stock dividends paid	(6,522		)	(6,222		)
Proceeds from exercise of stock options	861			114
Net cash provided by (used in) financing activities	(22,902		)	87,531

Net Increase in Cash and Cash Equivalents	17,566			50,013

Cash and Cash Equivalents at Beginning of Period	52,477			53,207
Cash and Cash Equivalents at End of Period	$	70,043		$	103,220

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

AMERICAN NATIONAL BANKSHARES INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Accounting Policies

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

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, goodwill and intangible assets, unfunded pension liability, other-than-temporary impairment of securities, accounting for merger and acquisition activity, accounting for acquired loans with specific credit-related deterioration, the valuation of deferred tax assets and liabilities, and the valuation of other real estate owned ("OREO").

All significant inter-company transactions and accounts are eliminated in consolidation, with the exception of the AMNB Trust and the MidCarolina Trusts, as detailed in Note 8.

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the results of the interim periods. The results of operations for the interim periods are not necessarily indicative of the results that may occur for any other period. Certain reclassifications have been made to prior period balances to conform to the current period presentation. These reclassifications did not have an impact on net income and were considered immaterial. These statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017.

Adoption of New Accounting Standards

On January 1, 2018, the Company adopted Accounting Standards Update ("ASU") 2016-01, "Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which amended the guidance on the classification and measurement of financial instruments. Upon adoption of ASU 2016-01, the Company reclassified $650,000 from accumulated other comprehensive loss to retained earnings for the difference in amortized cost and fair value. In 2018, the Company recognized the equity securities fair value change in net income. Previously, the fair value changes were recognized, net of tax, in other comprehensive loss. The adoption of ASU 2016-01 did not have a material effect on the Company's consolidated financial statements.

During the first quarter of 2018, the Company adopted ASU 2014-09, "Revenue from Contracts with Customers", and all subsequent amendments to the ASU (collectively "ASC 606"), which (i) creates a single framework for recognizing revenue from contracts with customers that fall within its scope and (ii) revises when it is appropriate to recognize a gain (loss) from the transfer of nonfinancial assets, such as OREO. The majority of the Company's revenue is from interest income, including loans and securities, that are outside the scope of the standard. The services that fall within the scope of the standard are presented within noninterest income on the consolidated statement of income and are recognized as revenue as the Company satisfies its obligations to the customer. The revenue that falls within the scope of ASC 606 is primarily related to service charges on deposit accounts, cardholder and merchant income, wealth advisory services income, other service charges and fees, sales of other real estate, insurance commissions and miscellaneous fees. ASC 606 did not result in a change to the accounting for any in-scope revenue streams; as such, no cumulative effect adjustment was recorded.

Recent Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-02, "Leases (Topic 842)." Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (i) a lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and (ii) a right-of-use asset, which is an asset that represents the lessee's right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted

upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The FASB made subsequent amendments to Topic 842 in July 2018 through ASU 2018-10 ("Codification Improvements to Topic 842, Leases.") and ASU 2018-11 ("Leases (Topic 842): Targeted Improvements.") Among these amendments is the provision in ASU 2018-11 that provides entities with an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new leases standard will continue to be in accordance with current GAAP (Topic 840, Leases). The Company has analyzed all leases currently in place and determined the adoption of ASU 2016-02 (as amended) will not have a material impact on its consolidated financial statements.

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments." The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for Securities and Exchange Commission ("SEC") filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company has implemented and completed a significant amount of a project plan with the assistance of an outside vendor. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment." The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Public business entities that are SEC filers should adopt the amendments in this ASU for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.

In March 2017, the FASB issued ASU 2017-08, "Receivables-Nonrefundable Fees and Other Costs (Subtopic 310‐20), Premium Amortization on Purchased Callable Debt Securities." The amendments in this ASU shorten the amortization period for certain callable debt securities purchased at a premium. Upon adoption of the standard, premiums on these qualifying callable debt securities will be amortized to the earliest call date. Discounts on purchased debt securities will continue to be accreted to maturity. The amendments are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. Upon transition, entities should apply the guidance on a modified retrospective basis, with a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and provide the disclosures required for a change in accounting principle. The Company is currently assessing the impact that ASU 2017-08 will have on its consolidated financial statements.

In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." The amendments in this ASU modify the designation and measurement guidance for hedge accounting as well as provide for increased transparency regarding the presentation of economic results on both the financial statements and related footnotes. Certain aspects of hedge effectiveness assessments will also be simplified upon implementation of this update. The amendments are effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted, including adoption in any interim period. The Company is currently assessing the impact that ASU 2017-12 will have on its consolidated financial statements.

In June 2018, the FASB issued ASU 2018-07, "Compensation- Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting." The amendments expand the scope of Topic 718 to include share-based payments issued to non-employees for goods or services, which were previously excluded. The amendments will align the accounting for share-based payments to nonemployees and employees more similarly. The amendments are effective for fiscal

years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-07 to have a material impact on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-13, "Fair Value Measurement (Topic 820): Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement." The amendments modify the disclosure requirements in Topic 820 to add disclosures regarding changes in unrealized gains and losses, the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements and the narrative description of measurement uncertainty. Certain disclosure requirements in Topic 820 are also removed or modified. The amendments are effective for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Certain of the amendments are to be applied prospectively while others are to be applied retrospectively. Early adoption is permitted. The Company does not expect the adoption of ASU 2018-13 to have a material impact on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-14, "Compensation-Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20): Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans." These amendments modify the disclosure requirements for employers that sponsor defined benefit pension or other postretirement plans. Certain disclosure requirements have been deleted while the following disclosure requirements have been added: the weighted-average interest crediting rates for cash balance plans and other plans with promised interest crediting rates and an explanation of the reasons for significant gains and losses related to changes in the benefit obligation for the period. The amendments also clarify the disclosure requirements in paragraph 715-20-50-3, which state that the following information for defined benefit pension plans should be disclosed: The projected benefit obligation ("PBO") and fair value of plan assets for plans with PBOs in excess of plan assets and the accumulated benefit obligation ("ABO") and fair value of plan assets for plans with ABOs in excess of plan assets. The amendments are effective for fiscal years ending after December 15, 2020. Early adoption is permitted. The Company is currently assessing the impact that ASU 2018-14 will have on its consolidated financial statements.

Note 2 – Securities

The amortized cost and fair value of investments in debt and equity securities at September 30, 2018 and December 31, 2017 were as follows (dollars in thousands):



	September 30, 2018
	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
Securities available for sale:
Federal agencies and GSEs	$	117,159	$	—	$	4,991	$	112,168
Mortgage-backed and CMOs	104,595		121		3,554		101,162
State and municipal	75,929		287		928		75,288
Corporate	7,151		30		22		7,159
Total securities available for sale	$	304,834	$	438	$	9,495	$	295,777

The Company adopted ASU 2016-01 effective January 1, 2018 and had equity securities with a fair value of $2,087,000 at September 30, 2018 and recognized in income $312,000 of unrealized holding gains in the first nine months of 2018. During the nine months ended September 30, 2018, the Company sold $431,000 in equity securities at fair value.



	December 31, 2017
	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
Securities available for sale:
Federal agencies and GSEs	$	114,246	$	8	$	2,127	$	112,127
Mortgage-backed and CMOs	106,163		293		1,140		105,316
State and municipal	92,711		1,262		347		93,626
Corporate	7,842		234		14		8,062
Equity securities	1,383		823		—		2,206
Total securities available for sale	$	322,345	$	2,620	$	3,628	$	321,337

Restricted Stock

Due to restrictions placed upon the Bank's common stock investment in the Federal Reserve Bank of Richmond ("FRB") and Federal Home Loan Bank of Atlanta ("FHLB"), these securities have been classified as restricted equity securities and carried at cost. The restricted securities are not subject to the investment security classification and are included as a separate line item on the Company's consolidated balance sheets. The FRB requires the Bank to maintain stock with a par value equal to 3.00% of its outstanding capital and an additional 3.00% is on call. The FHLB requires the Bank to maintain stock in an amount equal to 4.25% of outstanding borrowings and a specific percentage of the Bank's total assets. The cost of restricted stock at September 30, 2018 and December 31, 2017 was as follows (dollars in thousands):



	September 30, 2018		December 31, 2017
FRB stock	$	3,613	$	3,587
FHLB stock	1,626		2,523
Total restricted stock	$	5,239	$	6,110

Temporarily Impaired Securities

The following table shows estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2018. The reference point for determining when securities are in an unrealized loss position is month-end. Therefore, it is possible that a security's market value exceeded its amortized cost on other days during the past twelve-month period.

Available for sale securities that have been in a continuous unrealized loss position are as follows (dollars in thousands):



	Total				Less than 12 Months				12 Months or More
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Federal agencies and GSEs	$	112,168	$	4,991	$	34,414	$	469	$	77,754	$	4,522
Mortgage-backed and CMOs	95,154		3,554		36,050		840		59,104		2,714
State and municipal	51,631		928		38,892		407		12,739		521
Corporate	829		22		—		—		829		22
Total	$	259,782	$	9,495	$	109,356	$	1,716	$	150,426	$	7,779

Federal agencies and GSEs: The unrealized losses on the Company's investment in 25 government sponsored entities ("GSE") securities were caused by interest rate increases. Eighteen of these securities were in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2018.

Mortgage-backed securities: The unrealized losses on the Company's investment in 71 GSE mortgage-backed securities were caused by interest rate increases. Thirty-nine of these securities were in an unrealized loss position for 12 months or more. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost basis of the Company's investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2018.

Collateralized Mortgage Obligations: The unrealized losses associated with three private GSE collateralized mortgage obligations ("CMO") were due to normal market fluctuations. One of these securities was in an unrealized loss position for 12 months or more. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost basis of the Company's investments. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of its amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2018.

State and municipal securities: The unrealized losses on 72 state and municipal securities were caused by interest rate increases. Twenty of these securities were in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2018.

Corporate securities: The unrealized losses on two corporate securities were caused by interest rate increases. Both of these two securities were in an unrealized loss position for 12 months or more. The contractual terms of those investments do not permit the issuer to settle the securities at a price less than the amortized cost basis of the investments. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost basis, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at September 30, 2018.

Restricted stock: When evaluating restricted stock for impairment, its value is based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The Company does not consider restricted stock to be other-than-temporarily impaired at September 30, 2018, and no impairment has been recognized.

The table below shows estimated fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities had been in a continuous unrealized loss position, at December 31, 2017 (dollars in thousands):



	Total				Less than 12 Months				12 Months or More
	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Federal agencies and GSEs	$	99,133	$	2,127	$	45,474	$	321	$	53,659	$	1,806
Mortgage-backed and CMOs	90,806		1,140		64,449		533		26,357		607
State and municipal	34,550		347		27,442		159		7,108		188
Corporate	1,529		14		495		5		1,034		9
Total	$	226,018	$	3,628	$	137,860	$	1,018	$	88,158	$	2,610

Other-Than-Temporarily-Impaired Securities

As of September 30, 2018 and December 31, 2017, there were no securities classified as other-than-temporarily impaired.

Realized Gains and Losses

The following table presents the gross realized gains and losses on and the proceeds from the sale of securities available for sale during the three and nine months ended September 30, 2018 and 2017 (dollars in thousands):



	Three Months Ended September 30, 2018			Nine Months Ended September 30, 2018
Realized gains (losses):
Gross realized gains	$	237		$	342
Gross realized losses	(164		)	(261		)
Net realized gains	$	73		$	81
Proceeds from sales of securities	$	35,541		$	57,607

	Three Months Ended September 30, 2017			Nine Months Ended September 30, 2017
Realized gains (losses):
Gross realized gains	$	—		$	605
Gross realized losses	—			(15		)
Net realized gains	$	—		$	590
Proceeds from sales of securities	$	—		$	55,403

Note 3 – Loans

Loans, excluding loans held for sale, at September 30, 2018 and December 31, 2017, were comprised of the following (dollars in thousands):



	September 30, 2018		December 31, 2017
Commercial	$	284,176	$	251,666
Commercial real estate:
Construction and land development	99,546		123,147
Commercial real estate	632,022		637,701
Residential real estate:
Residential	205,277		209,326
Home equity	104,873		109,857
Consumer	5,259		4,428
Total loans	$	1,331,153	$	1,336,125

Acquired Loans

The outstanding principal balance and the carrying amount of these loans, including FASB Accounting Standards Codification ("ASC") 310-30, included in the consolidated balance sheets at September 30, 2018 and December 31, 2017 are as follows (dollars in thousands):



	September 30, 2018		December 31, 2017
Outstanding principal balance	$	66,544	$	79,523
Carrying amount	61,537		73,796

The outstanding principal balance and related carrying amount of acquired impaired loans, for which the Company applies ASC 310-30 to account for interest earned, as of the indicated dates are as follows (dollars in thousands):



	September 30, 2018		December 31, 2017
Outstanding principal balance	$	25,285	$	27,876
Carrying amount	21,221		23,430

The following table presents changes in the accretable yield on acquired impaired loans, for which the Company applies FASB ASC 310-30, for the nine months ended September 30, 2018 and the year ended December 31, 2017 (dollars in thousands):



	September 30, 2018			December 31, 2017
Balance at January 1	$	4,890		$	6,103
Accretion	(1,816		)	(3,117		)
Reclassification from nonaccretable difference	769			1,006
Other changes, net*	715			898
	$	4,558		$	4,890

* This line item represents changes in the cash flows expected to be collected due to the impact of non-credit changes such as prepayment assumptions, changes in interest rates on variable rate acquired impaired loans, and discounted payoffs that occurred in the period.

Past Due Loans

The following table shows an analysis by portfolio segment of the Company's past due loans at September 30, 2018 (dollars in thousands):



	30- 59 Days Past Due		60-89 Days Past Due		90 Days + Past Due and Still Accruing		Non- Accrual Loans		Total Past Due		Current		Total Loans
Commercial	$	7	$	—	$	—	$	1,054	$	1,061	$	283,115	$	284,176
Commercial real estate:
Construction and land development	—		—		—		30		30		99,516		99,546
Commercial real estate	45		—		—		215		260		631,762		632,022
Residential:
Residential	69		427		74		795		1,365		203,912		205,277
Home equity	129		—		—		144		273		104,600		104,873
Consumer	15		—		—		—		15		5,244		5,259
Total	$	265	$	427	$	74	$	2,238	$	3,004	$	1,328,149	$	1,331,153

The following table shows an analysis by portfolio segment of the Company's past due loans at December 31, 2017 (dollars in thousands):



	30- 59 Days Past Due		60-89 Days Past Due		90 Days + Past Due and Still Accruing		Non- Accrual Loans		Total Past Due		Current		Total Loans
Commercial	$	92	$	—	$	—	$	90	$	182	$	251,484	$	251,666
Commercial real estate:
Construction and land development	—		—		—		36		36		123,111		123,147
Commercial real estate	86		—		280		489		855		636,846		637,701
Residential:
Residential	282		71		79		1,343		1,775		207,551		209,326
Home equity	141		16		—		243		400		109,457		109,857
Consumer	21		5		—		—		26		4,402		4,428
Total	$	622	$	92	$	359	$	2,201	$	3,274	$	1,332,851	$	1,336,125

Impaired Loans

The following table presents the Company's impaired loan balances by portfolio segment, excluding acquired impaired loans, at September 30, 2018 (dollars in thousands):



	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial	$	32	$	32	$	—	$	48	$	4
Commercial real estate:
Construction and land development	—		—		—		—		—
Commercial real estate	496		492		—		583		29
Residential:
Residential	658		658		—		932		21
Home equity	51		51		—		123		9
Consumer	—		—		—		2		—
	$	1,237	$	1,233	$	—	$	1,688	$	63
With a related allowance recorded:
Commercial	$	1,002	$	1,000	$	791	$	427	$	49
Commercial real estate:
Construction and land development*	—		—		—		26		—
Commercial real estate*	—		—		—		23		—
Residential
Residential	176		176		9		384		7
Home equity*	—		—		—		160		1
Consumer*	—		—		—		—		—
	$	1,178	$	1,176	$	800	$	1,020	$	57
Total:
Commercial	$	1,034	$	1,032	$	791	$	475	$	53
Commercial real estate:
Construction and land development	—		—		—		26		—
Commercial real estate	496		492		—		606		29
Residential:
Residential	834		834		9		1,316		28
Home equity	51		51		—		283		10
Consumer	—		—		—		2		—
	$	2,415	$	2,409	$	800	$	2,708	$	120

* Allowance is reported as zero in the table due to presentation in thousands and rounding.

In the table above, recorded investment may exceed unpaid principal balance due to acquired loans with a premium and loans with unearned costs exceed unearned fees.

The following table presents the Company's impaired loan balances by portfolio segment, excluding acquired impaired loans, at December 31, 2017 (dollars in thousands):



	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Recorded Investment		Interest Income Recognized
With no related allowance recorded:
Commercial	$	4	$	4	$	—	$	19	$	1
Commercial real estate:
Construction and land development	—		—		—		56		4
Commercial real estate	791		789		—		1,069		66
Residential:
Residential	717		719		—		575		41
Home equity	142		142		—		109		10
Consumer	5		5		—		6		1
	$	1,659	$	1,659	$	—	$	1,834	$	123
With a related allowance recorded:
Commercial	$	202	$	201	$	154	$	150	$	16
Commercial real estate:
Construction and land development*	37		37		—		56		—
Commercial real estate*	34		32		—		126		11
Residential:
Residential	1,022		1,022		12		1,174		27
Home equity	263		261		1		251		1
Consumer*	—		—		—		5		—
	$	1,558	$	1,553	$	167	$	1,762	$	55
Total:
Commercial	$	206	$	205	$	154	$	169	$	17
Commercial real estate:
Construction and land development	37		37		—		112		4
Commercial real estate	825		821		—		1,195		77
Residential:
Residential	1,739		1,741		12		1,749		68
Home equity	405		403		1		360		11
Consumer	5		5		—		11		1
	$	3,217	$	3,212	$	167	$	3,596	$	178

* Allowance is reported as zero in the table due to presentation in thousands and rounding.

In the table above, recorded investment may exceed unpaid principal balance due to acquired loans with a premium and loans with unearned costs exceed unearned fees.

The following tables show the detail of loans modified as troubled debt restructurings ("TDRs") during the three and nine months ended September 30, 2018 included in the impaired loan balances (dollars in thousands):



	Loans Modified as a TDR for the
	Three Months Ended September 30, 2018
Loan Type	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial	—	$	—	$	—
Commercial real estate	—	—		—
Construction and land development	—	—		—
Home Equity	—	—		—
Residential real estate	—	—		—
Consumer	—	—		—
Total	—	$	—	$	—



	Loans Modified as a TDR for the
	Nine Months Ended September 30, 2018
Loan Type	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial	—	$	—	$	—
Commercial real estate	—	—		—
Construction and land development	—	—		—
Home Equity	—	—		—
Residential real estate	1	11		11
Consumer	—	—		—
Total	1	$	11	$	11

The following tables show the detail of loans modified as TDRs during the three and nine months ended September 30, 2017 included in the impaired loan balances (dollars in thousands):



	Loans Modified as a TDR for the
	Three Months Ended September 30, 2017
Loan Type	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial	1	$	45	$	45
Commercial real estate	—	—		—
Construction and land development	—	—		—
Home Equity	—	—		—
Residential real estate	—	—		—
Consumer	—	—		—
Total	1	$	45	$	45



	Loans Modified as a TDR for the
	Nine Months Ended September 30, 2017
Loan Type	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
Commercial	4	$	118	$	118
Commercial real estate	—	—		—
Construction and land development	—	—		—
Home Equity	2	57		57
Residential real estate	—	—		—
Consumer	—	—		—
Total	6	$	175	$	175

During the three and nine months ended September 30, 2018 and 2017, the Company had no loans that subsequently defaulted within twelve months of modification. The Company defines defaults as one or more payments that occur more than 90 days past the due date, charge-off or foreclosure subsequent to modification.

Residential Real Estate in Process of Foreclosure

The Company had $178,000 in residential real estate loans in the process of foreclosure at September 30, 2018 and $766,000 and $629,000 in residential OREO at September 30, 2018 and December 31, 2017, respectively.

Risk Grades

The following table shows the Company's loan portfolio broken down by internal risk grading as of September 30, 2018 (dollars in thousands):

Commercial and Consumer Credit Exposure

Credit Risk Profile by Internally Assigned Grade



	Commercial		Construction and Land Development		Commercial Real Estate Other		Residential		Home Equity
Pass	$	281,211	$	95,662	$	623,317	$	199,205	$	104,313
Special Mention	1,588		1,870		4,333		2,046		—
Substandard	1,377		2,014		4,372		4,026		560
Doubtful	—		—		—		—		—
Total	$	284,176	$	99,546	$	632,022	$	205,277	$	104,873

Consumer Credit Exposure

Credit Risk Profile Based on Payment Activity



	Consumer
Performing	$	5,259
Nonperforming	—
Total	$	5,259

The following table shows the Company's loan portfolio broken down by internal risk grading as of December 31, 2017 (dollars in thousands):

Commercial and Consumer Credit Exposure

Credit Risk Profile by Internally Assigned Grade



	Commercial		Construction and Land Development		Commercial Real Estate Other		Residential		Home Equity
Pass	$	248,714	$	114,502	$	625,861	$	200,405	$	107,705
Special Mention	1,763		7,114		6,914		4,438		1,325
Substandard	1,189		1,531		4,926		4,483		827
Doubtful	—		—		—		—		—
Total	$	251,666	$	123,147	$	637,701	$	209,326	$	109,857

Consumer Credit Exposure

Credit Risk Profile Based on Payment Activity



	Consumer
Performing	$	4,415
Nonperforming	13
Total	$	4,428

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

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

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

Loans classified in the Doubtful category typically have all the weaknesses inherent in loans classified as substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts,

conditions, and values highly questionable and improbable. However, these loans are not yet rated as loss because certain events may occur that may salvage the debt.

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

Note 4 – Allowance for Loan Losses and Reserve for Unfunded Lending Commitments

Changes in the allowance for loan losses and the reserve for unfunded lending commitments at and for the indicated dates and periods are presented below (dollars in thousands):



	Nine Months Ended September 30, 2018			Year Ended December 31, 2017			Nine Months Ended September 30, 2017
Allowance for Loan Losses
Balance, beginning of period	$	13,603		$	12,801		$	12,801
Provision for loan losses	(97		)	1,016			1,090
Charge-offs	(202		)	(690		)	(411		)
Recoveries	284			476			378
Balance, end of period	$	13,588		$	13,603		$	13,858

Reserve for Unfunded Lending Commitments
Balance, beginning of period	$	206		$	203		$	203
Provision for unfunded commitments	12			3			11
Charge-offs	—			—			—
Balance, end of period	$	218		$	206		$	214

The reserve for unfunded loan commitments is included in other liabilities.

The following table presents changes in the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at and for the nine months ended September 30, 2018 (dollars in thousands):



	Commercial			Commercial Real Estate			Residential Real Estate			Consumer			Total
Allowance for Loan Losses
Balance at December 31, 2017:	$	2,413		$	8,321		$	2,825		$	44		$	13,603
Provision for loan losses	818			(1,127		)	186			26			(97		)
Charge-offs	(10		)	(11		)	(86		)	(95		)	(202		)
Recoveries	65			4			139			76			284
Balance at September 30, 2018:	$	3,286		$	7,187		$	3,064		$	51		$	13,588

Balance at September 30, 2018:

Allowance for Loan Losses
Individually evaluated for impairment	$	791		$	—		$	9		$	—		$	800
Collectively evaluated for impairment	2,495			7,151			2,904			51			12,601
Acquired impaired loans	—			36			151			—			187
Total	$	3,286		$	7,187		$	3,064		$	51		$	13,588

Loans
Individually evaluated for impairment	$	1,034		$	496		$	885		$	—		$	2,415
Collectively evaluated for impairment	282,783			720,540			298,950			5,244			1,307,517
Acquired impaired loans	359			10,532			10,315			15			21,221
Total	$	284,176		$	731,568		$	310,150		$	5,259		$	1,331,153

The following table presents changes in the Company's allowance for loan losses by portfolio segment and the related loan balance total by segment at and for the year ended December 31, 2017 (dollars in thousands):



	Commercial			Commercial Real Estate			Residential Real Estate			Consumer			Total
Allowance for Loan Losses
Balance at December 31, 2016:	$	2,095		$	7,355		$	3,303		$	48		$	12,801
Provision for loan losses	377			999			(391		)	31			1,016
Charge-offs	(282		)	(93		)	(172		)	(143		)	(690		)
Recoveries	223			60			85			108			476
Balance at December 31, 2017:	$	2,413		$	8,321		$	2,825		$	44		$	13,603

Balance at December 31, 2017:

Allowance for Loan Losses
Individually evaluated for impairment	$	154		$	—		$	13		$	—		$	167
Collectively evaluated for impairment	2,259			8,203			2,645			44			13,151
Acquired impaired loans	—			118			167			—			285
Total	$	2,413		$	8,321		$	2,825		$	44		$	13,603

Loans
Individually evaluated for impairment	$	206		$	862		$	2,144		$	5		$	3,217
Collectively evaluated for impairment	251,185			747,819			306,066			4,408			1,309,478
Acquired impaired loans	275			12,167			10,973			15			23,430
Total	$	251,666		$	760,848		$	319,183		$	4,428		$	1,336,125

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

Note 5 – Goodwill and Other Intangible Assets

The Company records as goodwill the excess of the purchase price over the fair value of the identifiable net assets acquired. Impairment testing is performed annually, as well as when an event triggering impairment may have occurred. The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment. No indicators of impairment were identified as of June 30, 2018.

Core deposit intangibles resulting from the acquisition of MidCarolina Financial Corporation ("MidCarolina") in July 2011 were $6,556,000 and are being amortized on an accelerated basis over 108 months. Core deposit intangibles resulting from the acquisition of MainStreet BankShares, Inc. in January 2015 were $1,839,000 and are being amortized on an accelerated basis over 120 months.

The changes in the carrying amount of goodwill and intangibles for the nine months ended September 30, 2018, are as follows (dollars in thousands):



	Goodwill		Intangibles
Balance at December 31, 2017	$	43,872	$	1,191
Additions	—		—
Amortization	—		(210		)
Impairment	—		—
Balance at September 30, 2018	$	43,872	$	981

Note 6 – Short-term Borrowings

Short-term borrowings consist of customer repurchase agreements, overnight borrowings from the FHLB, and federal funds purchased. The Company has federal funds lines of credit established with two correspondent banks in the amounts of $15,000,000, each, and, additionally, has access to the FRB's discount window. All other short-term borrowings at December 31, 2017 were FHLB advances. Customer repurchase agreements are collateralized by securities of the U.S. Government or its agencies ("GSEs"). They mature daily. The interest rates may be changed at the discretion of the Company. The securities underlying these agreements remain under the Company's control. FHLB overnight borrowings contain floating interest rates that may change daily at the discretion of the FHLB. Federal funds purchased are unsecured overnight borrowings from other financial institutions. Short-term borrowings consisted of the following at September 30, 2018 and December 31, 2017 (dollars in thousands):



	September 30, 2018		December 31, 2017
Customer repurchase agreements	$	29,104	$	10,726
Other short-term borrowings	—		24,000
	$	29,104	$	34,726

Note 7 – Long-term Borrowings

Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans, second mortgage loans, home equity lines of credit, and commercial real estate loans. In addition, the Company pledges as collateral its capital stock in the FHLB and deposits with the FHLB. The Company has a line of credit with the FHLB equal to 30% of the Company's assets, subject to the amount of collateral pledged. As of September 30, 2018, $564,290,000 in eligible collateral was pledged under the blanket floating lien agreement which covers both short-term and long-term borrowings.

In the regular course of conducting its business, the Company takes deposits from political subdivisions of the states of Virginia and North Carolina. At September 30, 2018, the Bank's public deposits totaled $224,280,000. The Company is required to provide collateral to secure the deposits that exceed the insurance coverage provided by the Federal Deposit Insurance Corporation. This collateral can be provided in the form of certain types of government or agency bonds or letters of credit from the FHLB. At September 30, 2018, the Company had $190,000,000 in letters of credit with the FHLB outstanding, as well as $88,553,000 in agency, state, and municipal securities pledged to provide collateral for such deposits.

Note 8 – Junior Subordinated Debt

On April 7, 2006, AMNB Statutory Trust I, a Delaware statutory trust and a wholly owned unconsolidated subsidiary of the Company, issued $20,000,000 of preferred securities (the "Trust Preferred Securities") in a private placement pursuant to an applicable exemption from registration. The Trust Preferred Securities mature on June 30, 2036, but may be redeemed at the Company's option beginning on September 30, 2011. Distributions are cumulative and will accrue from the date of original issuance, but may be deferred by the Company from time to time for up to 20 consecutive quarterly periods. The Company has guaranteed the payment of all required distributions on the Trust Preferred Securities. The proceeds of the Trust Preferred Securities received by the trust, along with proceeds of $619,000 received by the trust from the issuance of common securities by the trust to the Company, were used to purchase $20,619,000 of the Company's junior subordinated debt securities (the "Junior Subordinated Debt"), issued pursuant to junior subordinated debentures entered into between the Company and Wilmington Trust Company, as trustee. The proceeds of the Junior Subordinated Debt were used to fund the cash portion of the merger consideration to the former shareholders of Community First Financial Corporation in connection with the Company's acquisition of that company in 2006, and for general corporate purposes.

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

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

A description of the junior subordinated debt securities outstanding payable to the trusts is shown below as of September 30, 2018 and December 31, 2017 (dollars in thousands):

Issuing Entity

Date Issued

Interest Rate

Maturity Date

Principal Amount

September 30, 2018

December 31, 2017

AMNB Trust I

4/7/2006

Libor plus

1.35%

6/30/2036

20,619

MidCarolina Trust I

10/29/2002

Libor plus

3.45%

11/7/2032

4,363

4,322

MidCarolina Trust II

12/3/2003

Libor plus

2.95%

10/7/2033

2,920

2,885

27,902

27,826

The principal amounts reflected above for the MidCarolina Trusts are net of fair value adjustments of $1,481,000 and $1,557,000 at September 30, 2018 and December 31, 2017, respectively. The original fair value adjustments of $1,197,000 and $1,021,000 were recorded as a result of the acquisition of MidCarolina on July 1, 2011, and are being amortized into interest expense over the remaining lives of the respective borrowings.

Note 9 - Derivative Financial Instruments and Hedging Activities

The Company uses derivative financial instruments ("derivatives") primarily to manage risks to the Company associated with changing interest rates. The Company's derivatives are hedging instruments in a qualifying hedge accounting relationship (cash flow or fair value hedge).

The Company designates derivatives as cash flow hedges when they are used to manage exposure to variability in cash flows on variable rate borrowings such as the Company's trust preferred capital notes. The Company uses interest rate swap agreements as part of its hedging strategy by exchanging variable-rate interest payments on a notional amount equal to the principal amount of the borrowings for fixed-rate interest payments, with such interest rates set based on benchmarked interest rates.

All interest rate swaps were entered into with counterparties that met the Company's credit standards and the agreements contain collateral provisions protecting the at-risk party. The Company believes that the credit risk inherent in these derivative contracts is not significant.

Terms and conditions of the interest rate swaps vary and amounts receivable or payable are recognized as accrued under the terms of the agreements. The Company assesses the effectiveness of each hedging relationship on a periodic basis. In accordance with ASC 815, "Derivatives and Hedging," the effective portions of the derivatives' unrealized gains or losses are recorded as a component of other comprehensive income. Based on the Company's assessment, its cash flow hedges are highly effective, but to the extent that any ineffectiveness exists in the hedge relationships, the amounts would be recorded in interest income and interest expense in the Company's consolidated statements of income.



(Dollars in thousands)	September 30, 2018
	Notional Amount		Positions	Assets		Liabilities		Cash Collateral Pledged
Cash flow hedges:
Interest rate swaps:
Variable-rate to fixed-rate swaps with counterparty	$	28,500	3	$	201	$	—	$	350

Note 10 – Stock Based Compensation

The Company's 2018 Equity Compensation Plan ("2018 Plan") was adopted by the Board of Directors of the Company on February 20, 2018, and approved by shareholders on May 15, 2018, at the Company's 2018 Annual Meeting of Shareholders. The 2018 Plan provides for the granting of restricted stock awards and incentive and non-statutory options to employees and directors on a periodic basis, at the discretion of the Board of Directors or a Board designated committee. The 2018 Plan authorizes the issuance of up to 675,000 shares of common stock. The 2018 Plan replaced the Company's stock incentive plan that was approved by the shareholders at the 2008 Annual Meeting and expired in February 2018 (the "2008 Plan").

Stock Options

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

A summary of stock option transactions for the nine months ended September 30, 2018 is as follows:



	Option Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value ($000)
Outstanding at December 31, 2017	50,985		$	24.09
Granted	—		—
Exercised	(35,310	)	24.37
Forfeited	—		—
Expired	(1,650	)	33.33
Outstanding at September 30, 2018	14,025		$	22.28	0.30 years	$	234
Exercisable at September 30, 2018	14,025		$	22.28	0.30 years	$	234

The fair value of options is estimated at the date of grant using the Black-Scholes option pricing model and expensed over the options' vesting period. No stock options have been granted since 2009. As of September 30, 2018, there were no unrecognized compensation expenses related to nonvested stock option grants.

Restricted Stock

The Company from time-to-time grants shares of restricted stock to key employees and non-employee directors. These awards help align the interests of these employees and directors with the interests of the shareholders of the Company by providing economic value directly related to increases in the value of the Company's common stock. The value of the stock awarded is established as the fair value of the stock at the time of the grant. The Company recognizes expense, equal to the total value of such awards, ratably over the vesting period of the stock grants. The majority of the restricted stock granted cliff vests at the end of a 36-month period beginning on the date of the grant. The remainder vests one-third each year beginning on the date of the grant. Nonvested restricted stock activity for the nine months ended September 30, 2018 is summarized in the following table.



Restricted Stock	Shares		Weighted Average Grant Date Value
Nonvested at December 31, 2017	46,501		$	26.28
Granted	18,192		39.52
Vested	(10,718	)	21.93
Forfeited	(483	)	34.70
Nonvested at September 30, 2018	53,492		$	31.58

As of September 30, 2018 and December 31, 2017, there was $820,000 and $538,000, respectively, in unrecognized compensation cost related to nonvested restricted stock granted under the 2008 Plan. The weighted average period over which this cost is expected to be recognized is 1.24 years. The share based compensation expense for nonvested restricted stock was $437,000 and $418,000 during the first nine months of 2018 and 2017, respectively.

The Company offers its outside directors alternatives with respect to director compensation. For 2018, the regular quarterly board retainer will be received in the form of shares of immediately vested, but restricted stock with a market value of $7,500. Monthly meeting fees can be received as $725 per meeting in cash or $900 in immediately vested, but restricted stock. Only outside directors receive board fees. The Company issued 10,865 and 9,891 shares and recognized share based compensation expense of $422,000 and $357,000 during the first nine months of 2018 and 2017, respectively.

Note 11 – Earnings Per Common Share

The following shows the weighted average number of shares used in computing earnings per common share and the effect on the weighted average number of shares of potentially dilutive common stock. Potentially dilutive common stock had no effect on income available to common shareholders. Nonvested restricted shares are included in the computation of basic earnings per share as the holder is entitled to full shareholder benefits during the vesting period including voting rights and sharing in nonforfeitable dividends. The following table presents basic and diluted earnings per share for the three and nine month periods ended September 30, 2018 and 2017.



	Three Months Ended September 30,
	2018			2017
	Shares	Per Share Amount		Shares	Per Share Amount
Basic earnings per share	8,712,443	$	0.66	8,644,310	$	0.55
Effect of dilutive securities - stock options	6,475	—		18,936	—
Diluted earnings per share	8,718,918	$	0.66	8,663,246	$	0.55



	Nine Months Ended September 30,
	2018			2017
	Shares	Per Share Amount		Shares	Per Share Amount
Basic earnings per share	8,691,423	$	2.02	8,639,433	$	1.52
Effect of dilutive securities - stock options	12,239	—		18,458	—
Diluted earnings per share	8,703,662	$	2.02	8,657,891	$	1.52

Outstanding stock options on common stock that were not included in computing diluted earnings per share for the nine month periods ended September 30, 2018 and 2017 because their effects were anti-dilutive, were 0 and 440 shares, respectively. There were no anti-dilutive stock options for the three month periods ended September 30, 2018 and 2017.

Note 12 – Employee Benefit Plans

The following information for the nine months ended September 30, 2018 and 2017 pertains to the Company's non-contributory defined benefit pension plan which was frozen in 2009. If lump sum payments exceed the service cost plus interest cost, an additional settlement charge will apply (dollars in thousands):



Components of Net Periodic Benefit Cost	Nine Months Ended September 30,
	2018			2017
Service cost	$	—		$	—
Interest cost	176			178
Expected return on plan assets	(265		)	(264		)
Recognized loss due to settlement	193			104
Recognized net actuarial loss	204			163
Net periodic cost	$	308		$	181

Note 13 – Fair Value of Financial Instruments

Determination of Fair Value

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with the fair value measurements and disclosures topic of FASB ASC 820, the fair value of an instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

The fair value guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

Fair Value Hierarchy

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



Level 1 –	Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 –	Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
Level 3 –	Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

The following describes the valuation techniques used by the Company to measure certain financial assets and financial liabilities recorded at fair value on a recurring basis in the financial statements:

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). If no observable market data is available, valuations are based upon third party model based techniques (Level 3). There were no securities recorded with a Level 3 valuation at September 30, 2018 or December 31, 2017.

Derivative asset (liability) - cash flow hedges: Cash flow hedges are recorded at fair value on a recurring basis. Cash flow hedges are valued by a third party using significant assumptions that are observable in the market and can be corroborated by market data. All of the Company's cash flow hedges are classified as Level 2.

The following table presents the balances of financial assets measured at fair value on a recurring basis at the dates indicated (dollars in thousands):



	Fair Value Measurements at September 30, 2018 Using
	Balance at September 30,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2018		Level 1		Level 2		Level 3
Assets:
Securities available for sale:
Federal agencies and GSEs	$	112,168	$	—	$	112,168	$	—
Mortgage-backed and CMOs	101,162		—		101,162		—
State and municipal	75,288		—		75,288		—
Corporate	7,159		—		7,159		—
Total securities available for sale	$	295,777	$	—	$	295,777	$	—
Equity securities	$	2,087	$	—	$	2,087	$	—
Derivative - cash flow hedges	$	201	$	—	$	201	$	—



	Fair Value Measurements at December 31, 2017 Using
	Balance at December 31,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2017		Level 1		Level 2		Level 3
Assets:
Securities available for sale:
Federal agencies and GSEs	$	112,127	$	—	$	112,127	$	—
Mortgage-backed and CMOs	105,316		—		105,316		—
State and municipal	93,626		—		93,626		—
Corporate	8,062		—		8,062		—
Equity securities	2,206		—		2,206		—
Total securities available for sale	$	321,337	$	—	$	321,337	$	—

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

The following describes the valuation techniques used by the Company to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

Loans held for sale: Loans held for sale are carried at fair value. These loans currently consist of one-to-four family residential loans originated for sale in the secondary market. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale (Level 2). As such, the Company records any fair value adjustments on a nonrecurring basis. No nonrecurring fair value adjustments were recorded on loans held for sale during the nine month period ended September 30, 2018 or the year ended December 31, 2017. Gains and losses on the sale of loans are recorded within mortgage banking income on the consolidated statements of income.

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

OREO: Measurement for fair values for OREO are the same as impaired loans. Any fair value adjustments are recorded in the period incurred as a valuation allowance against other real estate owned with the associated expense included in other real estate owned expense, net on the consolidated statements of income.

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



	Fair Value Measurements at September 30, 2018 Using
	Balance at September 30,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2018		Level 1		Level 2		Level 3
Assets:
Loans held for sale	$	1,934	$	—	$	1,934	$	—
Impaired loans, net of valuation allowance	378		—		—		378
Other real estate owned, net	916		—		—		916



	Fair Value Measurements at December 31, 2017 Using
	Balance at December 31,		Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
Description	2017		Level 1		Level 2		Level 3
Assets:
Loans held for sale	$	1,639	$	—	$	1,639	$	—
Impaired loans, net of valuation allowance	1,391		—		—		1,391
Other real estate owned, net	1,225		—		—		1,225

The following tables summarize the Company's quantitative information about Level 3 fair value measurements at the dates indicated:

Quantitative Information About Level 3 Fair Value Measurements at September 30, 2018



Assets	Valuation Technique	Unobservable Input	Rate

Impaired loans	Discounted appraised value	Selling cost	8.00%
	Discounted cash flow analysis	Market rate for borrower (discount rate)	3.25% - 9.80%

Other real estate owned, net	Discounted appraised value	Selling cost	8.00%

Quantitative Information About Level 3 Fair Value Measurements at December 31, 2017



Assets	Valuation Technique	Unobservable Input	Rate

Impaired loans	Discounted appraised value	Selling cost	8.00%
	Discounted cash flow analysis	Market rate for borrower (discount rate)	3.25% - 9.80%

Other real estate owned, net	Discounted appraised value	Selling cost	8.00%

ASC 825, "Financial Instruments," requires disclosure about fair value of financial instruments for interim periods and excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The carrying values and the exit pricing concept fair values of the Company's financial instruments at September 30, 2018 are as follows (dollars in thousands):



	Fair Value Measurements at September 30, 2018 Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Fair Value
	Carrying Value		Level 1		Level 2		Level 3		Balance
Financial Assets:
Cash and cash equivalents	$	70,043	$	70,043	$	—	$	—	$	70,043
Equity securities	2,087				2,087				2,087
Securities available for sale	295,777		—		295,777		—		295,777
Restricted stock	5,239		—		5,239		—		5,239
Loans held for sale	1,934		—		1,934		—		1,934
Loans, net of allowance	1,317,565		—		—		1,314,472		1,314,472
Bank owned life insurance	18,785		—		18,785		—		18,785
Accrued interest receivable	5,232		—		5,232		—		5,232
Derivative - cash flow hedges	201		—		201		—		201

Financial Liabilities:
Deposits	$	1,523,107	$	—	$	1,527,981	$	—	$	1,527,981
Repurchase agreements	29,104		—		29,104		—		29,104
Junior subordinated debt	27,902		—		—		22,673		22,673
Accrued interest payable	767		—		767		—		767

The carrying values and estimated fair values of the Company's financial instruments at December 31, 2017 are as follows (dollars in thousands):



	Fair Value Measurements at December 31, 2017 Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs		Fair Value
	Carrying Value		Level 1		Level 2		Level 3		Balance
Financial Assets:
Cash and cash equivalents	$	52,477	$	52,477	$	—	$	—	$	52,477
Securities available for sale	321,337		—		321,337		—		321,337
Restricted stock	6,110		—		6,110		—		6,110
Loans held for sale	1,639		—		1,639		—		1,639
Loans, net of allowance	1,322,522		—		—		1,317,737		1,317,737
Bank owned life insurance	18,460		—		18,460		—		18,460
Accrued interest receivable	5,231		—		5,231		—		5,231

Financial Liabilities:
Deposits	$	1,534,726	$	—	$	1,527,956	$	—	$	1,527,956
Repurchase agreements	10,726		—		10,726		—		10,726
Other short-term borrowings	24,000		—		24,000		—		24,000
Junior subordinated debt	27,826		—		—		28,358		28,358
Accrued interest payable	674		—		674		—		674

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

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

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

Restricted stock. The carrying value of restricted stock approximates fair value based on the redemption provisions of the respective entity.

Loans held for sale. The carrying amount is at fair value. Fair value is based on the price secondary markets are currently offering for similar loans using observable market data which is not materially different than cost due to the short duration between origination and sale

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

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

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

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

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

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

Long-term borrowings. The fair values of long-term borrowings are estimated using discounted cash flow analysis based on the interest rates for similar types of borrowing arrangements.

Junior subordinated debt. Fair value is calculated by discounting the future cash flows using the estimated current interest rates at which similar securities would be issued.

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

Derivative - cash flow hedges. Fair values are based on observable market data.

Off-balance sheet instruments. The fair value of letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At September 30, 2018 and December 31, 2017, the fair value of off-balance sheet instruments was deemed immaterial, and therefore was not included in the previous table.

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

Note 14 – Segment and Related Information

The Company has two reportable segments, community banking and trust and investment services.

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

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

Amounts shown in the "Other" column includes activities of the Company which are primarily debt service on trust preferred securities and corporate items.

Segment information as of and for the three and nine months ended September 30, 2018 and 2017 (unaudited), is shown in the following tables (dollars in thousands):



	Three Months Ended September 30, 2018
	Community Banking		Trust and Investment Services		Other			Intersegment Eliminations			Total
Interest income	$	17,124	$	—	$	93		$	—		$	17,217
Interest expense	2,078		—		388			—			2,466
Noninterest income	2,287		1,173		(80		)	—			3,380
Income (loss) before income taxes	7,228		634		(612		)	—			7,250
Net income (loss)	5,763		506		(484		)	—			5,785
Depreciation and amortization	487		2		—			—			489
Total assets	1,796,695		—		244,124			(234,328		)	1,806,491
Goodwill	43,872		—		—			—			43,872
Capital expenditures	390		—		—			—			390



	Three Months Ended September 30, 2017
	Community Banking		Trust and Investment Services		Other			Intersegment Eliminations			Total
Interest income	$	16,188	$	—	$	86		$	—		$	16,274
Interest expense	1,663		—		273			—			1,936
Noninterest income	2,479		1,318		7			—			3,804
Income (loss) before income taxes	6,554		794		(356		)	—			6,992
Net income (loss)	4,478		544		(235		)	—			4,787
Depreciation and amortization	558		3		—			—			561
Total assets	1,771,165		—		238,111			(228,735		)	1,780,541
Goodwill	43,872		—		—			—			43,872
Capital expenditures	449		—		—			—			449



	Nine Months Ended September 30, 2018
	Community Banking		Trust and Investment Services		Other			Intersegment Eliminations			Total
Interest income	$	50,604	$	—	$	273		$	—		$	50,877
Interest expense	5,787		—		1,008			—			6,795
Noninterest income	6,461		3,479		336			—			10,276
Income (loss) before income taxes	21,325		1,654		(1,132		)	—			21,847
Net income (loss)	17,141		1,330		(894		)	—			17,577
Depreciation and amortization	1,568		8		—			—			1,576
Total assets	1,796,695		—		244,124			(234,328		)	1,806,491
Goodwill	43,872		—		—			—			43,872
Capital expenditures	1,322		—		—			—			1,322



	Nine Months Ended September 30, 2017
	Community Banking		Trust and Investment Services		Other			Intersegment Eliminations			Total
Interest income	$	46,302	$	—	$	256		$	—		$	46,558
Interest expense	4,418		—		756			—			5,174
Noninterest income	6,882		3,522		19			—			10,423
Income (loss) before income taxes	18,140		1,853		(1,138		)	—			18,855
Net income (loss)	12,591		1,290		(752		)	—			13,129
Depreciation and amortization	1,833		9		—			—			1,842
Total assets	1,771,165		—		238,111			(228,735		)	1,780,541
Goodwill	43,872		—		—			—			43,872
Capital expenditures	2,177		11		—			—			2,188

Note 15 – Supplemental Cash Flow Information



	Nine Months Ended September 30,
	2018			2017
Supplemental Schedule of Cash and Cash Equivalents:
Cash and due from banks	$	32,688		$	26,949
Interest-bearing deposits in other banks	37,355			76,271
Cash and Cash Equivalents	$	70,043		$	103,220

Supplemental Disclosure of Cash Flow Information:
Cash paid for:
Interest on deposits and borrowed funds	$	6,702		$	5,135
Income taxes	3,776			5,465
Noncash investing and financing activities:
Transfer of loans to other real estate owned	532			1,233
Unrealized gains (losses) on securities available for sale	(7,226		)	1,596
Unrealized gains on cash flow hedges	201			—

Note 16 – Accumulated Other Comprehensive Income (Loss)

Changes in each component of accumulated other comprehensive income (loss) ("AOCI") for the three and nine months ended September 30, 2018 and 2017 (unaudited) were as follows (dollars in thousands):



For the Three Months Ended	Net Unrealized Gains (Losses) on Securities			Unrealized Losses on Cash Flow Hedges			Adjustments Related to Pension Benefits			Accumulated Other Comprehensive Income (Loss)

Balance at June 30, 2017	$	696		$	—		$	(1,724	)	$	(1,028	)

Net unrealized gains on securities available for sale, net of tax, $104	192			—			—			192

Reclassification adjustment for realized gains on securities, net of tax, $(0)	—			—			—			—

Balance at September 30, 2017	$	888		$	—		$	(1,724	)	$	(836	)

Balance at June 30, 2018	$	(5,446	)	$	(184	)	$	(2,280	)	$	(7,910	)

Net unrealized losses on securities available for sale, net of tax, $(440)	(1,525		)	—			—			(1,525		)

Reclassification adjustment for realized gains on securities, net of tax, $(16)	(57		)	—			—			(57		)

Unrealized losses on cash flow hedges, net of tax, $98	—			340			—			340

Balance at September 30, 2018	$	(7,028	)	$	156		$	(2,280	)	$	(9,152	)



For the Nine Months Ended	Net Unrealized Gains (Losses) on Securities			Unrealized Losses on Cash Flow Hedges		Adjustments Related to Pension Benefits			Accumulated Other Comprehensive Income (Loss)

Balance at December 31, 2016	$	(150	)	$	—	$	(1,724	)	$	(1,874	)

Net unrealized gains on securities available for sale, net of tax, $765	1,421			—		—			1,421

Reclassification adjustment for realized gains on securities, net of tax, $(207)	(383		)	—		—			(383		)

Balance at September 30, 2017	$	888		$	—	$	(1,724	)	$	(836	)

Balance at December 31, 2017	$	(796	)	$	—	$	(2,280	)	$	(3,076	)

Net unrealized losses on securities available for sale, net of tax, $(1,626)	(5,519		)	—		—			(5,519		)

Reclassification adjustment for gains on sales of securities, net of tax, $(18)	(63		)	—		—			(63		)

Reclassification for ASU 2016-01 adoption	(650		)	—		—			(650		)

Unrealized losses on cash flow hedges, net of tax, $45	—			156		—			156

Balance at September 30, 2018	$	(7,028	)	$	156	$	(2,280	)	$	(9,152	)

Reclassifications Out of Accumulated Other Comprehensive Income

For the Three and Nine months ended September 30, 2018 and 2017

(dollars in thousands)



For the Three Months Ended September 30, 2018	Amount Reclassified from AOCI			Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
Available for sale securities:
Realized gain on sale of securities	$	73		Securities gains, net
	(16		)	Income taxes
Total reclassifications	$	57		Net of tax



For the Three Months Ended September 30, 2017	Amount Reclassified from AOCI		Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
Available for sale securities:
Realized gain on sale of securities	$	—	Securities gains, net
	—		Income taxes
Total reclassifications	$	—	Net of tax



For the Nine Months Ended September 30, 2018	Amount Reclassified from AOCI			Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
Available for sale securities:
Realized gain on sale of securities	$	81		Securities gains, net
	(18		)	Income taxes
	63			Net of tax
Reclassification for ASU 2016-01 adoption	650			*
Total reclassifications	$	713


*	Reclassification from AOCI to retained earnings for unrealized holding gains on equity securities due to adoption of ASU 2016-01.



For the Nine Months Ended September 30, 2017	Amount Reclassified from AOCI			Affected Line Item in the Statement of Where Net Income is Presented
Details about AOCI Components
Available for sale securities:
Realized gain on sale of securities	$	590		Securities gains, net
	(207		)	Income taxes
Total reclassifications	$	383		Net of tax

Note 17 - Proposed Merger

On October 1, 2018, the Company announced that it had entered into an Agreement and Plan of Reorganization, dated October 1, 2018 (the “Merger Agreement”), with HomeTown Bankshares Corporation (“HomeTown”), pursuant to which the Company will acquire HomeTown in a business combination transaction valued at approximately $95.6 million at the time of the announcement. The combination will deepen the Company’s footprint in the Roanoke, Virginia metropolitan area and create a presence in the New River Valley with an office in Christiansburg, Virginia. Upon completion of the merger and with two office consolidations, the Company will have eight offices in the combined Roanoke/New River Valley market area. The

Company expects that it will have approximately $2.4 billion in assets upon completion of the merger, based on each company’s reported financial results as of June 30, 2018.

Pursuant and subject to the terms of the Merger Agreement, as a result of the merger, the holders of shares of HomeTown common stock will receive 0.4150 shares of the Company’s common stock for each share of HomeTown common stock held immediately prior to the effective date of the merger.

Subject to customary closing conditions, including regulatory and shareholder approvals, the Company expects the merger to close in the first quarter of 2019. Following completion of the merger, HomeTown's subsidiary bank, HomeTown Bank, will be merged with and into the Bank.

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

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

Forward-Looking Statements

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

A variety of factors, some of which are discussed in more detail in Item 1A – Risk Factors of the Company's Annual Report on Form 10-K for the year ended December 31, 2017 and Item 1A – Risk Factors of this Quarterly Report on Form 10-Q, may affect the operations, performance, business strategy, and results of the Company. Those factors include, but are not limited to, the following:


•	financial market volatility, including the level of interest rates, could affect the values of financial instruments and the amount of net interest income earned;


•	general economic or business conditions, either nationally or in the market areas in which the Company does business, may be less favorable than expected, resulting in deteriorating credit quality, reduced demand for credit, or a weakened ability to generate deposits;


•	competition among financial institutions may increase, and competitors may have greater financial resources and develop products and technology that enable those competitors to compete more successfully than the Company;


•	businesses that the Company is engaged in may be adversely affected by legislative or regulatory changes, including changes in accounting standards and tax laws;


•	the ability to retain key personnel;


•	the failure of assumptions underlying the allowance for loan losses; and


•	risks associated with mergers and acquisitions and other expansion activities.

On October 1, 2018, the Company entered into an Agreement and Plan of Reorganization (the “Merger Agreement”) with HomeTown Bankshares Corporation (“HomeTown”), pursuant to which the Company will acquire HomeTown in a merger transaction. In addition to the factors described above, the Company’s operations, performance, business strategy and results may be affected by the following factors:


•	the businesses of the Company and/or HomeTown may not be integrated successfully or such integration may be more difficult, time-consuming or costly than expected;


•	expected revenue synergies and cost savings from the merger may not be fully realized or realized within the expected timeframe;


•	revenues following the merger may be lower than expected;


•	customer and employee relationships and business operations may be disrupted by the merger; and


•	the ability to obtain required regulatory and shareholder approvals, and the ability to complete the merger on the expected timeframe may be more difficult, time-consuming or costly than expected.

Reclassification

In certain circumstances, reclassifications have been made to prior period information to conform to the 2018 presentation. There were no material reclassifications.

CRITICAL ACCOUNTING POLICIES

The accounting and reporting policies followed by the Company conform with U.S. generally accepted accounting principles ("GAAP") and they conform to general practices within the banking industry. The Company's critical accounting policies, which are summarized below, relate to (1) the allowance for loan losses, (2) mergers and acquisitions, (3) acquired loans with specific credit-related deterioration (4) goodwill and intangible assets, (5) other real estate owned, (6) deferred tax assets and liabilities, (7) other-than-temporary impairment of securities and (8) the unfunded pension liability. A summary of the Company's significant accounting policies is set forth in Note 1 to the Consolidated Financial Statements contained in the Form 10-K for the year ended December 31, 2017.

The financial information contained within the Company's financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset, or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method.

Allowance for Loan Losses

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

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

The Company uses certain practices to manage its credit risk. These practices include (1) appropriate lending limits for loan officers, (2) a loan approval process, (3) careful underwriting of loan requests, including analysis of borrowers, cash flows, collateral, and market risks, (4) regular monitoring of the portfolio, including diversification by type and geography, (5) review of loans by the Loan Review department, which operates independently of loan production, (6) regular meetings of the Credit Committee to discuss portfolio and policy changes and make decisions on large or unusual loan requests, and (7) regular meetings of the Asset Quality Committee which reviews the status of individual loans.

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

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

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

The formula allowance uses historical loss experience as an indicator of future losses, along with various qualitative factors, including levels and trends in delinquencies, nonaccrual loans, charge-offs and recoveries, trends in volume and terms of loans, effects of changes in underwriting standards, experience of lending staff, economic conditions, portfolio concentrations, regulatory, legal, competition, quality of loan review system, and value of underlying collateral. In the formula allowance for commercial and commercial real estate loans, the historical loss rate is combined with the qualitative factors, resulting in an adjusted loss factor for each risk-grade category of loans. The period-end balances for each loan risk-grade category are multiplied by the adjusted loss factor. Allowance calculations for residential real estate and consumer loans are calculated based on historical losses for each product category without regard to risk grade. This loss rate is combined with qualitative factors resulting in an adjusted loss factor for each product category.

The specific allowance uses various techniques to arrive at an estimate of loss for specifically identified impaired loans. These include:


•	The present value of expected future cash flows discounted at the loan's effective interest rate. The effective interest rate on a loan is the rate of return implicit in the loan (that is, the contractual interest rate adjusted for any net deferred loan fees or costs and any premium or discount existing at the origination or acquisition of the loan);


•	The loan's observable market price, or


•	The fair value of the collateral, net of estimated costs to dispose, if the loan is collateral dependent.

The use of these computed values is inherently subjective and actual losses could be greater or less than the estimates.

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

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

Mergers and Acquisitions

Business combinations are accounted for under the Financial Accounting Standards Board (the "FASB") Accounting Standards Codification ("ASC") 805, Business Combinations, using the acquisition method of accounting. The acquisition method of accounting requires an acquirer to recognize the assets acquired and the liabilities assumed at the acquisition date measured at their fair values as of that date. To determine the fair values, the Company will rely on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Under the acquisition method of accounting, the Company will identify the acquirer and the closing date and apply applicable recognition principles and conditions.

Acquisition-related costs are costs the Company incurs to effect a business combination. Those costs include advisory, legal, accounting, valuation, and other professional or consulting fees. Some other examples of costs to the Company include systems conversions, integration planning consultants and advertising costs. The Company will account for acquisition-related costs as expenses in the periods in which the costs are incurred and the services are received, with one exception. The costs to issue debt or equity securities will be recognized in accordance with other applicable GAAP. These acquisition-related costs have been and will be included within the consolidated statements of income classified within the noninterest expense caption.

Acquired Loans with Specific Credit-Related Deterioration

Acquired loans with specific credit deterioration are accounted for by the Company in accordance with FASB ASC 310-30, Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality. Certain acquired loans, those for which specific credit-related deterioration, since origination, is identified, are recorded at fair value reflecting the present value of the amounts expected to be collected. Income recognition on these loans is based on a reasonable expectation about the timing and amount of cash flows to be collected. Acquired loans deemed impaired and considered collateral dependent, with the timing of the sale of loan collateral indeterminate, remain on non-accrual status and have no accretable yield.

Goodwill and Intangible Assets

The Company performs its annual analysis as of June 30 each fiscal year. Accounting guidance permits preliminary assessment of qualitative factors to determine whether more substantial impairment testing is required. The Company chose to bypass the preliminary assessment and utilized a two-step process for impairment testing of goodwill. The first step tests for impairment, while the second step, if necessary, measures the impairment. No indicators of impairment were identified during the nine months ended September 30, 2018 or 2017.

Other Real Estate Owned

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less costs to sell at the date of foreclosure. Subsequent to foreclosure, management periodically performs valuations of the foreclosed assets based on updated appraisals, general market conditions, recent sales of similar properties, length of time the properties have been held, and our ability and intention with regard to continued ownership of the properties. The Company may incur additional write-downs of foreclosed assets to fair value less costs to sell if valuations indicate a further deterioration in market conditions.

Deferred Tax Assets and Liabilities

The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is "more likely than not" that all or a portion of the deferred tax asset will not be realized. "More likely than not" is defined as greater than a 50%

chance. Management considers all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is needed.

Other-than-temporary Impairment of Securities

Impairment of securities occurs when the fair value of a security is less than its amortized cost. For debt securities, impairment is considered other-than-temporary and recognized in its entirety in net income if either (1) the Company intends to sell the security or (2) it is more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis. If, however, the Company does not intend to sell the security and it is not more-likely-than-not that it will be required to sell the security before recovery, the Company must determine what portion of the impairment is attributable to a credit loss, which occurs when the amortized cost basis of the security exceeds the present value of the cash flows expected to be collected from the security. If there is no credit loss, there is no other-than-temporary impairment. If there is a credit loss, other-than-temporary impairment exists, and the credit loss must be recognized in net income and the remaining portion of impairment must be recognized in other comprehensive income.

Unfunded Pension Liability

The Company previously maintained a non-contributory, defined benefit pension plan for eligible full-time employees as specified by the plan. The Company froze its pension plan to new participants and converted its pension plan to a cash balance plan effective December 31, 2009. Plan assets, which consist primarily of mutual funds invested in marketable equity securities and corporate and government fixed income securities, are valued using market quotations. The Company's actuary determines plan obligations and annual pension expense using a number of key assumptions. Key assumptions may include the discount rate, the interest crediting rate, the estimated future return on plan assets and the anticipated rate of future salary increases. Changes in these assumptions in the future, if any, or in the method under which benefits are calculated may impact pension assets, liabilities or expense.

Derivative Financial Instruments

The Company uses derivatives primarily to manage risk associated with changing interest rates. The Company's derivative financial instruments consist of interest rate swaps that qualify as cash flow hedges of the Company's trust preferred notes. The Company recognizes derivative financial instruments at fair value as either an other asset or other liability in the consolidated balance sheets. The effective portion of the gain or loss on the Company's cash flow hedges is reported as a component of other comprehensive income, net of deferred income taxes, and is reclassified into earnings in the same period or periods during which the hedged transactions affect earnings.

Non-GAAP Presentations

Non-GAAP presentations are provided because the Company believes these may be valuable to investors. These include (1) the analysis of net interest income presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets and (2) the calculation of the efficiency ratio.

Internet Access to Corporate Documents

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

Announced Acquisition

On October 1, 2018, the Company and HomeTown (NASDAQ: HMTA) announced the signing of the Merger Agreement pursuant to which HomeTown will merge with and into the Company in a transaction valued at approximately $95.6 million at the time of the announcement. The combination will deepen the Company’s footprint in the Roanoke, Virginia metropolitan area and create a presence in the New River Valley with an office in Christiansburg, Virginia. Upon completion of the merger and with two office consolidations, the Company will have eight offices in the combined Roanoke/New River Valley market area. Based on reported financial results as of June 30, 2018, the combined company will have approximately $2.4 billion in assets, $1.8 billion in loans, and $2.0 billion in deposits across Virginia and North Carolina. Pursuant and subject to the terms of the Merger Agreement, as a result of the merger, the holders of shares of HomeTown common stock will receive 0.4150 shares of the Company’s common stock for each share of HomeTown common stock held immediately prior to the effective

date of the merger. Subject to customary closing conditions, including regulatory and shareholder approvals, the merger is expected to close in the first quarter of 2019. Following completion of the merger, HomeTown's subsidiary bank, HomeTown Bank, will be merged with and into the Bank.

HomeTown Bankshares Corporation is the parent company of HomeTown Bank, which officially opened for business on November 14, 2005. HomeTown Bank offers a full range of banking services to small and medium-size businesses, real estate investors and developers, private investors, professionals and individuals. HomeTown Bank serves three markets including the Roanoke Valley, the New River Valley and Smith Mountain Lake through six branches, seven ATMs, HomeTown Mortgage and HomeTown Investments.

RESULTS OF OPERATIONS

Earnings Performance

Three months ended September 30, 2018 and 2017

For the quarter ended September 30, 2018, the Company reported net income of $5,785,000 compared to $4,787,000 for the comparable quarter in 2017. The $998,000 or 20.8% increase was driven primarily by higher net interest income, resulting mostly from higher yields on the loan portfolio and greater loan volume. Also positively impacting income was the recent reduction in the corporate income tax rate, to 21% from 35% and a lower loan loss provision. The Company's tax expense for the quarter was $740,000 or 33.6% less than the comparable quarter of 2017. In addition, the Company had a small negative loan loss provision in the 2018 quarter compared to a $440,000 expense in the 2017 quarter.



SUMMARY INCOME STATEMENT
(Dollars in thousands)

Three Months Ended September 30,	2018			2017			$ Change			% Change
Interest income	$	17,217		$	16,274		$	943		5.8	%
Interest expense	(2,466		)	(1,936		)	(530		)	27.4
Net interest income	14,751			14,338			413			2.9
Provision for loan losses	23			(440		)	463			(105.2	)
Noninterest income	3,380			3,804			(424		)	(11.1	)
Noninterest expense	(10,904		)	(10,710		)	(194		)	1.8
Income tax expense	(1,465		)	(2,205		)	740			(33.6	)

Net income	$	5,785		$	4,787		$	998		20.8

Nine months ended September 30, 2018 and 2017

For the nine month period ended September 30, 2018, the Company reported net income of $17,577,000 compared to $13,129,000 for the comparable period in 2017. The $4,448,000 or 33.9% increase was driven by the same factors discussed above for the 2018 quarter.



SUMMARY INCOME STATEMENT
(Dollars in thousands)

Nine Months Ended September 30,	2018			2017			$ Change			% Change
Interest income	$	50,877		$	46,558		$	4,319		9.3	%
Interest expense	(6,795		)	(5,174		)	(1,621		)	31.3
Net interest income	44,082			41,384			2,698			6.5
Provision for loan losses	97			(1,090		)	1,187			(108.9	)
Noninterest income	10,276			10,423			(147		)	(1.4	)
Noninterest expense	(32,608		)	(31,862		)	(746		)	2.3
Income tax expense	(4,270		)	(5,726		)	1,456			(25.4	)

Net income	$	17,577		$	13,129		$	4,448		33.9

Net Interest Income

Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest bearing liabilities, primarily deposits and other funding sources. Fluctuations in interest rates as well as volume and mix changes in earning assets and interest bearing liabilities can materially impact net interest income. The following discussion of net interest income is presented on a taxable equivalent basis to facilitate performance comparisons among various taxable and tax-exempt assets, such as certain state and municipal securities. A tax rate of 21% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent basis in 2018, and a tax rate of 35% was used in 2017. Net interest income divided by average earning assets is referred to as the net interest margin. The net interest spread represents the difference between the weighted rate earned on average earning assets and the weighted rate paid on average interest-bearing liabilities.

Three months ended September 30, 2018 and 2017

Net interest income on a taxable equivalent basis increased $233,000 or 1.6%, for the third quarter of 2018 compared to the same quarter of 2017. The increase was driven by higher yields and higher loan volume.

For the third quarter of 2018, the Company's yield on interest-earning assets was 4.09%, compared to 4.03% for the third quarter of 2017. The cost of interest-bearing liabilities was 0.84% compared to 0.67%, primarily related to a 16 basis point (0.16%) increase in the cost of deposits. The interest rate spread was 3.25% compared to 3.36%. The net interest margin, on a fully taxable equivalent basis, was 3.51% compared to 3.56%, a decrease of five basis points (0.05%). The decrease in net interest margin related mostly to increases in the cost of deposits and also a decline in accretion income.

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the three months ended September 30, 2018 and 2017. Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.



	Net Interest Income Analysis (dollars in thousands)
	Three Months Ended September 30,

	Average Balance				Income/Expense				Yield/Rate
	2018		2017		2018		2017		2018		2017
Loans:
Commercial	$	268,296	$	233,455	$	2,715	$	2,282	4.01	%	3.88	%
Real estate	1,057,097		1,057,326		12,317		12,102		4.66		4.58
Consumer	4,949		4,648		76		92		6.09		7.85
Total loans	1,330,342		1,295,429		15,108		14,476		4.54		4.46

Securities:
Federal agencies and GSEs	128,284		92,822		732		445		2.28		1.92
Mortgage-backed and CMOs	107,817		77,663		604		399		2.24		2.06
State and municipal	84,147		95,861		583		862		2.77		3.60
Other securities	15,072		14,900		180		170		4.78		4.56
Total securities	335,320		281,246		2,099		1,876		2.50		2.67

Deposits in other banks	28,250		69,566		143		235		2.01		1.34

Total interest-earning assets	1,693,912		1,646,241		17,350		16,587		4.09		4.03

Non-earning assets	117,719		127,395

Total assets	$	1,811,631	$	1,773,636

Deposits:
Demand	$	231,339	$	215,486	12		11		0.02		0.02
Money market	377,074		336,501		839		463		0.88		0.55
Savings	132,450		124,949		10		9		0.03		0.03
Time	378,066		389,891		1,187		1,046		1.25		1.06
Total deposits	1,118,929		1,066,827		2,048		1,529		0.73		0.57

Customer repurchase agreements	11,896		48,461		17		53		0.57		0.43
Other short-term borrowings	2,176		—		12		—		2.21		—
Long-term borrowings	27,886		37,780		389		354		5.58		3.75
Total interest-bearing
liabilities	1,160,887		1,153,068		2,466		1,936		0.84		0.67

Noninterest bearing demand deposits	424,016		401,696
Other liabilities	11,674		9,846
Shareholders' equity	215,054		209,026
Total liabilities and
shareholders' equity	$	1,811,631	$	1,773,636

Interest rate spread									3.25	%	3.36	%
Net interest margin									3.51	%	3.56	%

Net interest income (taxable equivalent basis)					14,884		14,651
Less: Taxable equivalent adjustment ⁽¹⁾					133		313
Net interest income					$	14,751	$	14,338

(1) - Calculated using 21% and 35% statutory tax rate in 2018 and 2017, respectively, due to tax rate change.



Changes in Net Interest Income (Rate/Volume Analysis)
(in thousands)
	Three Months Ended September 30,
	2018 vs. 2017
				Change
	Increase			Attributable to
Interest income	(Decrease)			Rate			Volume
Loans:
Commercial	$	433		$	83		$	350
Real estate	215			218			(3		)
Consumer	(16		)	(22		)	6
Total loans	632			279			353
Securities:
Federal agencies and GSEs	287			95			192
Mortgage-backed and CMOs	205			39			166
State and municipal	(279		)	(182		)	(97		)
Other securities	10			8			2
Total securities	223			(40		)	263
Deposits in other banks	(92		)	85			(177		)
Total interest income	763			324			439

Interest expense
Deposits:
Demand	1			—			1
Money market	376			315			61
Savings	1			—			1
Time	141			174			(33		)
Total deposits	519			489			30
Customer repurchase agreements	(36		)	13			(49		)
Other short-term borrowings	12			—			12
Long-term borrowings	35			144			(109		)
Total interest expense	530			646			(116		)
Net interest income (taxable equivalent basis)	$	233		$	(322	)	$	555

Nine months ended September 30, 2018 and 2017

Net interest income on a taxable equivalent basis increased $2,100,000 or 5.0%, for the nine months ended September 30, 2018 compared to the same period of 2017. The increase was driven by higher yields and higher loan volume.

For the first nine months of 2018, the Company's yield on interest-earning assets was 4.03%, compared to 3.94% for the same period of 2017. The cost of interest-bearing liabilities was 0.77% compared to 0.61%, primarily related to a 15 basis point (0.15%) increase in the cost of deposits. The interest rate spread was 3.26% compared to 3.33%. The net interest margin, on a fully taxable equivalent basis, was 3.49% compared to 3.51%, a decrease of two basis points (0.02%). The decrease in net interest margin related mostly to increases in the cost of deposits and also a decline in accretion income.

The following presentation is an analysis of net interest income and related yields and rates, on a taxable equivalent basis, for the nine months ended September 30, 2018 and 2017. Nonaccrual loans are included in average balances. Interest income on nonaccrual loans, if recognized, is recorded on a cash basis or when the loan returns to accrual status.



	Net Interest Income Analysis (dollars in thousands)
	Nine Months Ended September 30,

	Average Balance				Income/Expense				Yield/Rate
	2018		2017		2018		2017		2018		2017
Loans:
Commercial	$	264,983	$	227,739	$	7,811	$	6,577	3.94	%	3.86	%
Real estate	1,062,075		1,019,185		36,594		34,228		4.59		4.48
Consumer	4,528		4,825		229		272		6.76		7.54
Total loans	1,331,586		1,251,749		44,634		41,077		4.47		4.38

Securities:
Federal agencies and GSEs	119,597		95,360		1,956		1,340		2.18		1.87
Mortgage-backed and CMOs	108,473		78,572		1,812		1,224		2.23		2.08
State and municipal	87,365		110,328		1,870		2,952		2.85		3.57
Other securities	15,126		16,147		531		536		4.68		4.43
Total securities	330,561		300,407		6,169		6,052		2.49		2.69

Deposits in other banks	37,981		58,385		516		469		1.82		1.07

Total interest-earning assets	1,700,128		1,610,541		51,319		47,598		4.03		3.94

Non-earning assets	118,487		126,414

Total assets	$	1,818,615	$	1,736,955

Deposits:
Demand	$	236,734	$	217,052	36		32		0.02		0.02
Money market	394,005		321,738		2,424		1,046		0.82		0.43
Savings	131,789		124,780		30		28		0.03		0.03
Time	377,915		381,852		3,256		2,975		1.15		1.04
Total deposits	1,140,443		1,045,422		5,746		4,081		0.67		0.52

Customer repurchase agreements	11,829		47,614		19		68		0.21		0.19
Other short-term borrowings	1,536		3,902		22		27		1.91		0.92
Long-term borrowings	27,861		37,748		1,008		998		4.82		3.53
Total interest-bearing
liabilities	1,181,669		1,134,686		6,795		5,174		0.77		0.61

Noninterest bearing demand deposits	414,643		386,355
Other liabilities	10,035		9,474
Shareholders' equity	212,268		206,440
Total liabilities and
shareholders' equity	$	1,818,615	$	1,736,955

Interest rate spread									3.26	%	3.33	%
Net interest margin									3.49	%	3.51	%

Net interest income (taxable equivalent basis)					44,524		42,424
Less: Taxable equivalent adjustment ⁽¹⁾					442		1,040
Net interest income					$	44,082	$	41,384

(1) - Calculated using 21% and 35% statutory tax rate in 2018 and 2017, respectively, due to tax rate change.



Changes in Net Interest Income (Rate/Volume Analysis)
(in thousands)
	Nine Months Ended September 30,
	2018 vs. 2017
				Change
	Increase			Attributable to
Interest income	(Decrease)			Rate			Volume
Loans:
Commercial	$	1,234		$	139		$	1,095
Real estate	2,366			902			1,464
Consumer	(43		)	(27		)	(16		)
Total loans	3,557			1,014			2,543
Securities:
Federal agencies and GSEs	616			241			375
Mortgage-backed and CMOs	588			94			494
State and municipal	(1,082		)	(530		)	(552		)
Other securities	(5		)	30			(35		)
Total securities	117			(165		)	282
Deposits in other banks	47			249			(202		)
Total interest income	3,721			1,098			2,623

Interest expense
Deposits:
Demand	4			1			3
Money market	1,378			1,101			277
Savings	2			—			2
Time	281			312			(31		)
Total deposits	1,665			1,414			251
Customer repurchase agreements	(49		)	8			(57		)
Other short-term borrowings	(5		)	18			(23		)
Long-term borrowings	10			311			(301		)
Total interest expense	1,621			1,751			(130		)
Net interest income (taxable equivalent basis)	$	2,100		$	(653	)	$	2,753

Noninterest Income, three months ended September 30, 2018 and 2017

For the quarter ended September 30, 2018, noninterest income decreased $424,000 or 11.1% compared to the comparable 2017 quarter. Details of individual accounts are shown in the table below.



	Three Months Ended September 30,
	(Dollars in thousands)
	2018			2017		$ Change			% Change
Noninterest income:
Trust fees	$	1,001		$	1,098	$	(97	)	(8.8	)%
Service charges on deposit accounts	605			622		(17		)	(2.7	)
Other fees and commissions	656			618		38			6.1
Mortgage banking income	551			612		(61		)	(10.0	)
Securities gains (losses), net	(17		)	—		(17		)	(100.0	)
Brokerage fees	172			219		(47		)	(21.5	)
Income from SBICs	150			86		64			74.4
Gains on premises and equipment, net	63			337		(274		)	(81.3	)
Other	199			212		(13		)	(6.1	)
Total noninterest income	$	3,380		$	3,804	$	(424	)	(11.1	)

The major driver of the decrease in noninterest income was a $337,000 gain on premises and equipment, from the sale of a bank owned commercial lot, reflected in the 2017 quarter. Trust fees decreased $97,000 and brokerage fees decreased $47,000 in the third quarter of 2018 compared to the same quarter last year. Mortgage banking income decreased $61,000 in the 2018 quarter compared to the 2017 quarter. Other fees and commissions were positively impacted by higher levels of debit card transaction volume. Net securities losses were $17,000 in the 2018 quarter compared to no gain or loss for the same quarter in 2017. Losses in the 2018 quarter were related to unrealized changes in the fair value of equity securities held by the Company and recorded in conformity with new accounting requirements for 2018. Income from Small Business Investment Companies ("SBICs") reflected a $64,000 increase compared to the 2017 quarter; this category of income is highly unpredictable.

Noninterest Income, nine months ended September 30, 2018 and 2017

For the nine months ended September 30, 2018, noninterest income decreased $147,000 or 1.4% compared to the comparable 2017 period. Details of individual accounts are shown in the table below.



	Nine Months Ended September 30,
	(Dollars in thousands)
	2018		2017		$ Change			% Change
Noninterest income:
Trust fees	$	2,875	$	2,918	$	(43	)	(1.5	)%
Service charges on deposit accounts	1,809		1,818		(9		)	(0.5	)
Other fees and commissions	1,977		1,852		125			6.7
Mortgage banking income	1,492		1,603		(111		)	(6.9	)
Securities gains, net	393		590		(197		)	(33.4	)
Brokerage fees	603		603		—			—
Income from SBICs	476		118		358			303.4
Gains on premises and equipment, net	66		337		(271		)	(80.4	)
Other	585		584		1			0.2
Total noninterest income	$	10,276	$	10,423	$	(147	)	(1.4	)

The major driver of the decrease in noninterest income was a $337,000 gain on premises and equipment, from the sale of a bank owned commercial lot, reflected in 2017. Trust fees decreased $43,000 and brokerage fees were unchanged in the first nine months of 2018 compared to the same period last year. Mortgage banking income decreased $111,000 in the 2018

period compared to the 2017 period. Other fees and commissions were positively impacted by higher levels of debit card transaction volume. Net securities gains decreased $197,000 in the 2018 period compared to the same period in 2017. Gains in the 2018 period were primarily related to unrealized changes in the fair value of equity securities held by the Company, recorded in conformity with new accounting requirements. Income from SBICs reflected a $358,000 increase compared to the 2017 period; this category of income is highly unpredictable.

Noninterest Expense, three months ended September 30, 2018 and 2017

For the three months ended September 30, 2018, noninterest expense increased $194,000 or 1.8%. Details of individual accounts are shown in the table below.



	Three Months Ended September 30,
	(Dollars in thousands)
	2018		2017		$ Change			% Change
Noninterest Expense
Salaries	$	5,285	$	5,072	$	213		4.2	%
Employee benefits	1,036		1,048		(12		)	(1.1	)
Occupancy and equipment	1,069		1,151		(82		)	(7.1	)
FDIC assessment	134		138		(4		)	(2.9	)
Bank franchise tax	291		276		15			5.4
Core deposit intangible amortization	56		80		(24		)	(30.0	)
Data processing	420		475		(55		)	(11.6	)
Software	307		303		4			1.3
Other real estate owned, net	46		62		(16		)	(25.8	)
Other	2,260		2,105		155			7.4
Total noninterest expense	$	10,904	$	10,710	$	194		1.8

Salaries expense increased $213,000 in the 2018 quarter as compared to the 2017 quarter primarily due to adjustments to fringe benefit accruals. Core deposit intangible amortization decreased $24,000 in the 2018 quarter compared to 2017 as the amortization expense relating to the Company's acquisition of MidCarolina Financial Corporation ("MidCarolina") in July 2011 was treated under the accelerated method and will be fully amortized in 2020.

Noninterest Expense, nine months ended September 30, 2018 and 2017

For the nine months ended September 30, 2018, noninterest expense increased $746,000 or 2.3%. Details of individual accounts are shown in the table below.



	Nine Months Ended September 30,
	(Dollars in thousands)
	2018		2017		$ Change			% Change
Noninterest Expense
Salaries	$	15,377	$	14,604	$	773		5.3	%
Employee benefits	3,322		3,229		93			2.9
Occupancy and equipment	3,297		3,367		(70		)	(2.1	)
FDIC assessment	412		401		11			2.7
Bank franchise tax	863		795		68			8.6
Core deposit intangible amortization	210		448		(238		)	(53.1	)
Data processing	1,309		1,464		(155		)	(10.6	)
Software	966		853		113			13.2
Other real estate owned, net	101		173		(72		)	(41.6	)
Other	6,751		6,528		223			3.4
Total noninterest expense	$	32,608	$	31,862	$	746		2.3

Salaries expense increased $773,000 in the 2018 period as compared to the 2017 period as a result of normal annual salary adjustments, additional employees for anticipated retirements and adjustments to fringe benefit accruals. Core deposit intangible amortization decreased $238,000 in the 2018 period compared to 2017 as the amortization expense relating to the Company's acquisition of MidCarolina was treated under the accelerated method and will be fully amortized in 2020.

Non-GAAP Financial Measures

The efficiency ratio is calculated by dividing noninterest expense excluding gains or losses on the sale of other real estate owned ("OREO") by net interest income including tax equivalent income on nontaxable loans and securities and noninterest income and excluding (1) gains or losses on securities and (2) gains or losses on sale of premises and equipment. The efficiency ratio for the 2018 quarter was 59.65% compared to 59.14% for the 2017 quarter. The Company expects gradual improvement in this ratio in coming quarters. This is a non-GAAP financial measure that the Company believes provides investors with important information regarding operational efficiency. Such information is not prepared in accordance with GAAP and should not be construed as such. Management believes, however, such financial information is meaningful to the reader in understanding operating performance, but cautions that such information not be viewed as a substitute for GAAP. The Company, in referring to its net income, is referring to income under GAAP. The components of the efficiency ratio calculation are summarized in the following table (dollars in thousands):



	Three Months Ended September 30,
	2018			2017
Efficiency Ratio
Noninterest expense	$	10,904		$	10,710
Subtract gain/add loss on sale OREO	(37		)	5
	$	10,867		$	10,715

Net interest income	$	14,751		$	14,338
Tax equivalent adjustment	133			313
Noninterest income	3,380			3,804
Add loss on securities	17			—
Subtract gain on sale of fixed assets	(63		)	(337		)
	$	18,218		$	18,118

Efficiency ratio	59.65		%	59.14		%

Net interest margin is calculated by dividing tax equivalent net interest income by total average earning assets. Because a portion of interest income earned by the Company is nontaxable, the tax equivalent net interest income is considered in the calculation of this ratio. Tax equivalent net interest income is calculated by adding the tax benefit realized from interest income that is nontaxable to total interest income then subtracting total interest expense. The tax rate utilized in calculating the tax benefit is 21% for the 2018 quarter and 35% for the 2017 quarter. The reconciliation of tax equivalent net interest income, which is not a measurement under GAAP, to net interest income, is reflected in the table below (in thousands):



	Three Months Ended September 30,
	2018			2017
Reconciliation of Net Interest Income to Tax-Equivalent Net Interest Income
Non-GAAP measures:
Interest income - loans	$	15,108		$	14,476
Interest income - investments and other	2,242			2,111
Interest expense - deposits	(2,048		)	(1,529		)
Interest expense - customer repurchase agreements	(17		)	(53		)
Interest expense - other short-term borrowings	(12		)	—
Interest expense - long-term borrowings	(389		)	(354		)
Total net interest income	$	14,884		$	14,651
Less non-GAAP measures:
Tax benefit realized on non-taxable interest income - loans	$	(46	)	$	(82	)
Tax benefit realized on non-taxable interest income - municipal securities	(87		)	(231		)
GAAP measures	$	14,751		$	14,338

Income Taxes

The effective tax rate for the third quarter of 2018 was 20.21% compared to 31.54% for the third quarter of 2017. The effective tax rate for the nine months ended September 30, 2018 and 2017 was 19.55% and 30.37%, respectively. The primary reason for the decrease in the effective rate is the Tax Cuts and Jobs Act that was adopted on December 22, 2017 which lowered the statutory rate from 35% to 21%. The effective tax rate is lower than the statutory rate each year as a result of income that is not taxable for federal income tax purposes in both years and the tax benefit from the exercise of stock options.

Fair Value Impact to Net Income

The following table presents the impact for the three and nine month periods ended September 30, 2018 of the accretable and amortizable fair value adjustments attributable to the July 2011 acquisition of MidCarolina and the January 2015 acquisition of MainStreet BankShares, Inc. ("MainStreet") on net interest income and pretax income (dollars in thousands):



		September 30, 2018
	Income Statement Effect	Accretion (Amortization) Three Months Ended			Accretion (Amortization) Nine Months Ended
Interest income/(expense):
Acquired performing loans	Income	$	123		$	338
Acquired impaired loans	Income	100			740
Junior subordinated debt	Expense	(25		)	(76		)
Net interest income		198			1,002

Noninterest (expense):
Amortization of core deposit intangible	Expense	(56		)	(210		)

Change in pretax income		$	142		$	792

During the third quarter of 2018, the Company received $59,000 in cash basis accretion income related to the early payoff of several acquired loans, compared to $333,000 for the comparable quarter of 2017.

The following table presents the impact for the three and nine month periods ended September 30, 2017 of the accretable and amortizable fair value adjustments attributable to the two acquisitions mentioned above on net interest income and pretax income (dollars in thousands):



		September 30, 2017
	Income Statement Effect	Accretion (Amortization) Three Months Ended			Accretion (Amortization) Nine Months Ended
Interest income/(expense):
Acquired performing loans	Income	$	125		$	567
Acquired impaired loans	Income	463			1,112
FHLB Advances	Expense	(6		)	(17		)
Junior subordinated debt	Expense	(25		)	(76		)
Net interest income		557			1,586

Noninterest (expense):
Amortization of core deposit intangible	Expense	(80		)	(448		)

Change in pretax income		$	477		$	1,138

The MidCarolina acquisition was effective July 1, 2011 and the MainStreet acquisition was effective January 1, 2015. Management expects that the acquisition accounting financial impact of these acquisitions will continue to decline in future quarters.

Impact of Inflation and Changing Prices

The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. The most significant effect of inflation is on noninterest expense, which tends to rise during periods of inflation. Changes in interest rates have a greater impact on a financial institution's profitability than do the effects of higher costs for goods and services. Through its balance sheet management practices, the Company has the ability to react to those changes and measure and monitor its interest rate and liquidity risk. During the reported periods, inflation has been low, and interest rates have been rising.

CHANGES IN FINANCIAL POSITION

BALANCE SHEET ANALYSIS

Securities

The securities portfolio generates income, plays a major role in the management of interest rate sensitivity, provides a source of liquidity, and is used to meet collateral requirements. The securities portfolio consists primarily of high credit quality investments, mostly federal agency, mortgage-backed, and state and municipal securities.

The available for sale securities portfolio was $295,777,000 at September 30, 2018, compared to $321,337,000 at December 31, 2017, a decrease of $25,560,000 or 8.0%. The decrease is net of $2,206,000 of equity securities classified as available for sale prior to the adoption of Accounting Standards Update 2016-01, which were reclassified on January 1, 2018 to fair value on the balance sheet. Also, as a result, the Company reclassified $650,000 of the unrealized holding gains on these equity securities from accumulated other comprehensive loss to retained earnings. Accordingly, the Company recognized $312,000 in net unrealized gains on these equity securities for the nine months ended September 30, 2018. At September 30, 2018, the available for sale portfolio had an amortized cost of $304,834,000 resulting in a net unrealized loss of $9,057,000. At December 31, 2017, the available for sale portfolio had an amortized cost of $322,345,000, resulting in a net unrealized loss of $1,008,000.

The Company is cognizant of the continuing historically low, but increasing interest rate environment and has elected to maintain a defensive asset liability strategy of purchasing high quality taxable securities of relatively short duration.

The Company experienced significant growth rates for earning assets and deposits in calendar year 2017. The magnitude and unpredictable timing of that growth generated periodic liquidity constraints. Consequently, management elected to selectively reduce portions of its securities portfolio in an effort to mitigate actual and anticipated liquidity challenges. The Company used these opportunities to selectively reduce the size of its tax exempt municipal portfolio, which was relatively less attractive at the lower tax rates effective for 2018. During the nine months ended September 30, 2018, the Company sold $57,290,000 in par value bonds and realized a net gain of $81,000. This compares to the nine months ended September 30, 2017, when the Company sold $53,930,000 in par value bonds and realized a net gain of $590,000. During the nine months ended September 30, 2018, the Company sold $431,000 in equity securities at fair value.

The Company manages its investment portfolio on an aggregate portfolio basis for purposes of monitoring and controlling average life and duration. Accordingly, some individual purchases may fall outside these overall guidelines. The Company will continue to purchase high quality, relatively low optionality bonds to the maximum extent practical and prudent, consistent with its liquidity and asset liability strategies, and regulatory requirements.

Loans

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

Total loans were $1,331,153,000 at September 30, 2018, compared to $1,336,125,000 at December 31, 2017, a decrease of $4,972,000 or 0.4%. The decrease is primarily due to over $40 million in large commercial loan payoffs during the period. Expectations for the remainder of 2018 and 2019 are for growth in loans at a moderate pace.

Average loans were $1,330,342,000 for the third quarter of 2018, compared to $1,295,429,000 for the third quarter of 2017, an increase of $34,913,000 or 2.7%.

Loans held for sale totaled $1,934,000 at September 30, 2018 and $1,639,000 at December 31, 2017. Loan production volume was $60,575,000 for the nine month period ended September 30, 2018 and $63,627,000 for the same period of 2017. These loans were approximately 60% purchase and 40% refinancing.

Management of the loan portfolio is organized around portfolio segments. Each segment is comprised of various loan types that are reflective of operational and regulatory reporting requirements. The following table presents the Company's loan portfolio by segment as of September 30, 2018 and December 31, 2017 (dollars in thousands):



	September 30, 2018		December 31, 2017
Commercial	$	284,176	$	251,666
Commercial real estate:
Construction and land development	99,546		123,147
Commercial real estate	632,022		637,701
Residential real estate:
Residential	205,277		209,326
Home equity	104,873		109,857
Consumer	5,259		4,428
Total loans	$	1,331,153	$	1,336,125

Provision for Loan Losses

The Company had a negative provision for loan losses of $97,000 for the nine month period ended September 30, 2018, compared to a provision of $1,090,000 for the same period ended September 30, 2017. The negative provision related to favorable adjustments on the acquired impaired loan loss allowance. The need for any additional provision in the nine month period ended September 30, 2018 was mitigated by slower growth in loans, continued strong asset quality metrics, and improvements in various qualitative factors used in computing loss reserve.

Allowance for Loan Losses

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

At September 30, 2018, the ALLL was $13,588,000 compared to $13,603,000 at December 31, 2017. The ALLL as a percentage of total loans was 1.02% at both dates.

At September 30, 2018, as part of the Company's methodology to evaluate the adequacy of its ALLL, the Company computed its ASC 450 loan balance by reducing total loans by acquired loans and loans that were evaluated for impairment individually. At September 30, 2017, the Company also reduced total loans by smaller balance nonaccrual loans evaluated for impairment in homogeneous pools. The FASB ASC 450 loan loss reserve balance is the total ALLL reduced by allowances associated with these other pools of loans.

The general allowance, ASC 450 (FAS 5) reserves to FASB ASC 450 loans, was 0.96% at September 30, 2018, compared to 1.04% at December 31, 2017. On a dollar basis, the reserve was $12,601,000 at September 30, 2018, compared to $13,151,000 at December 31, 2017. The percentage of the reserve to total loans has declined due to improving local and national economic conditions and continued strong asset quality metrics. This segment of the allowance represents by far the largest portion of the loan portfolio and the largest aggregate risk.

The specific allowance, ASC 310-40 (FAS 114) reserves to FASB ASC 310-40 loans, was 33.13% at September 30, 2018, compared to 5.18% at December 31, 2017. On a dollar basis, the reserve was $800,000 at September 30, 2018, compared to $167,000 at December 31, 2017. The increase in ASC 310-40 loans was mainly attributed to the addition of two commercial loans totaling approximately $600,000 moving from 90 days past due to non-accrual status. There is ongoing turnover in the composition of the impaired loan population, which decreased by a net $802,000 over December 31, 2017.

The specific allowance does not include reserves related to acquired loans with deteriorated credit quality. This reserve was $187,000 at September 30, 2018 compared to $285,000 at December 31, 2017. This is the only portion of the reserve related to acquired impaired loans. Cash flow expectations for these loans are reviewed on a quarterly basis and unfavorable changes in those estimates relative to the initial estimates can result in the need for additional loan loss provision. The following table presents the Company's loan loss and recovery experience for the periods indicated (dollars in thousands):



Summary of Loan Loss Experience
	Nine Months Ended September 30, 2018			Year Ended December 31, 2017
Balance at beginning of period	$	13,603		$	12,801

Charge-offs:
Construction and land development	—			35
Commercial real estate	11			58
Residential real estate	—			159
Home equity	86			13
Total real estate	97			265
Commercial and industrial	10			282
Consumer	95			143
Total charge-offs	202			690

Recoveries:
Construction and land development	—			43
Commercial real estate	4			17
Residential real estate	39			45
Home equity	100			40
Total real estate	143			145
Commercial and industrial	65			223
Consumer	76			108
Total recoveries	284			476

Net (recoveries) charge-offs	(82		)	214
Provision for loan losses	(97		)	1,016
Balance at end of period	$	13,588		$	13,603

Asset Quality Indicators

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



Asset Quality Ratios
	September 30, 2018		December 31, 2017
Allowance to loans	1.02	%	1.02	%
ASC 450 (FAS 5) ALLL	0.96		1.04
Net charge-offs (recoveries) to allowance ⁽¹⁾	(0.80	)	1.57
Net charge-offs (recoveries) to average loans ⁽¹⁾	(0.01	)	0.02
Nonperforming assets to total assets	0.18		0.21
Nonperforming loans to loans	0.17		0.19
Provision to net charge-offs (recoveries) ⁽¹⁾	118.29		474.77
Provision to average loans ⁽¹⁾	(0.01	)	0.08
Allowance to nonperforming loans	587.72		531.37

(1) - Annualized.

Nonperforming Assets (Loans and Other Real Estate Owned)

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

Nonperforming loans to total loans were 0.17% at September 30, 2018 and 0.19% at December 31, 2017.

Nonperforming assets include nonperforming loans and OREO. Nonperforming assets represented 0.18% and 0.21% of total assets at September 30, 2018 and December 31, 2017, respectively.

In most cases, it is the policy of the Company that any loan that becomes 90 days past due will automatically be placed on nonaccrual loan status, accrued interest reversed out of income, and further interest accrual ceased. Any payments received on such loans will be credited to principal. In some cases a loan in process of renewal may become 90 days past due. In these instances the loan may still be accruing because of a delayed renewal process in which the customer has not been billed. In accounting for acquired impaired loans, such loans are not classified as nonaccrual when they become 90 days past due. They are considered to be accruing because their interest income relates to the accretable yield and not to contractual interest payments.

Loans will only be restored to full accrual status after six consecutive months of payments that were each less than 30 days delinquent. The Company strictly adheres with this policy before restoring a loan to normal accrual status.

The following table presents the Company's nonperforming assets as of September 30, 2018 and December 31, 2017 (dollars in thousands):



Nonperforming Assets
	September 30, 2018		December 31, 2017
Nonaccrual loans:
Real estate	$	1,184	$	2,111
Commercial	1,054		90
Consumer	—		—
Total nonaccrual loans	2,238		2,201

Loans past due 90 days and accruing interest:
Real estate	74		359
Total past due 90 days and accruing interest	74		359

Total nonperforming loans	2,312		2,560

Other real estate owned	916		1,225

Total nonperforming assets	$	3,228	$	3,785

Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The following table shows loans that were considered impaired, exclusive of acquired impaired loans, as of September 30, 2018 and December 31, 2017 (dollars in thousands):



Impaired Loans
	September 30, 2018		December 31, 2017
Accruing	$	859	$	1,016
Nonaccruing	1,556		2,201
Total impaired loans	$	2,415	$	3,217

Troubled Debt Restructurings ("TDRs")

TDRs exist whenever the Company makes a concession to a customer based on the customer's financial distress that would not have otherwise been made in the normal course of business.

There were $1,120,000 in TDRs at September 30, 2018 compared to $1,306,000 at December 31, 2017. These loans are included in the impaired loan table above.

Other Real Estate Owned

Other real estate owned was $916,000 and $1,225,000 as of September 30, 2018 and December 31, 2017, respectively. OREO is initially recorded at fair value, less estimated costs to sell, at the date of foreclosure. Loan losses resulting from foreclosure are charged against the ALLL at that time. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of the new cost basis or fair value, less estimated costs to sell with any additional write-downs charged against earnings. For significant assets, these valuations are typically outside annual appraisals. The following table shows the Company's OREO as of September 30, 2018 and December 31, 2017 (dollars in thousands):



Other Real Estate Owned
	September 30, 2018		December 31, 2017
Construction and land development	$	78	$	318
1-4 family residential	766		629
Commercial real estate	72		278
	$	916	$	1,225

Deposits

The Company's deposits consist primarily of checking, money market, savings, and consumer and commercial time deposits. Total deposits were $1,523,107,000 at September 30, 2018 compared to $1,534,726,000 at December 31, 2017, a decrease of $11,619,000 or 0.8%.

Average interest bearing deposits were $1,118,929,000 for the third quarter of 2018, compared to $1,066,827,000 for the third quarter of 2017, an increase of $52,102,000 or 4.9%. Average noninterest bearing deposits for the 2018 quarter were $424,016,000, compared to $401,696,000 for the 2017 quarter, an increase of $22,320,000 or 5.6%.

The Company's primary focus on the liability side of the balance sheet is growing core deposits and their affiliated relationships. The increasing challenge in this rising rate environment is to fund the Bank in a cost effective and competitive manner. The Company's cost of deposits for the third quarter of 2018 was 0.73%, up from 0.57% for the third quarter of 2017.

Junior Subordinated Debt

The Company had three junior subordinated notes in the amounts of $20,619,000, $4,363,000, and $2,920,000 outstanding at September 30, 2018. These notes accrue at 1.35%, 3.45%, and 2.95%, respectively, above the 90-day LIBOR rate, adjusted quarterly. To add stability to net interest income and manage exposure to interest rate movement, the Company entered into three interest rate swaps in June 2018 on these notes. The swap contracts involve the payment of fixed-rate amounts to a counterparty in exchange for receipt of variable rate payments over the ten year life of the contracts. The effective interest rates on the swapped notes were 4.33%, 6.44%, and 5.93%, respectively at September 30, 2018.

Shareholders' Equity

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

Shareholders' equity was $216,066,000 at September 30, 2018 compared to $208,717,000 at December 31, 2017, an increase of $7,349,000 or 3.5%.

The Company paid cash dividends of $0.75 per share during the first nine months of 2018 while the aggregate basic and diluted earnings per share for the same period was $2.02.

In July 2013, the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency issued final rules that make technical changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules maintain the general structure of the prompt corrective action framework in effect at such time while incorporating certain increased minimum requirements. Effective January 1, 2015, the final rules require the Company and the Bank to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements, which will be phased-in over a four-year period. When fully phased-in on January 1, 2019, the rules will require the Company and the Bank to maintain such minimum ratios plus a 2.5% "capital conservation buffer" (other than for

the leverage ratio). The phase-in of the capital conservation buffer began on January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. Management believes the Company and the Bank will be compliant with the fully phased-in requirements when they become effective January 1, 2019.

The following table provides information on the regulatory capital ratios for the Company and the Bank at September 30, 2018 and December 31, 2017. Management believes, as of September 30, 2018, that the Company and the Bank more than satisfy all capital adequacy requirements to which they are subject.



	Percentage At September 30, 2018				Percentage At December 31, 2017
Risk-Based Capital Ratios:	Company		Bank		Company		Bank

Common equity tier 1 capital ratio	12.56	%	13.69	%	11.50	%	12.79	%
Tier 1 capital ratio	14.51		13.69		13.42		12.79
Total capital ratio	15.47		14.66		14.39		13.75

Leverage Capital Ratio:

Tier 1 leverage ratio	11.72		11.06		10.95		10.43

Stock Repurchase Plan

On November 19, 2015, the Company filed a Form 8-K with the SEC to announce the approval by its Board of Directors of a stock repurchase program. The plan authorized the repurchase of up to 300,000 shares of the Company's common shares over a two year period. The share purchase limit was established at such number to equal to approximately 3.5% of the 8,622,000 shares then outstanding at the time the Board approved the program. The program expired on November 19, 2017.

On January 19, 2018, the Company filed a Form 8-K with the SEC to announce the approval by its Board of another stock repurchase program. The program authorizes the repurchase of up to 300,000 shares of the Company's common stock over a two year period.

In the nine month period ended September 30, 2018 and 2017, the Company did not repurchase any shares.

Liquidity

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

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

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

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

The Company has a line of credit with the FHLB, equal to 30% of the Bank's assets, subject to the amount of collateral pledged. Under the terms of its collateral agreement with the FHLB, the Company provides a blanket lien covering all of its residential first mortgage loans, second mortgage loans, home equity lines of credit, and commercial real estate loans. In addition, the Company pledges as collateral its capital stock in and deposits with the FHLB. The Company had $190,250,000 outstanding in letters of credit at September 30, 2018 and $190,700,000 outstanding at December 31, 2017. The letters of credit provide the Bank with alternate collateral for securing public entity deposits above FDIC insurance levels, thereby providing less need for collateral pledging from the securities portfolio, and thereby maximizing on balance sheet liquidity.

Short-term borrowings are discussed in Note 6 and long-term borrowings are discussed in Note 7 in the Consolidated Financial Statements included in this report.

The Company has federal funds lines of credit established with two correspondent banks in the amounts of $15,000,000 each, and has access to the Federal Reserve Bank's discount window.

The Company has a relationship with Promontory Network, the sponsoring entity for the Certificate of Deposit Account Registry Service® ("CDARS"). Through CDARS, the Company is able to provide deposit customers with access to aggregate FDIC insurance in amounts exceeding $250,000. This gives the Company the ability, as and when needed, to attract and retain large deposits from insurance conscious customers. Under the Economic Growth, Regulatory Relief, and Consumer Protection Act signed into law on May 24, 2018, a well-capitalized bank with a CAMELS rating of 1 or 2 may hold reciprocal deposits up to the lesser of 20 percent of its total liabilities or $5 billion without those deposits being treated as brokered deposits. With CDARS, the Company has the option to keep deposits on balance sheet or sell them to other members of the network. Additionally, subject to certain limits, the Bank can use CDARS to purchase cost-effective funding without collateralization and in lieu of generating funds through traditional brokered CDs or the FHLB. In this manner, CDARS can provide the Company with another funding option. Thus, CDARS serves as a deposit-gathering tool and an additional liquidity management tool. Deposits through the CDARS program as of September 30, 2018 and December 31, 2017, were $30,470,000 and $25,838,000, respectively.

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

Off-Balance Sheet Activities

The Company enters into certain financial transactions in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. Other than subsidiaries to issue trust preferred securities, the Company does not have any off-balance sheet subsidiaries. Off-balance sheet transactions at September 30, 2018 and at December 31, 2017 were as follows (dollars in thousands):



	September 30, 2018		December 31, 2017
Commitments to extend credit	$	366,576	$	341,760
Standby letters of credit	13,735		13,647
Mortgage loan rate-lock commitments	11,066		5,089

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk Management

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

Interest Rate Risk Management

Interest rate risk and its impact on net interest income is a primary market risk exposure. The Company manages its exposure to fluctuations in interest rates through policies approved by the ALCO and Board of Directors, both of which receive and review periodic reports of the Company's interest rate risk position.

The Company uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation takes into account current balance sheet volumes and the scheduled repricing dates instrument level optionality, and maturities of assets and liabilities. It incorporates numerous assumptions including growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered asset sensitive when its earning assets (loans and securities) reprice faster or to a greater extent than its liabilities (deposits and borrowings). An asset sensitive balance sheet will produce relatively more net interest income when interest rates rise and less net interest income when they decline. Based on the Company's simulation analysis, management believes the Company's interest sensitivity position at September 30, 2018 is asset sensitive. Management expects that the general direction of market interest rates will be gradually up over the remainder of 2018.

Earnings Simulation

The following table shows the estimated impact of changes in interest rates on net interest income as of September 30, 2018 (dollars in thousands), assuming gradual and parallel changes in interest rates, and consistent levels of assets and liabilities. Net interest income for the following twelve months is projected to increase when interest rates are higher than current rates.



Estimated Changes in Net Interest Income
	September 30, 2018
	Change in Net Interest Income
Change in interest rates	Amount			Percent
Up 4.00%	$	6,945		11.9	%
Up 3.00%	5,269			9.1
Up 2.00%	3,614			6.2
Up 1.00%	1,917			3.3
Flat	—			—
Down 0.25%	(524		)	(0.9	)
Down 1.00%	(3,196		)	(5.5	)

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

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

Economic Value Simulation

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer-term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet.

The following table reflects the estimated change in net economic value over different rate environments using economic value simulation for the balances at the quarterly period ended September 30, 2018 (dollars in thousands):



Estimated Changes in Economic Value of Equity
	September 30, 2018
Change in interest rates	Amount		$ Change			% Change
Up 4.00%	$	382,239	$	77,361		25.4	%
Up 3.00%	369,732		64,854			21.3
Up 2.00%	353,601		48,723			16.0
Up 1.00%	332,504		27,626			9.1
Flat	304,878		—			—
Down 0.25%	296,149		(8,729		)	(2.9	)
Down 1.00%	264,467		(40,411		)	(13.3	)

Due to the current relatively low interest rate environment, no measurement was considered necessary for a further decline in interest rates. There have been no material changes to market risk as disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2017. Refer to those disclosures for further information.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

The Company's management, including the Chief Executive Officer and Chief Financial Officer, evaluated the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of September 30, 2018. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms. There were no significant changes in the Company's internal controls over financial reporting that occurred during the quarter ended September 30, 2018, that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

The following risk factors should be considered in addition to the risk factors previously disclosed in the Company's Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 9, 2018. Such factors relate to the Company’s proposed merger with HomeTown.

Combining the Company and HomeTown may be more difficult, costly or time-consuming than the Company expects.

The success of the merger of HomeTown with and into the Company (the “merger”) will depend, in part, on the Company’s ability to realize the anticipated benefits and cost savings from combining the businesses of the Company and HomeTown and to combine the businesses of the Company and HomeTown in a manner that permits growth opportunities and cost savings to be realized without materially disrupting the existing customer relationships of HomeTown or the Company or decreasing revenues due to loss of customers. However, to realize these anticipated benefits and cost savings, the Company must successfully combine the businesses of the Company and HomeTown. If the Company is not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully, or at all, or may take longer to realize than expected.

The Company and HomeTown have operated, and, until the completion of the merger, will continue to operate, independently. The success of the merger will depend, in part, on the Company’s ability to successfully combine the businesses of the Company and HomeTown. To realize these anticipated benefits, after the completion of the merger, the Company expects to integrate HomeTown’s business into its own. The integration process in the merger could result in the loss of key employees, the disruption of each party’s ongoing business, inconsistencies in standards, controls, procedures and policies that affect adversely either party’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the merger. The loss of key employees could adversely affect the Company’s ability to successfully conduct its business in the markets in which HomeTown now operates, which could have an adverse effect on the Company’s financial results and the value of its common stock. If the Company experiences difficulties with the integration process, the anticipated benefits of the merger may not be realized, fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be disruptions that cause the Company and HomeTown to lose customers or cause customers to withdraw their deposits from HomeTown’s or the Company’s banking subsidiaries, or other unintended consequences that could have a material adverse effect on the Company’s results of operations or financial condition after the merger. These integration matters could have an adverse effect on each of HomeTown and the Company during this transition period and for an undetermined period after consummation of the merger.

The Company may not be able to effectively integrate the operations of HomeTown Bank into the Bank.

The future operating performance of the Company and the Bank will depend, in part, on the success of the merger of HomeTown Bank and the Bank, which is expected to occur at the time of or as soon as reasonably practicable after the merger of the Company and HomeTown. The success of the merger of the banks will, in turn, depend on a number of factors, including the Company’s ability to: (i) integrate the operations and branches of HomeTown Bank and the Bank; (ii) retain the deposits and customers of HomeTown Bank and the Bank; (iii) control the incremental increase in noninterest expense arising from the merger in a manner that enables the combined bank to improve its overall operating efficiencies; and (iv) retain and integrate the appropriate personnel of HomeTown Bank into the operations of the Bank, as well as reducing overlapping bank personnel. The integration of HomeTown Bank and the Bank following the subsidiary bank merger will require the dedication of the time and resources of the banks’ management and may temporarily distract managements’ attention from the day-to-day business of the banks. If the Bank is unable to successfully integrate HomeTown Bank, the Bank may not be able to realize expected operating efficiencies and eliminate redundant costs.

Regulatory approvals may not be received, may take longer than expected or may impose conditions that are not presently anticipated or that could have an adverse effect on the Company following the merger.

Before the merger of HomeTown into the Company, or the merger of HomeTown Bank into the Bank, may be completed, the Company and HomeTown must obtain approvals from certain bank regulatory authorities. Other approvals, waivers or

consents from regulators may also be required. In determining whether to grant these approvals the regulators consider a variety of factors, including the regulatory standing of each party and the competitive effects of the contemplated transactions. An adverse development in either party’s regulatory standing or these factors could result in an inability to obtain approval or delay their receipt. The Community Reinvestment Act of 1977, as amended, and the regulations issued thereunder (collectively, the “CRA”) also requires that the bank regulatory authorities, in deciding whether to approve the merger and the subsidiary bank merger, assess the records of performance of the Bank and HomeTown Bank in meeting the credit needs of the communities they serve, including low and moderate income neighborhoods. As part of the review process under the CRA, it is not unusual for the bank regulatory authorities to receive protests and other adverse comments from community groups and others. Any such protests or adverse comments could prolong the period during which the merger and the subsidiary bank merger are subject to review by the bank regulatory authorities.

These regulators may impose conditions on the completion of the merger or the subsidiary bank merger or require changes to the terms of the merger or the subsidiary bank merger. Such conditions or changes could have the effect of delaying or preventing completion of the merger or the subsidiary bank merger or imposing additional costs on or limiting the revenues of the Company following the merger and the subsidiary bank merger, any of which might have an adverse effect on the Company following the merger.

The merger and the subsidiary bank merger may distract management of the Company and HomeTown from their other responsibilities.

The merger and the subsidiary bank merger could cause the respective management groups of the Company and HomeTown to focus their time and energies on matters related to the transaction that otherwise would be directed to their business and operations. Any such distraction on the part of either company’s management could affect its ability to service existing business and develop new business and adversely affect the business and earnings of the Company or HomeTown before the merger, or the business and earnings of the Company after the merger.

Termination of the Merger Agreement could negatively impact the Company.

If the Merger Agreement is terminated, the Company’s business may be impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the merger, without realizing any of the anticipated benefits of completing the merger. Additionally, if the Merger Agreement is terminated, the market price of the Company’s common stock could decline to the extent that the current market prices reflect a market assumption that the merger will be completed. Furthermore, costs relating to the merger, such as legal, accounting and financial advisory fees, must be paid even if the merger is not completed.

The Company and HomeTown will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees and customers may have an adverse effect on the Company and HomeTown. These uncertainties may impair the Company’s and HomeTown’s ability to attract, retain and motivate key personnel until the merger is completed, and could cause customers and others that deal with the Company and HomeTown to seek to change existing business relationships with the Company and HomeTown. Retention of certain employees by the Company and HomeTown may be challenging while the merger is pending, as certain employees may experience uncertainty about their future roles with the Company or HomeTown. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company or HomeTown, the Company’s or HomeTown’s business, or the business of the combined company following the merger, could be harmed. In addition, subject to certain exceptions, the Company and HomeTown have each agreed to operate its business in the ordinary course prior to closing and refrain from taking certain specified actions until the merger occurs, which may prevent the Company or HomeTown from pursuing attractive business opportunities that may arise prior to completion of the merger.

If the merger is not completed, the Company will have incurred substantial expenses without realizing the expected benefits of the merger.

The Company has incurred and will incur substantial expenses in connection with the negotiation and completion of the transactions contemplated by the Merger Agreement, as well as the costs and expenses of filing, printing and mailing the joint proxy statement/prospectus to shareholders to approve the merger and all filing and other fees paid to the SEC in connection with the merger. If the merger is not completed, the Company would have to incur these expenses without realizing the expected benefits of the merger.

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

On January 16, 2018, the Company's Board of Directors authorized a share repurchase program of up to 300,000 shares of the Company's outstanding common stock for a period of two years. Repurchases may be made through open market purchases or in privately negotiated transactions, and shares repurchased will be returned to the status of authorized and unissued shares of common stock. The actual timing, number, and value of shares repurchased under the program will be determined by management.

No shares of the Company's common stock were repurchased during the three months ended September 30, 2018. Under the share repurchase program, the Company has the remaining authority to repurchase up to 300,000 shares of the Company's common stock as of September 30, 2018.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

(a) Required 8-K disclosures

None

(b) Changes in Nominating Process

None

ITEM 6. EXHIBITS


2.1	Agreement and Plan of Reorganization, dated October 1, 2018, between American National Bankshares Inc. and HomeTown Bankshares Corporation (incorporated by reference to Exhibit 2.1 to Current Report on Form 8-K filed on October 5, 2018).

11.0 Refer to EPS calculation in the Notes to Financial Statements.

31.1 Section 302 Certification of Jeffrey V. Haley, President and Chief Executive Officer.

31.2 Section 302 Certification of William W. Traynham, Executive Vice President and Chief Financial Officer.

32.1 Section 906 Certification of Jeffrey V. Haley, President and Chief Executive Officer.

32.2 Section 906 Certification of William W. Traynham, Executive Vice President and Chief Financial Officer.

101

Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017, (ii) the Consolidated Statements of Income for the three and nine months ended September 30, 2018 and September 30, 2017, (iii) the Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and September 30, 2017, (iv) the Consolidated Statements of Changes in Shareholders' Equity for the nine months ended September 30, 2018 and September 30, 2017, (v) the Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and September 30, 2017, and (vi) the Notes to the Consolidated Financial Statements (furnished herewith).

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

AMERICAN NATIONAL BANKSHARES INC.






	By:	/s/ Jeffrey V. Haley
		Jeffrey V. Haley
		President and Chief Executive Officer
Date - November 5, 2018		(principal executive officer)

	By:	/s/ William W. Traynham
		William W. Traynham
		Executive Vice President and
		Chief Financial Officer
Date - November 5, 2018		(principal financial officer)

	By:	/s/ Cathy W. Liles
		Cathy W. Liles
		Senior Vice President and
		Chief Accounting Officer
Date - November 5, 2018		(principal accounting officer)

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AMERICAN NATIONAL BANKSHARES INC. Reports