Auburn National Bancorporation, Inc.
Annual Report 2013

Plain-text annual report

SUCCESS &SERVICE IN C HALLENGIN G TIM E S A U B U R N N AT I O N A L B A N C O R P O R AT I O N , I N C . 2 0 1 3 A N N U A L R E P O R T SUCCESS &SERVICE IN CH ALLEN GI NG TI M E S A U B U R N N A T I O N A L B A N C O R P O R A T I O N , I N C . 2 0 1 3 A N N U A L R E P O R T TO OUR SHAREHOLDERS AND FRIENDS The last few years have been trying for the banking industry as a whole. Recession, declining credit quality, a troubled housing market, reserve requirements, and modest loan demand have all been a challenge. AuburnBank has been tested by these factors, but, through the efforts of our officers and staff, and with the support of our directors we have met the test and your bank is doing well. We have always believed that credit issues and other problems needed prompt resolution and we have made some difficult decisions. As a result our reserves are strong, our loans are performing in a timely manner and we reported record earnings in 2013. This report details results that include earnings of $1.95 per share compared to $1.86 per share for the prior year. We were founded in 1907 because the citizens of Auburn and this area needed their own, local bank. From that beginning we have been dedicating our time, our resources, and our skills to our local communities. We are here for our customers. We take care of your money and we are here to help when you need additional resources. Thanks for allowing us to help you as an owner and as a customer of our bank. Remember, we are here for you. E.L. Spencer, Jr. Chairman, Board of Directors AuburnBank and ANBC CORPORATE PROFILE I am pleased to report that 2013 was a record earnings year for AuburnBank. Net income of $7.1 million or $1.95/per share was reported for the full year. This represents a 5% increase over net earnings for the year 2012. In addition to record earnings for the year, the Bank also continued to improve its credit quality, increase capital, reduce non-core funding, control our non-interest expense, and increase our annual dividend to shareholders. By reducing our higher cost borrowings by approximately $35 million in 2013, we improved our net interest income and positively improved the overall funding mix. On behalf of the entire AuburnBank family, I would like to thank our customers and our shareholders for making 2013 a special year. In the regulatory environment that we operate in, I would like to congratulate and commend our officers and staff on their commitment to providing top quality customer service and for their active involvement in many worthy community service organizations. As we move into our 107th year of operation, we look forward to providing the financial products and services that all of our customers need and desire. We extend our deepest gratitude for your support and for your business and we look forward to continuing to be your partner, neighbor and friend in 2014. Robert W. Dumas President and CEO AuburnBank SUCCESS&SERVICE IN CHALLENGING TIMES the past five years of challenging economic times, it is In order to understand AuburnBank’s success during important to look back at the very beginning of Auburn’s only remaining chartered financial institution. When Shel Toomer and a few supporters started The Bank of Auburn, they believed in several founding principles. The bank was organized to serve its citizens, the community and the college. From the very beginning, AuburnBank was focused on providing a safe place for customers to keep their money. In return, the bank would help the community by making loans to individuals, businesses, the city, and the TOP 200 COMMUNITY BANK IN THE NATION FOR SEVEN OF LAST EIGHT YEARS according to American Banker { } magazine based on average return on equity for a three year period. RECORD NET EARNINGS OVER $7 MILLION I N 2 0 1 3 college, in order to allow local businesses to grow its overall earnings, earnings per share, capital, and expand and to assist individuals with their dividends and maintain its asset quality. These financial needs. If we fast forward to the time-frame of 2009 – 2013, 102 years from the beginning of AuburnBank, the same principles that the original founders believed in are still guiding the leading financial institution in East Alabama. Because AuburnBank is still a community bank—a bank that cares—and because the bank believes in providing all customers with top quality service, the bank has continued to prosper even during tough economic times. Since are pretty good results when property values were falling and not many businesses were expanding. The desire to understand customer needs and then provide sound prudent solutions to those needs are skills required in order to help customers succeed. Yes, 2013 was a record earnings year for AuburnBank, but the results would not have been possible without the vision of our founders and the leadership and management of its current Board of Directors and the entire AuburnBank team. 2009, AuburnBank has continued to meet the On behalf of the AuburnBank family, thank you to financial needs and desires of its customers in the our shareholders and customers for believing and communities it serves. In addition, for the past trusting in a bank that has a conscience to do what five years, AuburnBank has been able to increase is right for its customers and its community. EIGHTEEN OUT OF THE LAST NINETEEN YEARS DIVIDENDS TO SHAREHOLDERS HAVE INCREASED They never declined { } during the recession. OVER $745 MILLION in Home Loans F R O M 2 0 0 9 T O 2 0 1 3 #1 IN MORTGAGE ORIGINATION MARKET SHARE IN LEE COUNTY Source: SNL Financial. Data originally sourced to the Home Mortgage Disclosure Act data compiled annually by the FFIEC. Most recent market share data from 2012. 30% MARKET SHARE FOR DEPOSITS (OVER $600 MILLION) # 1 OF 17 BANKS IN LEE COUNTY Source: FDIC Summary of Deposits. Data as of June 30, 2013. INCREASES IN EARNINGS PER SHARE FOR FIVE CONSECUTIVE YEARS SINCE 2009 A TIME OF GROWTH Opened Bent Creek Branch in Auburn. New Super Six Drive-Thru opens at main branch. New branch in Valley, Alabama opens. Main Office campus improvements. 2009 2010 2011 2012 COMMUNITY SERVICE Active involvement in community proj- ects and charitable and civic organizations has always been a part of AuburnBank’s core values. The bank continues to support numerous worthy causes along with many individuals of the AuburnBank family who also contribute to many worthwhile com- munity organizations and projects. Just like our record-breaking earnings in 2013, our employees also set a new record in our giving to the Lee County United Way. This is just one of the many ways that our organization gives back to sup- port the communities that we serve. Take a look around our community and you will find the AuburnBank team volunteer- ing and extending a helping hand to make a difference in our friends’ and neighbors’ well-being. Main Office campus improvements. 2013 Sara Beth Carrington (left) and Mellissa Stevens (right) donate during a recent blood drive. David Warren and Leigh Ann Thompson were an integral part of AuburnBank’s United Way drive. A TIME OF GROWTH AUBURN NATIONAL BANCORPORATION, INC. AND AUBURNBANK BOARD OF DIRECTORS Seated left to right: J. Tutt Barrett, William F. Ham, Jr., E.L. Spencer, Jr., Robert W. Dumas, and Anne M. May Standing: David E. Housel, Edward Lee Spencer, III, Terry W. Andrus, C. Wayne Alderman, and J.E. Evans Terry W. Andrus President, East Alabama Medical Center C. Wayne Alderman Secretary to ANBC Dean of Enrollment Services and former Dean, College of Business, Auburn University J. Tutt Barrett Attorney, Dean and Barrett Robert W. Dumas President & CEO, AuburnBank J.E. Evans Owner, Evans Realty William F. Ham, Jr. Mayor, City of Auburn & Owner, Varsity Enterprises David E. Housel Director of Athletics Emeritus, Auburn University Anne M. May Partner, Machen, McChesney & Chastain, CPAs E.L. Spencer, Jr. Chairman, AuburnBank and ANBC, Business Owner Edward Lee Spencer, III Investor AUBURNBANK OFFICERS E.L. Spencer, Jr. Chairman Robert W. Dumas President & Chief Executive Officer Jo Ann Hall Executive Vice President, Chief Operations Officer/ Chief Risk Officer Vernon C. Bice, Jr. Senior Vice President Residential Real Estate Terrell E. Bishop Senior Vice President, Senior Mortgage Loan Officer City President, Valley Branch James E. Dulaney Senior Vice President, Business Development/Marketing W. Thomas Johnson Senior Vice President, Senior Lender Marla Kickliter Senior Vice President, Compliance/Internal Audit Shannon O’Donnell Senior Vice President, Credit Administration Jerry Siegel Senior Vice President, IT/IS Chief Technology Officer C. Eddie Smith Senior Vice President, City President, Opelika Branch Bob R. Adkins Vice President, Commercial/Consumer Loans Patty Allen Vice President, Commercial/Consumer Loans Scottie Arnold Vice President, Retail Internet/ Operations Officer Kris Blackmon Vice President, Asset/Liability Manager Chief Investment Officer Susan K. McChesney Vice President, IT/IS Assistant Chief Technology Officer S. Mark Bridges Vice President, Commercial/Consumer Loans James R. Pack Vice President, Financial Reporting Laura Carrington Vice President, Human Resource Officer Kathy Crawford Vice President, Commercial/Consumer Loans Bruce Emfinger Vice President, Commercial/Consumer Loans David Hedges Vice President, Controller and CFO Ginnie Y. Lunsford Vice President, Consumer Loans/ Loan Operations Cyndee Redmond Vice President, Operational Coordinator for Electronic Products and Services John P. Ronan Vice President, Commercial/Consumer Loans Robert Smith Vice President, Commercial/Consumer Loans David Warren Vice President, Commercial/Consumer Loans Barbara Wilcox Vice President, Security and Bank Secrecy Act Officer Suzanne Gibson Assistant Vice President, Portfolio Management Officer Charlotte Lang Assistant Bank Secrecy Act Officer and Operations Officer Woody Odom Assistant Vice President, IT/IS Marcia Otwell Shareholder Relations and Administrative Officer Jeff Stewart Assistant Vice President, Consumer Loan Officer Christy A. Fogle Assistant Vice President, Loan Review Officer Sam S. Rainer Marketing Officer OPELIKA BRANCH ADVISORY BOARD Seated left to right: C. Eddie Smith and Sherrie M. Stanyard Standing: William G. Dyas, William H. Brown, Robert G. Young, William P. Johnston, and Doug M. Horn Not pictured: R. Kraig Smith, M.D. VALLEY BRANCH ADVISORY BOARD Seated left to right: Valerie G. Gray, Terrell E. Bishop, and H. David Ennis, Sr. Standing: Roy W. McClendon, Jr., Claud E. (Skip) McCoy, Jr., Frank P. Norman and John H. Hood, II William H. Brown President, Brown Agency, Inc. William G. Dyas Businessman Doug M. Horn Owner, Doug Horn Roofing & Contracting Co. William P. Johnston President, J & M Bookstore C. Eddie Smith President, AuburnBank of Opelika R. Kraig Smith, M.D. Lee OBGYN Sherrie Murphy Stanyard Senior Account Manager, Craftmaster Printers, Inc. Robert G. Young Vice President, Sales Young's Plant Farm, Inc. Terrell E. Bishop Senior Vice President, Senior Mortgage Loan Officer City President, Valley Branch H. David Ennis, Sr. President, Novelli-Ennis & Company, CPAs Valerie G. Gray Executive Director of the Chambers County Development Authority John H. Hood, II Pharmacist, Hood’s Pharmacy Roy W. McClendon, Jr. Retired Pharmacist Claud E. (Skip) McCoy, Jr. Attorney, Johnson, Caldwell & McCoy Law Firm Frank P. Norman Owner, Johnny’s New York Style Pizza and WingStop FINANCIAL HIGHLIGHTS Auburn National Bancorporation, Inc. Financial Highlights (Dollars in thousands, except per share data) Earnings Net Interest Income Provision for Loan Losses Net Earnings Per Share: Net Earnings Cash Dividends Book Value Shares Issued Weighted Average Shares Outstanding Financial Condition Total Assets Loans, net of unearned income Investment Securities Total Deposits Long Term Debt Stockholders’ Equity Selected Ratios Return on Average Total Assets Return on Average Total Equity Average Stockholders’ Equity to Average Assets Allowance for Loan Losses as a % of Loans Loans to Total Deposits For the Years Ended December 31, 2013 2012 2011 2010 2009 $20,922 $20,897 $19,225 $18,899 $18,815 400 7,118 1.95 0.84 17.70 3,815 6,763 1.86 0.82 19.26 2,450 5,538 1.52 0.80 17.96 3,580 5,346 1.47 0.78 15.47 5,250 2,404 0.66 0.76 15.42 3,957,135 3,643,003 3,957,135 3,957,135 3,957,135 3,642,831 3,642,735 3,642,851 3,957,135 3,644,691 751,343 383,339 271,219 668,844 12,217 64,485 0.94% 10.33% 9.07% 1.37% 57.31% 759,833 398,193 259,475 636,817 47,217 70,149 0.90% 9.85% 9.09% 1.69% 776,218 370,263 299,582 619,552 85,313 65,416 0.72% 9.10% 7.89% 1.87% 763,829 374,215 315,220 607,127 93,331 56,368 0.68% 9.00% 7.61% 2.05% $773,382 376,103 334,762 579,409 118,349 56,183 0.31% 4.23% 7.21% 1.73% 62.53% 59.76% 61.64% 64.91% Table of Contents Financial Section Auburn National Bancorporation, Inc. 2013 Annual Report BUSINESS INFORMATION MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL TABLES MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM AUDITED CONSOLIDATED FINANCIAL STATEMENTS: Consolidated Balance Sheets Consolidated Statements of Earnings Consolidated Statements of Comprehensive Income Consolidated Statements of Stockholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements STOCK PERFORMANCE GRAPH CORPORATE INFORMATION 2 3 – 22 23 – 32 33 34 35 36 37 38 39 40 – 75 77 Inside Back Cover Forward-Looking Statements SPECIAL CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS Various of the statements made herein under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Quantitative and Qualitative Disclosures about Market Risk”, “Risk Factors” and elsewhere, are “forward-looking statements” within the meaning and protections of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance, achievements or financial condition of the Company to be materially different from future results, performance, achievements or financial condition expressed or implied by such forward-looking statements. You should not expect us to update any forward-looking statements. All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation, (i) the effects of future economic, business and market conditions and changes, domestic and foreign, including seasonality; (ii) governmental monetary and fiscal policies; (iii)legislative and regulatory changes, including changes in banking, securities and tax laws, regulations and rules and their application by our regulators, including capital and liquidity requirements, and changes in the scope and cost of FDIC insurance; (iv) changes in accounting policies, rules and practices; (v) the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities, and the risks and uncertainty of the amounts realizable and the timing of dispositions of assets by the FDIC where we may have a participation or other interest; (vi) changes in borrower credit risks and payment behaviors; (vii) changes in the availability and cost of credit and capital in the financial markets, and the types of instruments that may be included as capital for regulatory purposes; (viii) changes in the prices, values and sales volumes of residential and commercial real estate; (ix) the effects of competition from a wide variety of local, regional, national and other providers of financial, investment and insurance services; (x) the failure of assumptions and estimates underlying the establishment of reserves for possible loan losses and other estimates; (xi) the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions; (xii) changes in technology or products that may be more difficult, costly, or less effective than anticipated; (xiii) the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions; (xiv) the failure of assumptions and estimates, as well as differences in, and changes to, economic, market and credit conditions, including changes in borrowers’ credit risks and payment behaviors from those used in our loan portfolio stress test; (xv) the risks that our deferred tax assets could be reduced if estimates of future taxable income from our operations and tax planning strategies are less than currently estimated, and sales of our capital stock could trigger a reduction in the amount of net operating loss carry-forwards that we may be able to utilize for income tax purposes; and (xvi) other factors and risks described under “Risk Factors” herein and in any of our subsequent reports that we make with the Securities and Exchange Commission (the “Commission” or “SEC”) under the Exchange Act. All written or oral forward-looking statements that are made by us or are attributable to us are expressly qualified in their entirety by this cautionary notice. We have no obligation and do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made. A more detailed description of these and other risks is contained in the Company’s 2013 Annual Report on Form 10- K and in any of our subsequent reports that we make with the Securities and Exchange Commission (the “Commission” or “SEC”) under the Exchange Act. page 1 Business Information BUSINESS INFORMATION Auburn National Bancorporation, Inc. (the “Company”) is a bank holding company registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company was incorporated in Delaware in 1990, and in 1994 it succeeded its Alabama predecessor as the bank holding company controlling AuburnBank, an Alabama state member bank with its principal office in Auburn, Alabama (the “Bank”). The Company and its predecessor have controlled the Bank since 1984. As a bank holding company, the Company may diversify into a broader range of financial services and other business activities than currently are permitted to the Bank under applicable laws, regulations and rules. The holding company structure also provides greater financial and operating flexibility than is presently permitted to the Bank. The Company’s principal executive offices are located at 100 N. Gay Street, Auburn, Alabama 36830, and its telephone number at such address is (334) 821-9200. The Company maintains an Internet website at www.auburnbank.com. The Company’s website and the information appearing on the website are not included or incorporated in, and are not part of, this report. The Company files annual, quarterly and current reports, proxy statements, and other information with the SEC. You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for more information on the operation of the public reference rooms. The SEC maintains an Internet site that contains reports, proxy, and other information. Our SEC filings are also available to the public free of charge from the SEC’s web site at www.sec.gov. Services The Bank offers checking, savings, transaction deposit accounts and certificates of deposit, and is an active residential mortgage lender in its primary service area. The Bank’s primary service area includes the cities of Auburn and Opelika, Alabama and nearby surrounding areas in East Alabama, primarily in Lee County. The Bank also offers commercial, financial, agricultural, real estate construction and consumer loan products and other financial services. The Bank is one of the largest providers of automated teller services in East Alabama and operates ATM machines in 13 locations in its primary service area. The Bank offers Visa® Checkcards, which are debit cards with the Visa logo that work like checks but can be used anywhere Visa is accepted, including ATMs. The Bank’s Visa Checkcards can be used internationally through the Cirrus® network. The Bank offers online banking and bill payment services through its Internet website, www.auburnbank.com. Loans and Loan Concentrations The Bank makes loans for commercial, financial and agricultural purposes, as well as for real estate mortgages, real estate acquisition, construction and development and consumer purposes. While there are certain risks unique to each type of lending, management believes that there is more risk associated with commercial, real estate acquisition, construction and development, agricultural and consumer lending than with residential real estate mortgage loans. To help manage these risks, the Bank has established underwriting standards used in evaluating each extension of credit on an individual basis, which are substantially similar for each type of loan. These standards include a review of the economic conditions affecting the borrower, the borrower’s financial strength and capacity to repay the debt, the underlying collateral and the borrower’s past credit performance. We apply these standards at the time a loan is made and monitor them periodically throughout the life of the loan. See “Legislative and Regulatory Changes” for a discussion of regulatory guidance on commercial real estate lending. The Bank has loans outstanding to borrowers in all industries within its primary service area. Any adverse economic or other conditions affecting these industries would also likely have an adverse effect on the local workforce, other local businesses, and individuals in the community that have entered into loans with the Bank. The auto manufacturing business and its suppliers have positively affected our local economy, but automobile manufacturing is cyclical and adversely affected by increases in interest rates. Decreases in automobile sales, including adverse changes due to interest rate increases, could adversely affect the Kia and Hyundai plants and their suppliers' local spending and employment, and could adversely affect economic conditions in the markets we serve. However, management believes that due to the diversified mix of industries located within the Bank’s primary service area, adverse changes in one industry may not necessarily affect other area industries to the same degree or within the same time frame. The Bank’s primary service area also is subject to both local and national economic conditions and fluctuations. While most loans are made within our primary service area, some residential mortgage loans are originated outside the primary service area, and the Bank from time to time has purchased loan participations from outside its primary service area. page 2 Management’s Discussion and Analysis MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion of our financial condition at December 31, 2013 and 2012 and our results of operations for the years ended December 31, 2013, 2012, and 2011. The purpose of this discussion is to provide information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein. In addition, this discussion and analysis contains forward-looking statements, so you should refer to Item 1A, “Risk Factors” and “Special Cautionary Notice Regarding Forward-Looking Statements”. OVERVIEW The Company was incorporated in 1990 under the laws of the State of Delaware and became a bank holding company after it acquired its Alabama predecessor, which was a bank holding company established in 1984. The Bank, the Company's principal subsidiary, is an Alabama state-chartered bank that is a member of the Federal Reserve System and has operated continuously since 1907. Both the Company and the Bank are headquartered in Auburn, Alabama. The Bank conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank operates full- service branches in Auburn, Opelika, Hurtsboro, Notasulga and Valley, Alabama. In-store branches are located in the Kroger and Wal-Mart SuperCenter stores in both Auburn and Opelika. The Bank also operates commercial loan production offices in Montgomery and Phenix City, Alabama. Summary of Results of Operations (Dollars in thousands, except per share data) Net interest income (a) Less: tax-equivalent adjustment Net interest income (GAAP) Noninterest income Total revenue Provision for loan losses Noninterest expense Income tax expense Net earnings Year ended December 31 2013 22,362 1,440 20,922 7,298 28,220 400 18,412 2,290 7,118 1.95 $ $ $ 2012 22,539 1,642 20,897 10,483 31,380 3,815 19,383 1,419 6,763 1.86 $ $ $ 2011 20,944 1,719 19,225 5,177 24,402 2,450 16,357 57 5,538 1.52 $ $ $ Basic and diluted earnings per share (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". Financial Summary The Company’s net earnings were $7.1 million, or $1.95 per share, for the full year 2013, compared to $6.8 million, or $1.86 per share, for the full year 2012. Net interest income (tax-equivalent) was $22.4 million for the full year 2013, compared to $22.5 million for the full year 2012. Although net interest income (tax-equivalent) declined slightly, continued improvement in the Company’s funding mix and cost of funds largely offset declining yields on earning assets. The provision for loan losses was $0.4 million for the full year 2013, compared to $3.8 million for the full year 2012. The decrease in the provision for loan losses was primarily due to a decline in net charge-offs and improvement in the overall credit quality of the loan portfolio, including lower levels of adversely classified and nonperforming loans. Net charge-offs were $1.9 million, or 0.48% of average loans, for the full year 2013, compared to $4.0 million, or 1.03% of average loans, for the full year 2012. This decrease was primarily due to a decline in net charge-offs for commercial real estate loans. In 2012, net charge-offs were impacted by a few individually significant charge-offs, including $3.1 million related to three borrowing relationships. page 3 Management’s Discussion and Analysis Noninterest income was $7.3 million in 2013, compared to $10.5 million in 2012. The decrease was primarily due to a non-recurring gain of $3.3 million realized in 2012 when the Company sold its interests in three affordable housing limited partnerships and a decrease in mortgage lending income of $0.6 million as rising rates negatively impacted refinance activity. These decreases were partially offset by a $1.0 million gain on sale of premises and equipment realized in 2013 when the Company sold certain real property in downtown Auburn that was no longer used for Company operations and was fully leased to third party tenants. Noninterest expense was $18.4 million in 2013, compared to $19.4 million in 2012. The decrease was primarily due to a decrease in prepayment penalties on long-term debt of $0.7 million. During 2013, the Company repaid $35.0 million long-term debt with a weighted average interest rate of 3.46% and incurred prepayment penalties of $3.0 million. During 2012, the Company repaid $38.0 million of long-term debt with a weighted average interest rate of 4.26% and incurred prepayment penalties of $3.7 million. Income tax expense for the full year 2013 was $2.3 million, compared to $1.4 million for the full year 2012. The Company’s effective income tax rate was 24.34% for the full year 2013, compared to 17.34% for the full year 2012. In addition to a 15% increase in the level of earnings before taxes, the Company’s effective tax rate increased because the Company’s annualized effective tax rate for 2012 was reduced by the reversal of a $0.5 million deferred tax valuation allowance related to capital loss carry-forwards. In 2013, the Company paid cash dividends of $3.1 million, or $0.84 per share. The Company remains well capitalized under current regulatory guidelines with a total risk-based capital ratio of 18.40%, a tier one risk-based capital ratio of 17.19%, and a tier one leverage capital ratio of 10.10% at December 31, 2013. CRITICAL ACCOUNTING POLICIES The accounting and financial reporting policies of the Company conform with U.S. generally accepted accounting principles and with general practices within the banking industry. In connection with the application of those principles, we have made judgments and estimates which, in the case of the determination of our allowance for loan losses, our assessment of other-than-temporary impairment, recurring and non-recurring fair value measurements, the valuation of other real estate owned, and the valuation of deferred tax assets, were critical to the determination of our financial position and results of operations. Other policies also require subjective judgment and assumptions and may accordingly impact our financial position and results of operations. Allowance for Loan Losses The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs. The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off. page 4 In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal and independent loan review processes. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan. As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment. The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At December 31, 2013 and 2012, and for the years then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups. The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors. The Company regularly re-evaluates its practices in determining the allowance for loan losses. During 2013, the Company implemented certain refinements to its allowance for loan losses methodology, specifically the way that historical loss factors are calculated. Prior to June 30, 2013, the Company calculated average losses for all loan segments using a rolling 6 quarter historical period. Beginning with the quarter ended June 30, 2013, the Company calculated average losses for all loan segments (except for the commercial real estate loan segment) using a rolling 8 quarter historical period in order to better capture the effects of the current economic cycle on the Company’s loan loss experience and continued this methodology through December 31, 2013. Based upon management’s review of charge-off trends for each loan segment, the Company continues to calculate average losses for the commercial real estate loan segment using a rolling 6 quarter historical period. Other than the changes discussed above, the Company has not made any changes to its calculation of historical loss periods that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings. Assessment for Other-Than-Temporary Impairment of Securities On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For equity securities with an unrealized loss, the Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; and recent events specific to the issuer or industry. Equity securities for which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses). For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into the amount that is credit related (credit loss component) and the amount due to all page 5 Management’s Discussion and Analysis Management’s Discussion and Analysis other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes. Fair Value Determination U.S. GAAP requires management to value and disclose certain of the Company’s assets and liabilities at fair value, including investments classified as available-for-sale and derivatives. ASC 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP and expands disclosures about fair value measurements. For more information regarding fair value measurements and disclosures, please refer to Note 17, Fair Value, of the consolidated financial statements that accompany this report. Fair values are based on active market prices of identical assets or liabilities when available. Comparable assets or liabilities or a composite of comparable assets in active markets are used when identical assets or liabilities do not have readily available active market pricing. However, some of the Company’s assets or liabilities may lack an available or comparable trading market characterized by frequent transactions between willing buyers and sellers. In these cases, fair value is estimated using pricing models that use discounted cash flows and other pricing techniques. Pricing models and their underlying assumptions are based upon management’s best estimates for appropriate discount rates, default rates, prepayments, market volatility and other factors, taking into account current observable market data and experience. These assumptions may have a significant effect on the reported fair values of assets and liabilities and the related income and expense. As such, the use of different models and assumptions, as well as changes in market conditions, could result in materially different net earnings and retained earnings results. Other Real Estate Owned Other real estate owned (“OREO”), consists of properties obtained through foreclosure or in satisfaction of loans and is reported at the lower of cost or fair value, less estimated costs to sell at the date acquired with any loss recognized as a charge-off through the allowance for loan losses. Additional OREO losses for subsequent valuation adjustments are determined on a specific property basis and are included as a component of other noninterest expense along with holding costs. Any gains or losses on disposal of OREO are also reflected in noninterest expense. Significant judgments and complex estimates are required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. As a result, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other OREO. Deferred Tax Asset Valuation A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more- likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of taxable income over the last three years and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the we will realize the benefits of these deductible differences at December 31, 2013. The amount of the deferred tax assets considered realizable, however, could be reduced if estimates of future taxable income are reduced. page 6 Average Balance Sheet and Interest Rates (Dollars in thousands) Loans and loans held for sale Securities - taxable Securities - tax-exempt (a) Total securities Federal funds sold Interest bearing bank deposits Total interest-earning assets Deposits: NOW Savings and money market Certificates of deposits less than $100,000 Certificates of deposits and other time deposits of $100,000 or more Total interest-bearing deposits Short-term borrowings Long-term debt Total interest-bearing liabilities Year ended December 31 2013 2012 2011 Average Yield/ Average Yield/ Average Yield/ $ $ Balance 390,288 195,850 67,797 263,647 48,671 5,634 708,240 Rate 5.28% 2.00% 6.25% 3.09% 0.22% 0.75% 4.08% Balance 395,938 199,794 77,447 277,241 27,466 Rate 5.54% 1.94% 6.24% 3.14% 0.20% 793 — 4.38% 701,438 101,034 171,413 105,631 0.32% 0.52% 1.36% 99,664 153,668 108,726 0.35% 0.56% 1.63% 155,781 533,859 2,817 31,518 568,194 22,362 1.77% 1.01% 0.50% 3.59% 1.15% 3.16% 161,128 523,186 2,970 49,115 575,271 22,539 2.08% 1.21% 0.54% 3.73% 1.42% 3.21% Balance 376,000 223,638 79,329 302,967 28,905 1,394 709,266 Rate 5.67% 2.69% 6.37% 3.65% 0.19% 0.05% 4.57% 90,565 138,428 114,490 0.58% 0.72% 1.95% 181,242 524,725 2,423 86,899 614,047 20,944 2.38% 1.54% 0.50% 3.91% 1.87% 2.95% $ $ Net interest income and margin (a) (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". $ $ RESULTS OF OPERATIONS Net Interest Income and Margin 2013 vs. 2012 comparison Net interest income (tax-equivalent) was $22.4 million in 2013, compared to $22.5 million in 2012. Although net interest income (tax-equivalent) declined slightly, management continues to seek to increase earnings by growing the Company’s loan portfolio (in total and as a percentage of earning assets), focusing on deposit pricing, and repaying higher- cost wholesale funding sources. These efforts to increase earnings were offset by management’s decision to reduce the Company’s securities portfolio as a percentage of total interest earning assets and carry higher levels of short-term interest earning assets (e.g. federal funds sold) during 2013. As a result, the Company’s net interest margin (tax-equivalent) declined to 3.16% in 2013, compared to 3.21% in 2012. The tax-equivalent yield on total interest-earning assets decreased by 30 basis points in 2013 from 2012 to 4.08%. The decrease was primarily due to the shift in our asset mix described above and increased pricing competition for quality loan opportunities in our markets, which has limited the Company’s ability to increase loans, generally, and to increase the yields on new and renewed loans, over the last several quarters. The cost of total interest-bearing liabilities decreased 27 basis points in 2013 from 2012 to 1.15%. The net decrease was largely the result of the continued shift in our deposit mix, as we increased our lower-cost noninterest-bearing demand deposits, interest bearing demand deposits (NOW accounts), and savings and money market accounts and concurrently reduced balances of higher-cost certificates of deposit and other higher-cost time deposits and long-term debt (i.e. wholesale funding). The Company continues to deploy various asset liability management strategies to manage its risk to interest rate fluctuations. The Company’s net interest margin could experience pressure due to lower reinvestment yields in the securities portfolio given the current interest rate environment, increased pricing competition for quality loan opportunities, and fewer opportunities to further reduce our cost of funds due to the already low level of deposit rates currently. page 7 Management’s Discussion and Analysis 2012 vs. 2011 comparison Net interest income (tax-equivalent) was $22.5 million in 2012, compared to $20.9 million in 2011, as net interest margin improvement offset a decline in average interest-earning assets of 1%. Net interest margin (tax-equivalent) was 3.21% in 2012, compared to 2.95% in 2011. The improved net interest margin reflected management’s efforts to increase earnings by shifting the Company’s asset mix through loan growth, focusing on deposit pricing, and repaying higher-cost wholesale funding sources. The cost of total interest-bearing liabilities decreased 45 basis points in 2012 from 2011 to 1.42%. The net decrease was largely the result of the continued shift in our deposit mix, as we increased our lower-cost noninterest-bearing demand deposits, interest bearing demand deposits (NOW accounts), and savings and money market accounts and concurrently reduced balances of higher-cost certificates of deposit and other higher-cost time deposits and long-term debt (i.e. wholesale funding). The tax-equivalent yield on total interest-earning assets decreased by 19 basis points in 2012 from 2011 to 4.38%. This decrease was primarily driven by a 51 basis point reduction in the tax-equivalent yield on total securities to 3.14% as reinvestment yields in the securities portfolio declined due to the continued low interest rate environment. Also, loan pricing for creditworthy borrowers continues to be competitive in our markets and has limited the Company’s ability to increase yields on new and renewed loans. Provision for Loan Losses The provision for loan losses represents a charge to earnings necessary to provide an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the probable losses on outstanding loans. The provision for loan losses amounted to $0.4 million, $3.8 million, and $2.5 million for the years ended December 31, 2013, 2012, and 2011, respectively. The provision for loan losses decreased in 2013 compared to 2012 primarily due to a decline in net charge-offs and improvement in the overall credit quality of the loan portfolio, including lower levels of adversely classified and nonperforming loans. Net charge-offs were $1.9 million, or 0.48% of average loans, in 2013, compared to $4.0 million, or 1.03% of average loans, in 2012. This decrease was primarily due to a decline in net charge-offs for commercial real estate loans. In 2012, net charge-offs were impacted by a few individually significant charge-offs, including $3.1 million related to three borrowing relationships. The provision for losses increased in 2012 compared to 2011 due to an increase in net charge-offs and loan portfolio growth. Net charge-offs were $4.0 million for 2012, compared to $3.2 million in 2011. This increase was primarily due to an increase in net charge-offs in the commercial real estate loan portfolio of $2.7 million, which was partially offset by declines in net charge-offs of $1.6 million and $0.4 million, respectively, in the construction and land development and commercial and industrial loan portfolios. Based upon its assessment of the loan portfolio, management adjusts the allowance for loan losses to an amount it believes to be appropriate to adequately cover probable losses in the loan portfolio. The Company’s allowance for loan losses to total loans decreased to 1.37% at December 31, 2013 from 1.69% at December 31, 2012. Based upon our evaluation of the loan portfolio, management believes the allowance for loan losses to be adequate to absorb our estimate of probable losses existing in the loan portfolio at December 31, 2013. While our policies and procedures used to estimate the allowance for loan losses, as well as the resultant provision for loan losses charged to operations, are believed adequate by management and are reviewed from time to time by our regulators, they are based on estimates and judgment and are therefore approximate and imprecise. Factors beyond our control, such as conditions in the local and national economy, a local real estate market or particular industry conditions exist which may negatively and materially affect our asset quality and the adequacy of our allowance for loan losses and, thus, the resulting provision for loan losses. page 8 Noninterest Income (Dollars in thousands) Service charges on deposit accounts Mortgage lending Bank-owned life insurance Gain on sale of affordable housing investments Affordable housing investment losses Gain on sale of premises and equipment Securities gains, net Other Total noninterest income Year ended December 31 2013 930 2,895 427 — — 1,018 651 1,377 7,298 $ $ 2012 1,111 3,445 445 3,268 — — 679 1,535 10,483 $ $ 2011 1,167 1,922 460 — (646) — 878 1,396 5,177 $ $ The Company’s income from mortgage lending is primarily attributable to the (1) origination and sale of new mortgage loans and (2) servicing of mortgage loans. Origination income, net, is comprised of gains or losses from the sale of the mortgage loans originated, origination fees, underwriting fees and other fees associated with the origination of loans, which are netted against the commission expense associated with these originations. The Company’s normal practice is to originate mortgage loans for sale in the secondary market and to either sell or retain the associated mortgage servicing rights (“MSRs”) when the loan is sold. MSRs are recognized based on the fair value of the servicing right on the date the corresponding mortgage loan is sold. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Servicing fee income is reported net of any related amortization expense. MSRs are also evaluated for impairment periodically. Impairment is determined by grouping MSRs by common predominant characteristics, such as interest rate and loan type. If the aggregate carrying amount of a particular group of MSRs exceeds the group’s aggregate fair value, a valuation allowance for that group is established. The valuation allowance is adjusted as the fair value changes. An increase in mortgage interest rates typically results in an increase in the fair value of the MSRs while a decrease in mortgage interest rates typically results in a decrease in the fair value of MSRs. The following table presents a breakdown of the Company’s mortgage lending income for 2013, 2012, and 2011. (Dollars in thousands) Origination income Servicing fees, net Decrease (increase) in MSR valuation allowance Total mortgage lending income 2013 vs. 2012 comparison Year ended December 31 2013 2,030 479 386 2,895 $ $ 2012 3,430 284 (269) 3,445 $ $ 2011 1,680 359 (117) 1,922 $ $ The decrease in service charges on deposit accounts was primarily due to a decline in insufficient funds charges, reflecting changes in customer behavior and spending patterns. The decrease in mortgage lending income was primarily due to a decline in origination income as refinance activity slowed. This decline was partially offset by a decrease in the valuation allowance for amortized MSRs and an increase in net servicing fees. Changes in the valuation allowance for amortized MSRs are recognized in earnings as a component of mortgage lending income. The decrease in the valuation allowance was primarily due to a slowing of prepayment speeds, which increased the value of our amortized MSRs. \ The Company recognized a gain on sale of $3.3 million related to the sale of its interests in three affordable housing limited partnerships in January 2012. There were no such transactions in 2013. In 2013, the Company recognized a $1.0 million gain on sale of premises and equipment when the Company sold certain real property in downtown Auburn that was no longer used for Company operations and was fully leased to third party tenants. page 9 Management’s Discussion and Analysis Net securities gains consist of realized gains and losses on the sale of securities and other-than-temporary impairment charges. Net securities gains were $0.7 million in both 2013 and 2012. Gross realized gains of $0.8 million in 2013 were reduced by gross realized losses of $0.1 million. Gross realized gains of $1.0 million in 2012 were reduced by gross realized losses of $0.2 million and $0.1 million in other-than-temporary impairment charges related to trust preferred securities. In December 2013, the Company sold all remaining trust preferred securities held by the Company for a net loss of $0.1 million. 2012 vs. 2011 comparison Service charges on deposit accounts were $1.1 million in 2012, compared to $1.2 million in 2011. The decrease was primarily due to a decline in insufficient funds charges, reflecting changes in customer behavior and spending patterns. Mortgage lending income was $3.4 million in 2012, compared to $1.9 million in 2011. A increase in the level of mortgage refinance activity during 2012 when compared to the levels experienced during 2011 contributed to the increase in mortgage lending income. The Company's income from mortgage lending typically fluctuates as mortgage interest rates change and is primarily attributable to origination and sale of new mortgage loans. The Company recognized a gain on sale of $3.3 million related to the sale of its interests in three affordable housing limited partnerships in January 2012. Accordingly, the Company did not receive any federal tax credits related to affordable housing partnership investments in 2012. Prior to the sale of these interests, the Company accrued its pro-rata share of partnership losses in noninterest income. In 2011, the Company accrued approximately $0.6 million related to affordable housing investment losses. The net gain on securities was $0.7 million in 2012, compared to a net gain of $0.9 million in 2011. Gross realized gains of $1.0 million in 2012 were reduced by gross realized losses of $0.2 million and other-than-temporary impairment charges of $0.1 million related to trust preferred securities. Gross realized gains of $1.7 million in 2011 were reduced by gross realized losses of $0.5 million and $0.3 million in other-than-temporary impairment charges related to trust preferred securities. Noninterest Expense (Dollars in thousands) Salaries and benefits Net occupancy and equipment Professional fees FDIC and other regulatory assessments Other real estate owned, net Prepayment penalties on long-term debt Other Total noninterest expense 2013 vs. 2012 comparison Year ended December 31 2013 8,788 1,335 774 512 570 3,028 3,405 18,412 $ $ 2012 8,691 1,332 704 686 323 3,720 3,927 19,383 $ $ 2011 8,167 1,404 735 792 2,007 — 3,252 16,357 $ $ Salaries and benefits expense increased primarily due to routine increases in salaries and wages. This increase was largely offset by a decrease in group health insurance costs. Beginning in 2013, the Company returned to a fully insured group health plan and was able to lower its benefits costs compared to 2012. Previously, the Company’s group health plan was self insured. The decrease in FDIC and other regulatory assessments expense was primarily due to a decrease in the Bank’s quarterly assessment rate as several variables utilized by the FDIC in calculating our deposit insurance assessments improved. Other real estate owned expense, net was $0.6 million in 2013, compared to $0.3 million in 2012. The increase was primarily due to realized holding losses or write-downs on the valuations of certain OREO properties. These properties could also be subject to future valuation adjustments as a result of updated appraisal information and further deterioration in real estate values, thus causing additional fluctuations in other real estate owned expense, net. Also, the Company will continue to incur expenses associated with maintenance costs and property taxes associated with these assets. page 10 During 2013, the Company repaid $35.0 million long-term debt with a weighted average interest rate of 3.46% and incurred prepayment penalties of $3.0 million. During 2012, the Company repaid $38.0 million of long-term debt with a weighted average interest rate of 4.26% and incurred prepayment penalties of $3.7 million. 2012 vs. 2011 comparison Salaries and benefits expense was $8.7 million in 2012, compared to $8.2 million in 2011. The increase in 2012 when compared to 2011 reflected routine increases coupled with an increase in the number of full-time equivalent employees due to the opening of a new branch during December 2011 in Valley, Alabama. FDIC and other regulatory assessments expense was $0.7 million in 2012, compared to $0.8 million in 2011. The decrease in 2012 when compared to 2011 was primarily due to the FDIC redefining the deposit insurance assessment base effective April 1, 2011. As a result, most FDIC insured institutions with less than $10 billion in assets experienced a reduction in their FDIC deposit insurance assessments. Other real estate owned expense, net was $0.3 million in 2012, compared to $2.0 million in 2011. The decrease was primarily due to a decline in realized holding losses or write-downs on the valuations of certain OREO properties. Despite the improvement in net expenses related to OREO, these properties could also be subject to future valuation adjustments as a result of updated appraisal information and further deterioration in real estate values, thus causing additional fluctuations in other real estate owned expense, net. Also, the Company will continue to incur expenses associated with maintenance costs and property taxes associated with these assets. On January 19, 2012, the Company restructured its balance sheet by paying off $38.0 million of FHLB advances with a weighted average interest rate of 4.26% and a weighted average duration of 2.6 years. In connection with repaying the FHLB advances, the Company incurred a $3.7 million prepayment penalty in 2012, compared to none in 2011. Income Tax Expense 2013 vs. 2012 comparison Income tax expense for 2013 was $2.3 million, compared to $1.4 million in 2012. The Company’s effective income tax rate was 24.34% in 2013, compared to 17.34% in 2012. In addition to a 15% increase in the level of earnings before taxes, the Company’s effective tax rate increased because the Company’s annualized effective tax rate for 2012 was reduced by the reversal of a $0.5 million deferred tax valuation allowance related to capital loss carry-forwards. 2012 vs. 2011 comparison Income tax expense for 2012 was $1.4 million, compared to $0.1 million in 2011. The Company’s effective income tax rate was 17.34% in 2012, compared to 1.02% in 2011. The increase in the Company’s effective tax rate was due to a 46% increase in the level of earnings before taxes and a decrease in federal tax credits related to the Company’s investments in affordable housing limited partnerships, which were sold in January 2012. The impact of these changes on the Company’s effective tax rate for the full year 2012 was partially reduced by the reversal of a previously established deferred tax asset valuation allowance of $0.5 million related to capital loss carry-forwards. Excluding the reversal of the valuation allowance, the Company’s effective tax rate for 2012 would have been approximately 23.51%. . page 11   Management’s Discussion and Analysis BALANCE SHEET ANALYSIS Securities Securities available-for-sale, were $271.2 million at December 31, 2013, an increase of $11.8 million, or 4%, compared to $259.5 million as of December 31, 2012. This increase reflects an increase in the amortized cost basis of securities available-for-sale of $27.1 million, which was partially offset by a decline in the fair value of securities-available- for sale of $15.4 million. The increase in the amortized cost basis of securities available-for-sale was primarily attributable to management allocating more funding to the investment portfolio as the loan portfolio declined and investment yields improved in 2013. The decrease in the fair value of securities was primarily due to an increase in long-term interest rates. The average tax-equivalent yields earned on total securities were 3.09% in 2013 and 3.14% in 2012. The following table shows the carrying value and weighted average yield of securities available-for-sale as of December 31, 2013 according to contractual maturity. Actual maturities may differ from contractual maturities of residential mortgage-backed securities (“RMBS”) because the mortgages underlying the securities may be called or prepaid with or without penalty. (Dollars in thousands) Agency obligations Agency RMBS State and political subdivisions Total available-for-sale Weighted average yield: Agency obligations Agency RMBS State and political subdivisions Total available-for-sale Loans (In thousands) Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total loans Less: unearned income $ $ $ 1 year or less 1 to 5 years 5 to 10 years After 10 Total years Fair Value December 31, 2013 — — — — — — — — — — 1,735 1,735 — — 4.14% 4.14% 23,247 8,306 21,366 52,919 2.06% 1.74% 4.05% 2.81% 21,275 154,052 41,238 216,565 2.79% 2.35% 4.12% 2.70% 44,522 162,358 64,339 271,219 2.34% 2.32% 4.10% 2.74% 2013 57,780 36,479 174,920 101,706 12,893 383,778 (439) 2012 59,334 37,631 183,611 105,631 12,219 398,426 (233) 2011 54,988 39,814 162,435 101,725 11,454 370,416 (153) 2010 53,288 47,850 166,241 96,241 10,676 374,296 (81) December 31 2009 53,884 56,820 156,928 97,407 11,236 376,275 (172) 376,103 Loans, net of unearned income $ 383,339 398,193 370,263 374,215 Total loans, net of unearned income, were $383.3 million at December 31, 2013, a decrease of $14.9 million, or 4%, from $398.2 million at December 31, 2012. The decrease was primarily attributable to reduced loan demand and increased competition for quality loan opportunities in our markets and management’s efforts to resolve problem loans as nonaccrual loans declined by $6.3 million in 2013. Four loan categories represented the majority of the loan portfolio as December 31, 2013: commercial real estate mortgage loans (46%), residential real estate mortgage loans (27%), commercial and industrial loans (15%) and construction and land development loans (10%). Within its residential real estate mortgage portfolio, the Company had junior lien mortgages of approximately $15.8 million, or 4%, of total loans, net of unearned income at both December 31, 2013 and 2012. For residential real estate mortgage loans with a consumer purpose, approximately $1.2 million and $1.3 million required interest-only payments at December 31, 2013 and 2012, respectively. The Company’s residential real estate mortgage portfolio does not include any option ARM loans, subprime loans, or any material amount of other high-risk consumer mortgage products. page 12 Purchased loan participations included in the Company’s loan portfolio were approximately $1.4 million and $3.1 million as of December 31, 2013 and 2012, respectively. All purchased loan participations are underwritten by the Company independent of the selling bank. In addition, all loans, including purchased participations, are evaluated for collectability during the course of the Company’s normal loan review procedures. If the Company deems a participation loan impaired, it applies the same accounting policies and procedures as described in “CRITICAL ACCOUNTING POLICIES.” The average yield earned on loans and loans held for sale was 5.28% in 2013 and 5.54% in 2012. The specific economic and credit risks associated with our loan portfolio include, but are not limited to, the effects of current economic conditions on our borrowers’ cash flows, real estate market sales volumes, valuations, and availability and cost of financing for properties, real estate industry concentrations, deterioration in certain credits, interest rate fluctuations, reduced collateral values or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and any violation of applicable laws and regulations. The Company attempts to reduce these economic and credit risks by adhering to loan to value guidelines for collateralized loans, investigating the creditworthiness of borrowers and monitoring borrowers’ financial position. Also, we establish and periodically review our lending policies and procedures. Banking regulations limit a bank’s credit exposure by prohibiting unsecured loan relationships that exceed 10% of its capital accounts; or 20% of capital accounts, if loans in excess of 10% are fully secured. Under these regulations, we are prohibited from having unsecured loan relationships in excess of approximately $16.0 million. Furthermore, we have an internal limit for aggregate credit exposure (loans outstanding plus unfunded commitments) to a single borrower of $14.4 million. Our loan policy requires that the Loan Committee of the Board of Directors approve any loan relationships that exceed this internal limit. At December 31, 2013, the Bank had no loan relationships exceeding these limits. We periodically analyze our commercial loan portfolio to determine if a concentration of credit risk exists in any one or more industries. We use classification systems broadly accepted by the financial services industry in order to categorize our commercial borrowers. Loan concentrations to borrowers in the following classes exceeded 25% of the Bank’s total risk-based capital at December 31, 2013 (and related balances at December 31, 2012). (In thousands) Lessors of 1-4 family residential properties Multi-family residential properties Shopping centers Allowance for Loan Losses $ December 31 2013 43,835 27,673 29,953 $ 2012 47,544 30,392 20,760 The Company maintains the allowance for loan losses at a level that management believes appropriate to adequately cover the Company’s estimate of probable losses in the loan portfolio. As of December 31, 2013 and 2012, respectively, the allowance for loan losses was $5.3 million and $6.7 million, respectively, which management believed to be adequate at each of the respective dates. The judgments and estimates associated with the determination of the allowance for loan losses are described under “CRITICAL ACCOUNTING POLICIES”. page 13 Management’s Discussion and Analysis A summary of the changes in the allowance for loan losses and certain asset quality ratios for each of the five years in the five year period ended December 31, 2013 is presented below. (Dollars in thousands) Allowance for loan losses: Balance at beginning of period Charge-offs: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total charge-offs Recoveries: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total recoveries Net charge-offs Provision for loan losses Ending balance as a % of loans as a % of nonperforming loans Net charge-offs as a % of average loans 2013 2012 2011 2010 2009 Year ended December 31 $ 6,723 6,919 7,676 6,495 4,398 (514) (39) (262) (808) (397) (2,020) 48 6 4 88 19 165 (1,855) 400 $ 5,268 1.37 % 124 % 0.48 % (289) (231) (3,184) (545) (85) (4,334) 54 46 71 134 18 323 (4,011) 3,815 6,723 1.69 64 1.03 (679) (1,758) (422) (533) (21) (3,413) 34 2 — 155 15 206 (3,207) 2,450 6,919 1.87 67 0.86 (537) (1,487) — (552) (111) (2,687) 63 54 — 151 20 288 (2,399) 3,580 7,676 2.05 65 0.64 (495) (2,088) — (704) (61) (3,348) 47 50 — 92 6 195 (3,153) 5,250 6,495 1.73 69 0.84 As noted under “CRITICAL ACCOUNTING POLICIES”, management assesses the adequacy of the allowance prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan quality indications and other pertinent factors. This evaluation is inherently subjective as it requires various material estimates and judgments including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The ratio of our allowance for loan losses to total loans outstanding was 1.37% at December 31, 2013, compared to 1.69% at December 31, 2012. In the future, the allowance to total loans outstanding ratio will increase or decrease to the extent the factors that influence our quarterly allowance assessment in their entirety either improve or weaken. Net charge-offs were $1.9 million, or 0.48% of average loans, in 2013, compared to net charge-offs of $4.0 million, or 1.03%, in 2012. In 2012, net charge-offs were affected by a few individually significant charge-offs in the commercial real estate portfolio segment, including $3.1 million related to three borrowing relationships. At December 31, 2013 and 2012, the ratio of our allowance for loan losses as a percentage of nonperforming loans was 124% and 64%, respectively. The increase was primarily due to payoffs received on three nonperforming commercial loans real estate loans during 2013 with a total recorded investment of $5.9 million and no related allowance for loan losses at December 31, 2012. Excluding these nonperforming loans, the ratio of our allowance for loan losses as a percentage of nonperforming loans was 144% at December 31, 2012. At December 31, 2013 and 2012, the Company’s recorded investment in loans considered impaired was $5.6 million and $10.5 million, respectively, with corresponding valuation allowances (included in the allowance for loan losses) at each respective date of $0.3 million. Our regulators, as an integral part of their examination process, periodically review the Company’s allowance for loan losses, and may require the Company to make additional provisions to the allowance for loan losses based on their judgment about information available to them at the time of their examinations. page 14 Nonperforming Assets At December 31, 2013 the Company had $8.1 million in nonperforming assets compared to $15.5 million at December 31, 2012. Nonperforming assets decreased during 2013 due to continued efforts by management to reduce and resolve problem assets. The majority of the balance in nonperforming assets at December 31, 2013 related to deterioration in the commercial real estate and construction and land development loan portfolios. The table below provides information concerning total nonperforming assets and certain asset quality ratios. (Dollars in thousands) Nonperforming assets: Nonperforming (nonaccrual) loans Other real estate owned Total nonperforming assets as a % of loans and foreclosed properties as a % of total assets Nonperforming loans as a % of total loans Accruing loans 90 days or more past due 2013 2012 2011 2010 2009 December 31 $ $ $ 4,261 3,884 8,145 2.10 % 1.08 % 1.11 % 73 10,535 4,919 15,454 3.83 2.03 2.65 58 10,354 7,898 18,252 4.83 2.35 2.80 — 11,833 8,125 19,958 5.22 2.61 3.16 — 9,352 7,292 16,644 4.34 2.15 2.49 5 The table below provides information concerning the composition of nonaccrual loans at December 31, 2013 and 2012, respectively. (In thousands) Nonaccrual loans: Commercial and industrial Construction and land development Commercial real estate Residential real estate Total nonaccrual loans / nonperfoming loans 2013 55 1,582 1,456 1,168 4,261 $ $ December 31 2012 60 1,706 6,714 2,055 10,535 The Company discontinues the accrual of interest income when (1) there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or (2) the principal or interest is more than 90 days past due, unless the loan is both well-secured and in the process of collection. At December 31, 2013, the Company had $4.3 million in loans on nonaccrual, compared to $10.5 million at December 31, 2012. The decrease was primarily attributable to a decrease of $5.3 million and $0.9 million in nonaccrual loans for the commercial real estate and residential real estate loan portfolio segments, respectively. Due to the weakening credit status of a borrower, the Company may elect to formally restructure certain loans to facilitate a repayment plan that minimizes the potential losses that we might incur. Restructured loans, or troubled debt restructurings (“TDRs”), are classified as impaired loans, and if the loans are on nonaccrual status as of the date of restructuring, the loans are included in the nonaccrual loan balances noted above. Nonaccrual loan balances do not include loans that have been restructured that were performing as of the restructure date. At December 31, 2013 and 2012, the Company had $1.6 million and $1.1 million, respectively, in accruing TDRs. At December 31, 2013 there were $73,000 in loans 90 days past due and still accruing interest compared to $58,000 at December 31, 2012. page 15 Management’s Discussion and Analysis The table below provides information concerning the composition of OREO at December 31, 2013 and 2012, respectively. (In thousands) Other real estate owned: Commercial: Building Developed lots Residential: Condominiums Undeveloped land Other Total other real estate owned December 31 2013 2012 $ $ 1,772 1,260 — 113 739 3,884 608 1,275 425 1,464 1,147 4,919 At December 31, 2013, the Company held $3.8 million in OREO, which we acquired from borrowers, a decrease of $1.0 million, or 21%, compared to December 31, 2012. At December 31, 2013, approximately $3.2 million, or 82%, of the total balance in OREO related to properties acquired from three borrowers. Potential Problem Loans Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Federal Reserve, the Company’s primary regulator, for loans classified as substandard, excluding nonaccrual loans. Potential problem loans, which are not included in nonperforming assets, amounted to $10.6 million, or 2.7% of total loans at December 31, 2013, compared to $12.6 million, or 3.2% of total loans at December 31, 2012. The table below provides information concerning the composition of potential problem loans at December 31, 2013 and 2012, respectively. (In thousands) Potential problem loans: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total potential problem loans December 31 2013 2012 $ $ 482 1,101 1,683 7,182 146 10,594 563 1,125 2,727 7,978 214 12,607 At December 31, 2013, approximately $0.8 million or 7.6% of total potential problem loans were past due at least 30 but less than 90 days. At December 31, 2013, the remaining balance of potential problem loans were current or past due less than 30 days. The following table is a summary of the Company’s performing loans that were past due at least 30 days but less than 90 days as of December 31, 2013 and 2012, respectively. (In thousands) Performing loans past due 30 to 89 days: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total performing loans past due 30 to 89 days page 16 2013 167 14 861 1,343 100 2,485 $ $ December 31 2012 173 8 230 1,537 62 2,010 Deposits (In thousands) Noninterest bearing demand NOW Money market Savings Certificates of deposit under $100,0000 Certificates of deposit and other time deposits of $100,000 or more Brokered certificates of deposit Total deposits 2013 125,740 99,406 147,116 35,383 104,964 139,721 16,514 668,844 $ $ December 31 2012 118,014 96,332 124,676 34,600 106,371 134,591 22,233 636,817 Total deposits were $668.9 million and $636.8 million at December 31, 2013 and 2012, respectively. The increase in total deposits of $32.0 million reflects market share growth in Chambers County due to the business development efforts of the Bank’s full-service branch in Valley, Alabama which opened in December 2011 and changes in customer preferences for short-term instruments in a low interest rate environment. The average rates paid on total interest-bearing deposits were 1.01% in 2013 and 1.21% in 2012. Noninterest bearing deposits were 19% of total deposits at both December 31, 2013 and 2012. Other Borrowings Other borrowings consist of short-term borrowings and long-term debt. Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase with an original maturity of one year or less. The Bank had available federal fund lines totaling $41.0 million with none outstanding at December 31, 2013, compared to $40.0 million with none outstanding at and December 31, 2012. Securities sold under agreements to repurchase totaled $3.4 million and $2.7 million at December 31, 2013 and 2012, respectively. The average rates paid on short-term borrowings were 0.50% in 2013 and 0.54% in 2012. Information concerning the average balances, weighted average rates, and maximum amounts outstanding for short-term borrowings during the three-year period ended December 31, 2013 is included in Note 10 to the accompanying consolidated financial statements included in this annual report. Long-term debt includes FHLB advances with an original maturity greater than one year, securities sold under agreements to repurchase with an original maturity greater than one year, and subordinated debentures related to trust preferred securities. The Bank had $5.0 million in long-term FHLB advances at December 31, 2013, compared to $25.0 million at December 31, 2012. During 2013, the Company repaid $20.0 million of FHLB advances with a weighted average interest rate of 3.38%. At December 31, 2013, the Bank had no securities sold under agreements to repurchase with an original maturity greater than one year, compared to $15.0 million at December 31, 2012. During 2013, the Company repaid $15.0 million of securities sold under agreements to repurchase with an interest rate of 3.58%. At both December 31, 2013 and 2012, the Company had $7.2 million in junior subordinated debentures related to trust preferred securities outstanding. The average rates paid on long-term debt were 3.59% in 2013 and 3.73% in 2012. CAPITAL ADEQUACY The Company's consolidated stockholders' equity was $64.5 million and $70.1 million as of December 31, 2013 and 2012, respectively. The change from December 31, 2012 was primarily driven by an other comprehensive loss due to the change in unrealized gains (losses) on securities available-for-sale of $9.7 million and cash dividends paid of $3.1 million, partially offset by net earnings of $7.1 million. The Company’s tier 1 leverage ratio was 10.10%, tier 1 risk-based capital ratio was 17.19% and total risk-based capital ratio was 18.40% at December 31, 2013. These ratios exceed the minimum regulatory capital percentages of 4.0% for Tier 1 leverage ratio, 4.0% for Tier 1 risk-based capital ratio and 8.0% for Total risk-based capital ratio. Based on current regulatory standards, the Company is classified as “well capitalized.” page 17 Management’s Discussion and Analysis MARKET AND LIQUIDITY RISK MANAGEMENT Management’s objective is to manage assets and liabilities to provide a satisfactory, consistent level of profitability within the framework of established liquidity, loan, investment, borrowing, and capital policies. The Bank’s Asset Liability Management Committee (“ALCO”) is charged with the responsibility of monitoring these policies, which are designed to ensure acceptable composition of asset/liability mix. Two critical areas of focus for ALCO are interest rate risk and liquidity risk management. Interest Rate Risk Management In the normal course of business, the Company is exposed to market risk arising from fluctuations in interest rates. The Company is subject to interest rate risk because assets and liabilities may mature or reprice at different times. For example, if liabilities reprice faster than assets, and interest rates are generally rising, earnings will initially decline. In addition, assets and liabilities may reprice at the same time but by different amounts. For example, when the general level of interest rates is rising, the Company may increase rates paid on interest bearing demand deposit accounts and savings deposit accounts by an amount that is less than the general increase in market interest rates. Also, short-term and long-term market interest rates may change by different amounts. For example, a flattening yield curve may reduce the interest spread between new loan yields and funding costs. Further, the remaining maturity of various assets and liabilities may shorten or lengthen as interest rates change. For example, if long-term mortgage interest rates decline sharply, mortgage-backed securities in the securities portfolio may prepay significantly earlier than anticipated, which could reduce earnings. Interest rates may also have a direct or indirect effect on loan demand, loan losses, mortgage origination volume, the fair value of MSRs and other items affecting earnings. ALCO measures and evaluates the interest rate risk so that we can meet customer demands for various types of loans and deposits. ALCO determines the most appropriate amounts of on-balance sheet and off-balance sheet items. Measurements used to help manage interest rate sensitivity include an earnings simulation and an economic value of equity model. Earnings simulation. Management believes that interest rate risk is best estimated by our earnings simulation modeling. On at least a quarterly basis, the following 12 month time period is simulated to determine a baseline net interest income forecast and the sensitivity of this forecast to changes in interest rates. The baseline forecast assumes an unchanged or flat interest rate environment. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of market interest rates for the next 12 months and other factors in order to produce various earnings simulations and estimates. To limit interest rate risk, we have guidelines for earnings at risk which seek to limit the variance of net interest income to less than a 10 percent decline for a 200 basis point gradual change up or down in rates from management’s baseline net interest income forecast over the next 12 months. The following table reports the variance of net interest income over the next 12 months assuming a gradual change in interest rates of 200 basis points when compared to the baseline net interest income forecast at December 31, 2013. Changes in Interest Rates 200 basis points (200) basis points NM=not meaningful Net Interest Income % Variance 1.35 % NM At December 31, 2013, our earnings simulation model indicated a slightly asset-sensitive position over the next 12 months, which could serve to improve net interest income during that time period if interest rates increased by 200 basis points. The actual realized change in net interest income would depend upon several factors, which could also serve to diminish, or eliminate the asset sensitivity noted above. The impact of rate scenarios assuming a gradual downward 200 basis point change in interest rates was not considered meaningful because of the historically low interest rate environment. Economic Value of Equity. Economic value of equity (“EVE”) measures the extent that estimated economic values of our assets, liabilities and off-balance sheet items will change as a result of interest rate changes. Economic values are estimated by discounting expected cash flows from assets, liabilities and off-balance sheet items, which establishes a base case EVE. In contrast with our earnings simulation model which evaluates interest rate risk over a 12 month timeframe, EVE uses a terminal horizon which allows for the re-pricing of all assets, liabilities, and off-balance sheet items. Further, EVE is measured using values as of a point in time and does not reflect any actions that ALCO might take in responding to or anticipating changes in interest rates, or market and competitive conditions. page 18 To help limit interest rate risk, we have a guideline stating that for a 200 basis point instantaneous change in interest rates up or down, EVE should not decrease by more than 25 percent. The following table reports the variance of EVE assuming an immediate change in interest rates of 200 basis points when compared to the base case EVE at December 31, 2013. Changes in Interest Rates 200 basis points (200) basis points NM=not meaningful EVE % Variance (16.16) % NM At December 31, 2013, the results of our EVE model would indicate that we are in compliance with our guidelines. The actual realized change in the economic value of equity would depend upon several factors, which could also serve to diminish, or eliminate the interest sensitivity noted above. The impact of rate shock scenarios assuming a downward 200 basis point change in interest rates was not considered meaningful because of the historically low interest rate environment. Earnings simulation and EVE are both modeling analyses, which change quarterly and consist of hypothetical estimates based upon numerous assumptions, including the interest rate levels, shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of paydowns and maturities of loans, investments and deposits, and others. While assumptions are developed based on the current economic and market conditions, management cannot make any assurances as to the predictive nature of these assumptions, including how these estimates may be affected by customer preferences, competitors, or competitive conditions, or that the predictions will be realized. In addition, each of the preceding analyses may not, on its own, be an accurate indicator of how our net interest income will be affected by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates, and other economic and market factors. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps and floors”) which limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the maturity of certain instruments. The ability of many borrowers to service their debts also may decrease during periods of rising interest rates or economic stress, which may differ across industries and economic sectors. Depositor and borrower behaviors also affect those relationships and results. ALCO reviews each of the above interest rate sensitivity analyses along with several different interest rate scenarios in seeking satisfactory, consistent levels of profitability within the framework of the Company’s established liquidity, loan, investment, borrowing, and capital policies. The Company may also use derivative financial instruments to improve the balance between interest-sensitive assets and interest-sensitive liabilities and as one tool to manage interest rate sensitivity while continuing to meet the credit and deposit needs of our customers. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. These swaps qualify as derivatives, but are not designated as hedging instruments. At December 31, 2013 and 2012, the Company had no derivative contracts to assist in managing interest rate sensitivity. Liquidity Risk Management Liquidity is the Company's ability to convert assets into cash equivalents in order to meet daily cash flow requirements, primarily for deposit withdrawals, loan demand and maturing obligations. Without proper management of its liquidity, the Company could experience higher costs of obtaining funds due to insufficient liquidity, while excessive liquidity can lead to a decline in earnings due to the opportunity cost of foregoing alternative higher-yielding investment opportunities. Liquidity is managed at two levels: at the Company and at the Bank. The management of liquidity at both levels is essential, because the Company and the Bank have different funding needs and sources, are separate legal entities, and each are subject to regulatory guidelines and requirements. page 19 Management’s Discussion and Analysis The primary source of funding and the primary source of liquidity for the Company includes dividends received from the Bank, and secondarily proceeds from the issuance of common stock or other securities. Primary uses of funds for the Company include dividends paid to shareholders, stock repurchases, and interest payments on junior subordinated debentures issued by the Company in connection with trust preferred securities. The junior subordinated debentures are presented as long-term debt in the accompanying consolidated balance sheets and the related trust preferred securities are includible in Tier 1 Capital for regulatory capital purposes. Primary sources of funding for the Bank include customer deposits, other borrowings, repayment and maturity of securities, and sale and repayment of loans. The Bank has access to federal funds lines from various banks and borrowings from the Federal Reserve discount window. In addition to these sources, the Bank has participated in the FHLB's advance program to obtain funding for its growth. Advances include both fixed and variable terms and are taken out with varying maturities. As of December 31, 2013, the Bank had a remaining available line of credit with the FHLB totaling $212.4 million. As of December 31, 2013, the Bank also had $41.0 million of federal funds lines, with none outstanding. Primary uses of funds include repayment of maturing obligations and growing the loan portfolio. The following table presents additional information about our contractual obligations as of December 31, 2013, which by their terms had contractual maturity and termination dates subsequent to December 31, 2013: (Dollars in thousands) Contractual obligations: Deposit maturities (1) Long-term debt Operating lease obligations Total Total 668,844 12,217 617 $681,678 $ $ Payments due by period 1 year or less 536,260 — 287 $536,547 1 to 3 years 75,784 — 285 $76,069 3 to 5 years More than 5 years 46,369 5,000 45 $51,414 10,431 7,217 — $17,648 (1) Deposits with no stated maturity (demand, NOW, money market, and savings deposits) are presented in the "1 year or less" column Management believes that the Company and the Bank have adequate sources of liquidity to meet all known contractual obligations and unfunded commitments, including loan commitments and reasonable borrower, depositor, and creditor requirements over the next 12 months. Off-Balance Sheet Arrangements At December 31, 2013, the Bank had outstanding standby letters of credit of $8.6 million and unfunded loan commitments outstanding of $38.9 million. Because these commitments generally have fixed expiration dates and many will expire without being drawn upon, the total commitment level does not necessarily represent future cash requirements. If needed to fund these outstanding commitments, the Bank has the ability to liquidate federal funds sold or securities available-for-sale, or on a short-term basis to borrow and purchase federal funds from other financial institutions. Mortgage lending activities Since 2009, we have primarily sold residential mortgage loans in the secondary market to Fannie Mae while retaining the servicing of these loans. The sale agreements for these residential mortgage loans with Fannie Mae and other investors include various representations and warranties regarding the origination and characteristics of the residential mortgage loans. Although the representations and warranties vary among investors, they typically cover ownership of the loan, validity of the lien securing the loan, the absence of delinquent taxes or liens against the property securing the loan, compliance with loan criteria set forth in the applicable agreement, compliance with applicable federal, state, and local laws, among other matters. As of December 31, 2013, the unpaid principal balance of the residential mortgage loans, which we have originated and sold, but retained the servicing rights was $356.3 million. Although these loans are generally sold on a non-recourse basis, except for breaches of customary seller representations and warranties, we may have to repurchase residential mortgage loans in cases where we breach such representations or warranties or the other terms of the sale, such as where we fail to deliver required documents or the documents we deliver are defective. Investors also may require the repurchase of a mortgage loan when an early payment default underwriting review reveals significant underwriting deficiencies, even if the mortgage loan has subsequently been brought current. Repurchase demands are typically reviewed on an individual loan by loan basis to validate the claims made by the investor and to determine if a contractually required repurchase event has occurred. We seek to reduce and manage the risks of potential repurchases or other claims by mortgage loan investors page 20 through our underwriting, quality assurance and servicing practices, including good communications with our residential mortgage investors. We were not required to repurchase any residential mortgage loans in 2013 or 2011. In 2012, we repurchased one residential mortgage loan with an unpaid principal balance of $0.3 million. This loan was current as to principal and interest at the time of repurchase, and we incurred no losses upon repurchase. We service all residential mortgage loans originated and sold by us to Fannie Mae. As servicer, our primary duties are to: (1) collect payments due from borrowers; (2) advance certain delinquent payments of principal and interest; (3) maintain and administer any hazard, title, or primary mortgage insurance policies relating to the mortgage loans; (4) maintain any required escrow accounts for payment of taxes and insurance and administer escrow payments; and (5) foreclose on defaulted mortgage loans or take other actions to mitigate the potential losses to investors consistent with the agreements governing our rights and duties as servicer. The agreement under which we act as servicer generally specifies a standard of responsibility for actions taken by us in such capacity and provides protection against expenses and liabilities incurred by us when acting in compliance with the respective servicing agreements. However, if we commit a material breach of our obligations as servicer, we may be subject to termination if the breach is not cured within a specified period following notice. The standards governing servicing and the possible remedies for violations of such standards are determined by servicing guides issued by Fannie Mae as well as the contract provisions established between Fannie Mae and the Bank. Remedies could include repurchase of an affected loan. Although to date repurchase requests related to representation and warranty provisions, and servicing activities have been limited, it is possible that requests to repurchase mortgage loans may increase in frequency if investors more aggressively pursue all means of recovering losses on their purchased loans. As of December 31, 2013, we believe that this exposure is not material due to the historical level of repurchase requests and loss trends, in addition to the fact that 99.5% of our residential mortgage loans serviced for Fannie Mae were current as of such date. We maintain ongoing communications with our investors and will continue to evaluate this exposure by monitoring the level and number of repurchase requests as well as the delinquency rates in our investor portfolios. Effects of Inflation and Changing Prices The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with GAAP and practices within the banking industry which require the measurement of financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. CURRENT ACCOUNTING DEVELOPMENTS The following Accounting Standards Updates (“Updates” or “ASUs”) have been issued by the FASB but are not yet effective. (cid:127) ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists; (cid:127) ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects; and (cid:127) ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. Information about these pronouncements is described in more detail below. ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, is expected to eliminate diversity in practice as it provides guidance on financial statement presentation of an unrecognized tax benefit when a net operating loss (NOL) carryforward, a similar tax loss, or a tax credit carryforward exists. These changes are effective for the Company in the first quarter of 2014 with prospective application applied to all unrecognized tax benefits that exist at the effective date. Early adoption and retrospective application are permitted. Adoption of this ASU will not have a significant impact on the financial statements of the Company. page 21 Management’s Discussion and Analysis ASU 2014-01, Accounting for Investments in Qualified Affordable Housing Projects, amends the criteria a company must meet to elect to account for investments in qualified affordable housing projects using a method other than the cost or equity methods. If the criteria are met, a company is permitted to amortize the initial investment cost in proportion to and over the same period as the total tax benefits the company expects to receive. The amortization of the initial investment cost and tax benefits are to be recorded in the income tax expense line. The Update also requires new disclosures about all investments in qualified affordable housing projects regardless of the accounting method used. These changes are effective for the Company in the first quarter of 2015 with retrospective application. Early adoption is permitted. The Company is evaluating the impact this ASU will have on our consolidated financial statements. ASU 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, clarifies the timing of when a creditor is considered to have taken physical possession of residential real estate collateral for a consumer mortgage loan, resulting in the reclassification of the loan receivable to real estate owned. A creditor has taken physical possession of the property when either (1) the creditor obtains legal title through foreclosure, or (2) the borrower transfers all interests in the property to the creditor via a deed in lieu of foreclosure or a similar legal agreement. The Update also requires disclosure of the amount of foreclosed residential real estate property held by the creditor and the recorded investment in residential real estate mortgage loans that are in process of foreclosure. These changes are effective for the Company in the first quarter of 2015 with retrospective application. Early adoption is permitted. Adoption of this ASU will not have a significant impact on the financial statements of the Company. page 22 Financial Tables Table 1 – Explanation of Non-GAAP Financial Measures In addition to results presented in accordance with GAAP, this annual report on Form 10-K includes certain designated net interest income amounts presented on a tax-equivalent basis, a non-GAAP financial measure, including the presentation of total revenue and the calculation of the efficiency ratio. The Company believes the presentation of net interest income on a tax-equivalent basis provides comparability of net interest income from both taxable and tax-exempt sources and facilitates comparability within the industry. Although the Company believes these non-GAAP financial measures enhance investors’ understanding of its business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP. The reconciliation of these non- GAAP financial measures from GAAP to non-GAAP are presented below. (in thousands) Net interest income (GAAP) Tax-equivalent adjustment Net interest income (Tax-equivalent) $ $ Fourth Quarter 5,279 342 5,621 Third Second Quarter 5,270 351 5,621 Quarter 5,232 365 5,597 2013 First Quarter 5,141 382 5,523 Fourth Quarter 5,325 396 5,721 Third Second Quarter 5,259 416 5,675 Quarter 5,312 416 5,728 2012 First Quarter 5,001 414 5,415 (In thousands) Net interest income (GAAP) Tax-equivalent adjustment Net interest income (Tax-equivalent) Year ended December 31 2013 20,922 1,440 22,362 2012 20,897 1,642 22,539 2011 19,225 1,719 20,944 2010 18,899 1,765 20,664 2009 18,815 1,633 20,448 $ $ page 23 Financial Tables Table 2 - Selected Financial Data (Dollars in thousands, except per share amounts) Income statement Tax-equivalent interest income (a) Total interest expense Tax equivalent net interest income (a) Provision for loan losses Total noninterest income Total noninterest expense Net earnings before income taxes and tax-equivalent adjustment Tax-equivalent adjustment Income tax expense (benefit) Net earnings Per share data: Basic and diluted net earnings Cash dividends declared Weighted average shares outstanding Basic and diluted Shares outstanding Book value Common stock price High Low Period-end To earnings ratio To book value Performance ratios: Return on average equity Return on average assets Dividend payout ratio Average equity to average assets Asset Quality: Allowance for loan losses as a % of: Loans Nonperforming loans Nonperforming assets as a % of: Loans and foreclosed properties Total assets Nonperforming loans as % of loans Net charge-offs as a % of average loans Capital Adequacy: Tier 1 risk-based capital ratio Total risk-based capital ratio Tier 1 Leverage ratio Other financial data: Net interest margin (a) Effective income tax expense (benefit) rate Efficiency ratio (b) Selected period end balances: Securities Loans, net of unearned income Allowance for loan losses Total assets Total deposits Long-term debt Total stockholders’ equity $ $ $ $ $ $ $ $ 2013 2012 2011 Year ended December 31 2009 2010 28,898 6,536 22,362 400 7,298 18,412 10,848 1,440 2,290 7,118 1.95 0.84 30,709 8,170 22,539 3,815 10,483 19,383 9,824 1,642 1,419 6,763 1.86 0.82 32,425 11,481 20,944 2,450 5,177 16,357 7,314 1,719 57 5,538 1.52 0.80 35,237 14,573 20,664 3,580 6,718 15,893 7,909 1,765 798 5,346 1.47 0.78 38,467 18,019 20,448 5,250 2,433 13,934 3,697 1,633 (340) 2,404 0.66 0.76 3,643,003 3,643,118 17.70 3,642,831 3,642,903 19.26 3,642,735 3,642,738 17.96 3,642,851 3,642,718 15.47 3,644,691 3,643,117 15.42 25.75 20.80 25.00 12.89x 141 % 10.33 % 0.94 % 43.08 % 9.07 % 1.37 % 124 % 2.10 % 1.08 % 1.11 % 0.48 % 17.19 % 18.40 % 10.10 % 3.16 % 24.34 % 62.08 % 26.65 18.23 20.85 11.21 108 9.85 0.90 44.09 9.09 1.69 64 3.83 2.03 2.65 1.03 16.20 17.46 9.58 3.21 17.34 58.70 20.37 18.52 18.52 12.10 103 9.10 0.72 52.63 7.89 1.87 67 4.83 2.35 2.80 0.86 15.40 16.66 8.82 2.95 1.02 62.62 22.00 16.86 20.06 13.74 130 9.00 0.68 53.06 7.61 2.05 65 5.22 2.61 3.16 0.64 14.57 15.82 8.47 2.86 12.99 58.04 271,219 383,339 5,268 751,343 668,844 12,217 64,485 259,475 398,193 6,723 759,833 636,817 47,217 70,149 299,582 370,263 6,919 776,218 619,552 85,313 65,416 315,220 374,215 7,676 763,829 607,127 93,331 56,368 30.00 18.07 19.69 29.39 128 4.23 0.31 115.15 7.21 1.73 69 4.34 2.15 2.49 0.84 13.73 14.98 8.13 2.78 (16.47) 60.90 334,762 376,103 6,495 773,382 579,409 118,349 56,183 (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". (b) Efficiency ratio is the result of noninterest expense divided by the sum of noninterest income and tax-equivalent net interest income. page 24 Table 3 - Selected Quarterly Financial Data (Dollars in thousands, except per share amounts) Income statement Tax-equivalent interest income (a) Total interest expense Tax equivalent net interest income (a) Provision for loan losses Total noninterest income Total noninterest expense Net earnings before income taxes and tax-equivalent adjustment Tax-equivalent adjustment Income tax expense Net earnings Per share data: Basic and diluted net earnings Cash dividends declared Weighted average shares outstanding Basic and diluted Shares outstanding, at period end Book value Common stock price High Low Period-end To earnings ratio To book value Performance ratios: Return on average equity Return on average assets Dividend payout ratio Average equity to average assets Asset Quality: Allowance for loan losses as a % of: Loans Nonperforming loans Nonperforming assets as a % of : Loans and foreclosed properties Total assets Nonperforming loans as % of loans Net charge-offs as % of average loans (c) Capital Adequacy: Tier 1 risk-based capital ratio Total risk-based capital ratio Tier 1 Leverage ratio Other financial data: Net interest margin (a) Effective income tax rate Efficiency ratio (b) Selected period end balances: Securities Loans, net of unearned income Allowance for loan losses Total assets Total deposits Long-term debt Total stockholders’ equity $ $ $ $ $ $ $ Fourth Third Second 7,108 1,487 5,621 — 2,140 5,188 2,573 342 501 1,730 7,207 1,586 5,621 — 1,432 4,274 2,779 351 636 1,792 7,226 1,629 5,597 — 2,071 4,724 2,944 365 672 1,907 2013 First 7,357 1,834 5,523 400 1,655 4,226 2,552 382 481 1,689 Fourth Third Second 7,646 1,925 5,721 1,065 1,788 4,023 2,421 396 365 1,660 7,628 1,953 5,675 1,550 2,017 3,770 2,372 416 347 1,609 7,773 2,045 5,728 600 1,814 4,048 2,894 416 449 2,029 2012 First 7,662 2,247 5,415 600 4,864 7,542 2,137 414 258 1,465 0.47 0.21 0.49 0.21 0.52 0.21 0.46 0.21 0.46 0.205 0.44 0.205 0.56 0.205 0.40 0.205 3,643,110 3,643,118 17.70 3,643,028 3,643,058 18.06 3,642,955 3,642,993 17.90 3,642,918 3,642,928 19.27 3,642,903 3,642,903 19.26 3,642,876 3,642,903 19.27 3,642,826 3,642,843 18.75 3,642,738 3,642,738 18.11 25.75 23.93 25.00 12.89 x 141 % 10.33 % 0.92 % 44.68 % 8.95 % 1.37 % 124 % 2.10 % 1.08 % 1.11 % 0.71 % 17.19 % 18.40 % 10.10 % 3.20 % 22.46 % 66.85 % 24.71 22.00 24.40 12.64 135 10.78 0.95 42.86 8.85 1.56 134 2.34 1.21 1.16 0.53 17.29 18.55 9.96 3.19 26.19 60.60 22.33 21.54 22.00 11.70 123 10.74 1.00 40.38 9.32 1.65 138 2.10 1.08 1.19 0.32 16.45 17.70 9.76 3.16 26.06 61.61 22.60 20.80 22.00 11.46 114 9.47 0.87 45.65 9.17 1.73 143 2.42 1.24 1.22 0.36 16.32 17.57 9.42 3.09 22.17 58.87 24.87 20.85 20.85 11.21 108 9.30 0.88 44.57 9.45 1.69 64 3.83 2.03 2.65 0.39 16.20 17.46 9.58 3.22 18.02 53.58 23.20 21.00 22.25 12.94 115 9.22 0.86 46.59 9.33 1.52 44 4.61 2.46 3.43 2.00 15.75 17.00 9.54 3.23 17.74 49.01 26.65 21.50 21.50 12.95 115 12.06 1.07 36.61 8.85 1.63 79 3.31 1.75 2.06 1.61 15.39 16.65 9.26 3.26 18.12 53.67 21.99 18.23 21.99 14.66 121 8.86 0.77 51.25 8.74 1.97 73 4.53 2.31 2.69 0.02 15.69 16.95 9.06 3.11 14.97 73.37 $ 271,219 383,339 5,268 751,343 668,844 12,217 64,485 259,467 380,705 5,946 744,602 650,421 22,217 65,807 270,794 390,726 6,457 767,747 666,490 27,217 65,211 270,219 390,570 6,769 772,155 659,056 37,217 70,217 259,475 398,193 6,723 759,833 636,817 47,217 70,149 254,819 397,738 6,045 753,467 629,824 47,217 70,206 277,246 399,370 6,503 766,161 644,246 47,217 68,292 299,902 380,377 7,496 760,522 641,195 47,308 65,972 (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". (b) Efficiency ratio is the result of noninterest expense divided by the sum of noninterest income and tax-equivalent net interest income. (c) Net charge-offs are annualized. page 25 Financial Tables Table 4 - Average Balance and Net Interest Income Analysis 2013 Year ended December 31 Average Balance Interest Income/ Yield/ Rate Expense Average Balance 106 0.22% 42 0.75% 195,850 67,797 263,647 48,671 5,634 708,240 3,912 2.00% 199,794 77,447 4,234 6.25% 8,146 3.09% 277,241 27,466 793 28,898 4.08% 701,438 (Dollars in thousands) Interest-earning assets: Loans and loans held for sale (1) $ 390,288 $ 20,604 5.28% $ 395,938 $ Securities - taxable Securities - tax-exempt (2) Total securities Federal funds sold Interest bearing bank deposits Total interest-earning assets Cash and due from banks Other assets Total assets Interest-bearing liabilities: Deposits: NOW Savings and money market Certificates of deposits less than $100,000 Certificates of deposits and other time deposits of $100,000 or more Total interest-bearing deposits Short-term borrowings Long-term debt 319 0.32% $ 99,664 886 0.52% 153,668 13,694 37,836 $ 759,770 14,125 39,742 $ 755,305 1,437 1.36% 108,726 $ 101,034 171,413 105,631 155,781 533,859 2,817 31,518 568,194 119,136 3,522 68,918 2,750 1.77% 161,128 5,392 1.01% 523,186 2,970 14 0.50% 49,115 1,130 3.59% 6,536 1.15% 575,271 107,948 3,410 68,676 Total interest-bearing Noninterest-bearing deposits Other liabilities Stockholders' equity Total liabilities and and stockholders' equity 2012 Interest Income/ Expense Yield/ Rate Average Balance 2011 Interest Income/ Yield/ Rate Expense 21,943 5.54% $ 376,000 $ 21,306 5.67% 6,006 2.69% 3,883 1.94% 223,638 5,056 6.37% 79,329 4,829 6.24% 11,062 3.65% 8,712 3.14% 302,967 56 0.19% 28,905 1 0.05% 1,394 32,425 4.57% 30,709 4.38% 709,266 54 0.20% — — 13,054 48,796 $ 771,116 349 0.35% $ 90,565 859 0.56% 138,428 527 0.58% 996 0.72% 1,769 1.63% 114,490 2,227 1.95% 3,347 2.08% 181,242 6,324 1.21% 524,725 2,423 16 0.54% 86,899 1,830 3.73% 8,170 1.42% 614,047 92,764 3,463 60,842 4,318 2.38% 8,068 1.54% 12 0.50% 3,401 3.91% 11,481 1.87% $ 759,770 $ 755,305 $ 771,116 Net interest income and margin $ 22,362 3.16% $ 22,539 3.21% $ 20,944 2.95% (1) Average loan balances are shown net of unearned income and loans on nonaccrual status have been included in the computation of average balances. (2) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 34%. page 26 Table 5 - Volume and Rate Variance Analysis Years ended December 31, 2013 vs. 2012 Years ended December 31, 2012 vs. 2011 $ $ $ (Dollars in thousands) Interest income: Loans and loans held for sale Securities - taxable Securities - tax-exempt (1) Total securities Federal funds sold Interest bearing bank deposits Total interest income Interest expense: Deposits: NOW Savings and money market Certificates of deposits less than $100,000 Certificates of deposits and other time deposits of $100,000 or more Total interest-bearing deposits Short-term borrowings Long-term debt Total interest expense $ $ $ (298) (79) (603) (682) 46 36 (898) 5 92 Due to change in Rate (2) Volume (2) Net Change (1,339) 29 (595) (566) 52 42 (1,811) (1,041) 108 8 116 6 6 (913) (30) 27 (35) (65) (332) (290) (42) (597) (932) (2) (700) (1,634) (503) (893) (1) (69) (963) (94) (39) (1) (631) (671) Net Change 637 (2,123) (227) (2,350) (2) (1) (1,716) (178) (137) (458) (971) (1,744) 4 (1,571) (3,311) Due to change in Rate (2) Volume (2) (468) (1,660) (110) (1,770) 1 (1) (2,238) (210) (222) (364) (553) (1,349) 1 (163) (1,511) 1,105 (463) (117) (580) (3) — 522 32 85 (94) (418) (395) 3 (1,408) (1,800) Net interest income $ (177) 50 (227) $ 1,595 (727) 2,322 (1) Yields on tax-exempt securities have been computed on a tax-equivalent basis using an income tax rate of 34%. (2) Changes that are not solely a result of volume or rate have been allocated to volume. page 27 Financial Tables Table 6 - Loan Portfolio Composition (In thousands) Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total loans Less: unearned income Loans, net of unearned income Less: allowance for loan losses $ 2013 57,780 36,479 174,920 101,706 12,893 383,778 (439) 383,339 (5,268) 2012 59,334 37,631 183,611 105,631 12,219 398,426 (233) 398,193 (6,723) Loans, net $ 378,071 391,470 2011 54,988 39,814 162,435 101,725 11,454 370,416 (153) 370,263 (6,919) 363,344 2010 53,288 47,850 166,241 96,241 10,676 374,296 (81) 374,215 (7,676) 366,539 December 31 2009 53,884 56,820 156,928 97,407 11,236 376,275 (172) 376,103 (6,495) 369,608 page 28 Table 7 - Loan Maturities and Sensitivities to Changes in Interest Rates (Dollars in thousands) Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total loans $ $ December 31, 2013 1 year 1 to 5 After 5 Adjustable Fixed or less 4,927 3,018 60 556 51 8,612 years 47,697 27,117 70,128 28,761 11,340 185,043 years 5,156 6,344 104,732 72,389 1,502 190,123 Total 57,780 36,479 174,920 101,706 12,893 383,778 Rate 36,015 19,154 25,587 51,386 3,127 135,269 Rate 21,765 17,325 149,333 50,320 9,766 248,509 Total 57,780 36,479 174,920 101,706 12,893 383,778 page 29 Financial Tables Table 8 - Allowance for Loan Losses and Nonperforming Assets (Dollars in thousands) Allowance for loan losses: Balance at beginning of period Charge-offs: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total charge-offs Recoveries: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total recoveries Net charge-offs Provision for loan losses Ending balance as a % of loans as a % of nonperforming loans Net charge-offs as % of average loans Nonperforming assets: Nonaccrual/nonperforming loans Other real estate owned Total nonperforming assets as a % of loans and foreclosed properties as a % total assets Nonperforming loans as a % of total loans Accruing loans 90 days or more past due 2013 2012 2011 2010 2009 Year ended December 31 $ 6,723 6,919 7,676 6,495 4,398 (514) (39) (262) (808) (397) (2,020) 48 6 4 88 19 165 (1,855) 400 $ $ $ $ 5,268 1.37 % 124 % 0.48 % 4,261 3,884 8,145 2.10 % 1.08 % 1.11 % 73 (289) (231) (3,184) (545) (85) (4,334) 54 46 71 134 18 323 (4,011) 3,815 6,723 1.69 64 1.03 (679) (1,758) (422) (533) (21) (3,413) 34 2 — 155 15 206 (3,207) 2,450 6,919 1.87 67 0.86 (537) (1,487) — (552) (111) (2,687) 63 54 — 151 20 288 (2,399) 3,580 7,676 2.05 65 0.64 10,535 4,919 15,454 3.83 2.03 2.65 58 10,354 7,898 18,252 4.83 2.35 2.80 — 11,833 8,125 19,958 5.22 2.61 3.16 — (495) (2,088) — (704) (61) (3,348) 47 50 — 92 6 195 (3,153) 5,250 6,495 1.73 69 0.84 9,352 7,292 16,644 4.34 2.15 2.49 5 page 30 2013 2012 2011 2010 2009 Amount %* Amount %* Amount %* Amount %* $ 386 15.1 $ 812 14.9 $ 948 14.8 $ 972 14.2 $ Amount %* 784 14.3 December 31 Table 9 - Allocation of Allowance for Loan Losses (Dollars in thousands) Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Unallocated Total allowance for loan losses $ 366 9.5 3,186 45.6 1,114 26.5 3.4 216 — 5,268 $ 1,545 9.4 3,137 46.1 1,126 26.5 3.1 103 — 6,723 $ * Loan balance in each category expressed as a percentage of total loans. 1,470 10.7 3,009 43.9 1,363 27.5 3.1 129 — 6,919 $ 2,223 12.8 2,893 44.4 1,336 25.7 2.9 141 111 7,676 $ 2,063 15.1 1,264 41.7 1,706 25.9 3.0 227 451 6,495 page 31 December 31, 2013 $ December 31, 2013 15,642 $ 15,136 15,642 40,886 15,136 84,571 40,886 156,235 84,571 156,235 $ $ Financial Tables Table 10 - CDs and Other Time Deposits of $100,000 or More Table 10 - CDs and Other Time Deposits of $100,000 or More (Dollars in thousands) Maturity of: (Dollars in thousands) 3 months or less Maturity of: Over 3 months through 6 months 3 months or less Over 6 months through 12 months Over 3 months through 6 months Over 12 months Over 6 months through 12 months Over 12 months Total CDs and other time deposits of $100,000 or more (1) Total CDs and other time deposits of $100,000 or more (1) (1) includes brokered certificates of deposit. (1) includes brokered certificates of deposit. page 32 Management’s Report on Internal Control Over Financial Reporting Management’s Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Under the direction of the Company’s Chief Executive Officer and Principal Financial and Accounting Officer, management has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013 in accordance with the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management has concluded that such internal control over financial reporting was effective as of December 31, 2013. This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to the final rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report. page 33 Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders Auburn National Bancorporation, Inc.: We have audited the accompanying consolidated balance sheets of Auburn National Bancorporation, Inc. and subsidiaries (the Company) as of December 31, 2013 and 2012, and the related consolidated statements of earnings, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2013. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Auburn National Bancorporation, Inc. and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013 in conformity with U.S. generally accepted accounting principles. Birmingham, Alabama March 24, 2014 page 34       Audited Financial Statements AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands, except share data) Assets: Cash and due from banks Federal funds sold Interest bearing bank deposits Cash and cash equivalents Securities available-for-sale Loans held for sale Loans, net of unearned income Allowance for loan losses Loans, net Premises and equipment, net Bank-owned life insurance Other real estate owned Other assets Total assets Liabilities: Deposits: Noninterest-bearing Interest-bearing Total deposits Federal funds purchased and securities sold under agreements to repurchase Long-term debt Accrued expenses and other liabilities Total liabilities Stockholders' equity: Preferred stock of $.01 par value; authorized 200,000 shares; issued shares - none Common stock of $.01 par value; authorized 8,500,000 shares; issued 3,957,135 shares Additional paid-in capital Retained earnings Accumulated other comprehensive (loss) income, net Less treasury stock, at cost - 314,017 shares and 314,232 shares at December 31, 2013 and 2012, respectively Total stockholders’ equity Total liabilities and stockholders’ equity See accompanying notes to consolidated financial statements $ $ $ $ 2013 13,437 26,965 13,820 54,222 271,219 2,296 383,339 (5,268) 378,071 10,442 17,503 3,884 13,706 751,343 $ $ 125,740 543,104 668,844 3,363 12,217 2,434 686,858 — 39 3,759 71,879 (4,552) (6,640) 64,485 $ 751,343 $ December 31 2012 18,762 42,682 505 61,949 259,475 2,887 398,193 (6,723) 391,470 10,528 17,076 4,919 11,529 759,833 118,014 518,803 636,817 2,689 47,217 2,961 689,684 — 39 3,756 67,821 5,174 (6,641) 70,149 759,833 page 35 Audited Financial Statements AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Earnings (Dollars in thousands, except share and per share data) Interest income: Loans, including fees Securities Federal funds sold and interest bearing bank deposits Total interest income Interest expense: Deposits Short-term borrowings Long-term debt Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Noninterest income: Service charges on deposit accounts Mortgage lending Bank-owned life insurance Gain on sale of affordable housing investments Affordable housing investment losses Gain on sale of premises and equipment Other Securities gains, net: Realized gains, net Total other-than-temporary impairments Non-credit portion of other-than-temporary impairments recognized in other comprehensive income Total securities gains, net Total noninterest income Noninterest expense: Salaries and benefits Net occupancy and equipment Professional fees FDIC and other regulatory assessments Other real estate owned, net Prepayment penalties on long-term debt Other Total noninterest expense Earnings before income taxes Income tax expense Net earnings Net earnings per share: Basic and diluted 2013 2012 2011 Year ended December 31 $ $ $ 20,604 6,706 148 27,458 5,392 14 1,130 6,536 20,922 400 20,522 930 2,895 427 — — 1,018 1,377 651 — — 651 7,298 8,788 1,335 774 512 570 3,028 3,405 18,412 9,408 2,290 7,118 1.95 $ $ $ 21,943 7,070 54 29,067 6,324 16 1,830 8,170 20,897 3,815 17,082 1,111 3,445 445 3,268 — — 1,535 809 (130) — 679 10,483 8,691 1,332 704 686 323 3,720 3,927 19,383 8,182 1,419 6,763 1.86 $ $ $ 21,306 9,343 57 30,706 8,068 12 3,401 11,481 19,225 2,450 16,775 1,167 1,922 460 — (646) — 1,396 1,216 (468) 130 878 5,177 8,167 1,404 735 792 2,007 — 3,252 16,357 5,595 57 5,538 1.52 Weighted average shares outstanding: Basic and diluted See accompanying notes to consolidated financial statements 3,643,003 3,642,831 3,642,735 page 36 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income (Dollars in thousands) Net earnings Other comprehensive (loss) income, net of tax: Unrealized net holding loss on other-than-temporarily impaired securities due to factors other than credit Unrealized net holding (loss) gain on all other securities Reclassification adjustment for net gain on securities recognized in net earnings Other comprehensive (loss) income Year ended December 31 2013 2012 2011 $ 7,118 $ 6,763 $ 5,538 — (9,315) (411) (9,726) — 1,379 (427) 952 (82) 7,959 (554) 6,423 Comprehensive (loss) income $ (2,608) $ 7,715 $ 11,961 See accompanying notes to consolidated financial statements page 37 Audited Financial Statements AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Common Stock Additional paid-in capital Amount earnings (loss) income Accumulated other Retained comprehensive Treasury 39 $ — — — — 39 $ — — — — 39 $ — — — — 39 $ 3,752 $ — — — 1 3,753 $ — — — 3 3,756 $ — — — 3 3,759 $ 61,421 $ 5,538 — (2,914) — 64,045 $ 6,763 — (2,987) — 67,821 $ 7,118 — (3,060) — 71,879 $ (2,201) $ — 6,423 — — 4,222 $ — 952 — — 5,174 $ — (9,726) — — (4,552) $ stock (6,643) $ — — — — (6,643) $ — — — 2 (6,641) $ — — — 1 (6,640) $ Total 56,368 5,538 6,423 (2,914) 1 65,416 6,763 952 (2,987) 5 70,149 7,118 (9,726) (3,060) 4 64,485 3,957,135 $ 3,957,135 $ Shares — — — — (Dollars in thousands, except share data) Balance, December 31, 2010 Net earnings Other comprehensive income Cash dividends paid ($0.80 per share) Sale of treasury stock (20 shares) Balance, December 31, 2011 Net earnings Other comprehensive income Cash dividends paid ($0.82 per share) Sale of treasury stock (165 shares) Balance, December 31, 2012 Net earnings Other comprehensive loss Cash dividends paid ($0.84 per share) Sale of treasury stock (215 shares) Balance, December 31, 2013 See accompanying notes to consolidated financial statements — — — — — — — — 3,957,135 $ 3,957,135 $ page 38 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (In thousands) Cash flows from operating activities: Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Provision for loan losses Depreciation and amortization Premium amortization and discount accretion, net Deferred tax expense (benefit) Net gain on securities available for sale Net gain on sale of loans held for sale Net loss on other real estate owned Loss on prepayment of long-term debt Loans originated for sale Proceeds from sale of loans Net gain on disposition of premises and equipment Increase in cash surrender value of bank owned life insurance Gain on sale of affordable housing partnership investments Loss on affordable housing partnership investments Net decrease in other assets Net (decrease) increase in accrued expenses and other liabilities Net cash provided by operating activities Cash flows from investing activities: Proceeds from sales of securities available-for-sale Proceeds from maturities of securities available-for-sale Purchase of securities available-for-sale Decrease (increase) in loans, net Net purchases of premises and equipment Decrease in FHLB stock Capital contributions to affordable housing limited partnerships Proceeds from sale of affordable housing limited partnerships Proceeds from sale of premises and equipment Proceeds from sale of other real estate owned Net cash (used in) provided by investing activities Cash flows from financing activities: Net increase in noninterest-bearing deposits Net increase (decrease) in interest-bearing deposits Net increase (decrease) in federal funds purchased and securities under agreements to repurchase Repayments or retirement of long-term debt Proceeds from sale of treasury stock Dividends paid Net cash (used in) provided by financing activities Net change in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosures of cash flow information: Cash paid during the period for: Interest Income taxes Supplemental disclosure of non-cash transactions: Real estate acquired through foreclosure See accompanying notes to consolidated financial statements Year ended December 31 2013 2012 2011 $ 7,118 $ 6,763 $ 5,538 400 827 1,956 1,537 (651) (2,030) 477 3,028 (94,980) 96,779 (1,018) (427) — — 1,232 (527) 13,721 40,251 54,737 (123,449) 10,721 (462) 1,153 — — 1,148 2,836 (13,065) 7,726 24,301 674 (38,028) 4 (3,060) (8,383) (7,727) 61,949 54,222 3,815 837 2,992 624 (679) (3,430) 245 3,720 (154,044) 156,967 — (445) (3,268) — 1,131 (171) 15,057 $ 57,650 112,005 (130,352) (33,456) (1,549) 2,067 — 8,499 — 4,249 19,113 $ 11,738 5,527 (116) (41,816) 5 (2,987) (27,649) $ 6,521 $ 55,428 61,949 $ 2,450 665 2,445 (368) (878) (1,680) 1,830 — (71,350) 73,550 — (460) — 646 1,015 685 14,088 128,715 95,641 (200,106) (2,824) (1,568) 856 (4,378) — — 1,966 18,302 18,616 (6,191) 120 (8,018) 1 (2,914) 1,614 34,004 21,424 55,428 $ $ $ $ $ 6,761 $ 758 8,535 $ 1,224 11,713 347 2,278 $ 1,515 $ 3,569 $ $ $ $ $ $ $ page 39 Audited Financial Statements AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business Auburn National Bancorporation, Inc. (the “Company”) is a bank holding company whose primary business is conducted by its wholly-owned subsidiary, AuburnBank (the “Bank”). AuburnBank is a commercial bank located in Auburn, Alabama. The Bank provides a full range of banking services in its primary market area, Lee County, which includes the Auburn-Opelika Metropolitan Statistical Area. Basis of Presentation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Auburn National Bancorporation Capital Trust I is an affiliate of the Company and was included in these consolidated financial statements pursuant to the equity method of accounting. Significant intercompany transactions and accounts are eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the balance sheet date and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses, fair value measurements, valuation of other real estate owned, and valuation of deferred tax assets. In the first quarter of 2013, the Company adopted new guidance related to the following Accounting Standards Updates (“Updates” or “ASUs”):  ASU 2011-11, Disclosures about Offsetting Assets and Liabilities;  ASU 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities; and  ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. In the third quarter of 2013, the Company adopted new guidance related to the following Update:  ASU 2013-10, Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes. Information about these pronouncements is described in more detail below. ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, expands the disclosure requirements for financial instruments and derivatives that may be offset in accordance with enforceable master netting agreements or similar arrangements. The disclosures are required regardless of whether the instruments have been offset (or netted) in the statement of financial position. Under ASU 2011-11, companies must describe the nature of offsetting arrangements and provide quantitative information about those agreements, including the gross and net amounts of financial instruments that are recognized in the statement of financial position. In January 2013, the FASB issued ASU 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, which clarifies the scope of the offsetting disclosures and addresses any unintended consequences due to feedback from stakeholders that standard commercial provisions of many contracts would equate to a master netting arrangement. These changes were effective for the Company in the first quarter of 2013 with retrospective application. Adoption of this ASU did not have any impact on the financial statements of the Company. ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, seeks to improve the reporting of reclassifications out of accumulated other comprehensive income. The amendments in this Update require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net page 40 income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. These changes were effective for the Company in the first quarter of 2013 with retrospective application. This Update did not affect our consolidated financial results as it amends only the presentation of comprehensive income. See Consolidated Statements of Comprehensive Income. ASU 2013-10, Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes, permits the Fed Funds Effective Swap Rate (Overnight Index Swap Rate) to be used as a U.S. benchmark interest rate for hedge accounting purposes, in addition to LIBOR and U.S. Treasury. The ASU also removes the restriction on using different benchmark rates for similar hedges. These changes are effective for the Company in the third quarter of 2013 with prospective application for qualifying new or redesignated hedging relationships entered into on or after July 17, 2013. Adoption of this ASU did not have a significant impact on the financial statements of the Company. Cash Equivalents Cash equivalents include cash on hand, cash items in process of collection, amounts due from banks, including interest bearing deposits with other banks, and federal funds sold. Securities Securities are classified based on management’s intention at the date of purchase. At December 31, 2013, all of the Company’s securities were classified as available-for-sale. Securities available-for-sale are used as part of the Company’s interest rate risk management strategy, and they may be sold in response to changes in interest rates, changes in prepayment risks or other factors. All securities classified as available-for-sale are recorded at fair value with any unrealized gains and losses reported in accumulated other comprehensive loss, net of the deferred income tax effects. Interest and dividends on securities, including the amortization of premiums and accretion of discounts are recognized in interest income over the anticipated life of the security using the effective interest method, taking into consideration prepayment assumptions. Realized gains and losses from the sale of securities are determined using the specific identification method. On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-temporarily impaired. For equity securities with an unrealized loss, the Company considers many factors including the severity and duration of the impairment; the intent and ability of the Company to hold the security for a period of time sufficient for a recovery in value; and recent events specific to the issuer or industry. Equity securities on which there is an unrealized loss that is deemed to be other-than-temporary are written down to fair value with the write-down recorded as a realized loss in securities gains (losses), net. For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write-down is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings, as a realized loss in securities gains (losses), and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes. Loans held for sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Loan sales are recognized when the transaction closes, the proceeds are collected, and ownership is transferred. Continuing involvement, through the sales agreement, consists of the right to service the loan for a fee for the life of the loan, if applicable. Gains on the sale of loans held for sale are recorded net of related costs, such as commissions, and reflected as a component of mortgage lending income in the consolidated statements of earnings. page 41 Audited Financial Statements In the course of conducting the Bank’s mortgage lending activities of originating mortgage loans and selling those loans in the secondary market, the Bank makes various representations and warranties to the purchaser of the mortgage loans. Every loan closed by the Bank’s mortgage center is run through a government agency automated underwriting system. Any exceptions noted during this process are remedied prior to sale. These representations and warranties also apply to underwriting the real estate appraisal opinion of value for the collateral securing these loans. Failure by the Company to comply with the underwriting and/or appraisal standards could result in the Company being required to repurchase the mortgage loan or to reimburse the investor for losses incurred (make whole requests) if such failure cannot be cured by the Company within the specified period following discovery. In 2012, we repurchased one residential mortgage loan with an unpaid principal balance of $0.3 million. This loan was current as to principal and interest at the time of repurchase, and we incurred no losses upon repurchase. Except for this loan, during 2013, 2012, and 2011, no loans were repurchased and no reimbursements for investor losses were made by the Company. Loans Loans are reported at their outstanding principal balances, net of any unearned income, charge-offs, and any deferred fees or costs on originated loans. Interest income is accrued based on the principal balance outstanding. Loan origination fees, net of certain loan origination costs, are deferred and recognized in interest income over the contractual life of the loan using the effective interest method. Loan commitment fees are generally deferred and amortized on a straight-line basis over the commitment period, which results in a recorded amount that approximates fair value. The accrual of interest on loans is discontinued when there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or the principal or interest is more than 90 days past due, unless the loan is both well-collateralized and in the process of collection. Generally, all interest accrued but not collected for loans that are placed on nonaccrual status is reversed against current interest income. Interest collections on nonaccrual loans are generally applied as principal reductions. The Company determines past due or delinquency status of a loan based on contractual payment terms. A loan is considered impaired when it is probable the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Individually identified impaired loans are measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. If the recorded investment in the impaired loan exceeds the measure of fair value, a valuation allowance may be established as part of the allowance for loan losses. Changes to the valuation allowance are recorded as a component of the provision for loan losses. Impaired loans also included troubled debt restructurings (“TDRs”). In the normal course of business, management may grant concessions to borrowers who are experiencing financial difficulty. The concessions granted most frequently for TDRs involve reductions or delays in required payments of principal and interest for a specified time, the rescheduling of payments in accordance with a bankruptcy plan or the charge-off of a portion of the loan. In most cases, the conditions of the credit also warrant nonaccrual status, even after the restructuring occurs. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructuring. TDR loans may be returned to accrual status if there has been at least a six-month sustained period of repayment performance by the borrower. Allowance for Loan Losses The allowance for loan losses is maintained at a level that management believes is adequate to absorb probable losses inherent in the loan portfolio. Loan losses are charged against the allowance when they are known. Subsequent recoveries are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, growth, composition of the loan portfolio, homogeneous pools of loans, risk ratings of specific loans, historical loan loss factors, identified impaired loans and other factors related to the portfolio. This evaluation is performed quarterly and is inherently subjective, as it requires various material estimates that are susceptible to significant change, including the amounts and timing of future cash flows expected to be received on any impaired loans. In addition, regulatory agencies, as an integral part of their examination process, will periodically review the Company’s allowance for loan losses, and may require the Company to record additions to the allowance based on their judgment about information available to them at the time of their examinations. Premises and Equipment Land is carried at cost. Buildings and equipment are carried at cost, less accumulated depreciation computed on a straight-line method over the useful lives of the assets or the expected terms of the leases, if shorter. Expected terms include lease option periods to the extent that the exercise of such options is reasonably assured. page 42 Other Real Estate Owned Other real estate owned (“OREO”) includes properties acquired through, or in lieu of, loan foreclosure that are held for sale and are initially recorded at the lower of the loan’s carrying amount or fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying value amount or fair value less cost to sell. Gains or losses realized upon sale of OREO and additional losses related to subsequent valuation adjustments are determined on a specific property basis and are included as a component of noninterest expense along with holding costs. Nonmarketable equity investments Nonmarketable equity investments include equity securities that are not publicly traded and securities acquired for various purposes. The Bank is required to maintain certain minimum levels of equity investments with certain regulatory and other entities in which the Bank has an ongoing business relationship based on the Bank’s common stock and surplus (with regard to the relationship with the Federal Reserve Bank) or outstanding borrowings (with regard to the relationship with the Federal Home Loan Bank of Atlanta). These securities are accounted for under the cost method and are included in other assets. For cost-method investments, on a quarterly basis, the Company evaluates whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment. If the Company determines that a decline in value is other-than-temporary, the Company will recognize the estimated loss in securities gains (losses), net. Transfers of Financial Assets Transfers of an entire financial asset (i.e. loan sales), a group of entire financial assets, or a participating interest in an entire financial asset (i.e. loan participations sold) are accounted for as sales when control over the assets have been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Mortgage Servicing Rights The Company recognizes as assets the rights to service mortgage loans for others, known as MSRs. The Company determines the fair value of MSRs at the date the loan is transferred. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of MSRs is analyzed monthly and is adjusted to reflect changes in prepayment speeds, as well as other factors. MSRs are evaluated for impairment based on the fair value of those assets. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established through a charge to earnings. The valuation allowance is adjusted as the fair value changes. MSRs are included in the other assets category in the accompanying consolidated balance sheets. Derivative Instruments In accordance with ASC Topic 815, Derivatives and Hedging, all derivative instruments are recorded on the consolidated balance sheet at their respective fair values. The accounting for changes in fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, on the reason for holding it. If the derivative instrument is not designated as part of a hedging relationship, the gain or loss on the derivative instrument is recognized in earnings in the period of change. None of the derivatives utilized by the Company have been designated as a hedge. Securities sold under agreements to repurchase Securities sold under agreements to repurchase generally mature less than one year from the transaction date. Securities sold under agreements to repurchase are reflected as a secured borrowing in the accompanying consolidated balance sheets at the amount of cash received in connection with each transaction. page 43 Audited Financial Statements Income Taxes Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The net deferred tax asset is reflected as a component of other assets in the accompanying consolidated balance sheets. Income tax expense or benefit for the year is allocated among continuing operations and other comprehensive income (loss), as applicable. The amount allocated to continuing operations is the income tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of (1) changes in certain circumstances that cause a change in judgment about the realization of deferred tax assets in future years, (2) changes in income tax laws or rates, and (3) changes in income tax status, subject to certain exceptions. The amount allocated to other comprehensive income (loss) is related solely to changes in the valuation allowance on items that are normally accounted for in other comprehensive income (loss) such as unrealized gains or losses on available-for-sale securities. In accordance with ASC 740, a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. The Company and its wholly-owned subsidiaries file a consolidated income tax return. Fair Value Measurements ASC 820, which defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 applies only to fair-value measurements that are already required or permitted by other accounting standards. The definition of fair value focuses on the exit price, i.e., 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, not the entry price, i.e., the price that would be paid to acquire the asset or received to assume the liability at the measurement date. The statement emphasizes that fair value is a market- based measurement; not an entity-specific measurement. Therefore, the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. For more information related to fair value measurements, please refer to Note 17, Fair Value. Subsequent Events The Company has evaluated the effects of events or transactions through the date of this filing that have occurred subsequent to December 31, 2013. The Company does not believe there are any material subsequent events that would require further recognition or disclosure. page 44 NOTE 2: BASIC AND DILUTED EARNINGS PER SHARE Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the year. Diluted net earnings per share reflect the potential dilution that could occur upon exercise of securities or other rights for, or convertible into, shares of the Company’s common stock. As of December 31, 2013, 2012, and 2011, respectively, the Company had no such securities or rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted earnings per share calculation. The basic and diluted earnings per share computations for the respective years are presented below. (Dollars in thousands, except share and per share data) Basic and diluted: Net earnings Weighted average common shares outstanding Earnings per share NOTE 3: VARIABLE INTEREST ENTITIES Year ended December 31 2013 2012 2011 $ $ 7,118 3,643,003 1.95 $ $ 6,763 3,642,831 1.86 $ $ 5,538 3,642,735 1.52 Generally, a variable interest entity (“VIE”) is a corporation, partnership, trust or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. At December 31, 2013, the Company did not have any consolidated VIEs to disclose but did have one nonconsolidated VIE, discussed below. Trust Preferred Securities The Company owns the common stock of a subsidiary business trust, Auburn National Bancorporation Capital Trust I, which issued mandatorily redeemable preferred capital securities (“trust preferred securities”) in the aggregate of approximately $7.0 million at the time of issuance. This trust meets the definition of a VIE of which the Company is not the primary beneficiary; the trust’s only assets are junior subordinated debentures issued by the Company, which were acquired by the trust using the proceeds from the issuance of the trust preferred securities and common stock. The junior subordinated debentures of approximately $7.2 million are included in long-term debt and the Company’s equity interest of $0.2 million in the business trust is included in other assets. Interest expense on the junior subordinated debentures is included in interest expense on long-term debt. The following table summarizes VIEs that are not consolidated by the Company as of December 31, 2013. (Dollars in thousands) Type: Trust preferred issuances NOTE 4: RESTRICTED CASH BALANCES Maximum Loss Exposure Liability Recognized Classification N/A $ 7,217 Long-term debt Regulation D of the Federal Reserve Act requires that banks maintain reserve balances with the Federal Reserve Bank based principally on the type and amount of their deposits. As of December 31, 2013 and 2012, the Bank did not have a required reserve balance at the Federal Reserve Bank. page 45 Audited Financial Statements NOTE 5: SECURITIES At December 31, 2013 and 2012, respectively, all securities within the scope of ASC 320, Investments – Debt and Equity Securities were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity December 31, 2013 and 2012, respectively, are presented below. 1 year or less 1 to 5 years 5 to 10 After 10 years years Fair Value Gross Unrealized Amortized Gains Losses Cost (Dollars in thousands) December 31, 2013 Agency obligations (a) Agency RMBS (a) State and political subdivisions $ — — — 1,735 44,522 — 23,247 — 8,306 154,052 162,358 64,339 21,275 21,366 41,238 — 4,557 $ 976 1,560 4,733 459 49,079 166,115 63,238 9,749 $ 278,432 $ — 1,735 52,919 216,565 271,219 Total available-for-sale December 31, 2012 Agency obligations (a) Agency RMBS (a) State and political subdivisions Trust preferred securities Total available-for-sale (a) Includes securities issued by U.S. government agencies or government sponsored entities. — 20,065 39,525 — 4,700 136,760 141,460 77,838 652 45,771 211,763 259,475 — — 111 — 111 1,830 — 1,830 21,006 — 54,891 652 19,460 $ $ 2,536 187 3,012 5,222 113 8,534 19 $ 39,357 162 138,610 — 72,616 693 154 335 $ 251,276 Securities with aggregate fair values of $120.5 million and $134.0 million at December 31, 2013 and 2012, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, Federal Home Loan Bank (“FHLB”) advances, and for other purposes required or permitted by law. Included in other assets on the accompanying consolidated balance sheets are cost-method investments. The carrying amounts of cost-method investments were $1.8 and $3.0 million at December 31, 2013 and 2012, respectively. Cost- method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock. Gross Unrealized Losses and Fair Value The fair values and gross unrealized losses on securities at December 31, 2013 and 2012, respectively, segregated by those securities that have been in an unrealized loss position for less than 12 months and 12 months or more are presented below. (Dollars in thousands) December 31, 2013: Agency obligations Agency RMBS State and political subdivisions Total December 31, 2012: Agency obligations Agency RMBS Trust preferred securities Total Less than 12 Months 12 Months or Longer Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses $ $ $ $ 35,933 109,774 9,575 155,282 9,966 25,207 — 35,173 3,182 4,393 459 8,034 19 162 — 181 8,590 7,683 — 16,273 — — 346 346 1,376 339 — 1,715 44,523 $ 117,457 9,575 171,555 $ — — 154 154 9,966 $ 25,207 346 35,519 $ 4,558 4,732 459 9,749 19 162 154 335 page 46 For the securities in the previous table, the Company does not have the intent to sell and has determined it is not more likely than not that the Company will be required to sell the security before recovery of the amortized cost basis, which may be maturity. The Company assesses each security for credit impairment. For debt securities, the Company evaluates, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. For cost-method investments, the Company evaluates whether an event or change in circumstances has occurred during the reporting period that may have a significant adverse effect on the fair value of the investment. In determining whether a loss is temporary, the Company considers all relevant information including: the length of time and the extent to which the fair value has been less than the amortized cost basis; adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors, including changes in technology or the discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security or changes in the quality of the credit enhancement); the historical and implied volatility of the fair value of the security; the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future; failure of the issuer of the security to make scheduled interest or principal payments; any changes to the rating of the security by a rating agency; and recoveries or additional declines in fair value subsequent to the balance sheet date.        Agency obligations The unrealized losses associated with agency obligations were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government- sponsored entities and did not have any credit losses given the explicit government guarantee or other government support. Agency residential mortgage-backed securities (“RMBS”) The unrealized losses associated with agency RMBS were primarily driven by changes in interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support. Securities of U.S. states and political subdivisions The unrealized losses associated with securities of U.S. states and political subdivisions were primarily driven by changes in interest rates and were not due to the credit quality of the securities. Some of these securities are guaranteed by a bond insurer, but management did not rely on the guarantee in making its investment decision. These securities will continue to be monitored as part of the Company’s quarterly impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. As a result, the Company expects to recover the entire amortized cost basis of these securities. Cost-method investments At December 31, 2013, cost-method investments with an aggregate cost of $1.8 million were not evaluated for impairment because the Company did not identify any events or changes in circumstances that may have a significant adverse effect on the fair value of these cost-method investments. The carrying values of the Company’s investment securities could decline in the future if the financial condition of an issuer deteriorates and the Company determines it is probable that it will not recover the entire amortized cost basis for the security. As a result, there is a risk that significant other-than-temporary impairment charges may occur in the future. page 47 Audited Financial Statements Other-Than-Temporarily Impaired Securities The following table presents a roll-forward of the credit loss component of the amortized cost of debt securities that the Company has written down for other-than-temporary impairment and the credit component of the loss is recognized in earnings (referred to as “credit-impaired” debt securities). Other-than-temporary impairments recognized in earnings for the years ended 2013, 2012, and 2011, for credit-impaired debt securities are presented as additions in two components based upon whether the current period is the first time the debt security was credit-impaired (initial credit impairment) or is not the first time the debt security was credit-impaired (subsequent credit impairments). The credit loss component is reduced if the Company sells, intends to sell, or believes it will be required to sell previously credit-impaired debt securities. Additionally, the credit loss component is reduced if the Company receives cash flows in excess of what it expected to receive over the remaining life of the credit-impaired debt security, the security matures or the security is fully written- down and deemed worthless. Changes in the credit loss component of credit-impaired debt securities were: (Dollars in thousands) Balance, beginning of period Additions: Subsequent credit impairments Reductions: Securities sold Securities fully written down and deemed worthless Balance, end of period Other-Than-Temporary Impairment Year ended December 31 $ $ 2013 1,257 — (757) (500) — 2012 3,276 130 (2,149) — 1,257 2011 2,938 338 — — 3,276 The following table presents details of the other-than-temporary impairment related to securities. (Dollars in thousands) Other-than-temporary impairment charges (included in earnings): Debt securities: Individual issuer trust preferred securities Total debt securities Total other-than-temporary impairment charges (included in earnings) Other-than-temporary impairment on debt securities: Recorded as part of gross realized losses: Credit-related Securities with intent to sell Recorded directly to other comprehensive income for non-credit related impairment Total other-than-temporary impairment on debt securities $ $ $ $ $ Realized Gains and Losses Year ended December 31 2013 2012 2011 — — — — — 130 130 130 130 — — — — 130 338 338 338 338 — 130 468 The following table presents the gross realized gains and losses on sales and other-than-temporary impairment charges related to securities. (Dollars in thousands) Gross realized gains Gross realized losses Other-than-temporary impairment charges Realized gains, net $ $ 2013 745 (94) — 651 Year ended December 31 2012 1,005 (196) (130) 679 2011 1,698 (482) (338) 878 page 48 NOTE 6: LOANS AND ALLOWANCE FOR LOAN LOSSES (In thousands) Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total loans Less: unearned income Loans, net of unearned income 2013 57,780 36,479 $ 56,102 118,818 174,920 57,871 43,835 101,706 12,893 383,778 (439) 383,339 $ December 31 2012 59,334 37,631 64,368 119,243 183,611 58,087 47,544 105,631 12,219 398,426 (233) 398,193 $ $ Loans secured by real estate were approximately 81.6% of the total loan portfolio at December 31, 2013. At December 31, 2013, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama and surrounding areas. In accordance with ASC 310, a portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for loan losses. As part of the Company’s quarterly assessment of the allowance, the loan portfolio is disaggregated into the following portfolio segments: commercial and industrial, construction and land development, commercial real estate, residential real estate and consumer installment. Where appropriate, the Company’s loan portfolio segments are further disaggregated into classes. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity’s method for monitoring and determining credit risk. The following describe the risk characteristics relevant to each of the portfolio segments. Commercial and industrial (“C&I”) — includes loans to finance business operations, equipment purchases, or other needs for small and medium-sized commercial customers. Also included in this category are loans to finance agricultural production. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower. Construction and land development (“C&D”) — includes both loans and credit lines for the purpose of purchasing, carrying and developing land into commercial developments or residential subdivisions. Also included are loans and lines for construction of residential, multi-family and commercial buildings. Generally the primary source of repayment is dependent upon the sale or refinance of the real estate collateral. Commercial real estate (“CRE”) — includes loans disaggregated into two classes: (1) owner occupied and (2) other.  Owner occupied – includes loans secured by business facilities to finance business operations, equipment and owner-occupied facilities primarily for small and medium-sized commercial customers. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower, who owns the property.  Other – primarily includes loans to finance income-producing commercial and multi-family properties. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, single retail stores, industrial buildings, warehouses and apartments leased generally to local businesses and residents. Generally the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates as well as the financial health of the borrower. page 49 Audited Financial Statements Residential real estate (“RRE”) — includes loans disaggregated into two classes: (1) consumer mortgage and (2) investment property.   Consumer mortgage – primarily includes first or second lien mortgages and home equity lines to consumers that are secured by a primary residence or second home. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history and property value. Investment property – primarily includes loans to finance income-producing 1-4 family residential properties. Generally the primary source of repayment is dependent upon income generated from leasing the property securing the loan. The underwriting of these loans takes into consideration the rental rates as well as the financial health of the borrower. Consumer installment — includes loans to individuals both secured by personal property and unsecured. Loans include personal lines of credit, automobile loans, and other retail loans. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and if applicable, property value. The following is a summary of current, accruing past due and nonaccrual loans by portfolio class as of December 31, 2013 and 2012. (In thousands) Current Past Due 90 days Loans Accruing Accruing Total 30-89 Days Greater than Accruing Non- Accrual Total Loans December 31, 2013: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total December 31, 2012: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total $ 57,558 34,883 54,214 118,389 172,603 56,191 42,935 99,126 12,789 $ 376,959 $ 59,101 35,917 63,323 113,344 176,667 55,521 46,460 101,981 12,157 $ 385,823 167 14 861 — 861 745 598 1,343 100 2,485 173 8 — 230 230 1,202 335 1,537 62 2,010 — — 57,725 34,897 55 1,582 $ 57,780 36,479 1,027 429 1,456 866 302 1,168 — 4,261 56,102 118,818 174,920 57,871 43,835 101,706 12,893 $ 383,778 — 55,075 — 118,389 — 173,464 57,005 43,533 100,538 12,893 379,517 69 — 69 4 73 — — 59,274 35,925 60 1,706 $ 59,334 37,631 — 63,323 — 113,574 — 176,897 1,045 5,669 6,714 64,368 119,243 183,611 58 — 58 — 58 56,781 46,795 103,576 12,219 387,891 1,306 749 2,055 — 58,087 47,544 105,631 12,219 10,535 $ 398,426 The gross interest income which would have been recorded under the original terms of those nonaccrual loans had they been accruing interest, amounted to approximately $270 thousand, $511 thousand and $494 thousand for the years ended December 31, 2013, 2012, and 2011, respectively. page 50 Allowance for Loan Losses The allowance for loan losses as of and for the years ended December 31, 2013, 2012 and 2011, is presented below. (In thousands) Beginning balance Charged-off loans Recovery of previously charged-off loans Net charge-offs Provision for loan losses Ending balance Year ended December 31 2013 6,723 (2,020) 165 (1,855) 400 5,268 $ $ 2012 6,919 (4,334) 323 (4,011) 3,815 6,723 $ $ $ $ 2011 7,676 (3,413) 206 (3,207) 2,450 6,919 The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. The Company deems loans impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs. The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off. In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal and independent loan review processes. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan. As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment. The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At December 31, 2013 and 2012, and for the years then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups. page 51 Audited Financial Statements The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors. The Company regularly re-evaluates its practices in determining the allowance for loan losses. During 2013, the Company implemented certain refinements to its allowance for loan losses methodology, specifically the way that historical loss factors are calculated. Prior to June 30, 2013, the Company calculated average losses for all loan segments using a rolling 6 quarter historical period. Beginning with the quarter ended June 30, 2013, the Company calculated average losses for all loan segments (except for the commercial real estate loan segment) using a rolling 8 quarter historical period in order to better capture the effects of the current economic cycle on the Company’s loan loss experience and continued this methodology through December 31, 2013. Based upon management’s review of charge-off trends for each loan segment, the Company continues to calculate average losses for the commercial real estate loan segment using a rolling 6 quarter historical period. Other than the changes discussed above, the Company has not made any changes to its calculation of historical loss periods that would impact the calculation of the allowance for loan losses or provision for loan losses for the periods included in the accompanying consolidated balance sheets and statements of earnings. The following table details the changes in the allowance for loan losses by portfolio segment for the years ended December 31, 2013, 2012, and 2011. (in thousands) Balance, December 31, 2010 $ Charge-offs Recoveries Net charge-offs Provision Balance, December 31, 2011 $ Charge-offs Recoveries Net charge-offs Provision Balance, December 31, 2012 $ Charge-offs Recoveries Net charge-offs Provision Balance, December 31, 2013 $ Commercial and industrial 972 (679) 34 (645) 621 948 (289) 54 (235) 99 812 (514) 48 (466) 40 386 Construction and land Development 2,223 (1,758) 2 (1,756) 1,003 1,470 (231) 46 (185) 260 1,545 (39) 6 (33) (1,146) 366 Commercial Real Estate Residential Real Estate 2,893 (422) — (422) 538 3,009 (3,184) 71 (3,113) 3,241 3,137 (262) 4 (258) 307 3,186 1,336 (533) 155 (378) 405 1,363 (545) 134 (411) 174 1,126 (808) 88 (720) 708 1,114 Consumer Installment 141 (21) 15 (6) (6) 129 (85) 18 (67) 41 103 (397) 19 (378) 491 216 Unallocated 111 $ — — — (111) — $ — — — — — $ — — — — — $ Total 7,676 (3,413) 206 (3,207) 2,450 6,919 (4,334) 323 (4,011) 3,815 6,723 (2,020) 165 (1,855) 400 5,268 page 52 The following table presents an analysis of the allowance for loan losses and recorded investment in loans by portfolio segment and impairment methodology as of December 31, 2013 and 2012. Collectively evaluated (1) Individually evaluated (2) Total Allowance Recorded Allowance Recorded Allowance Recorded (In thousands) December 31, 2013: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total December 31, 2012: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total $ $ $ $ for loan investment for loan investment for loan investment losses in loans losses in loans losses in loans 386 278 3,014 1,114 216 5,008 812 1,416 3,003 1,126 103 6,460 57,656 34,897 171,987 100,780 12,893 378,213 59,165 36,008 176,085 104,414 12,219 387,891 — 88 172 — — 260 — 129 134 — — 263 124 1,582 2,933 926 — 5,565 169 1,623 7,526 1,217 — 10,535 386 366 3,186 1,114 216 5,268 812 1,545 3,137 1,126 103 6,723 57,780 36,479 174,920 101,706 12,893 383,778 59,334 37,631 183,611 105,631 12,219 398,426 (1) Represents loans collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for unimpaired loans (2) Represents loans individually evaluated for impairment in accordance with ASC 310-30, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans. page 53 Audited Financial Statements Credit Quality Indicators The credit quality of the loan portfolio is summarized no less frequently than quarterly using categories similar to the standard asset classification system used by the federal banking agencies. The following table presents credit quality indicators for the loan portfolio segments and classes. These categories are utilized to develop the associated allowance for loan losses using historical losses adjusted for qualitative and environmental factors and are defined as follows:    Pass – loans which are well protected by the current net worth and paying capacity of the obligor (or guarantors, if any) or by the fair value, less cost to acquire and sell, of any underlying collateral. Special Mention – loans with potential weakness that may, if not reversed or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans are not adversely classified and do not expose an institution to sufficient risk to warrant an adverse classification. Substandard Accruing – loans that exhibit a well-defined weakness which presently jeopardizes debt repayment, even though they are currently performing. These loans are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected;  Nonaccrual – includes loans where management has determined that full payment of principal and interest is in doubt. (In thousands) December 31, 2013 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total December 31, 2012 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total Pass Special Mention Substandard Accruing Nonaccrual Total loans $ 53,060 33,616 4,183 180 53,430 117,490 170,920 50,392 40,517 90,909 12,713 361,218 58,487 34,490 59,270 111,719 170,989 49,462 43,559 93,021 11,850 368,837 $ $ $ 770 91 861 1,137 1,310 2,447 34 7,705 224 310 2,528 653 3,181 1,544 1,033 2,577 155 6,447 482 1,101 875 808 1,683 5,476 1,706 7,182 146 10,594 563 1,125 1,525 1,202 2,727 5,775 2,203 7,978 214 12,607 55 1,582 $ 57,780 36,479 1,027 429 1,456 866 302 1,168 — 4,261 56,102 118,818 174,920 57,871 43,835 101,706 12,893 $ 383,778 60 1,706 $ 59,334 37,631 1,045 5,669 6,714 64,368 119,243 183,611 1,306 749 2,055 — 58,087 47,544 105,631 12,219 10,535 $ 398,426 page 54 Impaired loans The following table presents details related to the Company’s impaired loans. Loans which have been fully charged-off do not appear in the following table. The related allowance generally represents the following components which correspond to impaired loans:   Individually evaluated impaired loans equal to or greater than $500,000 secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate loans). Individually evaluated impaired loans equal to or greater than $250,000 not secured by real estate (nonaccrual commercial and industrial and consumer loans). The following table sets forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at December 31, 2013 and 2012. (In thousands) With no allowance recorded: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total With allowance recorded: Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Total Total impaired loans December 31, 2013 Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance $ $ $ $ 124 2,879 1,217 518 1,735 952 207 1,159 5,897 452 875 602 1,477 1,929 7,826 — (1,682) (190) (89) (279) (198) (35) (233) (2,194) (67) — — — (67) (2,261) 124 1,197 1,027 429 1,456 754 172 926 3,703 385 875 602 1,477 1,862 5,565 $ $ (1) Unpaid principal balance represents the contractual obligation due from the customer. (2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance. (3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses. 88 110 62 172 260 260 page 55 Audited Financial Statements (In thousands) With no allowance recorded: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total With allowance recorded: Construction and land development Commercial real estate: Owner occupied Total commercial real estate Total Total impaired loans December 31, 2012 Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance $ $ $ $ 169 2,879 787 7,914 8,701 971 508 1,479 13,228 471 899 899 1,370 — (1,682) (212) (1,862) (2,074) (152) (110) (262) (4,018) (45) — — (45) 169 1,197 575 6,052 6,627 819 398 1,217 9,210 426 899 899 1,325 14,598 (4,063) 10,535 129 134 134 263 263 $ $ (1) Unpaid principal balance represents the contractual obligation due from the customer. (2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance. (3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses. The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class. Year ended December 31, 2013 Year ended December 31, 2012 Year ended December 31, 2011 Average Total interest Average Total interest Average Total interest recorded income recorded income recorded income investment recognized investment recognized investment recognized $ 188 9 $ 194 13 $ 316 1,603 1,972 1,454 3,426 786 274 1,060 6,277 — 51 12 63 — — — 72 $ 3,888 2,449 2,621 5,070 861 652 1,513 10,665 — 4,136 64 — 64 — — — $ 77 1,828 2,374 4,202 1,376 146 1,522 10,176 9 — 24 — 24 — — — 33 (In thousands) Impaired loans: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total $ page 56 Troubled Debt Restructurings Impaired loans also include troubled debt restructuring (“TDRs”). In the normal course of business, management may grant concessions to borrowers who are experiencing financial difficulty. A concession may include, but is not limited to, delays in required payments of principal and interest for a specified period, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date or reduction of the face amount or maturity amount of the debt. A concession has been granted when, as a result of the restructuring, the Bank does not expect to collect all amounts due, including interest at the original stated rate. A concession may have also been granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. In determining whether a loan modification is a TDR, the Company considers the individual facts and circumstances surrounding each modification. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructuring. Similar to other impaired loans, TDRs are measured for impairment based on the present value of expected payments using the loan’s original effective interest rate as the discount rate, or the fair value of the collateral, less selling costs if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, impairment is recognized by establishing a valuation allowance as part of the allowance for loan losses or a charge-off to the allowance for loan losses. In periods subsequent to the modification, all TDRs are evaluated individually, including those that have payment defaults, for possible impairment. The following is a summary of accruing and nonaccrual TDRs and the related loan losses, by portfolio segment and class. (In thousands) December 31, 2013 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total December 31, 2012 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total TDRs Accruing Nonaccrual Total Related Allowance $ $ $ $ 124 — 875 602 1,477 — — — 1,601 169 — 899 — 899 — — — 1,068 — 1,582 285 429 714 754 172 926 3,222 — 1,623 1,045 432 1,477 819 188 1,007 4,107 124 1,582 1,160 1,031 2,191 754 172 926 4,823 169 1,623 1,944 432 2,376 819 188 1,007 5,175 $ $ $ $ — 88 110 62 172 — — — 260 — 129 134 — 134 — — — 263 At December 31, 2013, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured. page 57 Audited Financial Statements The following table summarizes loans modified in a TDR during the respective years both before and after modification. ($ in thousands) December 31, 2013 Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total December 31, 2012 Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Consumer mortgages Investment property Total residential real estate Total December 31, 2011 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Residential real estate: Investment property Total residential real estate Total Pre- Post- modification outstanding recorded investement modification outstanding recorded investement Number of contracts $ 390 387 1 1 2 3 3 1 4 8 4 4 2 6 2 2 4 14 2 3 5 1 6 1 1 12 $ $ $ $ 882 1,037 1,919 849 172 1,021 3,330 882 1,041 1,923 844 172 1,016 3,326 5,419 4,305 3,167 1,803 4,970 863 567 1,430 11,819 791 4,925 3,127 1,229 4,356 391 391 $ 10,463 2,225 1,657 3,882 858 563 1,421 9,608 523 4,894 2,840 1,229 4,069 391 391 9,877 The majority of the loans modified in a TDR during the years ended December 31, 2013, 2012, and 2011, respectively, included delays in required payments of principal and/or interest or where the only concession granted by the Company was that the interest rate at renewal was not considered to be a market rate. For the year ended December 31, 2012, decreases in the post modification outstanding recorded investment were primarily due to principal payments made by borrowers at the date of modification for construction and land development loans and A/B note restructurings for two owner occupied commercial real estate loans. In certain circumstances, the Company may require the borrower to reduce the principal balance in order to grant an extension or renewal of the loan. Total charge-offs related to B notes were $0.9 million for the year ended December 31, 2012. For the year ended December 31, 2011, decreases in the post modification outstanding recorded investment were primarily due to two A/B note restructurings, where the B note was charged off. Total charge-offs related to B notes during the year ended December 31, 2011 were approximately $0.6 million. page 58 The following table summarizes the recorded investment in loans modified in a TDR within the previous twelve months for which there was a payment default (defined as 90 days or more past due) during the respective years. ($ in thousands) December 31, 2013 Construction and land development Commercial real estate: Other Total commercial real estate Total December 31, 2012 Construction and land development Total December 31, 2011 Commercial real estate: Owner occupied Other Total commercial real estate Total (1) Amount as of applicable month end during the respective year for which there was a payment default. NOTE 7: PREMISES AND EQUIPMENT Premises and equipment at December 31, 2013 and 2012 is presented below. (Dollars in thousands) Land Buildings and improvements Furniture, fixtures, and equipment Total premises and equipment Less: accumulated depreciation Premises and equipment, net Number of Contracts Recorded investment (1) 1 1 1 2 1 1 2 1 3 3 $ $ $ $ $ $ 1,197 425 425 1,622 2,386 2,386 1,172 1,201 2,373 2,373 2013 5,288 8,539 3,164 16,991 (6,549) 10,442 $ $ December 31 2012 4,983 9,110 3,132 17,225 (6,697) 10,528 Depreciation expense was approximately $418 thousand, $366 thousand, and $328 thousand for the years ended December 31, 2013, 2012 and 2011, respectively, and is a component of net occupancy and equipment expense in the consolidated statements of earnings. NOTE 8: MORTGAGE SERVICING RIGHTS, NET Mortgage servicing rights (“MSRs”) are recognized based on the fair value of the servicing rights on the date the corresponding mortgage loans are sold. An estimate of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income. Servicing fee income is recorded net of related amortization expense and recognized in earnings as part of mortgage lending income. The Company has recorded MSRs related to loans sold without recourse to Fannie Mae. The Company generally sells conforming, fixed-rate, closed-end, residential mortgages to Fannie Mae. MSRs are included in other assets on the accompanying consolidated balance sheets. The Company periodically evaluates MSRs for impairment. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established. The valuation allowance is adjusted page 59 Audited Financial Statements as the fair value changes. Changes in the valuation allowance are recognized in earnings as a component of mortgage lending income. The following table details the changes in amortized MSRs and the related valuation allowance for the years ended December 31, 2013, 2012, and 2011. (Dollars in thousands) Beginning balance Additions, net Amortization expense Change in valuation allowance Ending balance Valuation allowance included in MSRs, net: Beginning of period End of period Fair value of amortized MSRs: Beginning of period End of period Year ended December 31 $ $ $ $ 2013 1,526 822 (384) 386 2,350 386 — 1,526 3,452 2012 1,245 966 (416) (269) 1,526 117 386 1,245 1,526 2011 1,189 415 (242) (117) 1,245 — 117 1,335 1,245 Data and assumptions used in the fair value calculation related to MSRs at December 31, 2013 and 2012, respectively, are presented below. (Dollars in thousands) Unpaid principal balance Weighted average prepayment speed (CPR) Discount rate (annual percentage) Weighted average coupon interest rate Weighted average remaining maturity (months) Weighted average servicing fee (basis points) $ 2013 356,334 7.5 % 10.0 % 3.9 % 268 25.0 December 31 2012 283,306 23.7 11.0 3.9 275 25.0 At December 31, 2013, the weighted average amortization period for MSRs was 7.5 years. Estimated amortization expense for each of the next five years is presented below. (Dollars in thousands) 2014 2015 2016 2017 2018 NOTE 9: DEPOSITS $ December 31, 2013 313 272 242 209 183 At December 31, 2013, the scheduled maturities of certificates of deposit and other time deposits are presented below. (Dollars in thousands) 2014 2015 2016 2017 2018 Thereafter Total certificates of deposit and other time deposits page 60 $ December 31, 2013 128,615 58,045 17,739 25,985 20,384 10,431 261,199 $ Additionally, at December 31, 2013 and 2012, approximately $156.2 and $156.8 million, respectively, of certificates of deposit and other time deposits were issued in denominations of $100,000 or greater. At December 31, 2013 and 2012, the amount of deposit accounts in overdraft status that were reclassified to loans on the accompanying consolidated balance sheets was not material. NOTE 10: SHORT-TERM BORROWINGS At December 31, 2013, 2012, and 2011, the composition of short-term borrowings is presented below. (Dollars in thousands) Federal funds purchased: 2013 2012 Weighted Weighted 2011 Weighted Amount Avg. Rate Amount Avg. Rate Amount Avg. Rate $ As of December 31 Average during the year Maximum outstanding at any month-end Securities sold under agreements to repurchase: $ As of December 31 Average during the year Maximum outstanding at any month-end — 43 2,376 3,363 2,774 3,363 — 0.92 % 0.50 % 0.50 % $ $ — 225 1,925 2,689 2,746 3,174 — 0.96 % $ 0.50 % 0.50 % $ — 6 — 2,805 2,416 2,936 — 1.00 % 0.50 % 0.50 % Federal funds purchased represent unsecured overnight borrowings from other financial institutions by the Bank. The Bank had available federal fund lines totaling $41.0 million with none outstanding at December 31, 2013. Securities sold under agreements to repurchase represent short-term borrowings with maturities less than one year collateralized by a portion of the Company’s securities portfolio. Securities with an aggregate carrying value of $6.9 million and $8.0 million at December 31, 2013 and 2012, respectively, were pledged to secure securities sold under agreements to repurchase. NOTE 11: LONG-TERM DEBT At December 31, 2013 and 2012, the composition of long-term debt is presented below. (Dollars in thousands) FHLB advances, due 2014 to 2018 Securities sold under agreements to repurchase, due 2017 Subordinated debentures, due 2033 Total long-term debt 2013 2012 Amount 5,000 — 7,217 Weighted Avg. Rate $ 3.59% — 3.38 Amount 25,000 15,000 7,217 12,217 3.47% $ 47,217 $ $ Weighted Avg. Rate 3.42% 4.21 3.38 3.66% The Bank had $5.0 million and $25.0 million of FHLB advances with original maturities greater than one year at December 31, 2013 and 2012, respectively. Securities with an aggregate carrying value of $1.0 million and $1.5 million and certain qualifying residential mortgage loans with an aggregate carrying value of $42.1 million and $45.5 million at December 31, 2013 and 2012, respectively, were pledged to secure long-term FHLB advances. The Bank had no securities sold under agreements to repurchase with an original maturity greater than one year at December 31, 2013 and $15.0 million in securities sold under agreements to repurchase with an original maturity greater than one year at December 31, 2012. Securities with an aggregate carrying value of $19.0 million at December 31, 2012 were pledged to secure long-term securities sold under agreements to repurchase. page 61 Audited Financial Statements The Company formed Auburn National Bancorporation Capital Trust I, a wholly-owned statutory business trust, in 2003. The Trust issued $7.0 million of trust preferred securities that were sold to third parties. The proceeds from the sale of the trust preferred securities and trust common securities that we hold, were used to purchase subordinated debentures of $7.2 million from the Company, which are presented as long-term debt in the consolidated balance sheets and qualify for inclusion in Tier 1 capital for regulatory capital purposes, subject to certain limitations. The debentures mature on December 31, 2033 and have been redeemable since December 31, 2008. The following is a schedule of contractual maturities of long-term debt: (Dollars in thousands) FHLB advances Subordinated debentures Total long-term debt $ $ 2014 — — — 2015 — — — 2016 — — — 2017 — — — 2018 Thereafter 5,000 — 5,000 — 7,217 7,217 Total 5,000 7,217 12,217 NOTE 12: OTHER COMPREHENSIVE INCOME (LOSS) Comprehensive income is defined as the change in equity from all transactions other than those with stockholders, and it includes net earnings and other comprehensive income (loss). Other comprehensive income (loss) for the years ended December 31, 2013, 2012, and 2011, is presented below. (In thousands) Pre-tax amount Tax benefit Net of (expense) tax amount 2013: Unrealized net holding loss on all other securities Reclassification adjustment for net gain on securities recognized in net earnings $ Other comprehensive loss $ 2012: Unrealized net holding gain on all other securities Reclassification adjustment for net gain on securities recognized in net earnings $ Other comprehensive income 2011: Unrealized net holding loss on other-than-temporarily impaired securities due to factors other than credit $ $ Unrealized net holding gain on all other securities Reclassification adjustment for net gain on securities recognized in net earnings Other comprehensive income $ (14,761) (651) (15,412) 2,188 (679) 1,509 (130) 11,187 (878) 10,179 5,446 240 5,686 (809) 252 (557) 48 (4,128) 324 (3,756) (9,315) (411) (9,726) 1,379 (427) 952 (82) 7,059 (554) 6,423 page 62 NOTE 13: INCOME TAXES For the years ended December 31, 2013, 2012, and 2011 the components of income tax expense from continuing operations are presented below. Year ended December 31 (Dollars in thousands) Current income tax expense: Federal State Total current income tax expense Deferred income tax expense (benefit): Federal State Total deferred income tax expense (benefit) 2013 2012 $ 594 159 753 1,330 207 1,537 737 58 795 472 152 624 Total income tax expense $ 2,290 1,419 2011 72 353 425 (344) (24) (368) 57 Total income tax expense differs from the amounts computed by applying the statutory federal income tax rate of 34% to earnings before income taxes. A reconciliation of the differences for the years ended December 31, 2013, 2012, and 2011, is presented below. (Dollars in thousands) Earnings before income taxes Amount $ 9,408 Percent of pre-tax earnings Percent of pre-tax earnings Amount 8,182 Percent of pre-tax earnings Amount 5,595 2013 2012 2011 Income taxes at statutory rate Tax-exempt interest State income taxes, net of federal tax effect Low-income housing credit Bank owned life insurance Change in valuation allowance Other 3,199 (884) 242 — (145) — (122) 34.0 % (9.4) 2.6 — (1.5) — (1.3) Total income tax expense $ 2,290 24.4 % 2,782 (997) 179 — (151) (505) 111 1,419 34.0 % (12.2) 1,902 (1028) 34.0 % (18.4) 2.2 — (1.8) (6.2) 1.4 17.4 % 183 (891) (157) — 48 57 3.3 (15.9) (2.8) — 0.9 1.1 % page 63 Audited Financial Statements The Company had net deferred tax assets of $5.4 million and $1.2 million at December 31, 2013 and 2012, respectively, included in other assets on the consolidated balance sheets. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2013 and 2012 are presented below: (Dollars in thousands) Deferred tax assets: Allowance for loan losses Other-than-temporary impairment on securities Unrealized loss on securities Write-downs on other real estate owned Tax credit carry-forwards Other Total deferred tax assets Deferred tax liabilities: Premises and equipment Unrealized gain on securities Originated mortgage servicing rights Other Total deferred tax liabilities Net deferred tax asset December 31 2013 2012 $ 1,944 — 2,661 282 1,137 531 6,555 90 — 867 205 1,162 $ 5,393 2,480 464 — 489 932 670 5,035 11 3,025 563 192 3,791 1,244 A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more- likely-than-not that some portion of the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projection for future taxable income over the periods which the temporary differences resulting in the remaining deferred tax assets are deductible, management believes it is more-likely-than-not that the Company will realize the benefits of these deductible differences at December 31, 2013. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income are reduced. The change in the net deferred tax asset for the years ended December 31, 2013, 2012, and 2011, is presented below. (Dollars in thousands) Net deferred tax asset: Balance, beginning of year Deferred tax (expense) benefit related to continuing operations Stockholders' equity, for accumulated other comprehensive loss (income) Balance, end of year Year ended December 31 2013 2012 2011 $ $ 1,244 (1,537) 5,686 5,393 2,425 (624) (557) 1,244 5,813 368 (3,756) 2,425 ASC 740 defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. This section also provides guidance on the de-recognition, measurement, and classification of income tax uncertainties in interim periods. As of December 31, 2013, the Company had no unrecognized tax benefits related to federal or state income tax matters. The Company does not anticipate any material increase or decrease in unrecognized tax benefits during 2014 relative to any tax positions taken prior to December 31, 2013. As of December 31, 2013, the Company has accrued no interest and no penalties related to uncertain tax positions. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. The Company and its subsidiaries file consolidated U.S. federal and State of Alabama income tax returns. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service and the State of Alabama for the years ended December 31, 2010 through 2013. page 64 NOTE 14: EMPLOYEE BENEFIT PLAN The Company has a 401(k) Plan that covers substantially all employees. Participants may contribute up to 10% of eligible compensation subject to certain limits based on federal tax laws. The Company’s matching contributions to the Plan are determined by the board of directors. Participants become 20% vested in their accounts after two years of service and 100% vested after six years of service. Company matching contributions to the Plan were $115 thousand, $115 thousand, and $110 thousand for the years ended December 31, 2013, 2012, and 2011, respectively, and are included in salaries and benefits expense. NOTE 15: DERIVATIVE INSTRUMENTS Financial derivatives are reported at fair value in other assets or other liabilities on the accompanying Consolidated Balance Sheets. The accounting for changes in the fair value of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship. For derivatives not designated as part of a hedging relationship, the gain or loss is recognized in current earnings within other noninterest income on the accompanying Consolidated Statements of Earnings. From time to time, the Company may enter into interest rate swaps (“swaps”) to facilitate customer transactions and meet their financing needs. Upon entering into these swaps, the Company enters into offsetting positions in order to minimize the risk to the Company. These swaps qualify as derivatives, but are not designated as hedging instruments. At December 31, 2013 and December 31, 2012, the Company had no derivative contracts to assist in managing its own interest rate sensitivity. Interest rate swap agreements involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument contract is negative, the Company owes the customer or counterparty and therefore, has no credit risk. A summary of the Company’s interest rate swaps as of and for the years ended December 31, 2013 and 2012 is presented below. (Dollars in thousands) December 31, 2013: Pay fixed / receive variable Pay variable / receive fixed Total interest rate swap agreements December 31, 2012: Pay fixed / receive variable Pay variable / receive fixed Total interest rate swap agreements Other Assets Estimated Fair Value Other Liabilities Estimated Fair Value Other noninterest income Gains (Losses) — 844 844 — 1,210 1,210 844 — 844 1,210 — 1,210 $ $ $ $ 366 (366) — 115 (115) — Notional 5,017 5,017 10,034 5,367 5,367 10,734 $ $ $ $ page 65 Audited Financial Statements NOTE 16: COMMITMENTS AND CONTINGENT LIABILITIES Credit-Related Financial Instruments The Company is party to credit related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments. At December 31, 2013 and 2012, the following financial instruments were outstanding whose contract amount represents credit risk: (Dollars in thousands) Commitments to extend credit Standby letters of credit December 31 2013 38,870 8,562 $ 2012 48,525 7,093 $ Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various assets as collateral, including accounts receivable, inventory, equipment, marketable securities, and property to support those commitments for which collateral is deemed necessary. The Company has recorded a liability for the estimated fair value of these standby letters of credit in the amount of $78 thousand and $74 thousand at December 31, 2013 and 2012, respectively. Other Commitments Minimum lease payments under leases classified as operating leases due in each of the five years subsequent to December 31, 2013, are as follows: 2014, $287 thousand; 2015, $174 thousand; 2016, $111 thousand; 2017, $45 thousand; 2018, none. Contingent Liabilities The Company and the Bank are involved in various legal proceedings, arising in connection with their business. In the opinion of management, based upon consultation with legal counsel, the ultimate resolution of these proceeding will not have a material adverse affect upon the consolidated financial condition or results of operations of the Company and the Bank. page 66 NOTE 17: FAIR VALUE Fair Value Hierarchy “Fair value” is defined by ASC 820, Fair Value Measurements and Disclosures, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for an asset or liability at the measurement date. GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: Level 1—inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets. Level 2—inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable for the asset or liability, either directly or indirectly. Level 3—inputs to the valuation methodology are unobservable and reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset or liability. Level changes in fair value measurements Transfers between levels of the fair value hierarchy are generally recognized at the end of the reporting period. The Company monitors the valuation techniques utilized for each category of financial assets and liabilities to ascertain when transfers between levels have been affected. The nature of the Company’s financial assets and liabilities generally is such that transfers in and out of any level are expected to be infrequent. For the years ended December 31, 2013, 2012, and 2011, there were no transfers between levels and no changes in valuation techniques for the Company’s financial assets and liabilities. Assets and liabilities measured at fair value on a recurring basis Securities available-for-sale Fair values of securities available for sale were primarily measured using Level 2 inputs. For these securities, the Company obtains pricing from third party pricing services. These third party pricing services consider observable data that may include broker/dealer quotes, market spreads, cash flows, market consensus prepayment speeds, benchmark yields, reported trades for similar securities, market consensus prepayment speeds, credit information and the securities’ terms and conditions. On a quarterly basis, management reviews the pricing received from the third party pricing services for reasonableness given current market conditions. As part of its review, management may obtain non-binding third party broker quotes to validate the fair value measurements. In addition, management will periodically submit pricing provided by the third party pricing services to another independent valuation firm on a sample basis. This independent valuation firm will compare the price provided by the third party pricing service with its own price and will review the significant assumptions and valuation methodologies used with management. Interest rate swap agreements The carrying amount of interest rate swap agreements was included in other assets and accrued expenses and other liabilities on the accompanying consolidated balance sheets. The fair value measurements for our interest rate swap agreements were based on information obtained from a third party bank. This information is periodically tested by the Company and validated against other third party valuations. If needed, other third party market participants may be utilized to corroborate the fair value measurements for our interest rate swap agreements. The Company classified these derivative assets and liabilities within Level 2 of the valuation hierarchy. These swaps qualify as derivatives, but are not designated as hedging instruments. page 67 Audited Financial Statements The following table presents the balances of the assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 and 2012, respectively, by caption, on the accompanying consolidated balance sheets by ASC 820 valuation hierarchy (as described above). (Dollars in thousands) December 31, 2013: Securities available-for-sale: Agency obligations Agency RMBS State and political subdivisions Total securities available-for-sale Other assets (1) Total assets at fair value Other liabilities(1) Total liabilities at fair value December 31, 2012: Securities available-for-sale: Agency obligations Agency RMBS State and political subdivisions Trust preferred securities Total securities available-for-sale Other assets (1) Total assets at fair value Other liabilities(1) Total liabilities at fair value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Amount $ $ $ $ $ $ 44,522 162,358 64,339 271,219 844 272,063 844 844 39,525 141,460 77,838 652 259,475 1,210 260,685 1,210 1,210 — — — — — — — — — — — — — — — — — 44,522 162,358 64,339 271,219 844 272,063 844 844 39,525 141,460 77,838 — 258,823 1,210 260,033 1,210 1,210 — — — — — — — — — — — 652 652 — 652 — — (1)Represents the fair value of interest rate swap agreements. Assets and liabilities measured at fair value on a nonrecurring basis Loans held for sale Loans held for sale are carried at the lower of cost or fair value. Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Loans held for sale are classified within Level 2 of the fair value hierarchy. Impaired Loans Loans considered impaired under ASC 310-10-35, Receivables, are loans for which, based on current information and events, it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent. The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs page 68 for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above. Other real estate owned Other real estate owned, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less costs to sell upon transfer of the loans to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, a loss is recognized in noninterest expense. Mortgage servicing rights, net Mortgage servicing rights, net, included in other assets on the accompanying consolidated balance sheets, are carried at the lower of cost or estimated fair value. MSRs do not trade in an active market with readily observable prices. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Periodically, the Company will review broker surveys and other market research to validate significant assumptions used in the model. The significant unobservable inputs include prepayment speeds or the constant prepayment rate (“CPR”) and the weighted average discount rate. Because the valuation of MSRs requires the use of significant unobservable inputs, all of the Company’s MSRs are classified within Level 3 of the valuation hierarchy. The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2013 and 2012, respectively, by caption, on the accompanying consolidated balance sheets and by ASC 820 valuation hierarchy (as described above): (Dollars in thousands) December 31, 2013: Loans held for sale Loans, net(1) Other real estate owned Other assets (2) Total assets at fair value December 31, 2012: Loans held for sale Loans, net(1) Other real estate owned Other assets (2) Total assets at fair value Quoted Prices in Active Markets Other Significant for Observable Unobservable Identical Assets Amount (Level 1) Inputs (Level 2) Inputs (Level 3) $ $ $ $ 2,296 5,305 3,884 2,350 13,835 2,887 10,272 4,919 1,526 19,604 — — — — — — — — — — 2,296 — — — 2,296 2,887 — — — 2,887 — 5,305 3,884 2,350 11,539 — 10,272 4,919 1,526 16,717 (1)Loans considered impaired under ASC 310-10-35 Receivables. This amount reflects the recorded investment in impaired loans, net of any related allowance for loan losses. (2)Represents MSRs, net, carried at lower of cost or estimated fair value. page 69 Audited Financial Statements Quantitative Disclosures for Level 3 Fair Value Measurements The following is a reconciliation of the beginning and ending balances of recurring fair value measurements for trust preferred securities, included within available-for-sale securities, and recognized in the accompanying consolidated balance sheets using Level 3 inputs: (Dollars in thousands) Beginning balance Total realized and unrealized gains and (losses): Included in net earnings Included in other comprehensive income Sales Settlements Ending balance Year ended December 31 $ 2013 652 $ 2012 1,986 $ (87) 41 (606) — — $ (6) 146 (974) (500) 652 $ $ 2011 2,149 (338) 175 — — 1,986 The Company had no Level 3 assets measured at fair value on a recurring basis at December 31, 2013. For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2013, the significant unobservable inputs used in the fair value measurements are presented below. Carrying Amount Valuation Technique Significant Unobservable Input of Input Weighted Average (Dollars in thousands) Nonrecurring: Impaired loans $ 5,305 Appraisal Appraisal discounts (%) Other real estate owned 3,884 Appraisal Appraisal discounts (%) Mortgage servicing rights, net 2,350 Discounted cash flow Prepayment speed or CPR (%) Discount rate (%) Fair Value of Financial Instruments 17.6% 14.0% 7.5% 10.0% ASC 825, Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow analyses. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather are a good–faith estimate of the fair value of financial instruments held by the Company. ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: Loans, net Fair values for loans were calculated using discounted cash flows. The discount rates reflected current rates at which similar loans would be made for the same remaining maturities. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820 and generally produces a higher value than an exit-price approach. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments. Loans held for sale Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Time Deposits Fair values for time deposits were estimated using discounted cash flows. The discount rates were based on rates currently offered for deposits with similar remaining maturities. page 70 Long-term debt The fair value of the Company’s fixed rate long-term debt is estimated using discounted cash flows based on estimated current market rates for similar types of borrowing arrangements. The carrying amount of the Company’s variable rate long-term debt approximates its fair value. The carrying value, related estimated fair value, and placement in the fair value hierarchy of the Company’s financial instruments at December 31, 2013 and 2012 are presented below. This table excludes financial instruments for which the carrying amount approximates fair value. Financial assets for which fair value approximates carrying value included cash and cash equivalents. Financial liabilities for which fair value approximates carrying value included noninterest-bearing demand, interest-bearing demand, and savings deposits due to these products having no stated maturity. In addition, financial liabilities for which fair value approximates carrying value included overnight borrowings such as federal funds purchased and securities sold under agreements to repurchase. (Dollars in thousands) December 31, 2013: Financial Assets: Loans, net (1) Loans held for sale Financial Liabilities: Time Deposits Long-term debt December 31, 2012: Financial Assets: Loans, net (1) Loans held for sale Financial Liabilities: Time Deposits Long-term debt Carrying amount Estimated fair value Level 1 inputs Level 2 inputs Level 3 Inputs Fair Value Hierarchy $ 378,071 $ 2,296 387,180 2,310 $ $ 261,199 $ 263,985 $ 12,217 12,569 $ 391,470 2,887 $ 399,533 2,952 $ $ 263,195 $ 267,636 $ 47,217 51,752 $ $ $ $ — — — — — — — — $ — 2,310 387,180 — 263,985 $ 12,569 — — $ — 2,952 399,533 — 267,636 $ 51,752 — — (1) Represents loans, net of unearned income and the allowance for loan losses. page 71 Audited Financial Statements NOTE 18: RELATED PARTY TRANSACTIONS A director of the Company is an officer in a construction company that the Company contracted with during 2012 and 2011 for the construction of a new branch facility in Valley, Alabama and the construction of a new drive-through banking facility and completion of other site work on the Bank’s main office campus in Auburn, Alabama. Total payments made to the construction company under the terms of the construction contracts were $0.4 million, $1.2 million and $0.8 million for the years ended December 31, 2013, 2012, and 2011, respectively. Another executive officer and director of the Company is the owner of a heating and air conditioning company that the Company contracted with during 2011 for the replacement and improvement of the heating and cooling systems in the Bank’s 23,000 square foot operations center. Total payments made to the heating and air conditioning company under the terms of the contract were $82 thousand and $200 thousand for the years ended December 31, 2012 and 2011, respectively. The Bank has made, and expects in the future to continue to make in the ordinary course of business, loans to directors and executive officers of the Company, the Bank, and their affiliates. In management’s opinion, these loans were made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements, and do not represent more than normal credit risk. An analysis of such outstanding loans is presented below. (Dollars in thousands) Loans outstanding at December 31, 2012 New loans/advances Repayments Loans outstanding at December 31, 2013 Amount 5,405 3,327 (4,471) 4,261 $ $ During 2013 and 2012, certain executive officers and directors of the Company and the Bank, including companies with which they are affiliated, were deposit customers of the bank. Total deposits for these persons at December 31, 2013 and 2012 amounted to $20.3 million and $19.1 million, respectively. NOTE 19: REGULATORY RESTRICTIONS AND CAPITAL RATIOS The Company and the Bank are subject to various regulatory capital requirements and policies administered by federal and State of Alabama banking regulators. Failure to meet minimum capital requirements can initiate certain mandatory – and possibly additional discretionary – actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and Bank’s assets, liabilities, and certain off–balance sheet items as calculated under regulatory accounting practices. The Company’s and Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors, including anticipated capital needs. Supervisory assessments of capital adequacy may differ significantly from conclusions based solely upon risk-based capital ratios. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) Tier 1 leverage capital ratio, Tier 1 risk-based ratio and total risk-based ratio. Management believes, as of December 31, 2013, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2013, the Bank is “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum total risk–based, Tier I risk–based, and Tier I leverage ratios as set forth in the table. Management has not received any notification from the Company’s or the Bank's regulators that changes the Bank’s regulatory capital status. page 72 The actual capital amounts and ratios and the aforementioned minimums as of December 31, 2013 and 2012 are presented below. (Dollars in thousands) At December 31, 2013: Tier 1 Leverage Capital Auburn National Bancorporation $ AuburnBank Tier 1 Risk-Based Capital Auburn National Bancorporation $ AuburnBank Total Risk-Based Capital Auburn National Bancorporation $ AuburnBank At December 31, 2012: Tier 1 Leverage Capital Auburn National Bancorporation $ AuburnBank Tier 1 Risk-Based Capital Auburn National Bancorporation $ AuburnBank Total Risk-Based Capital Auburn National Bancorporation $ AuburnBank Actual Minimum for capital adequacy purposes Minimum to be well capitalized Amount Ratio Amount Ratio Amount Ratio 76,037 74,716 10.10 % $ 9.94 30,119 30,069 4.00 % 4.00 $ N/A 37,587 76,037 74,716 17.19 % $ 16.84 17,696 17,742 4.00 % 4.00 $ N/A 26,614 N/A 5.00 % N/A 6.00 % 81,385 80,064 18.40 % $ 18.05 35,392 35,485 8.00 % 8.00 $ N/A 44,356 N/A 10.00 % 71,982 71,277 9.58 % $ 9.50 30,069 30,011 4.00 % 4.00 $ N/A 37,514 71,982 71,277 16.20 % $ 16.02 17,768 17,794 4.00 % 4.00 $ N/A 26,691 N/A 5.00 % N/A 6.00 % 77,558 76,853 17.46 % $ 17.28 35,536 35,588 8.00 % 8.00 $ N/A 44,485 N/A 10.00 % Dividends paid by the Bank are a principal source of funds available to the Company for payment of dividends to its stockholders and for other needs. Applicable federal and state statutes and regulations impose restrictions on the amounts of dividends that may be declared by the subsidiary bank. State law and Federal Reserve policy restrict the Bank from declaring dividends in excess of the sum of the current year’s earnings plus the retained net earnings from the preceding two years without prior approval. In addition to the formal statutes and regulations, regulatory authorities also consider the adequacy of the Bank’s total capital in relation to its assets, deposits, and other such items. Capital adequacy considerations could further limit the availability of dividends from the Bank. At December 31, 2013, the Bank could have declared additional dividends of approximately $9.8 million without prior approval of regulatory authorities. As a result of this limitation, approximately $60.4 million of the Company’s investment in the Bank was restricted from transfer in the form of dividends. page 73 Audited Financial Statements NOTE 20: AUBURN NATIONAL BANCORPORATION (PARENT COMPANY) The Parent Company’s condensed balance sheets and related condensed statements of earnings and cash flows are as follows: CONDENSED BALANCE SHEETS (Dollars in thousands) Assets: Cash and due from banks Investment in bank subsidiary Premises and equipment Other assets Total assets Liabilities: Accrued expenses and other liabilities Long-term debt Total liabilities Stockholders' equity Total liabilities and stockholders' equity CONDENSED STATEMENTS OF EARNINGS (Dollars in thousands) Income: Dividends from bank subsidiary Noninterest income Total income Expense: Interest expense Noninterest expense Total expense Earnings before income tax benefit and equity in undistributed earnings of bank subsidiary Income tax expense (benefit) Earnings before equity in undistributed earnings of bank subsidiary Equity in undistributed earnings of bank subsidiary Net earnings $ $ $ $ December 31 2013 2012 2,408 70,164 — 846 73,418 1,716 7,217 8,933 64,485 73,418 1,316 76,547 158 1,162 79,183 1,817 7,217 9,034 70,149 79,183 Year ended December 31 2013 2012 $ $ 3,304 1,284 4,588 236 302 538 4,050 275 3,775 3,343 7,118 3,231 288 3,519 236 318 554 2,965 (45) 3,010 3,753 6,763 2011 3,158 385 3,543 236 485 721 2,822 (31) 2,853 2,685 5,538 page 74 CONDENSED STATEMENTS OF CASH FLOWS (Dollars in thousands) Cash flows from operating activities: Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization Net gain on disposition of premises and equipment Net decrease in other assets Net decrease in other liabilities Equity in undistributed earnings of bank subsidiary Net cash provided by operating activities Cash flows from investing activities: Purchases of premises and equipment Proceeds from sale of premises and equipment to third party Proceeds from sale of premises and equipment to bank subsidiary Capital contribution to bank subsidiary Net cash provided by (used in) investing activities Cash flows from financing activities: Proceeds from sale of treasury stock Dividends paid Net cash used in financing activities Net change in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Year ended December 31 2013 2012 2011 $ 7,118 6,763 5,538 28 (1,018) 316 (101) (3,343) 3,000 — 1,148 — — 1,148 4 (3,060) (3,056) 1,092 1,316 2,408 29 — 16 (109) (3,753) 2,946 (17) — — — (17) 5 (2,987) (2,982) (53) 1,369 1,316 80 — 22 (727) (2,685) 2,228 — — 4,450 (3,200) 1,250 1 (2,914) (2,913) 565 804 1,369 $ page 75 This Page Intentionally Left Blank. page 76 Stock Performance Graph STOCK PERFORMANCE GRAPH The following performance graph compares the cumulative, total return on the Company’s Common Stock from December 31, 2008 to December 31, 2013, with that of the Nasdaq Composite Index and SNL Southeast Bank Index (assuming a $100 investment on December 31, 2008). Cumulative total return represents the change in stock price and the amount of dividends received over the indicated period, assuming the reinvestment of dividends. Total Return Performance Auburn National Bancorporation, Inc. NASDAQ Composite SNL Southeast Bank 300 250 200 150 100 50 e u l a V x e d n I 0 12/31/08 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13 Index Auburn National Bancorporation, Inc. NASDAQ Composite SNL Southeast Bank 12/31/08 100.00 100.00 100.00 Period Ending 12/31/09 12/31/10 12/31/11 12/31/12 120.53 200.63 94.75 101.30 145.36 100.41 107.43 171.74 97.49 103.28 170.38 57.04 12/31/13 149.88 281.22 128.40 page 77 CORPORATE INFORMATION Corporate Headquarters Investor Relations A copy of the Company’s annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC), as well as our other SEC filings and our latest press releas- es are available free of charge through a link on our internet website at www.auburnbank. com. Requests for these documents may also be made by emailing Investor Relations at investorrelations@auburnbank.com or by contacting Investor Relations by telephone or mail at the Company’s corporate headquarters. Common Stock Listing Auburn National Bancorporation, Inc. Common Stock is traded on the Nasdaq Global Market under the symbol AUBN. Dividend Reinvestment and Stock Purchase Plan Auburn National Bancorporation, Inc. offers a Dividend Reinvestment Plan (DRIP) for automatic reinvestment of dividends in the stock of the company. Participants in the DRIP may also purchase additional shares with optional cash payments. For additional information or for an authorization form, please contact Investor Relations. Direct Deposit of Dividends Dividends may be automatically deposited into a shareholder’s checking or savings account free of charge. For more information, contact Investor Relations. 100 N. Gay Street P.O. Box 3110 Auburn, AL 36831-3110 Phone: 334-821-9200 Fax: 334-887-2796 www.auburnbank.com Independent Auditors KPMG LLP Wells Fargo Tower Suite 1800 420 20th Street N. Birmingham, AL 35203 Shareholder Services Shareholders desiring to change the name, address or ownership of Auburn National Bancorporation, Inc. common stock or to report lost certificates should contact our Transfer Agent: Registrar and Transfer Company 10 Commerce Drive Cranford, NJ 07016-3572 Phone: 1-800-368-5948 Fax: 1-908-497-2318 e-mail: info@rtco.com For frequently asked questions, visit the Transfer Agent’s home page at www.rtco.com Annual Meeting Tuesday, May 13, 2014 3:00 p.m. (Central Time) AuburnBank Center 132 N. Gay Street Auburn, AL 36830 100 N. Gay Street, P.O. Box 3110, Auburn, AL 36831-3110 Telephone: 334-821-9200 Fax: 334-887-2796 www.auburnbank.com Member FDIC 

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