Auburn National Bancorporation, Inc.
Annual Report 2017

Plain-text annual report

Strength. Vision. Service. A T R I B U T E TO M R . E . L . S P E N C E R , J R . AUBURN NATIONAL BANCORPORATION, INC. 2017 ANNUAL REPORT Corporate Information CORPORATE HEADQUARTERS 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 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 releases 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 INDEPENDENT AUDITORS Relations at investorrelations@auburnbank.com or Elliott Davis Decosimo LLC/PLLC 200 East Broad Street Greenville, SC 29606 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: Computershare P. O. Box 505000 Louisville, KY 40233 Phone: 1-800-368-5948 For frequently asked questions, visit theTransfer Agent’s home page at: www.computershare.com ANNUAL MEETING Tuesday, May 8, 2018 3:00 p.m. (Central Time) AuburnBank Center 132 N. Gay Street Auburn, AL 36830 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 Telephone: 334-821-9200 Fax: 334-887-2796 Strength.Vision. Service. Auburn National Bancorporation, Inc. 2017 Annual Report To Our Shareholders and Friends I am pleased to report that 2017 was another productive year for our bank. Our earnings were strong and we ended the year with a record loan portfolio. As you know, I became Chairman Emeritus in October of 2017 and will continue to serve as a Director. It has been an honor and a privilege to have served as your Chairman, President and CEO for nearly 42 years working with a talented team of employees and directors who are here for our customers. Through the years AuburnBank has maintained our history of success and our reputation for taking care of our customers. We still do and the phrase “May I help you?” means something to us. 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 take care of your money and we take pride in giving back to our communities. Thank you for allowing us to help you as an owner and as a customer of our bank. I look forward to continuing my service as a Director with the same goals and vision for our bank — to serve you our customer and shareholder “Because We Care.” E.L. Spencer, Jr. Chairman Emeritus, Board of Directors AuburnBank and ANBC Corporate Profile 2017 was a successful year for AuburnBank. We finished the year with net income of $7,845,654. Net interest income increased by 7% and our net interest margin ended the year at 3.29%. Asset quality remains strong and our capital position is well above the minimum amounts required to be “well capitalized” under current regulatory standards. Dividends of $0.92 per share were paid to our shareholders in 2017. The annual cash dividend paid to shareholders has increased in 22 of the last 23 years. In October of 2017, our Chairman, leader and friend Mr. E. L. Spencer, Jr. decided to retire as Chairman and CEO of Auburn National Bancorporation, Inc. after 37 years of service in that position. He remains on the Board as Chairman Emeritus and continues to provide leadership and guidance for our Bank. In the feature article on the following pages there are a few highlights and achievements that are directly attributable to Mr. Spencer during his chairmanship. All that have had the pleasure of working with him during his tenure have truly been blessed. His legacy of hard work, integrity, and caring about each employee and customer are why AuburnBank continues to thrive in good economic times and difficult economic times. I believe the original founders of our Bank would be pleased with the growth and success of the first and only remaining bank chartered in Auburn. Mr. E. L. Spencer, Jr. has ensured the continued success of Bank of Auburn, Auburn National Bank and AuburnBank through his exceptional leadership and management skills. Thank you Mr. Spencer for your tireless efforts in making AuburnBank “One Great Bank” and for your many contributions that have enabled the communities we serve to grow and prosper. Robert W. Dumas President/CEO AuburnBank Strength. Vision. Service. A TRIBUTE TO MR. E. L. SPEN CER, JR. If you do what’s right for the community, it will always turn out good for the bank. —E.L. SPENCER, JR. Edward Lee Spencer Jr. measures the success of AuburnBank beyond numbers on a spreadsheet. As chairman of the board of directors and a board member for 42 years, Spencer would argue the com- pany’s continued commitment to customer service, teamwork and community involvement are better indicators of a company’s stature. It is a legacy that he built and one that continues to move the bank forward today. Elected to the chairman’s position in 1980, Spencer navigated the company through both good and challenging economic times, never losing sight of ser- vice. “If you do what’s right for the community, it will always turn out good for the bank,” Spencer was often quoted as saying. He crossed over from bank customer to director when he joined AuburnBank’s board of directors in 1975. During his tenure, Spencer steered the bank from $25 million in assets to almost $850 million in assets. “Mr. Spencer’s focus has always been on improving management and provid- ing quality service. Hiring good people brings good results,” says Bob Dumas, president and CEO of AuburnBank. “If we made mistakes, Mr. Spencer always encouraged us to learn from them and move on. I’ve never known a better leader, mentor and friend.” He has a very basic business plan. Try it and work smart. You can do it if you meet your obligations and take care of your customer. Born in Loachapoka, Ala., Spencer moved with his family to Auburn before the age of 3. His education included the Lee County school system and then Alabama Polytechnic Institute (now Auburn University). Spencer was the first Fulbright Scholarship recipient from API and attended Keele University in England where he also served his commission with the U.S. Air Force in the 406th Fighter Inceptor Wing. Spencer demonstrated his love of people and the betterment of community as he returned to work in the family business. He expanded E.L. Spencer Lumber Company into Spencer Heating and Air Conditioning, Lee Electrical Supply and Auburn Millwork in addition to other construction and real estate ventures. Spencer began his relationship with AuburnBank as a customer, borrowing money to build houses for low-income families. “I think it’s important to note, at the time, there wasn’t an avenue for home ownership for those in the lower-income brackets. Mr. Spencer recognized a need and not only built the houses, but also financed them. There was not one foreclosure which is significant about how those individuals felt about him and his willingness to give a hand to those in the community with housing needs,” says Dumas. When asked about meeting housing needs, Mr. Spencer stated, “As I looked at the market place, I did not see dollar signs. I saw opportunity, and I also realized that if you are going to do anything, you have to have great folks with you and you have to turn them loose and rely on their talent, loyalty and effort.” In addition to many business accolades, including decades of service on the East Alabama Medical Center board and mem- bership into the Alabama Business Hall of Fame, Spencer also received the 2016 Auburn University Lifetime Achievement Award. Always with humility, E. L. Spencer, Jr. credits any success to the qualities that his parents lovingly instilled in him – hard work, preparation, faith and a belief in helping your neighbor. “When I started out in business, I didn’t have much except the ability to shake someone’s hand and ask, ‘May I help you? How may I serve you?’ It’s about all I had to offer, but I think this same foundation is what sets AuburnBank apart from other financial institutions,” Spencer has said. “We still answer our phones.” When I started out in business, I didn’t have much except the ability to shake someone’s hand and ask, ‘May I help you? How may I serve you?’ —E.L. SPENCER, JR. Married to his high school sweetheart, the former Ruth Priester, the couple resides on the family farm where both sons, Spence and Steve, have built homes and raised their families. Daughter Sandra is retired from Alabama Cooperative Extension System and also resides in Auburn. “AuburnBank excels today because of the exceptional leadership Mr. Spencer has provided through the years. He has positioned the company as a leader through cutting-edge technology and products while maintaining the human touch. His passion for helping his fellow neighbor is prevalent in everything we do at AuburnBank,” says Dumas. E. L. Spencer, Jr., a builder, leader and visionary. He is synonymous with AuburnBank. A humble, successful businessman who credits his family as his greatest achievement. On behalf of the AuburnBank family (both current and former) employees, customers and shareholders, we sincerely thank you and look forward to continuing to build on your legacy, “May I help you?” AuburnBank A Legacy of Service and Growth Under E.L. Spencer’s Leadership Tiger Town Branch AuburnBank branched out again in 2017. In August, a new full-service branch opened in Opelika at Tiger Town featuring three drive- up windows, a drive-up ATM and hometown people you know and trust. It’s another exciting investment we’re proud to make in our community. Auburn National Bancorporation, Inc. and AuburnBank Board of Directors Seated left to right: Amy B. Murphy, E.L. Spencer, Jr., David E. Housel, Dr. Patricia Wade. Standing: William F. Ham, Jr., Anne M. May, Terry W. Andrus, Edward Lee Spencer, III, C. Wayne Alderman, J. Tutt Barrett, and Robert W. Dumas. Terry W. Andrus President, East Alabama Medical Center C. Wayne Alderman Secretary to ANBC Dean and Professor Emeritus, College of Business, Auburn University J. Tutt Barrett Attorney, Dean and Barrett Robert W. Dumas President & CEO, AuburnBank 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 Amy B. Murphy Director of Graduate Programs, Accounting, Auburn University E.L. Spencer, Jr. Chairman Emeritus, AuburnBank and ANBC, Business Owner Edward Lee Spencer, III Investor Dr. Patricia Wade Physician, Auburn Cardiovascular AuburnBank Officers E.L. Spencer, Jr. Chairman Emeritus Robert W. Dumas President & Chief Executive Officer Terrell E. Bishop Senior Vice President, City President, Valley Branch S. Mark Bridges Senior Vice President, Commercial/Consumer Loans James E. Dulaney Senior Vice President, Business Development/Marketing David Hedges Executive Vice President, Chief Financial Officer W. Thomas Johnson Senior Vice President, Senior Lender Marla Kickliter Senior Vice President, Compliance/Internal Auditor Mike King Senior Vice President, Mortgage Lending Division Shannon O’Donnell Senior Vice President, Credit Administration/Chief Risk Officer Jerry Siegel Senior Vice President, IT/IS Chief Technology Officer C. Eddie Smith Senior Vice President, City President, Opelika Branch Robert Smith Senior Vice President, Chief Lending Officer James Walker Senior Vice President, Chief Accounting Officer Bob R. Adkins Vice President, Commercial/Consumer Loans Patty Allen Vice President, Commercial/Consumer Loans Scottie Arnold Vice President, Administration Deposit Products/Services Kris Blackmon Vice President, Asset/Liability Manager Chief Investment Officer Laura Carrington Vice President, Human Resource Officer Kathy Crawford Vice President, Commercial/Consumer Loans Bruce Emfinger Vice President, Commercial/Consumer Loans Jeff Stanfield Vice President, Commercial/Consumer Loans James Salter Vice President, Commercial/Consumer Loans Christy A. Fogle Vice President, Credit Administration Pam Fuller Vice President, Operations Ginnie Y. Lunsford Vice President, Loan Operations Marcia Otwell Vice President, Administration/Shareholder Relations James R. Pack Vice President, Financial Reporting Cyndee Redmond Vice President, Treasury Management and Electronic Services David Warren Vice President, Commercial/Consumer Loans Karen Bence Assistant Vice President Security, BSA/OFAC Officer Hope Woods Assistant BSA Officer, Assistant Security Officer Suzanne Gibson Assistant Vice President, Portfolio Management Officer Woody Odom Assistant Vice President, IT/IS Joanna Watts IT/IS Officer Rhonda Sanders Deposit Operations, Customer Identification Program Officer Leigh Ann Thompson Branch Operations Administrative Officer Opelika Branch Advisory Board Seated left to right: Sherrie M. Stanyard, C. Eddie Smith, and William G. Dyas. Standing: R. Kraig Smith, M.D., Robert G. Young, William P. Johnston, and Doug M. Horn. Not pictured: William H. Brown. Valley Branch Advisory Board William H. Brown President, Brown Agency, Inc. William G. Dyas Realtor, First Realty Doug M. Horn Owner, Doug Horn Roofing & Contracting Co. William P. Johnston President, J & M Bookstore C. Eddie Smith Senior Vice President, City President, Opelika Branch 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, City President, Valley Branch H. David Ennis, Sr. President, Novelli-Ennis & Company, CPAs 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 Seated left to right: H. David Ennis, Sr., Terrell E. Bishop, and Roy W. McClendon, Jr. Standing: John H. Hood, II, Claud E. (Skip) McCoy, Jr., and Frank P. Norman. Auburn National Bancorporation, Inc. FINANCIAL HIGHLIGHTS (Dollars in thousands, except per share data) Corporate Information Earnings Net Interest Income Provision for Loan Losses Net Earnings Per Share: Net Earnings Cash Dividends Book Value Shares Issued For the Years Ended December 31, 2017 2016 2015 2014 2013 $24,526 $22,732 $22,718 $21,453 $20,922 <300> 7,846 2.15 0.92 23.85 <485> 8,150 2.24 0.90 22.55 200 7,858 2.16 0.88 21.94 50 7,448 2.04 0.86 20.80 400 7,118 1.95 0.84 17.70 3,957,135 3,957,135 3,957,135 3,957,135 3,957,135 Weighted Average Shares Outstanding 3,643,616 3,643,523 3,643,478 3,643,328 3,643,003 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 853,381 453,651 257,697 757,659 3,217 86,906 0.94% 9.17% Average Stockholders’ Equity to Average Assets 10.30% Allowance for Loan Losses as a % of Loans Loans to Total Deposits 1.05% 59.88% 831,943 430,946 243,572 739,143 3,217 82,177 0.98% 9.65% 10.14% 1.08% 58.30% 817,189 426,410 241,687 723,627 7,217 79,949 0.98% 9.98% 9.79% 1.01% 789,231 402,954 267,603 693,390 12,217 75,799 0.97% 10.53% 9.17% 1.20% 751,343 383,339 271,219 668,844 12,217 64,485 0.94% 10.33% 9.07% 1.37% 58.93% 58.11% 57.31% Financial Section Auburn National Bancorporation, Inc. 2017 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 – INTERNAL CONTROL OVER FINANCIAL REPORTING REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM – FINANCIAL STATEMENTS 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 TABLE OF CONTENTS 3 4 – 22 23 – 31 32 33 – 34 35 36 37 38 39 40 41 – 73 75 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; (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, including the disruption effects of financial technology and other competitors who are not subject to the same regulations as the Company and the Bank; (x) the failure of assumptions and estimates underlying the establishment of allowances for possible loan losses and other asset impairments, losses valuations of assets and liabilities 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) cyber-attacks and data breaches that may compromise our systems or customers’ information; (xv) 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 tests and other evaluations; (xvi) the risks that our deferred tax assets (“DTAs”), if any, 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 (xvii) 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. PAGE 2 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 and regulations. The holding company structure also provides greater financial and operating flexibility than is presently permitted to the Bank. The Bank has operated continuously since 1907 and currently conducts its business primarily in East Alabama, including Lee County and surrounding areas. The Bank has been a member of the Federal Reserve System since April 1995. The Bank’s primary regulators are the Federal Reserve and the Alabama Superintendent of Banks (the “Alabama Superintendent”). The Bank has been a member of the Federal Home Loan Bank of Atlanta (the “FHLB”) since 1991. 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 Plus® network. The Bank offers online banking, bill payment and other electronic services through its Internet website, www.auburnbank.com. Our online banking services, bill payment and electronic services are subject to certain cybersecurity risks. See “Risk Factors – Our information systems may experience interruptions and security breaches. 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 “Lending Practices” 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. For example, 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 nearby Kia and Hyundai automotive 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 3 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, 2017 and 2016 and our results of operations for the years ended December 31, 2017 and 2016. 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, Notasulga and Valley, Alabama. The Bank also operates a commercial loan production office in 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 Basic and diluted net earnings per share (a) Tax-equivalent. See "Table 1 - Explanation of Non-GAAP Financial Measures". Financial Summary Year ended December 31 2017 25,731 1,205 24,526 3,441 27,967 (300) 16,784 3,637 7,846 2.15 $ $ $ 2016 24,008 1,276 22,732 3,383 26,115 (485) 15,348 3,102 8,150 2.24 $ $ $ The Company’s net earnings were $7.8 million, or $2.15 per share, for the full year 2017, compared to $8.2 million, or $2.24 per share, for the full year 2016. The decrease in the Company’s 2017 earnings was primarily due to a deferred tax asset remeasurement adjustment of $0.4 million as a result of a lowered enacted corporate tax rate. The Tax Cuts and Jobs Act, signed into law December 22, 2017, lowered the Company’s federal corporate tax rate from 34% to 21%, which will lower the Company’s provision for federal income taxes in future years. However, the Company was required to remeasure the value of its net deferred tax assets by $0.4 million as of December 31, 2017. Excluding the impact of the tax remeasurement adjustment, net earnings would have been $8.2 million, or $2.25 per share, for the full year 2017, compared to $8.2 million, or $2.24 per share for the full year 2016. Net interest income (tax-equivalent) was $25.7 million in 2017, compared to $24.0 million in 2016. This increase was primarily due to loan growth and an increase in interest income from securities available-for-sale as management reduced its investment in federal funds sold and interest-bearing bank deposits and increased its investment in securities as market yields improved. The Company also lowered its deposit costs and repurchased higher-cost wholesale funding sources. Average loans were $441.0 million in 2017, an increase of $10.2 million or 2%, from 2016. PAGE 4 The Company recorded a negative provision for loan losses of $0.3 million for 2017, compared to a negative provision of $0.5 million for 2016. Annualized net recoveries as a percent of average loans were 0.09% and 0.19% for 2017 and 2016, respectively. The Company recognized a recovery of $0.4 million from the payoff of two nonperforming commercial loans during 2017 and $1.2 million from the payoff of one nonperforming construction and land development loan during 2016. Noninterest income was $3.4 million in 2017 and 2016, respectively. A decrease in mortgage lending income of $0.2 million as mortgage loan production declined was offset by $0.2 million improvement in securities gains (losses), net. Noninterest expense was $16.8 million in 2017, compared to $15.3 million in 2016. The increase was primarily due to a gain on early extinguishment of debt of $0.8 million realized in 2016. The Company purchased $4.0 million of trust preferred securities related to its junior subordinated debentures with a floating rate of 3.63% in 2016. In addition, other real estate owned expense increased $0.4 million primarily due to realized holding gains on the sale of OREO in 2016 and salaries and benefits increased $0.2 million in 2017 due to routine annual increases. Income tax expense was $3.6 million in 2017 compared to $3.1 million in 2016. The Company’s effective income tax rate was 31.67% in 2017, compared to 27.57% in 2016. The increase in the effective tax rate was primarily attributable to a $0.4 million tax remeasurement adjustment discussed above. We continue to review the impact of the 2017 Tax Act to our operations, which may result in additional adjustments to future periods’ results of operations. Excluding the impact of the tax remeasurement adjustment, the Company’s effective tax rate would have been 28.46% during 2017 reflecting an increase in the level of earnings before taxes and a decrease in tax exempt earnings from the bank-owned life insurance. In 2017, the Company paid cash dividends of $3.4 million, or $0.92 per share. The Company remains “well capitalized” under current regulatory guidelines with a total risk-based capital ratio of 17.91%, a Tier 1 risk-based capital ratio of 16.98%, a Tier 1 leverage capital ratio of 10.95% and a Common Equity Tier 1 (“CET1”) capital ratio of 16.42% at December 31, 2017. 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. PAGE 5 MANAGEMENT’S DISCUSSION AND ANALYSIS 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, independent loan review process. 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, 2017 and 2016, 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. Beginning with the quarter ended December 31, 2016, the Company implemented certain refinements to its allowance for loan losses methodology in order to better capture the effects of the most recent economic cycle on the Company’s loan loss experience. First, the Company increased its look-back period for calculating average losses for all loan segments to 31 quarters. Prior to December 31, 2016, the Company calculated average losses for all loan segments using a rolling 20 quarter look-back period. For the year ended December 31, 2017, the Company increased its look-back period to 35 quarters to continue to include the losses incurred by the Company beginning with the first quarter 2009. The Company will likely continue to increase its look-back period to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. Second, the Company increased the range of basis point adjustments allowed for qualitative and environmental factors to approximately 200 basis points, an increase of 65 basis points, or 48%, compared to the 135 basis point range used prior to December 31, 2016. After performing sensitivity testing of its calculation of the allowance for loan losses, the Company determined that it should increase the range of basis points allowed for qualitative and environmental factors in order to provide sufficient latitude in determining estimated probable credit losses during periods of economic stress. Third, the Company reduced the percentage allocation for qualitative and environmental factors on a weighted average basis to 21% of total basis points allocable at December 31, 2016, compared to 25% of total basis points allocable at September 30, 2016. The Company believes a decrease in the percentage allocation of qualitative environmental factors on a weighted average basis was appropriate due to the extension of its look-back period described above. If the Company did not make the changes described above, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $0.9 million, or 0.21% of total loans, at December 31, 2016. Other than the changes discussed above, the Company has not made any material changes to its methodology 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. PAGE 6 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 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 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 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. PAGE 7 MANAGEMENT’S DISCUSSION AND ANALYSIS 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 we will realize the benefits of these deductible differences at December 31, 2017. The amount of the deferred tax assets considered realizable, however, could be reduced if estimates of future taxable income are reduced. The 2017 Tax Act reduced the federal corporate income tax rate to 21% compared to 35%. We believe this reduction in tax rate will benefit us in 2018 and later years. We continue reviewing the impact of the 2017 Tax Act to our operations, which may result in additional adjustments to future periods’ results of operations. 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 Total interest-bearing deposits Short-term borrowings Long-term debt Total interest-bearing liabilities $ 2017 Average Balance 442,101 197,108 69,881 266,989 32,342 41,317 782,749 Yield/ Rate 4.70% 2.15% 5.07% 2.91% 1.05% 1.04% 3.75% 125,935 230,121 198,457 554,513 3,476 3,217 561,206 25,731 0.20% 0.37% 1.18% 0.62% 0.52% 3.89% 0.64% 3.29% Year ended December 31 2016 Average Balance 432,180 166,870 68,507 235,377 49,446 70,064 787,067 121,723 232,601 212,662 566,986 2,973 6,474 576,433 24,008 Yield/ Rate 4.73% 1.97% 5.48% 2.99% 0.50% 0.51% 3.57% 0.27% 0.38% 1.23% 0.68% 0.50% 3.52% 0.71% 3.05% $ $ 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 Net interest income (tax-equivalent) was $25.7 million in 2017, compared to $24.0 million in 2016. This increase was primarily due to loan growth and an increase in interest income from securities available-for-sale as management reduced its investment in federal funds sold and interest bearing bank deposits and increased its investment securities as market yields improved. The Company also lowered its deposit costs and repurchased higher-cost wholesale funding sources. The tax-equivalent yield on total interest-earning assets increased by 18 basis points in 2017 from 2016 to 3.75%. Increases in yields on short-term assets, including federal funds sold and interest bearing bank deposits, due to recent increases in the Federal Reserve’s federal funds rate targets, were partially offset by declining loan yields resulting from pricing competition for quality loan opportunities in our markets and declining securities yields due to lower reinvestment rates for municipal bonds. PAGE 8 The cost of total interest-bearing liabilities decreased 7 basis points in 2017 from 2016 to 0.64%. The net decrease was largely a result of the continued shift in our funding mix, as we increased our lower-cost interest-bearing demand deposits (NOW accounts) and concurrently reduced our balances of higher-cost certificates of deposits and long-term debt. 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 reduced earning asset yields during this extended period of low interest rates, increased competition for quality loan opportunities, and possible increases in our costs of funds and our variable rate assets, if the Federal Reserve continues its gradual increase in interest rates. The Company anticipates that this challenging competitive environment will continue in 2018 and it is unclear what impact the reduction in corporate tax rates under the Tax Cuts and Jobs Act will have on the interest rates the Company is able to charge for loans or pay on deposits though it is believed it will increase competition. However, the Company believes our net interest income should increase in 2018 compared to 2017 primarily due to an increase in average earning asset volumes, primarily 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 Company recorded a negative provision for loan losses of $0.3 million and $0.5 million for the years ended December 31, 2017 and 2016, respectively. Net recoveries were $0.4 million, or 0.09% of average loans and $0.08 million, or 0.19% of average loans, for the years ended December 31, 2017 and 2016, respectively. The Company recognized a recovery of $0.4 million from the payoff of two nonperforming commercial loans during 2017 and $1.2 million from the payoff of one nonperforming construction and land development loan during 2016. 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 1.05% at December 31, 2017 from 1.08% at December 31, 2016. 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, 2017. 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. Noninterest Income (Dollars in thousands) Service charges on deposit accounts Mortgage lending Bank-owned life insurance Securities gains (losses), net Other Total noninterest income Year ended December 31 2017 746 777 442 51 1,425 3,441 $ $ 2016 773 947 456 (221) 1,428 3,383 $ $ 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 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. PAGE 9 MANAGEMENT’S DISCUSSION AND ANALYSIS The Company evaluates MSRs for impairment on a quarterly basis. 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 2017 and 2016. (Dollars in thousands) Origination income Servicing fees, net Decrease (increase) in MSR valuation allowance Total mortgage lending income Year ended December 31 2017 504 272 1 777 $ $ 2016 764 184 (1) 947 $ $ The decrease in mortgage lending income was primarily due to a decrease in the volume of mortgage loans originated and sold. Securities gains (losses), net consist of realized gains and losses on the sale of securities and other-than-temporary impairment charges. Net gains realized on the sale of securities were $51 thousand for 2017, compared to net losses realized on the sale of securities of $221 thousand for 2016. The Company did not incur any other-than-temporary impairment charges in 2017 and 2016. Noninterest Expense (Dollars in thousands) Salaries and benefits Net occupancy and equipment Professional fees FDIC and other regulatory assessments Other real estate owned, net Gain on early extinguishment of debt Other Total noninterest expense Year ended December 31 2017 10,011 1,471 966 346 5 — 3,985 16,784 $ $ 2016 9,826 1,474 825 406 (371) (790) 3,978 15,348 $ $ The increase in salaries and benefits expense reflects routine annual increases. The increase in professional fees expense was primarily due to increases in professional fees associated with our mortgage lending division. The decrease in FDIC and other regulatory assessments expense was primarily due to a decrease in the Bank’s initial assessment rate during the third quarter of 2016. In addition to changes in the FDIC assessment rate formula for banks with less than $10 billion in assets, the initial assessment rate for all banks decreased effective July 1, 2016 due to the Deposit Insurance Reserve Fund ratio exceeding 1.15% at June 30, 2016. The increase in other real estate owned expense was primarily due to gains realized from sale of OREO in 2016. During 2016 the Company recognized a $0.8 million gain on early extinguishment of debt when it purchased $4.0 million of the $7.0 million in outstanding trust preferred securities issued by Auburn National Bancorporation Capital Trust I. (the “Trust”) and deemed an equivalent amount of the related junior subordinated debentures issued by the Company as no longer outstanding. PAGE 10 Income Tax Expense Income tax expense was $3.6 million in 2017 compared to $3.1 million in 2016. The Company’s effective income tax rate was 31.67% in 2017, compared to 27.57% in 2016. The increase in the effective tax rate was primarily attributable to a $0.4 million tax remeasurement adjustment previously discussed. Excluding the impact of the tax remeasurement adjustment, the Company’s effective tax rate would have been 28.46% during 2017 reflecting an increase in the level of earnings before taxes and a decrease in tax exempt earnings from the bank-owned life insurance. BALANCE SHEET ANALYSIS Securities Securities available-for-sale were $257.7 million at December 31, 2017, an increase of $14.1 million, or 5%, compared to $243.6 million as of December 31, 2016. This increase reflects an increase in the amortized cost basis of securities available-for-sale of $13.7 million and an increase in the fair value of securities available-for-sale of $0.4 million. The increase in the amortized cost basis of securities available-for-sale was primarily due to management increasing the Company’s investment securities as market yields improved in early 2017. The average tax-equivalent yields earned on total securities were 2.91% in 2017 and 2.99% in 2016. The following table shows the carrying value and weighted average yield of securities available-for-sale as of December 31, 2017 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, 2017 — — — — — — — — 29,253 — 2,564 31,817 1.85% — 3.97% 2.02% 23,809 11,201 9,999 45,009 2.04% 2.45% 3.65% 2.50% — 121,871 59,000 180,871 — 2.37% 3.21% 2.64% 53,062 133,072 71,563 257,697 1.93% 2.38% 3.30% 2.54% 2017 59,086 39,607 239,033 106,863 9,588 454,177 (526) 2016 49,850 41,650 220,439 110,855 8,712 431,506 (560) 2015 52,479 43,694 203,853 116,673 10,220 426,919 (509) 2014 54,329 37,298 192,006 107,641 12,335 403,609 (655) December 31 2013 57,780 36,479 174,920 101,706 12,893 383,778 (439) Loans, net of unearned income $ 453,651 430,946 426,410 402,954 383,339 Total loans, net of unearned income, were $453.7 million at December 31, 2017, an increase of $22.7 million, or 5%, from $430.9 million at December 31, 2016. Four loan categories represented the majority of the loan portfolio at December 31, 2017: commercial real estate mortgage loans (53%), residential real estate mortgage loans (24%), commercial and industrial loans (13%) and construction and land development loans (9%). Approximately 18% of the Company’s commercial real estate loans were classified as owner-occupied at December 31, 2017. PAGE 11 MANAGEMENT’S DISCUSSION AND ANALYSIS Within its residential real estate mortgage portfolio, the Company had junior lien mortgages of approximately $12.6 million, or 3%, and $13.7 million, or 3%, of total loans, net of unearned income at December 31, 2017 and 2016, respectively. For residential real estate mortgage loans with a consumer purpose, approximately $2.1 million and $1.4 million required interest-only payments at December 31, 2017 and 2016, 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. The average yield earned on loans and loans held for sale was 4.70% in 2017 and 4.73% in 2016. 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 positions. 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 secured loan relationships in excess of approximately $18.8 million. Furthermore, we have an internal limit for aggregate credit exposure (loans outstanding plus unfunded commitments) to a single borrower of $16.9 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, 2017, the Bank had one loan relationship exceeding our internal limit. 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, 2017 (and related balances at December 31, 2016). (In thousands) Multi-family residential properties Lessors of 1-4 family residential properties Shopping centers Office buildings Hotel/motel Allowance for Loan Losses $ 2017 52,167 47,323 39,966 24,483 22,384 $ December 31 2016 46,998 45,291 40,925 22,366 19,080 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, 2017 and 2016, respectively, the allowance for loan losses was $4.8 million and $4.6 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 12 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, 2017 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 recoveries (charge-offs) Provision for loan losses Ending balance $ as a % of loans as a % of nonperforming loans Net (recoveries) charge-offs as a % of average loans 2017 2016 2015 2014 2013 Year ended December 31 $ 4,643 4,289 4,836 5,268 6,723 (449) — — (107) (40) (596) 461 347 — 115 87 1,010 414 (300) 4,757 1.05 % 160 % (97) — (194) (182) (67) (540) 29 1,212 — 127 11 1,379 839 (485) 4,643 1.08 196 (100) — (866) (89) (59) (1,114) 22 17 — 313 15 367 (747) 200 4,289 1.01 158 (46) (235) — (438) (89) (808) 71 8 119 112 16 326 (482) 50 4,836 1.20 433 (514) (39) (262) (808) (397) (2,020) 48 6 4 88 19 165 (1,855) 400 5,268 1.37 124 (0.09) % (0.19) 0.18 0.12 0.48 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 1.05% at December 31, 2017, compared to 1.08% at December 31, 2016. 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 recoveries were $0.4 million, or 0.09% of average loans, in 2017, compared to recoveries of $0.8 million, or 0.19%, in 2016. In 2017, the Company recognized a recovery of $0.4 million from the payoff of two nonperforming commercial loans. In 2016, the Company recognized a recovery of $1.2 million from the payoff of one nonperforming construction and land development loan. At December 31, 2017 and 2016, the Company’s recorded investment in loans considered impaired was $2.7 million and $2.1 million, respectively, with corresponding valuation allowances (included in the allowance for loan losses) of $42 thousand and $31 thousand at December 31, 2017 and 2016, respectively. 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 13 MANAGEMENT’S DISCUSSION AND ANALYSIS Nonperforming Assets At December 31, 2017 the Company had $3.0 million in nonperforming assets compared to $2.5 million at December 31, 2016. 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 other real estate owned as a % of total assets Nonperforming loans as a % of total loans Accruing loans 90 days or more past due 2017 2016 2015 2014 2013 December 31 $ $ $ 2,972 — 2,972 0.66 % 0.35 % 0.66 % — 2,370 152 2,522 0.59 0.30 0.55 — 2,714 252 2,966 0.70 0.36 0.64 — 1,117 534 1,651 0.41 0.21 0.28 — 4,261 3,884 8,145 2.10 1.08 1.11 73 The table below provides information concerning the composition of nonaccrual loans at December 31, 2017 and 2016, respectively. (In thousands) Nonaccrual loans: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total nonaccrual loans / nonperforming loans December 31 2017 2016 $ $ 31 — 2,188 739 14 2,972 37 32 2,027 252 22 2,370 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, 2017, the Company had $3.0 million in loans on nonaccrual, compared to $2.4 million at December 31, 2016. 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, 2017 and 2016, the Company had $0.5 and $0.2 million, respectively, in accruing TDRs. At December 31, 2017 and 2016, there were no loans 90 days past due and still accruing interest. The table below provides information concerning the composition of OREO at December 31, 2017 and 2016, respectively. (In thousands) Other real estate owned: Commercial: Developed lots Residential Total other real estate owned PAGE 14 December 31 2017 2016 $ $ — — — 37 115 152 At December 31, 2017, the Company held no OREO properties acquired from borrowers compared to $0.2 million at December 31, 2016. 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 $5.7 million, or 1.3% of total loans at December 31, 2017, compared to $5.8 million, or 1.4% of total loans at December 31, 2016. The table below provides information concerning the composition of potential problem loans at December 31, 2017 and 2016, 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 2017 119 468 733 4,253 78 5,651 $ $ December 31 2016 233 340 854 4,326 90 5,843 At December 31, 2017, approximately $0.8 million or 13.4% of total potential problem loans were past due at least 30 but less than 90 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, 2017 and 2016, 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 Deposits (In thousands) Noninterest bearing demand NOW Money market Savings Certificates of deposit under $100,000 Certificates of deposit and other time deposits of $100,000 or more Brokered certificates of deposit Total deposits December 31 2017 2016 $ $ $ $ 8 — — 1,058 57 1,123 2017 193,917 146,999 173,251 55,421 69,960 107,711 10,400 757,659 66 395 242 1,301 38 2,042 December 31 2016 181,890 117,943 179,643 51,530 77,255 120,510 10,372 739,143 PAGE 15 MANAGEMENT’S DISCUSSION AND ANALYSIS Total deposits were $757.7 million and $739.1 million at December 31, 2017 and 2016, respectively. The increase in total deposits of $18.5 million and the change in deposit mix reflect customer preferences for short-term instruments in a low interest rate environment. The average rates paid on total interest-bearing deposits were 0.62% in 2017 and 0.68% in 2016. Noninterest bearing deposits were 26% and 25% of total deposits at both December 31, 2017 and 2016, respectively. 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, 2017 and 2016, respectively. Securities sold under agreements to repurchase totaled $2.7 million and $3.4 million at December 31, 2017 and 2016, respectively. The average rates paid on short-term borrowings was 0.52% in 2017 and 2016, respectively. Information concerning the average balances, weighted average rates, and maximum amounts outstanding for short-term borrowings during the two- year period ended December 31, 2017 is included in Note 10 to the accompanying consolidated financial statements included in this annual report. Long-term debt includes subordinated debentures related to trust preferred securities. The Company had $3.2 million in junior subordinated debentures related to trust preferred securities outstanding at December 31, 2017 and 2016, respectively. The debentures mature on December 31, 2033 and have been redeemable since December 31, 2008. The average rates paid on long-term debt were 3.89% in 2017 and 3.52% in 2016. CAPITAL ADEQUACY The Company's consolidated stockholders' equity was $86.9 million and $82.2 million as of December 31, 2017 and 2016, respectively. The change from December 31, 2016 was primarily driven by net earnings of $7.8 million, partially offset by cash dividends paid of $3.4 million. The Company’s Tier 1 leverage ratio was 10.95%, Common Equity Tier 1 (“CET1”) risk-based capital ratio was 16.42%, Tier 1 risk-based capital ratio was 16.98%, and total risk-based capital ratio was 17.91% at December 31, 2017. These ratios exceed the minimum regulatory capital percentages of 5.0% for Tier 1 leverage ratio, 6.5% for CET1 risk-based capital ratio, 8.0% for Tier 1 risk-based capital ratio, and 10.0% for total risk-based capital ratio to be considered “well capitalized.” Based on current regulatory standards, the Company is classified as “well capitalized.” 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 an acceptable asset/liability composition. 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 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 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. PAGE 16 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 help limit interest rate risk, we have guidelines for earnings at risk which seek to limit the variance of net interest income from gradual changes in interest rates. For changes up or down in rates from management’s flat interest rate forecast over the next 12 months, policy limits for net interest income variances are as follows:     +/- 20% for a gradual change of 400 basis points +/- 15% for a gradual change of 300 basis points +/- 10% for a gradual change of 200 basis points +/- 5% for a gradual change of 100 basis points The following table reports the variance of net interest income over the next 12 months assuming a gradual change in interest rates up or down when compared to the baseline net interest income forecast at December 31, 2017. Changes in Interest Rates 400 basis points 300 basis points 200 basis points 100 basis points (100) basis points (200) basis points (300) basis points (400) basis points NM=not meaningful Net Interest Income % Variance 2.39 % 1.10 1.07 0.08 0.43 NM NM NM At December 31, 2017, our earnings simulation model indicated that we were in compliance with the policy guidelines noted above. 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 17 MANAGEMENT’S DISCUSSION AND ANALYSIS To help limit interest rate risk, we have stated policy guidelines for an instantaneous basis point change in interest rates, such that our EVE should not decrease from our base case by more than the following:     45% for an instantaneous change of +/- 400 basis points 35% for an instantaneous change of +/- 300 basis points 25% for an instantaneous change of +/- 200 basis points 15% for an instantaneous change of +/- 100 basis points The following table reports the variance of EVE assuming an immediate change in interest rates up or down when compared to the baseline EVE at December 31, 2017. Changes in Interest Rates 400 basis points 300 basis points 200 basis points 100 basis points (100) basis points (200) basis points (300) basis points (400) basis points NM=not meaningful EVE % Variance (19.05) % (13.39) (8.20) (3.32) (1.46) NM NM NM At December 31, 2017, our EVE model indicated that we were in compliance with the policy guidelines noted above. Each of the above 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, including market perceptions. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities 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. 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, 2017 and 2016, 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. PAGE 18 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. 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, 2017, the Bank had a remaining available line of credit with the FHLB totaling $244.4 million. As of December 31, 2017, 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, 2017, which by their terms had contractual maturity and termination dates subsequent to December 31, 2017: (Dollars in thousands) Contractual obligations: Deposit maturities (1) Long-term debt Operating lease obligations Total Total 757,659 3,217 103 $760,979 $ $ Payments due by period 1 year or less 657,912 — 65 $657,977 1 to 3 years 70,546 — 38 $70,584 3 to 5 years More than 5 years 29,201 — — $29,201 — 3,217 — $3,217 (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, 2017, the Bank had outstanding standby letters of credit of $7.4 million and unfunded loan commitments outstanding of $57.0 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. Residential mortgage lending and servicing 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. PAGE 19 MANAGEMENT’S DISCUSSION AND ANALYSIS As of December 31, 2017, the unpaid principal balance of residential mortgage loans, which we have originated and sold, but retained the servicing rights was $312.3 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 through our underwriting, quality assurance and servicing practices, including good communications with our residential mortgage investors. In 2017, as a result of the representation and warranty provisions contained in the Company’s sale agreements with Fannie Mae, the Company was required to repurchase three loans with an aggregate principal balance of $0.6 million, which were current as to principal and interest at the time of repurchase. During 2016, the Company was required to repurchase one loan with an aggregate principal balance of $0.2 million that was current as to principal and interest at the time of repurchase. At December 31, 2017, the Company had no pending repurchase requests related to representation and warranty provisions. 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, 2017, we believe that this exposure is not material due to the historical level of repurchase requests and loss trends, the results of our quality control reviews, and the fact that 99% 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. PAGE 20 CURRENT ACCOUNTING DEVELOPMENTS The following Accounting Standards Updates (“Updates” or “ASUs”) have been issued by the FASB but are not yet effective.        ASU 2014-09, Revenue from Contracts with Customers (Topic 606); ASU 2015-14, Revenue from Contracts with Customers (Topic 606)– Deferral of the Effective Date; ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities; ASU 2016-02, Leases (Topic 842); ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments; and ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash Information about these pronouncements is described in more detail below. ASU 2014-09, Revenue from Contracts with Customers, was developed as a joint project with the International Accounting Standards Board to remove inconsistencies in revenue and provide a more robust framework for addressing revenue issues. The ASU's core principle is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. In August 2015, the FASB issued ASU 2015-14, which deferred the effective date by one year (i.e., interim and annual reporting periods beginning after December 15, 2017). Early adoption is permitted, but not before the original effective date (i.e., interim and annual reporting periods beginning after December 15, 2016). The ASU may be adopted using either a modified retrospective method or a full retrospective method. The Company adopted the ASU during the first quarter of 2018, as required, using a modified retrospective approach. The majority of the Company’s revenue stream is generated from financial instruments which are not within the scope of this ASU. However, the Company has evaluated the impact for other fee-based income and has concluded that this standard will not materially impact its financial statements. ASU 2016-01, Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, enhances the reporting model for financial instruments to provide users of financial statements with more decision-useful information. The ASU addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Some of the amendments include the following: (1) Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (2) Simplify the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (4) Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value; among others. For public business entities, the amendments of this ASU are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this ASU on January 1, 2018 did not have a material impact on the Company’s Consolidated Financial Statements. The Company is currently evaluating methods of measuring fair value of its loan portfolio using an exit price notion as noted in (3) above. PAGE 21 MANAGEMENT’S DISCUSSION AND ANALYSIS ASU 2016-02, Leases, requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet. A lessee should recognize in the statement of financial position a liability to make lease payments (the lease liability) and a right-of-use asset representing its right to use the underlying asset for lease term. The new guidance is effective for annual and interim reporting periods beginning after December 15, 2018. The amendment should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements. ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): - Measurement of Credit Losses on Financial Instruments, amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. For assets held at amortized cost basis, the new standard eliminates the probable initial recognition threshold in current GAAP and, instead, requires an entity to reflect its current estimate of all expected credit losses using a broader range of information regarding past events, current conditions and forecasts assessing the collectability of cash flows. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. For available for sale debt securities, credit losses should be measured in a manner similar to current GAAP, however the new standard will require that credit losses be presented as an allowance rather than as a write-down. The new guidance affects entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities that are SEC filers, the new guidance is effective for annual and interim periods in fiscal years beginning after December 15, 2019 early adoption is permitted beginning in 2019. The Company is currently evaluating the impact of the new guidance on its consolidated financial statements. ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, provides guidance on eight specific cash flow issues where current GAAP is either unclear or does not include specific guidance on classification in the statement of cash flows. The new guidance is effective for annual and interim reporting periods in fiscal years beginning after December 15, 2017. As this guidance only affects classification within the statement of cash flows, adoption of this ASU on January 1, 2018 did not have a material impact on the Company’s Consolidated Financial Statements. ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted cash, amends guidance on how the statement of cash flows presents the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The amendments in this Update do not provide a definition of restricted cash or restricted cash equivalents. The new guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments are applied using a retrospective transition method to each period transitioned. As this guidance only affects classification within the statement of cash flows, adoption of this ASU on January 1, 2018 did not have a material impact on the Company’s Consolidated Financial Statements. 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 is presented below. (In thousands) Net interest income (GAAP) Tax-equivalent adjustment Net interest income (Tax-equivalent) Year ended December 31 2017 24,526 1,205 25,731 2016 22,732 1,276 24,008 2015 22,718 1,342 24,060 2014 21,453 1,288 22,741 2013 20,922 1,440 22,362 $ $ 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 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 other real estate owned Total assets Nonperforming loans as % of loans Net (recoveries) charge-offs as a % of average loans Capital Adequacy: CET 1 risk-based capital ratio 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 $ $ $ $ $ $ $ $ 2017 2016 2015 Year ended December 31 2013 2014 29,325 3,594 25,731 (300) 3,441 16,784 12,688 1,205 3,637 7,846 28,092 4,084 24,008 (485) 3,383 15,348 12,528 1,276 3,102 8,150 28,495 4,435 24,060 200 4,532 16,372 12,020 1,342 2,820 7,858 28,105 5,364 22,741 50 3,933 15,104 11,520 1,288 2,784 7,448 2.15 0.92 2.24 0.90 2.16 0.88 2.04 0.86 28,898 6,536 22,362 400 7,298 18,412 10,848 1,440 2,290 7,118 1.95 0.84 3,643,616 3,643,668 23.85 3,643,504 3,643,523 22.55 3,643,428 3,643,478 21.94 3,643,278 3,643,328 20.80 3,643,003 3,643,118 17.70 40.25 30.75 38.90 18.09x 163 % 9.17 % 0.94 % 42.79 % 10.30 % 1.05 % 160 % 0.66 % 0.35 % 0.66 % (0.09) % 16.42 % 16.98 % 17.91 % 10.95 % 3.29 % 31.67 % 57.53 % 31.31 24.56 31.31 13.98 139 9.65 0.98 40.18 10.14 1.08 196 0.59 0.30 0.55 (0.19) 16.44 17.00 17.95 10.27 3.05 27.57 56.03 30.39 23.15 29.62 13.78 135 9.98 0.98 40.74 9.79 1.01 158 0.70 0.36 0.64 0.18 15.28 16.57 17.44 10.35 3.17 26.41 57.26 25.80 22.10 23.64 11.59 114 10.53 0.97 42.16 9.17 1.20 433 0.41 0.21 0.28 0.12 na 17.45 18.54 10.32 3.15 27.21 56.62 25.75 20.80 25.00 12.89 141 10.33 0.94 43.08 9.07 1.37 124 2.10 1.08 1.11 0.48 na 17.19 18.40 10.10 3.16 24.34 62.08 257,697 453,651 4,757 853,381 757,659 3,217 86,906 243,572 430,946 4,643 831,943 739,143 3,217 82,177 241,687 426,410 4,289 817,189 723,627 7,217 79,949 267,603 402,954 4,836 789,231 693,390 12,217 75,799 271,219 383,339 5,268 751,343 668,844 12,217 64,485 (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 - Average Balance and Net Interest Income Analysis (Dollars in thousands) Interest-earning assets: Loans and loans held for sale (1) 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 Total interest-bearing deposits Short-term borrowings Long-term debt Total interest-bearing liabilities Noninterest-bearing deposits Other liabilities Stockholders' equity Total liabilities and and stockholders' equity $ $ $ 2017 Interest Income/ Expense 20,781 4,229 3,545 7,774 341 429 29,325 248 852 2,351 3,451 18 125 3,594 Average Balance 442,101 $ 197,108 69,881 266,989 32,342 41,317 782,749 13,386 34,291 830,426 125,935 230,121 198,457 554,513 3,476 3,217 561,206 180,891 2,788 85,541 Year ended December 31 Yield/ Rate Average Balance 4.70% $ 2.15% 5.07% 2.91% 1.05% 1.04% 3.75% $ 0.20% $ 0.37% 1.18% 0.62% 0.52% 3.89% 0.64% 432,180 $ 166,870 68,507 235,377 49,446 70,064 787,067 13,126 32,127 832,320 121,723 232,601 212,662 566,986 2,973 6,474 576,433 167,695 3,760 84,432 $ 830,426 $ 832,320 2016 Interest Income/ Expense 20,453 3,282 3,754 7,036 249 354 28,092 Yield/ Rate 4.73% 1.97% 5.48% 2.99% 0.50% 0.51% 3.57% 333 890 2,618 3,841 15 228 4,084 0.27% 0.38% 1.23% 0.68% 0.50% 3.52% 0.71% Net interest income and margin $ 25,731 3.29% $ 24,008 3.05% (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 25 FINANCIAL TABLES Table 4 - Volume and Rate Variance Analysis $ $ $ (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 Total interest-bearing deposits Short-term borrowings Long-term debt Total interest expense Years ended December 31, 2017 vs. 2016 Years ended December 31, 2016 vs. 2015 Net Due to change in Net Due to change in Change Rate (2) Volume (2) Change Rate (2) Volume (2) 328 947 (209) 738 92 75 1,233 (85) (38) (267) (390) 3 (103) (490) (138) 298 (279) 19 272 373 526 (93) (29) (99) (221) — 24 (197) 466 $ 649 70 719 (180) (298) 707 $ 8 $ (9) (168) (169) 3 (127) (293) (31) (569) (192) (761) 112 277 (403) (15) 58 (337) (294) (3) (54) (351) (910) (176) (199) (375) 158 80 (1,047) (33) (6) (113) (152) — 10 (142) 879 (393) 7 (386) (46) 197 644 18 64 (224) (142) (3) (64) (209) Net interest income $ 1,723 723 1,000 $ (52) (905) 853 (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 26 Table 5 - 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 $ 2017 59,086 39,607 239,033 106,863 9,588 454,177 (526) 453,651 (4,757) Loans, net $ 448,894 2016 49,850 41,650 220,439 110,855 8,712 431,506 (560) 430,946 (4,643) 426,303 2015 52,479 43,694 203,853 116,673 10,220 426,919 (509) 426,410 (4,289) 422,121 2014 54,329 37,298 192,006 107,641 12,335 403,609 (655) 402,954 (4,836) 398,118 December 31 2013 57,780 36,479 174,920 101,706 12,893 383,778 (439) 383,339 (5,268) 378,071 PAGE 27 FINANCIAL TABLES Table 6 - Loan Maturities and Sensitivities to Changes in Interest Rates 1 year 1 to 5 After 5 Adjustable Fixed December 31, 2017 (Dollars in thousands) $ Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total loans $ or less 37,317 23,959 28,543 11,571 3,846 105,236 years 10,254 14,006 91,939 23,951 5,277 145,427 years 11,515 1,642 118,551 71,341 465 203,514 Total 59,086 39,607 239,033 106,863 9,588 454,177 Rate 16,716 12,463 8,365 53,457 1,037 92,038 Rate 42,370 27,144 230,668 53,406 8,551 362,139 Total 59,086 39,607 239,033 106,863 9,588 454,177 PAGE 28 Table 7 - 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 recoveries (charge-offs) Provision for loan losses Ending balance as a % of loans as a % of nonperforming loans Net (recoveries) charge-offs as % of average loans Nonperforming assets: Nonaccrual/nonperforming loans Other real estate owned Total nonperforming assets as a % of loans and other real estate owned as a % total assets Nonperforming loans as a % of total loans Accruing loans 90 days or more past due 2017 2016 2015 2014 2013 Year ended December 31 $ 4,643 4,289 4,836 5,268 6,723 (449) — — (107) (40) (596) 461 347 — 115 87 1,010 414 (300) $ 4,757 1.05 % 160 % (0.09) % 2,972 — 2,972 0.66 % 0.35 % 0.66 % — $ $ $ (97) — (194) (182) (67) (540) 29 1,212 — 127 11 1,379 839 (485) 4,643 1.08 196 (0.19) 2,370 152 2,522 0.59 0.30 0.55 — (100) — (866) (89) (59) (1,114) 22 17 — 313 15 367 (747) 200 4,289 1.01 158 0.18 2,714 252 2,966 0.70 0.36 0.64 — (46) (235) — (438) (89) (808) 71 8 119 112 16 326 (482) 50 4,836 1.20 433 0.12 1,117 534 1,651 0.41 0.21 0.28 — (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 PAGE 29 FINANCIAL TABLES Table 8 - Allocation of Allowance for Loan Losses (Dollars in thousands) Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total allowance for loan losses $ 2017 2016 2015 2014 2013 Amount %* Amount %* Amount %* Amount %* $ 653 13.0 $ 540 11.6 $ 523 12.3 $ 639 13.5 $ Amount %* 15.1 386 December 31 734 8.7 2,126 52.7 1,071 23.5 2.1 $ 173 4,757 812 2,071 1,107 113 4,643 9.7 51.0 25.7 2.0 $ 669 1,879 1,059 159 4,289 10.2 47.8 27.3 2.4 $ 974 9.2 1,928 47.5 1,119 26.7 3.1 176 4,836 $ 9.5 45.5 26.5 3.4 366 3,186 1,114 216 5,268 * Loan balance in each category expressed as a percentage of total loans. PAGE 30 Table 9 - CDs and Other Time Deposits of $100,000 or More (Dollars in thousands) Maturity of: 3 months or less Over 3 months through 6 months Over 6 months through 12 months Over 12 months Total CDs and other time deposits of $100,000 or more (1) (1) Includes brokered certificates of deposit. December 31, 2017 $ $ 5,140 9,732 37,355 65,884 118,111 PAGE 31 MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management’s Report on Internal Control Over Financial Reporting Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting. Internal control is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation of reliable published financial statements. Internal control over financial reporting includes self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. Because of inherent limitations in any system of internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time. Management assessed the Company’s internal control over financial reporting as of December 31, 2017. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this assessment, the Chief Executive Officer and Chief Financial Officer assert that the Company maintained effective internal control over financial reporting as of December 31, 2017 based on the specified criteria. The effectiveness of the Company’s internal control over financial reporting as of December 31, 2017 has been audited by Elliott Davis LLC, the independent registered public accounting firm who also has audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K. Elliott Davis LLC’s attestation report on the Company’s internal control over financial reporting appears on the following page and is incorporated by reference herein. Changes in Internal Control Over Financial Reporting During the period covered by this report, there has not been any change in the Company’s internal controls over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting. PAGE 32 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Report of Independent Registered Public Accounting Firm  The Board of Directors and Stockholders  Auburn National Bancorporation, Inc.  Opinion on the Internal Control Over Financial Reporting  We  have  audited  Auburn  National  Bancorporation,  Inc.  and  subsidiaries’  (the  “Company”)  internal  control  over  financial  reporting  as  of  December  31,  2017,  based  on  criteria  established  in Internal  Control  —  Integrated  Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013 (the “COSO  criteria”). In our opinion, the Company maintained, in all material respects, effective internal control over financial  reporting as of December 31, 2017, based on the COSO criteria.  We  have  also  audited,  in  accordance  with  the  standards  of  the  Public  Company  Accounting  Oversight  Board  (United  States)  (“PCAOB”), the  consolidated  balance  sheets  of  the  Company  as  of December 31,  2017  and 2016  and the related consolidated statements of earnings, comprehensive income, stockholders’ equity, and cash flows  of the Company for the years then ended and our report dated March 13, 2018 expressed an unqualified opinion.  Basis for Opinion  The Company’s management is responsible for maintaining effective internal control over financial reporting and  for its assessment of the effectiveness of internal control over financial reporting in the accompanying Report of  Management. Our responsibility is to express an opinion on the Company’s internal control over financial reporting  based  on  our  audit.  We  are  a  public  accounting  firm  registered  with  the  PCAOB  and  are  required  to  be  independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules  and regulations of the Securities and Exchange Commission and the PCAOB.  We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and  perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting  was  maintained  in  all  material  respects.  Our  audit  included  obtaining  an  understanding  of  internal  control  over  financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and  operating  effectiveness  of  internal  control  based  on  the  assessed  risk.  Our  audit  also  included  performing  such  other  procedures  as  we  considered  necessary  in  the  circumstances.  We  believe  that  our  audit  provides  a  reasonable basis for our opinion.  Definition and Limitations of Internal Control Over Financial Reporting  A  company's  internal  control  over  financial  reporting  is  a  process  designed  to  provide  reasonable  assurance  regarding the reliability of financial reporting and the preparation of consolidated financial statements for external  purposes in accordance with generally accepted accounting principles. A company's internal control over financial  reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable  detail,  accurately  and  fairly  reflect  the  transactions  and  dispositions  of  the  assets  of  the  company;  (2)  provide  reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial  statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the  company are being made only in accordance with authorizations of management and directors of the company;  and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or  disposition of the company's assets that could have a material effect on the consolidated financial statements.  PAGE 33                                  REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Because  of  its  inherent  limitations,  internal  control  over  financial  reporting  may  not  prevent  or  detect  misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that  controls  may  become  inadequate  because  of  changes  in  conditions,  or  that  the  degree  of  compliance  with  the  policies or procedures may deteriorate.  Greenville, South Carolina  March 13, 2018 PAGE 34       Report of Independent Registered Public Accounting Firm  The Board of Directors and Stockholders  Auburn National Bancorporation, Inc.  Opinion on the Consolidated Financial Statements  We  have  audited  the  accompanying  consolidated  balance  sheets  of  Auburn  National  Bancorporation,  Inc.  and  subsidiaries (the “Company”)  as of December 31, 2017 and 2016, the related consolidated statements of earnings,  comprehensive income, stockholders’ equity, and cash flows for the years then ended, and the related notes to the  consolidated  financial  statements  and  schedules  (collectively,  the  “consolidated  financial  statements”).  In  our  opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the  Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for the years then  ended, in conformity with accounting principles generally accepted in the United States of America.  We  have  also  audited,  in  accordance  with  the  standards  of  the  Public Company  Accounting  Oversight  Board  (United States) (“PCAOB”), the Company's internal control over financial reporting as of December 31, 2017, based  on  criteria  established  in Internal  Control  —  Integrated  Framework issued  by  the  Committee  of  Sponsoring  Organizations  of  the  Treadway  Commission  in  2013,  and  our  report  dated  March  13,  2018  expressed  an  unqualified opinion on the effectiveness of the Company's internal control over financial reporting.  Basis for Opinion  These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is  to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public  accounting firm registered with the PCAOB and are required to be independent with respect to the Company in  accordance  with  U.S.  federal  securities  laws  and  the  applicable  rules  and  regulations  of  the  Securities  and  Exchange Commission and the PCAOB.  We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan  and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are  free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess  the  risks  of  material  misstatement  of  the  consolidated  financial  statements,  whether  due  to  error  or  fraud,  and  performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence  regarding  the  amounts  and  disclosures  in  the  consolidated  financial  statements.  Our  audits  also  included  evaluating  the  accounting  principles  used  and  significant  estimates  made  by  management,  as  well  as  evaluating  the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable  basis for our opinion.  We have served as the Company's auditor since 2015.  Greenville, South Carolina  March 13, 2018 PAGE 35                                    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, net Less treasury stock, at cost - 313,467 shares and 313,612 shares at December 31, 2017 and 2016, respectively Total stockholders’ equity Total liabilities and stockholders’ equity See accompanying notes to consolidated financial statements $ $ $ $ 2017 12,942 41,540 51,046 105,528 257,697 1,922 453,651 (4,757) 448,894 13,791 18,330 — 7,219 853,381 $ $ 193,917 563,742 757,659 2,658 3,217 2,941 766,475 — 39 3,771 90,299 (566) (6,637) 86,906 December 31 2016 15,673 42,096 63,508 121,277 243,572 1,497 430,946 (4,643) 426,303 12,602 17,888 152 8,652 831,943 181,890 557,253 739,143 3,366 3,217 4,040 749,766 — 39 3,767 85,716 (708) (6,637) 82,177 $ 853,381 $ 831,943 PAGE 36 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: Taxable Tax-exempt 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 Other Securities gains (losses), 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 Gain on early extinguishment of debt Other Total noninterest expense Earnings before income taxes Income tax expense Net earnings Net earnings per share: Basic and diluted Year ended December 31 2017 2016 $ 20,781 $ 20,453 4,229 2,340 770 28,120 3,451 18 125 3,594 24,526 (300) 24,826 746 777 442 1,425 51 3,441 10,011 1,471 966 346 5 — 3,985 16,784 11,483 3,637 7,846 2.15 $ $ 3,282 2,478 603 26,816 3,841 15 228 4,084 22,732 (485) 23,217 773 947 456 1,428 (221) 3,383 9,826 1,474 825 406 (371) (790) 3,978 15,348 11,252 3,102 8,150 2.24 $ $ Weighted average shares outstanding: Basic and diluted See accompanying notes to consolidated financial statements 3,643,616 3,643,504 PAGE 37 AUDITED FINANCIAL STATEMENTS AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income (Dollars in thousands) Net earnings Other comprehensive income (loss), net of tax: Unrealized net holding gain (loss) on all other securities Reclassification adjustment for net (gain) loss on securities recognized in net earnings Other comprehensive income (loss) Comprehensive income See accompanying notes to consolidated financial statements Year ended December 31 2017 7,846 $ 263 (32) 231 8,077 $ 2016 8,150 (2,784) 139 (2,645) 5,505 $ $ PAGE 38 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Common Stock Amount Additional paid-in capital — — — — Shares 3,957,135 $ (Dollars in thousands, except share data) Balance, December 31, 2015 Net earnings Other comprehensive loss Cash dividends paid ($0.90 per share) Sale of treasury stock (45 shares) Balance, December 31, 2016 Net earnings Other comprehensive income Reclassification of certain tax effects Cash dividends paid ($0.92 per share) Sale of treasury stock (145 shares) 3,957,135 $ Balance, December 31, 2017 See accompanying notes to consolidated financial statements — — — — — 3,957,135 $ 39 — — — — 39 $ — — — — — 39 $ 3,766 — — — 1 3,767 $ — — — — 4 3,771 $ Accumulated other Retained comprehensive Treasury earnings 80,845 8,150 — (3,279) — 85,716 7,846 — 89 (3,352) — 90,299 income (loss) 1,937 — (2,645) — — (708) $ — 231 (89) — — (566) $ $ $ stock Total (6,638) $ — — — 1 (6,637) $ — — — — — (6,637) $ 79,949 8,150 (2,645) (3,279) 2 82,177 7,846 231 — (3,352) 4 86,906 PAGE 39 AUDITED FINANCIAL STATEMENTS 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 Net (gain) loss on securities available for sale Net gain on sale of loans held for sale Net gain on other real estate owned Gain early extinguishment of debt Loans originated for sale Proceeds from sale of loans Increase in cash surrender value of bank owned life insurance 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 Increase in loans, net Net purchases of premises and equipment Increase in FHLB stock Proceeds from sale of other real estate owned Net cash used in investing activities Cash flows from financing activities: Net increase in noninterest-bearing deposits Net increase (decrease) in interest-bearing deposits Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase Repayments or retirement of long-term debt Dividends paid Net cash 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 2017 2016 $ 7,846 $ 8,150 (300) 1,016 2,133 356 (51) (504) (5) - (29,796) 29,651 (442) 592 (1,095) 9,401 10,374 32,945 (59,160) (22,291) (1,618) (13) 157 (39,606) 12,027 6,489 (708) — (3,352) 14,456 (15,749) 121,277 105,528 3,624 3,289 — $ $ $ $ $ $ $ (485) 1,200 1,677 461 221 (764) (392) (790) (42,860) 43,343 (455) 412 769 10,487 26,110 63,410 (97,494) (4,097) (1,206) (25) 720 (12,582) 25,073 (9,557) 415 (3,210) (3,279) 9,442 7,347 113,930 121,277 4,108 2,203 400 $ $ $ $ $ $ $ PAGE 40 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. Accounting Standards Adopted in 2017 In 2017, the Company adopted new guidance related to the following Accounting Standards Update (“Update” or “ASU”):  ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. Information about this pronouncement is described in more detail below. ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, requires Companies to reclassify the stranded effects in other comprehensive income to retained earnings as a result of the change in the tax rates under the Tax Cuts and Jobs Act. The Company has opted to early adopt this pronouncement by retrospective application to each period in which the effect of the change in the tax rate under the Tax Cuts and Jobs Act is recognized. The impact of the reclassification from other comprehensive income to retained earnings is $89 thousand. 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, 2017, 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 income, 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. PAGE 41 AUDITED FINANCIAL STATEMENTS 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 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. 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. 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. PAGE 42 Impaired loans also include 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. 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. PAGE 43 AUDITED FINANCIAL STATEMENTS 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. 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. 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 Accounting Standards Codification (“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. 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, Income Taxes, 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. PAGE 44 Fair Value Measurements ASC 820, Fair Value Measurements, 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, 2017. The Company does not believe there are any material subsequent events that would require further recognition or disclosure. NOTE 2: BASIC AND DILUTED NET 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, 2017 and 2016, respectively, the Company had no such securities or other rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted net earnings per share calculation. The basic and diluted net 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 Net earnings per share NOTE 3: VARIABLE INTEREST ENTITIES Year ended December 31 2017 2016 $ $ 7,846 3,643,616 2.15 $ $ 8,150 3,643,504 2.24 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, 2017, 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 (the “Trust”), which issued mandatorily redeemable preferred capital securities (“trust preferred securities”) in 2003 in the aggregate of approximately $7.0 million at the time of issuance. The 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. PAGE 45 AUDITED FINANCIAL STATEMENTS In October 2016, the Company purchased $4.0 million par amount of outstanding trust preferred securities issued by the Trust. These securities were sold by the FDIC, as receiver of a failed bank that had held the trust preferred securities. The Company used dividends from the Bank to purchase these trust preferred securities and has deemed an equivalent amount of the related junior subordinated debentures issued by the Company as no longer outstanding. The Company realized a pre-tax gain of $0.8 million on the early extinguishment of debt in this transaction. Following the transaction, the Company had outstanding $3.2 million in junior subordinated debentures held by the trust related to the remaining $3.0 million of trust preferred securities outstanding and not purchased by the Company. The outstanding principal amount of debentures related to those trust preferred securities remains included in the Company’s Tier I capital for regulatory purposes. The following table summarizes VIEs that are not consolidated by the Company as of December 31, 2017. (Dollars in thousands) Type: Trust preferred issuances NOTE 4: RESTRICTED CASH BALANCES Maximum Loss Exposure Liability Recognized Classification N/A $ 3,217 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, 2017 and 2016, the Bank did not have a required reserve balance at the Federal Reserve Bank. NOTE 5: SECURITIES At December 31, 2017 and 2016, 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 at December 31, 2017 and 2016, 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, 2017 Agency obligations (a) Agency RMBS (a) State and political subdivisions $ $ — — — 29,253 — 2,564 23,809 11,201 9,999 — 121,871 59,000 53,062 133,072 71,563 79 330 1,616 — 45,009 31,817 Total available-for-sale December 31, 2016 Agency obligations (a) Agency RMBS (a) State and political subdivisions Total available-for-sale $ (a) Includes securities issued by U.S. government agencies or government sponsored entities. 45,471 127,787 70,314 243,572 — 110,644 57,624 168,268 19,893 16,171 10,210 46,274 22,531 972 2,480 25,983 3,047 — — 3,047 180,871 257,697 $ 2,025 331 551 1,509 2,391 904 $ 1,639 237 53,887 134,381 70,184 2,780 $ 258,452 973 $ 46,113 1,805 $ 129,041 69,539 3,512 $ 244,693 734 $ Securities with aggregate fair values of $149.4 million and $137.2 million at December 31, 2017 and 2016, 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 $1.4 million at December 31, 2017 and 2016, respectively. Cost-method investments primarily include non-marketable equity investments, such as FHLB of Atlanta stock and Federal Reserve Bank (“FRB”) stock. PAGE 46 Gross Unrealized Losses and Fair Value The fair values and gross unrealized losses on securities at December 31, 2017 and 2016, 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, 2017: Agency obligations Agency RMBS State and political subdivisions Total December 31, 2016: Agency obligations Agency RMBS State and political subdivisions Total $ $ $ $ Less than 12 Months 12 Months or Longer Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses 14,381 53,440 2,009 69,830 20,352 89,062 20,444 129,858 99 363 22 484 973 1,805 734 3,512 20,353 50,729 10,155 81,237 — — — — 805 1,276 215 2,296 34,734 $ 104,169 12,164 151,067 $ — — — — 20,352 $ 89,062 20,444 129,858 $ 904 1,639 237 2,780 973 1,805 734 3,512 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. PAGE 47 AUDITED FINANCIAL STATEMENTS 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, 2017, cost-method investments with an aggregate cost of $1.4 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. Other-Than-Temporarily Impaired Securities Credit-impaired debt securities are debt securities where the Company has written down the amortized cost basis of a security for other-than-temporary impairment and the credit component of the loss is recognized in earnings. At December 31, 2017 and 2016, respectively, the Company had no credit-impaired debt securities and there were no additions or reductions in the credit loss component of credit-impaired debt securities during the years ended December 31, 2017 and 2016, respectively. Realized Gains and Losses The following table presents the gross realized gains and losses on sales related to securities. (Dollars in thousands) Gross realized gains Gross realized losses Realized gains (losses), net NOTE 6: LOANS AND ALLOWANCE FOR LOAN LOSSES (In thousands) Commercial and industrial Construction and land development Commercial real estate: Owner occupied Multifamily 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 PAGE 48 Year ended December 31 $ $ 2017 51 — 51 2016 166 (387) (221) 2017 59,086 39,607 $ December 31 2016 49,850 41,650 44,192 52,167 142,674 239,033 59,540 47,323 106,863 9,588 454,177 (526) 453,651 $ 49,745 46,998 123,696 220,439 65,564 45,291 110,855 8,712 431,506 (560) 430,946 $ $ Loans secured by real estate were approximately 84.9% of the total loan portfolio at December 31, 2017. At December 31, 2017, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama and surrounding areas. In accordance with ASC 310, Receivables, 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 three classes: (1) owner occupied (2) multi-family and (3) 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.  Multifamily – primarily includes loans to finance income-producing multi-family properties. Loans in this class include loans for 5 or more unit residential property and apartments leased to 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.  Other – primarily includes loans to finance income-producing commercial properties. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, single retail stores, industrial buildings, and warehouses 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. 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. PAGE 49 AUDITED FINANCIAL STATEMENTS 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, 2017 and 2016. (In thousands) Current Past Due 90 days Loans Accrual Accruing Accruing Total 30-89 Days Greater than Accruing Non- Total Loans $ $ $ December 31, 2017: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Multifamily Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total December 31, 2016: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Multifamily Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total $ 59,047 39,607 44,192 52,167 140,486 236,845 58,195 46,871 105,066 9,517 450,082 49,747 41,223 49,564 46,998 121,608 218,170 64,059 45,243 109,302 8,652 427,094 8 — — — — — 746 312 1,058 57 1,123 66 395 43 — 199 242 1,282 19 1,301 38 2,042 — — — — — — — — — — — — — — — — — — — — — — 59,055 39,607 44,192 52,167 140,486 236,845 58,941 47,183 106,124 9,574 451,205 49,813 41,618 49,607 46,998 121,807 218,412 65,341 45,262 110,603 8,690 429,136 31 $ — 59,086 39,607 — — 2,188 2,188 599 140 739 14 2,972 $ 44,192 52,167 142,674 239,033 59,540 47,323 106,863 9,588 454,177 37 $ 32 49,850 41,650 138 — 1,889 2,027 223 29 252 22 2,370 $ 49,745 46,998 123,696 220,439 65,564 45,291 110,855 8,712 431,506 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 $140 thousand and $107 thousand for the years ended December 31, 2017 and 2016, respectively. PAGE 50 Allowance for Loan Losses The allowance for loan losses as of and for the years ended December 31, 2017 and 2016, is presented below. (In thousands) Beginning balance Charged-off loans Recovery of previously charged-off loans Net recoveries Provision for loan losses Ending balance Year ended December 31 2017 2016 4,643 (596) 1,010 414 (300) 4,757 $ $ 4,289 (540) 1,379 839 (485) 4,643 $ $ 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, independent loan review process. 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, 2017 and 2016, 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. Beginning with the quarter ended December 31, 2016, the Company implemented certain refinements to its allowance for loan losses methodology in order to better capture the effects of the most recent economic cycle on the Company’s loan loss experience. First, the Company increased its look-back period for calculating average losses for all loan segments to 31 quarters. Prior to December 31, 2016, the Company calculated average losses for all loan segments using a rolling 20 quarter look-back period. For the year ended December 31, 2017, the Company increased its look back period to 35 quarters to continue to include losses incurred by the Company beginning with the first quarter of 2009. The Company will likely continue to increase its look-back period to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. Second, the Company increased the range of basis point adjustments allowed for qualitative and environmental factors to approximately 200 basis points, an increase of 65 basis points, or 48%, compared to the 135 basis point range used prior to December 31, 2016. After performing sensitivity testing of its calculation of the allowance for loan losses, the Company determined that it should increase the range of basis points allowed for qualitative and environmental factors in order to provide sufficient latitude in determining estimated probable credit losses during periods of economic stress. Third, the Company reduced the percentage allocation for qualitative and environmental factors on a weighted average basis to 21% of total basis points allocable at December 31, 2016, compared to 25% of total basis points allocable at September 30, 2016. The Company believes a decrease in the percentage allocation of qualitative environmental factors on a weighted average basis was appropriate due to the extension of its look-back period described above. If the Company did not make the changes described above, the Company’s calculated allowance for loan loss allocation would have decreased by approximately $0.9 million, or 0.21% of total loans, at December 31, 2016. Other than the changes discussed above, the Company has not made any material changes to its methodology 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, 2017 and 2016. (in thousands) Balance, December 31, 2015 Charge-offs Recoveries Net (charge-offs) recoveries Provision Balance, December 31, 2016 Charge-offs Recoveries Net recoveries Provision Balance, December 31, 2017 Commercial and industrial 523 (97) 29 (68) 85 540 (449) 461 12 101 653 $ $ $ Construction and land Development Commercial Real Estate Residential Real Estate Consumer Installment Total 669 — 1,212 1,212 (1,069) 812 — 347 347 (425) 734 1,879 (194) — (194) 386 2,071 — — — 55 2,126 1,059 (182) 127 (55) 103 1,107 (107) 115 8 (44) 1,071 159 $ (67) 11 (56) 10 113 $ (40) 87 47 13 173 $ 4,289 (540) 1,379 839 (485) 4,643 (596) 1,010 414 (300) 4,757 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, 2017 and 2016. Collectively evaluated (1) Individually evaluated (2) Total Allowance Recorded Allowance Recorded Allowance Recorded (In thousands) December 31, 2017: Commercial and industrial Construction and land development Commercial real estate Residential real estate Consumer installment Total December 31, 2016: 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 622 734 2,115 1,071 173 4,715 540 812 2,040 1,107 113 4,612 59,055 39,607 236,322 106,863 9,588 451,435 49,835 41,618 218,356 110,855 8,712 429,376 31 — 11 — — 42 — — 31 — — 31 31 — 2,711 — — 2,742 15 32 2,083 — — 2,130 653 734 2,126 1,071 173 4,757 540 812 2,071 1,107 113 4,643 59,086 39,607 239,033 106,863 9,588 454,177 49,850 41,650 220,439 110,855 8,712 431,506 (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. 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. PAGE 53 AUDITED FINANCIAL STATEMENTS (In thousands) December 31, 2017 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Multifamily Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total December 31, 2016 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Multifamily Other Total commercial real estate Residential real estate: Consumer mortgage Investment property Total residential real estate Consumer installment Total Impaired loans Pass Special Mention Substandard Accruing Nonaccrual Total loans $ 58,842 39,049 43,615 52,167 139,695 235,477 54,101 46,463 100,564 9,430 443,362 49,558 41,165 48,788 46,998 121,326 217,112 59,450 44,109 103,559 8,580 419,974 $ $ $ 94 90 240 — 395 635 1,254 53 1,307 66 2,192 22 113 414 — 32 446 2,613 105 2,718 20 3,319 119 468 337 — 396 733 3,586 667 4,253 78 5,651 233 340 405 — 449 854 3,278 1,048 4,326 90 5,843 31 $ — 59,086 39,607 — — 2,188 2,188 599 140 739 14 2,972 37 32 138 — 1,889 2,027 223 29 252 22 2,370 $ $ $ 44,192 52,167 142,674 239,033 59,540 47,323 106,863 9,588 454,177 49,850 41,650 49,745 46,998 123,696 220,439 65,564 45,291 110,855 8,712 431,506 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 thousand secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate). Individually evaluated impaired loans equal to or greater than $250 thousand not secured by real estate (nonaccrual commercial and industrial and consumer loans). PAGE 54 The following table sets forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at December 31, 2017 and 2016. (In thousands) With no allowance recorded: Commercial real estate: Other Total commercial real estate Total With allowance recorded: Commercial and industrial Commercial real estate: Owner occupied Total commercial real estate Total Total impaired loans December 31, 2017 Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance 3,630 3,630 3,630 52 175 175 227 (1,094) (1,094) (1,094) (21) — — (21) 2,536 2,536 2,536 31 $ 175 175 206 $ 3,857 (1,115) 2,742 $ $ $ $ $ 31 11 11 42 42 (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. (In thousands) With no allowance recorded: Commercial and industrial Construction and land development Commercial real estate: Other Total commercial real estate Total With allowance recorded: Commercial real estate: Owner occupied Total commercial real estate Total Total impaired loans December 31, 2016 Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance $ $ $ $ $ 15 140 2,874 2,874 3,029 193 193 193 — (108) (984) (984) (1,092) — — — 15 32 1,890 1,890 1,937 193 193 193 $ $ 3,222 (1,092) 2,130 $ 31 31 31 31 (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. PAGE 55 AUDITED FINANCIAL STATEMENTS 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. (In thousands) Impaired loans: Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Total Troubled Debt Restructurings Year ended December 31, 2017 Year ended December 31, 2016 Average recorded Total interest income Average recorded Total interest income investment recognized investment recognized $ $ 50 11 184 2,096 2,280 2,341 — — 10 1 11 11 $ $ 31 94 699 1,687 2,386 2,511 2 — 31 — 31 33 Impaired loans also include troubled debt restructurings (“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. In determining the appropriate accrual status at the time of restructure, the Company evaluates whether a restructured loan has adequate collateral protection, among other factors. 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. PAGE 56 The following is a summary of accruing and nonaccrual TDRs and the related loan losses, by portfolio segment and class. (In thousands) December 31, 2017 Commercial and industrial Commercial real estate: Owner occupied Other Total commercial real estate Total December 31, 2016 Commercial and industrial Construction and land development Commercial real estate: Owner occupied Other Total commercial real estate Total TDRs Accruing Nonaccrual Total Related Allowance $ $ $ $ — 175 287 462 462 15 — 193 — 193 208 31 — 1,431 1,431 1,462 — 32 — 1,818 1,818 1,850 31 $ 175 1,718 1,893 1,924 15 32 193 1,818 2,011 2,058 $ $ $ 31 11 — 11 42 — — 31 — 31 31 At December 31, 2017, there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured. The following table summarizes loans modified in a TDR during the respective years both before and after modification. ($ in thousands) December 31, 2017 Commercial and industrial Commercial real estate: Other Total commercial real estate Total December 31, 2016 Commercial real estate: Other Total commercial real estate Total Pre- Post- modification outstanding recorded investment modification outstanding recorded investment Number of contracts 1 1 1 2 3 3 3 $ $ $ $ $ 34 1,275 1,275 1,309 3,147 3,147 3,147 34 1,266 1,266 1,300 3,137 3,137 3,137 The majority of the loans modified in a TDR during the years ended December 31, 2017 and 2016, 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. The Company had no TDRs with a payment default during the years ended December 31, 2017 and 2016. PAGE 57 AUDITED FINANCIAL STATEMENTS NOTE 7: PREMISES AND EQUIPMENT Premises and equipment at December 31, 2017 and 2016 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 $ $ 2017 7,473 10,394 3,161 21,028 (7,237) 13,791 December 31 2016 7,231 9,478 3,210 19,919 (7,317) 12,602 Depreciation expense was approximately $428 thousand and $470 thousand for the years ended December 31, 2017 and 2016, respectively, and is a component of net occupancy and equipment expense in the consolidated statements of earnings. NOTE 8: MORTGAGE SERVICING RIGHTS, NET 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 evaluates MSRs for impairment on a quarterly basis. 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 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, 2017 and 2016. (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 PAGE 58 Year ended December 31 $ $ $ $ 2017 1,952 224 (533) 1 1,644 1 — 2,678 2,528 2016 2,316 324 (687) (1) 1,952 — 1 3,086 2,678 Data and assumptions used in the fair value calculation related to MSRs at December 31, 2017 and 2016, 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) $ 2017 312,318 10.2 % 10.0 % 3.8 % 253 25.0 December 31 2016 338,434 10.9 10.0 3.8 257 25.0 At December 31, 2017, the weighted average amortization period for MSRs was 5.9 years. Estimated amortization expense for each of the next five years is presented below. (Dollars in thousands) 2018 2019 2020 2021 2022 NOTE 9: DEPOSITS $ December 31, 2017 262 221 188 157 134 At December 31, 2017, the scheduled maturities of certificates of deposit and other time deposits are presented below. (Dollars in thousands) 2018 2019 2020 2021 2022 Total certificates of deposit and other time deposits December 31, 2017 88,324 $ 53,936 16,610 8,055 21,146 188,071 $ Additionally, at December 31, 2017 and 2016, approximately $55.2 million and $59.5 million, respectively, of certificates of deposit and other time deposits were issued in denominations of $250 thousand or greater. At December 31, 2017 and 2016, the amount of deposit accounts in overdraft status that were reclassified to loans on the accompanying consolidated balance sheets was not material. PAGE 59 AUDITED FINANCIAL STATEMENTS NOTE 10: SHORT-TERM BORROWINGS At December 31, 2017 and 2016, the composition of short-term borrowings is presented below. (Dollars in thousands) Federal funds purchased: 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 2017 Weighted 2016 Weighted Amount Avg. Rate Amount Avg. Rate $ $ — 9 — 2,658 3,467 4,152 — 2.01 % 0.50 % 0.52 % $ $ — 1.21 % 0.50 % 0.50 % — 14 — 3,366 2,969 3,507 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, 2017. 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 $5.8 million and $6.0 million at December 31, 2017 and 2016, respectively, were pledged to secure securities sold under agreements to repurchase. NOTE 11: LONG-TERM DEBT At December 31, 2017 and 2016, the composition of long-term debt is presented below. (Dollars in thousands) Subordinated debentures, due 2033 Total long-term debt 2017 2016 Amount Weighted Avg. Rate 3,217 4.63% 3,217 4.63% Amount Weighted Avg. Rate 3,217 3.88% 3,217 3.88% $ $ $ $ The Company formed Auburn National Bancorporation Capital Trust I (the “Trust”), 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 junior 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. In October 2016, the Company purchased $4.0 million par amount of outstanding trust preferred securities issued by the Trust. These securities were sold by the FDIC, as receiver of a failed bank that held the trust preferred securities. The Company used dividends from the Bank to purchase these trust preferred securities and has deemed an equivalent amount of the related subordinated debentures issued by the company as no longer outstanding. The Company realized a pre-tax gain of $0.8 million on the early extinguishment of debt in this transaction. Following the transaction, the Company had outstanding $3.2 million in junior subordinated debentures held by the Trust related to the remaining $3.0 million of trust preferred securities outstanding and not purchased by the Company. The outstanding principal amount of debentures related to those trust preferred securities remains included in the Company’s Tier 1 capital for regulatory purposes. PAGE 60 The following is a schedule of contractual maturities of long-term debt: (Dollars in thousands) Subordinated debentures Total long-term debt 2018 — — 2019 — — 2020 — — 2021 — — 2022 Thereafter 3,217 — 3,217 — Total 3,217 3,217 $ 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, 2017 and 2016, is presented below. (In thousands) 2017: Unrealized net holding gain on all other securities Reclassification adjustment for net gain on securities recognized in net earnings Other comprehensive income 2016: Unrealized net holding loss on all other securities Reclassification adjustment for net loss on securities recognized in net earnings Other comprehensive loss $ $ $ $ Pre-tax Tax (expense) Net of amount benefit tax amount 417 (51) 366 (4,412) 221 (4,191) (154) 19 (135) 1,628 (82) 1,546 263 (32) 231 (2,784) 139 (2,645) NOTE 13: INCOME TAXES For the years ended December 31, 2017 and 2016 the components of income tax expense from continuing operations are presented below. (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 Total income tax expense Year ended December 31 $ 2017 2,782 499 3,281 384 (28) 356 $ 3,637 2016 2,143 498 2,641 464 (3) 461 3,102 PAGE 61 AUDITED FINANCIAL STATEMENTS 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, 2017 and 2016, is presented below. (Dollars in thousands) Earnings before income taxes Income taxes at statutory rate Tax-exempt interest State income taxes, net of federal tax effect Bank-owned life insurance Federal tax reform impact Other Total income tax expense $ 2017 2016 Percent of pre-tax earnings 34.0 % (7.0) 2.8 (1.3) 3.2 — Amount 11,483 3,904 (813) 325 (150) 370 1 Percent of pre-tax earnings 34.0 % (7.6) 2.9 (1.4) — (0.3) Amount 11,252 3,826 (857) 325 (155) — (37) $ 3,637 31.7 % 3,102 27.6 % The Tax Cuts and Jobs Act was signed into law on December 22, 2017. The net tax expense recognized as a result of the remeasurement of deferred taxes is presented as Federal tax reform impact in the above table. The Company had net deferred tax assets of $0.8 million and $1.3 million at December 31, 2017 and 2016, 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, 2017 and 2016 are presented below: (Dollars in thousands) Deferred tax assets: Allowance for loan losses Unrealized loss on securities Other Total deferred tax assets Deferred tax liabilities: Premises and equipment Originated mortgage servicing rights Other Total deferred tax liabilities Net deferred tax asset 2017 1,195 190 216 1,601 241 413 158 812 789 December 31 2016 1,713 414 316 2,443 205 721 237 1,163 1,280 $ $ 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, 2017. 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. PAGE 62 The change in the net deferred tax asset for the years ended December 31, 2017 and 2016, is presented below. (Dollars in thousands) Net deferred tax asset: Balance, beginning of year Deferred tax expense related to continuing operations Stockholders' equity, for accumulated other comprehensive (income) loss Balance, end of year Year ended December 31 2017 1,280 (356) (135) 789 $ $ 2016 195 (461) 1,546 1,280 ASC 740, Income Taxes, 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, 2017, 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 2018 relative to any tax positions taken prior to December 31, 2017. As of December 31, 2017, 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, 2014 through 2017. 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 $127 thousand and $124 thousand for the years ended December 31, 2017 and 2016, 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, 2017 and December 31, 2016, 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. PAGE 63 AUDITED FINANCIAL STATEMENTS A summary of the Company’s interest rate swaps as of and for the years ended December 31, 2017 and 2016 is presented below. (Dollars in thousands) December 31, 2017: Pay fixed / receive variable Pay variable / receive fixed Total interest rate swap agreements December 31, 2016: Pay fixed / receive variable Pay variable / receive fixed Total interest rate swap agreements Other Assets Estimated Fair Value Other Liabilities Estimated Fair Value Notional Other noninterest income Gains (Losses) $ $ $ $ 3,617 3,617 7,234 3,967 3,967 7,934 — 52 52 — 241 241 52 — 52 241 — 241 $ $ $ $ 189 (189) — 199 (199) — 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, 2017 and 2016, the following financial instruments were outstanding whose contract amount represents credit risk: (Dollars in thousands) Commitments to extend credit Standby letters of credit $ 2017 57,014 7,390 $ December 31 2016 45,979 7,432 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 $79 thousand and $84 thousand at December 31, 2017 and 2016, respectively. Other Commitments Minimum lease payments under leases classified as operating leases due in each of the five years subsequent to December 31, 2017, are as follows: 2018, $65 thousand; 2019, $35 thousand; 2020, $3 thousand; 2021, none ; 2022, none. PAGE 64 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 effect upon the consolidated financial condition or results of operations of the Company and the Bank. 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, 2017 and 2016, 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, 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 65 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, 2017 and 2016, respectively, by caption, on the accompanying consolidated balance sheets by ASC 820 valuation hierarchy (as described above). (Dollars in thousands) December 31, 2017: 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, 2016: 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 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Amount $ $ $ $ $ $ 53,062 133,072 71,563 257,697 52 257,749 52 52 45,471 127,787 70,314 243,572 241 243,813 241 241 — — — — — — — — — — — — — — — — 53,062 133,072 71,563 257,697 52 257,749 52 52 45,471 127,787 70,314 243,572 241 243,813 241 241 — — — — — — — — — — — — — — — — (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. PAGE 66 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 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. PAGE 67 AUDITED FINANCIAL STATEMENTS The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2017 and 2016, respectively, by caption, on the accompanying consolidated balance sheets and by ASC 820 valuation hierarchy (as described above): (Dollars in thousands) December 31, 2017: Loans held for sale Loans, net(1) Other assets (2) Total assets at fair value December 31, 2016: 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) $ $ $ $ 1,922 2,700 1,644 6,266 1,497 2,099 152 1,952 5,700 — — — — — — — — — 1,922 — — 1,922 1,497 — — — 1,497 — 2,700 1,644 4,344 — 2,099 152 1,952 4,203 (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. At December 31, 2017 and 2016 and for the years then ended, the Company had no Level 3 assets measured at fair value on a recurring basis. For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2017, 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 $ 2,700 Appraisal Appraisal discounts (%) Mortgage servicing rights, net 1,644 Discounted cash flow Prepayment speed or CPR (%) Discount rate (%) 16.9% 10.2% 10.0% Fair Value of Financial Instruments 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. PAGE 68 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. 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, 2017 and 2016 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, 2017: Financial Assets: Loans, net (1) Loans held for sale Financial Liabilities: Time Deposits Long-term debt December 31, 2016: 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 $ $ $ $ 448,894 1,922 $ 447,468 1,950 $ 188,071 3,217 $ 185,564 $ 3,217 426,303 1,497 $ 428,446 1,507 $ 208,137 3,217 $ 207,791 $ 3,217 $ $ $ $ — — — — — — — — — 1,950 $ 447,468 — 185,564 3,217 $ — — — 1,507 $ 428,446 — 207,791 3,217 $ — — (1) Represents loans, net of unearned income and the allowance for loan losses. PAGE 69 AUDITED FINANCIAL STATEMENTS NOTE 18: RELATED PARTY TRANSACTIONS 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, 2016 New loans/advances Repayments Loans outstanding at December 31, 2017 Amount 3,944 336 (1,212) 3,068 $ $ During 2017 and 2016, 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, 2017 and 2016 amounted to $17.8 million. 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) common equity Tier 1 ratio, Tier 1 leverage ratio, Tier 1 risk-based ratio and total risk- based ratio. Management believes, as of December 31, 2017, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2017, the Bank is “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum common equity Tier 1, total risk-based, Tier 1 risk- based, and Tier 1 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 70 The actual capital amounts and ratios and the aforementioned minimums as of December 31, 2017 and 2016 are presented below. Actual Minimum for capital adequacy purposes Minimum to be well capitalized Amount Ratio Amount Ratio Amount Ratio (Dollars in thousands) At December 31, 2017: Tier 1 Leverage Capital Auburn National Bancorporation $ AuburnBank Common Equity Tier 1 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, 2016: Tier 1 Leverage Capital Auburn National Bancorporation $ AuburnBank Common Equity Tier 1 Capital Auburn National Bancorporation $ AuburnBank Tier 1 Risk-Based Capital Auburn National Bancorporation $ AuburnBank Total Risk-Based Capital Auburn National Bancorporation $ AuburnBank 90,382 89,217 10.95 % $ 10.82 33,012 32,978 4.00 % 4.00 $ N/A 41,222 N/A 5.00 % 87,382 89,217 16.42 % $ 16.74 23,949 23,987 4.50 % 4.50 $ N/A 34,648 N/A 6.50 90,382 89,217 16.98 % $ 16.74 31,932 31,983 6.00 % 6.00 $ N/A 42,644 N/A 8.00 % 95,300 94,135 17.91 % $ 17.66 42,576 42,644 8.00 % 8.00 $ N/A 53,305 N/A 10.00 % 85,480 84,287 10.27 % $ 10.14 33,293 33,259 4.00 % 4.00 $ N/A 41,574 N/A 5.00 % 82,642 84,287 16.44 % $ 16.74 22,621 22,663 4.50 % 4.50 $ N/A 32,736 N/A 6.50 85,480 84,287 17.00 % $ 16.74 30,162 30,218 6.00 % 6.00 $ N/A 40,290 N/A 8.00 % 90,254 89,061 17.95 % $ 17.68 40,216 40,290 8.00 % 8.00 $ N/A 50,363 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, 2017, the Bank could have declared additional dividends of approximately $10.2 million without prior approval of regulatory authorities. As a result of this limitation, approximately $78.5 million of the Company’s investment in the Bank was restricted from transfer in the form of dividends. PAGE 71 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: December 31 2017 2016 1,170 88,741 1,760 91,671 1,548 3,217 4,765 86,906 91,671 2,190 83,984 881 87,055 1,661 3,217 4,878 82,177 87,055 Year ended December 31 2017 3,471 141 3,612 125 — 225 350 3,262 (58) 3,320 4,526 7,846 2016 6,709 129 6,838 228 (790) 193 (369) 7,207 157 7,050 1,100 8,150 $ $ $ $ $ $ CONDENSED BALANCE SHEETS (Dollars in thousands) Assets: Cash and due from banks Investment in bank subsidiary 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 Gain on early extinguishment of debt Noninterest expense Total expense Earnings before income tax benefit and equity in undistributed earnings of bank subsidiary Income tax (benefit) expense Earnings before equity in undistributed earnings of bank subsidiary Equity in undistributed earnings of bank subsidiary Net earnings PAGE 72 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: Gain on early extinguishment of debt Net increase in other assets Net (decrease) increase in other liabilities Equity in undistributed earnings of bank subsidiary Net cash provided by operating activities Cash flows from financing activities: Repayments or retirement of long-term debt 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 2017 2016 $ 7,846 8,150 — (879) (109) (4,526) 2,332 — (3,352) (3,352) (1,020) 2,190 1,170 (790) (36) 268 (1,100) 6,492 (3,210) (3,279) (6,489) 3 2,187 2,190 $ PAGE 73 This Page Intentionally Left Blank. PAGE 74 STOCK PERFORMANCE GRAPH Stock Performance Graph The following performance graph compares the cumulative, total return on the Company’s Common Stock from December 31, 2012 to December 31, 2017, with that of the Nasdaq Composite Index and SNL Southeast Bank Index (assuming a $100 investment on December 31, 2012). 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 Index SNL Southeast Bank Index 300 250 e u l a V x e d n I 200 150 100 50 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16 12/31/17 Index Auburn National Bancorporation, Inc. NASDAQ Composite SNL Southeast Bank 12/31/12 100.00 100.00 100.00 12/31/13 124.35 140.12 135.52 12/31/14 121.78 160.78 152.63 12/31/15 157.82 171.97 150.24 12/31/16 172.15 187.22 199.45 12/31/17 219.60 242.71 246.72 Period Ending PAGE 75 Corporate Information CORPORATE HEADQUARTERS 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 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 releases 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 INDEPENDENT AUDITORS Relations at investorrelations@auburnbank.com or Elliott Davis Decosimo LLC/PLLC 200 East Broad Street Greenville, SC 29606 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: Computershare P. O. Box 505000 Louisville, KY 40233 Phone: 1-800-368-5948 For frequently asked questions, visit theTransfer Agent’s home page at: www.computershare.com ANNUAL MEETING Tuesday, May 8, 2018 3:00 p.m. (Central Time) AuburnBank Center 132 N. Gay Street Auburn, AL 36830 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 Telephone: 334-821-9200 Fax: 334-887-2796 Strength. Vision. Service. A T R I B U T E TO M R . E . L . S P E N C E R , J R . AUBURN NATIONAL BANCORPORATION, INC. 2017 ANNUAL REPORT 

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