ChoiceOne Financial Services, Inc.
Annual Report 2012

Plain-text annual report

CHOICEONE FINANCIAL SERVICES, INC. 2012 ANNUAL REPORT TO SHAREHOLDERS CHOICEONE FINANCIAL SERVICES, INC. 2012 Annual Report to Shareholders Contents To Our Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . About ChoiceOne Financial Services, Inc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 3 5 6 Management’s Report on Internal Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Corporate and Shareholder Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Directors and Officers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 2 CHOICEONE FINANCIAL SERVICES, INC. To Our Shareholders This 2012 Annual Report to Shareholders contains our audited financial statements, detailed financial review and all of the information that regulations of the Securities and Exchange Commission (the “SEC”) require to be presented in annual reports to shareholders. For legal purposes, this is the ChoiceOne Financial Services, Inc. 2012 Annual Report to Shareholders. Although attached to our proxy statement, this report is not part of our proxy statement, is not considered to be soliciting material and is not considered to be filed with the SEC except to the extent that it is expressly incorporated by reference in a document filed with the SEC. Shareholders who would like to receive even more detailed information than that contained in this 2012 Annual Report to Shareholders are invited to request our Annual Report on Form 10-K. Our Annual Report on Form 10-K for the year ended December 31, 2012, including the financial statements and financial statement schedules, will be provided to any shareholder, without charge, upon written request to Mr. Thomas Lampen, Treasurer, ChoiceOne Financial Services, Inc., 109 East Division Street, Sparta, Michigan 49345. ABOUT CHOICEONE FINANCIAL SERVICES, INC. ChoiceOne Financial Services, Inc. is a single-bank holding company. Its principal banking subsidiary, ChoiceOne Bank (Sparta, Michigan), primarily serves communities in portions of Kent, Muskegon, Newaygo, and Ottawa counties in Michigan where ChoiceOne’s offices are located and the areas immediately surrounding those communities. Currently ChoiceOne serves those markets through thirteen full-service offices. ChoiceOne Insurance Agencies, Inc. is a wholly-owned subsidiary of ChoiceOne Bank and sells insurance and investment products. ChoiceOne’s business is primarily concentrated in a single industry segment – banking. ChoiceOne Bank is a full-service banking institution that offers a variety of deposit, payment, credit and other financial services to all types of customers. These services include time, savings, and demand deposits, safe deposit services, and automated transaction machine services. Loans, both commercial and consumer, are extended primarily on a secured basis to corporations, partnerships and individuals. Commercial lending covers such categories as business, industry, agricultural, construction, inventory and real estate. ChoiceOne Bank’s consumer loan department makes direct loans to consumers and purchasers of residential property. The principal source of revenue for ChoiceOne is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 62%, 67%, and 69% of total revenues in 2012, 2011, and 2010, respectively. Interest from securities accounted for 12%, 11%, and 10% of total revenues in 2012, 2011, and 2010, respectively. STOCK INFORMATION Several brokers trade ChoiceOne’s common shares in the over-the-counter bulletin board market. There is no well-established public trading market for the shares and trading activity is infrequent. ChoiceOne’s trading volume and recent share price information can be viewed under the symbol ‘COFS.OB’ on certain financial websites. The range of high and low bid prices for shares of common stock for each quarterly period during the past two years is as follows: First Quarter Second Quarter Third Quarter Fourth Quarter 2012 2011 Low $11.25 13.01 13.50 14.30 High $14.14 15.38 16.50 15.50 Low $11.00 10.50 10.60 10.26 High $20.00 13.00 12.75 12.50 The prices listed above are over-the-counter market quotations reported to ChoiceOne by its market makers listed in this annual report. The over-the-counter market quotations reflect inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. As of February 28, 2013, the average bid price for shares of ChoiceOne common stock was $16.05. As of February 28, 2013, there were 3,299,120 shares of ChoiceOne Financial Services, Inc. common stock issued and outstanding. As of February 28, 2013, there were 777 shareholders of record of ChoiceOne Financial Services, Inc. common stock. 3 The following table summarizes cash dividends declared per share of common stock during 2012 and 2011: First Quarter Second Quarter Third Quarter Fourth Quarter Total 2012 $ 0.12 0.12 0.13 0.13 $ 0.50 2011 $ 0.12 0.12 0.12 0.12 $ 0.48 ChoiceOne’s principal source of funds to pay cash dividends is the earnings and dividends paid by ChoiceOne Bank. ChoiceOne Bank is restricted in its ability to pay cash dividends under current banking regulations. See Note 21 to the consolidated financial statements for a description of these restrictions. Based on information presently available, management expects ChoiceOne to declare and pay regular quarterly cash dividends in 2013, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other things. 4 ChoiceOne Financial Services, Inc. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) 2012 2011 2010 2009 2008 For the year Net interest income . . . . . . . . . . . . . . . . . . . . . . . . $ Provision for loan losses . . . . . . . . . . . . . . . . . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . . Income tax expense/(benefit) . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . . . . . . . . . 17,675 2,515 6,889 16,444 5,605 1,343 4,262 1,648 Per share Basic earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted earnings . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . . . . . . . . . Shareholders’ equity (at year end) . . . . . . . . . . . . 1.29 1.29 0.50 18.35 Average for the year Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Gross loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129,337 307,639 408,785 6,130 59,431 500,636 At year end Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Gross loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138,242 311,468 424,199 420 60,506 508,913 $ $ $ $ 17,922 3,700 6,139 15,788 4,573 1,060 3,513 1,578 1.07 1.07 0.48 17.58 104,986 317,271 396,474 8,461 56,098 486,478 118,025 320,127 403,365 8,447 57,904 495,914 $ $ $ $ 16,995 3,950 5,569 15,249 3,365 654 2,711 1,572 0.83 0.83 0.48 16.56 86,437 315,031 374,274 16,477 54,012 469,484 94,979 316,940 389,884 8,473 54,313 480,524 $ $ $ $ 15,996 4,875 5,421 15,259 1,283 (195) 1,478 1,563 0.45 0.45 0.48 16.21 76,934 320,328 347,007 28,857 53,115 453,876 78,987 322,716 365,010 21,980 52,926 465,915 $ $ $ $ 15,331 3,475 4,083 14,711 1,228 (207) 1,435 2,202 0.44 0.44 0.68 16.08 85,086 326,420 347,190 38,803 53,411 465,741 81,941 325,977 346,998 39,957 52,185 463,551 Selected financial ratios Return on average assets . . . . . . . . . . . . . . . . . . . Return on average shareholders’ equity . . . . . . . . Cash dividend payout as a percentage of net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity to assets (at year end) . . . . . 0.85% 7.17 0.72% 6.26 0.58% 5.02 0.33% 2.78 0.31% 2.69 38.67 11.89 44.92 11.68 57.99 11.30 105.75 11.36 153.45 11.26 5 ChoiceOne Financial Services, Inc. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. (“ChoiceOne” or the “Company”), and its wholly-owned subsidiaries, ChoiceOne Bank (the “Bank”) and ChoiceOne Insurance Agencies, Inc. (the “Insurance Agency”). This discussion should be read in conjunction with the consolidated financial statements and related footnotes. FORWARD-LOOKING STATEMENTS This discussion and other sections of this annual report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and ChoiceOne itself. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “predicts,” “projects,” “may,” “could,” variations of such words and similar expressions are intended to identify such forward-looking statements. Management’s determination of the provision and allowance for loan losses, the carrying value of goodwill and loan servicing rights, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary) and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise. Risk factors include, but are not limited to, the risk factors discussed in Item 1A of the Company’s Annual Report on Form 10-K; changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking laws and regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior as well as their abilities to repay loans; changes in the local and national economies; changes in market conditions; the level and timing of asset growth; various other local and global uncertainties such as acts of terrorism and military actions; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about capital and credit availability and concerns about the Michigan economy in particular. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The purpose of this section of the 2012 Annual Report to Shareholders is to provide a narrative discussion about the Company’s financial condition and results of operations during 2012. Management’s discussion and analysis of financial condition and results of operations as well as disclosures found elsewhere in the 2012 Annual Report to Shareholders are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the market value of securities, allowance for loan losses and loan servicing rights. Actual results could differ from those estimates. Securities Securities available for sale may be sold prior to maturity due to changes in interest rate, prepayment risks, yield, availability of alternative investments, liquidity needs, credit rating changes, or other factors. Securities classified as available for sale are reported at their fair value. Declines in the fair value of securities below their cost that are considered to be “other than temporary” are recorded as losses in the income statement. In estimating whether a fair value decline is considered to be “other than temporary,” management considers the length of time and extent that the security’s fair value has been less than its carrying value, the financial condition and near-term prospects of the issuer, and the Bank’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Market values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the fair value of securities is recorded as a valuation adjustment and reported net of tax effect in other comprehensive income. 6 Allowance for Loan Losses The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios. Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and current economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Company’s assets reported on the balance sheet as well as its net income. Loan Servicing Rights Loan servicing rights represent the estimated value of servicing loans that are sold with servicing retained by ChoiceOne. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Management’s accounting treatment of loan servicing rights is estimated based on current prepayment speeds that are typically market driven. Management believes the accounting estimate related to loan servicing rights is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of significant changes within long-term interest rates affecting the prepayment speeds for current loans being serviced and (2) the impact of recognizing an impairment loss could have a material effect on ChoiceOne’s net income. Management has obtained a third-party valuation of its loan servicing rights to corroborate its current carrying value at the end of each reporting period. Goodwill Generally accepted accounting principles require that the fair values of the assets and liabilities of an acquired entity be recorded at their fair value on the date of acquisition. The fair values are determined using both internal computations and information obtained from outside parties when deemed necessary. The net difference between the price paid for the acquired company and the net value of its balance sheet is recorded as goodwill. Accounting principles also require that goodwill be evaluated for impairment on an annual basis or more frequently whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Management performed its annual review of goodwill as of June 30, 2012. ChoiceOne engaged an outside consulting firm to assist in the goodwill impairment analysis. The following steps were used in the valuation: determination of the reporting unit, determination of the appropriate standard of value, determination of the appropriate level of value, calculation of fair value, and comparison of the fair value computed to the equity carrying value. It was determined that the relevant reporting unit to be valued was ChoiceOne Bank. The standard of value used in the valuation was fair value as determined by generally accepted accounting principles. The appropriate level of value was determined to be the controlling interest level. The appraisal methodology used to calculate the fair value included the following valuation approaches: Income Approach: A discounted cash flow value was calculated based on earnings capacity. The discount rate used for the calculation was 12.50%. The growth assumption for assets was 1.8% for the first year and 2.0% in subsequent years. In addition, it was assumed that cost savings of 20% of noninterest expense would occur as a result of synergies and cost reductions from a change in control. Market Approach: The analysis was based on price-to-earnings multiples, price-to-tangible book value ratios, and core deposit premiums for selected bank sale transactions. The Asset Approach was also an approach reviewed, but it was not used in determining the fair value since it did not render a control level indication of value. The results from the valuation approaches were used to calculate an estimate of the fair value of ChoiceOne’s equity. The fair value was compared to the carrying value of equity to determine whether the Step 1 test under generally accepted accounting principles that govern the valuation of goodwill was passed. The goodwill analysis determined that the fair value of ChoiceOne’s equity exceeded the carrying value by 10.8%. Based on this assessment, management believed that there was no indication of goodwill impairment. Taxes Income taxes include both a current and deferred portion. Deferred tax assets and liabilities are recorded to account for differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. Generally accepted accounting principles require that deferred tax assets be reviewed to determine whether a valuation allowance should be established using a “more likely than not” standard. Based on its review of ChoiceOne’s deferred tax assets as of December 31, 2012, management determined that a valuation allowance of $89,000 was necessary. 7 RESULTS OF OPERATIONS Summary (Dollars in thousands) Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year ended December 31 2012 17,675 (2,515) 6,889 (16,444) (1,343) $ 2011 17,922 (3,700) 6,139 (15,788) (1,060) $ 2010 16,995 (3,950) 5,569 (15,249) (654) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,262 $ 3,513 $ 2,711 Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . Return on average equity . . . . . . . . . . . . . . . . . . . . . . . 2012 0.85% 7.17% 2011 0.72% 6.26% 2010 0.58% 5.02% Net income for 2012 was $4,262,000, which represented a $749,000 or 21% increase from 2011. The growth in net income resulted from an increase in noninterest income and a decrease in the provision for loan losses, which was partially offset by a decrease in net interest income and an increase in noninterest expense in 2012 compared to 2011. The increase in noninterest income was due primarily to increases in gains on sales of loans and gains on sales of securities. The decrease in the provision for loan losses resulted from lower net charge-offs in 2012 than in 2011. The decrease in net interest income was primarily due to a lower average rate on average earning assets resulting in a decrease in ChoiceOne’s net interest spread in 2012 compared to the prior year. The increase in noninterest expense was due to higher salaries and benefits, data processing, professional fees, and other noninterest expense as well as smaller increases in other expense categories in 2012 compared to the prior year offset by decreases in supplies and postage and FDIC insurance expenses. Net income for 2011 was $3,513,000, which represented an $802,000 or 30% increase from 2010. The growth in net income resulted from increases in net interest income and noninterest income and a decrease in the provision for loan losses, which was partially offset by an increase in noninterest expense in 2011 compared to 2010. The increase in net interest income was due to growth in average earning assets and an increase in ChoiceOne’s net interest spread in 2011 compared to the prior year. The expansion in noninterest income was due to growth in customer service charges and other noninterest income and an improvement in gains (losses) on sales of other assets in 2011 compared to 2010. The decrease in the provision for loan losses resulted from lower net charge-offs in 2011 than in 2010 and a $1.8 million reduction in nonperforming loans from December 31, 2010 to December 31, 2011. The increase in noninterest expense was due to higher salaries and benefits, professional fees, and other noninterest expense as well as smaller increases in other expense categories in 2011 compared to the prior year. Dividends Cash dividends of $1,648,000 or $0.50 per common share were declared in 2012, compared to $1,578,000 or $0.48 per common share in 2011 and $1,572,000 or $0.48 per common share in 2010. Dividends declared were $0.13 per share for the last two quarters and $0.12 per share for the first two quarters in 2012. Dividends declared were $0.12 for each quarter in 2011 and 2010. The dividend yield on ChoiceOne’s common stock was 3.53% in 2012, compared to 4.05% in 2011 and 4.79% in 2010. The cash dividend payout as a percentage of net income was 39% in 2012, compared to 45% in 2011 and 58% in 2010. ChoiceOne’s principal source of funds to pay cash dividends is the earnings of the Bank. The availability of these earnings is dependent upon the capital needs, regulatory constraints and other factors involving the Bank. Regulatory constraints include the maintenance of minimum capital ratios and limits based on net income and retained earnings of the Bank for the past three years. ChoiceOne expects to pay quarterly cash dividends in 2013 to shareholders based on the actual earnings of the Bank, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other things. 8 Table 1 – Average Balances and Tax-Equivalent Interest Rates (Dollars in thousands) 2012 Year ended December 31 2011 Average Balance Interest Average Rate Average Balance Interest Average Rate Average Balance 2010 Interest Average Rate Assets Loans (1) (2) . . . . . . . . . . . . . . . . $ 307,639 $ 16,891 1,958 Taxable securities (3) . . . . . . . . . 2,053 Tax-exempt securities (1) . . . . . . 25 Other . . . . . . . . . . . . . . . . . . . . . . 90,783 38,554 10,021 5.49%$ 317,271 $ 18,417 2.16 1,789 71,871 5.32 1,913 33,115 0.25 20 8,426 5.80% $ 315,031 $ 19,103 1,460 50,997 2.49 2,110 35,440 5.78 22 6,498 0.25 6.06% 2.86 5.95 0.34 Noninterest-earning assets (4) Interest-earning assets . . . . . . . . . . 446,997 53,639 Total assets . . . . . . . . . . . . . . . $ 500,636 Liabilities and Shareholders’ Equity Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . $ 136,118 50,252 138,805 6,130 22,282 Savings deposits . . . . . . . . . . . . . . . . . . . . . . Certificates of deposit Advances from FHLB . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . Interest-bearing liabilities . . . . 353,587 Demand deposits . . . . . . . . . . . . . Other noninterest-bearing liabilities . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . 83,810 3,808 441,205 59,431 Total liabilities and 20,927 4.68 430,683 55,795 $ 486,478 22,139 5.14 407,966 61,518 $ 469,484 22,695 5.56 364 59 1,664 271 186 2,544 0.27%$ 124,575 0.12 45,698 1.20 153,494 4.42 8,461 0.83 21,179 0.72 353,407 541 51 2,364 307 290 3,553 0.43% $ 108,522 40,534 0.11 160,390 1.54 16,477 3.63 19,273 1.37 1.01 345,196 553 80 3,281 748 304 4,966 0.51% 0.20 2.05 4.54 1.58 1.44 72,707 4,266 430,380 56,098 64,828 5,448 415,472 54,012 shareholders’ equity . . . . . . . $ 500,636 $ 486,478 $ 469,484 Net interest income (tax-equivalent basis) – interest spread . . . . . . . . . Tax-equivalent adjustment (1) . . . . . Net interest income . . . . . . . . . . . . . Net interest income as a percentage of earning assets (tax-equivalent basis) . . . . . . . . . . . . . . . . . . . . . . 18,383 3.96% 18,586 4.13% 17,729 4.12% (708) $ 17,375 (664) $ 17,922 (734) $ 16,995 4.11% 4.32% 4.35% (1) (2) Interest on nontaxable securities and loans has been adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 34% for the years presented. Interest on loans included net origination fees charged on loans of approximately $885,000, $831,000, and $751,000 in 2012, 2011, and 2010, respectively. Interest on taxable securities includes dividends on Federal Home Loan Bank and Federal Reserve Bank stock. (3) (4) Noninterest-earning assets include loans on a nonaccrual status, which averaged approximately $4,364,000, $6,256,000, and $10,286,000 in 2012, 2011, and 2010, respectively. Net Interest Income As shown in Tables 1 and 2, tax-equivalent net interest income decreased $203,000 in 2012 compared to 2011. The decrease was attributed to a 46 basis point decline in the average rate on interest bearing assets offset by a 29 basis point decline in average interest bearing liabilities. The effect of the reduction in ChoiceOne’s net interest spread was partially offset by growth of $16.3 million in average interest-earning assets in 2012 compared to 2011. 9 The average balance of loans increased $9.6 million in 2012 compared to 2011. Combined with a 31 basis point decrease in the average rate earned on loans, interest income on loans declined $1,526,000 in 2012 compared to the prior year. The average balance of total securities increased by $24.4 million in 2012 compared to 2011. This growth in the average balance, partially offset by a lower average rate earned on securities, caused interest income from securities to increase $169,000 in 2012 compared to the prior year. A small increase in the average balance of other interest-earning assets resulted in an increase of $5,000 in 2012 compared to 2011. As average loans experienced a decline in 2012 compared to 2011, growth in securities was ChoiceOne’s method to achieve growth in earning assets in 2012. The average balance of interest-bearing demand deposits increased $11.5 million in 2012 compared to 2011. The effect of this increase, offset by a 16 basis point decline in the average rate paid, caused interest expense to be $177,000 lower in 2012 than in the prior year. The effect of $4.6 million of growth in average savings deposits caused an $8,000 increase in interest expense in 2012 compared to the prior year. The average balance of certificates of deposit was $14.7 million lower in 2012 than in the prior year. Approximately $12.1 million of the certificates of deposit decline was related to certificates from ChoiceOne’s local markets, while the remaining $2.6 million resulted from a lower level of brokered certificates. The average balance decrease plus the effect of a 34 basis point decline in the average rate paid caused interest expense on certificates of deposit to fall $700,000 in 2012 compared to 2011. A $2.3 million decrease in the average balance of Federal Home Loan Bank advances, partially offset by a 79 basis point increase in the average rate paid, caused interest expense to decline $36,000 in 2012 compared to the prior year. The increase in the rate paid on FHLB advances in 2012 compared to 2011 was caused by the payoff of a $3 million advance with an interest rate of 2.54% in June 2012. Interest expense on other interest-bearing liabilities fell $104,000 in 2012 compared to 2011 due to a reduction of 54 basis points in the average interest rate paid, which was partially offset by a $1.1 million increase in the average balance. The growth experienced in interest-bearing demand deposits and savings deposits was primarily due to depositors choosing the liquidity and safety afforded by this type of deposit as compared to certificates of deposit or nonbank investments. ChoiceOne’s net interest income spread was 3.96% (shown in Table 1) for 2012, compared to 4.13% in 2011. The average yield received on interest-earning assets in 2012 decreased 46 basis points to 4.68% while the average rate paid on interest-bearing liabilities in 2012 fell 29 basis points to 0.72%. The decline in general market interest rates in both 2011 and 2012 caused the reduction in rates for both assets and liabilities in the two time periods. Table 2 – Changes in Tax-Equivalent Net Interest Income (Dollars in thousands) Year ended December 31 2012 Over 2011 Total Volume Rate 2011 Over 2010 Volume Rate Total Increase (decrease) in interest income (1) Loans (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$(1,526) $ (548) 429 Taxable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Tax-exempt securities (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other 169 140 5 $ (978) $ (686) $ 135 538 (136) (30) (260) (157) 1 329 (197) (2) $ (821) (209) (61) 28 Net change in tax-equivalent income . . . . . . . . . . . . . . . . . (1,212) 182 (1,394) (556) 507 (1,063) Increase (decrease) in interest expense (1) Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates of deposit Advances from Federal Home Loan Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other (177) 8 (700) (36) (104) Net change in interest expense . . . . . . . . . . . . . . . . . . . . . . (1,009) 46 5 (211) (95) 15 (240) (223) 3 (489) 59 (119) (12) (29) (917) (441) (14) (769) (1,413) 76 9 (136) (312) 28 (335) (88) (38) (781) (129) (42) (1,078) Net change in tax-equivalent net interest income . . . . . . . .$ (203) $ 422 $ (625) $ 857 $ 842 $ 15 (1) The volume variance is computed as the change in volume (average balance) multiplied by the previous year’s interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year’s volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Interest on tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 34% for the years presented. (2) 10 Tax-equivalent net interest income increased $857,000 in 2011 compared to 2010. The growth was due to growth of $15.4 million in average interest-earning assets in 2011 compared to 2010 and a 10 basis point increase in ChoiceOne’s net interest income spread compared to 2010. The higher level of average interest-earning assets contributed an additional $842,000 in net interest income in 2011 compared to 2010, while the growth in the net interest income spread caused an increase of $15,000 in net interest income in 2011 compared to the prior year. The average balance of loans increased $2.2 million in 2011 compared to 2010. A 26 basis point decrease in the average rate earned on loans had a larger impact on interest income on loans as it declined $686,000 in 2011 compared to the prior year. The average balance of total securities increased by $18.5 million in 2011 compared to 2010. This growth in the average balance, partially offset by a lower average rate earned on securities, caused interest income from securities to increase $132,000 in 2011 compared to the prior year. A decrease in the average balance of other interest-earning assets, offset by an increase in the average rate earned resulted in a decrease in interest income of $2,000 in 2011 compared to 2010. Although the average balance of loans grew slightly in 2011 compared to 2010, loan demand continued to be sluggish due to continued concerns about the Michigan economy. Growth in securities was due to ChoiceOne’s desire to achieve growth in earning assets. The average balance of interest-bearing demand deposits increased $16.1 million in 2011 compared to 2010. The effect of this increase, offset by an 8 basis point decline in the average rate paid, caused interest expense to be $12,000 lower in 2011 than in the prior year. The effect of a 9 basis point decrease in the average rate paid on savings deposits in 2011 compared to 2010 was partially offset by the effect of growth of $5.2 million in the average balance as interest expense dropped $29,000. The average balance of certificates of deposit was $6.9 million lower in 2011 than in the prior year. Approximately $5.3 million of the certificates of deposit decline was related to certificates from ChoiceOne’s local markets, while the remaining $1.6 million was a lower level of brokered certificates. The average balance decrease plus the effect of a 51 basis point decline in the average rate paid caused interest expense on certificates of deposit to fall $917,000 in 2011 compared to 2010. An $8.0 million decrease in the average balance of Federal Home Loan Bank advances and a 91 basis point decrease in the average rate paid caused interest expense to decline $441,000 in 2011 compared to the prior year. Interest expense on other interest-bearing liabilities fell $14,000 in 2011 compared to 2010 due to a reduction of 21 basis points in the average interest rate paid, which was partially offset by a $1.9 million increase in the average balance. The growth experienced in interest-bearing demand deposits and savings deposits was primarily due to depositors choosing the liquidity and safety afforded by this type of deposit as compared to certificates of deposit or nonbank investments. 11 Allowance and Provision For Loan Losses Information regarding the allowance and provision for loan losses can be found in Table 3 below: Table 3 – Provision and Allowance For Loan Losses (Dollars in thousands) 2012 2011 2010 2009 2008 Allowance for loan losses at beginning of year . . . . . . . . . . . . . . . $ 5,213 $ 4,729 $ 4,322 $ 3,600 $ 3,600 Charge-offs: Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 405 869 — 887 338 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,499 Recoveries: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Agricultural Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 61 224 — 119 214 623 45 228 1,357 — 1,677 361 3,668 10 32 89 — 104 217 452 — 765 1,523 — 1,152 444 3,884 — 68 16 — 27 230 341 — 1,558 1,218 14 1,369 535 4,694 — 102 58 29 106 246 541 — 1,193 816 — 1,252 567 3,828 — 60 35 — 6 252 353 Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,876 2,515 3,216 3,700 3,543 3,950 4,153 4,875 3,475 3,475 Allowance for loan losses at end of year . . . . . . . . . . . . . . . . . . . . $ 5,852 $ 5,213 $ 4,729 $ 4,322 $ 3,600 Allowance for loan losses as a percentage of: Total loans as of year end . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nonaccrual loans, accrual loans past due 90 days or more and troubled debt restructurings . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio of net charge-offs to average total loans outstanding during the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan recoveries as a percentage of prior year’s charge-offs . . . . . 1.88% 1.63% 1.49% 1.34% 1.10% 86% 78% 56% 31% 39% 0.61% 17% 1.01% 12% 1.12% 7% 1.30% 14% 1.06% 15% As shown in Table 3, the provision for loan losses was $1,185,000 lower in 2012 than in 2011. The reduction in the provision level resulted from a decrease of $1,341,000 in net charge-offs experienced in 2012 compared to 2011. Net charge-offs of residential real estate loans declined $805,000 and net charge-offs of commercial real estate loans decreased $623,000 in 2012 compared to 2011, while net charge-offs of commercial and industrial loans increased $148,000. Agricultural loans and consumer loans net charge-offs both decline slightly in 2012 compared to 2011. Management believes that the lower net charge-off levels are due in part to the improving economy in the bank’s market areas. The allowance for loan losses as a percentage of total loans increased from 1.63% as of the end of 2011 to 1.88% as of the end of 2012. The coverage ratio of the allowance for loan losses to nonperforming loans increased from 78% as of December 31, 2011 to 86% as of December 31, 2012. This was due to growth of $639,000 in the allowance balance during 2012. ChoiceOne had $700,000 of specific allowance allocations for problem loans as of the end of 2012, compared to $431,000 as of the prior year end. Special allowance amounts have been allocated where the fair values of loans were considered to be less than their carrying values. ChoiceOne obtains valuations on collateral dependent loans when the loan is considered by management to be impaired and uses the valuation amounts in the determination of fair value. Management believes the specific reserves allocated to certain problem loans at the end of 2012 and 2011 were reasonable based on the circumstances surrounding each particular borrower. 12 The following schedule presents an allocation of the allowance for loan losses to the various loan categories as of the years ended December 31: (Dollars in thousands) Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer Unallocated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 140 381 2,596 15 1,923 250 547 $ 2011 55 609 2,299 34 1,847 197 172 $ 2010 181 641 1,729 2 1,554 243 379 $ 2009 124 735 1,546 3 1,590 306 18 2008 242 616 996 5 1,124 351 266 Total allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . $ 5,852 $ 5,213 $ 4,729 $ 4,322 $ 3,600 The increase in the allowance allocation to agricultural loans was due in part to weather conditions that affected certain agricultural borrowers in 2012. The decrease in the allowance allocation to commercial and industrial loans and the increase in the allocation to commercial real estate loans were based on the perceived risk level in these loan categories. Management maintains the allowance at a level that it believes adequately provides for losses inherent in the loan portfolio. Such losses are estimated by a variety of factors, including specific examination of certain borrowing relationships and consideration of historical losses incurred on certain types of credits. Current economic conditions and declining collateral values affect loss estimates. Management focuses on early identification of problem credits through ongoing reviews by management and the independent loan review function. Based on the current state of the economy and a recent review of the loan portfolio, management believes that the allowance for loan losses as of December 31, 2012 is adequate. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur, the provision and allowance for loan losses will be reviewed by the Bank’s management and adjusted as necessary. Noninterest Income Total noninterest income increased $750,000 in 2012 compared to 2011. Customer service charges decreased $89,000 in 2012 compared to the prior year as lower income from overdraft fees was partially offset by growth in debit card interchange fees. Gains on sales of loans grew $962,000 in 2012 compared to 2011 as proceeds from loan sales totaled $46 million in 2012 compared to $27 million in 2011. An increase of $290,000 in gains on sales of securities was caused by sales of $9.4 million of securities in 2012 compared to $3.3 million in the prior year. Losses on sales of other assets were $387,000 higher in 2012 than in the prior year as write-downs of values of other real estate properties and losses on sales of properties were more in 2012 than in 2011. Earnings on life insurance policies were $93,000 higher in 2012 than the prior year as a result of a death benefit received. The $158,000 decrease in other noninterest income in 2012 compared to 2011 was primarily due to lower ATM surcharge fees. Total noninterest income increased $570,000 in 2011 compared to 2010. Customer service charges increased $294,000 in 2011 compared to the prior year as growth in debit card interchange fees and checking account fees were partially offset by a continued decline in overdraft fees. Gains on sales of securities declined $408,000 in 2011 compared to the prior year. Gains on sales of securities in 2010 included $386,000 from sales of preferred stock that represented a recovery of losses recognized on money market preferred securities in 2008. Gains (losses) on sales of other assets improved by $461,000 as write-downs of values of other real estate properties and losses on sales of properties were less in 2011 than in 2010. Most of the $163,000 increase in other noninterest income resulted from amortization of mark-to-market adjustment of mortgage servicing fees that ended in October 2010. Noninterest Expense Total noninterest expense increased $656,000 in 2012 compared to 2011. Salaries and benefits increased $525,000 in 2012 compared to the prior year as a result of higher commission expense related to mortgage originations, performance bonuses, and supplemental retirement expense. Data processing expense was $112,000 higher in 2012 than in 2011 due to higher software maintenance costs. Professional fees grew $94,000 higher in 2012 than in 2011 due to increased use of outside consultants. Supplies and postage expense was $87,000 lower in 2012 than in 2011 as a result of postage savings from increased electronic statement usage. The $52,000 increase in advertising and promotional expense in 2012 compared to the prior year was caused by higher radio and television advertising and website development expenses. FDIC insurance expense declined $111,000 in 2012 compared to 2011 due to a change in the insurance assessment base beginning in the second quarter of 2011. 13 Total noninterest expense increased $539,000 in 2011 compared to 2010. Salaries and benefits increased $308,000 in 2011 compared to the prior year as a result of staffing additions and increased incentives. Occupancy and equipment expense was $90,000 higher in 2011 than in 2010 as depreciation expense, utilities, and various other expenses increased from the prior year. The $89,000 increase in data processing expense in 2011 compared to the prior year resulted from higher costs related to electronic banking usage. Professional fees were $118,000 higher in 2011 than in 2010 due to increases in legal, accounting, and consulting costs. Loan and collection expense declined $103,000 in 2011 compared to 2010 due to lower collection costs for problem loans, including amounts paid for outside collection services. FDIC insurance expense was $153,000 lower in 2011 than in the prior year due to a change in the assessment base for insurance beginning in the second quarter of 2011. Other noninterest expense grew by $178,000 in 2011 compared to 2010 as a result of increases in training and recruiting expenses, directors’ fees, loan-related expense, and a number of other expense accounts. Income Taxes Income taxes were $1,343,000 in 2012, compared to tax expense of $1,060,000 in 2011 and a tax expense of $654,000 in 2010. The increase in income tax expense from 2010 to 2011 and from 2011 to 2012 was caused by higher income before income tax compared to the prior year in 2011 and 2012. In addition, the portion of income before income tax comprised of nontaxable income declined in both 2011 and 2012, which caused the effective tax rate to be higher. Financial Condition Summary Total assets were $508.9 million as of December 31, 2012, which represented an increase of $13.0 million or 3% from the end of 2011. Securities available for sale increased $20.2 million during 2012 as management purchased securities to use funds that were provided by a decline in loans and deposit growth. Loans declined $8.7 million in 2012 with most of the decrease occurring in commercial real estate and agricultural loans. Total deposits grew $20.8 million in 2012 due to increases in checking and savings deposits, which were partially offset by a decrease in local and brokered certificates of deposit. Securities The Bank’s securities available for sale balances as of December 31 were as follows: (Dollars in thousands) U.S. Government and federal agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ U.S. Treasury notes and bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and municipal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign debt FDIC-guaranteed financial institution debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 40,268 7,398 64,678 12,526 6,712 1,001 — 1,909 2011 40,413 — 54,499 9,780 6,011 — 2,038 1,535 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 134,492 $ 114,276 The securities available for sale portfolio increased $20.2 million from December 31, 2011 to December 31, 2012. ChoiceOne purchased $69.6 million of securities during 2012 to replace securities that matured or were called and to provide growth in earning assets. Approximately $34.9 million in various securities were called or matured in 2012. Principal payments for municipal and mortgage-backed securities totaling $4.2 million were received during 2012. Various securities totaling approximately $9.4 million were sold during 2012 for net gains totaling $419,000. The Bank’s Investment Committee continues to monitor the portfolio and purchases securities as it considers prudent. Also, certain securities are sold under agreements to repurchase and management plans to continue this practice as a low-cost source of funding. State and municipal securities as of the end of 2011 included a security that matured on September 1, 2009 and was not redeemed by the issuer. A principal payment of $29,000 was received in October 2009 on the par value of $500,000. Impairment losses totaling $141,000 had been recorded in 2009 and 2010 due to uncertainty as to when or how much principal repayment would be received. Settlement was reached with the security’s issuer in December 2011 and ChoiceOne received the remaining carrying value of the security in the first quarter of 2012. 14 Equity securities included a money market preferred security (MMP) of $1,000,000, a trust preferred security of $500,000, preferred stock of $263,000, and common stock of $146,000 as of December 31, 2012 and an MMP of $768,000, a trust preferred security of $500,000, and preferred stock of $267,000 as of December 31, 2011. Management will continue to monitor its securities in 2013. Securities may be sold if believed prudent from a risk standpoint. Loans The Bank’s loan portfolio as of December 31 was as follows: (Dollars in thousands) Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate - residential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 31,791 67,365 19,367 93,312 1,056 98,577 Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 311,468 $ 2011 38,929 58,685 18,657 106,250 1,169 96,437 320,127 The loan portfolio (excluding loans held for sale) decreased $8.7 million from December 31, 2011 to December 31, 2012. Economic concerns in ChoiceOne’s market areas continued to affect loan demand in 2012. The decline in agricultural loans was caused by increased competition for this type of loan as well as the impact of weather conditions in the second quarter of 2012. The growth in commercial and industrial loans resulted from calling efforts by ChoiceOne’s loan officers. Commercial real estate loans continued to be affected by reduced real estate collateral values in 2012. The increase in residential real estate loans resulted from management’s decision to hold certain longer term fixed-rates loans in portfolio instead of selling them in the secondary market. Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. In addition to its review of the loan portfolio for impaired loans, management also monitors various nonperforming loans. Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or past due 90 days or more, which are considered troubled debt restructurings. The balances of these nonperforming loans as of December 31 were as follows: (Dollars in thousands) Loans accounted for on a nonaccrual basis . . . . . . . . . . . . $ Loans contractually past due 90 days or more as to principal or interest payments . . . . . . . . . . Loans considered troubled debt restructurings which are not included above . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 2,331 30 4,405 6,766 $ $ 2011 4,155 70 2,448 6,673 Nonaccrual loans included $94,000 in agricultural loans, $220,000 in commercial and industrial loans, $33,000 in consumer loans, $1,230,000 in commercial real estate loans, and $754,000 in residential real estate loans as of December 31, 2012. Nonaccrual loans included $26,000 in agricultural loans, $143,000 in commercial and industrial loans, $22,000 in consumer loans, $2,790,000 in commercial real estate loans, and $1,174,000 in residential real estate loans as of December 31, 2011. The decreases in nonaccrual loans in 2012 were caused by charge-offs, transfers to other real estate owned, and payments received on loans. Loans considered troubled debt restructurings which were not on a nonaccrual basis and were not 90 days or more past due as to principal or interest payments consisted of $72,000 in agricultural loans, $32,000 in consumer loans, $2,581,000 in commercial real estate loans, and $1,720,000 in residential real estate loans at December 31, 2012, compared to $1,197,000 in commercial real estate loans and $1,251,000 of residential real estate loans at December 31, 2011. Troubled debt restructurings consist of loans where the terms have been modified to assist the borrowers in making their payments. The modifications can include capitalization of interest onto the principal balance, reduction in interest rate, and extension of the loan term. 15 Management also maintains a list of loans that are not classified as nonperforming loans but where some concern exists as to the borrowers’ abilities to comply with the original loan terms. These loans totaled $14.2 million as of December 31, 2012, compared to $22.4 million as of December 31, 2011. Deposits and Other Funding Sources The Bank’s deposit balances as of December 31 were as follows: (Dollars in thousands) Noninterest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$ Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Local certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Brokered certificates of deposit $ 2012 101,861 66,569 60,806 63,406 130,057 1,500 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 424,199 $ 2011 78,263 64,498 63,007 46,737 144,983 5,877 403,365 Total deposits increased $20.8 million from December 31, 2011 to December 31, 2012. Local deposits grew $25.2 million while brokered certificates of deposit declined $4.4 million during 2012. Management believes that the local deposit growth was due in part to the attractiveness of FDIC-guaranteed deposits in contrast to the uncertainty of alternative investments. Deposit growth also resulted from new product offerings and calling efforts on business and municipal clients. Management believes that some of the local certificate of deposit decrease consisted of transfers into the other interest-bearing deposit accounts since the liquidity obtained offset the relatively small difference in the interest rate paid. Securities sold under agreements to repurchase decreased $2.3 million during 2012. The reduction was due to a maturity of a $5 million structured repurchase agreement with a correspondent bank, which was partially offset by growth in sweep repurchase accounts used by the Bank’s local customers. Advances from the Federal Home Loan Bank of Indianapolis decreased $8.0 million in 2012 due to maturities and payments on advances. A blanket collateral agreement covering residential real estate loans was pledged against all outstanding advances at the end of 2012. Approximately $46 million of additional advances were available as of December 31, 2012 based on the collateral pledged. In 2013, management will continue to focus its marketing efforts toward growth in local deposits. If local deposit growth is insufficient to support asset growth, management believes that advances from the FHLB, repurchase agreements and brokered certificates of deposit can address corresponding funding needs. Shareholders’ Equity Total shareholders’ equity increased $2.6 million from December 31, 2011 to December 31, 2012. The growth in equity resulted from the retention of earnings in 2012 as net income exceeded dividends paid by $2.6 million. Funds provided by issuances of common stock were offset by a small decrease in other comprehensive income in 2012. Note 21 to the consolidated financial statements presents regulatory capital information for the Bank at the end of 2012 and 2011. All three capital ratios presented increased in 2012 as a result of more growth in capital than assets during the year. Management will monitor these capital ratios closely during 2013 as they relate to asset growth and earnings retention. ChoiceOne’s Board of Directors and management do not plan to allow capital to decrease below those levels necessary to be considered “well capitalized” by regulatory guidelines. The Board of Directors and management believe that ChoiceOne’s capital level as of December 31, 2012 is adequate for the foreseeable future. 16 Table 4 – Contractual Obligations The following table discloses information regarding the maturity of ChoiceOne’s contractual obligations at December 31, 2012: (Dollars in thousands) Contractual Obligations Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank . . . . . . Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . Other obligations . . . . . . . . . . . . . . . . . . . . . . . . . . $ Total 131,557 19,572 420 36 1,027 $ Payment Due By Period Less than 1 year 1-3 Years 3-5 Years More than 5 Years $ 86,086 19,572 28 36 71 $ 32,117 — 60 — 171 $ 12,819 — 64 — 191 535 — 268 — 594 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 152,612 $ 105,793 $ 32,348 $ 13,074 $ 1,397 Liquidity and Interest Rate Risk Net cash from operating activities was $9.6 million for 2012 compared to $12.5 million for 2011. Lower proceeds from sales of other real estate owned and net changes in other assets and liabilities contributed to the change in 2012. Cash used in investing activities was $16.6 million in 2012 compared to $31.1 million in 2011. The decrease was caused by a reduction in loan balances in 2012 in contrast to growth in 2011. Cash flows from financing activities were $8.9 million in 2012 compared to $11.6 million in the prior year. A higher level of maturities and payments on Federal Home Loan Bank advances and a decline in the balance of repurchase agreements was partially offset by more growth in deposits in 2012 than in 2011. ChoiceOne’s primary market risk exposure occurs in the form of interest rate risk. Liquidity risk also can have an impact but to a lesser extent. ChoiceOne’s business is transacted in U.S. dollars with no foreign exchange risk exposure. Agricultural loans comprise a relatively small portion of ChoiceOne’s total assets. Management believes that ChoiceOne’s exposure to changes in commodity prices is insignificant. Management believes that the current level of liquidity is sufficient to meet the Bank’s normal operating needs. This belief is based upon the availability of deposits from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds purchased lines from correspondent banks, and advances available from the FHLB. Liquidity risk deals with ChoiceOne’s ability to meet its cash flow requirements. These requirements include depositors desiring to withdraw funds and borrowers seeking credit. Relatively short-term liquid funds exist in the form of lines of credit to purchase federal funds at four of the Bank’s correspondent banks. As of December 31, 2012, the amount of federal funds available for purchase from the Bank’s correspondent banks totaled approximately $33 million. ChoiceOne had no federal funds purchased at the end of 2012 or 2011. The Bank also has a line of credit secured by ChoiceOne’s commercial loans with the Federal Reserve Bank of Chicago for $57 million, which is designated for nonrecurring short-term liquidity needs. Longer-term liquidity needs may be met through local deposit growth, maturities of securities, normal loan repayments, advances from the FHLB, brokered certificates of deposit, and income retention. Approximately $46 million of borrowing capacity was available from the FHLB based on residential real estate loans pledged as collateral at year-end 2012. The acceptance of brokered certificates of deposit is not limited as long as the Bank’s capital to assets ratio is considered to be “well capitalized” under regulatory guidelines. Interest rate risk is related to liquidity because each is affected by maturing assets and sources of funds. ChoiceOne’s Asset/Liability Management Committee (the “ALCO”) attempts to stabilize the interest rate spread and avoid possible adverse effects when unusual or rapid changes in interest rates occur. The ALCO uses a simulation model to measure the Bank’s interest rate risk. The model incorporates changes in interest rates on rate-sensitive assets and liabilities. The degree of rate sensitivity is affected by prepayment assumptions that exist in the assets and liabilities. One method the ALCO uses of measuring interest rate sensitivity is the ratio of rate- sensitive assets to rate-sensitive liabilities. An asset or liability is considered to be rate-sensitive if it matures or otherwise reprices within a given time frame. 17 Table 5 documents the maturity or repricing schedule for ChoiceOne’s rate-sensitive assets and liabilities for selected time periods. Table 5 – Maturities and Repricing Schedule (Dollars in thousands) 0-3 Months As of December 31, 2012 1-5 Years 3-12 Months Over 5 Years Total Assets Securities available for sale . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . Federal Reserve Bank stock . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash surrender value of life insurance policies . . . . . Rate-sensitive assets . . . . . . . . . . . . . . . . . . . . . . . . $ 7,968 2,478 — 1,874 109,286 — 121,606 $ 27,957 — — — 88,979 — 116,936 $ 63,551 — — — 103,628 — 167,179 Liabilities Interest-bearing demand deposits . . . . . . . . . . . . . . . . Money market deposits . . . . . . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . Advances from FHLB . . . . . . . . . . . . . . . . . . . . . . . . 66,569 60,806 63,406 37,801 19,572 7 Rate-sensitive liabilities . . . . . . . . . . . . . . . . . . . . . 248,161 — — — 47,956 — 21 47,977 — — — 45,265 — 125 45,390 Rate-sensitive assets less rate-sensitive liabilities: Asset (liability) gap for the period . . . . . . . . . . . . . $(126,555) $ 68,959 $ 121,789 Cumulative asset (liability) gap . . . . . . . . . . . . . . . $(126,555) $ (57,596) $ 64,193 $ $ $ 35,016 — 1,272 — 9,575 9,970 55,833 $ 134,492 2,478 1,272 1,874 311,468 9,970 461,554 — — — 535 — 267 802 66,569 60,806 63,406 131,557 19,572 420 342,330 55,031 $ 119,224 119,224 Under this method, the ALCO measures interest rate sensitivity by focusing on the one-year repricing gap. ChoiceOne’s ratio of rate- sensitive assets to rate-sensitive liabilities that matured or repriced within a one-year time frame was 81% at December 31, 2012, compared to 80% at December 31, 2011. Table 5 above shows the entire balance of interest-bearing demand deposits, savings deposits, money market deposits, and overnight repurchase agreements in the shortest repricing term. Although these categories have the ability to reprice immediately, management has some control over the actual timing or extent of the changes in interest rates on these liabilities. The ALCO plans to continue to monitor the ratio of rate-sensitive assets to rate-sensitive liabilities on a quarterly basis in 2013. As interest rates change during 2013, the ALCO will attempt to match its maturing assets with corresponding liabilities to maximize ChoiceOne’s net interest income. Another method the ALCO uses to monitor its interest rate sensitivity is to subject rate-sensitive assets and liabilities to interest rate shocks. At December 31, 2012, management used a simulation model to subject its assets and liabilities up to an immediate 400 basis point increase. The maturities of loans and mortgage-backed securities were affected by certain prepayment assumptions. Maturities for interest-bearing core deposits were based on an estimate of the period over which they would be outstanding. The maturities of advances from the FHLB were based on their contractual maturity dates. In the case of variable rate assets and liabilities, repricing dates were used to determine their values. The simulation model measures the effect of immediate interest rate changes on both net interest income and shareholders’ equity. 18 Table 6 provides an illustration of hypothetical interest rate changes as of December 31, 2012 and 2011, respectively: Table 6 – Sensitivity to Changes in Interest Rates (Dollars in thousands) Change in Interest Rates 400 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Base rate scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Dollars in thousands) Change in Interest Rates 400 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 basis point rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Base rate scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 basis point decline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2012 Net Interest Income Percent Change Market Value of Equity Percent Change 17,057 17,262 17,391 17,488 17,657 17,226 16,851 16,550 16,489 -3% $ -2% -2% -1% —% -2% -5% -6% -7% 2011 71,148 76,058 79,555 82,396 83,731 77,256 71,641 72,430 72,335 -15% -9% -5% -2% —% -8% -14% -13% -14% Net Interest Income Percent Change Market Value of Equity Percent Change 18,346 18,229 18,023 17,787 17,630 17,381 17,073 16,868 16,837 +4% $ +3% +2% +1% —% -1% -3% -4% -4% 72,748 76,878 79,279 81,377 82,249 77,911 70,812 70,806 70,766 -12% -7% -4% -1% —% -5% -14% -14% -14% As of both December 31, 2012 and December 31, 2011, the Bank was within its guidelines for immediate rate shocks up and down for both net interest income and the market value of shareholders’ equity. The ALCO plans to continue to monitor the effect of changes in interest rates on both net interest income and shareholders’ equity and will make changes in the duration of its rate-sensitive assets and rate-sensitive liabilities where necessary. 19 ChoiceOne Financial Services, Inc. MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of ChoiceOne Financial Services, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting that is designed to produce reliable financial statements in conformity with United States generally accepted accounting principles. The system of internal control over financial reporting as it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial statement preparation. Management assessed the effectiveness of the Company’s system of internal control over financial reporting as of December 31, 2012, as required by Section 404 of the Sarbanes-Oxley Act of 2002. Management’s assessment is based on the criteria for effective internal control over financial reporting as described in “Internal Control – Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management has concluded that, as of December 31, 2012, its system of internal control over financial reporting was effective and meets the criteria of the “Internal Control – Integrated Framework.” This annual report is not required to include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. James A. Bosserd President and Chief Executive Officer March 27, 2013 Thomas L. Lampen Treasurer March 27, 2013 20 Plante & Moran, PLLC Suite 400 634 Front Avenue N.W. Grand Rapids, MI 49504 Tel: 616.774.8221 Fax: 616.774.0702 plantemoran.com REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of ChoiceOne Financial Services, Inc. We have audited the accompanying consolidated balance sheet of ChoiceOne Financial Services, Inc. as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each year in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of ChoiceOne Financial Services, Inc. as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for each year in the three-year period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Plante & Moran, PLLC Grand Rapids, Michigan March 27, 2013 21 (Dollars in thousands) Assets ChoiceOne Financial Services, Inc. CONSOLIDATED BALANCE SHEETS December 31 2012 2011 Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,034 — 19,034 Securities available for sale (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Reserve Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment, net (Note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate owned, net (Note 7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash value of life insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Intangible assets, net (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,492 2,478 1,272 1,874 311,468 (5,852) 305,616 12,121 2,019 9,970 1,724 13,728 4,585 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 508,913 $ Liabilities Deposits – noninterest-bearing (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deposits – interest-bearing (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 101,861 322,338 424,199 Repurchase agreements (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities (Notes 11 and 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,572 420 4,216 17,125 — 17,125 114,276 2,478 1,271 1,262 320,127 (5,213) 314,914 12,080 1,934 9,834 2,172 13,728 4,840 495,914 78,263 325,102 403,365 21,869 8,447 4,329 Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448,407 438,010 Shareholders’ Equity (Note 21) Preferred stock; shares authorized: 100,000; shares outstanding: none . . . . . . . . . . . . . . . . . . Common stock and paid-in capital, no par value; shares authorized: 7,000,000; shares outstanding: 3,298,081 in 2012 and 3,293,269 in 2011 (Note 14) . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income, net (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 46,649 11,501 2,356 60,506 — 46,602 8,887 2,415 57,904 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 508,913 $ 495,914 See accompanying notes to consolidated financial statements. 22 Years ended December 31 2012 2011 2010 16,875 $ 18,398 $ 19,081 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data) Interest income Loans, including fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taxable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax exempt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses . . . . . . . . . . . . . . . . . . . Noninterest income Customer service charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Insurance and investment commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of loans (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of securities (Note 2) Loss on other than temporary impairment of securities (Note 2) . . . . . . . . . Gains (losses) on sales and write-downs of other assets (Note 7) . . . . . . . . Earnings on life insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense Salaries and benefits (Notes 13 and 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Occupancy and equipment (Note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Data processing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Professional fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Supplies and postage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advertising and promotional Intangible asset amortization (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan and collection expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FDIC insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,958 1,361 25 20,219 2,087 271 186 2,544 17,675 2,515 15,160 3,365 711 1,634 419 — (358) 447 671 6,889 7,873 2,256 1,852 887 430 212 448 589 377 1,520 16,444 5,605 1,343 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,262 Basic earnings per common share (Note 15) . . . . . . . . . . . . . . . . . . . . . . . . $ Diluted earnings per common share (Note 15) . . . . . . . . . . . . . . . . . . . . . . . $ Dividends declared per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.29 1.29 0.50 $ $ $ $ See accompanying notes to consolidated financial statements. 23 1,789 1,268 20 21,475 2,956 307 290 3,553 17,922 3,700 14,222 3,454 672 672 129 — 29 354 829 6,139 7,348 2,247 1,740 793 517 160 448 575 488 1,472 15,788 4,573 1,060 3,513 1.07 1.07 0.48 $ $ $ $ 1,460 1,398 22 21,961 3,914 748 304 4,966 16,995 3,950 13,045 3,160 690 682 537 (94) (432) 360 666 5,569 7,040 2,157 1,651 675 497 168 448 678 641 1,294 15,249 3,365 654 2,711 0.83 0.83 0.48 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income, net of tax: Unrealized holding gains on available for sale securities . . . . . . . . . . . . . . . . Funded status of post-retirement benefit plan . . . . . . . . . . . . . . . . . . . . . . . . Less: Reclassification adjustment for gain recognized in earnings, net of tax (Note 2) Other comprehensive income/(loss), net of tax . . . . . . . . . . . . . . . . . . . . . . . Years ended December 31 2012 2011 $ 4,262 $ 3,513 $ 240 (22) 218 277 (59) 1,615 (15) 1,600 85 1,515 2010 2,711 419 (14) 405 292 113 Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,203 $ 5,028 $ 2,824 See accompanying notes to consolidated financial statements. 24 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Dollars in thousands, except per share data) Number of Shares Common Stock and Paid in Capital Accumulated Other Comprehensive Income, Net Retained Earnings Total Balance, January 1, 2010 . . . . . . . . . . . . . . . . . . . . . . . 3,265,714 $ 46,326 $ 5,813 $ 787 $ 52,926 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . . . . . Shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in ESOP repurchase obligation . . . . . . . . . . . . Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . Effect of employee stock purchases . . . . . . . . . . . . . . . Cash dividends declared ($0.48 per share) . . . . . . . . . . 2,711 113 14,805 (4) 125 — (16) 15 11 (1,572) 2,711 113 125 — (16) 15 11 (1,572) Balance, December 31, 2010 . . . . . . . . . . . . . . . . . . . . 3,280,515 $ 46,461 $ 6,952 $ 900 $ 54,313 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income . . . . . . . . . . . . . . . . . . . . Shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in ESOP repurchase obligation . . . . . . . . . . . . Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . Effect of employee stock purchases . . . . . . . . . . . . . . . Cash dividends declared ($0.48 per share) . . . . . . . . . . 3,513 1,515 12,754 127 (1) 5 10 (1,578) 3,513 1,515 127 (1) 5 10 (1,578) Balance, December 31, 2011 . . . . . . . . . . . . . . . . . . . . 3,293,269 $ 46,602 $ 8,887 $ 2,415 $ 57,904 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive (loss) . . . . . . . . . . . . . . . . . . . . . Shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares repurchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in ESOP repurchase obligation . . . . . . . . . . . . Effect of employee stock purchases . . . . . . . . . . . . . . . Cash dividends declared ($0.50 per share) . . . . . . . . . . 4,262 (59) 9,812 (5,000) 123 (75) (12) 11 (1,648) 4,262 (59) 123 (75) (12) 11 (1,648) Balance, December 31, 2012 . . . . . . . . . . . . . . . . . . . . 3,298,081 $ 46,649 $ 11,501 $ 2,356 $ 60,506 See accompanying notes to consolidated financial statements. 25 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Adjustments to reconcile net income to net cash from operating activities: Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation expense on stock options and employee purchases . . . . . . . . . . . . . . . Gains on sales of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on other than temporary impairment of securities . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans originated for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from loan sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Gains)/losses on sales of other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs of other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales of other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred federal income tax expense/(benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in: Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Sales of securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maturities, prepayments and calls of securities available for sale . . . . . . . . . . . . . . . . . Purchases of securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase of Federal Reserve Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sale of Federal Home Loan Bank stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan originations and payments, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additions to premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Net change in deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payments on Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beginning cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Supplemental disclosures of cash flow information: Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans transferred to other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate owned transferred to premises and equipment . . . . . . . . . . . . . . . . . . . . . See accompanying notes to consolidated financial statements. 26 Years ended December 31 2012 2011 2010 4,262 $ 3,513 $ 2,711 2,515 900 1,569 11 (419) — (1,634) (44,889) 45,622 (447) (51) 405 1,259 (132) 667 4 9,642 9,369 39,098 (69,564) (1) — 5,065 311 (921) (16,643) 20,834 (2,297) — (8,027) 123 (75) (1,648) 8,910 1,909 17,125 19,034 2,625 1,425 1,718 20 $ $ 3,700 944 1,300 15 (129) — (672) (25,685) 26,611 (354) (279) 255 3,015 378 2,391 (2,458) 12,545 3,310 18,687 (43,651) (1) 411 (9,375) — (499) (31,118) 13,481 (380) 250 (276) 127 — (1,578) 11,624 (6,949) 24,074 17,125 3,608 765 2,972 — $ $ 3,950 903 1,173 26 (537) 94 (682) (28,816) 28,088 (360) (96) 528 1,174 (163) 875 357 9,225 6,059 22,271 (44,063) — — 875 — (1,510) (16,368) 24,874 1,565 — (13,525) 125 — (1,572) 11,467 4,324 19,750 24,074 5,112 285 1,358 — ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include ChoiceOne Financial Services, Inc., its wholly-owned subsidiary, ChoiceOne Bank, and ChoiceOne Bank’s wholly-owned subsidiary, ChoiceOne Insurance Agencies, referred to as “ChoiceOne”). Intercompany transactions and balances have been eliminated in consolidation. (together Inc. Nature of Operations ChoiceOne Bank (the “Bank”) is a full-service community bank that offers commercial, consumer, and real estate loans as well as traditional demand, savings and time deposits to both commercial and consumer clients in portions of Kent, Muskegon, Newaygo, and Ottawa counties in Michigan. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and real estate. Commercial loans are expected to be repaid from the cash flows from operations of businesses. Real estate loans are collateralized by either residential or commercial real estate. ChoiceOne Insurance Agencies, Inc. (the “Insurance Agency”) is a wholly-owned subsidiary of the Bank. The Insurance Agency sells insurance policies such as life and health for both commercial and consumer clients. The Insurance Agency also offers alternative investment products such as annuities and mutual funds through a registered broker. Together, the Bank and the Insurance Agency account for substantially all of ChoiceOne’s assets, revenues and operating income. Use of Estimates To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, ChoiceOne’s management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Actual results may differ from these estimates. Estimates associated with securities available for sale, the allowance for loan losses, other real estate owned, core deposit intangible assets, loan servicing rights, goodwill, and fair values of certain financial instruments are particularly susceptible to change. Cash and Cash Equivalents Cash and cash equivalents are defined to include cash on hand, demand deposits with other banks, and federal funds sold. Cash flows are reported on a net basis for customer loan and deposit transactions, deposits with other financial institutions, and short-term borrowings with original terms of 90 days or less. Securities Securities are classified as available for sale because they might be sold before maturity. Securities classified as available for sale are carried at fair value, with unrealized holding gains and losses reported separately in the accumulated other comprehensive income or loss section of shareholders’ equity, net of tax effect. Restricted investments in Federal Reserve Bank stock and Federal Home Loan Bank stock are carried at cost. Equity securities consist of investments in preferred stock, trust-preferred securities, and investments in common stock of other financial institutions. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized using the level-yield method without anticipating prepayments. Gains or losses on sales are recorded on the trade date based on the amortized cost of the security sold. Management evaluates securities for other-than-temporary impairment (“OTTI”) on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. The evaluation of securities includes consideration given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, whether the market decline was affected by macroeconomic conditions and whether ChoiceOne has the intent to sell the security or more likely than not will be required to sell the security before its anticipated recovery. In analyzing an issuer’s financial condition, management may consider whether the securities are issued by the federal government or its agencies, or U.S. Government sponsored enterprises, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time. When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether ChoiceOne intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. If ChoiceOne intends to sell or it 27 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS is more likely than not it will be required to sell the security before recovery of its amortized cost basis, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment. If a security is determined to be other-than-temporarily impaired, but ChoiceOne does not intend to sell the security, only the credit portion of the estimated loss is recognized in earnings, with the other portion of the loss recognized in other comprehensive income. Loans Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Loans held for sale are reported at the lower of cost or market, on an aggregate basis. Interest income on loans is reported on the interest method and includes amortization of net deferred loan fees and costs over the estimated loan term. Interest on loans is accrued based upon the principal balance outstanding. The accrual of interest is discontinued at the time at which commercial loans are 90 days past due unless the loan is secured by sufficient collateral and is in the process of collection. Interest on consumer or real estate secured loans is discontinued at the time at which the loan is 120 days past due unless the credit is secured by sufficient collateral and is in the process of collection. Past due status is based on the contractual terms of the loan. In all cases, loans are placed into nonaccrual status or charged off at an earlier date if collection of principal or interest is considered doubtful. Interest accrued but not received is reversed against interest income when the loans are placed into nonaccrual status. Interest received on such loans is applied to principal until qualifying for return to accrual. Loans are returned to accrual basis when all the principal and interest amounts contractually due are brought current and future payment is reasonably assured. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses. The allowance is increased by the provision for loan losses and decreased by loans charged off less any recoveries of charged off loans. Management estimates the allowance balance required based on past loan loss experience, the nature and volume of the loan portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Loan losses are charged against the allowance when management believes the collectability of a loan balance is not possible. The allowance consists of general and specific components. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful. A loan is impaired when full payment under the loan terms is not expected. Commercial loans are evaluated for impairment on an individual loan basis. If a loan is considered impaired, a portion of the allowance for loan losses is allocated to the loan so that it is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans such as consumer and real estate mortgage loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Land is carried at cost. Land improvements are depreciated using the straight-line method with useful lives ranging from 7 to 15 years. Building and related components are depreciated using the straight-line method with useful lives ranging from 5 to 39 years. Leasehold improvements are depreciated over the shorter of the estimated life or the lease term. Furniture and equipment are depreciated using the straight-line method with useful lives ranging from 3 to 7 years. Fixed assets are periodically reviewed for impairment. If impaired, the assets are recorded at fair value. Other Real Estate Owned Real estate properties acquired in the collection of a loan are initially recorded at the lower of our basis in the loans or fair value at acquisition establishing a new cost basis. Any reduction to fair value from the carrying value of the related loan is accounted for as a loan loss. After acquisition, a valuation allowance reduces the reported amount to the lower of the initial amount or fair value less costs to sell. Expenses to repair or maintain properties are included within other noninterest expenses. Gains and losses upon disposition and changes in the valuation allowance are reported net within other noninterest income. 28 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loan Servicing Rights Servicing rights represent the allocated value of servicing rights on loans sold with servicing retained. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Impairment is evaluated based on the fair value of the rights, using groupings of the underlying loans as to interest rates and then, secondarily, as to geographic and prepayment characteristics. Fair value is determined using prices for similar assets with similar characteristics when available or based upon discounted cashflows using market-based assumptions. Any impairment of a grouping is reported as a valuation allowance. Goodwill Goodwill results from business acquisitions and represents the excess of the purchase price over the fair value of the acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment will be recognized in the period identified. Loan Commitments and Related Financial Instruments Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit issued to meet financing needs of customers. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Employee Benefit Plans ChoiceOne’s 401(k) plan allows participants to contribute up to the IRS maximum. Contributions from ChoiceOne to its 401(k) plan are discretionary. ChoiceOne also allows retired employees to participate in its health insurance plan. Employees who have attained age 55 and completed at least ten years of service to ChoiceOne are eligible to participate as a retiree until they are eligible for Medicare. These postretirement benefits are accrued during the years in which the employee provides service. Employee Stock Ownership Plan The cost of shares issued to the Employee Stock Ownership Plan (the “ESOP”) but not yet allocated to participants is presented as a reduction of shareholders’ equity. Compensation expense is recorded based on the market price of the shares as they are committed to be released for allocation to participant accounts. The difference between the market price and the cost of shares committed to be released is recorded as an adjustment to additional paid-in capital. Dividends on allocated ESOP shares are recorded as a reduction of retained earnings while dividends on unallocated ESOP shares are reflected as a reduction of debt and accrued interest. Upon distribution of shares to a participant, the participant has the right to require the Company to purchase his or her shares at fair value in accordance with the terms and conditions of the ESOP. As such, these shares are not classified in shareholders’ equity as permanent equity. Income Taxes Income tax expense is the sum of the current year income tax due and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the 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. Earnings Per Share Basic earnings per common share (“EPS”) is based on weighted-average common shares outstanding. The weighted-average number of shares used in the computation of basic and diluted EPS includes shares allocated to the ESOP. Diluted EPS further assumes issue of any dilutive potential common shares issuable under stock options. Comprehensive Income Comprehensive income consists of net income and other comprehensive income or loss. Other comprehensive income or loss includes unrealized gains and losses on securities available for sale, net of tax, and changes in the funded status of postretirement plans which are also recognized as a separate component of shareholders’ equity. Loss Contingencies Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe that there are any such matters that may have a material effect on the financial statements. 29 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Cash Restrictions Cash on hand or on deposit with the Federal Reserve Bank of $318,000 and $111,000 was required to meet regulatory reserve and clearing requirements at December 31, 2012 and 2011, respectively. The balance in excess of the amount required was interest- bearing as of December 31, 2012 and December 31, 2011. Stock-Based Compensation ChoiceOne records stock-based compensation cost using the fair value method. Compensation costs related to stock options granted is disclosed in Note 14. Dividend Restrictions Banking regulations require the maintenance of certain capital levels and may limit the amount of dividends that may be paid by the Bank to ChoiceOne (see Note 21). Fair Value of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, which are more fully documented in Note 19 to the consolidated financial statements. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. Operating Segments While ChoiceOne’s management monitors the revenue streams of various products and services for the Bank and Insurance Agency, operations and financial performance are evaluated on a company-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated into one reportable operating segment. Recent Accounting Pronouncements During 2012, ChoiceOne adopted new guidance related to the presentation of comprehensive income in the financial statements. Among other changes, the new guidance eliminated the option to only present comprehensive income in the statement of equity. ChoiceOne has elected to report comprehensive income in a separate statement of comprehensive income that begins with net income. The change in presentation has been applied retrospectively and the 2011 and 2010 financial statements have been restated to conform to the new presentation method. Other than the change in presentation of comprehensive income and related disclosures, the new guidance did not have a material effect on the financial statements. In 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU 2011-02”). This update applies to all creditors, both public and non-public, and was introduced to provide clarification surrounding troubled debt restructurings (“TDR”). The primary characteristics that previously caused a restructuring to quality as a TDR still exist: (1) the restructuring constitutes a concession to the borrower and (2) the borrower is experiencing financial difficulties. The update provides additional details and examples to provide clarity surrounding these items. The update also prohibits the use of the effective interest rate test when determining whether the restructuring constitutes a concession. The update is effective for annual reporting periods ending on or after December 15, 2012 (therefore, December 31, 2012, for ChoiceOne). Lastly the disclosure requirements set forth by ASU 2010-20 regarding TDRs, and later deferred by ASU 2011-01 until December 31, 2012 for ChoiceOne, are included in Note 3. Other than the additional disclosures, these updates did not have a significant impact on the financial statements. In 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS (“ASU 2011-04”). This update to Fair Value Measurement (Topic 820) results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments in this update explain how to measure fair value. The do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. However, this update does require expanding disclosure related to the nature and significance of inputs that are used in estimating and measuring the fair value of financial instruments. The amendments in this update are to be applied prospectively and are effective for annual reporting periods beginning after December 15, 2011 (therefore, December 31, 2012, for ChoiceOne). This update did not have a significant impact on the financial statements. In July 2012, the FASB issued ASU No. 2012-02, Intangibles – Goodwill and Other: Testing Indefinite-Lived Intangible Assets for Impairment (“ASU 2012-02”) to reduce the cost and complexity of testing indefinite-lived intangible assets for impairment. ASU 2012-02 gives an entity the option of first assessing qualitative factors to determine whether the existence of events and circumstances 30 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Subtopic 350-30. An entity also has the option to bypass the qualitative assessment for any indefinite-lived asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. ASU 2012-02 is effective for fiscal years beginning after September 15, 2012 and early adoption is permitted. The adoption of ASU 2012-02 is not expected to have a material impact on ChoiceOne’s consolidated financial condition or results of operations. Reclassifications Certain amounts presented in prior year consolidated financial statements have been reclassified to conform to the current year’s presentation. Note 2 – Securities The fair value of securities available for sale and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) at December 31 were as follows: (Dollars in thousands) Amortized Cost U.S. Government and federal agency . . . . . . . . . . . . . . . . . . . . . . . . $ U.S. Treasury notes and bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and municipal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign debt Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,815 7,362 62,248 12,218 6,600 1,000 1,902 2012 Gross Unrealized Gains $ 455 45 2,668 308 113 1 12 Gross Unrealized Losses (2) $ (9) (238) — (1) — (5) $ Fair Value 40,268 7,398 64,678 12,526 6,712 1,001 1,909 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 131,145 $ 3,602 $ (255) $ 134,492 (Dollars in thousands) Amortized Cost U.S. Government and federal agency . . . . . . . . . . . . . . . . . . . . . . . . $ State and municipal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FDIC-guaranteed financial institution debt . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,829 51,859 9,511 5,914 2,010 1,751 2011 Gross Unrealized Gains $ 584 2,729 276 100 28 16 Gross Unrealized Losses $ — $ (89) (7) (3) — (232) Fair Value 40,413 54,499 9,780 6,011 2,038 1,535 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 110,874 $ 3,733 $ (331) $ 114,276 Information regarding sales of securities available for sale follows: (Dollars in thousands) 2012 2011 2010 Proceeds from sales of securities . . . . . . . . . . . . . . . . . . $ Gross realized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross realized losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss on other than temporary impairment $ 9,369 421 2 — $ 3,310 133 4 — 6,059 540 3 94 31 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Contractual maturities of securities available for sale at December 31, 2012 were as follows: (Dollars in thousands) Due within one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Due after one year through five years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due after five years through ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities, not due at a specific date . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value 31,817 53,249 32,565 2,426 120,057 12,526 1,909 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 134,492 Various securities were pledged as collateral for securities sold under agreements to repurchase. The carrying amount of securities pledged as collateral at December 31 was as follows: (Dollars in thousands) Securities pledged for securities sold under agreements to repurchase . . . . . . . . . . . . . . . . . . . . $ 2012 27,085 $ 2011 27,421 Securities with unrealized losses at year-end 2012 and 2011, aggregated by investment category and length of time the individual securities have been in a continuous unrealized loss position, were as follows: (Dollars in thousands) Less than 12 months Fair Value Unrealized Losses 2012 More than 12 months Unrealized Losses Fair Value Total Fair Value Unrealized Losses U.S. Government agencies . . . . . . . . . . . . . . . . $ U.S. Treasury notes and bonds . . . . . . . . . . . . . State and municipal . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . Total temporarily impaired . . . . . . . . . . . . . . $ 1,997 2,187 7,623 768 146 12,721 $ $ (2) $ (9) (203) (1) (5) (220) $ — $ — 811 — — 811 $ — $ — (35) — — (35) $ 1,997 2,187 8,434 768 146 13,532 $ $ (2) (9) (238) (1) (5) (255) (Dollars in thousands) Less than 12 months Fair Value Unrealized Losses 2011 More than 12 months Total Fair Value Unrealized Losses Fair Value Unrealized Losses . . . . . . . . . . . . . . . . . . . . . $ State and municipal Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . $ 2,938 2,045 1,023 — Total temporarily impaired . . . . . . . . . . . . . . $ 6,006 $ (28) $ (7) (3) — (38) $ $ 1,245 — — 768 (61) $ — — (232) $ 4,183 2,045 1,023 768 2,013 $ (293) $ 8,019 $ (89) (7) (3) (232) (331) One municipal security with a fair value of $306,000 was considered to be other than temporarily impaired as of December 31, 2011. The issuer of the security defaulted upon its maturity of September 1, 2009. Impairment losses totaling $141,000 had been recorded through the end of 2010 due to uncertainty as to how much and when principal repayment would be received. Settlement was reached with the security’s issuer in December 2011 and the bond’s carrying value was reclassified from securities to other assets in January 2012 upon termination of the bond’s contractual agreement. ChoiceOne received the carrying value of the security in the second quarter of 2012. 32 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ChoiceOne evaluates all securities on a quarterly basis to determine whether unrealized losses are temporary or other than temporary. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of ChoiceOne to retain its investment in the issue for a period of time sufficient to allow for any anticipated recovery in fair value. Management believed that unrealized losses as of December 31, 2012 were temporary in nature and were caused primarily by changes in interest rates, increased credit spreads, and reduced market liquidity and were not caused by the credit status of the issuer. No other than temporary impairments were recorded in 2012 or 2011. Note 3 – Loans and Allowance for Loan Losses The Bank’s loan portfolio as of December 31 was as follows: (Dollars in thousands) 2012 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Agricultural Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate – commercial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate – construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Real estate – residential . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,790 67,365 19,367 93,312 1,056 98,578 Loans, gross . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311,468 (5,852) 38,929 58,685 18,657 106,250 1,169 96,437 320,127 (5,213) Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 305,616 $ 314,914 ChoiceOne manages its credit risk through the use of its loan policy and its loan approval process and by monitoring of loan credit performance. The loan approval process for commercial loans involves individual and group approval authorities. Individual authority levels are based on the experience of the lender. Group authority approval levels can consist of an internal loan committee that includes the Bank’s President or Senior Lender and other loan officers for loans that exceed individual approval levels, or a loan committee of the Board of Directors for larger commercial loans. Most consumer loans are approved by individual loan officers based on standardized underwriting criteria, with larger consumer loans subject to approval by the internal loan committee. Ongoing credit review of commercial loans is the responsibility of the loan officers. ChoiceOne’s internal credit committee meets at least monthly and reviews loans with payment issues and loans with a risk rating of 5, 6, or 7. Risk ratings of commercial loans are reviewed periodically and adjusted if needed. ChoiceOne’s consumer loan portfolio is primarily monitored on an exception basis. Loans where payments are past due are turned over to the Bank’s collection department, who works with the borrower to bring payments current or takes other actions when necessary. In addition to internal reviews of credit performance, ChoiceOne contracts with a third party for independent loan review that monitors the loan approval process and the credit quality of the loan portfolio. 33 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Activity in the allowance for loan losses and balances in the loan portfolio were as follows: (Dollars in thousands) Commercial and Industrial Agricultural Consumer Commercial Real Estate Construction Real Estate Residential Real Estate Unallocated Total 2012 Allowance for Loan Losses Beginning balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 $ — 5 80 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 140 $ 609 $ (405) 61 116 381 $ 197 $ (338) 214 177 2,299 $ (869) 224 942 34 $ — — (19) 1,847 $ (887) 119 844 250 $ 2,596 $ 15 $ 1,923 $ 172 $ — — 375 547 $ 5,213 (2,499) 623 2,515 5,852 Individually evaluated for impairment . . . . . . . . . . . $ 1 $ 112 $ — $ 449 $ — $ 138 $ — $ 700 Collectively evaluated for impairment . . . . . . . . . . . $ 139 $ 269 $ 250 $ 2,147 $ 15 $ 1,785 $ 547 $ 5,152 Loans Individually evaluated for impairment . . . . . . . . . . . $ Collectively evaluated for impairment . . . . . . . . . . . 166 $ 198 $ 32 $ 31,624 67,167 19,335 3,723 $ 89,589 — $ 1,056 1,820 96,578 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,790 $ 67,365 $ 19,367 $ 93,312 $ 1,056 $ 98,578 $ 5,939 305,529 $ 311,468 2011 Allowance for Loan Losses Beginning balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 181 $ (45) 10 (91) 55 $ 641 $ (228) 32 164 609 $ 243 $ (361) 217 98 1,729 $ (1,357) 89 1,838 1,554 $ 2 $ — (1,677) 104 — 1,866 32 379 $ — — (207) 4,729 (3,668) 452 3,700 197 $ 2,299 $ 34 $ 1,847 $ 172 $ 5,213 Individually evaluated for impairment . . . . . . . . . . . $ — $ 7 $ — $ 424 $ — $ — $ — $ 431 Collectively evaluated for impairment . . . . . . . . . . . $ 55 $ 602 $ 197 $ 1,875 $ 34 $ 1,847 $ 172 $ 4,782 Loans Individually evaluated for impairment . . . . . . . . . . . $ Collectively evaluated for impairment . . . . . . . . . . . — $ 163 $ — $ 2,758 $ — $ 38,929 58,522 18,657 103,492 1,169 1,580 94,857 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 38,929 $ 58,685 $ 18,657 $ 106,250 $ 1,169 $ 96,437 $ 4,501 315,626 $ 320,127 34 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Commercial and Industrial Agricultural Consumer Commercial Real Estate Construction Real Estate Residential Real Estate Unallocated Total 2010 Allowance for Loan Losses Beginning balance . . . . . . . . . . . . . . . . . . . . . . . . . . $ Charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 124 $ — — 57 181 $ 735 $ (765) 68 603 641 $ 306 $ (444) 230 151 1,546 $ (1,523) 16 1,690 1,590 $ 3 $ — (1,152) 27 — 1,089 (1) 243 $ 1,729 $ 2 $ 1,554 $ 18 — — 361 379 $ 4,322 (3,884) 341 3,950 $ 4,729 Individually evaluated for impairment . . . . . . . . . . . $ — $ 50 $ — $ 531 $ — $ — $ — $ 581 Collectively evaluated for impairment . . . . . . . . . . . $ 181 $ 591 $ 243 $ 1,198 $ 2 $ 1,554 $ 379 $ 4,148 Loans Individually evaluated for impairment . . . . . . . . . . . $ Collectively evaluated for impairment . . . . . . . . . . . 39 $ 272 $ — $ 3,529 $ 29,642 55,675 16,709 112,822 — $ 853 2,733 94,666 Ending balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,681 $ 55,947 $ 16,709 $ 116,351 $ 853 $ 97,399 $ 6,573 310,367 $316,940 The process to monitor the credit quality of ChoiceOne’s loan portfolio includes tracking (1) the risk ratings of business loans, (2) the level of classified business loans, and (3) delinquent and nonperforming consumer loans. Business loans are risk rated on a scale of 1 to 8. A description of the characteristics of the ratings follows: Risk ratings 1 and 2: These loans are considered pass credits. They exhibit good to exceptional credit risk and demonstrate the ability to repay the loan from normal business operations. Risk rating 3: These loans are considered pass credits. They exhibit acceptable credit risk and demonstrate the ability to repay the loan from normal business operations. Risk rating 4: These loans are considered watch credits. They have potential developing weaknesses that, if not corrected, may cause deterioration in the ability of the borrower to repay the loan. While a loss is possible for a loan with this rating, it is not anticipated. Risk rating 5: These loans are considered special mention credits. Loans in this risk rating are considered to be inadequately protected by the net worth and debt service coverage of the borrower or of any pledged collateral. These loans have well defined weaknesses that may jeopardize the borrower’s ability to repay the loan. If the weaknesses are not corrected, loss of principal and interest could be probable. Risk rating 6: These loans are considered substandard credits. These loans have well defined weaknesses, the severity of which makes collection of principal and interest in full questionable. Loans in this category may be placed on nonaccrual status. Risk rating 7: These loans are considered doubtful credits. Some loss of principal and interest has been determined to be probable. The estimate of the amount of loss could be affected by factors such as the borrower’s ability to provide additional capital or collateral. Loans in this category are on nonaccrual status. Risk rating 8: These loans are considered loss credits. They are considered uncollectible and will be charged off against the allowance for loan losses. 35 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Information regarding the Bank’s credit exposure as of December 31 was as follows: (Dollars in thousands) Corporate Credit Exposure - Credit Risk Profile By Creditworthiness Category Agricultural Commercial and Industrial Commercial Real Estate 2012 2011 2012 2011 2012 2011 Risk ratings 1 and 2 . . . . . . . . . . . . . . . . . . . . . . $ Risk rating 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk rating 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk rating 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk rating 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk rating 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,615 16,173 5,040 1,939 19 4 $ 6,486 20,211 9,499 2,672 57 4 $ 9,040 43,549 13,417 855 361 143 $ 4,149 30,109 21,993 1,669 680 85 $ $ 2,711 45,295 30,223 7,847 6,960 276 6,403 45,034 33,462 14,313 5,009 2,029 $ 31,790 $ 38,929 $ 67,365 $ 58,685 $ 93,312 $ 106,250 Consumer Credit Exposure - Credit Risk Profile Based On Payment Activity Performing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Nonperforming . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,334 33 2012 $ 19,367 2011 18,634 23 18,657 $ $ Consumer Construction Real Estate 2012 2011 $ $ 1,056 — 1,056 $ $ 1,169 — 1,169 $ $ Residential Real Estate 2012 98,018 560 98,578 2011 95,732 705 96,437 $ $ The following schedule provides information on loans that were considered troubled debt restructurings (“TDRs”) that were modified during the twelve months ended December 31, 2012 and December 31, 2011: (Dollars in thousands) Number of Loans Agricultural . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . 1 2 1 5 3 December 31, 2012 Pre- Modification Outstanding Recorded Investment 72 $ 159 32 1,990 353 Post- Modification Outstanding Recorded Investment 72 $ 149 32 1,990 353 12 $ 2,606 $ 2,596 December 31, 2011 Pre- Modification Outstanding Recorded Investment Post- Modification Outstanding Recorded Investment Number of Loans — $ 1 — 7 5 13 $ — $ 48 — 1,789 639 2,476 $ — 48 — 1,789 639 2,476 The pre-modification and post-modification outstanding recorded investment represents amounts as of the date of loan modification. If a difference exists between the pre-modification and post-modification outstanding recorded investment, it represents impairment recognized through the provision for loan losses computed based on a loan’s post-modification present value of expected future cash flows discounted at the loan’s original effective interest rate. If no difference exists, a loss is not expected to be incurred based on an assessment of the borrower’s expected cash flows. 36 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following schedule provides information on TDRs as of December 31, 2012 where the borrower was past due with respect to principal and/or interest for 30 days or more during the twelve months ended December 31, 2012 and December 31, 2011 that had been modified during the 12-month period prior to the default: (Dollars in thousands) Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . With Payment Defaults During the Following Periods: December 31, 2012 December 31, 2011 Number of Loans Recorded Investment Number of Loans Recorded Investment 1 2 1 1 — 5 $ $ 72 149 32 68 — 321 — 1 — 3 7 11 $ $ — 48 — 1,135 865 2,048 Loans are classified as performing when they are current as to principal and interest payments or are past due on payments less than 90 days. Loans are classified as nonperforming when they are past due 90 days or more as to principal and interest payments or are considered a troubled debt restructuring. Impaired loans by loan category as of December 31 follow: (Dollars in thousands) Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 2012 With no related allowance recorded Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . With an allowance recorded Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 49 — 577 — 720 72 149 32 3,146 1,820 5,219 166 198 32 3,723 1,820 $ 441 49 — 848 — 1,338 72 169 32 3,193 1,820 5,286 513 218 32 4,041 1,820 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,939 $ 6,624 $ 37 $ — $ — — — — — 19 $ 223 — 1,586 1,366 3,194 14 112 6 1,576 364 2,072 33 335 6 3,162 1,730 $ 5,266 $ 1 112 — 449 138 700 1 112 — 449 138 700 — 6 — — 48 54 1 — — 24 20 45 1 6 — 24 68 99 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized 2011 With no related allowance recorded Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — $ 102 1,122 1,580 — $ 105 1,538 1,580 Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,804 3,223 — $ — — — — With an allowance recorded Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 61 1,636 — 1,697 — 163 2,758 1,580 — 63 2,120 — 2,183 — 168 3,658 1,580 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,501 $ 5,406 $ — 7 424 — 431 — 7 424 — 431 An aging analysis of loans by loan category as of December 31 follows: (Dollars in thousands) $ 45 167 2,369 1,620 4,201 — 85 1,490 — 1,575 45 252 3,859 1,620 $ 5,776 $ 30 to 59 Days (1) 60 to 89 Days (1) Greater Than 90 Days (1) Total (1) Loans Not Past Due Total Loans 90 Days Past Due and Accruing . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 Agricultural Commercial and industrial . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . Construction real estate . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . 262 102 173 64 — 1,438 $ — $ — $ 198 33 339 — 559 $ 262 304 234 471 — 2,688 31,529 67,061 19,133 92,841 1,056 95,889 $ $ 31,790 67,365 19,367 93,312 1,056 98,578 4 28 68 — 691 791 $ 2,039 $ $ 1,129 $ 3,959 $ 307,509 $ 311,468 $ . . . . . . . . . . . . . . . . . . . . . . . . . $ 2011 Agricultural Commercial and industrial . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . Construction real estate . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . 151 541 104 1,752 — 1,320 $ — $ 143 52 713 — 1,015 22 97 23 1,816 — 705 $ 173 781 179 4,281 — 3,040 $ 38,756 57,904 18,478 101,969 1,169 93,397 $ $ 38,929 58,685 18,657 106,250 1,169 96,437 $ 3,868 $ 1,923 $ 2,663 $ 8,454 $ 311,673 $ 320,127 $ (1) Includes nonaccrual loans. 38 — — 15 50 65 — — 6 — 6 — — 21 50 71 — — 1 — — 29 30 — — 2 — — 68 70 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Nonaccrual loans by loan category as of December 31 follow: (Dollars in thousands) Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Construction real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2012 94 220 33 1,230 — 754 $ 2,331 $ 2011 26 143 22 2,790 — 1,174 4,155 Note 4 – Mortgage Banking Activity in secondary market loans during the year was as follows: (Dollars in thousands) 2012 2011 2010 Loans originated for resale, net of principal payments . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from loan sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net gains on sales of loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing fees, net of amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,889 45,622 1,634 131 $ 25,685 26,611 672 161 $ 28,816 28,088 682 41 Loans serviced for others are not reported as assets in the accompanying consolidated balance sheets. The unpaid principal balances of these loans were $97 million and $96 million at December 31, 2012 and 2011, respectively. The Bank maintains custodial escrow balances in connection with these serviced loans; however, such escrows were immaterial at December 31, 2012 and 2011. Activity for loan servicing rights (included in other assets) was as follows: (Dollars in thousands) Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capitalized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 318 289 (134) $ 2011 347 94 (123) $ 473 $ 318 $ $ $ 2010 491 122 (266) 347 The fair value of loan servicing rights was $807,000 and $797,000 as of December 31, 2012 and 2011, respectively. Consequently, a valuation allowance was not necessary at year-end 2012 or 2011. The fair value of servicing rights at December 31, 2012 was determined using a discount rate of 7.7% and prepayment speeds ranging from 14% to 34%. The fair value of servicing rights at December 31, 2011 was determined using a discount rate of 7.7% and prepayment speeds ranging from 7% to 26%. Note 5 – Premises and Equipment As of December 31, premises and equipment consisted of the following: (Dollars in thousands) Land and land improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Furniture and equipment $ Total cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 4,108 38 11,190 4,556 19,892 (7,771) 2011 4,084 36 11,080 3,768 18,968 (6,888) Premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,121 $ 12,080 39 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Depreciation expense was $900,000, $944,000, and $903,000 for 2012, 2011 and 2010, respectively. The Bank leases certain branch properties and automated-teller machine locations in its normal course of business. Rent expense totaled $98,000, $75,000, and $78,000 for 2012, 2011 and 2010, respectively. Rent commitments under non-cancelable operating leases were as follows, before considering renewal options that generally are present (dollars in thousands): 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 36 Note 6 – Goodwill and Intangible Assets Goodwill There were no changes in the goodwill balance in 2012 or 2011. ChoiceOne engaged an outside consulting firm to assist management in performing its annual evaluation of goodwill for impairment as of June 30, 2012. The following steps were used in the valuation: determination of the reporting unit, determination of the appropriate standard of value, determination of the appropriate level of value, calculation of fair value, and comparison of the fair value computed to the equity carrying value. It was determined that the relevant reporting unit to be valued was ChoiceOne Bank. The standard of value used in the valuation was fair value as determined by generally accepted accounting principles. The appropriate level of value was determined to be the controlling interest level. The appraisal methodology used to calculate the fair value included the income approach, which was a discounted cash flow value based on projected earnings capacity. The income approach used a discount rate of 12.50%, a growth assumption of 1.8% for assets for the first year and 2.0% in subsequent years, and an assumption of cost savings of 20% of noninterest expense as a result of synergies and cost reductions from a change in control. The appraisal methodology also included the market approach, which was based on price-to- earnings multiples, price-to-tangible book value ratios, and core deposit premiums for selected bank sale transactions. The asset approach was also an approach that was reviewed, but it was not used in determining the fair value since it did not render a control level indication of value. The results from the valuation approaches were used to calculate an estimate of the fair value of ChoiceOne’s equity, which was compared to the carrying value of equity to determine whether the Step 1 test under generally accepted accounting principles that govern the valuation of goodwill was passed. The goodwill analysis determined that the fair value of ChoiceOne’s equity exceeded the carrying value by 10.8%. Based on this assessment, management believed that there was no indication of goodwill impairment at June 30, 2012. Based on the testing performed and a review of factors that might impact ChoiceOne’s stock value subsequent to the annual evaluation, no impairment of goodwill was deemed to exist as of December 31, 2012. Acquired Intangible Assets Information for acquired intangible assets at December 31 follows: (Dollars in thousands) 2012 2011 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Core deposit intangible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,134 347 4,481 $ $ 2,549 208 2,757 $ $ 4,134 347 4,481 $ $ 2,136 173 2,309 40 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The core deposit intangible and other intangible assets are being amortized on a straight-line basis over ten years. Aggregate amortization expense was $448,000 for 2012, 2011 and 2010. The estimated amortization expense for the next four years ending December 31 is as follows: (Dollars in thousands) Core Deposit Intangible Other Intangible Assets Total 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 413 413 413 346 35 35 35 34 448 448 448 380 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,585 $ 139 $ 1,724 Note 7 – Other Real Estate Owned Other real estate owned represents residential and commercial properties primarily owned as a result of loan collection activities and is reported net of a valuation allowance. Activity within other real estate owned was as follows: (Dollars in thousands) Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Transfers from loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification to buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains/(losses) on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 2011 2010 $ $ $ 1,934 1,718 (20) (1,259) 51 (405) 1,953 2,972 — (3,015) 279 (255) 2,201 1,358 — (1,174) 96 (528) Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,019 $ 1,934 $ 1,953 Note 8 – Deposits Deposit balances as of December 31 consisted of the following: (Dollars in thousands) Noninterest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money market deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Local certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Brokered certificates of deposit $ 2012 101,861 66,569 60,806 63,406 130,057 1,500 $ 2011 78,263 64,498 63,007 46,737 144,983 5,877 Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 424,199 $ 403,365 41 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Scheduled maturities of certificates of deposit at December 31 were as follows: (Dollars in thousands) 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,086 21,923 10,194 7,769 5,050 535 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 131,557 The Bank had certificates of deposit issued in denominations of $100,000 or greater totaling $66.9 million and $70.9 million at December 31, 2012 and 2011, respectively. The Bank had brokered certificates of deposit totaling $1.5 million at December 31, 2012 compared to $5.9 million at December 31, 2011. As of December 31, 2012, the weighted average interest rate on the brokered certificate of deposit was 1.40%. In addition, the Bank had $14.2 million of certificates of deposit as of December 31, 2012 and $18.3 million as of December 31, 2011 that had been issued through the Certificate of Deposit Account Registry Service (CDARS). Although certificates of deposit issued through CDARS are issued to local customers, this type of deposit is classified as brokered deposits for regulatory purposes. Note 9 – Repurchase Agreements Securities sold under agreements to repurchase are advances to the Bank by customers or another bank. These agreements are direct obligations of the Bank and are secured by securities held in safekeeping at a correspondent bank. Repurchase agreements with Bank customers mature daily. As of December 31, 2011, the Bank had a $5 million structured repurchase agreement with a correspondent bank maturing on July 31, 2012 with a fixed interest rate of 4.55%. Information regarding repurchase agreements follows: (Dollars in thousands) Outstanding balance at December 31 . . . . . . . . . . . . . . . . . . . . . $ Average interest rate at December 31 . . . . . . . . . . . . . . . . . . . . . Average balance during the year . . . . . . . . . . . . . . . . . . . . . . . . . $ Average interest rate during the year Maximum month end balance during the year . . . . . . . . . . . . . . $ . . . . . . . . . . . . . . . . . . . . . 2012 19,572 0.25% 22,185 0.84% 24,662 2011 21,869 1.27% 20,815 1.38% 22,249 $ $ $ Note 10 – Federal Home Loan Bank Advances At December 31, advances from the Federal Home Loan Bank (the “FHLB”) were as follows: (Dollars in thousands) 2012 2011 Maturity of November 2024 with a fixed interest rate of 3.98% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 420 Maturities ranging from November 2012 to November 2024, fixed interest rates ranging from 2.54% to 4.16%, with an average rate of 3.58% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total advances outstanding at year-end . . . . . . . . . . . . . . . . . . . . . $ 420 $ $ 8,447 8,447 42 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Penalties are charged on fixed rate advances that are paid prior to maturity. A $3,000,000 advance was paid prior to its maturity in June 2012 and a $37,000 prepayment penalty was charged. No fixed rate advances were paid prior to maturity in 2011 or 2010. Advances were secured by residential real estate loans with a carrying value of approximately $74 million at December 31, 2012 and $69 million at December 31, 2011. Based on this collateral, the Bank was eligible to borrow an additional $46 million at year-end 2012. The scheduled maturities of advances from the FHLB at December 31, 2012 were as follows (dollars in thousands): 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 28 29 30 32 33 268 420 Note 11 – Income Taxes Information as of December 31 and for the year follows: (Dollars in thousands) Provision for Income Taxes Current federal income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred federal income tax expense/(benefit) . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Reconciliation of Income Tax Provision to Statutory Rate Income tax computed at statutory federal rate of 34% . . . . . . . . . . . . . . . . . . . . $ Tax exempt interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax exempt earnings on bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . Nondeductible interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 2011 2010 $ $ $ 1,475 (132) 1,343 2012 1,906 (466) (152) 13 42 $ $ $ 682 378 1,060 2011 1,555 (437) (121) 16 47 817 (163) 654 2010 1,144 (483) (122) 25 90 Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,343 $ 1,060 $ 654 Effective income tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24% 23% 19% 43 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Components of Deferred Tax Assets and Liabilities Deferred tax assets: 2012 2011 Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs on other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative minimum tax credit carryforward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other $ 920 349 255 — 294 779 341 339 75 327 Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,818 1,861 Deferred tax liabilities: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unrealized gains on securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase accounting adjustments from merger . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan servicing rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock dividends received from Federal Home Loan Bank . . . . . . . . . . . . . . . . . . . . . . . . . . Post-retirement benefits obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,396 1,138 602 161 83 75 112 3,567 1,382 1,157 743 108 83 87 103 3,663 Net deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,749) $ (1,802) ChoiceOne had a deferred tax asset of $45,000 as of December 31, 2012 and December 31, 2011 that resulted from capital losses incurred on the sales of equity securities in 2009 and 2010. A capital loss of $72,000 was carried back to 2007 during 2011 which utilized $24,000 of the deferred tax asset. A valuation allowance of $45,000 had been recorded as of December 31, 2012 and December 31, 2011 due to the uncertainty as to ChoiceOne’s ability to generate capital gains in the future that can offset the capital loss carryforward. ChoiceOne also had a deferred tax asset of $44,000 as of December 31, 2012 and December 31, 2011 that was related to unexercised stock options. A valuation allowance for the entire balance had been recorded due to the fact that the exercise price of most of the options was higher than the market price of ChoiceOne’s stock as of the end of 2012 and the exercise price of all of the options was higher than the market price of ChoiceOne’s stock as of the end of 2011. The valuation allowances totaling $89,000 as of December 31, 2012 and December 31, 2011 have been netted against the total deferred tax assets listed above. Note 12 – Related Party Transactions Loans to executive officers, directors and their affiliates were as follows at December 31: (Dollars in thousands) Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ New loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repayments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 6,254 669 (1,087) $ 2011 6,568 948 (1,262) Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,836 $ 6,254 Deposits from executive officers, directors and their affiliates were $12.5 million and $14.8 million at December 31, 2012 and 2011, respectively. Note 13 – Employee Benefit Plans 401(k) Plan: The 401(k) plan allows employees to contribute up to the IRS maximum. Matching company contributions to the plan are discretionary. Expense of this plan was $178,000, $115,000, and $112,000 in 2012, 2011, and 2010, respectively. 44 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Employee Stock Ownership Plan: Employees participate in an Employee Stock Ownership Plan (the “ESOP”). ChoiceOne may make discretionary contributions to the ESOP. Shares of ChoiceOne common stock are allocated to participants based on relative compensation earned and compensation expense is recorded when allocated. Dividends on allocated shares increase the participant accounts. Participants become fully vested upon completing six years of qualifying service. Participants receive the shares at the end of employment. A participant may require stock received to be repurchased by ChoiceOne at any time. ChoiceOne did not contribute to the ESOP nor was any expense recorded in 2012, 2011, or 2010. Shares held by the ESOP as of December 31 were as follows: (Dollars in thousands) Shares allocated to participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shares unallocated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shares of ChoiceOne stock held by ESOP . . . . . . . . . . . . . . . . . . . . . . . . 2012 5,355 — 5,355 2011 5,355 — 5,355 2010 5,355 — 5,355 Fair value of allocated shares, subject to repurchase obligation, recorded in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 77 $ 64 $ 64 Post-retirement Benefits Plan: ChoiceOne maintains an unfunded post-retirement health care plan, which permits employees (and their dependents) the ability to participate upon retirement from ChoiceOne. ChoiceOne does not pay any portion of the health care premiums charged to its retired participants. A liability has been accrued for the obligation under this plan. ChoiceOne incurred negative post-retirement benefit expense of $10,000 in 2012, $11,000 in 2011, and $15,000 in 2010. The post-retirement obligation liability was $158,000 as of December 31, 2012 and $131,000 as of December 31, 2011. Deferred Compensation Plans: A deferred director compensation plan covers former directors of Valley Ridge Bank, which was acquired by ChoiceOne in 2006. Under the plan, ChoiceOne pays each former director the amount of director fees deferred plus interest at rates ranging from 5.50% to 5.84% over various periods as elected by each director. The payout periods range from one month to ten years beginning with the individual’s termination of service. A liability has been accrued for the obligation under this plan. ChoiceOne incurred deferred compensation plan expense of $15,000, $17,000, and $20,000 in 2012, 2011, and 2010, respectively. The deferred compensation liability was $261,000 as of December 31, 2012 and $287,000 as of December 31, 2011. A supplemental retirement plan covers four former executive officers of Valley Ridge Bank. Under the plan, ChoiceOne pays these individuals a specific amount of compensation plus interest at 7.50% over a 15-year period commencing upon early retirement age (as defined in the plan) or normal retirement age (as defined in the plan). A liability has been accrued for the obligation under this plan. ChoiceOne incurred deferred compensation plan expense of $120,000 in 2012, $32,000 in 2011, and $41,000 in 2010. Deferred compensation liabilities of $766,000 and $715,000 were outstanding as of December 31, 2012 and December 31, 2011, respectively. Note 14 – Stock Options Options to buy stock have been granted to key employees under an incentive stock option plan to provide them with additional equity interest in ChoiceOne. ChoiceOne recognized compensation expense of $0 in 2012, $5,000 in 2011, and $15,000 in 2010 in connection with stock options that vested for current participants during these years. The Amended and Restated Executive Stock Incentive Plan under which the stock options were granted expired in 2012. A new Stock Incentive Plan was approved by the Registrant’s shareholders at the Annual Meeting held on April 25, 2012. The new plan provides for the issuance of up to 100,000 shares of common stock. At December 31, 2012, there were 100,000 shares available for future grants. 45 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of the activity in the plan follows: . . . . . Options outstanding, beginning of year Options granted . . . . . . . . . . . . . . . . . . . . . . . . Options exercised . . . . . . . . . . . . . . . . . . . . . . Options forfeited or expired . . . . . . . . . . . . . . Options outstanding, end of year . . . . . . . . . . . 2012 2011 2010 Weighted average exercise price $ $ $ $ 16.62 — 13.70 15.97 16.95 Weighted average exercise price $16.46 — $13.44 — $16.62 Weighted average exercise price $16.46 — — — $16.46 Shares 49,232 — — — 49,232 Shares 49,232 — 2,576 — 46,656 Shares 46,656 — 2,625 7,131 36,900 Options exercisable at December 31 . . . . . . . . 36,900 $ 16.95 46,656 $16.62 46,357 $16.64 The range of prices for options outstanding and exercisable at the end of 2012 ranged from $13.50 to $21.43 per share. The weighted average remaining contractual life of options outstanding and exercisable at the end of 2012 was approximately 3.2 years. A total of 12,100 options had an exercise price lower than ChoiceOne’s closing stock price as of the end of 2012, while 24,800 options had an exercise price higher than the closing stock price. Information pertaining to options outstanding at December 31, 2012 is as follows: Exercise price of stock options: $13.50 . . . . . . . . . . . . . . . . . . . . $13.70 . . . . . . . . . . . . . . . . . . . . $16.31 . . . . . . . . . . . . . . . . . . . . $17.95 . . . . . . . . . . . . . . . . . . . . $18.85 . . . . . . . . . . . . . . . . . . . . $21.43 . . . . . . . . . . . . . . . . . . . . Number of options outstanding at year-end Number of options exercisable at year-end Average remaining contractual life (in years) 10,000 2,100 5,512 8,000 5,250 6,038 10,000 2,100 5,512 8,000 5,250 6,038 5.07 0.04 1.06 4.05 3.05 2.05 The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. ChoiceOne uses historical data to estimate the volatility of the market price of ChoiceOne stock and employee terminations within the valuation model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. No options were granted in 2012, 2011, or 2010. There were no shares that were vested during 2012. As of December 31, 2012, there was no unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plan. 46 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 15 – Earnings Per Share (Dollars in thousands, except per share data) 2012 2011 2010 Basic Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,262 $ 3,513 $ 2,711 Weighted average common shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,296,462 3,286,969 3,273,151 Basic earnings per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.29 $ 1.07 $ 0.83 Diluted Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,262 $ 3,513 $ 2,711 Weighted average common shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . Plus: dilutive effect of assumed exercises of stock options . . . . . . . . . . . . . . . . . . 3,296,462 436 3,286,969 — 3,273,151 — Average shares and dilutive potential common shares . . . . . . . . . . . . . . . . . . . . . 3,296,898 3,286,969 3,273,151 Diluted earnings per common share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.29 $ 1.07 $ 0.83 There were 28,625 stock options as of December 31, 2012, 46,656 as of December 31, 2011, and 49,232 as of December 31, 2010 considered to be anti-dilutive to earnings per share and thus have been excluded from the calculations above. Note 16 – Other Comprehensive Income (Loss) Other comprehensive income (loss) components and related taxes follow: (Dollars in thousands) Unrealized holding gains on available for sale securities . . . . . . . . . . . . . . . . . . $ Less reclassification adjustments for gains included in net income . . . . . . . . . . Net unrealized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less tax effect Net-of-tax amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in funded status of post-retirement benefit plan . . . . . . . . . . . . . . . . . . . Tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net-of-tax amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2012 363 419 $ (56) (19) (37) (34) (12) (22) $ 2011 2,448 129 2,319 789 1,530 (23) (8) (15) Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (59) $ 1,515 $ 2010 635 443 192 65 127 (21) (7) (14) 113 Accumulated other comprehensive income, a component of equity, was comprised of the following at December 31: (Dollars in thousands) Unrealized holding gains on available for sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . $ Unrecognized actuarial gains on post-retirement benefit plan . . . . . . . . . . . . . . . . . . . . . . Tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 3,347 223 (1,214) 2,356 $ $ 2011 3,402 258 (1,245) 2,415 47 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 17 – Condensed Financial Statements of Parent Company Condensed Balance Sheets (Dollars in thousands) Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Securities available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment in ChoiceOne Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Liabilities Mandatory redeemable shares under ESOP, at fair value . . . . . . . . . . . . . . . . . . . . . . $ Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31 2012 $ $ $ 135 628 27 59,810 60,600 77 17 94 Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,506 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,600 $ (Dollars in thousands) Condensed Statements of Income Years Ended December 31 2012 1,710 16 — 2011 1,695 7 33 $ $ 1,726 89 1,637 29 1,666 2,596 4,262 $ 1,735 81 1,654 16 1,670 1,843 3,513 $ Interest and dividends from ChoiceOne Bank . . . . . . . . . . . . . . . . . . . . . . . $ Interest and dividends from other securities . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax and equity in undistributed net income of subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before equity in undistributed net income of subsidiary . . . . . . . . . Equity in undistributed net income of subsidiary . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 48 2011 487 218 26 57,264 57,995 65 26 91 57,904 57,995 2010 1,641 7 — 1,648 67 1,581 23 1,604 1,107 2,711 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Condensed Statements of Cash Flows Years Ended December 31 2012 2011 2010 4,262 $ 3,513 $ 2,711 (Dollars in thousands) Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Adjustments to reconcile net income to net cash from operating activities: Equity in undistributed net income of subsidiary . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from operating activities . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Maturities of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from investing activities . . . . . . . . . . . . . . . . . . . . . . . . . Cash flows from financing activities: Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from financing activities . . . . . . . . . . . . . . . . . . . . . . . . . (2,596) 2 (1) (10) 1,657 — (409) (409) 123 (75) (1,648) (1,600) (1,843) — 50 17 1,737 — — — 127 — (1,578) (1,451) (1,107) — (17) (18) 1,569 200 (202) (2) 125 — (1,572) (1,447) 120 81 201 Net change in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beginning cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (352) 487 135 $ 286 201 487 $ 49 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 18 – Financial Instruments Financial instruments as of the dates indicated were as follows (dollars in thousands): December 31, 2012 Assets: Cash and due from banks . . . . . . . . . . . . $ Securities available for sale . . . . . . . . . . . Federal Home Loan Bank and Federal Reserve Bank stock . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net Liabilities: Noninterest-bearing deposits . . . . . . . . . . Interest-bearing deposits . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Carrying Amount Estimated Fair Value 19,034 134,492 $ 19,034 134,492 $ 19,034 — $ — $ 131,893 — 2,599 3,750 1,874 305,616 101,861 322,338 19,572 420 3,750 1,933 310,175 101,861 323,457 19,573 485 Carrying Amount Estimated Fair Value — — — — — — — 3,750 1,933 — — — 310,175 101,861 323,457 19,573 485 — — — — December 31, 2011 Assets: Cash and due from banks . . . . . . . . . . . . $ Securities available for sale . . . . . . . . . . . Federal Home Loan Bank and Federal Reserve Bank stock . . . . . . . . . . . . . . . Loans held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net Liabilities: Noninterest-bearing deposits . . . . . . . . . . Interest-bearing deposits . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . 17,125 114,276 $ 17,125 114,276 3,749 1,262 314,914 78,263 325,102 21,869 8,447 3,749 1,262 319,017 78,263 326,123 21,083 8,664 The estimated fair values approximate the carrying amounts for all assets and liabilities except those described later in this paragraph. The methodology for determining the estimated fair value for securities available for sale is described in Note 19. The estimated fair value for loans is based on the rates charged at December 31 for new loans with similar maturities, applied until the loan is assumed to reprice or be paid. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns. The estimated fair values for time deposits and FHLB advances are based on the rates paid at December 31 for new deposits or FHLB advances, applied until maturity. The estimated fair values for other financial instruments and off-balance sheet loan commitments are considered nominal. 50 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 19 – Fair Value Measurements The following tables present information about the Bank’s assets and liabilities measured at fair value on a recurring basis at December 31, 2012 and December 31, 2011, and the valuation techniques used by the Bank to determine those fair values. In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Bank has the ability to access. Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Bank’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability. There were no liabilities measured at fair value as of December 31, 2012 or December 31, 2011. Disclosures concerning assets measured at fair value are as follows: Assets Measured at Fair Value on a Recurring Basis (Dollars in Thousands) Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Balance at Date Indicated Investment Securities, Available for Sale – December 31, 2012 U.S. Government and federal agency . . . . . . . . . . . . . . U.S. Treasury notes and bonds . . . . . . . . . . . . . . . . . . . State and municipal . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment Securities, Available for Sale – December 31, 2011 U.S. Government and federal agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State and municipal Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FDIC-guaranteed financial institution debt . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $— — — — — — — $— $— — — — — — $— 51 $ 40,268 7,398 62,579 12,526 6,712 1,001 1,409 $131,893 $ 40,413 52,228 9,780 6,011 2,038 1,035 $111,505 $ — — 2,099 — — — 500 $2,599 $ — 2,271 — — — 500 $2,771 $ 40,268 7,398 64,678 12,526 6,712 1,001 1,909 $134,492 $ 40,413 54,499 9,780 6,011 2,038 1,535 $114,276 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Securities classified as available for sale are generally reported at fair value utilizing Level 2 inputs. ChoiceOne’s external investment advisor obtained fair value measurements from an independent pricing service that uses matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair value measurements considered observable data that may include dealer quotes, market spreads, cash flows and the bonds’ terms and conditions, among other things. Securities classified in Level 2 included U.S. Government and federal agency securities, state and municipal securities, mortgage-backed securities, corporate bonds, FDIC—guaranteed financial institution debt, and equity securities. The Company classified certain state and municipal securities and privately issued trust preferred securities as Level 3. Based on the lack of observable market data, estimated fair values were based on the observable data available and reasonable unobservable market data. ChoiceOne reviewed the methodologies used to estimate the fair values of all securities in 2012. Based on an updated analysis, it was determined that the fair values of U.S. Government and federal agency securities, corporate securities, and FDIC-guaranteed financial institution debt were based upon Level 2 inputs. These securities classes, which were previously disclosed as based on Level 1 inputs, have been adjusted accordingly. Changes in Level 3 Assets Measured at Fair Value on a Recurring Basis (Dollars in Thousands) Investment Securities, Available for Sale Balance, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total realized and unrealized gains included in income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total unrealized gains (losses) included in other comprehensive income . . . . . . . . . . . . . . . . Net purchases, sales, calls, and maturities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net transfers into Level 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2012 2011 $ 2,771 — (9) (163) — 2,839 — 164 (299) 67 Balance, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,599 $ 2,771 Of the Level 3 assets that were still held by the Bank at December 31, 2012, the net unrealized loss for the twelve months ended December 31, 2012 was $9,000, which is recognized in other comprehensive income in the consolidated balance sheet. A total of $564,000 of Level 3 securities were purchased in 2012. One security was reclassified from a Level 2 measurement of fair value to a Level 3 measurement in 2011 as a result of a change in the marketability of the security. Both observable and unobservable inputs may be used to determine the fair value of positions classified as Level 3 assets and liabilities. As a result, the unrealized gains and losses for these assets and liabilities presented in the tables above may include changes in fair value that were attributable to both observable and unobservable inputs. Available for sale investment securities categorized as Level 3 assets consist of bonds issued by local municipalities and a trust- preferred security. The Bank estimates the fair value of these assets based on the present value of expected future cash flows using management’s best estimate of key assumptions, including forecasted interest yield and payment rates, credit quality and a discount rate commensurate with the current market and other risks involved. 52 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Bank also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets are not normally measured at fair value, but can be subject to fair value adjustments in certain circumstances, such as impairment. Disclosures concerning assets measured at fair value on a non-recurring basis are as follows: Assets Measured at Fair Value on a Non-recurring Basis (Dollars in Thousands) Balance at Dates Indicated Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Impaired Loans December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . Other Real Estate December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . $ 5,939 $ 4,501 $ 2,019 $ 1,934 $ — $ — $ — $ — $ — $ — $ — $ — $ 5,939 $ 4,501 $ 2,019 $ 1,934 Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Bank estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals). The changes in fair value consisted of charge-downs of impaired loans that were posted to the allowance for loan losses and write-downs of other real estate owned that were posted to a valuation account. The fair value of other real estate owned was based on appraisals or other reviews of property values, adjusted for estimated costs to sell. Note 20 – Off-Balance Sheet Activities Some financial instruments, such as loan commitments, credit lines, letters of credit, and overdraft protection, are issued to meet customers’ financing needs. These are agreements to provide credit or to support the credit of others, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies are used to make such commitments as are used for loans, including obtaining collateral at exercise of the commitment. The contractual amount of financial instruments with off-balance sheet risk was as follows at December 31: (Dollars in thousands) 2012 2011 Fixed Rate Variable Rate Fixed Rate Variable Rate Unused lines of credit and letters of credit . . . . . . . . . . . . . . $ Commitments to fund loans (at market rates) . . . . . . . . . . . . 2,474 5,145 $ 49,196 5,798 $ 2,868 3,610 $ 47,217 1,919 Commitments to fund loans are generally made for periods of 180 days or less. The fixed rate loan commitments have interest rates ranging from 1.00% to 4.35% and maturities ranging from 1 year to 30 years. Note 21 – Regulatory Capital ChoiceOne Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If only adequately capitalized, regulatory approval is required to accept 53 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS brokered deposits. If undercapitalized, capital distributions are limited, as are asset growth and expansion, and plans for capital restoration are required. At year-end 2012 and 2011, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s categories. Actual capital levels and minimum required levels for ChoiceOne Bank were as follows: (Dollars in thousands) Minimum Required for Capital Adequacy Purposes Ratio Ratio Amount Actual Amount Minimum Required to be Well Capitalized Under Prompt Corrective Action Regulations Ratio Amount 46,004 42,015 42,015 13.7% $26,856 13,428 12.5 19,191 8.8 8.0% $33,570 20,142 4.0 23,988 4.0 10.0% 6.0 5.0 43,042 38,960 38,960 12.5% $27,510 13,755 11.3 18,801 8.3 8.0% $34,387 20,632 4.0 23,502 4.0 10.0% 6.0 5.0 December 31, 2012 Total capital (to risk weighted assets) Tier 1 capital (to risk weighted assets) . . . . . . . . . . . . . . . . Tier 1 capital (to average assets) . . . . . . $ December 31, 2011 Total capital (to risk weighted assets) Tier 1 capital (to risk weighted assets) . . . . . . . . . . . . . . . . Tier 1 capital (to average assets) . . . . . . $ Banking regulations limit capital distributions by state-chartered banks. Generally, capital distributions are limited to undistributed net income for the current and prior two years. At December 31, 2012, approximately $5,546,000 was available for ChoiceOne Bank to pay dividends to ChoiceOne Financial Services, Inc. ChoiceOne’s ability to pay dividends to shareholders is dependent on the Bank, which is restricted by state law and regulations. Note 22 – Quarterly Financial Data (Unaudited) (Dollars in thousands) Interest Income Net Interest Income Net Income Earnings Per Share Fully Diluted Basic 2012 First Quarter . . . . . . . . . . . . . . . . . . . . . . . . $ Second Quarter . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . 2011 First Quarter . . . . . . . . . . . . . . . . . . . . . . . . .$ Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . $ $ 5,175 5,004 5,103 4,937 5,282 5,386 5,399 5,408 $ $ 4,419 4,290 4,512 4,454 4,345 4,472 4,523 4,582 $ $ 1,015 1,021 1,122 1,104 704 904 886 1,019 $ $ 0.31 0.31 0.34 0.33 0.21 0.28 0.27 0.31 0.31 0.31 0.34 0.33 0.21 0.28 0.27 0.31 There were no significant fluctuations in the quarterly financial data in 2011 or 2012. The growth in net income that occurred in 2012 was due to reduced provision for loan losses and increased noninterest income, which was partially offset by a decline in net interest income and growth in noninterest expenses. 54 ChoiceOne Financial Services, Inc. CORPORATE AND SHAREHOLDER INFORMATION Corporate Headquarters ChoiceOne Financial Services, Inc. ChoiceOne Bank Alpine Office ChoiceOne Insurance Agencies, Inc. Sparta Office 109 East Division Street Sparta, Michigan 49345 Phone: (616) 887-7366 Fax: (616) 887-7990 Website: www.choiceone.com Market Makers in ChoiceOne Financial Services, Inc. Stock Boenning & Scattergood Powell, Ohio (866) 326-8113 Stock Registrar and Transfer Agent Registrar and Transfer Company 10 Commerce Drive Cranford, New Jersey 07016 (800) 368-5948 Annual Shareholder Meeting The 2013 Annual Shareholder Meeting of ChoiceOne Financial Services, Inc., will be held at 11:00 a.m. local time on Wednesday, May 1, 2013, at Moss Ridge Golf Club in Ravenna, Michigan. 5050 Alpine Avenue NW Comstock Park, Michigan 49321 109 East Division Street Sparta, Michigan 49345 Cedar Springs Office 4170 – 17 Mile Road Cedar Springs, Michigan 49319 Coopersville Office 661 West Randall Street Coopersville, Michigan 49404 Egelston Office 5475 East Apple Avenue Muskegon, Michigan 49442 Fremont Office 1423 West Main Street Fremont, Michigan 49412 Grant Office 10 West Main Street Grant, Michigan 49327 Kent City Office 450 West Muskegon Street Kent City, Michigan 49330 Newaygo Office 246 West River Valley Newaygo, Michigan 49337 Ravenna Office 3069 Slocum Road Ravenna, Michigan 49451 Rockford Office 6795 Courtland Drive Rockford, Michigan 49341 Sparta - Main Office 109 East Division Street Sparta, Michigan 49345 Sparta - Appletree Office 416 West Division Street Sparta, Michigan 49345 55 Officers ChoiceOne Financial Services, Inc. James A. Bosserd President and Chief Executive Officer Louis D. Knooihuizen Senior Vice President Michael E. McHugh Senior Vice President Mary J. Johnson Secretary Thomas L. Lampen Treasurer ChoiceOne Financial Services, Inc. DIRECTORS AND OFFICERS Directors ChoiceOne Financial Services, Inc. Jerome B. Arends Directors ChoiceOne Financial Services, Inc. (continued) Former President and Chief Executive Officer of Ravenna Farm Equipment (Agricultural Equipment Supplier) Nels W. Nyblad President, Nyblad Orchards (Fruit Producer) Frank G. Berris Roxanne M. Page CPA and Partner, Beene Garter LLP (Certified Public Accountants) Donald VanSingel Vice Chairman of The Board, ChoiceOne Financial Services, Inc. and ChoiceOne Bank Former Consultant, Governmental Consultant Services, Inc. Former Legislator, Michigan House of Representatives President and Chief Executive Officer, American Gas & Oil Co., Inc. (Distributor of Petroleum Products) James A. Bosserd President and Chief Executive Officer, ChoiceOne Financial Services, Inc. and ChoiceOne Bank K. Timothy Bull President, Moon Lake Orchards, Inc. (Fruit Producer) William F. Cutler, Jr. Former Vice President, H. H. Cutler Co. (Apparel Manufacturer) Lewis G. Emmons President, Emmons Development (Real Estate Development) Stuart Goodfellow Chairman of The Board, ChoiceOne Financial Services, Inc. and ChoiceOne Bank Former Owner, Goodfellow Blueberry Farms Former Owner, Goodfellow Vending Services (Vending Company) Gary Gust Former President, Gust Construction Company (General Contractor) Paul L. Johnson Former President, Falcon Resources, Inc. (Automotive and Furniture Design) Dennis C. Nelson, DDS General Dentistry 56 Officers ChoiceOne Bank James A. Bosserd President Chief Executive Officer Lee A. Braford Senior Vice President Chief Credit Officer Sheila R. Clark Senior Vice President Human Resources Director Mary J. Johnson Senior Vice President Operations/Cashier Louis D. Knooihuizen Senior Vice President Chief Lending Officer Thomas L. Lampen, CPA Senior Vice President Chief Financial Officer Michael E. McHugh Senior Vice President Accounting, Sales & Marketing Kelly J. Potes Senior Vice President Retail Banking & GM Investments/Ins. Linda K. Anderson Vice President Call Center & Regional/Branch Sales Manager, Rockford Brian R. Bacon Vice President Commercial Loan Officer Kent G. Gagnon Vice President Business Development Denise L. Gates Vice President Regional/Branch Sales Manager, Cedar Springs Gregory M. Goss Vice President Security/BSA Officer Amy S. Homich Vice President Marketing & Business Development Officers ChoiceOne Bank (continued) Officers ChoiceOne Bank (continued) Paul E. Tucker Assistant Vice President Network Administrator Cynthia J. Watson Assistant Vice President Operations Jennifer M. Bellamy Commercial Loan Officer Veronica M. Bishop Call Center Manager Candace J. Bouwkamp Administrative Services Manager Patricia J. Brown Branch Sales Manager, Egelston Susan Compton Branch Sales Manager, Kent City Lee J. Decker Consumer Loan Manager/ IT Specialist Gary B. Hall Mortgage Sales Manager John K. Harpst Mortgage Operations Manager Carrie J. Olson Branch Sales Manager, Alpine Officers ChoiceOne Insurance Agencies, Inc. James A. Bosserd President Kelly J. Potes, CFP Senior Vice President Randy A. Schmidt, CFP Vice President Investment Advisor/Agent Thomas L. Lampen, CPA Treasurer Kevin T. Kelling Vice President Mortgage Loan Sales & Operations Officer Peggy A. O’Dea Vice President Regional/Branch Sales Manager, Coopersville Nicole N. Sakowski Vice President Collections Department Manager Daniel C. Wheat Vice President Regional/Branch Sales Manager, Grant Lisa R. Beard Assistant Vice President Branch Sales Manager – Fremont Rita A. Flintoff Assistant Vice President Branch Sales Manager – Newaygo Stephen P. Grey Assistant Vice President Credit Department Manager & Loan Officer Jason J. Herbig Assistant Vice President Network Administrator Rebecca J. Johnson Assistant Vice President Retail Banking Bonnie K. Koehn Assistant Vice President Branch Sales Manager – Sparta Main & Appletree Linda S. Nichols Assistant Vice President Branch Sales Manager, Ravenna Lori J. O’Brien Assistant Vice President Loan Operations Jason A. Parker Assistant Vice President Commercial Loan Officer Maria J. Roossinck Assistant Vice President Risk Management 57 

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