CHOICEONE FINANCIAL SERVICES, INC. 2013 ANNUAL REPORT TO SHAREHOLDERS CHOICEONE FINANCIAL SERVICES, INC. 2013 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 2013 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. 2013 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 2013 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, 2013, 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 twelve 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%, 62%, and 67% of total revenues in 2013, 2012, and 2011, respectively. Interest from securities accounted for 13%, 12%, and 11% of total revenues in 2013, 2012, and 2011, 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 2013 2012 Low $14.21 15.00 16.40 16.25 High $16.47 17.00 17.09 17.10 Low $11.25 13.01 13.50 14.30 High $14.14 15.38 16.50 15.50 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, 2014, the average bid price for shares of ChoiceOne common stock was $17.50. 3 As of February 28, 2014, there were 3,296,537 shares of ChoiceOne Financial Services, Inc. common stock issued and outstanding. As of February 28, 2014, there were 761 shareholders of record of ChoiceOne Financial Services, Inc. common stock. The following table summarizes cash dividends declared per share of common stock during 2013 and 2012: First Quarter Second Quarter Third Quarter Fourth Quarter Total 2013 $0.13 0.13 0.14 0.14 $0.54 2012 $0.12 0.12 0.13 0.13 $0.50 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 2014, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other factors. 4 ChoiceOne Financial Services, Inc. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) 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 . . . . . . . . . . . . . . . . Per share Basic earnings . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . . . . . Shareholders’ equity (at year end) . . . . . . . . . Average for the year Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross loans . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . At year end Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross loans . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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) . . 2013 2012 2011 2010 2009 $ $ $ $ 17,596 300 6,402 16,821 6,877 1,783 5,094 1,780 1.55 1.54 0.54 18.68 133,704 312,798 410,462 7,415 61,317 502,333 139,832 315,966 418,127 6,392 61,558 514,575 $ $ $ $ 17,675 2,515 6,889 16,444 5,605 1,343 4,262 1,648 1.29 1.29 0.50 18.35 129,337 307,639 408,785 6,130 59,431 500,636 138,242 311,468 424,199 420 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 1.01% 8.31 34.93 11.96 0.85% 7.17 38.67 11.89 0.72% 6.26 44.92 11.68 0.58% 5.02 57.99 11.30 0.33% 2.78 105.75 11.36 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 2013 Annual Report to Shareholders is to provide a narrative discussion about the Company’s financial condition and results of operations during 2013. Management’s discussion and analysis of financial condition and results of operations as well as disclosures found elsewhere in the 2013 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, the amount of the allowance for loan losses, loan servicing rights, and goodwill valuation. Actual results could differ from those estimates. Securities Securities available for sale may be sold prior to maturity due to changes in interest rates, 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. Under recently issued accounting pronouncements, ChoiceOne is permitted to first perform a qualitative assessment to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of equity is less than its carrying value. If the conclusion is that it is more likely than not that the fair value of equity is more than its carrying value, no further testing in the form of a quantitative assessment is necessary. If the conclusion is that it is more likely than not that the fair value of equity is less than its carrying value, then a two-step quantitative assessment test is performed to identify any potential goodwill impairment. Prior to 2013, ChoiceOne was required to perform a quantitative assessment and 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% in 2012. Based on this assessment, management believed that there was no indication of goodwill impairment. 7 Management performed a qualitative assessment of goodwill as of June 30, 2013 and December 31, 2013. The analysis was performed including evaluation of the share price, book value, and financial results of ChoiceOne as compared to the previous year. Additionally, industry and market conditions were evaluated and compared to 2011 and 2012. Average deal prices in the Midwest of closed transactions have indicated increases in deal values to tangible common equity, deal values to earnings, and core deposit premiums when compared to the observed prices used in the 2012 quantitative assessment. Further, macro-economic trends have been on a positive trajectory recently and there have been no adverse legal, regulatory, contractual, political or other factors that have materially impacted ChoiceOne. Upon completion of the qualitative assessment, ChoiceOne believed that it was more likely than not that the fair value of ChoiceOne’s equity exceeded the carrying value at the assessment dates and there was no further quantitative assessment necessary. 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, 2013, management determined that a valuation allowance of $85,000 was necessary. RESULTS OF OPERATIONS Summary (Dollars in thousands) Net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . Noninterest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year ended December 31, 2013 17,596 (300) 6,402 (16,821) (1,783) 5,094 $ $ 2012 17,675 (2,515) 6,889 (16,444) (1,343) 4,262 $ $ 2011 17,922 (3,700) 6,139 (15,788) (1,060) 3,513 $ $ Return on average assets . . . . . . . . . . . . . . . . . . . . . . . . Return on average shareholders' equity . . . . . . . . . . . . 2013 1.01% 8.31 2012 0.85% 7.17 2011 0.72% 6.26 Net income for 2013 was $5,094,000, which represented an $832,000 or 20% increase from 2012. The growth in net income resulted primarily from a lower provision for loan losses, which was partially offset by a decrease in net interest income and an increase in noninterest expense in 2013 compared to 2012. Net charge-offs were lower in 2013 than 2012, which caused the need for less provision expense. Although average earning assets grew $4.3 million in 2013, net interest income decreased $79,000 in 2013 compared to the prior year as a 31 basis point decrease in the rate earned on earning assets was applied to a larger dollar volume than the 31 basis point reduction in the rate paid on interest-bearing liabilities. The increase in noninterest expense was due to higher salaries and benefits and other noninterest expense in 2013 compared to the prior year. 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. Dividends Cash dividends of $1,780,000 or $0.54 per common share were declared in 2013, compared to $1,648,000 or $0.50 per common share in 2012 and $1,578,000 or $0.48 per common share in 2011. Dividends declared were $0.14 per share for the last two quarters and $0.13 per share for the first two quarters in 2013. 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. The dividend yield on ChoiceOne’s common stock was 3.16% in 2013, compared to 3.42% in 2012 and 3.84% in 2011. The cash dividend payout as a percentage of net income was 35% in 2013, compared to 39% in 2012 and 45% in 2011. 8 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 2014 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. Table 1 – Average Balances and Tax-Equivalent Interest Rates (Dollars in thousands) Assets: Average Balance 2013 Interest Year ended December 31, 2012 Average Rate Average Balance Interest Average Rate Average Balance 2011 Interest Average Rate Loans (1) (2) . . . . . . . . . . . . . . $ 312,798 91,083 Taxable securities (3) . . . . . . . 42,621 Nontaxable securities (1) . . . . 4,817 Other . . . . . . . . . . . . . . . . . . . . 451,319 Interest-earning assets . . . . . $ 15,814 1,812 2,099 12 _________________ 19,737 5.06% $ 307,639 90,783 1.99 38,554 4.92 0.25 10,021 446,997 4.37 $ 16,891 1,958 2,053 25 _________________ 20,927 5.49% $ 317,271 71,871 2.16 33,115 5.32 8,426 0.25 430,683 4.68 $ 18,417 1,789 1,913 20 _________________ 22,139 5.80% 2.49 5.78 0.25 5.14 Noninterest-earning assets (4) . . . . . . . . . . . . . 51,014 _______ Total assets . . . . . . . . . . . . . . $ 502,333 _______ _______ Liabilities and Shareholders’ Equity: Interest-bearing demand deposits . . . . . . . . . $ 132,053 65,484 119,072 Savings deposits . . . . . . . . . . . Certificates of deposit . . . . . . . Advances from Federal 53,639 _______ $ 500,636 _______ _______ 55,795 _______ $ 486,478 _______ _______ $ 261 40 1,027 0.20% $136,118 0.06 50,252 138,805 0.86 $ 364 59 1,664 0.27% $ 124,575 45,698 0.12 153,494 1.20 $ 541 51 2,364 0.43% 0.11 1.54 45 46 _________________ 1,419 0.61 0.23 0.41 _________________ 7,415 20,034 344,058 93,853 271 186 _________________ 2,544 4.42 0.83 0.72 _________________ 6,130 22,282 353,587 83,810 307 290 _________________ 3,553 3.63 1.37 1.01 _________________ 8,461 21,179 353,407 72,707 Home Loan Bank . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . Interest-bearing liabilities . . . Demand deposits . . . . . . . . . . . Other noninterest- bearing liabilities . . . . . . . . . Total liabilities . . . . . . . . . . . Shareholders’ equity . . . . . . . . 3,105 _______ 441,016 61,317 _______ Total liabilities and shareholders’ equity . . . . . . $ 502,333 _______ _______ 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) . . . . . . . . . . . . . . . . . . . . 3,808 _______ 441,205 59,431 _______ $ 500,636 _______ _______ 4,266 _______ 430,380 56,098 _______ $ 486,478 _______ _______ 18,318 3.96% ____ ____ 18,383 _______ _______ 3.96% 18,586 _______ _______ 4.13% (722) _______ $ 17,596 _______ _______ (708) _______ $ 17,675 _______ _______ (664) _______ $ 17,922 _______ _______ 4.06% ____ ____ _______ _______ 4.11% _______ _______ 4.32% (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 $909,000, $885,000, and $831,000 in 2013, 2012, and 2011, 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 $2,132,000, $4,364,000, and $6,256,000 in 2013, 2012, and 2011, respectively. 9 Net Interest Income As shown in Tables 1 and 2, tax-equivalent net interest income decreased $65,000 in 2013 compared to 2012. The decrease was attributed to a 31 basis point decline in the average rate on interest-earning assets offset by a 31 basis point decline in the average rate on interest-bearing liabilities. ChoiceOne’s net interest spread remained constant in 2013 compared to 2012 as growth of $4.3 million in average interest-earning assets was offset by a decline of $9.5 million in average interest-bearing liabilities. The average balance of loans increased $5.2 million in 2013 compared to 2012. $4.0 million of the growth came from loans to businesses in ChoiceOne’s markets as calling efforts were emphasized in 2013. The remaining $1.2 million resulted from retail lending, which was bolstered by marketing and ChoiceOne’s referral program. Combined with a 43 basis point decrease in the average rate earned on loans, interest income on loans declined $1,077,000 in 2013 compared to the prior year. The average balance of total securities increased by $4.4 million in 2013 compared to 2012 as securities were purchased to provide earning assets growth. This growth in the average balance was offset by a lower average rate earned on securities, which caused interest income from securities to decrease $100,000 in 2013 compared to the prior year. The average balance of other interest-earning assets decreased $5.2 million as excess funds were deployed toward loan and securities growth, resulting in a decrease of $13,000 in interest income for 2013 compared to 2012. The average balance of interest-bearing demand deposits decreased $4.1 million in 2013 compared to 2012. The effect of this decrease, combined with a 7 basis point decline in the average rate paid, caused interest expense to be $103,000 lower in 2013 than in the prior year. The effect of $15.2 million of growth in average savings deposits offset by a decrease in average rate paid of 6 basis points caused a $19,000 decrease in interest expense in 2013 compared to the prior year. The average balance of certificates of deposit was $19.7 million lower in 2013 than in the prior year. Approximately $16 million of the certificates of deposit decline was related to certificates from ChoiceOne’s local markets, while the remaining $3.7 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 $637,000 in 2013 compared to 2012. A $1.3 million increase in the average balance of Federal Home Loan Bank advances, offset by a 381 basis point decrease in the average rate paid, caused interest expense to decline $226,000 in 2013 compared to the prior year. Interest expense on other interest-bearing liabilities fell $140,000 in 2013 compared to 2012 due to a reduction of 60 basis points in the average interest rate paid, plus the effect of a $2.2 million decrease in the average balance. The growth experienced in 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 both 2013 and 2012. The average yield received on interest- earning assets in 2013 decreased 31 basis points to 4.37% while the average rate paid on interest-bearing liabilities in 2013 fell 31 basis points to 0.41%. The decline in general market interest rates in both 2012 and 2013 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, 2013 Over 2012 Total Volume Rate 2012 Over 2011 Volume Total Rate Increase (decrease) in interest income(1) Loans(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,077) $ Taxable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nontaxable securities(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in tax-equivalent income . . . . . . . . . . . . . . . (146) 46 (13) (1,190) 279 $ (1,356) $ (1,526) $ 7 207 (13) 480 (153) (161) — (1,670) 169 140 5 (1,212) (548) $ (978) (260) 429 (157) 297 4 1 (1,394) 182 Increase (decrease) in interest expense (1) Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net change in interest expense . . . . . . . . . . . . . . . . . . . Net change in tax-equivalent net interest income . . . . . $ (103) (19) (637) (226) (140) (1,125) (65) $ (11) 15 (214) 47 (17) (180) 660 $ (92) (34) (423) (273) (123) (945) (725) $ (177) 8 (700) (36) (104) (1,009) (203) $ (223) 46 3 5 (489) (211) 59 (95) (119) 15 (240) (769) 422 $ (625) 10 (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) 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. The average balance of loans decreased $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 $309,000 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. 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) 2013 Allowance for loan losses at beginning of year . . . . . . . $ 5,852 2012 $ 5,213 2011 $ 4,729 2010 $ 4,322 2009 $ 3,600 Charge-offs: Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . Real estate - residential . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries: Agricultural . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial and industrial . . . . . . . . . . . . . . . . . . . . . Real estate - commercial . . . . . . . . . . . . . . . . . . . . . . Real estate - construction . . . . . . . . . . . . . . . . . . . . . . Real estate - residential . . . . . . . . . . . . . . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 122 858 — 732 351 2,151 6 337 84 — 132 175 734 Net charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,417 Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . 300 — 405 869 — 887 338 2,499 5 61 224 — 119 214 623 1,876 2,515 45 228 1,357 — 1,677 361 3,668 10 32 89 — 104 217 452 3,216 3,700 — 765 1,523 — 1,152 444 3,884 — 68 16 — 27 230 341 3,543 3,950 — 1,558 1,218 14 1,369 535 4,694 — 102 58 29 106 246 541 4,153 4,875 Allowance for loan losses at end of year . . . . . . . . . . . . $ 4,735 $ 5,852 $ 5,213 $ 4,729 $ 4,322 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 1.52% 1.88% 1.63% 1.49% 1.34% 62% 86% 78% 56% 31% outstanding during the year . . . . . . . . . . . . . . . . . . . . 0.45% 0.61% 1.01% 1.12% 1.30% Loan recoveries as a percentage of prior year’s charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29% 17% 12% 7% 14% As shown in Table 3, the provision for loan losses was $2,215,000 lower in 2013 than in 2012. The reduction in the provision level resulted from a decrease of $459,000 in net charge-offs experienced in 2013 compared to 2012. Net charge-offs of residential real estate loans declined $168,000 and net charge-offs of commercial real estate loans increased $129,000 in 2013 compared to 2012, while net charge-offs of commercial and industrial loans decreased $559,000. Agricultural loan and consumer loan net charge-offs both increased slightly in 2013 compared to 2012. 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 decreased from 1.88% as of the end of 2012 to 1.52% as of the end of 2013. The coverage ratio of the allowance for loan losses to nonperforming loans decreased from 86% as of December 31, 2012 to 62% as of December 31, 2013. This was due to a decline of $1,117,000 in the allowance balance during 2013. ChoiceOne had $1,063,000 of specific allowance allocations for problem loans as of the end of 2013, compared to $700,000 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 2013 and 2012 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total allowance for loan losses . . . . . . . . . . . . . . . . . . $ 2013 178 562 1,842 12 1,626 192 323 $ 4,735 $ 2012 140 381 2,596 15 1,923 250 547 $ 5,852 $ 2011 55 609 2,299 34 1,847 197 172 $ 5,213 $ 2010 181 641 1,729 2 1,554 243 379 $ 4,729 $ 2009 124 735 1,546 3 1,590 306 18 $ 4,322 The increase in the allowance allocation to commercial and industrial loans was caused by an increase in loans rated 5, 6, or 7 from $1,359,000 as of December 31, 2012 to $1,697,000 as of December 31, 2013. The decrease in the allowance allocation to commercial real estate loans was due to a decrease in loans rated 5, 6, or 7 from $15,083,000 as of December 31, 2012 to $12,696,000 as of December 31, 2013. The decline in the allowance allocation to residential real estate loans occurred as a result of a reduction in historical charge-off levels in this loan category. 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, 2013 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 decreased $487,000 in 2013 compared to 2012. Customer service charges increased $312,000 in 2013 compared to the prior year due to growth in overdraft fees and debit card volume. An increase in insurance and investment commissions of $115,000 in 2013 compared to 2012 was due to overall higher volumes including brokerage fees for investment transactions for customers, including REIT sales. Gains on sales of securities decreased $282,000 primarily due to the rise in interest rates during 2013, which negated any gains securities had built up. Losses on sales of other assets were $464,000 higher in 2013 than in the prior year as write-downs of values of other real estate properties and losses on sales of properties were significantly higher in 2013 than in 2012. Earnings on life insurance policies decreased $148,000 in 2013 compared to 2012 as the prior year included a death benefit received. 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 higher 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. Noninterest Expense Total noninterest expense increased $377,000 in 2013 compared to 2012. Salaries and benefits increased $367,000 in 2013 compared to the prior year as a result of higher commission expense related to investment sales, performance bonuses, and the hiring of several new employees. Occupancy and equipment expense increased $85,000 from 2012 to 2013 primarily due to several small remodeling projects and information technology related equipment purchases. Supplies and postage expense was $63,000 higher in 2013 than in 2012 as a result of a postage increase and additional supplies purchased to build stock. The $212,000 decrease in collection expense in 2013 compared to the prior year was caused by a lower level of other real estate properties. FDIC insurance expense declined $47,000 in 2013 compared to 2012 due to 2013 benefiting from a full year under a lower insurance assessment base changed during 2012. 13 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. Income Taxes Income taxes were $1,783,000 in 2013, compared to tax expense of $1,343,000 in 2012 and a tax expense of $1,060,000 in 2011. The increase in income tax expense from 2011 to 2012 and from 2012 to 2013 was caused by higher income before income tax compared to the prior year in 2012 and 2013. The effective tax rate was 26% in 2013, compared to 24% in 2012 and 23% in 2011. The increase in the effective tax rate was caused by the portion of income before income tax comprised of nontaxable income declining in both 2012 and 2013. Financial Condition Summary Total assets were $514.6 million as of December 31, 2013, which represented an increase of $5.7 million or 1.1% from the end of 2012. Securities available for sale increased $1.6 million during 2013 as management purchased securities to support asset growth. Loans increased $4.5 million in 2013, with most of the increase occurring in commercial non-real estate and agricultural loans. The allowance for loan losses decreased $1.1 million as the quality of loans continued to improve allowing for lower net charge-offs and minimal provision expense. Net other real estate owned decreased $1.5 million in 2013 with increased effort of the bank to reduce this balance and therefore collection expenses. Total deposits fell $6.1 million in 2013 due to decreases in checking deposits and local certificates of deposit, which were partially offset by an increase in savings deposits. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Asset-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 43,722 7,224 64,775 8,470 8,815 990 1,603 483 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 136,082 $ 2012 40,268 7,398 64,678 12,526 6,712 1,001 1,909 — $ 134,492 The securities available for sale portfolio increased $1.6 million from December 31, 2012 to December 31, 2013. ChoiceOne purchased $40.7 million of securities during 2013 to replace securities that matured or were called and to provide growth in earning assets. Approximately $22 million in various securities were called or matured in 2013. Principal payments for municipal and mortgage-backed securities totaling $4 million were received during 2013. Various securities totaling approximately $8.8 million were sold during 2013 for net gains totaling $136,000. 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) and a trust preferred security totaling $1,389,000, and common stock of $214,000 as of December 31, 2013. As of December 31, 2012, equity securities included an MMP of $1,000,000, a trust preferred security of $500,000, preferred stock of $263,000, and common stock of $146,000. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 37,048 68,530 19,931 96,987 890 92,580 Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 315,966 $ 2012 31,790 67,365 19,367 93,312 1,056 98,578 $ 311,468 The loan portfolio (excluding loans held for sale) increased $4.5 million from December 31, 2012 to December 31, 2013. Economic factors in ChoiceOne’s market areas show signs of improvement, which affected loan demand in 2013. The significant increase in agricultural loans was caused by ideal weather conditions and record crops in 2013. The growth in commercial and industrial loans as well as commercial real estate loans resulted from calling efforts by ChoiceOne’s loan officers. The decrease in residential real estate loans resulted from a continued low interest rate environment for most of 2013 with high competition in the market to refinance higher interest rate loans. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2013 3,123 11 4,523 7,657 $ $ 2012 2,331 30 4,405 6,766 Nonaccrual loans included $452,000 in agricultural loans, $372,000 in commercial and industrial loans, $2,000 in consumer loans, $1,606,000 in commercial real estate loans, and $691,000 in residential real estate loans as of December 31, 2013. 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. The increase in nonaccrual loans in 2013 was caused by loans experiencing payment difficulties where management believed it was prudent to cease the accrual of interest. 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 $29,000 in consumer loans, $2,576,000 in commercial real estate loans, and $1,918,000 in residential real estate loans at December 31, 2013, compared to $72,000 in agricultural loans, $32,000 in consumer loans, $2,581,000 in commercial real estate loans and $1,720,000 of residential real estate loans at December 31, 2012. 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. 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 $14.0 million as of December 31, 2013, compared to $14.2 million as of December 31, 2012. 15 Deposits and Other Funding Sources The Bank’s deposit balances as of December 31 were as follows: (Dollars in thousands) 2013 Noninterest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 102,243 64,560 Interest-bearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,110 Money market deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63,681 Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,533 Local certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — Brokered certificates of deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 418,127 2012 $ 101,861 66,569 60,806 63,406 130,057 1,500 $ 424,199 Total deposits decreased $6.1 million from December 31, 2012 to December 31, 2013. Local deposits fell $17.5 million and brokered certificates of deposit declined $1.5 million during 2013. Management believes that the decline in both local deposits and brokered deposits is in part due to the customer base both reentering the stock market and wanting more liquid funds available as seen in the increase in money market deposits of $14.3 million. Securities sold under agreements to repurchase increased $6.5 million during 2013. The increase was due to growth in sweep repurchase accounts used by the Bank’s local customers. Advances from the Federal Home Loan Bank of Indianapolis increased $6 million in 2013 due to additional advances taken to offset the deposit decline. A blanket collateral agreement covering residential real estate loans was pledged against all outstanding advances at the end of 2013. Approximately $40.2 million of additional advances were available as of December 31, 2013 based on the collateral pledged. In 2014, 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 $1.1 million from December 31, 2012 to December 31, 2013. The growth in equity resulted from the retention of earnings in 2013 as net income exceeded dividends paid by $3.3 million. Other comprehensive income declined $2.2 million in 2013 primarily due to rising interest rates affecting the gains held on the portfolio of securities. Note 21 to the consolidated financial statements presents regulatory capital information for the Bank at the end of 2013 and 2012. All three capital ratios presented increased in 2013 as a result of more growth in capital than assets during the year. Management will monitor these capital ratios closely during 2014 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, 2013 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, 2013: (Dollars in thousands) Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank . . . . . . . . . Operating leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payment Due by Period Less than 1 year $ $ 66,783 26,033 6,029 49 82 98,976 Total $ 112,533 26,033 6,392 137 936 $ 146,031 1 - 3 Years $ $ 33,717 — 62 88 177 34,044 3 - 5 Years 11,461 — 67 — 181 11,709 $ $ More than 5 Years $ $ 572 — 234 — 496 1,302 Liquidity and Interest Rate Risk Net cash from operating activities was $10.4 million for 2013 compared to $9.6 million for 2012. Lower loan originations for sale, lower provision for loan losses and net changes in other assets and liabilities contributed to the change in 2013. Cash used in investing activities was $13.4 million in 2013 compared to $16.6 million in 2012. The decrease was caused by a reduction in the purchases of securities offset by loan origination and payment activity in 2013 in contrast to 2012. Cash flows from financing activities were $4.5 million in 2013 compared to $8.9 million in the prior year. Proceeds from the Federal Home Loan Bank and the change in repurchase agreements was offset by less deposits in 2013 than in 2012. 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, 2013, the amount of federal funds available for purchase from the Bank’s correspondent banks totaled approximately $34 million. ChoiceOne had no federal funds purchased at the end of 2013 or 2012. The Bank also has a line of credit secured by ChoiceOne’s commercial loans with the Federal Reserve Bank of Chicago for $67 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 $40.2 million of borrowing capacity was available from the FHLB based on residential real estate loans pledged as collateral at year-end 2013. 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) 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 . . . . . . . . . . . . . . . . . . . . Liabilities 0-3 Months $ 2,694 $ 2,478 — 931 101,579 — $ 107,682 $ As of December 31, 2013 1-5 Years 3-12 Months Over 5 Years 16,426 $ — — — 79,064 — 95,490 $ 84,517 $ — — — 126,644 — 211,161 $ 32,445 $ — 1,272 — 8,679 10,269 52,665 $ Interest-bearing demand deposits . . . . . . . . . . . Money market deposits . . . . . . . . . . . . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . . . . Certificates of deposits . . . . . . . . . . . . . . . . . . . Repurchase agreements . . . . . . . . . . . . . . . . . . . Advances from FHLB . . . . . . . . . . . . . . . . . . . . Rate-sensitive liabilities . . . . . . . . . . . . . . . . . $ 64,560 $ 75,110 63,681 21,892 26,033 3,007 $ 254,283 $ — $ — — 44,666 — 3,022 47,688 $ — $ — — 45,403 — 129 45,532 $ — $ — — 572 — 234 806 $ Total 136,082 2,478 1,272 931 315,966 10,269 466,998 64,560 75,110 63,681 112,533 26,033 6,392 348,309 Rate-sensitive assets less rate-sensitve liabilities: Asset (liability) gap for the period . . . . . . . . . $ (146,601) $ 47,802 $ 165,629 $ 51,859 $ 118,689 Cumulative asset (liability) gap . . . . . . . . . . . $ (146,601) $ (98,799) $ 66,830 $ 118,689 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 67% at December 31, 2013, compared to 81% at December 31, 2012. 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 2014. As interest rates change during 2014, 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, 2013, 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 18 used to determine their values. The simulation model measures the effect of immediate interest rate changes on both net interest income and shareholders’ equity. Table 6 provides an illustration of hypothetical interest rate changes as of December 31, 2013 and 2012: Table 6 – Sensitivity to Changes in Interest Rates Change in Interest Rate 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 . . . . . . . . . . . . . . . . . . . . . . . Change in Interest Rate 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 . . . . . . . . . . . . . . . . . . . . . . . $ $ Net Interest Income 17,910 18,108 18,277 18,458 18,830 18,214 17,748 17,376 17,279 Net Interest Income 17,057 17,262 17,391 17,488 17,657 17,226 16,851 16,550 16,489 2013 Percent Change -5% -4% -3% -2% —% -3% -6% -8% -8% 2012 Percent Change -3% -2% -2% -1% —% -2% -5% -6% -7% $ $ Market Value of Equity 85,498 90,365 95,034 98,997 100,573 94,075 82,563 73,398 72,943 Market Value of Equity 71,148 76,058 79,555 82,396 83,731 77,256 71,641 72,430 72,335 Percent Change -15% -10% -6% -2% —% -6% -18% -27% -27% Percent Change -15% -9% -5% -2% —% -8% -14% -13% -14% As of both December 31, 2013 and December 31, 2012, 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, 2013, 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”) in 1992. Based on this assessment, management has concluded that, as of December 31, 2013, 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 , 2014 Thomas L. Lampen Treasurer March 27, 2014 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, 2013 and 2012, 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, 2013. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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, 2013 and 2012, and the consolidated results of its operations and its cash flows for each year in the three-year period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America. Plante & Moran, PLLC Grand Rapids, Michigan March 27, 2014 21 (Dollars in thousands) Assets ChoiceOne Financial Services, Inc. CONSOLIDATED BALANCE SHEETS December 31, 2013 2012 Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,479 $ 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities Deposits - noninterest-bearing (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits - interest-bearing (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Repurchase agreements (Note 9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Advances from Federal Home Loan Bank (Note 10) . . . . . . . . . . . . . . . . . . . . . Other liabilities (Notes 11 and 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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: 3,295,463 in 2013 and 3,298,081 in 2012 (Note 14) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income, net (Note 16) . . . . . . . . . . . . . . . . . Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . See accompanying notes to consolidated financial statements. $ $ $ 136,082 2,478 1,272 931 315,966 (4,735) 311,231 11,995 508 10,269 1,275 13,728 4,327 514,575 102,243 315,884 418,127 26,033 6,392 2,465 453,017 — 46,595 14,815 148 61,558 514,575 $ $ $ 134,492 2,478 1,272 1,874 311,468 (5,852) 305,616 12,121 2,019 9,970 1,724 13,728 4,585 508,913 101,861 322,338 424,199 19,572 420 4,216 448,407 — 46,649 11,501 2,356 60,506 508,913 22 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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) . . . . . . . . . . . . . . . . . . . . . . . . . . Gains (losses) on sales and write-downs of other assets (Note 7) . . . . Earnings on life insurance policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 assets amortization (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . Loan and collection expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FDIC insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total noninterest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense (Note 11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per common share (Note 15) . . . . . . . . . . . . . . . . . . . . Diluted earnings per common share (Note 15) . . . . . . . . . . . . . . . . . . . Dividends declared per common share . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ See accompanying notes to consolidated financial statements. 23 Year ended December 31, 2013 2012 2011 $ 15,801 $ 16,875 $ 18,398 1,812 1,390 12 19,015 1,328 45 46 1,419 17,596 300 17,296 3,677 826 1,566 137 (822) 299 719 6,402 8,240 2,341 1,832 887 493 239 449 377 330 1,633 16,821 6,877 1,783 5,094 1.55 1.54 0.54 $ $ $ $ 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 4,262 1.29 1.29 0.50 $ $ $ $ 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 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Dollars in thousands) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Years ended December 31, 2013 5,094 $ 2012 4,262 $ 2011 3,513 Other comprehensive income: Unrealized holding gains/(losses) on available for sale securities . . Less reclassification adjustments for gains included in net income Net unrealized gains/(losses) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net-of-tax amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in funded status of post-retirement benefit plan . . . . . . . . . Less tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net-of-tax amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income/(loss), net of tax . . . . . . . . . . . . . . . . (3,226) 137 (3,363) (1,143) (2,220) 19 7 12 (2,208) 363 419 (56) (19) (37) (34) (12) (22) (59) 2,448 129 2,319 789 1,530 (23) (8) (15) 1,515 Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,886 $ 4,203 $ 5,028 See accompanying notes to consolidated financial statements. 24 ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER’ EQUITY (Dollars in thousands, except per share data) Balance, January 1, 2011 . . . . . . . . . . . . . . . . . . . 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) . . . . . Number of Shares 3,280,515 12,754 Common Stock and Paid in Capital $ 46,461 127 (1) 5 10 Retained Earnings $ 6,952 3,513 (1,578) Accumulated Other Comprehensive Income/(Loss), Net Total $ 900 $ 54,313 1,515 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 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive loss . . . . . . . . . . . . . . . . . . Shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shared repurchased . . . . . . . . . . . . . . . . . . . . . . . Change in ESOP repurchase obligation . . . . . . . . Effect of employee stock purchases . . . . . . . . . . . Restricted stock units issued . . . . . . . . . . . . . . . . Cash dividends declared ($0.54 per share) . . . . . 5,094 (2,208) 8,850 (11,468) 130 (192) (14) 11 11 (1,780) 5,094 (2,208) 130 (192) (14) 11 11 (1,780) Balance, December 31, 2013 . . . . . . . . . . . . . . . 3,295,463 $ 46,595 $ 14,815 $ 148 $ 61,558 See accompanying notes to consolidated financial statements. 25 (Dollars in thousands) Cash flows from operating activities: ChoiceOne Financial Services, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 2012 2013 2011 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash from operating activities $ 5,094 $ 4,262 $ 3,513 Provision for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compensation expense on employee stock purchases and restricted stock units . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans originated for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from loan sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Earnings on bank-owned life insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains 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 (benefit)/expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 Reserve 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. 300 927 1,636 22 (137) (1,566) (42,906) 45,204 (299) (122) 926 1,604 59 289 (667) 10,364 8,790 26,072 (40,687) — — (6,812) — (801) (13,438) (6,072) 6,461 7,000 (1,028) 130 (192) (1,780) 4,519 1,445 19,034 20,479 1,456 2,000 897 — 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 — $ $ 26 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, Inc. (together referred to as “ChoiceOne”). Intercompany transactions and balances have been eliminated in consolidation. 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. 27 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 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 that collection 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 residential 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 the Bank’s 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 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 make contributions to their individual accounts under the plan in amounts 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 post-retirement benefits are accrued during the years in which the employee provides service. Employee Stock Ownership Plan Dividends on Employee Stock Ownership Plan (the “ESOP”) shares are recorded as a reduction of retained earnings. 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 or restricted stock units granted. 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 post-retirement 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 $352,000 and $318,000 was required to meet regulatory reserve and clearing requirements at December 31, 2013 and 2012, respectively. The balance in excess of the amount required was interest-bearing as of December 31, 2013 and December 31, 2012. Stock-Based Compensation The Company values share-based stock option awards granted using the Black-Scholes option-pricing model. The Company recognizes compensation expense for its awards on a straight-line basis over the requisite service period for the entire award (straight-line attribution method), ensuring that the amount of compensation cost recognized at any date at least equals the portion of the grant-date fair value of the award that is vested at that time. Compensation costs related to stock options granted is disclosed in Note 14. Effective July 1, 2013, ChoiceOne granted Restricted Stock Units to a select group of employees under the Stock Incentive Plan of 2012. All of the Restricted Stock Units are initially unvested and vest in three annual installments on each of the next three anniversaries of the grant date. Certain additional vesting provisions apply. Each unit, once vested, is settled by delivery of one share of ChoiceOne common stock. 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 In February 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“ASU 2013-02”), to improve the reporting of reclassifications out of accumulated other comprehensive income. ASU 2013-02 requires that an entity report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. generally accepted accounting principles (“GAAP”) to be reclassified in its entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about these amounts. ASU 2013-02 is effective prospectively for reporting periods beginning after December 15, 2012. ChoiceOne adopted ASU 2013-02 as of January 1, 2013. The adoption of ASU 2013-02 did not have a material impact on ChoiceOne’s consolidated financial condition or results of operations. 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 indicates that it is more likely than not that an 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 an 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 an 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. ChoiceOne adopted ASU 2012-02 as of January 1, 2013. The adoption of ASU 2012-02 did not have a material impact on ChoiceOne’s consolidated financial condition or results of operations. 30 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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) U.S. Government and federal agency . . U.S. Treasury notes and bonds . . . . . . . State and municipal . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . Foreign debt . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . Asset-backed securities . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . (Dollars in thousands) U.S. Government and federal agency . . U.S. Treasury notes and bonds . . . . . . . State and municipal . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . Foreign debt . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . Amortized Cost $ $ 44,059 7,285 64,215 8,541 8,805 1,000 1,707 486 136,098 Amortized Cost $ $ 39,815 7,362 62,248 12,218 6,600 1,000 1,902 131,145 2013 Gross Unrealized Gains Gross Unrealized Losses $ $ 166 17 1,622 95 61 — 7 — 1,968 $ $ (503) (78) (1,062) (166) (51) (10) (111) (3) (1,984) 2012 Gross Unrealized Gains Gross Unrealized Losses $ $ 455 45 2,668 308 113 1 12 3,602 $ $ (2) (9) (238) — (1) — (5) (255) Fair Value 43,722 7,224 64,775 8,470 8,815 990 1,603 483 136,082 Fair Value 40,268 7,398 64,678 12,526 6,712 1,001 1,909 134,492 $ $ $ $ Information regarding sales of securities available for sale follows: (Dollars in thousands) Proceeds from sales of securities . . . . . . . . . Gross realized gains . . . . . . . . . . . . . . . . . . Gross realized losses . . . . . . . . . . . . . . . . . . $ 2013 8,790 197 60 $ 2012 9,369 421 2 $ 2011 3,310 133 4 31 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Contractual maturities of securities available for sale at December 31, 2013 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value $ 24,680 67,387 31,240 2,702 126,009 8,470 1,603 $ 136,082 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 . . . . . . . . . . . . . . . $ 2013 31,919 2012 27,085 $ Securities with unrealized losses at year-end 2013 and 2012, 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 U.S. Government agencies . . . . . $ U.S. Treasury notes and bonds . . State and municipal . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . Foreign debt . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . Asset-backed securities . . . . . . . . Total temporarily impaired . . . $ 25,104 5,190 19,532 6,380 2,823 990 1,096 — 61,115 $ $ (503) (78) (740) (166) (51) (10) (111) — (1,659) (Dollars in thousands) Less than 12 months 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) 2013 More than 12 months Unrealized Fair Losses Value — $ — 5,030 — 398 — — 483 5,911 $ — — (322) — — — — (3) (325) 2012 More than 12 months Fair Value Unrealized Losses — $ — 811 — — 811 $ — — (35) — — (35) $ $ $ $ Total Fair Value Unrealized Losses 25,104 5,190 24,562 6,380 3,221 990 1,096 483 67,026 $ $ (503) (78) (1,062) (166) (51) (10) (111) (3) (1,984) Total Fair Value 1,997 2,187 8,434 768 146 13,532 Unrealized Losses $ $ (2) (9) (238) (1) (5) (255) $ $ $ $ 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 32 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS sufficient to allow for any anticipated recovery in fair value. Management believed that unrealized losses as of December 31, 2013 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 2013 or 2012. During 2013, a security formerly classified as a state and municipal security was reclassified as an asset-backed security. There were no other reclassifications during 2013 or 2012. At December 31, 2013, there were 113 securities with an unrealized loss, compared to 28 securities with an unrealized loss as of December 31, 2012. The increase in the number of securities in an unrealized loss position was caused by a rise in longer-term market interest rates that began in the second quarter of 2013. Note 3 – Loans and Allowance for Loan Losses 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, gross . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2013 37,048 68,530 19,931 96,987 890 92,580 315,966 (4,735) 311,231 $ $ 2012 31,790 67,365 19,367 93,312 1,056 98,578 311,468 (5,852) 305,616 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, which 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 Real Estate Commercial Construction Real Estate Residential Real Estate Unallocated Total 2013 Allowance for Loan Losses Beginning balance . . . . . . . . . . . . . . . . . . $ Charge-offs . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . Provision . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance . . . . . . . . . . . . . . . . . . . . $ 140 $ (88) 6 120 178 $ 381 $ (122) 337 (34) 562 $ 250 $ (351) 175 118 192 $ 2,596 $ (858) 84 20 1,842 $ 15 $ — — (3) 12 $ 1,923 $ (732) 132 303 1,626 $ 547 $ 5,852 — (2,151) 734 — (224) 300 323 $ 4,735 Individually evaluated for impairment . . . $ — $ 53 $ 3 $ 699 $ — $ 308 $ — $ 1,063 Collectively evaluated for impairment . . . $ 178 $ 509 $ 189 $ 1,143 $ 12 $ 1,318 $ 323 $ 3,672 Loans Individually evaluated for impairment . . . $ Collectively evaluated for impairment . . . Ending balance . . . . . . . . . . . . . . . . . . . . $ 452 $ 36,596 37,048 $ 776 $ 67,754 68,530 $ 37 $ 19,894 19,931 $ 4,195 $ 92,792 96,987 $ — $ 890 890 $ 2,827 89,753 92,580 $ 8,287 307,679 $315,966 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 . . . . . . . . . . . . . . . . . . . . . . . . . Ending balance . . . . . . . . . . . . . . . . . . . . $ 55 $ — 5 80 140 $ 609 $ (405) 61 116 381 $ 197 $ (338) 214 177 250 $ 2,299 $ (869) 224 942 2,596 $ 34 $ — — (19) 15 $ 1,847 $ (887) 119 844 1,923 $ 172 $ 5,213 — (2,499) 623 — 375 2,515 547 $ 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 . . Ending balance . . . . . . . . . . . . . . . . . . . . $ 166 $ 31,624 31,790 $ 198 $ 67,167 67,365 $ 32 $ 19,335 19,367 $ 3,723 $ 89,589 93,312 $ — $ 1,056 1,056 $ 1,820 96,758 98,578 $ 5,939 305,529 $311,468 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 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 98 197 $ 1,729 $ (1,357) 89 1,838 2,299 $ 2 $ — — 32 34 $ 1,554 $ (1,677) — 104 — 1,866 1,847 $ 379 $ 4,729 (3,668) 452 (207) 3,700 172 $ 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 . . Ending balance . . . . . . . . . . . . . . . . . . . . $ — $ 38,929 38,929 $ 163 $ 58,522 58,685 $ — $ 2,758 $ 18,657 18,657 $ 106,250 $ 103,492 — $ 1,169 1,169 $ 1,580 94,857 96,437 $ 4,501 315,626 $320,127 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: Corporate Credit Exposure - Credit Risk Profile By Creditworthiness Category (Dollars in thousands) Risk ratings 1 and 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk rating 3 . . . . . . . . . . . . . . . . Risk rating 4 . . . . . . . . . . . . . . . . Risk rating 5 . . . . . . . . . . . . . . . . Risk rating 6 . . . . . . . . . . . . . . . . Risk rating 7 Agricultural Commercial and Industrial Commercial Real Estate 2013 $ 8,339 23,036 4,330 1,193 150 — $ 37,048 2012 2013 2012 2013 2012 $ $ 8,615 16,173 5,040 1,939 19 4 31,790 $ $ 7,333 46,943 12,557 1,025 608 64 68,530 $ $ 9,040 43,549 13,417 855 361 143 67,365 $ $ 3,000 53,681 27,610 6,813 5,818 65 96,987 $ $ 2,711 45,295 30,223 7,847 6,960 276 93,312 Consumer Credit Exposure - Credit Risk Profile Based On Payment Activity Performing . . . . . . . . . . . . . . . . . . Nonperforming . . . . . . . . . . . . . . . Consumer 2013 $ 19,931 — $ 19,931 2012 19,334 33 19,367 $ $ Construction Real Estate 2012 1,056 — 1,056 2013 890 — 890 $ $ $ $ Residential Real Estate 2013 92,568 12 92,580 $ $ 2012 98,018 560 98,578 $ $ The following schedule provides information on loans that were considered troubled debt restructurings (“TDRs”) that were modified during the twelve months ended December 31, 2013 and December 31, 2012: (Dollars in thousands) Agricultural . . . . . . . . . . . . . . . Commercial and industrial . . . Consumer . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . Residential real estate . . . . . . . December 31, 2013 Pre- Post- Modification Modification Outstanding Outstanding Recorded Investment Recorded Investment Number of Loans — $ 1 — 4 2 7 $ — $ 216 — 948 112 1,276 $ — 216 — 948 112 1,276 Number of Loans 1 2 1 5 3 12 December 31, 2012 Pre- Post- $ Modification Modification Outstanding Outstanding Recorded Recorded Investment Investment 72 149 32 1,990 353 2,596 72 159 32 1,990 353 2,606 $ $ $ 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, 2013 and 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, 2013 and December 31, 2012 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, 2013 December 31, 2012 Number of Loans — — 1 3 1 5 Recorded Investment — — 29 573 71 673 $ $ Number of Loans 1 2 1 1 — 5 Recorded Investment $ $ 72 149 32 68 — 321 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 2013 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 . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 452 229 2 782 891 2,356 — 547 35 3,413 1,936 5,931 452 776 37 4,195 2,827 8,287 $ $ 455 300 3 843 1,128 2,729 — 554 35 3,997 1,936 6,522 455 854 38 4,840 3,064 9,251 $ $ — $ — — — — — — 53 3 699 308 1,063 — 53 3 699 308 1,063 $ 204 85 3 693 456 1,441 112 377 43 4,126 2,207 6,865 316 462 46 4,819 2,663 8,306 $ $ 7 — — 25 7 39 1 11 3 217 81 313 8 11 3 242 88 352 37 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 . . . . . . . . . . . . . . Total $ 94 49 — 577 — 720 72 149 32 3,146 1,820 5,219 166 198 32 3,723 1,820 5,939 $ $ 441 49 — 848 — 1,338 72 169 32 3,193 1,820 5,286 513 218 32 4,041 1,820 6,624 $ $ — $ — — — — — 1 112 — 449 138 700 1 112 — 449 138 700 $ 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 $ $ — 6 — — 48 54 1 — — 24 20 45 1 6 — 24 68 99 38 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS An aging analysis of loans by loan category as of December 31 follows: (Dollars in thousands) 30 to 59 Days (1) 60 to 89 Days (1) Greater Than 90 Days (1) Loans Not Past Due Total Loans Total (1) 90 Days Past Due and Accruing 2013 Agricultural . . . . . . . . . . . . . . . . . . . . . . $ Commercial and industrial . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . Construction real estate . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . $ 2012 Agricultural . . . . . . . . . . . . . . . . . . . . . . $ Commercial and industrial . . . . . . . . . . . Consumer . . . . . . . . . . . . . . . . . . . . . . . . Commercial real estate . . . . . . . . . . . . . . Construction real estate . . . . . . . . . . . . . Residential real estate . . . . . . . . . . . . . . . $ (1) Includes nonaccrual loans 9 $ 93 60 901 — 673 1,736 $ 261 $ 102 173 64 — 1,439 2,039 $ 1 $ 352 7 884 — 186 1,430 $ — $ 4 28 68 — 691 791 $ 428 $ 73 — 242 — 167 910 $ — $ 198 33 339 — 559 1,129 $ 438 $ 518 67 2,027 — 1,026 4,076 $ 311,890 $ 315,966 $ 37,048 $ 68,530 19,931 96,987 890 92,580 36,610 $ 68,012 19,864 94,960 890 91,554 261 $ 304 234 471 — 2,689 3,959 $ 307,509 $ 311,468 $ 31,529 $ 67,061 19,133 92,841 1,056 95,889 31,790 $ 67,365 19,367 93,312 1,056 98,578 — — — — — 11 11 — — 1 — — 29 30 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 452 372 2 1,606 — 691 3,123 $ $ 2012 94 220 33 1,230 — 754 2,331 $ $ Note 4 – Mortgage Banking Activity in secondary market loans during the year was as follows: (Dollars in thousands) 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 . . . . . . . . . . . . . . $ 2013 42,906 45,204 1,566 167 $ 2012 44,889 45,622 1,634 131 $ 2011 25,685 26,611 672 161 Loans serviced for others are not reported as assets in the accompanying consolidated balance sheets. The unpaid principal balances of these loans were $98 million and $97 million at December 31, 2013 and 2012, respectively. The Bank maintains custodial escrow balances in connection with these serviced loans; however, such escrows were immaterial at December 31, 2013 and 2012. 39 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2013 473 211 (140) 544 $ $ 2012 318 289 (134) 473 $ $ 2011 347 94 (123) 318 The fair value of loan servicing rights was $958,000 and $807,000 as of December 31, 2013 and 2012, respectively. Consequently, a valuation allowance was not necessary at year-end 2013 or 2012. The fair value of servicing rights at December 31, 2013 was determined using a discount rate of 8.25% and prepayment speeds ranging from 7% to 23%. 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%. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2013 4,221 38 11,838 4,517 20,614 (8,619) 11,995 $ $ 2012 4,108 38 11,190 4,556 19,892 (7,771) 12,121 Depreciation expense was $927,000, $900,000, and $944,000 for 2013, 2012 and 2011, respectively. The Bank leases certain branch properties and automated-teller machine locations in its normal course of business. Rent expense totaled $56,000, $98,000, and $75,000 for 2013, 2012 and 2011, respectively. Rent commitments under non-cancelable operating leases were as follows, before considering renewal options that generally are present (dollars in thousands): 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 49 50 38 137 Note 6 – Goodwill and Intangible Assets There were no changes in the goodwill balance in 2013 or 2012. ChoiceOne evaluates goodwill annually for impairment. Recently issued accounting pronouncements allow a company to first perform a qualitative assessment for goodwill prior to a quantitative assessment (Step 1 assessment). If the results of the qualitative assessment indicate that it is more likely than not that goodwill is impaired, then a quantitative assessment must be performed. If not, there is no further assessment required. 40 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Prior to 2013, ChoiceOne was required to perform a quantitative assessment and 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. Management performed a qualitative assessment of goodwill as of June 30, 2013 and December 31, 2013. The analysis was performed including evaluation of the share price, book value, and financial results of ChoiceOne as compared to the previous year. Additionally, industry and market conditions were evaluated and compared to 2011 and 2012. Average deal prices in the Midwest of closed transactions have indicated increases in deal values to tangible common equity, deal values to earnings, and core deposit premiums when compared to the observed prices used in the 2012 quantitative assessment. Further, macro-economic trends have been on a positive trajectory recently and there have been no adverse legal, regulatory, contractual, political or other factors that have materially impacted ChoiceOne. Upon completion of the qualitative assessment, ChoiceOne believed that it was more likely than not that the fair value of ChoiceOne's equity exceeded the carrying value at the assessment dates and there was not further quantitative assessment necessary for 2013. 41 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Acquired Intangible Assets Information for acquired intangible assets at December 31 follows: (Dollars in thousands) 2013 2012 Core deposit intangible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Other intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Gross Carrying Amount Accumulated Amortization 2,963 243 3,206 4,134 $ 347 4,481 $ $ $ Gross Carrying Amount Accumulated Amortization 2,549 208 2,757 4,134 $ 347 4,481 $ The core deposit intangible and other intangible assets are being amortized on a straight-line basis over ten years. Intangible assets are reviewed for impairment on a quarterly basis. No impairment was indicated as of December 31, 2013 or December 31, 2012. Aggregate amortization expense was $449,000 for 2013 and $448,000 for both 2012 and 2011. The estimated amortization expense for the next three years ending December 31 is as follows: (Dollars in thousands) Core Deposit Intangible Other Intangible Assets 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 413 $ 413 345 1,171 $ 35 $ 35 34 104 $ Note 7 – Other Real Estate Owned Total 448 448 379 1,275 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: Balance, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Transfers from loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reclassification to buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2013 2,019 $ 897 — (1,604) 122 (926) 508 $ 2012 1,934 $ 1,718 (20) (1,259) 51 (405) 2,019 $ 2011 1,953 2,972 — (3,015) 279 (255) 1,934 42 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ Scheduled maturities of certificates of deposit at December 31 were as follows: 2013 102,243 64,560 75,110 63,681 112,533 — 418,127 $ $ 2012 101,861 66,569 60,806 63,406 130,057 1,500 424,199 (Dollars in thousands) 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2013 66,783 23,663 10,054 5,037 6,424 572 112,533 The Bank had certificates of deposit issued in denominations of $100,000 or greater totaling $45.8 million and $66.9 million at December 31, 2013 and 2012, respectively. The Bank had no brokered certificates of deposit at December 31, 2013 compared to $1.5 million at December 31, 2012. In addition, the Bank had $4.1 million of certificates of deposit as of December 31, 2013 and $14.2 million as of December 31, 2012 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. 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 . . . . . . . . . . . . . . $ $ $ 2013 26,033 0.22% 19,456 0.23% 26,995 $ $ $ 2012 19,572 0.25% 22,185 0.84% 24,662 43 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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) Maturity of November 2024 with fixed interest rate of 3.98% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 392 $ 420 Maturities ranging from February 2014 to May 2014, fixed interest rates ranging from 0.39% to 0.41%, with an average rate of 0.40% . . . . . . . . . . . . . . . . . . . . . . . . Total advances outstanding at year-end . . . . . . . . . . . . . . $ 6,000 6,392 $ — 420 2013 2012 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 2013 or 2011. Advances were secured by residential real estate loans with a carrying value of approximately $71 million at December 31, 2013 and $74 million at December 31, 2012. Based on this collateral, the Bank was eligible to borrow an additional $40.2 million at year-end 2013. The scheduled maturities of advances from the FHLB at December 31, 2013 were as follows: (Dollars in thousands) 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 6,029 30 32 33 34 234 6,392 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2013 1,724 59 1,783 2013 2,338 (476) (101) 8 14 1,783 $ $ $ $ 2012 1,475 (132) 1,343 2012 1,906 (466) (152) 13 42 1,343 $ $ $ $ 2011 682 378 1,060 2011 1,555 (437) (121) 16 47 1,060 $ $ $ $ Effective income tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26% 24% 23% 44 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Components of Deferred Tax Assets and Liabilities Deferred tax assets: Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Deferred compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-downs on other real estate owned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2013 1,075 316 119 214 1,724 1,279 — 462 185 83 82 132 2,223 499 $ $ 2012 920 349 255 294 1,818 1,396 1,138 602 161 83 75 112 3,567 1,749 ChoiceOne had a deferred tax asset of $42,000 as of December 31, 2013 and December 31, 2012 that resulted from capital losses incurred on the sales of equity securities in 2009 and 2010. A valuation allowance of $42,000 had been recorded as of December 31, 2013 and December 31, 2012 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, 2013 and December 31, 2012 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 2013 and 2012. The valuation allowances totaling $86,000 as of December 31, 2013 and December 31, 2012 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2013 5,836 612 (1,286) 5,162 $ $ 2012 6,254 669 (1,087) 5,836 Deposits from executive officers, directors and their affiliates were $11.4 million and $12.5 million at December 31, 2013 and 2012, respectively. Note 13 – Employee Benefit Plans 401(k) Plan: The 401(k) plan allows employees to contribute to their individual accounts under the plan amounts up to the IRS maximum. Matching company contributions to the plan are discretionary. Expense of this plan was $91,000, $178,000, and $115,000 in 2013, 2012, and 2011, respectively. 45 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 2013, 2012, or 2011. 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 . . . . . . . . . . . . . 2013 5,355 — 5,355 2012 5,355 — 5,355 2011 5,355 — 5,355 Fair value of allocated shares, subject to repurchase obligation, recorded in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 91 $ 77 $ 65 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 $11,000 in 2013, $10,000 in 2012, and $11,000 in 2011. The post-retirement obligation liability was $125,000 as of December 31, 2013 and $158,000 as of December 31, 2012. 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 $14,000, $15,000, and $17,000 in 2013, 2012, and 2011, respectively. The deferred compensation liability was $233,000 as of December 31, 2013 and $261,000 as of December 31, 2012. 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. The effective interest rate used for the accrual for the retirement liability is based on long-term interest rates. As a result, an increase in long-term interest rates during 2013 caused a decrease in plan expense in 2013 while a decline in long-term interest during 2012 caused an increase in plan expense. ChoiceOne incurred negative deferred compensation plan expense of $1,000 in 2013 and positive deferred compensation plan expense of $120,000 and $32,000 in 2012 and 2011, respectively. Deferred compensation liabilities of $696,000 and $766,000 were outstanding as of December 31, 2013 and December 31, 2012, respectively. Note 14 - Stock Based Compensation Options to buy stock have been granted to key employees under an incentive stock option plan to provide them with additional equity interests in ChoiceOne. ChoiceOne recognized compensation expense of $0 in 2013, $0 in 2012, and $5,000 in 2011 in connection with stock options 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, 2013, there were 100,000 shares available for future grants. 46 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A summary of the activity in the plan follows: 2013 2012 2011 Weighted average exercise price Shares Weighted average exercise price Shares Shares Options outstanding, beginning of year . . Options granted . . . . . . . . . . . . . . . . . . . . . Options exercised . . . . . . . . . . . . . . . . . . . Options forfeited or expired . . . . . . . . . . . Options outstanding, end of year . . . . . . . 40,725 $ — 2,100 $ — 38,625 $ 16.99 — 13.70 — 17.29 46,656 $ — 2,625 $ 3,306 $ 40,725 $ 16.62 — 13.70 13.04 16.99 49,232 $ — 2,576 $ — 46,656 $ Weighted average exercise price 16.46 — 13.44 — 16.62 Options exercisable at December 31 . . . . . 38,625 $ 17.29 40,725 $ 16.99 46,656 $ 16.62 The range of prices for options outstanding and exercisable at the end of 2013 ranged from $13.50 to $21.43 per share. The weighted average remaining contractual life of options outstanding and exercisable at the end of 2013 was approximately 2.32 years. A total of 10,000 options had an exercise price lower than ChoiceOne’s closing stock price as of the end of 2013, while 28,625 options had an exercise price higher than the closing stock price. Information pertaining to options outstanding at December 31, 2013 is as follows: Exercise price of stock options: $13.50 . . . . . . . . . . . . . . . . . . . . . . . . . . . $16.31 . . . . . . . . . . . . . . . . . . . . . . . . . . . $17.95 . . . . . . . . . . . . . . . . . . . . . . . . . . . $18.85 . . . . . . . . . . . . . . . . . . . . . . . . . . . $21.43 . . . . . . . . . . . . . . . . . . . . . . . . . . . Number of options outstanding at year-end Number of options exercisable at year-end 10,000 6,299 9,500 6,000 6,826 10,000 6,299 9,500 6,000 6,826 Average remaining contractual life (in years) 4.07 0.06 3.05 2.05 1.05 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 2013, 2012, or 2011. There were no shares that were vested during 2013. As of December 31, 2013, there was no unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plan. ChoiceOne granted Restricted Stock Units effective July 1, 2013 to a select group of employees under the Stock Incentive Plan of 2012. All of the Restricted Stock Units are initially unvested and vest in three annual installments on each of the next three anniversaries of the grant date. Certain additional vesting provisions apply. Each unit, once vested, is settled by delivery of one share of ChoiceOne common stock. ChoiceOne recognized compensation expense of $11,000 in 2013 in connection with restricted stock units for current participants during these years. At December 31, 2013 there were 3,300 units issued with an approximate stock value of $62,000. 47 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 15 - Earnings Per Share (Dollars in thousands, except per share data) Basic Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2013 2012 5,094 $ 4,262 $ 2011 3,513 Weighted average common shares outstanding . . . . . . . . . . . . . . . 3,296,408 3,296,462 3,286,969 Basic earnings per common share . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.55 $ 1.29 $ 1.07 Diluted Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Weighted average common shares outstanding . . . . . . . . . . . . . . . Plus dilutive stock options and restricted stock units . . . . . . . . . . Weighted average common shares outstanding and 5,094 $ 4,262 $ 3,513 3,296,408 5,653 3,296,462 436 3,286,969 — potentially dilutive shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,302,061 3,296,898 3,286,969 Diluted earnings per common share . . . . . . . . . . . . . . . . . . . . . . . $ 1.54 $ 1.29 $ 1.07 There were 28,625 stock options as of both December 31, 2013 and December 31, 2012, and 46,656 as of December 31, 2011 considered to be anti-dilutive to earnings per share and thus have been excluded from the calculations above. Note 16 - Accumulated Other Comprehensive Income Accumulated other comprehensive income, a component of equity, was comprised of the following at December 31: (Dollars in thousands) Unrealized holding gains/(losses) on available for sale securities . . . . . . . . . . . . . . . . Unrecognized actuarial gains on post-retirement benefit plan . . . . . . . . . . . . . . . . . . . Tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net accumulated other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ 2013 (16) $ 242 (78) 148 $ 2012 3,347 223 (1,214) 2,356 December 31, 2013 637 684 29 60,354 61,704 91 55 146 61,558 61,704 $ $ $ $ 2012 135 628 27 59,810 60,600 77 17 94 60,506 60,600 48 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Condensed Statements of Income (Dollars in thousands) 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ Years Ended December 31, 2013 2,399 19 1 2,419 98 2,321 31 2,352 2,742 5,094 $ $ 2012 1,710 $ 16 — 1,726 89 1,637 29 1,666 2,596 4,262 $ (Dollars in thousands) Condensed Statements of Cash Flows 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expense of restricted stock units . . . . . . . . . . . . . . . . . . . . . . Changes in other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash from operating activities . . . . . . . . . . . . . . . . . . . Cash flows from investing activities: Sale 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 . . . . . . . . . . . . . . . . . . . Years Ended December 31, 2013 2012 5,094 $ 4,262 $ (2,742) 2 10 (2) 37 2,399 70 (125) (55) 130 (192) (1,780) (1,842) (2,596) 2 — (1) (10) 1,657 — (409) (409) 123 (75) (1,648) (1,600) Net change in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beginning cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 502 135 637 $ (352) 487 135 $ 2011 1,695 7 33 1,735 81 1,654 16 1,670 1,843 3,513 2011 3,513 (1,843) — — 50 17 1,737 — — — 127 — (1,578) (1,451) 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) Quoted Prices In Active Markets for Identical Assets (Level 1) Significant Other Significant Observable Unobservable Inputs (Level 2) Inputs (Level 3) Carrying Amount Estimated Fair Value 20,479 $ 136,082 20,479 $ 136,082 20,479 $ 214 — $ 124,540 — 11,328 3,750 931 311,231 102,243 315,884 26,033 6,392 3,750 957 313,659 102,243 316,222 26,034 6,428 — — — — — — — 3,750 957 — — — 313,659 102,243 316,222 26,034 6,428 — — — — 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 — — — — — — — 3,750 1,933 — — — 310,175 101,861 323,457 19,573 485 — — — — December 31, 2013 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 . . . . . . 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 . . . . . . 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 value of deposits is based on comparing the average rate paid on deposits compared to the three month Libor rate which is assumed to be the replacement value of these deposits. At December 31, 2013, all average rates were lower than the three month Libor rate causing fair values to be significantly less than carrying amounts. 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, 2013 and December 31, 2012, 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, 2013 or December 31, 2012. Disclosures concerning assets measured at fair value are as follows: (Dollars in Thousands) Assets Measured at Fair Value on a Recurring Basis Investment Securities, Available for Sale - December 31, 2013 U. S. Government and federal agency . . . . . . . . . . . . U. S. Treasury notes and bonds . . . . . . . . . . . . . . . . . State and municipal . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed . . . . . . . . . . . . . . . . . . . . . . . . . . . . Corporate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Foreign debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Asset backed securities . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Quoted Prices In Active Markets for Identical Assets (Level 1) $ $ $ $ — — — — — — 214 — 214 — — — — — — — — 51 Significant Other Observable Inputs (Level 2) $ 43,722 7,224 55,234 8,470 8,417 990 — 483 $ 124,540 $ 40,268 7,398 62,579 12,526 6,712 1,001 1,409 $ 131,893 Significant Unobservable Inputs (Level 3) $ $ $ $ — — 9,541 — 398 — 1,389 — 11,328 — — 2,099 — — — 500 2,599 Balance at Date Indicated $ 43,722 7,224 64,775 8,470 8,815 990 1,603 483 $ 136,082 $ 40,268 7,398 64,678 12,526 6,712 1,001 1,909 $ 134,492 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 2013 and 2012. Based on further analysis, it was determined that the fair values of several local municipal securities were based upon Level 3 inputs. These securities classes, which were previously disclosed as based on Level 2 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 2013 2,599 — 125 3,890 4,714 Balance, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 11,328 $ 2012 2,771 — (9) (163) — 2,599 Of the Level 3 assets that were still held by the Bank at December 31, 2013, the net unrealized gain (loss) for the twelve months ended December 31, 2013 and 2012 was $4,000 and ($9,000), respectfully, which is recognized in other comprehensive income in the consolidated balance sheets. A total of $2,540,000 and $564,000 of Level 3 securities were purchased in 2013 and 2012, respectively. 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. 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: 52 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Assets Measured at Fair Value on a Non-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) ___________ $ 8,288 $ 5,939 $ 508 $ 2,019 Balances at Dates Indicated __________ $ 8,288 $ 5,939 $ 508 $ 2,019 Impaired Loans December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . Other Real Estate December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . 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) Unused lines of credit and letters of credit . . . . . . . . . . . . . $ Commitments to fund loans (at market rates) . . . . . . . . . . 3,495 7,464 Fixed Rate 2013 2012 Variable Rate 66,421 1,899 $ Fixed Rate $ 2,474 5,145 Variable Rate 49,196 5,798 $ Commitments to fund loans are generally made for periods of 180 days or less. The fixed rate loan commitments have interest rates ranging from 3.75% to 7.25% and maturities ranging from 1 year to 30 years. Note 21 – Regulatory Capital ChoiceOne and the Bank are 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 brokered deposits. If undercapitalized, capital distributions are limited, as are asset growth and expansion, and plans for capital restoration are required. At year-end 2013 and 2012, the most recent regulatory notifications categorized ChoiceOne and 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 ChoiceOne or the Bank’s categories. 53 ChoiceOne Financial Services, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Actual capital levels and minimum required levels for ChoiceOne and the Bank were as follows: (Dollars in thousands) Minimum Required for Capital Adequacy Purposes Actual Amount Ratio Amount Ratio Minimum Required to be Well Capitalized Under Prompt Corrective Action Regulations Ratio Amount December 31, 2013 ChoiceOne Financial Services Inc. Total capital (to risk weighted assets) . . . . $ 50,530 46,406 Tier 1 capital (to risk weighted assets) . . . . 46,406 Tier 1 capital (to average assets) . . . . . . . . ChoiceOne Bank Total capital (to risk weighted assets) . . . . $ 49,340 45,216 Tier 1 capital (to risk weighted assets) . . . . 45,216 Tier 1 capital (to average assets) . . . . . . . . December 31, 2012 ChoiceOne Financial Services Inc. Total capital (to risk weighted assets) . . . . $ 46,670 42,698 Tier 1 capital (to risk weighted assets) . . . . 42,698 Tier 1 capital (to average assets) . . . . . . . . ChoiceOne Bank Total capital (to risk weighted assets) . . . . $ 46,004 42,015 Tier 1 capital (to risk weighted assets) . . . . 42,015 Tier 1 capital (to average assets) . . . . . . . . 14.4%$ 28,077 14,039 13.2 19,517 9.5 8.0% $ 35,097 21,058 4.0 24,396 4.0 14.1%$ 28,048 14,024 12.9 19,489 9.3 8.0% $ 35,060 21,036 4.0 24,361 4.0 13.9% $ 26,880 13,440 12.7 19,216 8.9 8.0% $ 33,600 20,160 4.0 24,021 4.0 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 10.0% 6.0 5.0 10.0% 6.0 5.0 10.0% 6.0 5.0 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, 2013, approximately $7,180,000 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, except per share) Interest Income Net Interest Income Net Income Earnings Per Share Fully Diluted Basic 2013 First Quarter . . . . . . . . . . . . . . . . Second Quarter . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . 2012 First Quarter . . . . . . . . . . . . . . . . . Second Quarter . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . . $ $ $ $ 4,816 4,807 4,735 4,657 5,175 5,004 5,103 4,937 4,427 $ 4,448 4,391 4,330 4,419 $ 4,290 4,512 4,454 $ $ 1,235 1,312 1,201 1,346 1,015 1,021 1,122 1,104 $ $ 0.37 0.40 0.37 0.41 0.31 0.31 0.34 0.33 0.37 0.40 0.36 0.41 0.31 0.31 0.34 0.33 There were no significant fluctuations in the quarterly financial data in 2012 or 2013. The growth in net income that occurred in 2013 was due to a reduced provision for loan losses, which was partially offset by a decline in noninterest income and increase 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 9916 Brewster Lane 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 2014 Annual Shareholder Meeting of ChoiceOne Financial Services, Inc., will be held at 11:00 a.m. local time on Wednesday, April 30, 2014, 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 Mary J. Johnson Secretary Louis D. Knooihuizen Senior Vice President 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 Vice Chairman of The Board, ChoiceOne Financial Services, Inc. and ChoiceOne Bank Certified Public Accountant and Partner, Beene Garter LLP (Certified Public Accountants) Chief Executive Officer, American Gas & Oil Co., Inc. (Distributor of Petroleum Products) James A. Bosserd President and Chief Executive OfficerChoiceOne 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) Gary D. Gust Former President, Gust Construction Company (General Contractor) Jack G. Hendon Cofounder and Partner, H&S Companies (CPAs and Business Consultants) Paul L. Johnson Chairman of The Board, ChoiceOne Financial Services, Inc. and ChoiceOne Bank Former President, Falcon Resources, Inc. (Automotive and Furniture Design) Dennis C. Nelson, DDS President, Nelson Family Dentistry (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 Senior Vice President Chief Financial Officer Kelly J. Potes Senior Vice President Retail Banking & GM Investments/Ins. Linda K. Anderson Vice President Retail Banking & Consumer Loans Brian R. Bacon Vice President Commercial Loan Officer Kent G. Gagnon Vice President Business Development Denise L. Gates Vice President Regional/Branch Sales Manager Gregory M. Goss Vice President Security/BSA Officer Adom Greeland Vice President Operations/IT Amy S. Homich Vice President Marketing & Business Development ChoiceOne Financial Services, Inc. DIRECTORS AND OFFICERS (continued) Officers ChoiceOne Bank (continued) Officers ChoiceOne Bank (continued) Bonnie K. Koehn Vice President Regional Branch Sales Manager Linda S. Nichols Assistant Vice President Branch Sales Manager, Ravenna Peggy A. O’Dea Vice President Business Development/Branch Sales Manager Coopersville Nicole N. Sakowski Vice President Collections Manager Daniel C. Wheat Vice President Commercial Loan Officer/Branch Sales Manager-Grant Lisa R. Beard Assistant Vice President Branch Sales Manager - Fremont Jennifer M. Bellamy Assistant Vice President Commercial Loan Officer Veronica M. Bishop Assistant Vice President Call Center Manager Patricia J. Brown Assistant Vice President Branch Sales Manager, Egelston Lee J. Decker Assistant Vice President Consumer Loan Manager Rita A. Flintoff Lori J. O’Brien Assistant Vice President Loan Operations Jason A. Parker Assistant Vice President Commercial Loan Officer Kyle R. Purdy, CPA Assistant Vice President Controller Maria J. Roossinck Assistant Vice President Risk Management Paul E. Tucker Assistant Vice President Network Administrator Cynthia J. Watson Assistant Vice President Operations Candace J. Bouwkamp Assistant Controller Susan Compton Branch Sales Manager, Kent City Josh Hucul Credit Manager Carrie J. Olson Branch Sales Manager, Alpine Assistant Vice President Branch Sales Manager – Newaygo Officers ChoiceOne Insurance Agencies, Inc. Gary B. Hall Assistant Vice President Mortgage Sales Manager John K. Harpst Assistant Vice President Mortgage Operations Manager Jason J. Herbig Assistant Vice President Network Administrator Rebecca J. Johnson Assistant Vice President Retail Operations 57 James A. Bosserd President Mary J. Johnson Secretary Thomas L. Lampen Treasurer Kelly J. Potes, CFP Senior Vice President Randy A. Schmidt, CFP Vice President Investment Advisor/Agent