Farmers Bankshares, Inc.
Annual Report 2013

Plain-text annual report

Opening Doors for Generations FARMERS BANK Annual Report 2013 C O U R T E O U S | P R O M P T | R E L I A B L E | S E C U R E The accompanying notes are an integral part of these consolidated financial statements. 1 Our Mission It is the mission of Farmers Bank to be unique and distinct from all other financial institutions, set apart by excelling in the following areas: To offer a superior level of service that is responsive, courteous, cooperative and professional. To remain an independent financial institution close to the people of Isle of Wight County, Southampton County, the City of Suffolk and the surrounding communities, being sensitive to their financial needs and designing and offering products to specifically meet those needs. To be good corporate citizens, serving as leaders to strengthen our communities and promote their welfare. To employ men and women who are loyal to the bank and committed to our direction, policies and goals. To bring our shareholders a fair rate of return on their investments. 2 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. 1 Dear Shareholder, During the past several years your Board of Directors, Management and Staff were committed to making Farmers Bank healthier, stronger and well positioned for the future. We accomplished this goal by concentrating on credit quality and working diligently to lower classified and non-earning assets. During 2012 we deleveraged our balance sheet of low yielding investments that were offset with high costs deposits and borrowings. We are pleased to inform you that these strategies were effective and have increased your shareholder value through improved core earnings during 2013. Net income, excluding extraordinary items surpassed those in 2012 by $400,000 or seventeen percent. While loan growth was essentially flat, problem loans were replaced with higher quality credits. Average non- interest bearing deposits grew almost sixteen percent, helping to lower our cost of funds. As many financial institutions have experienced tighter net interest margins, ours has expanded by almost thirty basis points through actions taken at the end of 2012 and into 2013. As previously disclosed in our letter to shareholders earlier this year, all outstanding preferred stock to the U.S. Treasury’s Capital Purchase Program was repaid on December 31, 2013. This repayment and the approximately $11 million in capital notes issued at the holding company level has positioned us for growth and expansion in 2014 and beyond. As your Board of Directors and Management shift our focus to strategic planning for the future we are eager and motivated. We have a management team that is dedicated to customer service and technology going forward. We will strive to offer products and services that are convenient, useful and dependable. We have been opening doors for generations through long term customer relationships within our communities and understand that the Bank is successful when our customers are successful. Our Board of Directors, Management and Staff are active and invested in the communities in which we serve and are driven to promote and encourage our customers. Kindly accept my sincere thanks for your loyalty and continued support of Farmers Bank. Your core business, involvement in our service communities and promotion of the bank provide a base for stability and growth. You, our owners, are an asset that we do not take for granted and again we express our deep appreciation. Sincerely, Richard J. Holland Jr. Chairman and Chief Executive Officer Farmers Bank is healthier, stronger and well positioned for the future. Board of Directors Richard J. Holland, Jr. Chairman William A. Gwaltney, Jr. Vice Chairman Indika Farms, Inc., President G. Thomas Alphin, Jr. Commonwealth Gin, Co-Owner Harold U. Blythe Retired Bank CEO William L. Chorey Chorey & Associates Realty, Ltd., Owner/Broker E. Dana Dickens, III Hampton Roads Partnership, Retired President & CEO David T. Owen Wakefield Farm Service, Inc., President Peter D. Pruden, III Taste Unlimited, Co-Owner William H. Riddick, III Attorney at Law - Smithfield Kent B. Spain Suffolk Insurance Corporation, Executive Vice President O. A. Spady Retired Entrepreneur Executive Management Richard J. Holland, Jr. Chairman of the Board & Chief Executive Officer Vernon M. Towler President & Chief Lending Officer Patricia T. Allen Senior Vice President, Director of Loan Administration Kathy C. Bryant Senior Vice President, Director of Human Resources Norman F. Carr, Jr. Senior Vice President, Smithfield Market Kristy E. DeJarnette Senior Vice President, Chief Financial Officer Shirley B. Robinson Executive Secretary Bank Officers William N. Bailey Vice President, Information Technology Lauren P. Harper Vice President, Loans Elizabeth D. Jones Vice President, Loans Clayton N. Minter Vice President, Chief Credit Officer William D. Pollard, Jr. Vice President, Loans Chad A. Rountree Vice President, Windsor Market H. Hadley Whitlock, Jr. Vice President, Loans Susan B. Williamson Vice President, Compliance Thomas L. Woodward, III Vice President, Suffolk Market Andrea B. Curry Assistant Vice President, Operations Kelly D. Dewitt BSA, AML, OFAC & Security Officer Blanche E. Hecker Assistant Vice President, Retail Joanne F. Joyner Assistant Vice President, Retail Erin W. Park Assistant Vice President, Controller Suffolk Community Board Pictured left to right: Timothy K. Palmer Attorney at Law & Certified Public Accountant Christie New Craig Vice Chairman of the Chesapeake School Board and Chief of Staff for Delegate John Cosgrove Alison Dodson Anderson Owner, A. Dodson’s David E. Russell (Chairman) President, Tile & Terrazzo, LLC Not Pictured: James C. Adams, III President, Featherlite Coaches Financial Highlights At or for the Years Ended December 31, 2013 2012 2011 Summary of Operations Interest income Interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses Non-interest income Non-interest expense Income before income taxes Income taxes Net income Per Share and Shares Outstanding (1) Basic net income Book value at end of period Basic weighted average shares outstanding Shares outstanding at period end Balance Sheet Data Total assets Total loans, net Total deposits Borrowings Selected Performance Ratios Return on average assets Return on average stockholders’ equity Net interest margin (2) Non-interest income as a percentage of total revenue (3) Efficiency ratio (4) Asset Quality Ratios Nonperforming loans to period-end loans Allowance for loan losses to period-end loans Net charge-offs to average loans outstanding Capital (Bank Only) Tier 1 leverage ratio Total risk-based capital ratio Stockholder’s equity (Dollars in thousands, except per share data) $15,909 3,182 12,727 (500) 13,227 1,337 10,150 4,414 1,098 $3,316 $4.66 $54.06 607,357 608,020 $412,162 221,843 343,350 20,000 0.85% 8.30% 3.53% 9.50% 69.16% 2.45% 3.22% 0.23% 10.37% 18.40% $43,104 $17,371 4,900 12,471 0 12,471 3,381 10,811 5,041 1,310 $3,731 $5.22 $55.85 605,821 607,366 $19,618 6,655 12,963 3,965 8,998 2,793 10,336 1,455 239 $1,216 $1.11 $43.67 605,399 606,658 $392,343 220,402 325,680 20,000 $423,729 223,422 341,713 40,000 0.89% 9.00% 3.26% 21.33% 70.89% 2.13% 3.68% 0.17% 0.27% 3.30% 3.06% 17.72% 69.38% 2.71% 3.80% 2.17% 9.55% 17.51% $42,992 8.09% 15.89% $39,290 (1) Computed based on the weighted average number of shares outstanding during each period. (2) Net interest margin is net interest income divided by average interest earning assets. (3) Total revenue consists of net interest income and non-interest income. (4) Efficiency ratio is non-interest expense divided by the sum of net interest income and non-interest income. Net Interest Margin Return on Assets Tier 1 Leverage Ratio 2011 2012 2013 2011 2012 2013 2011 2012 2013 2.8% 2.9% 3.0% 3.1% 3.2% 3.3% 3.4% 3.5% 3.6% 0.00% 0.25% 0.50% 0.75% 1.00% 0.00% 4.00% 8.00% 12.00% Farmers Bankshares, Inc. Consolidated Financial Statements for Years Ended December 31, 2013 and 2012 Contents Independent Auditors’ Report ......................................................................................................................... Consolidated Balance Sheets ........................................................................................................................... Consolidated Statements of Operations .......................................................................................................... Page 2 3 4 Consolidated Statements of Comprehensive Income………………………………………………………………………. .. 5 Consolidated Statements of Changes in Stockholders' Equity ....................................................................... 6 Consolidated Statements of Cash Flows ......................................................................................................... 7 - 8 Notes to Consolidated Financial Statements .................................................................................................. 9 - 44 Independent Auditors’ Report To the Board of Directors and Shareholders Farmers Bankshares, Inc. Windsor, Virginia We have audited the accompanying consolidated financial statements of Farmers Bankshares, Inc. which comprise the consolidated balance sheets as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the consolidated financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Farmers Bankshares, Inc., as of December 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Charlotte, North Carolina February 20, 2014 Farmers Bankshares, Inc. Consolidated Balance Sheets December 31, 2013 2012 Assets Cash and cash equivalents Cash and due from banks Federal Funds sold Total cash and cash equivalents Available-for-sale securities (Note 3) Loans, net of allowance for loan losses of $7,381,066 and $8,423,052, respectively (Note 4) Premises and equipment, net (Note 5) Other real estate owned Accrued interest Prepaid expenses Income taxes receivable Net deferred tax asset Non-marketable equity securities (Note 6) Bank-owned life insurance Other assets $ 20,986,999 10,523,685 31,510,684 $ 15,001,762 4,448,861 19,450,623 140,293,318 135,547,857 221,842,775 5,038,166 1,788,798 1,796,866 388,920 213,466 1,056,385 2,256,089 5,844,964 131,718 380,651,465 220,402,341 4,749,080 1,178,212 1,831,195 674,806 346,296 - 2,506,839 5,608,421 47,657 372,892,704 Total assets $ 412,162,149 $ 392,343,327 Liabilities and Stockholders' Equity Deposits Noninterest-bearing deposits Interest-bearing deposits (Note 7) Total deposits Federal Home Loan Bank borrowings (Note 9) Capital notes (Note 8) Securities sold under agreements to repurchase (Note 9) Deferred compensation plans Net deferred tax liability Other liabilities Accrued interest Total liabilities Stockholders' equity Non-cummulative perpetual preferred stock (Series A), no par value, 8,752 shares authorized, issued and outstanding at December 31, 2012 Non-cummulative perpetual preferred stock (Series B), no par value, 438 shares authorized, issued and outstanding at December 31, 2012 Common stock, $0.625 par value; 10,000,000 shares authorized; 608,020 and 607,336 shares issued and outstanding at December 31, 2013 and 2012, including nonvested shares of -0- and 420 shares, respectively Capital surplus Retained earnings Accumulated other comprehensive income Total stockholders' equity $ 71,039,645 272,310,842 343,350,487 20,000,000 11,253,475 2,595,776 971,455 - 886,085 234,354 379,291,632 - - 380,015 2,695,613 28,853,472 941,417 32,870,517 $ 57,260,973 268,419,434 325,680,407 20,000,000 - 1,747,780 753,184 261,546 582,382 325,585 349,350,884 8,632,556 457,271 379,323 2,652,804 26,360,240 4,510,249 42,992,443 Total liabilities and stockholders' equity $ 412,162,149 $ 392,343,327 The accompanying notes are an integral part of these consolidated financial statements. 3 3 The accompanying notes are an integral part of these consolidated financial statements. Farmers Bankshare, Inc. Consolidated Statements of Operations Interest income Interest and fees on loans Interest on available-for-sale securities Interest on tax exempt available-for-sale securities Interest on federal funds sold Other interest income Total interest and dividend income Interest expense Interest on deposits Interest on Federal Home Loan Bank advances Interest on repurchase agreements Interest on federal funds purchased Total interest expense Net interest income Provision (recovery) for loan losses Net interest income after provision for loan losses Noninterest income Service charges Gain on disposition of securities Gain on sale of premises and equipment Other income Total noninterest income Noninterest expense Salaries and employee benefits Equipment expense Occupancy expense Bank franchise tax Advertising and marketing Data processing Loan related legal and other expenses Federal Deposit Insurance Corporation assessment Loss on sale and write-downs of other real estate owned Prepayment penalty on borrowings Other Total noninterest expense Income before income taxes Income tax expense (Note 11) Net income Preferred stock dividend and accretion of discount Net income attributable to common shareholders Basic earnings per common share (Note 18) Diluted earnings per common share Cash dividends declared per common share Years Ended December 31, 2013 2012 $ 12,103,930 2,559,424 1,163,005 22,270 60,225 15,908,854 $ 13,112,991 3,096,712 1,086,221 11,067 64,402 17,371,393 2,690,428 485,607 5,366 469 3,181,870 12,726,984 (500,000) 13,226,984 345,983 109,232 - 881,539 1,336,754 5,421,728 657,278 594,080 381,498 381,409 772,958 169,653 291,640 120,919 - 1,358,861 10,150,024 4,413,714 1,097,970 3,849,221 1,042,622 4,073 3,914 4,899,830 12,471,563 - 12,471,563 349,856 1,367,954 842,513 820,634 3,380,957 5,028,703 675,422 526,765 320,857 298,086 790,131 350,808 338,193 574,623 557,523 1,349,860 10,810,971 5,041,549 1,310,234 3,315,744 488,399 2,827,345 $ $ $ $ 4.66 4.66 0.55 3,731,315 570,257 3,161,058 $ $ $ $ 5.22 5.22 0.52 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. 4 4 Farmers Bankshares, Inc. Consolidated Statements of Comprehensive Income Net income Other comprehensive income (loss): Unrealized holding gains (losses) on available-for-sale securities Tax effect Unrealized holding gains (losses) on available-for-sale securities, net of tax amount Reclassification adjustment for realized gains Tax effect Reclassification adjustment for realized gains, net of tax amount Other comprehensive income (loss), net of tax Comprehensive income (loss) Years Ended December 31, 2013 2012 $ 3,315,744 $ 3,731,315 (5,298,090) 1,801,351 2,464,244 (837,843) (3,496,739) 1,626,401 (109,232) 37,139 (72,093) (3,568,832) (253,088) $ (1,367,954) 465,104 (902,850) 723,551 4,454,866 $ 5 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. 5 Farmers Bankshares, Inc. Farmers Bankshares, Inc. Consolidated Statements of Changes in Stockholders' Equity Consolidated Statements of Changes in Stockholders' Equity Balances, December 31, 2011 Preferred Preferred Stock Stock Series A Series A $ 8,520,487 Preferred Preferred Stock Stock Series B Series B 476,103 $ Common Stock Common Stock 378,636 $ Capital Surplus Retained Earnings Capital Surplus $ $ 2,613,991 23,514,208 $ 3,786,698 Accumulated Other Comprehensive Income Retained Earnings Accumulated Other Comprehensive Income $ Total 39,290,123 $ 8,520,487 - $ 476,103 - $ 378,636 - $ 2,613,991 - $ 3,731,315 23,514,208 $ 3,786,698 3,731,315 Balances, December 31, 2011 Balances, December 31, 2012 Net income Changes in net unrealized gain on securities available for Net income sale, net of reclassification adjustment and tax effect Changes in net unrealized gain on securities available for Issuance of common stock - stock compensation plan sale, net of reclassification adjustment and tax effect Issuance of common stock - director stock plan Preferred stock net accretion, (amortization) and costs Issuance of common stock - stock compensation plan Cash dividends declared on preferred shares Issuance of common stock - director stock plan Cash dividends declared on common shares, $0.52 per share Preferred stock net accretion, (amortization) and costs Cash dividends declared on preferred shares Cash dividends declared on common shares, $0.52 per share Net income Changes in net unrealized gain on securities available for sale, net of reclassification adjustment and tax effect Repurchase of perferred stock Balances, December 31, 2012 Net income Issuance of common stock - stock compensation plan Changes in net unrealized gain on securities available for Issuance of common stock - director stock plan sale, net of reclassification adjustment and tax effect Preferred stock net accretion, (amortization) and costs Cash dividends declared on preferred shares Repurchase of perferred stock Cash dividends declared on common shares, $0.55 per share Issuance of common stock - stock compensation plan Balances, December 31, 2013 Issuance of common stock - director stock plan Preferred stock net accretion, (amortization) and costs Cash dividends declared on preferred shares Cash dividends declared on common shares, $0.55 per share Balances, December 31, 2013 - - - - - - - 112,069 - - 112,069 8,632,556 - - - - - - - - (18,832) - - - - (18,832) 457,271 - - - - 263 424 - - - 379,323 - - - 263 424 - - - - 14,737 24,076 - - - 2,652,804 - - - - - (93,237) (477,020) (315,026) 26,360,240 - 14,737 24,076 - - - 3,315,744 8,632,556 - (8,752,400) - - - - 119,844 (8,752,400) - - - $ - - 119,844 - - $ - 457,271 - (437,600) - - - - (19,671) - (437,600) - $ - - - (19,671) - - $ - - 379,323 - - 263 429 - - - - - 263 $ 429 - - - - 2,652,804 - - 14,738 28,071 - - - - - 14,738 $ 28,071 - - - (100,173) (388,226) (334,113) 28,853,472 - - - $ - (100,173) (388,226) (334,113) 28,853,472 $ $ 380,015 2,695,613 941,417 $ 380,015 $ 2,695,613 $ 941,417 3,731,315 723,551 - - - (93,237) (477,020) (315,026) 26,360,240 3,315,744 4,510,249 (3,568,832) - - - - - - - - - - - - - - - - - Total $ 39,290,123 3,731,315 723,551 15,000 24,500 (477,020) (315,026) 42,992,443 3,315,744 (3,568,832) (9,190,000) 15,001 28,500 - - (388,226) (334,113) 32,870,517 $ - 723,551 15,000 723,551 24,500 - - (477,020) - (315,026) - 42,992,443 - - 3,315,744 4,510,249 (3,568,832) (9,190,000) - 15,001 28,500 (3,568,832) - $ (388,226) - (334,113) - 32,870,517 - - - - The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. 6 6 The accompanying notes are an integral part of these consolidated financial statements. 6 Farmers Bankshares, Inc. Consolidated Statements of Cash Flows Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Depreciation Provision (recovery) for loan losses Provision for deferred income taxes Amortization of investment securities premiums Net gain on disposition of available-for-sale securities Loss on sales and writedowns on other real estate owned Capitalization of costs associated with other real estate owned Gain on sale of premises and equipment Increase in cash value of bank owned life insurance Compensation expense for stock issuance Director expense for stock issuance Change in operating assets and liabilities Interest receivable Interest payable Prepaid expenses Income taxes receivable Other assets Deferred compensation Other liabilities Net cash provided by operating activities Cash flows from investing activities Proceeds from sales, prepayments and maturities of available-for-sale securities Purchase of available-for-sale securities Proceeds from sale of non-marketable equity securities Purchase of non-marketable equity securities Proceeds from sale of other real estate owned Loan originations, net of repayments Proceeds from sale of premises and equipment Purchases of premises and equipment Net cash provided by (used in) investing activities Cash flows from financing activities Cash dividends paid on preferred shares Cash dividends paid on common shares Repurchase of perferred stock Proceeds from issuance of capital notes Proceeds from FHLB borrowings Repayment of FHLB borrowings Change in noninterest-bearing deposits Change in interest-bearing deposits Change in securities sold under agreements to repurchase Net cash provided by (used in) financing activities Net increase in cash and cash equivalents Cash and cash equivalents Beginning of the year End of year Years Ended December 31, 2013 2012 $ 3,315,744 $ 3,731,315 448,786 (500,000) 520,557 1,239,767 (109,232) 120,919 (16,801) - (236,543) 15,001 28,500 34,329 (91,231) 285,886 132,830 (3,061) 218,271 133,457 5,537,179 26,300,963 (37,584,280) 254,200 (3,450) 614,297 (2,350,434) - (737,872) (13,506,576) (388,226) (163,867) (9,190,000) 11,253,475 5,000,000 (5,000,000) 13,778,672 3,891,408 847,996 20,029,458 12,060,061 438,944 - 406,105 1,846,775 (1,367,954) 574,623 - (842,513) (210,442) 15,000 24,500 163,749 (310,515) 235,678 209,127 419,957 112,196 69,183 5,515,728 58,506,561 (21,471,125) 947,200 (4,800) 1,302,938 2,301,638 1,009,886 (364,492) 42,227,806 (477,020) (315,026) - - - (20,000,000) 6,837,359 (22,870,054) 812,268 (36,012,473) 11,731,061 19,450,623 7,719,562 $ 31,510,684 $ 19,450,623 The accompanying notes are an integral part of these consolidated financial statements. 7 7 The accompanying notes are an integral part of these consolidated financial statements. Farmers Bankshares, Inc. Consolidated Statements of Cash Flow (concluded) Supplemental disclosure of cash flow information Cash paid for Income taxes Interest on deposits and other borrowings Supplemental schedule of non-cash investing activities Change in unrealized gains on available-for-sale securities, net of income tax Transfer of loans to other real estate owned Contribution of other real estate owned Years Ended December 31, 2013 2012 $ 460,000 3,273,101 $ 695,000 5,210,345 $ (3,568,832) $ 723,551 (1,410,000) (81,000) (781,166) - The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. 8 8 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 1 - Organization and nature of business Farmers Bankshares, Inc. (the “Company”) was organized and incorporated under the laws of the Commonwealth of Virginia on July 26, 2013. On December 31, 2013, the Company was consummated as the Bank Holding Company of Farmers Bank, Windsor, Virginia (the “Bank”) through a reorganization plan, under the laws of the Commonwealth of Virginia. As of this date, the Bank became a wholly-owned subsidiary of Farmers Bankshares, Inc. The Bank was formed on November 12, 1919 and has offices in Windsor, Smithfield, Suffolk, and Courtland, Virginia. Through its banking subsidiary the Company provides a wide variety of banking services primarily in southeastern Virginia. The Bank provides small and mid-sized businesses, professionals, corporate executives and entrepreneurs with banking services comparable to those of the large national and regional institutions. These services include loans that are priced on a deposit-based relationship, direct access to the Bank's decision makers, and quick, innovative response to customers’ financial needs. If customers have credit requirements that exceed the Bank's credit limits, the Bank seeks to accommodate those customers by arranging loans on a participation basis with other financial institutions. Note 2 - Summary of significant accounting policies Basis of presentation and consolidation - The consolidated financial statements of the Company are prepared in conformity with accounting principles generally accepted in the United States of America. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, the Bank and FB Properties of Virginia, L.L.C., which owns certain Bank assets. All significant intercompany balances and transactions have been eliminated in consolidation. Cash and cash equivalents - For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest-bearing deposits with banks and federal funds sold, all of which mature within 90 days or less. The Company is required by the Federal Reserve to maintain average reserve balances. For the final quarterly reporting period in 2013 and 2012, the aggregate amount of daily-required balances was $46,000 and $19,000, respectively. Investment securities - Investments in debt securities classified as held-to-maturity, if any, are stated at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. The Company held no such securities during the periods reported in the financial statements. Investments in debt securities classified as trading, if any, are stated at fair value. Such securities are purchased and held principally for the purpose of selling them in the near term. Unrealized holding gains and losses for trading securities are included in the statements of operations. The Company held no such securities during the periods reported on in the financial statements. Investments not classified as either held-to-maturity or trading are classified as available-for-sale. Debt securities classified as available-for-sale are stated at fair value with unrealized holding gains and losses excluded from earnings and reported as a component of accumulated other comprehensive income until realized. The income statement line items impacted by the reclassification of realized gains (losses) on the sale of securities are the gains (losses) on sales of securities and income tax expense line items in the income statement. Gains and losses on the sale of securities are determined using the specific identification method and are recognized on a trade date basis. Other than temporary declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost, if any, are included in earnings as realized losses. 9 9 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 2 - Summary of significant accounting policies (continued) Investment securities (concluded) - In determining, whether other-than-temporary impairment exists, management considers many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) if the Company expects to recover the amortized cost basis in the security. Loans - The Bank grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by commercial and consumer mortgage loans throughout Southeastern Virginia. The ability of the Bank’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area. Loans that management has the intent and ability to hold for the foreseeable future or until maturity generally are stated at their outstanding unpaid principal balances. Interest income is accrued on the unpaid principal balance for all loan classes. Discounts and premiums are amortized to income using the interest method. Net deferred fees and costs are amortized over the lives of the applicable loans using the effective interest rate method. Allowance for loan losses - The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance consists of a specific, a historic and a qualitative, general component. The specific component relates to loans that are considered impaired. For such loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of an impaired loan are lower than the carrying value of that loan. The historic component covers non-classified and criticized loans and is based on historical loss experience adjusted for qualitative factors. The qualitative reserve of the allowance reflects adjustments to historical experience to account for current conditions impacting the loan portfolio. For all classes, a loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. The allowance model is applied to determine the specific allowance balance for impaired loans and the general allowance balance for unimpaired loans grouped by loan type. 10 10 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 2 - Summary of significant accounting policies (continued) Allowance for loan losses (concluded) - The Bank’s loan charge-off policy for all loan classes is to charge down loans to net realizable value once a portion of the loan is determined to be uncollectible, and the underlying collateral shortfall is assessed. Loans are moved to nonaccrual status when the loan becomes 90 days delinquent or a portion of the loan is determined to be uncollectible and supporting collateral is not considered to be sufficient to cover potential losses. Nonaccrual loans are reviewed monthly to determine if all or a portion of the loan is uncollectible. Nonaccrual loans that are determined to be solely collateral dependent are monitored for possible charge downs to net realizable value upon determination that they are impaired. Income recognition on impaired and non-accrual loans - All classes of loans are generally classified as non-accrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well- secured and in the process of collection. All classes of loans that are on a current payment status or past due less than 90 days may also be classified as non-accrual, if repayment in full of principal and/or interest is in doubt. All classes of loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance by the borrower, in accordance with the contractual terms of interest and principal. When all classes of loans are classified as non-accrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a non-accrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Cash interest receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. Other real estate owned - Real estate acquired through, or in lieu of, foreclosure is held for sale and is initially recorded at fair value less estimated cost to sale at the date of foreclosure, establishing a new cost basis. Principal and interest losses existing at the time of acquisition of such assets are charged against the allowance for loan losses and interest income, respectively. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less estimated cost to sell. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. Revenue and expenses from operations associated with other real estate owned and the impact of any subsequent changes in the carrying value are included in other expenses. Premises and equipment - Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. For financial reporting purposes, assets are depreciated over their estimated useful lives using the straight-line method. Useful lives for these assets are within the following ranges, buildings from 10-39 years, equipment, furniture and fixtures 3-15 years, computer equipment 3-7 years and software 3-5 years. For income tax purposes, the accelerated cost recovery system and the modified accelerated cost recovery system are used. Non-marketable equity securities - Non-marketable equity securities are restricted securities, carried at cost, and periodically evaluated for impairment. These securities are restricted, do not have a readily determinable fair value, and lack a market. Because of the redemption provisions of the Federal Reserve Bank and Federal Home Loan Bank stock, the Bank estimated that the fair value equaled or exceeded the cost of these investments and the investments were not impaired. Income taxes - Income taxes are provided for the tax effects of transactions reported in the financial statements, and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of investment securities, deferred loan fees, allowance for loan losses, deferred compensation, interest on non-performing loans and accumulated depreciation for financial and income tax reporting. 11 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 2 - Summary of significant accounting policies (continued) Income taxes (concluded) - Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered in income. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. Management has evaluated all other tax positions that could have a significant effect on the financial statements and determined the Company had no uncertain income tax positions at December 31, 2013 and 2012. The years ending on or after December 31, 2010 remain subject to examination by federal and state tax authorities. The Company recognizes interest and/or penalties related to income tax matters in income tax expense. Deferred compensation plans - The Company maintains deferred compensation and retirement arrangements with certain officers. The Company's policy is to accrue the estimated amounts to be paid under the contracts over the expected period of active employment. The Company purchased life insurance contracts to fund the expected liabilities under the contracts. Earnings per common share - Basic earnings per share (EPS) are computed by dividing income available to common shareholders by the weighted-average number of shares outstanding for the period. Diluted earnings per share reflect the potential dilution if restricted stock, or other common stock equivalents, would result in the issuance of additional shares of common stock that share in earnings. Potential common shares that may be issued by the Company relate solely to outstanding non-vested restricted stock. Off-balance sheet financial instruments - In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit, standby letters of credit, and financial guarantees written. Such financial instruments are generally recorded in the financial statements when they become payable. A reserve for these off-balance sheet financial instruments is considered immaterial as is the fair value of the financial guarantees. Use of estimates - The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimation of fair values - The following notes summarize the major methods and assumptions used in estimating the fair value of financial instruments: Short-term financial instruments are valued at their carrying amounts included in the Company’s balance sheet, which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments. This approach applies to cash and cash equivalents, deposits in other banks, federal funds sold, and short-term borrowings. Loans are valued on the basis of estimated future receipts of principal and interest, discounted at various rates. Loan prepayments are assumed to occur at the same rate as in previous periods when interest rates were at levels similar to current levels. Future cash flows for homogeneous categories of consumer loans are estimated on a portfolio basis and discounted at current rates offered for similar loan terms to new borrowers with similar credit profiles. A liquidity discount is not considered in determining the fair value of the loan portfolio. Investment securities are valued at quoted market prices, if available. The fair value of equity investments in the restricted stock of the FRB and FHLB approximates the carrying value due to the redemptive provisions of these securities. 12 12 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 2 - Summary of significant accounting policies (continued) Estimation of fair values (concluded) – For unquoted securities, the fair value is estimated by the Company on the basis of financial and other information. The carrying amounts of accrued interest approximate fair value. The fair value of demand deposits and deposits with no defined maturity is taken to be the amount payable on demand at the reporting date. The fair value of fixed-maturity deposits is estimated using discounted cash flow analyses and rates currently offered for deposits of similar remaining maturities. The intangible value of long-term relationships with depositors is not taken into account in estimating the fair values disclosed. Fair values of capital notes are based on market prices for debt securities having similar maturity and interest rate characteristics. The impact of the Company’s assessment of its own credit risk is not factored into the fair value of the notes. The carrying amounts of federal funds purchased and borrowings under repurchase agreements approximate their fair values. The fair values of the Company’s Federal Home Loan Bank advances are estimated using discounted cash flow analyses based on current rates offered on similar debt instruments. It is not practicable to separately estimate the fair values for off-balance-sheet credit commitments, including standby letters of credit and guarantees written, due to the lack of cost-effective, reliable measurement methods for these instruments. Certain significant estimates - Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of other real estate owned. Management uses available information to recognize losses on loans and other real estate owned. Future additions to the allowances may be necessary based on changes in local economic conditions and other factors. Management believes the allowances recorded at December 31, 2013 and 2012 are sufficient to cover inherent losses in the portfolio. Recent accounting pronouncements - In February 2013, the FASB issued ASU 2013-02, “Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” The amendments in this ASU require an entity to present (either on the face of the statement where net income is presented or in the notes) the effects on the line items of net income of significant amounts reclassified out of accumulated other comprehensive income. In addition, the amendments require a cross-reference to other disclosures currently required for other reclassification items to be reclassified directly to net income in their entirety in the same reporting period. Companies should apply these amendments for fiscal years, and interim periods within those years, beginning on or after December 15, 2012. The Company has included the required disclosures from ASU 2013-02 in the notes to the consolidated financial statements. In January 2014, the FASB issued ASU 2014-4, “Troubled Debt Restructurings by Creditors (Subutopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure”. The amendments in this Update clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. 13 13 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 2 - Summary of significant accounting policies (concluded) Recent accounting pronouncements (concluded) - Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The adoption of this standard is not expected to have a material impact on the consolidated financial statements of the Company. Reclassifications - Certain reclassifications have been made to prior period balances to conform to the current year presentation. Note 3 - Available-for-sale securities At December 31, 2013 and 2012, securities are as follows: December 31, 2013 State and municipal Residential mortgage-backed securities Collateralized mortgage obligations Small Business Administration Pools December 31, 2012 State and municipal Residential and mortgage-backed securities Collateralized mortgage obligations Small Business Administration Pools Amortized Cost $ 35,063,849 19,433,360 46,669,105 37,700,613 $ 138,866,927 Gross Unrealized Gains $ 871,128 225,046 408,420 1,570,008 $ 3,074,602 Gross Unrealized Losses $ 276,408 584,986 786,817 - $ 1,648,211 Fair Value $ 35,658,569 19,073,420 46,290,708 39,270,621 $ 140,293,318 Amortized Cost $ 29,965,718 15,559,345 39,214,311 43,974,771 $ 128,714,145 Gross Unrealized Gains $ 2,472,981 575,618 1,016,326 2,827,311 $ 6,892,236 Gross Unrealized Losses $ - - 58,524 - $ 58,524 Fair Value $ 32,438,699 16,134,963 40,172,113 46,802,082 $ 135,547,857 At December 31, 2013 and 2012, gross unrealized losses and fair value by length of time that the individual securities have been in a continuous unrealized loss position, are as follows: December 31, 2013 Available-for-sale securities: State and municipal Residential mortgage-backed securities Collateralized mortgage obligations Total temporarily impaired Continuous Unrealized Losses Existing for: Approximate Market Value Less than 12 Months More than 12 Months Total Losses $ 10,648,954 11,044,258 20,991,354 $ 276,408 584,986 776,449 $ - - 10,368 $ 276,408 584,986 786,817 investment securities $ 42,684,566 $ 1,637,843 $ 10,368 $ 1,648,211 14 14 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 3 - Available-for-sale securities (continued) December 31, 2012 Available-for-sale securities: Collateralized mortgage obligations Collateralized mortgage obligations Total temporarily impaired investment securities Continuous Unrealized Losses Existing for: Approximate Market Value Less than 12 Months More than 12 Months Total Losses $ 317,490 2,124,623 $ 11,330 - $ - 47,194 $ 11,330 47,194 $ 2,442,113 $ 11,330 $ 47,194 $ 58,524 State and municipal - The Company’s unrealized losses on state and municipal securities were caused by the interest rate fluctuations. The severity and duration of these unrealized losses will fluctuate with interest rates in the economy. Based on the credit quality of the issuers, and because of the Company’s intent to hold the securities until a market price recovery or maturity, and it is more likely than not that the Company will not be required to sell these securities before their anticipated recovery, the Company does not consider these investments other than temporarily impaired. Residential and mortgage-backed securities and collateralized mortgage obligations- The Company’s unrealized losses on residential and mortgage-backed securities and collateralized mortgage obligations were caused by the interest rate fluctuations. The severity and duration of these unrealized losses will fluctuate with interest rates in the economy. Because our mortgage- related securities are backed by FNMA and FHLMC, which are GSEs, or are collateralized by securities backed by these agencies, and because of the Company’s intent to hold the securities until a market price recovery or maturity, and it is more likely than not that the Company will not be required to sell these securities before their anticipated recovery, the Company does not consider these investments other than temporarily impaired. At December 31, 2013 and 2012, securities with a carrying value of approximately $17,016,641 and $20,514,874, respectively, are pledged to the Commonwealth of Virginia to secure public deposits. In addition, at December 31, 2013 and 2012, securities with a carrying value of $4,792,267 and $4,214,038, respectively, are pledged to the Federal Home Loan Bank to secure advances. Investment securities with carrying values of $3,213,431 and $3,585,603 are pledged to secure repurchase agreements at December 31, 2013 and 2012, respectively. At December 31, 2013, the amortized cost and fair value of debt securities by maturity date are as follows: Due in one year or less Due from one to five years Due from five to ten years Due after ten years Total debt securities Gross realized gains on available-for-sale securities were: Residential mortgage-backed securities Small Business Administration Pools State and muncipals Total gross realized gains 15 Amortized Cost $ - 193,631 13,065,105 125,608,191 $ 138,866,927 Fair Value $ - 199,012 13,447,775 126,646,531 $ 140,293,318 2013 $ 109,074 - 158 $ 109,232 2012 $ 462,214 611,246 294,494 $ 1,367,954 15 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 3 - Available-for-sale securities (concluded) There were no gross realized losses on available-for-sale securities during 2013 or 2012. Proceeds from the sale of available-for-sale securities totaled $4,878,319 and $34,386,865 for the years ended December 31, 2013 and 2012, respectively. Note 4 - Loans and Allowance for Loan Losses General - The Bank provides to its customers a full range of short- to medium-term commercial, agricultural, Small Business Administration guaranteed, mortgage, home equity, and personal loans, both secured and unsecured. The Bank also makes real estate mortgage and construction loans. At December 31, 2013 and 2012, loans consisted of the following: Mortgage loans on real estate: Construction Commercial Real Estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Total mortgage loans on real estate Commercial and industrial Agricultural Individuals Total loans Less: Allowance for loan losses Net deferred loan fees and costs Loans, net 2013 2012 $ 31,261,147 $ 33,539,112 34,726,441 58,036,590 41,339,445 7,377,067 11,425,387 184,166,077 23,072,880 19,659,415 2,240,940 229,139,312 (7,381,066) 84,529 $ 221,842,775 33,056,579 56,691,698 42,555,168 8,090,850 10,428,101 184,361,508 23,652,191 18,536,728 2,213,473 228,763,900 (8,423,052) 61,493 $ 220,402,341 Real Estate Loans - Real estate loans include construction and land development loans, commercial real estate loans, home equity lines of credit and residential mortgages. Construction/development lending totaled $31.3 million and $33.5 million at December 31, 2013 and 2012, respectively. The Bank originates one-to-four family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provides financing to builders and consumers for the construction of pre-sold homes. The Bank generally receives a pre-arranged permanent financing commitment from an outside banking entity prior to financing the construction of pre-sold homes. The Bank also makes commercial real estate construction loans, primarily for owner-occupied properties. The Bank limits its construction lending risk through adherence to established underwriting procedures. Residential one-to-four family loans amounted to $41.3 million and $42.6 million at December 31, 2013 and 2012, respectively. Commercial real estate loans totaled $92.8 million and $89.7 million at December 31, 2013 and 2012, respectively. This lending has involved loans secured by owner-occupied commercial buildings for office, storage and warehouse space, as well as non-owner occupied commercial buildings. The Bank generally requires the personal guaranty of borrowers and a demonstrated cash flow capability sufficient to service the debt. Loans secured by commercial real estate may be larger in size and may involve a greater degree of risk than one-to-four family residential mortgage loans. Payments on such loans are often dependent on successful operation or management of the properties. 16 16 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 – Loans and Allowance for Loan Losses (continued) Commercial and Industrial Loans - At December 31, 2013 and 2012, the Bank’s commercial loan portfolio totaled $23.1 million and $23.7 million, respectively. Commercial loans include both secured and unsecured loans for working capital, expansion, and other business purposes. Short-term working capital loans are secured by accounts receivable, inventory and/or equipment. The Bank also makes term commercial loans secured by equipment and real estate. Lending decisions are based on an evaluation of the financial strength, cash flow, management and credit history of the borrower, and the quality of the collateral securing the loan. With few exceptions, the Bank requires personal guarantees and secondary sources of repayment. Commercial loans generally provide greater yields and re-price more frequently than other types of loans, such as real estate loans. Agricultural Loans – Agricultural loans totaled $19.7 million and $18.5 million at December 31, 2013 and 2012, respectively and include loans secured by farm equipment, inventory and farm land. Lending decisions are based on an evaluation of the financial strength, cash flow, management and credit history of the borrower, and the quality of the collateral securing the loan. Payments on such loans are often dependent on successful operation or management of the farming operation. Loans to Individuals - Loans to individuals (consumer loans) include automobile loans, boat and recreational vehicle financing, and miscellaneous secured and unsecured personal loans and totaled $2.2 million at December 31, 2013 and 2012, respectively. Consumer loans generally can carry significantly greater risks than other loans, even if secured, if the collateral consists of rapidly depreciating assets such as automobiles and equipment. Repossessed collateral securing a defaulted consumer loan may not provide an adequate source of repayment of the loan. Consumer loan collections are sensitive to job loss, illness and other personal factors. The Bank manages the risks inherent in consumer lending by following established credit guidelines and underwriting practices designed to minimize risk of loss. Loan Approvals - The Bank’s loan policies and procedures establish the basic guidelines governing its lending operations. The guidelines address the type of loans that the Bank seeks, target markets, underwriting and collateral requirements, terms, interest rate and yield considerations and compliance with laws and regulations. All loans or credit lines are subject to approval procedures and amount limitations. These limitations apply to the borrower’s total outstanding indebtedness to the Bank, including any indebtedness as a guarantor. The policies are reviewed and approved at least annually by the Board of Directors of the Bank. The Bank supplements its own supervision of the loan underwriting and approval process with periodic loan reviews by independent, outside professionals experienced in loan review. Responsibility for loan review and loan underwriting resides with the Chief Credit Officer position. This position is responsible for loan underwriting and approval. On an annual basis, the Board of Directors of the Bank determines officers lending authority. Authorities may include loans, letters of credit, overdrafts, uncollected funds and such other authorities as determined by the Board of Directors. Substantially all of the Bank's loans have been granted to customers in the Hampton Roads area of Virginia. Credit Review and Evaluation - The Bank outsources the credit risk review function which reports to the Board of Directors. The focus of the engagement is on policy compliance and proper grading of higher credit risk loans as well as new and existing loans on a sample basis. Additional reporting for problem/criticized assets has been developed along with an after- the-fact loan review. The Bank uses a risk grading program to facilitate the evaluation of probable inherent loan losses and the adequacy of the allowance for loan losses. In this program, risk grades are initially assigned by loan officers, reviewed by the Chief Credit Officer and reviewed by credit review analysts on a test basis. The Bank strives to maintain the loan portfolio in accordance with conservative loan underwriting policies that result in loans specifically tailored to the needs of the Bank’s market area. Every effort is made to identify and minimize the credit risks associated with such lending strategies. 17 17 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Credit Review and Evaluation (concluded) - All loans are risk graded on a scale from 1 (highest quality) to 9 (loss). Acceptable loans at inception are grades 1 through 5. These grades have underwriting requirements that at least meet the minimum requirements of a secondary market source. If borrowers do not meet credit history requirements, other mitigating criteria such as substantial liquidity and low loan-to-value ratios could be considered and would generally have to be met in order to make the loan. The Bank’s loan policy states that a guarantor may be necessary if reasonable doubt exists as to the borrower’s ability to repay. The Board of Directors has authorized the loan officers to have individual approval authority for risk grade 1 through 5 loans up to maximum exposure limits for each customer. New or renewed loans that are graded 6 (special mention) or lower must have approval from the Chief Credit Officer and Chief Lending Officer. Any changes in risk assessments as determined by loan officers, credit administrators, regulatory examiners and management are also considered. The risk grades, normally assigned by the loan officers when the loan is originated and reviewed by the Chief Credit Officer, are based on several factors including historical data, current economic factors, composition of the portfolio, and evaluations of the total loan portfolio and assessments of credit quality within specific loan types. In some cases the risk grades are assigned by the Chief Credit Officer or the Chief Lending Officer, depending upon dollar exposure. Because these factors are dynamic, the provision for loan losses can fluctuate. Credit quality reviews are based primarily on analyses of borrowers’ cash flows, with asset values considered only as a second source of payment. Credit analysts work with lenders in underwriting, structuring and risk grading the Bank’s credits. The Chief Lending Officer and the Chief Credit Officer focus on lending policy compliance, credit risk grading, and credit risk reviews on larger dollar exposures. Management uses the information developed from the procedures above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in determining the appropriate levels of the allowance for loan losses. The following is a summary of the credit risk grade definitions for all loan types: “1” — Prime – Credits in this category are virtually risk-free and are well-collateralized by cash or cash-equivalent instruments held by the Bank. The repayment program is well-defined and achievable, and repayment sources are numerous. No material documentation deficiencies or exceptions exist. “2” — Good – This grade is reserved for loans secured by readily marketable collateral, or loans within guidelines to borrowers with liquid financial statements. A liquid financial statement is generally a financial statement with substantial liquid assets, particularly relative to the debts. These loans have excellent sources of repayment, with no significant identifiable risk of collection, and conform in all respects to Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind). “3” — Acceptable 1 – This grade is reserved for the Bank’s top quality loans. These loans have excellent sources of repayment, with no significant identifiable risk of collection. Generally, loans assigned this risk grade will demonstrate the following characteristics:  Conformity in all respects with Bank policy, guidelines, underwriting standards, and Federal and State regulations (no exceptions of any kind).  Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor. 18 18 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) “4” — Acceptable 2 – This grade is given to acceptable loans. These loans have adequate sources of repayment, with little identifiable risk of collection. Loans assigned this risk grade will demonstrate the following characteristics:  General conformity to the Bank's underwriting requirements, with limited exceptions to the Bank's policy, product or underwriting guidelines. All exceptions noted have documented mitigating factors that offset any additional risk associated with the exceptions noted.  Documented historical cash flow that meets or exceeds required minimum Bank guidelines, or that can be supplemented with verifiable cash flow from other sources.  Adequate secondary sources to liquidate the debt, including combinations of liquidity, liquidation of collateral, or liquidation value to the net worth of the borrower or guarantor. “5” — Weak Pass – This grade is given to acceptable loans that show signs of weakness in either adequate sources of repayment or collateral, but have demonstrated mitigating factors that minimize the risk of delinquency or loss. Loans assigned this grade may demonstrate some or all of the following characteristics:  Additional exceptions to the Bank's policy requirements, product guidelines or underwriting standards that present a higher degree of risk to the Bank. Although the combination and/or severity of identified exceptions is greater for this risk grade, the exceptions may be properly mitigated by other documented factors that offset any additional risks.  Unproved, insufficient or marginal primary sources of repayment that appear sufficient to service the debt at this time. Repayment weaknesses may be due to minor operational issues, financial trends, or reliance on projected (not historic) performance.  Marginal or unproven secondary sources to liquidate the debt, including combinations of liquidation of collateral and liquidation value to the net worth of the borrower or guarantor. “6” — Special Mention – Special Mention loans include the following characteristics:  Loans with underwriting guideline tolerances and/or exceptions and with no mitigating factors;  Extending loans that are currently performing satisfactorily but with potential weaknesses that may, if not corrected, weaken the asset or inadequately protect the Bank's position at some future date. Potential weaknesses are the result of deviations from prudent lending practices; or  Loans where adverse economic conditions have developed subsequent to the loan origination that do not jeopardize liquidation of the debt, but do substantially increase the level of risk, may also warrant this rating. “7” — Substandard – A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt; they are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Loans consistently not meeting the repayment schedule should be downgraded to substandard. Loans in this category are characterized by deterioration in quality exhibited by any number of well-defined weaknesses requiring corrective action. The weaknesses may include, but are not limited to:  High debt to worth ratios  Declining or negative earnings trends  Declining or inadequate liquidity  Questionable repayment sources  Lack of well-defined secondary repayment source, and  Unfavorable competitive comparisons. Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals. 19 19 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) “8” — Doubtful – Loans classified Doubtful have all the weaknesses inherent in loans classified Substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:  Injection of capital  Alternative financing  Liquidation of assets or the pledging of additional collateral. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non-accrual status, and no definite repayment schedule exists. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off. “9” — Loss – Loans classified Loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off the loan even though partial recovery may be effected in the future. Probable Loss portions of problem assets should be charged against the Reserve for Loan Losses. Loans may reside in this classification for administrative purposes for a period not to exceed the earlier of thirty (30) days or calendar quarter-end. The following is a summary of credit quality indicators by class at December 31, 2013 and 2012: Real Estate Credit Exposure as of December 31, 2013 Commercial Real Estate Owner occupied Non-owner occupied $ - 298 5,071 12,937 13,677 161 2,583 - - 34,727 $ (in thousands) $ - 175 9,944 22,092 17,573 872 7,381 - - 58,037 $ Construction $ - - 2,840 7,327 8,362 8,735 3,997 - - 31,261 $ Residential 1-4 Family $ - 103 12,875 13,271 10,428 3,208 1,454 - - 41,339 $ Multifamily $ - - 115 5,164 1,643 - 455 - - 7,377 $ Equity lines of credit $ - 537 5,664 3,869 1,064 21 270 - - 11,425 $ Prime Good Acceptable 1 Acceptable 2 Weak Pass Special Mention Substandard Doubtful Loss 20 20 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Other Credit Exposures as of December 31, 2013 Commerical and industrial Agricultural Individuals Total Prime Good Acceptable 1 Acceptable 2 Weak Pass Special Mention Substandard Doubtful Loss - $ - 2,067 12,186 7,774 911 135 - - 23,073 $ - $ - 3,088 12,998 2,302 465 806 - - 19,659 $ - $ - 545 993 302 401 - - - 2,241 $ - $ 1,113 42,209 90,837 63,125 14,774 17,081 - - $ 229,139 Real Estate Credit Exposure as of December 31, 2012 Commercial Real Estate Owner occupied Non-owner occupied - $ 385 5,172 10,700 10,255 1,925 4,620 - - 33,057 $ (in thousands) $ - 258 10,767 22,074 16,463 1,879 5,251 - - 56,692 $ Construction - $ - 3,658 8,409 9,210 5,503 6,759 - - 33,539 $ Residential 1-4 Family $ - 210 16,948 14,399 6,389 1,663 2,696 250 - 42,555 $ Multifamily - $ - 807 2,406 4,164 - 714 - - 8,091 $ Equity lines of credit - $ 1,041 5,710 2,789 589 26 273 - - 10,428 $ Prime Good Acceptable 1 Acceptable 2 Weak Pass Special Mention Substandard Doubtful Loss 21 21 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Other Credit Exposures as of December 31, 2012 Commerical and industrial Agricultural Individuals Total Prime Good Acceptable 1 Acceptable 2 Weak Pass Special Mention Substandard Doubtful Loss - $ - 3,063 12,997 7,119 379 94 - - 23,652 $ $ 1 - 2,818 7,265 7,557 724 172 - - 18,537 $ - $ 52 534 869 337 418 - 3 - 2,213 $ $ 1 1,946 49,477 81,908 62,083 12,517 20,579 253 - $ 228,764 Nonaccrual loans and past due loans - Nonperforming assets include loans classified as nonaccrual, foreclosed bank-owned property and loans past due 90 days or more on which interest is still being accrued. There were two financing receivables with total current principal balance of $352,822 past due over 90 days accruing interest as of December 31, 2013. These two loans were in the process of collection at December 31, 2013 and are expected to be repaid in full. There were no financing receivables past due over 90 days accruing interest as of December 31, 2012. Nonaccrual loans as of December 31, 2013 totaled $5.6 million, or 2.45% of total loans, compared with $4.9 million, or 2.14% of total loans, as of December 31, 2012. The Bank aggressively pursues the collection and repayment of all loans. Other nonperforming assets, such as repossessed and foreclosed collateral are aggressively liquidated by the Bank’s management. The total number of loans on nonaccrual status as of December 31, 2013 and 2012 was 18 and 15, respectively. For the years ended December 31, 2013 and 2012, the Bank recognized no interest income on nonaccrual loans. If interest on those loans had been accrued in accordance with the original terms, interest income would have increased by approximately $181,249 and $400,000 for the years ended December 31, 2013 and 2012, respectively. The following is a breakdown of nonaccrual loans as of December 31, 2013 and 2012: Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commerical and industrial Agricultural Individuals Total 2013 2012 $ 2,896,720 $ 3,200,801 126,654 1,688,240 372,204 455,300 76,954 - - - $ 5,616,072 450,000 - 1,161,652 - 47,632 25,018 - 3,097 4,888,200 $ 22 22 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Nonaccrual loans and past due loans (concluded) - All classes of loans are considered past due if the required principal and interest income have not been received as of the date such payments were due. The following tables present the Bank’s aged analysis of past due loans as of December 31, 2013 and 2012: December 31, 2013 Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days Greater Than 90 Days Still Accruing (in thousands) Total Past Due Current Total Loans $ 162 $ - $ 2,133 $ - $ 2,295 $ 28,966 $ 31,261 - - 200 - - 40 - - 402 $ - 179 - - - - - - 179 $ 127 - - 455 25 - - - 2,740 $ - 254 - - - - 99 - 353 $ 127 433 200 455 25 40 99 - 3,674 $ 34,600 57,604 41,139 6,922 11,400 23,033 19,560 2,241 225,465 $ 34,727 58,037 41,339 7,377 11,425 23,073 19,659 2,241 229,139 $ December 31, 2012 Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days Greater Than 90 Days Still Accruing (in thousands) Total Past Due Current Total Loans $ 29 $ - $ 179 $ - $ 208 $ 33,331 $ 33,539 482 - 275 - - 55 - - 841 $ - - 250 - - - - - 250 $ 450 - 772 - - - - - 1,401 $ - - - - - - - - $ - 932 - 1,297 - - 55 - - 2,492 $ 32,125 56,692 41,258 8,091 10,428 23,597 18,537 2,213 226,272 $ 33,057 56,692 42,555 8,091 10,428 23,652 18,537 2,213 228,764 $ 23 23 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Troubled Debt Restructurings - In order to maximize the collection of loan balances, the Bank evaluates troubled loan accounts on a case-by-case basis to determine if a loan modification would be appropriate. Loan modifications may be utilized where there is a reasonable chance that an appropriate modification would allow the Bank’s customers to continue servicing debt. A loan is a troubled debt restructuring (“TDR”) if both of the following exist: 1) a creditor has granted a concession to the debtor, and, 2) the debtor is experiencing financial difficulties. Non-accruing loans that are modified can be placed back on accrual status when both principal and interest are current and it is probable that the Bank will be able to collect all amounts due (both principal and interest) according to the terms of the loan agreement and a sustained period of payment performance is demonstrated. Interest on troubled debt restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur and a sustained payment performance period is obtained. For the years ended December 31, 2013 and 2012, the following table presents a breakdown of the types of concession made by loan class: Year ended December 31, 2013 Post- Modification Outstanding Recorded Investment Pre-Modification Outstanding Recorded Investment Number of loans Year ended December 31, 2012 Post- Modification Outstanding Recorded Investment Pre-Modification Outstanding Recorded Investment Number of loans Extended payment terms Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total - $ - $ - 1 2 1 - - - 1 - 5 1,414,426 1,712,802 115,200 1,390,611 1,701,451 111,110 - - - - - - 750,000 636,008 - - $ 3,992,428 $ 3,839,180 9 1 3 8 - - 1 2 - 24 $ 5,602,459 $ 5,321,372 208,842 4,678,564 1,466,022 208,842 4,532,947 1,364,275 - - - - - - 172,110 172,110 - - $ 12,127,997 $ 11,599,546 The restructured loans generally include terms to reduce the interest rate and extend payment terms. The Bank did not forgive any principal associated with any of the above loans during 2013. Within the last 12 months, two loans that were restructured in 2012, with a total principal balance of $919,100 subsequently defaulted and were foreclosed upon. There were no loans that were restructured within the last 12 months during 2012 that subsequently defaulted. These modifications resulted in specific reserves in the Bank’s allowance for loan losses of $195,008 and $240,968 as of December 31, 2013 and 2012, respectively. 24 24 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Troubled Debt Restructurings (concluded) - There are three TDRs that are on non-accrual status and have a total current principal balance of $2.5 million as of December 31, 2013. There were four TDRS that were on non-accrual status and had a total current principal balance of $3.4 million as of December 31, 2012. Twenty TDRs with a current principal balance of $9.8 million and twenty-one TDRs with current principal balance of $8.2 million were considered performing loans and are accruing interest based on their sustained payment performance as of December 31, 2013 and 2012, respectively. The specific reserve portion of the allowance for loan losses on TDRs is determined by discounting the restructured cash flows at the original effective rate of the loan before modification or is based on the underlying collateral value less costs to sell, if repayment of the loan is collateral-dependent. If the resulting amount is less than the recorded book value, the Bank either establishes a valuation allowance as a component of the allowance for loan losses or charges off the impaired balance if it determines that such amount is a confirmed loss. This method is used consistently for all segments of the portfolio. Impaired Loans - Management considers certain loans graded “doubtful” (loans graded 8) or “loss” (loans graded 9) to be individually impaired and may consider “substandard” loans (loans graded 7) individually impaired depending on the borrower’s payment history. The Bank measures impairment based upon discounted probable cash flows or the value of the collateral. Collateral value is assessed based on collateral value trends, liquidation value trends, and other liquidation expenses to determine logical and credible discounts that may be needed. Updated appraisals are required for all impaired loans and typically at renewal or modification of larger loans if the appraisal is more than 12 months old. Impaired loans for all classes of loans typically include nonaccrual loans, loans over 90 days past due still accruing, troubled debt restructured loans and other potential problem loans considered impaired based on other underlying factors. Potential problem loans totaled $14.8 million and $12.5 million as of December 31, 2013 and 2012, respectively. These totals include loans which are currently performing and are not included in nonaccrual or restructured loans above, but about which we have serious doubts as to the borrower’s ability to comply with present repayment terms. These loans are likely to be included later in nonaccrual, past due or troubled debt restructured loans, so they are considered by management in assessing the adequacy of the allowance for loan losses. No additional funds are committed to be advanced in connection with impaired loans. 25 25 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) The following tables present the Bank's investment in loans considered to be impaired and related information on those impaired loans as of December 31, 2013 and 2012: December 31, 2013 Impaired loans without a related allowance for loan losses Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Impaired loans with a related allowance for loan losses Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total impaired loans Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total impaired loans Recorded Investment Unpaid Principal Balance Related Allowance (in thousands) Year to Date Average Recorded Investment Interest Income Recognized $ 1,431 $ 1,504 $ - $ 1,942 $ 107 2,583 3,504 897 455 239 - 170 - 2,583 3,504 897 682 239 - 170 - 2,567 2,567 - 3,877 557 - 30 135 636 - - 3,877 557 - 30 135 636 - - - - - - - - - 659 - 568 113 - 30 4 195 - 2,623 3,709 929 700 244 - 172 - 2,584 - 3,942 572 - 31 84 711 - 168 193 45 8 8 - 13 - 92 - 186 30 - - 3 44 - $ 3,998 $ 4,071 $ 659 $ 4,526 $ 199 2,583 7,381 1,454 455 269 135 806 - 17,081 $ 2,583 7,381 1,454 682 269 135 806 - 17,381 $ - 568 113 - 30 4 195 - 1,569 $ 2,623 7,651 1,501 700 275 84 883 - 18,243 $ 168 379 75 8 8 3 57 - 897 $ 26 26 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) December 31, 2012 Impaired loans without a related allowance for loan losses Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Impaired loans with a related allowance for loan losses Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total impaired loans Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Total impaired loans Recorded Investment Unpaid Principal Balance Related Allowance (in thousands) Year to Date Average Recorded Investment Interest Income Recognized $ 5,972 $ 5,972 $ - $ 5,932 $ 376 3,463 2,527 1,688 75 225 14 172 - 4,014 2,527 1,760 75 449 14 172 - 788 862 1,158 2,723 1,257 639 48 80 - 3 1,158 2,723 1,257 639 97 80 - 3 - - - - - - - - 120 78 87 445 229 38 65 - 3 4,060 2,569 1,800 77 227 30 173 - 875 1,184 2,769 947 645 50 94 - 5 223 151 88 5 10 2 12 - 38 72 106 56 42 1 6 - 1 $ 6,760 $ 6,834 $ 120 $ 6,807 $ 414 4,621 5,250 2,945 714 273 94 172 3 20,832 $ 5,172 5,250 3,017 714 546 94 172 3 21,802 $ 78 87 445 229 38 65 - 3 1,065 $ 5,244 5,338 2,747 722 277 124 173 5 21,437 $ 295 257 144 47 11 8 12 1 1,189 $ 27 27 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Allowance for Loan Losses - The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate for probable losses that have been incurred within the existing portfolio of loans. The primary risks inherent in the Bank’s loan portfolio, including the adequacy of the allowance or reserve for loan losses, are based on management’s assumptions regarding, among other factors, general and local economic conditions, which are difficult to predict and are beyond the Bank’s control. In estimating these risks, and the related loss reserve levels, management also considers the financial conditions of specific borrowers and credit concentrations with specific borrowers, groups of borrowers, and industries. The allowance for loan losses is adjusted by direct charges to provision expense. Losses on loans are charged against the allowance for loan losses in the accounting period in which they are determined by management to be uncollectible. Recoveries during the period are credited to the allowance for loan losses. The Bank realized negative provisions of $500,000 for the year ended December 31, 2013. There was no provision for loan losses for the year ended December 31, 2012. During 2012 the Bank received several large recoveries, which were credited to the allowance. The recoveries and the continued improvement in our credit related trends were the main contributors to the negative provisions in 2013 and no provision for loan losses during 2012. The provision expense is determined by the Bank’s allowance for loan losses model. The components of the model are specific reserves for impaired loans and a general allocation for unimpaired loans. The general allocation has three components, an estimate based on historical loss experience, an additional estimate based on internal and external environmental factors due to the uncertainty of historical loss experience in predicting current embedded losses in the portfolio that will be realized in the future and an unallocated portion to cover uncertainties that could affect management’s estimate of probable losses. In determining the general allowance allocation, the ratios from the actual loss history for the various categories are applied to the homogeneous pools of loans in each category. During 2012 management increased the historical look back period included in its allowance for losses on loans estimation. Management determined increasing the look back period from eight to twelve quarters was more reflective of the Bank’s historical loss experience in order to estimate losses inherent in the loan portfolio. The impact of this change in estimation was an increase in the reserve of $1.4 million during 2012. The portion of the general allocation on environmental factors includes estimates of losses related to the following:  Current national and local economic conditions  Composition of the nature and volume of the portfolio  Changes in the trend or volume of past due, watch list and classified loans  The existence and effect of concentrations or changes in concentrations upon the portfolio  The existence and effect of granularity in the size of credits in the portfolio  The existence and effect of loan to values in excess of regulatory guidance – percentage of loans in each category with Reg H exceptions  Cumulative effect of other factors such as loan portfolio quality, underwriting strength and general determinations about the portfolio held by executive management. Markets served by the Bank continue to experience softening from the general economy and declines in real estate values. Other factors impacting the allowance at December 31, 2013 were watch list trends, unemployment rate trends, government spending expectations and underwriting and servicing assessments. During 2011 the Bank charged-off approximately $1.9 million of principal on a construction loan of $3.4 million due to the deteriorating financial condition of the borrower and a current appraisal on the collateral. In 2012 the Bank entered into an agreement to sell this note to a third party for $2 million. This transaction resulted in a recovery of approximately $714,000 which increased the Bank’s allowance for loan losses and is included in recoveries on construction loans in the 2012 table below. 28 28 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (continued) Allowance for Loan Losses (continued) - The following tables present changes in the allowance for loan losses for the years ended December 31, 2013 and 2012: Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals December 31, 2012 Charge-offs Recoveries Provision (Amounts in thousands) December 31, 2013 $ 2,137 $ 250 $ 23 $ (312) $ 1,598 925 1,227 1,962 354 301 1,138 335 44 8,423 $ - - 129 227 5 18 - - - 37 - 17 7 - 2 631 $ 5 89 $ (32) 501 (370) 63 (21) (537) 215 (7) (500) $ 893 1,728 1,500 190 292 590 550 40 7,381 $ Mortgage loans on real estate: Construction Commercial real estate: Non-owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals December 31, 2011 Charge-offs Recoveries Provision (Amounts in thousands) December 31, 2012 $ 3,842 $ 72 $ 807 $ (2,440) $ 2,137 678 883 1,665 56 269 1,302 93 27 8,815 $ 551 - 790 - 40 132 - 4 1,589 $ 67 - 293 - 16 14 - - 1,197 $ 731 344 794 298 56 (46) 242 21 $ - 925 1,227 1,962 354 301 1,138 335 44 8,423 $ 29 29 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 4 - Loans and Allowance for Loan Losses (concluded) Allowance for Loan Losses (concluded) - The activity in the allowance for loan loss for 2013 and 2012 are summarized by loan class as follows: As of December 31, 2013 Mortgage loans on real estate: Construction Commercial real estate: Non owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals As of December 31, 2012 Mortgage loans on real estate: Construction Commercial real estate: Non owner occupied Owner occupied Residential 1-4 family Multifamily Equity lines of credit Commercial and industrial Agricultural Individuals Reserves for loans individually evaluated for impairment Loans individually evaluated for impairment Reserves for loans collectively evaluated for impairment Loans collectively evaluated for impairment (Amounts in thousands) $ 659 $ 3,998 $ 939 $ 27,263 - 568 113 - 30 4 195 - 1,569 $ 2,583 7,381 1,454 455 269 135 806 - 17,081 $ 893 1,160 1,387 190 262 586 355 40 5,812 $ 32,144 50,656 39,885 6,922 11,156 22,938 18,853 2,241 212,058 $ Reserves for loans individually evaluated for impairment Loans individually evaluated for impairment Reserves for loans collectively evaluated for impairment Loans collectively evaluated for impairment (Amounts in thousands) $ 120 $ 6,760 $ 2,017 $ 26,779 78 87 445 229 38 65 - 3 1,065 $ 4,621 5,250 2,945 714 273 94 172 3 20,832 $ 847 1,140 1,517 125 263 1,073 335 41 7,358 $ 28,436 51,442 39,610 7,377 10,155 23,558 18,365 2,210 207,932 $ 30 30 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 5 - Premises and equipment At December 31, 2013 and 2012, premises and equipment consist of the following: Land Buildings Equipment, furniture and fixtures Computer equipment Software Less accumulated depreciation Construction in progress Total premises and equipment, net 2013 $ 1,666,727 5,594,344 2,685,561 302,841 463,176 10,712,649 (5,696,414) 21,931 $ 5,038,166 2012 $ 1,666,727 5,370,026 2,205,990 302,841 451,125 9,996,709 (5,247,629) - $ 4,749,080 For 2013 and 2012, depreciation charged to operating expense was $448,786 and $438,944, respectively. During 2012, the Bank sold a parcel of land resulting in a gain of $842,513. Note 6 - Non-marketable equity securities Non-marketable equity securities consist of the following at December 31, 2013 and 2012: Federal Home Loan Bank stock Federal Reserve Bank stock Community Bankers' Bank stock Bankers Title, LLC Senior Housing Crime Prevention Foundation stock Total non-marketable equity securities 2013 $ 1,371,300 273,900 61,300 49,589 500,000 $ 2,256,089 2012 $ 1,535,700 360,250 61,300 49,589 500,000 $ 2,506,839 Note 7 - Interest-bearing deposits Interest-bearing deposits consist of the following: NOW accounts Money market accounts Savings accounts Certificates of deposits and IRAs $100,000 and over Certificates of deposits and IRAs under $100,000 Total interest-bearing deposits 2013 $ 31,415,299 89,663,359 21,580,454 49,470,689 80,181,041 $ 272,310,842 2012 $ 28,379,608 68,840,024 21,414,822 56,496,579 93,288,401 $ 268,419,434 31 31 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 7 - Interest-bearing deposits (concluded) At December 31, 2013, the scheduled maturities of time deposits are as follows: 2014 2015 2016 2017 2018 Thereafter $ 48,397,834 27,856,759 22,034,195 11,443,102 19,919,840 - Total time deposits $ 129,651,730 Note 8 – Capital notes During the fourth quarter of 2013, the Company closed the private placement of unregistered debt securities (the “2013 Offering”) pursuant to which the Company issued approximately $11.3 million in principal of notes (the “2013 Notes”). The 2013 Notes have not been and will not be registered under the Securities Act of 1933 and may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. The 2013 Notes bear interest at the rate of 5% per year with interest payable quarterly in arrears. The 2013 Notes mature on December 31, 2018, but are subject to prepayment in whole or in part on or after December 31, 2014 at the Company’s sole discretion on 30 days written notice to the holders. There are no assets pledged as collateral for the 2013 Notes. The Company used approximately $6.2 million of the proceeds from the 2013 Offering in December to repay the funds associated with the United States Treasury’s Capital Purchase Program (see Note 20). Of these capital notes, $900,000 is due to executive officers and board members of the Bank as of December 31, 2013. Interest expense of $3,375 was paid to these related parties on the capital notes for the year ended December 31, 2013. Note 9 - Securities sold under agreements to repurchase and other borrowings Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one day from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. Information concerning securities sold under agreements to repurchase is summarized, as follows: Balance at December 31, Average balance during the year Average interest rate during the year Maximum month-end balance during the year 2013 $ 2,595,776 $ 2,160,045 0.25% $ 3,148,511 2012 $ 1,747,780 $ 1,636,172 0.25% $ 2,736,487 The Bank has arrangements with various banks which enables the Bank to borrow up to $30,000,000 in federal funds on an unsecured basis, at a variable rate. At December 31, 2013 and 2012, the Bank had outstanding federal funds purchased in the amount of $-0-. The Bank also has arrangements with the Federal Home Loan Bank which enables the Bank to borrow up to twenty-five percent of total assets. 32 32 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 9 - Securities sold under agreements to repurchase and other borrowings (concluded) At December 31, 2013 and 2012, Federal Home Loan Bank advances were as follows: December 31, 2013 Maturity date September 2, 2014 August 31, 2015 May 29, 2018 January 8, 2014 Call Feature - - One-time call - Amount $ 5,000,000 5,000,000 5,000,000 5,000,000 Rate 1.963% 3.080% 3.690% 0.280% Total FHLB borrowings/weighted average rate $ 20,000,000 2.253% December 31, 2012 Maturity date July 8, 2013 September 2, 2014 August 31, 2015 May 29, 2018 Call Feature - - - One-time call Amount $ 5,000,000 5,000,000 5,000,000 5,000,000 Rate 1.380% 1.963% 3.080% 3.690% Total FHLB borrowings/weighted average rate $ 20,000,000 2.530% The carrying value of loans pledged as collateral to the Federal Home Loan Bank were $31,964,545 and $66,322,974 at December 31, 2013 and 2012, respectively. During 2012, the Bank prepaid $20 million in FHLB advances with a weighted average rate of 3.04%. These advances were paid prior to their maturity date in order to enhance future earnings by way of reduction in interest expense. These repayments resulted in a prepayment penalty on borrowings equaling $557,523. Note 10 - Employee benefit plans Profit sharing plan - The Company has a profit sharing plan covering substantially all employees. Contributions to the plan are determined annually by the Compensation Committee and are the lesser of 10% of the participants' base compensation or 10% of the net income of the Bank. Employee benefits expense included $335,000 and $315,000 for the plan for 2013 and 2012, respectively. Post-retirement benefits - The Company has entered into deferred compensation arrangements with certain key personnel which call for the payment of benefits upon the retirement or death of the individuals. These arrangements are funded through life insurance policies on the individuals, with the intent that the proceeds from the life insurance policies approximate amounts payable under the deferred compensation arrangements. The liabilities associated with these deferred compensation arrangements were $971,455 and $753,184 as of December 31, 2013 and 2012, respectively. Salaries and employee benefits expense included $221,811 and $115,736 of expense related to these arrangements for 2013 and 2012, respectively. 33 33 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 11 - Income taxes The principal components of the income tax expense as of December 31, 2013 and 2012 are as follows: Federal - current tax provision Federal - deferred 2013 $ 577,413 520,557 $ 1,097,970 2012 $ 904,129 406,105 $ 1,310,234 The differences between expected federal income taxes at statutory rates and actual income tax expense are summarized as follows: Income tax expense computed at federal statutory rate (34%) Tax effects of: Tax-exempt interest Non-deductible expenses Other 2013 $ 1,500,663 2012 $ 1,714,127 (448,919) 20,776 25,450 (415,876) 13,470 (1,487) Total income tax expense $ 1,097,970 $ 1,310,234 The Bank's deferred tax assets and liabilities and their components are included in other assets and liabilities on the balance sheets. The components of these deferred tax assets and liabilities are as follows: 2013 2012 Deferred tax assets: Allowance for loan losses Deferred compensation Interest on non-performing loans Write-down of value related to other real estate owned Other Total deferred tax asset Deferred tax liabilities: Accumulated accretion on available-for-sale investment securities Accumulated depreciation Net unamortized deferred fees and expenses Net unrealized gain on available-for-sale securities Total deferred tax liability $ 1,363,456 338,248 26,246 296,570 43,416 2,067,936 $ 1,786,428 262,832 118,213 291,820 11,375 2,470,668 (130,727) (366,845) (29,006) (484,973) (1,011,551) (127,233) (260,610) (20,908) (2,323,463) (2,732,214) Net deferred tax asset (liability) $ 1,056,385 $ (261,546) 34 34 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 11 - Income taxes (concluded) In evaluating whether the Bank will realize the full benefit of its net deferred tax asset, it considers both positive and negative evidence, including recent earnings trends and projected earnings, asset quality, etc. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. Positive evidence considered by the Bank includes a long history of earnings and expected continued earnings in 2014 given the improvement in credit quality metrics. Credit quality metrics during 2013, such as the adversely classified assets ratio, net charge-offs as a percent of loans and nonaccrual loan balances continually improved providing further positive evidence. As a result, the Bank has concluded that no valuation allowance is deemed necessary at this time. Note 12 - Commitments and contingencies The Company leases banking premises and various equipment for periods extending through December 2017. Total rental expense was $187,351 and $122,327 for 2013 and 2012, respectively. Pursuant to the terms of non-cancelable lease agreements in effect at December 31, 2013, pertaining to bank premises and equipment, future minimum rental commitments under various operating leases are as follows: $ 125,765 111,109 90,939 5,002 - $ 332,815 2014 2015 2016 2017 2018 Various legal claims also arise from time to time in the normal course of business which, in the opinion of management, will have no material effect on the Company's consolidated financial statements. Note 13 - Related party transactions In the ordinary course of business, the Bank has loan and deposit transactions with its executive officers and directors, and with companies in which the officers and directors have a significant financial interest. These transactions are at substantially the same rates as similarly situated customers. A summary of related party loan activity during 2013 and 2012 is as follows: Beginning balance, January 1 Originations Repayments Ending balance, December 31, 2013 $ 2,508,622 1,649,450 (564,499) $ 3,593,573 2012 $ 3,121,031 378,767 (991,176) $ 2,508,622 Commitments to extend credit to related parties amounted to $7,557,701 and $5,836,917at December 31, 2013 and 2012, respectively. Deposits from related parties held by the Bank amounted to $8,212,635 and $5,240,773 at December 31, 2013 and 2012, respectively. 35 35 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 14 - Credit commitments and concentrations of credit risk Commitments to extend credit are agreements to lend funds to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments for equity lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management's credit evaluation of the customer. Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines of credit are uncollateralized, usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed. Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments if deemed necessary. The amounts of loan commitments, guarantees and standby letters of credit are set out in the following table as of December 31, 2013 and 2012. Because many commitments and almost all standby letters of credit and guarantees expire without being funded in whole or in part, the contract amounts are not estimates of future cash flows. A summary of loan commitments and standby letters of credit is as follows: Loan commitments Standby letters of credit and guarantees written 2013 $ 51,266,040 $ 400,566 2012 $ 46,508,908 $ 487,527 Standby letters of credit outstanding at December 31, 2013 expire during 2014. Loan commitments, standby letters of credit and written guarantees have off-balance sheet credit risk because only origination fees and accruals for probable losses, if any, are recognized in the statements of financial position until the commitments are fulfilled or the standby letters of credit or guarantees expire. Credit risk represents the accounting loss that would be recognized at the reporting date if counterparties failed completely to perform as contracted. The credit risk amounts are equal to the contractual amounts, assuming that the amounts are fully advanced and collateral or other security is of no value. The Bank's policy is to require customers to provide collateral prior to the disbursement of approved loans. For retail loans, the Bank usually retains a security interest in the property or products financed, which provides repossession rights in the event of default by the customer. For business loans and financial guarantees, collateral is usually in the form of inventory or marketable securities (held in trust) or property (notations on title). Concentrations of credit risk (whether on or off-balance sheet) arising from financial instruments exist in relation to certain groups of customers. A group concentration arises when a number of counterparties have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. A group concentration exists as most of the Bank's customers are located within southeastern Virginia. The credit risk amounts represent the maximum accounting loss that would be recognized at the reporting date if counterparties failed completely to perform as contracted and any collateral or security proved to be of no value. The Bank has experienced little difficulty in accessing collateral when required. 36 36 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 15 - Regulatory matters The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2013, the Bank meets all capital adequacy requirements to which it is subject. As of December 31, 2013, the most recent notification from the Board of Governors of the Federal Reserve Board categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category. The Bank's actual capital amounts (dollars in thousands) and ratios are presented in the table below: Actual Amount Ratio For Capital Adequacy Purposes Amount Ratio (Dollars in thousands) Under Prompt Corrective Well Capitalized Amount Ratio As of December 31, 2013: Total Capital (to Risk-Weighted Assets) $ 45,294 18.4% $ 19,697 8% $ 24,622 10% Tier I Capital (to Risk-Weighted Assets) 42,163 17.1% 9,849 4% 14,773 Tier I Capital (to Average Assets) 42,163 10.4% 16,270 4% 20,338 6% 5% As of December 31, 2012: Total Capital (to Risk-Weighted Assets) $ 41,508 17.5% $ 18,967 8% $ 23,709 10% Tier I Capital (to Risk-Weighted Assets) 38,482 16.2% 9,483 4% 14,225 Tier I Capital (to Average Assets) 38,482 9.5% 16,122 4% 20,152 6% 5% The above tables set forth the capital position and analysis for the Bank only. Because total assets on a consolidated basis are less than $500 million, the Company is not subject to the consolidated capital requirements imposed by the Bank Holding Company Act. Consequently, the Company does not calculate its financial ratios on a consolidated basis. If calculated, the capital ratios for the Company on a consolidated basis would no longer be comparable to the capital ratios of the Bank because the proceeds of the capital notes do not qualify as equity capital on a consolidated basis. 37 37 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 16 - Fair value measurements The Company refers to the Fair Value Measurements and Disclosures Topic of the FASB Accounting Standards Codification (ASC 820) to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. This guidance clarifies that fair value of certain assets and liabilities is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The fair market value measurement specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels of the fair value hierarchy are based on these two types of inputs are as follows: Level 1 – Valuation is based on quoted prices in active markets for identical assets and liabilities. Level 2 – Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market. Level 3 – Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market. The following describes the valuation techniques used by the Company to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the consolidated financial statements: Securities available for sale - Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that considers observable market data (Level 2). The following table presents the balances of available-for-sale securities measured at fair value on a recurring basis as of December 31, 2013 and 2012: Description State and municipal Residential mortgage-backed securities Collateralized mortgage obligations Small Business Administration Pools Balance as of December 31, 2013 $ 35,658,569 19,073,420 46,290,708 39,270,621 $ 140,293,318 Level 1 $ - - - - $ - Level 2 $ 35,658,569 19,073,420 46,290,708 39,270,621 $ 140,293,318 Level 3 $ - - - - $ - 38 38 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 16 - Fair value measurements (continued) Description State and municipal Residential mortgage-backed securities Collateralized mortgage obligations Small Business Administration Pools Balance as of December 31, 2012 $ 32,438,699 16,134,963 40,172,113 46,802,082 $ 135,547,857 Level 1 Level 2 Level 3 $ - - - - $ - $ 32,438,699 16,134,963 40,172,113 46,802,082 $ 135,547,857 $ - - - - $ - Certain financial assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets. The following describes the valuation techniques used by the Company to measure certain financial assets recorded at fair value on a nonrecurring basis in the consolidated financial statements: Impaired Loans - Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on the observable market price of the loan, the fair value of the collateral or by using the discounted cash flow method. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company. The Company records impaired loans secured by real estate as Level 3 assets. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports are recorded as Level 3 assets. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Statements of Operations. Other real estate owned - Other real estate owned is considered held for sale and is adjusted to fair value less estimated selling costs upon transfer of the loan to foreclosed assets. Fair value is based upon independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. The Company considers the other real estate owned as nonrecurring Level 3. The following table summarizes the Company’s financial assets that were measured at fair value on a nonrecurring basis during the periods. Description Assets Other real estate owned Impaired loans Total assets Balance as of December 31, 2013 Level 1 Level 2 Level 3 $ 616,000 6,232,267 $ 6,848,267 $ - - $ - $ - - $ - $ 616,000 6,232,267 $ 6,848,267 39 39 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 16 - Fair value measurements (concluded) Description Assets Other real estate owned Impaired loans Total assets Balance as of December 31, 2012 Level 1 Level 2 Level 3 $ 445,020 5,632,314 $ 6,077,334 $ - - $ - $ - - $ - $ 445,020 5,632,314 $ 6,077,334 The following table summarized quantitative information about Level 3 fair value measurements: Description Assets Fair Value at December 31, 2013 Valuation Technique Unobservable Input Range (Weighted Average) Other real estate owned Impaired loans $ 616,000 6,232,267 Total assets $ 6,848,267 Discounted appraisals Discounted appraisals Discounted cash flows Collateral discounts Collateral discounts Discount rate 10-20% 10-30% 6% Description Assets Fair Value at December 31, 2012 Valuation Technique Unobservable Input Range (Weighted Average) Other real estate owned Impaired loans $ 445,020 5,632,314 Total assets $ 6,077,334 Discounted appraisals Discounted appraisals Discounted cash flows Collateral discounts Collateral discounts Discount rate 10-20% 10-20% 6% The following table presents the carrying amounts and fair value of the Company's financial instruments as of December 31, 2013 and 2012. FASB Accounting Standards Codification’s Financial Instruments (ASC 825), defines the fair value of financial instruments as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The carrying amounts in the table are included in the balance sheets under the indicated captions. Financial assets: Cash and cash equivalents Investment securities, available-for-sale Loans, net Accrued interest receivable Financial liabilities: Demand deposits, NOW, savings and money market accounts Time deposits Accrued interest payable FHLB Advances Securities sold under agreement to repurchase 2013 2012 Carrying amount Estimated fair value Carrying amount Estimated fair value (Dollars in thousands) $ 31,511 140,293 221,843 1,797 $ 31,511 140,293 221,561 1,797 $ 19,451 135,548 220,402 1,831 $ 19,451 135,548 221,723 1,831 213,699 129,652 234 20,000 2,596 213,699 131,899 234 20,751 2,596 175,895 149,785 326 20,000 1,748 175,895 153,522 326 21,196 1,748 40 40 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 17 - Stock incentive plan The Board approved a stock incentive plan effective January 1, 2007. The plan authorizes the grant of awards for a period of ten years. The number of shares authorized for issuance under the plan is limited to 2.25% of the total authorized and unissued shares of common stock. Three types of awards may be granted under the plan: Incentive Stock Options, Nonqualified Stock Options and Restricted Stock. The Bank granted restricted stock awards during 2007, 2008 and 2010. The Bank accounts for this plan in accordance with the Stock Compensation Topic of the FASB Accounting Standards Codification (ASC 718). The non-vested equity share or non-vested equity share unit awarded to an employee is measured at its fair value on the grant date. The compensation expense is recognized over the requisite service period. The fair value of the shares of restricted stock was determined by an outside appraisal. The vesting requirements range from 1 to 5 years. The compensation expense recognized for the years ended December 31, 2013 and 2012 was $15,001 and $15,000, respectively. Members of the Board of Directors of the Bank can elect to receive a portion or all of their director’s fees in the form of common stock. During the year ended December 31, 2013 and 2012, the expense related to these issuances was $28,500 and $24,500, respectively. A summary of the status of the non-vested shares in relation to our restricted stock awards as of December 31, 2013 and 2012, and changes during the years ended December 31, 2013 and 2012, is presented below; the weighted average price is the weighted average fair value at the date of grant: Restricted Share Awards Nonvested - Beginning of the year Granted Vested Forfeited Nonvested - End of year Note 18 - Earnings per share 2013 2012 Shares 420 - (420) - - Weighted Average Price $ 35.75 - 35.75 - $ - Shares 840 - (420) - 420 Weighted Average Price $ 35.75 - 35.75 - $ 35.75 The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock. Potential dilutive common stock had no effect on income attributable to common shareholders. Basic Net income, as reported Preferred stock dividends and accretion of discount Net income attributable to common shareholders Average common shares outstanding Basic earnings per share amount Diluted Net income attributable to common shareholders Average common shares outstanding Effect of dilutive unvested restricted stock awards Average diluted shares outstanding Diluted earnings per share 41 2013 2012 $ 3,315,744 488,399 $ 2,827,345 $ 3,731,315 570,257 $ 3,161,058 607,357 605,821 $ 4.66 $ 5.22 $ 2,827,345 $ 3,161,058 607,357 - 607,357 605,821 - 605,821 $ 4.66 $ 5.22 41 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 19 – Condensed financial statements of parent company On July 26, 2013, the Board of Directors of the Bank approved an Agreement and Plan of Reorganization and Share Exchange (the “Agreement”) whereby the Bank would become a subsidiary of Farmers Bankshares, Inc., a company incorporated in Virginia on July 26, 2013 for the purpose of becoming a holding company for the Bank. The Agreement provided for the statutory share exchange of all of the Bank’s common stock held by stockholders for the common stock of Farmers Bankshares, Inc., on a one-for-one basis. The Agreement was approved by the Bank’s stockholders at a special meeting of the Bank’s stockholders held on September 26, 2013 (the “Special Stockholders’ Meeting”). The holding company reorganization was consummated on December 31, 2013. Prior to the holding company reorganization, Farmers Bankshares, Inc. conducted no operations other than obtaining regulatory approval for the holding company reorganization. As this event is considered reorganization under common control, the consolidated financial statements, discussion of the statements and all other information presented herein for the year ending December 31, 2013 are presented for the Company as a consolidated entity. Financial information pertaining only to Farmers Bankshares, Inc. is as follows: Balance Sheet Cash Taxes receivable Investment in Farmers Bank Other assets Total assets Assets December 31, 2013 $ 1,042,892 14,348 43,104,139 190,863 44,352,242 $ Liabilities and Stockholders' Equity Liabilities Capital notes, 5% due December 31, 2018 Other liabilities Total liabilities Stockholders' equity Common stock, $0.625 par value Capital surplus Retained earnings Accumulated other comprehensive income Total stockholders' equity $ 11,253,475 228,250 11,481,725 380,015 2,695,613 28,853,472 941,417 32,870,517 Total liabilities and stockholders' equity $ 44,352,242 42 42 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 19 – Condensed financial statements of parent company (concluded) Statements of Operations Income Operating expenses Interest expense Legal and professional fees Other expenes Total expenses Allocated income tax benefits Income before equity in undistrbuted income of subsidiary Year Ended December 31, 2013 $ 170,246 42,201 23,125 14,260 79,586 (14,348) 105,008 Equity in undistributed income - Farmers Bank Net income $ 3,210,736 3,315,744 Statement of Cash Flows Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Taxes receivable Other assets Other liabilities Equity in undistributed net income of Farmers Bank Net cash used in operating activities Cash flows from investing activities Investment in Farmers Bank Net cash used in investing activities Cash flows from financing activities Proceeds from issuance of 5% capital notes due December 31, 2018 Repurchase of preferred stock Cash dividends paid on preferred shares Net cash provided by financing activities Increase in cash and cash equivalents Cash and cash equivalents Beginning of the year End of year 43 Year Ended December 31, 2013 $ 3,315,744 (14,348) (190,863) 58,004 (3,210,736) (42,199) (4,000,000) (4,000,000) 11,253,475 (6,127,000) (41,384) 5,085,091 1,042,892 - $ 1,042,892 43 Farmers Bankshares, Inc. Notes to Consolidated Financial Statements For Years Ended December 31, 2013 and 2012 Note 20 – Capital Purchase Program (“CPP”) On January 23, 2009, the Bank issued 8,752 shares of non-cumulative perpetual preferred stock (“Series A”) for $9.2 million and 438 warrants to the U.S Treasury as a condition to its participation in the Capital Purchase Program (“CPP”). The warrants were exercised immediately upon the issuance of the Series A preferred stock, which resulted in the issuance of 438 shares of non-cumulative perpetual preferred stock (“Series B”). Proceeds from this sale of preferred stock are used for general corporate purposes, including supporting the continued, anticipated growth of the Bank. On January 9, 2013, the Bank redeemed thirty-five percent, or 3,063 of the total 8,752 shares of its Series A Preferred Stock. The Bank paid $3,085,973 to redeem this portion of the Series A Preferred Stock, consisting of $3,063,000 in liquidation value and $22,973 of accrued and unpaid dividends associated with the preferred stock being redeemed. During the fourth quarter of 2013, the Company received approval from the Treasury and its federal regulator to redeem the Preferred Stock issued to the Treasury. On December 31, 2013, the Bank redeemed the remaining preferred stock, or 5,689 shares of Series A Preferred Stock and 438 shares of Series B Preferred Stock. The Bank paid $6,168,383 to redeem this portion of the Series A and Series B Preferred Stock, consisting of $6,127,000 in liquidation value and $41,383 of accrued and unpaid dividends associated with the preferred stock being redeemed. Note 21 – Subsequent events The Company has evaluated subsequent events through February 20, 2014, in connection with the preparation of these financial statements which is the date the financial statements were available to be issued. 44 44 This page has intentionally been left blank. Branch Locations www.farmersbankva.com • 757-242-6111 J H Lee & Sons, Inc. River Stone Chophouse Courtland 28319 Southampton Parkway, Suite D Harbour View – Suffolk 6255 College Drive, Suite L Nansemond River Golf Club Harper’s Table Hillpoint – Suffolk 3100 Godwin Boulevard Lakeside – Suffolk 1008 West Washington Street Smithfield Station Cotton Harvest Smithfield 1119 South Church Street, PO Box 888 Windsor 50 East Windsor Boulevard, PO Box 285 FARMERS BANK www.farmersbankva.com 

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