UNITED STATES
 SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q
(Mark One)

       Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2016

or

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _____________to_____________

Commission File No.: 000-25805

Fauquier Bankshares, Inc.
(Exact name of registrant as specified in its charter)

10 Courthouse Square, Warrenton, Virginia
 
20186
(Address of principal executive offices)
 
(Zip Code)

(540) 347-2700
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)  Yes No

The registrant had 3,756,362 shares of common stock outstanding as of May 5, 2016.
1




FAUQUIER BANKSHARES, INC.
INDEX




Part I.       FINANCIAL INFORMATION
 
   
Page
Item 1.
Financial Statements
3
     
 
Consolidated Balance Sheets as of March 31, 2016 (unaudited) and December 31, 2015
3
     
 
Consolidated Statements of Income (unaudited) for the Three Months Ended March 31, 2016 and 2015
4
     
 
Consolidated Statements of Comprehensive Income (unaudited) for the Three Months Ended March 31, 2016 and  2015
 5 
     
 
Consolidated Statements of Changes in Shareholders' Equity (unaudited) for the Three Months Ended March 31, 2016 and 2015
6
     
 
Consolidated Statements of Cash Flows (unaudited) for the Three Months Ended March 31, 2016 and 2015
7
     
 
Notes to Consolidated Financial Statements
8
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
30
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
42
     
Item 4.
Controls and Procedures
42
     
Part II.     OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
43
     
Item 1A.
Risk Factors
43
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
43
     
Item 3.
Defaults Upon Senior Securities
43
     
Item 4.
Mine Safety Disclosures
43
     
Item 5.
Other Information
43
     
Item 6.
Exhibits
44
     
SIGNATURES
45
   
2


Part I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

 
Fauquier Bankshares, Inc. and Subsidiaries
 
Consolidated Balance Sheets

 
 
March 31,
   
December 31,
 
 
 
2016
   
2015
 
(In thousands, except share and per share data) 
 
(Unaudited)
   
(Audited)
 
Assets
           
Cash and due from banks
 
$
4,953
   
$
5,235
 
Interest-bearing deposits in other banks
   
50,716
     
47,971
 
Federal funds sold
   
8
     
9
 
Securities available for sale
   
53,049
     
55,224
 
Restricted investments
   
1,282
     
1,286
 
Loans
   
449,464
     
446,862
 
   Allowance for loan losses
   
(4,376
)
   
(4,193
)
Net loans
   
445,088
     
442,669
 
Bank premises and equipment, net
   
20,221
     
20,461
 
Accrued interest receivable
   
1,455
     
1,462
 
Other real estate owned, net of allowance
   
1,356
     
1,356
 
Bank-owned life insurance
   
12,603
     
12,511
 
Other assets
   
13,195
     
13,216
 
Total assets
 
$
603,926
   
$
601,400
 
 
               
Liabilities
               
Deposits:
               
Noninterest-bearing
 
$
95,173
   
$
97,015
 
Interest-bearing:
               
  Checking
   
226,614
     
223,154
 
  Savings and money market accounts
   
140,350
     
140,173
 
  Time deposits
   
63,992
     
63,952
 
Total interest-bearing
   
430,956
     
427,279
 
  Total deposits
   
526,129
     
524,294
 
 
               
Federal Home Loan Bank advances
   
12,989
     
13,007
 
Junior subordinated debt
   
4,124
     
4,124
 
Other liabilities
   
7,626
     
7,342
 
Total liabilities
   
550,868
     
548,767
 
 
               
Shareholders' Equity
               
Common stock, par value, $3.13; authorized 8,000,000 shares; issued and outstanding: 2016: 3,761,438 shares including 33,137 non-vested shares; 2015: 3,744,562 shares including 33,267 non-vested shares
   
11,670
     
11,616
 
Retained earnings
   
41,688
     
41,477
 
Accumulated other comprehensive (loss), net
   
(300
)
   
(460
)
Total shareholders' equity
   
53,058
     
52,633
 
Total liabilities and shareholders' equity
 
$
603,926
   
$
601,400
 
 
               
 
See accompanying Notes to Consolidated Financial Statements.
               
3


Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
For the Three Months Ended March 31, 2016 and 2015

(In thousands, except per share data) 
 
 
2016
   
2015
 
Interest Income
           
Interest and fees on loans
 
$
4,867
   
$
4,962
 
Interest and dividends on securities available for sale:
               
Taxable interest income
   
251
     
295
 
Interest income exempt from federal income taxes
   
53
     
57
 
Dividends
   
25
     
21
 
Interest on deposits in other banks
   
61
     
38
 
Total interest income
   
5,257
     
5,373
 
                 
Interest Expense
               
Interest on deposits
   
309
     
431
 
Interest on Federal Home Loan Bank advances
   
81
     
80
 
Distribution on capital securities of subsidiary trusts
   
50
     
49
 
Total interest expense
   
440
     
560
 
                 
Net interest income
   
4,817
     
4,813
 
                 
Provision for loan losses
   
200
     
-
 
                 
Net interest income after provision for loan losses
   
4,617
     
4,813
 
                 
Other Income
               
Trust and estate income
   
347
     
458
 
Brokerage income
   
71
     
80
 
Service charges on deposit accounts
   
527
     
530
 
Other service charges, commissions and income
   
441
     
208
 
Total other income
   
1,386
     
1,276
 
                 
Other Expenses
               
Salaries and benefits
   
2,633
     
2,623
 
Occupancy expense of premises
   
603
     
601
 
Furniture and equipment
   
408
     
346
 
Marketing expense
   
132
     
116
 
Legal, audit and consulting expense
   
282
     
272
 
Data processing expense
   
313
     
330
 
Federal Deposit Insurance Corporation expense
   
166
     
94
 
Loss on sale, impairment and expense of other real estate owned, net
   
1
     
-
 
Other operating expenses
   
798
     
833
 
Total other expenses
   
5,336
     
5,215
 
                 
Income before income taxes
   
667
     
874
 
                 
Income tax expense
   
61
     
131
 
                 
Net Income
 
$
606
   
$
743
 
                 
Earnings per Share, basic
 
$
0.16
   
$
0.20
 
                 
Earnings per Share, assuming dilution
 
$
0.16
   
$
0.20
 
                 
Dividends per Share
 
$
0.12
   
$
0.12
 

See accompanying Notes to Consolidated Financial Statements.
4


Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Comprehensive Income
(Unaudited)
For the Three Months Ended March 31, 2016 and 2015

(In thousands)
 
2016
   
2015
 
Net Income
 
$
606
   
$
743
 
Other comprehensive income (loss), net of tax:
               
Interest rate swap, net of tax effect of $29 in 2016 and $16 in 2015
   
(56
)
   
(31
)
Change in fair value of securities available for sale net of tax effect of $(111) in 2016 and $(87) in 2015
   
216
     
169
 
Total other comprehensive income, net of tax of $(82) in 2016 and $(71) in 2015
   
160
     
138
 
Comprehensive Income
 
$
766
   
$
881
 
                         
See accompanying Notes to Consolidated Financial Statements.
5


Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
(Unaudited)
For the Three Months Ended March 31, 2016 and 2015
 
(In thousands)
 
Common
Stock
   
Retained
Earnings
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
 
Balance, December 31, 2014
 
$
11,568
   
$
43,690
   
$
(101
)
 
$
55,157
 
Net income
           
743
             
743
 
Other comprehensive income net of tax effect of $(71)
                   
138
     
138
 
Cash dividends ($0.12 per share)
           
(450
)
           
(450
)
Amortization of unearned compensation, restricted stock awards
           
40
             
40
 
Issuance of common stock - non-vested shares (11,925 shares)
   
37
     
(37
)
           
-
 
Issuance of common stock - vested shares (3,458 shares)
   
11
     
49
             
60
 
Balance, March 31, 2015
 
$
11,616
   
$
44,035
   
$
37
   
$
55,688
 
 
                               
Balance, December 31, 2015
 
$
11,616
   
$
41,477
   
$
(460
)
 
$
52,633
 
Net income
           
606
             
606
 
Other comprehensive income net of tax effect of $(82)
                   
160
     
160
 
Cash dividends ($0.12 per share)
           
(451
)
           
(451
)
Amortization of unearned compensation, restricted stock awards
           
42
             
42
 
Issuance of common stock - non-vested shares (12,470 shares)
   
40
     
(40
)
           
-
 
Issuance of common stock - vested shares (4,536 shares)
   
14
     
54
             
68
 
Balance, March 31, 2016
 
$
11,670
   
$
41,688
   
$
(300
)
 
$
53,058
 
 
See accompanying Notes to Consolidated Financial Statements.
6


Fauquier Bankshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
For the Three Months Ended March 31, 2016 and 2015
 
(In thousands)
 
2016
   
2015
 
Cash Flows from Operating Activities
           
Net income
 
$
606
   
$
743
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
   
362
     
354
 
Provision for loan losses
   
200
     
-
 
Loss on interest rate swaps
   
-
     
12
 
Amortization of security premiums, net
   
19
     
17
 
Amortization of unearned compensation, net of forfeiture
   
48
     
72
 
Issuance of vested restricted stock
   
68
     
60
 
Changes in assets and liabilities:
               
  (Increase) decrease in other assets
   
(147
)
   
126
 
  (Decrease) in other liabilities
   
(12
)
   
(565
)
Net cash provided by operating activities
   
1,144
     
819
 
 
               
Cash Flows from Investing Activities
               
Proceeds from maturities, calls and principal payments of securities available for sale
   
4,542
     
1,896
 
Purchase of securities available for sale
   
(2,059
)
   
(2
)
Purchase of premises and equipment
   
(122
)
   
(203
)
Redemptions restricted securities
   
4
     
8
 
Net (increase) in loans
   
(2,413
)
   
(4,115
)
Net cash (used in) investing activities
   
(48
)
   
(2,416
)
 
               
Cash Flows from Financing Activities
               
Net increase in demand deposits, NOW accounts and savings accounts
   
1,795
     
18
 
Net increase (decrease) in certificates of deposit
   
40
     
(9,076
)
(Decrease) in FHLB advances
   
(18
)
   
(17
)
Cash dividends paid on common stock
   
(451
)
   
(450
)
Net cash provided by (used in) financing activities
   
1,366
     
(9,525
)
 
               
Increase (Decrease) in cash and cash equivalents
   
2,462
     
(11,122
)
 
               
Cash and Cash Equivalents
               
Beginning
   
53,215
     
64,376
 
 
               
Ending
 
$
55,677
   
$
53,254
 
 
               
Supplemental Disclosures of Cash Flow Information
               
Cash payments for:
               
Interest
 
$
437
   
$
583
 
Income taxes
 
$
-
   
$
-
 
 
               
Supplemental Disclosures of Noncash Investing Activities
               
Unrealized gain on securities available for sale, net of tax
 
$
216
   
$
169
 
Unrealized (loss) on interest rate swap, net of tax
 
$
(56
)
 
$
(31
)
 
               

See accompanying Notes to Consolidated Financial Statements.
7

FAUQUIER BANKSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements

Note 1. General

The consolidated financial statements include the accounts of Fauquier Bankshares, Inc. ("the Company") and its wholly-owned subsidiary, The Fauquier Bank ("the Bank"), and the Bank's wholly-owned subsidiary, Fauquier Bank Services, Inc. The consolidated financial statements do not include the accounts of Fauquier Statutory Trust II, a wholly-owned subsidiary of the Company. In consolidation, significant intercompany financial balances and transactions have been eliminated. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial positions as of March 31, 2016 and December 31, 2015 and the results of operations for the three months ended March 31, 2016 and 2015. The notes included herein should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company's 2015 Annual Report on Form 10-K filed with the Securities and Exchange Commission (the "SEC").

The results of operations for the three months ended March 31, 2016 are not necessarily indicative of the results expected for the full year or any other interim period.

Recent Accounting Pronouncements

In August 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-15, "Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern."  This update is intended to provide guidance about management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures.  Management is required under the new guidance to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity's ability to continue as a going concern within one year after the date the financial statements are issued when preparing financial statements for each interim and annual reporting period.  If conditions or events are identified, the ASU specifies the process that must be followed by management and also clarifies the timing and content of going concern footnote disclosures in order to reduce diversity in practice.  The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2016. Early adoption is permitted.  The Company does not expect the adoption of ASU 2014-15 to have a material impact on its consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, "Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities." The amendments in ASU 2016-01, among other things: (1) Require equity investments (expect those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (2) Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (3) Require separate presentation of financial assets and liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables); and (4) Eliminate the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements.

In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)." Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee's obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee's right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is currently assessing the impact that ASU 2016-02 will have on its consolidated financial statements.

8

In March 2016, the FASB issued ASU No. 2016-03, "Intangibles-Goodwill and Other (Topic 350), Business Combinations (Topic 805), Consolidation (Topic 810) and Derivatives and Hedging (Topic 815): Effective Date and Transition Guidance."  The amendments to this ASU make the guidance in ASUs 2014-02, 2014-03, 2014-07, and 2014-18 effective immediately by removing their effective dates. The amendments also include transition provisions that provide that private companies are able to forgo a preferability assessment the first time they elect the accounting alternatives within the scope of this ASU. Any subsequent change to an accounting policy election requires justification that the change is preferable under Topic 250, Accounting Changes and Error Corrections. The amendments in this ASU also extend the transition guidance in ASUs 2014-02, 2014-03, 2014-07, and 2014-18 indefinitely. While this ASU extends transition guidance for Updates 2014-07 and 2014-18, there is no intention to change how transition is applied for those two ASUs. The Company is currently assessing the impact that ASU 2016-03 will have on its consolidated financial statements.

During March 2016, the FASB issued ASU No. 2016-05, "Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships." The amendments in this ASU clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedge accounting criteria remain intact. The amendments are effective for public business entities for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The Company does not expect the adoption of ASU 2016-05 to have a material impact on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-07, "Investments – Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting." The amendments in this ASU eliminate the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The amendments require that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor's previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required.  In addition, the amendments in this ASU require that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings the unrealized holding gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method. The amendments are effective for all entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. The amendments should be applied prospectively upon their effective date to increases in the level of ownership interest or degree of influence that result in the adoption of the equity method. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-07 to have a material impact on its consolidated financial statements.

During March 2016, the FASB issued ASU No. 2016-09, "Compensation – Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting." The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: (1) income tax consequences; (2) classification of awards as either equity or liabilities; and (3) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company is currently assessing the impact that ASU 2016-09 will have on its consolidated financial statements.

Note 2. Securities

The amortized cost and fair value of securities available for sale, with unrealized gains and losses follows:

   
March 31, 2016
 
   
Amortized
   
Gross Unrealized
   
Gross Unrealized
   
Fair
 
(In thousands)
 
Cost
   
Gains
   
(Losses)
   
Value
 
Obligations of U.S. Government corporations and agencies
 
$
43,084
   
$
586
   
$
(46
)
 
$
43,624
 
Obligations of states and political subdivisions
   
5,922
     
261
     
-
     
6,183
 
Corporate bonds
   
3,689
     
-
     
(826
)
   
2,863
 
Mutual funds
   
372
     
7
     
-
     
379
 
   
$
53,067
   
$
854
   
(872
)
 
$
53,049
 

9

   
December 31, 2015
 
   
Amortized
   
Gross Unrealized
   
Gross Unrealized
   
Fair
 
(In thousands)
 
Cost
   
Gains
   
(Losses)
   
Value
 
Obligations of U.S. Government corporations and agencies
 
$
45,605
   
$
352
   
$
(165
)
 
$
45,792
 
Obligations of states and political subdivisions
   
5,924
     
276
     
-
     
6,200
 
Corporate bonds
   
3,671
     
-
     
(811
)
   
2,860
 
Mutual funds
   
370
     
2
     
-
     
372
 
   
$
55,570
   
$
630
   
$
(976
)
 
$
55,224
 

The amortized cost and fair value of securities available for sale, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without penalties.

   
March 31, 2016
 
(In thousands)
 
Amortized Cost
   
Fair Value
 
Due in one year or less
 
$
2,412
   
$
2,424
 
Due after one year through five years
   
8,565
     
8,712
 
Due after five years through ten years
   
6,598
     
6,840
 
Due after ten years
   
35,120
     
34,694
 
Equity securities
   
372
     
379
 
   
$
53,067
   
$
53,049
 

There were no impairment losses on securities during the three months ended March 31, 2016 and 2015.

During the three months ended March 31, 2016, no securities were sold, and one security totaling $3.0 million was called. Over the same period, one security totaling $2.1 million was purchased. During the three months ended March 31, 2015, no securities were sold, called, matured or purchased.

The following table shows the Company securities with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2016 and December 31, 2015, respectively.

(In thousands)
 
Less than 12 Months
   
12 Months or More
   
Total
 
March 31, 2016
 
Fair Value
   
Unrealized
(Losses)
   
Fair Value
   
Unrealized
(Losses)
   
Fair Value
   
Unrealized
(Losses)
 
                                     
Obligations of U.S. Government, corporations and agencies
 
$
6,510
   
$
(8
)
 
$
2,451
   
$
(38
)
 
$
8,961
   
$
(46
)
Corporate bonds
   
553
     
(70
)
   
2,310
     
(756
)
   
2,863
     
(826
)
Total temporary impaired securities
 
$
7,063
   
$
(78
)
 
$
4,761
   
$
(794
)
 
$
11,824
   
$
(872
)
 
 
(In thousands)
 
Less than 12 Months
   
12 Months or More
   
Total
 
December 31, 2015
 
Fair Value
   
Unrealized
(Losses)
   
Fair Value
   
Unrealized
(Losses)
   
Fair Value
   
Unrealized
(Losses)
 
                                                 
Obligations of U.S. Government, corporations and agencies
 
$
14,357
   
$
(76
)
 
$
3,645
   
$
(89
)
 
$
18,002
   
$
(165
)
Corporate bonds
   
560
     
(58
)
   
2,531
     
(753
)
   
3,091
     
(811
)
Total temporary impaired securities
 
$
14,917
   
$
(134
)
 
$
6,176
   
$
(842
)
 
$
21,093
   
$
(976
)

10

The nature of securities which were temporarily impaired at March 31, 2016 consisted of three corporate bonds with a cost basis net of other-than-temporary impairment ("OTTI")  totaling $3.7 million and a temporary loss of approximately $826,000. The value of these corporate bonds is based on quoted market prices for similar assets. They are the "Class B" or subordinated "mezzanine" tranche of pooled trust preferred securities. The trust preferred securities are collateralized by the interest and principal payments made on trust preferred capital offerings by a geographically diversified pool of approximately 58 different financial institutions per bond. They have an estimated maturity of 18 years. These bonds could have been called at par on the five year anniversary date of issuance, which has already passed for all the bonds. The bonds reprice every three months at a fixed rate index above the three-month London Interbank Offered Rate ("LIBOR"). These bonds have sufficient collateralization and cash flow projections to satisfy their valuation based on the cash flow portion of the OTTI test under authoritative accounting guidance as of March 31, 2016. The bonds, totaling $2.9 million at fair value, are projected to repay the full outstanding interest and principal and are now classified as performing corporate bond investments. During the three months ended March 31, 2016, $27,000 of interest income was recorded.

Additional information regarding each of the pooled trust preferred securities as of March 31, 2016 follows:

(Dollars in thousands)
Cost, net of
OTTI loss
   
Fair Value(1)
   
Percent of
Underlying
Collateral
Performing
   
Percent of
Underlying
Collateral in
Deferral
   
Percent of
Underlying
Collateral in
Default
   
Cumulative
Amount of
OTTI Loss
   
Cumulative Other
Comprehensive
Loss (Income), net of tax
benefit
 
                                       
$
1,658
   
$
1,140
     
79.1
%
   
3.8
%
   
17.1
%
 
$
299
   
$
342
 
 
1,408
     
1,170
     
80.3
%
   
9.1
%
   
10.6
%
   
592
     
157
 
 
623
     
553
     
82.2
%
   
8.1
%
   
9.7
%
   
377
     
47
 
$
3,689
   
$
2,863
                           
$
1,268
   
$
546
 

(1)
Current Moody's Ratings range from B2 to Caa3.
 
The Company monitors these pooled trust preferred securities in its portfolio as to collateral, issuer defaults and deferrals, which as a general rule, indicate that additional impairment may have occurred. Due to the continued stress on banks in general, and the issuer banks in particular, as a result of overall economic conditions, the Company acknowledges that it may have to recognize additional impairment in future periods; however the extent, timing, and probability of any additional impairment cannot be reasonably estimated at this time.

The following roll forward reflects the amount related to credit losses recognized in earnings (in accordance with FASB Accounting Standards Codification ("ASC") 320-10-35-34D):

(In thousands)
Beginning balance as of December 31, 2015
 
$
1,360
 
Add: Amount related to the credit loss for which an other-than-temporary impairment was not previously recognized
   
-
 
Add: Increases to the amount related to the credit loss for which an other-than temporary impairment was previously recognized
   
-
 
Less: Realized losses for securities sold
   
-
 
Less: Securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the Company intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis
   
-
 
Less: Increases in cash flows expected to be collected that are recognized over the remaining life of the security (See FASB ASC 320-10-35-35)
   
(92
)
Ending balance as of March 31, 2016
 
$
1,268
 

The carrying value of securities pledged to secure deposits and for other purposes amounted to $44.5 million and $44.5 million at March 31, 2016 and December 31, 2015, respectively.

11

Note 3. Loans and Allowance for Loan Losses

Allowance for Loan Losses and Recorded Investment in Loans Receivable

   
As of and for the Three Months Ended March 31, 2016
 
(In thousands)
 
Commercial
and Industrial
   
Commercial
Real Estate
   
Construction
and Land
   
Consumer
   
Student
   
Residential
Real Estate
   
Home Equity
Line of Credit
   
Unallocated
   
Total
 
Allowance for Loan Losses
                                                     
Beginning balance at 12/31/2015
 
$
526
   
$
1,162
   
$
924
   
$
13
   
$
117
   
$
886
   
$
356
   
$
209
   
$
4,193
 
Charge-offs
   
-
     
-
     
-
     
(10
)
   
(10
)
   
-
     
-
     
-
     
(20
)
Recoveries
   
1
     
-
     
-
     
1
     
-
     
-
     
1
     
-
     
3
 
Provision
   
(2
)
   
55
     
15
     
13
     
(1
)
   
10
     
(10
)
   
120
     
200
 
Ending balance at 3/31/2016
 
$
525
   
$
1,217
   
$
939
   
$
17
   
$
106
   
$
896
   
$
347
   
$
329
   
$
4,376
 
                                                                         
Ending balances individually evaluated for impairment
 
$
126
   
$
-
   
$
296
   
$
-
   
$
-
   
$
-
   
$
-
   
$
-
   
$
422
 
                                                                         
Ending balances collectively evaluated for impairment
 
$
399
   
$
1,217
   
$
643
   
$
17
   
$
106
   
$
896
   
$
347
   
$
329
   
$
3,954
 
                                                                         
Loans Receivable
                                                                       
Individually evaluated for impairment
 
$
242
   
$
2,872
   
$
3,508
   
$
-
   
$
-
   
$
416
   
$
70
           
$
7,108
 
Collectively evaluated for impairment
   
25,603
     
156,199
     
46,483
     
2,988
     
14,854
     
152,824
     
43,405
             
442,356
 
Ending balance at 3/31/2016
 
$
25,845
   
$
159,071
   
$
49,991
   
$
2,988
   
$
14,854
   
$
153,240
   
$
43,475
           
$
449,464
 
12


   
As of and for the Year Ended December 31, 2015
 
(In thousands)
 
Commercial
and Industrial
   
Commercial
Real Estate
   
Construction
and Land
   
Consumer
   
Student
   
Residential
Real Estate
   
Home Equity
Line of Credit
   
Unallocated
   
Total
 
Allowance for Loan Losses
                                                     
Beginning balance at 12/31/2014
 
$
516
   
$
1,943
   
$
699
   
$
37
   
$
72
   
$
1,424
   
$
296
   
$
404
   
$
5,391
 
Charge-offs
   
(8,525
)
   
(568
)
   
(17
)
   
(10
)
   
(50
)
   
(167
)
   
(50
)
   
-
     
(9,387
)
Recoveries
   
102
     
-
     
-
     
14
     
-
     
52
     
21
     
-
     
189
 
Provision
   
8,433
     
(213
)
   
242
     
(28
)
   
95
     
(423
)
   
89
     
(195
)
   
8,000
 
Ending balance at 12/31/2015
 
$
526
   
$
1,162
   
$
924
   
$
13
   
$
117
   
$
886
   
$
356
   
$
209
   
$
4,193
 
                                                                         
Ending balances individually  evaluated for impairment
 
$
111
   
$
-
   
$
296
   
$
-
   
$
-
   
$
-
   
$
-
   
$
-
   
$
407
 
                                                                         
Ending balances collectively  evaluated for impairment
 
$
415
   
$
1,162
   
$
628
   
$
13
   
$
117
   
$
886
   
$
356
   
$
209
   
$
3,786
 
                                                                         
Loans Receivable
                                                                       
Individually evaluated for impairment
 
$
217
   
$
2,896
   
$
3,515
   
$
-
   
$
-
   
$
419
   
$
70
           
$
7,117
 
Collectively evaluated for impairment
   
23,488
     
157,140
     
46,340
     
3,160
     
15,518
     
150,156
     
43,943
             
439,745
 
Ending balance at 12/31/2015
 
$
23,705
   
$
160,036
   
$
49,855
   
$
3,160
   
$
15,518
   
$
150,575
   
$
44,013
           
$
446,862
 

The Company's allowance for loan losses has three basic components: the specific allowance, the general allowance, and the unallocated components. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans identified as impaired. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans and other consumer loans. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not identified as impaired.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

13

Credit Quality Indicators

   
As of March 31, 2016
 
(In thousands)
 
Commercial
and Industrial
   
Commercial
Real Estate
   
Construction
and Land
   
Consumer
   
Student
   
Residential
Real Estate
   
Home Equity
Line of Credit
   
Total
 
Grade:
                                               
Pass
 
$
23,098
   
$
147,221
   
$
38,045
   
$
2,985
   
$
14,854
   
$
144,136
   
$
39,976
   
$
410,315
 
Special mention
   
835
     
6,933
     
7,524
     
3
     
-
     
2,243
     
789
     
18,327
 
Substandard
   
1,912
     
4,917
     
4,422
     
-
     
-
     
6,861
     
2,710
     
20,822
 
Doubtful
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Loss
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Total
 
$
25,845
   
$
159,071
   
$
49,991
   
$
2,988
   
$
14,854
   
$
153,240
   
$
43,475
   
$
449,464
 

   
As of December 31, 2015
 
(In thousands)
 
Commercial
and Industrial
   
Commercial
Real Estate
   
Construction
and Land
   
Consumer
   
Student
   
Residential
Real Estate
   
Home Equity
Line of Credit
   
Total
 
Grade:
                                               
Pass
 
$
20,657
   
$
148,409
   
$
38,105
   
$
3,157
   
$
15,518
   
$
141,428
   
$
40,351
   
$
407,625
 
Special mention
   
1,120
     
6,678
     
7,542
     
3
     
-
     
2,318
     
854
     
18,515
 
Substandard
   
1,928
     
4,949
     
4,208
     
-
     
-
     
6,773
     
2,808
     
20,666
 
Doubtful
   
-
     
-
     
-
     
-
     
-
     
56
     
-
     
56
 
Loss
   
-
     
-
     
-
     
-
     
-
     
-
     
-
     
-
 
Total
 
$
23,705
   
$
160,036
   
$
49,855
   
$
3,160
   
$
15,518
   
$
150,575
   
$
44,013
   
$
446,862
 


Age Analysis of Past Due Loans Receivable

   
As of March 31, 2016
 
(In thousands)
 
30-59 Days
Past Due
   
60-89 Days
Past Due
   
90 Days or More Past Due
   
Total Past Due
   
Current
   
Total Financing
Receivables
   
Carrying
Amount > 90
Days and
Accruing
   
Nonaccruals
 
Commercial and industrial
 
$
224
   
$
103
   
$
81
   
$
408
   
$
25,437
   
$
25,845
   
$
-
   
$
187
 
Commercial real estate
   
-
     
901
     
-
     
901
     
158,170
     
159,071
     
-
     
-
 
Construction and land
   
436
     
346
     
1,462
     
2,244
     
47,747
     
49,991
     
-
     
1,462
 
Consumer
   
9
     
8
     
-
     
17
     
2,971
     
2,988
     
-
     
-
 
Student (U.S. Government guaranteed)
   
942
     
343
     
2,241
     
3,526
     
11,328
     
14,854
     
2,241
     
-
 
Residential real estate
   
688
     
291
     
227
     
1,206
     
152,034
     
153,240
     
-
     
227
 
Home equity line of credit
   
359
     
-
     
-
     
359
     
43,116
     
43,475
     
-
     
-
 
Total
 
$
2,658
   
$
1,992
   
$
4,011
   
$
8,661
   
$
440,803
   
$
449,464
   
$
2,241
   
$
1,876
 

14

   
As of December 31, 2015
 
(In thousands)
 
30-59 Days Past Due
   
60-89 Days Past Due
   
90 Days or More Past Due
   
Total Past Due
   
Current
   
Total Financing
Receivables
   
Carrying
Amount > 90
Days and
Accruing
   
Nonaccruals
 
Commercial and industrial
 
$
235
   
$
-
   
$
-
   
$
235
   
$
23,470
   
$
23,705
   
$
-
   
$
110
 
Commercial real estate
   
-
     
296
     
-
     
296
     
159,740
     
160,036
     
-
     
-
 
Construction and land
   
599
     
-
     
1,462
     
2,061
     
47,794
     
49,855
     
-
     
1,512
 
Consumer
   
-
     
26
     
-
     
26
     
3,134
     
3,160
     
-
     
-
 
Student (U.S. Government guaranteed)
   
1,331
     
987
     
2,814
     
5,132
     
10,386
     
15,518
     
2,814
     
-
 
Residential real estate
   
887
     
90
     
228
     
1,205
     
149,370
     
150,575
     
-
     
227
 
Home equity line of credit
   
291
     
-
     
-
     
291
     
43,722
     
44,013
     
-
     
-
 
Total
 
$
3,343
   
$
1,399
   
$
4,504
   
$
9,246
   
$
437,616
   
$
446,862
   
$
2,814
   
$
1,849
 

The Company began purchasing rehabilitated student loans under the Federal Rehabilitated Student Loan Program during the quarter ended December 31, 2012. The repayment of both principal and accrued interest are 98% guaranteed by the U.S. Department of Education. At March 31, 2016, $2.2 million of the student loans were 90 days or more past due and still accruing.

Impaired Loans Receivable

   
March 31, 2016
 
(In thousands)
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With no specific allowance recorded:
                             
Commercial and industrial
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 
Commercial real estate
   
2,872
     
2,872
     
-
     
2,884
     
36
 
Construction and land
   
1,660
     
1,660
     
-
     
1,660
     
6
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
416
     
416
     
-
     
418
     
4
 
Home equity line of credit
   
70
     
70
     
-
     
70
     
2
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
                                         
With an allowance recorded:
                                       
Commercial and industrial
 
$
242
   
$
257
   
$
126
   
$
254
   
$
1
 
Commercial real estate
   
-
     
-
     
-
     
-
     
-
 
Construction and land
   
1,848
     
1,848
     
296
     
1,851
     
16
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
-
     
-
     
-
     
-
     
-
 
Home equity line of credit
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
                                         
Total:
                                       
Commercial and industrial
 
$
242
   
$
257
   
$
126
   
$
254
   
$
1
 
Commercial real estate
   
2,872
     
2,872
     
-
     
2,884
     
36
 
Construction and land
   
3,508
     
3,508
     
296
     
3,511
     
22
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
416
     
416
     
-
     
418
     
4
 
Home equity line of credit
   
70
     
70
     
-
     
70
     
2
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
7,108
   
$
7,123
   
$
422
   
$
7,137
   
$
65
 
15


   
December 31, 2015
 
(In thousands)
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
With no specific allowance recorded:
                             
Commercial and industrial
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
 
Commercial real estate
   
2,896
     
2,896
     
-
     
3,205
     
49
 
Construction and land
   
2,988
     
2,988
     
-
     
3,027
     
88
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
419
     
419
     
-
     
428
     
18
 
Home equity line of credit
   
70
     
70
     
-
     
70
     
3
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
                                         
With an allowance recorded:
                                       
Commercial and industrial
 
$
217
   
$
230
   
$
111
   
$
234
   
$
5
 
Commercial real estate
   
-
     
-
     
-
     
-
     
-
 
Construction and land
   
527
     
527
     
296
     
531
     
13
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
-
     
-
     
-
     
-
     
-
 
Home equity line of credit
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
                                         
Total:
                                       
Commercial and industrial
 
$
217
   
$
230
   
$
111
   
$
234
   
$
5
 
Commercial real estate
   
2,896
     
2,896
     
-
     
3,205
     
49
 
Construction and land
   
3,515
     
3,515
     
296
     
3,558
     
101
 
Student (U.S. Government guaranteed)
   
-
     
-
     
-
     
-
     
-
 
Residential real estate
   
419
     
419
     
-
     
428
     
18
 
Home equity line of credit
   
70
     
70
     
-
     
70
     
3
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Total
 
$
7,117
   
$
7,130
   
$
407
   
$
7,495
   
$
176
 

Authoritative accounting guidance requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. Authoritative accounting guidance also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

A loan is considered impaired when it is probable that the Bank will be unable to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered "insignificant" and would not indicate an impairment situation, if in management's judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under authoritative accounting guidance. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

At March 31, 2016, there were $4.0 million of commercial loans classified as substandard which were deemed not to be impaired because borrowers continue to abide by the terms of their original loan agreements and are substandard based on their industry or changes in their cash flow that have not yet resulted in past dues. Impaired loans totaled $7.1 million at March 31, 2016 and December 31, 2015. Approximately $6.9 million of loans classified as impaired at March 31, 2016 were collateralized by commercial buildings, residential real estate, or land.

No additional funds are committed to be advanced in connection with impaired loans.

16

There were no loans modified in a troubled debt restructuring ("TDRs") and defaults on TDRs occurring within 12 months of modification during the three months ended March 31, 2016 and 2015. At March 31, 2016, 12 TDRs, totaling $7.0 million, remain in the portfolio. Eight of the loans, totaling $5.5 million, were on accrual status and performing in accordance with the modified terms. The remaining four loans, totaling $1.6 million, remained in nonaccrual status due to irregular payments. Appropriate specific reserves have been established. Restructured loans are included in the specific reserve calculation in the allowance for loan losses and are included in impaired loans.

At March 31, 2016, the Company had no foreclosed residential real estate property in its possession. There were two residential real estate properties with a total carrying value of $242,000 that were in the process of foreclosure.

 Non-performing Assets, Restructured Loans Still Accruing, and Loans Contractually Past Due

(Dollars in thousands)
 
March 31, 2016
   
December 31, 2015
   
March 31, 2015
 
Non-accrual loans
 
$
1,876
   
$
1,849
   
$
1,593
 
Other real estate owned
   
1,356
     
1,356
     
1,406
 
Total non-performing assets
   
3,232
     
3,205
     
2,999
 
Restructured loans still accruing
   
5,459
     
5,495
     
7,402
 
Student loans (U.S. Government guaranteed) past due 90 days or more and still accruing
   
2,241
     
2,814
     
2,721
 
Loans past due 90 or more days and still accruing
   
-
     
-
     
2
 
Total non-performing and other risk assets
 
$
10,932
   
$
11,514
   
$
13,124
 
                         
Allowance for loan losses to total loans
   
0.97
%
   
0.94
%
   
1.21
%
Non-accrual loans to total loans
   
0.42
%
   
0.41
%
   
0.36
%
Allowance for loan losses to non-accrual loans
   
233.26
%
   
226.77
%
   
338.10
%
Total non-accrual loans and restructured loans still accruing to total loans
   
1.63
%
   
1.64
%
   
2.02
%
Allowance for loan losses to non-accrual loans and  restructured loans still accruing
   
59.66
%
   
57.09
%
   
59.88
%
Total non-performing assets to total assets
   
0.54
%
   
0.53
%
   
0.50
%

Restructured loans on non-accrual status are included with non-accrual loans and not with restructured loans in the above table.

Note 4. Junior Subordinated Debt

On September 21, 2006, the Company's wholly-owned Connecticut statutory business trust privately issued $4.0 million face amount of the trust's Floating Rate Capital Securities in a pooled capital securities offering ("Trust II"). Simultaneously, the trust used the proceeds of that sale to purchase $4.0 million principal amount of the Company's Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. The interest rate on the capital security resets every three months at 1.70% above the then current three month LIBOR. Interest is paid quarterly.  Total capital securities at March 31, 2016 and December 31, 2015 were $4,124,000. The Trust II issuance of capital securities and the respective subordinated debentures are callable at any time after five years from the issue date. The subordinated debentures are an unsecured obligation of the Company and are junior in right of payment to all present and future senior indebtedness of the Company. The capital securities are guaranteed by the Company on a subordinated basis.

Note 5. Derivative Instruments and Hedging Activities

Accounting principles generally accepted in the United States ("GAAP") requires that all derivatives be recognized in the Consolidated Financial Statements at their fair values. On the date that the derivative contract is entered into, the Company designates the derivative as a hedge of variable cash flows to be paid or received in conjunction with recognized assets or liabilities, as a cash flow or fair value hedge. For a derivative treated as a cash flow hedge, the ineffective portion of changes in fair value is reported in current period earnings. The effective portion of the cash flow hedge is recorded as an adjustment to the hedged item through other comprehensive income. For a derivative treated as a fair value hedge, the gain or loss on the derivative as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings in interest income. The Company uses interest rate swaps to reduce interest rate risks and to manage net interest income.

17

The Company formally assesses, both at the hedges' inception, and on an on-going basis, whether derivatives used in hedging transactions have been highly effective in offsetting changes in cash flows of hedged items and whether those derivatives are expected to remain highly effective in subsequent periods. The Company discontinues hedge accounting when (a) it determines that a derivative is no longer effective in offsetting changes in cash flows of a hedged item; (b) the derivative expires or is sold, terminated or exercised; (c) probability exists that the forecasted transaction will no longer occur; or (d) management determines that designating the derivative as a hedging instrument is no longer appropriate. In all cases in which hedge accounting is discontinued and a derivative remains outstanding, the Company will carry the derivative at fair value in the Consolidated Financial Statements, recognizing changes in fair value in current period income in the consolidated statement of income.

The Company follows GAAP, FASB ASU 815-10-50 "Disclosures about Derivative Instruments and Hedging Activities", which includes the disclosure requirements for derivative instruments and hedging activities to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance and cash flows.

Interest differentials paid or received under the swap agreements are reflected as adjustments to interest income. These interest rate swap agreements include both cash flow and fair value hedge derivative instruments that qualify for hedge accounting. The notional amounts of the interest rate swaps are not exchanged and do not represent exposure to credit loss. In the event of default by a counter party, the risk in these transactions is the cost of replacing the agreements at current market rates.

The Company entered into an interest rate swap agreement on July 1, 2010 to manage the interest rate exposure on its Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036. By entering into this agreement, the Company converts a floating rate liability into a fixed rate liability through 2020. Under the terms of the agreement, the Company receives interest quarterly at the rate equivalent to three plus 1.70%, repricing every three months on the same date as the Company's Floating Rate Junior Subordinated Deferrable Interest Debentures due 2036, and pays interest expense monthly at the fixed rate of 4.91%. The interest expense on the interest rate swap was $27,000 and $30,000 for each of the three months ended March 31, 2016 and 2015, respectively. The swap is designated as a cash flow hedge and changes in the fair value are recorded as an adjustment through other comprehensive income.

The Company entered into three swap agreements to manage the interest rate risk related to three commercial loans. The agreements allow the Company to convert fixed rate assets to floating rate assets through 2020 and 2025. The Company receives interest monthly at the rate equivalent to one month LIBOR, plus a spread repricing on the same date as the loans, and pays interest at fixed rates. The interest expense on the interest rate swaps was $25,000 and $32,000 for the three months ended March 31, 2016 and 2015, respectively. These swaps are designated as fair value hedges and changes in fair value are recorded in current earnings.

Cash collateral held at other banks for these swaps was $1.1 million at March 31, 2016. Collateral posted and received is dependent on the market valuation of the underlying hedges.

The effects of derivative instruments on the Consolidated Financial Statements for March 31, 2016 and December 31, 2015 are as follows:

(In thousands)
 
March 31, 2016
Derivatives designated as hedging instruments
 
Notional/
Contract
Amount
   
Estimated Net
Fair Value
 
Fair Value
Balance Sheet
Location
 
Expiration
Dates From
 
Expiration Dates To
Interest rate swap-cash flow
 
$
4,000
   
$
(375
)
Other Liabilities
   
-
 
9/15/2020
Interest rate swaps-fair value
   
6,925
     
(250
)
Other Liabilities
 
9/26/2022
 
4/9/2025


18

   
March 31, 2016
 
 
Derivatives in cash flow hedging relationships
 
 
Amount of Gain (Loss)
Recognized in OCI on
Derivatives, net of tax
(Effective Portion)
 
Location of Gain or
(Loss) Recognized in
Income on Derivative
(Ineffective Portion)
 
Amount of Gain (Loss)
Recognized in Income
on Derivative
(Ineffective Portion)
 
Interest rate swaps
 
$
(56
)
Not applicable
 
$
-
 


(In thousands)
March 31, 2016
 
Derivatives in fair value hedging relationships
Income Statement
Classification
 
Gain or
(Loss) on Swaps
 
Interest rate swaps
Interest income
 
$
-
 


 (In thousands)
 
December 31, 2015
Derivatives designated as hedging instruments
 
 
Notional/
Contract
Amount
   
Estimated Net
Fair Value
 
Fair Value
Balance Sheet
Location
 
Expiration
Date From
 
Expiration Dates To
Interest rate swap-cash flow
 
$
4,000
   
$
(289
)
Other Liabilities
   
-
 
9/15/2020
Interest rate swaps-fair value
   
973
     
2
 
Other Assets
   
-
 
9/26/2022
Interest rate swap-fair value
   
5,996
     
(46
)
Other Liabilities
 
2/14/2022
 
4/9/2025


   
December 31, 2015
 
 
Derivatives in cash flow hedging relationships
 
 
Amount of Gain (Loss)
Recognized in OCI on
Derivatives, net of tax
(Effective Portion)
 
Location of Gain or
(Loss) Recognized in
Income on Derivative
(Ineffective Portion)
 
Amount of Gain (Loss)
Recognized in Income
on Derivative
(Ineffective Portion)
 
Interest rate swaps
 
$
10
 
Not applicable
 
$
-
 

(In thousands)
December 31, 2015
 
Derivatives in fair value hedging relationships
 
Income Statement
Classification
 
Gain or
(Loss) on Swaps
 
Interest rate swaps
Interest Income
 
$
(112
)

19

Note 6. Earnings Per Share

The following table shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of dilutive potential common stock.

   
Three Months Ended
   
Three Months Ended
 
   
March 31, 2016
   
March 31, 2015
 
   
Shares
   
Per Share Amount
   
Shares
   
Per Share Amount
 
Basic earnings per share
   
3,750,937
   
$
0.16
     
3,737,111
   
$
0.20
 
Effect of dilutive securities, stock-based awards
   
12,651
             
14,111
         
Diluted earnings per share
   
3,763,588
   
$
0.16
     
3,751,222
   
$
0.20
 

Non-vested restricted shares have voting rights and receive non-forfeitable dividends during the vesting period; therefore, they are included in calculating basic earnings per share. The portion of non-vested performance-based stock awards that are expected to vest, but have not yet been awarded are included in the diluted earnings per share.

Note 7. Stock Based Compensation

Stock Incentive Plan

On May 19, 2009, the shareholders of the Company approved the Company's Stock Incentive Plan (the "Plan"), which superseded and replaced the Omnibus Stock Ownership and Long Term Incentive Plan.

Under the Plan, stock options, stock appreciation rights, non-vested and/or restricted shares, and long-term performance unit awards may be granted to directors and certain employees for purchase of the Company's common stock. The effective date of the Plan is March 19, 2009, the date the Company's Board approved the Plan, and it has a termination date of December 31, 2019. The Company's Board may terminate, suspend or modify the Plan within certain restrictions. The Plan authorizes for issuance 350,000 shares of the Company's common stock. The Plan requires that options be granted at an exercise price equal to at least 100% of the fair market value of the common stock on the date of the grant. Such options are generally not exercisable until three years from the date of issuance and generally require continuous employment during the period prior to exercise. The options will expire in no more than ten years after the date of grant. The stock options, stock appreciation rights, restricted shares, and long-term performance unit awards for certain employees are generally subject to vesting requirements and are subject to forfeiture if vesting and other contractual provision requirements are not met. The Company did not grant stock options during the three months ended March 31, 2016 and 2015; there were no options outstanding at March 31, 2016.

Restricted Shares

The restricted shares are accounted for using the fair market value of the Company's common stock on the date the restricted shares were awarded. The restricted shares issued to certain officers are subject to a vesting period, whereby, the restrictions on the shares lapse on the third year anniversary of the date the restricted shares were awarded. Compensation expense for these shares is recognized over the three year period. The restricted shares issued to non-employee directors are not subject to a vesting period, and compensation expense is recognized at the date the shares are granted.

The Company has granted awards of non-vested shares to certain officers and vested shares to non-employee directors under the Plan: 12,340 shares and 10,227 shares of non-vested restricted stock to executive officers, and 4,536 shares and 3,458 shares of vested restricted stock to non-employee directors on February 18, 2016 and February 19, 2015, respectively. The compensation expense for these non-vested shares is recognized over a period of three years, and was $42,000 and $40,000, net of forfeiture, for the three months ended March 31, 2016 and 2015, respectively. As of March 31, 2016, there was $333,000 of total unrecognized compensation cost related to these non-vested shares, which will be recorded in conjunction with the vesting periods over the remaining 33 months. Compensation expense for the non-employee directors is recognized at the date the shares are granted and during the three months ended March 31, 2016 and 2015, $68,000 and $60,000 was recognized, respectively.

20

A summary of the status of the Company's non-vested restricted shares granted under the Plan is presented below:

   
Three Months Ended
March 31, 2016
 
   
Shares
   
Weighted Average
Fair Value
 
             
Non-vested at January 1, 2016
   
33,267
   
$
14.74
 
                 
Granted
   
16,876
     
15.12
 
Vested
   
(17,006
)
   
12.73
 
Forfeited
   
-
         
Non-vested at March 31, 2016
   
33,137
   
$
15.60
 

The Company granted performance-based stock rights relating to 12,049 and 10,227 shares to certain officers on February 18, 2016 and February 19, 2015, under the Plan. The performance-based stock rights are accounted for using the fair market value of the Company's common stock on the date awarded, and adjusted as the market value of the stock changes. The performance-based stock rights issued to executive officers are subject to a vesting period, whereby the restrictions on the shares lapse on the third year anniversary of the date the shares were awarded. Until vesting, the shares are not issued and not included in shares outstanding. The awards are subject to the Company reaching a predetermined three year performance average on the return on average equity ratio, also as compared to a predetermined peer group of banks. The compensation expense for performance-based stock rights totaled $7,000 and $32,000 for the three months ended March 31, 2016 and 2015, respectively. As of March 31, 2016, there was $133,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plans.

A summary of the status of the Company's non-vested performance-based stock rights is presented below:

   
Three Months Ended
March 31, 2016
 
   
Performance
Based Stock
Rights (Shares)
   
Weighted Average
Fair Value
 
             
Non-vested at January 1, 2016
   
33,443
   
$
14.74
 
                 
Granted
   
12,049
     
15.17
 
Vested
   
-
         
Forfeited
   
(12,470
)
   
11.91
 
Non-vested at March 31, 2016
   
33,022
   
$
15.97
 

Note 8. Employee Benefit Plans

The Company has a defined contribution retirement plan under Internal Revenue Code of 1986 ("Code") Section 401(k) covering all employees who are at least 18 years of age. Under the plan, a participant may contribute an amount up to 100% of their covered compensation for the year, not to exceed the dollar limit set by law (Code Section 402(g)). The Company will make an annual matching contribution equal to 100% on the first 1% of compensation deferred and 50% on the next 5% of compensation deferred, for a maximum match of 3.5% of compensation. Beginning in 2010, the Company began making an additional safe harbor contribution equal to 6% of compensation to all eligible participants. The Company's 401(k) expenses for the three months ended March 31, 2016 and 2015 were $184,000 and $164,000, respectively.

21

The Company also maintains a Director Deferred Compensation Plan ("Deferred Compensation Plan"). This plan provides that any non-employee director of the Company or the Bank may elect to defer receipt of all or any portion of his or her compensation as a director. A participating director may elect to have amounts deferred under the Deferred Compensation Plan held in a deferred cash account, which is credited on a quarterly basis with interest equal to the highest rate offered by the Bank at the end of the preceding quarter. Alternatively, a participant may elect to have a deferred stock account in which deferred amounts are treated as if invested in the Company's common stock at the fair market value on the date of deferral. The value of a stock account will increase and decrease based upon the fair market value of an equivalent number of shares of common stock. In addition, the deferred amounts deemed invested in common stock will be credited with dividends on an equivalent number of shares. Amounts considered invested in the Company's common stock are paid, at the election of the director, either in cash or in whole shares of the common stock and cash in lieu of fractional shares. Directors may elect to receive amounts contributed to their respective accounts in one or up to five installments. There are no directors currently participating in the Deferred Compensation Plan.

The Company has a nonqualified deferred compensation plan for a former key employee's retirement, in which the contribution expense is solely funded by the Company. The retirement benefit to be provided is variable based upon the performance of underlying life insurance policy assets. For the three months ended March 31, 2016 and 2015, deferred compensation expense was $9,000 and $8,000, respectively.

Concurrent with the establishment of the deferred compensation plan for the former employee, the Company purchased life insurance policies on this employee with the Company named as owner and beneficiary. These life insurance policies are intended to be utilized as a source of funding the plan. Income on these life insurance policies amounted to $8,000 for each of the three months ended March 31, 2016 and 2015. The Company has recorded $1.3 million in cash surrender value of these policies at both March 31, 2016 and December 31, 2015 which is included in Bank Owned Life Insurance line item of the Consolidated Balance Sheet.

Note 9. Fair Value Measurement

The Company follows ASC 820 "Fair Value Measurement and Disclosures" to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. ASC 820 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.

ASC 820 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 under ASC 820 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.

22

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 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 (Level 2).  If the inputs used to provide the evaluation for certain securities are unobservable and/or there is little, if any, market activity then the security would fall to the lowest level of the hierarchy (Level 3).  The Company's investment portfolio is primarily valued using fair value measurements that are considered to be Level 2.  The Company has contracted with a third party portfolio accounting service vendor for valuation of its securities. The vendor's primary source for security valuation is Interactive Data Corporation ("IDC"), which evaluates securities based on market data.  IDC utilizes evaluated pricing models that vary by asset class and include available trade, bid, and other market information.  Generally, the methodology includes broker quotes, proprietary modes, vast descriptive terms and conditions databases, as well as extensive quality control programs.  

Interest rate swaps: Interest rate swaps are recorded at fair value on a recurring basis.  The Company utilizes interest rate swap agreements as part of the management of interest rate risk to modify the repricing characteristics of certain portions of the Company's interest-bearing assets and liabilities.  The Company has contracted with a third party to provide valuations for interest rate swaps using standard valuation techniques and therefore classifies such valuation as Level 2.  The Company has considered counterparty credit risk in the valuation of its interest rate swap assets and has considered its own credit risk in the valuation of its interest rate swap liabilities.

23

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2016 and December 31, 2015 by levels within the valuation hierarchy:

   
Fair Value Measurements Using
 
(In thousands)
 
Balance
   
Quoted Prices in Active Markets for Identical Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
Assets at March 31, 2016:
                       
Available for sale securities:
                       
Obligations of U.S. Government corporations and agencies
 
$
43,624
   
$
-
   
$
43,624
   
$
-
 
Obligations of states and political subdivisions
   
6,183
     
-
     
6,183
     
-
 
Corporate bonds
   
2,863
     
-
     
2,863
     
-
 
Mutual funds
   
379
     
379
     
-
     
-
 
Total available for sale securities
   
53,049
     
379
     
52,670
     
-
 
                                 
Total assets at fair value
 
$
53,049
   
$
379
   
$
52,670
   
$
-
 
                                 
Liabilities at March 31, 2016:
                               
Interest rate swaps
 
$
625
   
$
-
   
$
625
   
$
-
 
Total liabilities at fair value
 
$
625
   
$
-
   
$
625
   
$
-
 
                                 
Assets at December 31, 2015:
                               
Available for sale securities:
                               
Obligations of U.S. Government corporations and agencies
 
$
45,792
   
$
-
   
$
45,792
   
$
-
 
Obligations of states and political subdivisions
   
6,200
     
-
     
6,200
     
-
 
Corporate bonds
   
2,860
     
-
     
2,860
     
-
 
Mutual funds
   
372
     
372
     
-
     
-
 
Total available for sale securities
   
55,224
     
372
     
54,852
     
-
 
                                 
Interest rate swaps
   
2
     
-
     
2
     
-
 
Total assets at fair value
 
$
55,226
   
$
372
   
$
54,854
   
$
-
 
                                 
Liabilities at December 31, 2015:
                               
Interest rate swaps
 
$
335
   
$
-
   
$
335
   
$
-
 
Total liabilities at fair value
 
$
335
   
$
-
   
$
335
   
$
-
 

There were no Level 3 assets measured at estimated fair value on a recurring basis as of March 31, 2016 or December 31, 2015.

Certain 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.

24

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 financial statements:

Impaired Loans: A loan is 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 an impaired loan can be based on either the observable market price of the loan or the fair value of the collateral securing the loan. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the Company's collateral is real estate.  The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal, of one year or less, conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is more than one year old and not solely based on observable market comparables or management determines the fair value of the collateral is further impaired below the appraised value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, of one year or less, 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 receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the Allowance for Loan Losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Income. At March 31, 2016, the Company's Level 3 loans for which a reserve has been established, consisted of three loans totaling $187,000 secured by business assets and inventory with a reserve of $123,000, and one loan totaling $314,000 secured by real estate with a reserve of $275,000.

Other Real Estate Owned ("OREO"):  Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO.  Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs.  Fair value is based upon independent market prices, appraised values of the collateral, or management's estimation of the value of the collateral.  When the fair value of the collateral is based on an observable market price or a current appraised value, the Company considers the OREO as nonrecurring Level 2.  When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company considers the OREO as nonrecurring Level 3.  Total valuation of OREO property was $1.4 million at March 31, 2016 and December 31, 2015.

The following table summarizes the Company's financial assets that were measured at fair value at March 31, 2016 and December 31, 2015.

   
Carrying Value at March 31, 2016
 
 (In thousands)
 
Balance as of
March 31, 2016
   
Quoted Prices in Active Markets for
Identical Assets
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant Other
Unobservable Inputs
(Level 3)
 
Assets:
                       
Impaired loans, net
 
$
1,668
   
$
-
   
$
1,565
   
$
103
 
Other real estate owned, net
   
1,356
     
-
     
1,356
     
-
 


   
Carrying Value at December 31, 2015
 
 (In thousands)
 
Balance as of
December 31, 2015
   
Quoted Prices in Active Markets for
Identical Assets
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant Other
Unobservable Inputs
(Level 3)
 
Assets:
                       
Impaired loans, net
 
$
337
   
$
-
   
$
293
   
$
44
 
Other real estate owned, net
   
1,356
     
-
     
1,356
     
-
 

25

The following table displays quantitative information about Level 3 Fair Value Measurements at March 31, 2016 and December 31, 2015.

   
Quantitative Information about Level 3 Fair Value Measurements at March 31, 2016
 
(In thousands)
 
Fair
Value
 
Valuation Technique(s)
Unobservable Input
 
Weighted Average Discount
 
Impaired loans
 
$
103
 
Appraised values
Age of appraisal, current market conditions, and experience within local markets
   
79
%
Total
 
$
103
             


   
Quantitative Information about Level 3 Fair Value Measurements at December 31, 2015
 
(In thousands)
 
Fair
Value
 
Valuation Technique(s)
Unobservable Input
 
Weighted Average Discount
 
Impaired loans
 
$
44
 
Appraised values
Age of appraisal, current market conditions, experience within local markets, and U.S. Government guarantees.
   
90
%
Total
 
$
44
             

The estimated fair values of the Company's financial instruments are as follows:

   
Fair Value Measurements at March 31, 2016
 
(In thousands)
 
Carrying
Value as of
March 31, 2016
   
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Other
Unobservable
Inputs
(Level 3)
   
Fair Value
as of
March 31, 2016
 
Assets
                             
Cash and short-term investments
 
$
55,677
   
$
55,821
   
$
-
   
$
-
   
$
55,821
 
Securities available for sale
   
53,049
     
379
     
52,670
     
-
     
53,049
 
Restricted investments
   
1,282
     
-
     
1,282
     
-
     
1,282
 
Net loans
   
445,088
     
-
     
447,051
     
103
     
447,154
 
Accrued interest receivable
   
1,455
     
-
     
1,455
     
-
     
1,455
 
BOLI
   
12,603
     
-
     
12,603
     
-
     
12,603
 
Total financial assets
 
$
569,154
   
$
56,200
   
$
515,061
   
$
103
   
$
571,364
 
                                         
Liabilities
                                       
Deposits
 
$
526,129
   
$
-
   
$
526,423
   
$
-
   
$
526,423
 
Borrowings
   
12,989
     
-
     
13,239
     
-
     
13,239
 
Junior subordinated debt
   
4,124
     
-
     
4,353
     
-
     
4,353
 
Accrued interest payable
   
111
     
-
     
111
     
-
     
111
 
Interest rate swaps
   
625
     
-
     
625
     
-
     
625
 
Total financial liabilities
 
$
543,978
   
$
-
   
$
544,751
   
$
-
   
$
544,751
 

26

   
Fair Value Measurements at December 31, 2015
 
(In thousands)
 
Carrying
Value as of
December 31, 2015
   
Quoted Prices
in Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Other
Unobservable
Inputs
(Level 3)
   
Fair Value
as of
December 31, 2015
 
Assets
                             
Cash and short-term investments
 
$
53,215
   
$
53,031
   
$
-
   
$
-
   
$
53,031
 
Securities available for sale
   
55,224
     
372
     
54,852
     
-
     
55,224
 
Restricted investments
   
1,286
     
-
     
1,286
     
-
     
1,286
 
Net loans
   
442,669
     
-
     
443,724
     
44
     
443,768
 
Accrued interest receivable
   
1,462
     
-
     
1,462
     
-
     
1,462
 
Interest rate swaps
   
2
     
-
     
2
     
-
     
2
 
BOLI
   
12,511
     
-
     
12,511
     
-
     
12,511
 
Total financial assets
 
$
566,369
   
$
53,403
   
$
513,837
   
$
44
   
$
567,284
 
                                         
Liabilities
                                       
Deposits
 
$
524,294
   
$
-
   
$
524,094
   
$
-
   
$
524,094
 
Borrowings
   
13,007
     
-
     
13,081
     
-
     
13,081
 
Junior subordinated debt
   
4,124
     
-
     
4,185
     
-
     
4,185
 
Accrued interest payable
   
108
     
-
     
108
     
-
     
108
 
Interest rate swaps
   
335
     
-
     
335
     
-
     
335
 
Total financial liabilities
 
$
541,868
   
$
-
   
$
541,803
   
$
-
   
$
541,803
 

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices.  However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. ASC 820 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and cash equivalents: The carrying amounts of cash and short-term instruments with a maturity of three months or less approximate fair value. Instruments with maturities of greater than three months are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar instruments.

Securities:  For securities and marketable equity securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. For other securities held as investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair values are based on quoted market prices for similar securities. Restricted securities are carried at cost based on redemption provisions of the issuers. See Note 2 "Securities" of the Notes to Consolidated Financial Statements for further discussion on determining fair value for pooled trust preferred securities.

Loans Receivable:  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans (e.g., one-to-four family residential), credit card loans, and other consumer loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. Fair values for other loans (i.e., commercial real estate and investment property mortgage loans, commercial and industrial loans) are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Fair values for nonperforming loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

27

 Accrued Interest:  The carrying amounts of accrued interest approximate fair value.

Life Insurance:  The carrying amount of life insurance contracts is assumed to be a reasonable fair value. Life insurance contracts are carried on the balance sheet at their redemption value. This redemption value is based on existing market conditions and therefore represents the fair value of the contract.

Interest Rate Swaps:  The fair values are based on quoted market prices or mathematical models using current and historical data.

Deposit Liabilities:  The fair values disclosed for demand deposits (i.e., interest and non-interest bearing checking, statement savings and money market accounts) are, by definition, equal to the amount payable at the reporting date (that is, their carrying  amounts). Fair values of fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered to a schedule of aggregated expected monthly maturities on time deposits.

Borrowed Funds:  The fair values of the Company's advances from the Federal Home Loan Bank of Atlanta and other borrowings are estimated using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements.

Off-Balance-Sheet Financial Instruments:  The fair value of commitments to extend credit is estimated using the fees currently charged to enter similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The fair values of standby letters of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date.

At March 31, 2016 and December 31, 2015, the fair values of loan commitments and standby letters of credit were deemed immaterial.

The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk.

28

Note 10.  Accumulated Other Comprehensive Income

Changes in Accumulated Other Comprehensive Income by Component (1)

 (In thousands)
 
Gains and Losses on Cash Flow Hedges
   
Unrealized Gains and Losses on Available for Sale Securities
   
Supplemental Executive Retirement Plans
   
Total
 
                         
Balance December 31, 2015
 
$
(190
)
 
$
(229
)
 
$
(41
)
 
$
(460
)
Other comprehensive income (loss) before reclassifications
   
(56
)
   
216
     
-
     
160
 
Amounts reclassified from accumulated other comprehensive income
   
-
     
-
     
-
     
-
 
Net current-period other comprehensive income (loss)
   
(56
)
   
216
     
-
     
160
 
Balance March 31, 2016
 
$
(246
)
 
$
(13
)
 
$
(41
)
 
$
(300
)
                                 
Balance December 31, 2014
 
$
(200
)
 
$
160
   
$
(61
)
 
$
(101
)
Other comprehensive income (loss) before reclassifications
   
(31
)
   
169
     
-
     
138
 
Amounts reclassified from accumulated other comprehensive income
   
-
     
-
     
-
     
-
 
Net current-period other comprehensive income (loss)
   
(31
)
   
169
     
-
     
138
 
Balance March 31, 2015
 
$
(231
)
 
$
329
   
$
(61
)
 
$
37
 
(1) All amounts are net of tax. Amounts in parentheses indicate debits.

Note 11.  Investment in Affordable Housing Projects

The Company has investments in certain affordable housing projects located in the Commonwealth of Virginia through six limited liability partnerships of the Bank. These partnerships exist to develop and preserve affordable housing for low income families through residential rental property projects. The Company exerts no control over the operating or financial policies of the partnerships. Return on these investments is through receipt of tax credits and other tax benefits which are subject to recapture by taxing authorities based on compliance features at the project level. The investments are due to expire by 2032. The Company accounts for the affordable housing investments using the equity method and has recorded $4.2 million in other assets at March 31, 2016. The Company has also recorded $2.7 million in other liabilities related to capital calls through 2019. The related federal tax credits and other tax benefits for the three months ended March 31, 2016 and 2015 were $121,000 and $193,000, respectively, and were included in income tax expense in the Consolidated Statements of Income. There were $56,000 in flow-through losses recognized during the quarter ended March 31, 2016. In the quarter ended March 31, 2015, $279,000 of flow through losses were recognized in other income in the Consolidated Statement of Income.

Note 12.  Subsequent Event

Subsequent to March 31, 2016 and this Form 10-Q, the Company received $1.3 million in a recovery on a previously charged off commercial loan.  It will be recorded in the allowance for loan losses in the quarter ended June 30, 2016 and may impact provisions to the allowance in future quarters.

29

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
 
In addition to the historical information contained herein, this report contains forward-looking statements. Forward-looking statements are based on certain assumptions and describe future plans, strategies, and expectations of Fauquier Bankshares, Inc. ("the Company"), and are generally identifiable by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" "may," "will" or similar expressions. Although we believe our plans, intentions and expectations reflected in these forward-looking statements are reasonable, we can give no assurance that these plans, intentions, or expectations will be achieved. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain, and actual results could differ materially from those contemplated. Factors that could have a material adverse effect on our operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, the legislative/regulatory climate, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Board of Governors of the Federal Reserve System, the quality or composition of the Bank's loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area, our plans to expand our branch network and increase our market share, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements in this report and you should not place undue reliance on such statements, which reflect our position as of the date of this report.

GENERAL
 
The Company was incorporated under the laws of the Commonwealth of Virginia on January 13, 1984. The Company is a registered bank holding company and owns all of the voting shares of The Fauquier Bank ("the Bank").  The Company engages in its business through the Bank, a Virginia state-chartered bank that commenced operations in 1902. The Company has no significant operations other than owning the stock of the Bank. The Company had issued and outstanding 3,761,438 shares of common stock, par value $3.13 per share, held by approximately 340 holders of record at the close of business on March 31, 2016.  The Bank has 11 full service branch offices located in the Virginia communities of Old Town-Warrenton, Warrenton, Catlett, The Plains, Sudley Road-Manassas, New Baltimore, Bealeton, Bristow, Haymarket, Gainesville, and Centreville Road-Manassas. The executive offices of the Company and the main office of the Bank are located at 10 Courthouse Square, Warrenton, Virginia 20186.

The Bank's general market area principally includes Fauquier County, western Prince William County, and neighboring communities and is located approximately 50 miles southwest of Washington, D.C.

The Bank provides a range of consumer and commercial banking services to individuals, businesses and industries. The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"). The basic services offered by the Bank include: interest bearing and non-interest-bearing demand deposit accounts, money market deposit accounts, NOW accounts, time deposits, safe deposit services, automated teller machine ("ATM"), debit and credit cards, cash management, direct deposits, notary services, night depository, prepaid debit cards, cashier's checks, domestic and international collections, savings bonds, automated teller services, drive-in tellers, mobile and internet banking, telephone banking, and banking by mail. In addition, the Bank makes secured and unsecured commercial and real estate loans, issues stand-by letters of credit and grants available credit for installment, unsecured and secured personal loans, residential mortgages and home equity loans, as well as automobile and other types of consumer financing. The Bank provides ATM cards, as a part of the Maestro, Accel and Plus ATM networks, thereby permitting customers to utilize the convenience of larger ATM networks.  The Bank also is a member of the Certificate of Deposit Account Registry Service ("CDARS") and Insured Cash Sweep Service ("ICS"), to provide customers multi-million dollar FDIC insurance on certificates of deposit investments and deposit sweeps through the transfer and/or exchange with other FDIC insured institutions. CDARS and ICS are registered service marks of Promontory Interfinancial Network, LLC.

30

The Bank operates a Wealth Management Services ("WMS" or "Wealth Management") division that began with the granting of trust powers to the Bank in 1919. The WMS division provides personalized services that include investment management, trust, estate settlement, retirement, insurance, and brokerage services.
 
The Bank, through its subsidiary Fauquier Bank Services, Inc., has equity ownership interests in Bankers Insurance, LLC, a Virginia independent insurance company, Bankers Title Shenandoah, LLC, a title insurance company, and Infinex Investments, Inc., a full service broker/dealer. Bankers Insurance and Bankers Title Shenandoah are owned by a consortium of Virginia community banks, and Infinex is owned by banks and banking associations in various states.

The revenues of the Bank are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment and mortgage-backed securities, and short-term investments. The principal sources of funds for the Bank's lending activities are its deposits, repayment of loans, the sale and maturity of investment securities, and borrowings from the Federal Home Loan Bank of Atlanta ("FHLB"). Additional revenues are derived from fees for deposit-related and WMS-related services. The Bank's principal expenses are the interest paid on deposits and operating and general administrative expenses.

As is the case with banking institutions generally, the Bank's operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System ("Federal Reserve"). As a Virginia-chartered bank and a member of the Federal Reserve, the Bank is supervised and examined by the Federal Reserve and the Virginia State Corporation Commission. Interest rates on competing investments and general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans.

As of March 31, 2016, the Company had total consolidated assets of $603.9 million, total loans net of allowance for loan losses of $445.1 million, total consolidated deposits of $526.1 million, and total consolidated shareholders' equity of $53.1 million.
 
CRITICAL ACCOUNTING POLICIES
 
GENERAL. The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the Company's transactions could change.

ALLOWANCE FOR LOAN LOSSES. The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) Accounting Standards Codification ("ASC") 450 "Contingencies" which requires that losses be accrued when they are probable of occurring and estimable, (ii) ASC 310 "Receivables" which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) Securities and Exchange Commission ("SEC") Staff Accounting Bulletin No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues," which requires adequate documentation to support the allowance for loan losses estimate.

31

The Company's allowance for loan losses has three basic components: the specific allowance, the general allowance and the unallocated component. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans identified as impaired. The specific allowance uses various techniques to arrive at an estimate of loss.  All troubled debt restructurings ("TDRs"), regardless of loan type or amount, are evaluated individually for impairment. Analysis of the borrower's overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not identified as impaired. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized.  The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Specifically, the Company uses both external and internal qualitative factors when determining the non-loan-specific allowances. The external factors utilized include: unemployment in the Company's defined market area of Fauquier County, Prince William County, and the City of Manassas ("market area"), as well as state and national unemployment trends; new residential construction permits for the market area; bankruptcy statistics for the Virginia Eastern District and trends for the United States; and foreclosure statistics for the market area and the state. Quarterly, these external qualitative factors as well as relevant anecdotal information are evaluated from data compiled from local periodicals such as The Washington Post, The Fauquier Times Democrat, and The Bull Run Observer, which cover the Company's market area. Additionally, data is gathered from the Federal Reserve Beige Book for the Richmond Federal Reserve District, Global Insight's monthly economic review, the George Mason School of Public Policy Center for Regional Analysis, and daily economic updates from various other sources. Internal Bank data utilized includes: loans past due aging statistics, nonperforming loan trends, trends in collateral values, loan concentrations, loan review status downgrade trends, and lender turnover and experience trends. Both external and internal data is analyzed on a rolling eight quarter basis to determine risk profiles for each qualitative factor. Ratings are assigned through a defined matrix to calculate the allowance consistent with authoritative accounting literature. A narrative summary of the reserve allowance is produced quarterly and reported directly to the Company's Board of Directors. The Company's application of these qualitative factors to the allowance for loan losses has been consistent over the reporting period.

The Company employs an independent outsourced loan review function, which annually substantiates and/or adjusts internally generated risk ratings. This independent review is reported directly to the Company's Board of Directors' audit committee, and the results of this review are factored into the calculation of the allowance for loan losses.

EXECUTIVE OVERVIEW
 
This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community. The Company and the Bank's primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management.

32

Net income of $606,000 for the first quarter of 2016 was an 18.4% decrease from the net income for the first quarter of 2015 of $743,000.  Loans, net of reserve, totaling $445.1 million at March 31, 2016, increased 0.5% when compared with December 31, 2015, and increased 1.3% when compared with March 31, 2015.  Deposits, totaling $526.1 million at March 31, 2016, increased 0.3% when compared with December 31, 2015, and increased 1.9% when compared with March 31, 2015.  Assets under WMS management, totaling $347.6 million in market value at March 31, 2016, decreased 0.6% from December 31, 2015 and decreased 22.9% from March 31, 2015.

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, competition for loans and deposits, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management's current projections, net interest income may increase as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank's net interest margin resulting from competitive market conditions and/or a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income. The current absolute level of historically low market interest rates, as well as the current slowness of new loan production, is also projected to result in a decrease in net interest income.

The Bank's non-performing assets totaled $3.2 million or 0.54% of total assets at March 31, 2016, as compared with $3.2 million or 0.53% of total assets at December 31, 2015, and $3.0 million or 0.50% of total assets at March 31, 2015. Nonaccrual loans totaled $1.9 million or 0.42% of total loans at March 31, 2016 compared with $1.8 million or 0.41% of total loans at December 31, 2015, and $1.6 million or 0.36% of total loans at March 31, 2015. There was a $200,000 provision for loan losses for the first three months of 2016, and no provision for the first three months of 2015. There were net charge-offs of $17,000 during the three months ended March 31, 2016 compared with net charge-offs of $5,000 for the same three months of 2015. Total allowance for loan losses was $4.4 million or 0.97% of total loans at March 31, 2016 compared with $4.2 million or 0.94% of loans at December 31, 2015 and $5.4 million or 1.21% of loans at March 31, 2015.  The decrease in the allowance percentage from March 31, 2015 to March 31, 2016 was due primarily to the low level of net charge-offs during the quarter ended March 31, 2016, the relatively low level of non-accrual loans, and the decline in restructured loans still accruing.

COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED MARCH 31, 2016 AND 2015

NET INCOME
Net income of $606,000 for the quarter ended March 31, 2016 was an 18.4% decrease from the net income for the quarter ended March 31, 2015 of $743,000.   Earnings per share on a fully diluted basis were $0.16 for the first quarter of 2016 compared with $0.20 for the first quarter of 2015. Profitability as measured by return on average assets decreased from 0.50% in the first quarter of 2015 to 0.41% for the same period in 2016. Profitability as measured by return on average equity decreased from 5.42% to 4.59% over the same respective quarters in 2015 and 2016.

NET INTEREST INCOME AND EXPENSE
Net interest income increased $4,000 or 0.1% to $4.82 million for the quarter ended March 31, 2016 from $4.81 million for the quarter ended March 31, 2015.  The increase in net interest income was due primarily to the decrease in interest expense on deposits of $122,000. This was mostly offset by reduced interest income on loans and taxable investments of $95,000 and $44,000, respectively, over the same period.  The Company's net interest margin was 3.59% for both the first quarter of 2016 and 2015.

Total interest income decreased $116,000 or 2.2% to $5.26 million for the first quarter of 2016 from $5.37 million for the first quarter of 2015. This decrease was primarily due to the decline in the yield on earning assets from 4.01% during the first quarter of 2015 to 3.91% during the first quarter of 2016.

33

The tax-equivalent average yield on loans was 4.41% for the first quarter of 2016, down from 4.58% in the first quarter of 2015. Average loan balances increased $4.2 million or 0.9% from $442.2 million during the first quarter of 2015 to $446.4 million during the first quarter of 2016. The decrease in yield, partially offset by the increase in average loan balances, resulted in a $95,000 or 1.9% decline in interest and fee income from loans for the first quarter of 2016, compared with the same period in 2015. On a tax equivalent basis, the decrease was $100,000 or 2.0%.

Average investment security balances decreased $3.8 million from $58.0 million in the first quarter of 2015 to $54.2 million in the first quarter of 2016. The tax-equivalent average yield on investments decreased from 2.78% for the first quarter of 2015 to 2.63% for the first quarter of 2016.  Non-tax-equivalent interest and dividend income on security investments decreased $44,000 or 11.8%, from $373,000 for the first quarter of 2015 to $329,000 for the first quarter of 2016. Tax equivalent interest and dividend income on security investments declined $47,000 over the same period.

Interest income on deposits in other banks totaled $61,000 for the first quarter of 2016 compared with $38,000 for the first quarter of 2015, primarily due to the 22 basis point increase in the rate earned over the respective periods.

Total interest expense decreased $120,000 or 21.4% from $560,000 for the first quarter of 2015 to $440,000 for the first quarter of 2016 primarily due to the decline in average balances and the rate paid on time deposits.

Interest paid on deposits decreased $122,000 or 28.3% from $431,000 for the first quarter of 2015 to $309,000 for the first quarter of 2016.   Average balances on time deposits declined $19.7 million or 23.6% from $83.4 million to $63.7 million while the average rate decreased from 1.33% for the first quarter of 2015 to 0.86% for the first quarter of 2016, resulting in $139,000 less interest expense.  Average money market account balances increased $1.1 million from the first quarter of 2015 to the first quarter of 2016 while the rate remained the same at 0.21%, resulting in $1,000 more interest expense.  Average savings account balances increased $7.4 million or 9.3% from the first quarter of 2015 to the first quarter of 2016, and the average rate increased from 0.10% to 0.11%, resulting in an increase of $3,000 in interest expense for the first quarter of 2016.  Average interest bearing checking balances increased $7.9 million or 3.7% from the first quarter of 2015 to the first quarter of 2016, while the average rate increased from 0.21% to 0.22%, resulting in an increase of $13,000 in interest expense for the first quarter of 2016.

Interest expense on FHLB advances was $81,000 and $80,000 for the quarter ended March 31, 2016 and 2015, respectively. Interest expense on capital securities was $50,000 and $49,000 for the first quarter of 2016 and 2015, respectively. 
 
The average rate on total interest-bearing liabilities decreased from 0.51% in the first quarter of 2015 to 0.40% for the first quarter of 2016.

The following table sets forth information relating to the Company's average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

34

Average Balances, Income and Expense, and Average Yields and Rates

   
Three Months Ended March 31, 2016
   
Three Months Ended March 31, 2015
 
(Dollars in thousands)
 
Average
   
Income/
   
Average
   
Average
   
Income/
   
Average
 
Assets
 
Balances
   
Expense
   
Rate
   
Balances
   
Expense
   
Rate
 
Loans
                                   
Taxable
 
$
439,026
   
$
4,818
     
4.41
%
 
$
434,931
   
$
4,905
     
4.57
%
Tax-exempt (1)
   
5,549
     
74
     
5.38
%
   
6,290
     
87
     
5.62
%
Nonaccrual (2)
   
1,849
     
-
     
-
     
1,002
     
-
     
-
 
Total Loans
   
446,424
     
4,892
     
4.41
%
   
442,223
     
4,992
     
4.58
%
 
                                               
Securities
                                               
Taxable
   
48,477
     
276
     
2.28
%
   
51,756
     
316
     
2.44
%
Tax-exempt (1)
   
5,685
     
80
     
5.61
%
   
6,224
     
87
     
5.57
%
Total securities
   
54,162
     
356
     
2.63
%
   
57,980
     
403
     
2.78
%
 
                                               
Deposits in banks
   
45,287
     
61
     
0.54
%
   
48,962
     
38
     
0.32
%
Federal funds sold
   
9
     
-
     
0.36
%
   
11
     
-
     
0.17
%
Total earning assets
   
545,882
     
5,309
     
3.91
%
   
549,176
   
$
5,433
     
4.01
%
 
                                               
Less: Reserve for loan losses
   
(4,289
)
                   
(5,442
)
               
Cash and due from banks
   
4,941
                     
5,470
                 
Bank premises and equipment, net
   
20,384
                     
21,051
                 
Other real estate owned
   
1,356
                     
1,406
                 
Other assets
   
25,785
                     
25,639
                 
Total Assets
 
$
594,059
                   
$
597,300
                 
 
                                               
Liabilities and Shareholders' Equity
                                               
Deposits
                                               
Demand deposits
 
$
93,695
                   
$
88,472
                 
 
                                               
Interest-bearing deposits
                                               
Checking accounts
   
220,031
   
$
122
     
0.22
%
   
212,108
   
$
109
     
0.21
%
Money market accounts
   
53,745
     
28
     
0.21
%
   
52,646
     
27
     
0.21
%
Savings accounts
   
86,513
     
23
     
0.11
%
   
79,157
     
20
     
0.10
%
Time deposits
   
63,740
     
136
     
0.86
%
   
83,427
     
275
     
1.33
%
Total interest-bearing deposits
   
424,029
     
309
     
0.29
%
   
427,338
     
431
     
0.41
%
 
                                               
Federal funds purchased
   
-
     
-
     
0.00
%
   
-
     
-
     
0.00
%
Federal Home Loan Bank advances
   
12,998
     
81
     
2.50
%
   
13,067
     
80
     
2.49
%
Junior subordinated debt
   
4,124
     
50
     
4.84
%
   
4,124
     
49
     
4.83
%
Total interest-bearing liabilities
   
441,151
     
440
     
0.40
%
   
444,529
     
560
     
0.51
%
 
                                               
Other liabilities
   
6,102
                     
8,691
                 
Shareholders' equity
   
53,111
                     
55,608
                 
Total Liabilities & Shareholders' Equity
 
$
594,059
                   
$
597,300
                 
 
                                               
Net interest income (tax equivalent basis)
         
$
4,869
     
3.51
%
         
$
4,873
     
3.50
%
Less: tax equivalent basis
         
$
52
                   
$
60
         
Net interest income
         
$
4,817
                   
$
4,813
         
                                                 
Interest expense as a percent of average earning assets
                   
0.32
%
                   
0.41
%
Net interest margin
                   
3.59
%
                   
3.59
%

 
 
 
(1)   Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.
 
(2)  Nonaccrual loans are included in the average balance of total loans and total earning assets.

35

RATE VOLUME ANALYSIS

The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); and changes in rates (change in rate multiplied by old volume). Changes in rate-volume, which cannot be separately identified, are allocated proportionately between changes in rate and changes in volume.
 
 
 
Three Months Ended March 31, 2016 Compared to
Three Months Ended March 31, 2015
 
 
       
Due to
   
Due to
 
(In thousands)
 
Change
   
Volume
   
Rate
 
Interest Income
                 
Loans; taxable
 
$
(87
)
 
$
46
   
$
(133
)
Loans; tax-exempt (1)
   
(13
)
   
(10
)
   
(3
)
Securities; taxable
   
(40
)
   
(20
)
   
(20
)
Securities; tax-exempt (1)
   
(7
)
   
(7
)
   
-
 
Deposits in banks
   
23
     
(3
)
   
26
 
Federal funds sold
   
-
     
-
     
-
 
Total Interest Income
   
(124
)
   
6
     
(130
)

                   
Interest Expense
                 
Checking accounts
   
13
     
4
     
9
 
Money market accounts
   
1
     
1
     
-
 
Savings accounts
   
3
     
2
     
1
 
Time deposits
   
(139
)
   
(65
)
   
(74
)
Federal funds purchased and securities sold under agreements to repurchase
   
-
     
-
     
-
 
Federal Home Loan Bank advances
   
1
     
-
     
1
 
Subordinated debt
   
1
     
-
     
1
 
Total Interest Expense
   
(120
)
   
(58
)
   
(62
)
Net Interest Income
 
$
(4
)
 
$
64
   
$
(68
)
 
(1) Income and rates on non-taxable assets are computed on a tax equivalent basis using a federal tax rate of 34%.
  
PROVISION FOR LOAN LOSSES
There was a $200,000 provision for loan losses for the first quarter of 2016 compared with no provision for the first quarter of 2015.

The amount of the provision for loan loss is based upon management's continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank's delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. The loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends are also utilized in determining the allowance. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.
36

  
OTHER INCOME
Total other income increased by $110,000 or 8.6% from $1.28 million for the first quarter of 2015 to $1.39 million in the first quarter of 2016. Non-interest income is derived primarily from recurring non-interest fee income, which consists primarily of fiduciary trust and other Wealth Management fees, brokerage fees, service charges on deposit accounts, debit card interchange income and other fee income.  Other service charges, commissions and income increased $233,000 from first quarter 2015 to first quarter 2016 primarily due to the reduction of passive losses within community development tax credit investments from year to year. This was partially offset by an $111,000 decrease in trust and estate income. Trust and estate income decreased $111,000 or 24.2% from the first quarter of 2015 to the first quarter of 2016 primarily due to the negative impact caused by the resignation of two investment management personnel during September 2015. Management believes that there may be an approximate $500,000 annual reduction in fees on managed investment accounts and related assets as result of their resignation. .

Brokerage service revenues were $71,000 for the first quarter of 2016 compared with $80,000 the first quarter of 2015.

Service charges on deposit accounts decreased $3,000 or 0.6% to $527,000 for the first quarter of 2016 compared to one year earlier.  

Other service charges, commissions and fees increased $233,000 or 112.0% from $208,000 in first quarter of 2015 to $441,000 in the first quarter of 2016 primarily due to the increased recognition of passive losses within community development tax credit investments in 2015.  Passive losses within community development tax credit investments were $56,000 in the first quarter of 2016 compared with $279,000 in the first quarter of 2015. These passive losses will be more than offset in future periods by federal tax credits related to low/moderate income housing and/or buildings of historical significance. Included in other service charges, commissions, and income is debit card interchange income, net, which totaled $261,000 and $252,000 for the first quarters of 2016 and 2015, respectively.

OTHER EXPENSE
Total other expense increased $121,000 or 2.3% during the first quarter of 2016 compared with the first quarter of 2015. During the first quarter of 2016, FDIC deposit insurance expense and furniture and equipment expense were the largest contributors to the overall increase.

Salaries and employees' benefits increased $10,000 or 0.4% from first quarter 2015 to first quarter 2016.  The increase was primarily due to the annual increases in salaries for the first quarter of 2016 compared with the first quarter of 2015, as well as an increase in active full-time equivalent employees from 144 as of March 31, 2015 to 147 as of March 31, 2016. These were partially offset by a decline in expenses related to performance-based compensation over the same period.  At March 31, 2016, the Bank had approximately 11 full-time equivalent positions to be filled over the remainder of 2016, primarily to meet staffing needs in its retail branch network.
 
Occupancy expense increased $2,000 or 0.3%.  Furniture and equipment expense increased $62,000 or 17.9%, from first quarter 2015 to first quarter 2016 due a quarterly timing difference regarding computer replacement expenditures. Management expects total furniture and equipment expenditures for all of 2016 to be similar to 2015.

Marketing expense increased $16,000 or 13.8% from the first quarter of 2015 to $132,000 for the first quarter of 2016 due to timing differences. Management expects total marketing expenditures for all of 2016 to be similar to 2015.

Legal, auditing and consulting expense increased $10,000 or 3.7% from the first quarter of 2015 to $282,000 for the first quarter of 2016 primarily due to the increase in legal expense associated with the recovery on loans charged-off in 2015.

Data processing expense decreased $17,000 or 5.2% for the first quarter of 2016 compared with the same time period in 2015 due to the new pricing structure the Bank has with its core third-party data processing provider.

FDIC deposit insurance expense increased $72,000 from $94,000 for the first quarter of 2015 to $166,000 for the first quarter of 2016 due to historic qualitative factors, such as the large increase in total 2015 loan charge-offs, used to calculate the FDIC deposit insurance premium expense. 

Other operating expenses decreased $35,000 or 4.2% in the first quarter of 2016 compared with the first quarter of 2015 primarily due to the decline in check card fraud charge-offs. During the first quarter of 2015, the Bank's check card fraud charge-offs were impacted by the data breach of the Home Depot payment data systems during the fourth quarter of 2014.

37

INCOME TAXES
Income tax expense was $61,000 for the quarter ended March 31, 2016 compared with $131,000 for the quarter ended March 31, 2015. The effective tax rate was 9.2% and 15.0% for the first quarter of 2016 and 2015, respectively. The effective tax rate differed from the statutory federal income tax rate of 34% due to the Bank's investment in tax-exempt loans and securities, income from the bank owned life insurance purchases and death benefit, and community development tax credits. The Company utilized tax credits of $121,000 during the first quarter of 2016, compared with $193,000 for the same quarter in the previous year, and projects that it will utilize approximately $300,000 in tax credits over the next three quarters of 2016.

COMPARISON OF FINANCIAL CONDITION AT MARCH 31, 2016 AND DECEMBER 31, 2015
Total assets were $603.9 million at March 31, 2016 compared with $601.4 million at December 31, 2015, an increase of 0.4% or $2.5 million. Balance sheet categories reflecting significant changes include interest-bearing deposits in other banks, securities available for sale, loans, and deposits. Each of these categories is discussed below.

INTEREST-BEARING DEPOSITS IN OTHER BANKS. Interest-bearing deposits in other banks were $50.7 million at March 31, 2016, an increase of $2.7 million from December 31, 2015. The increase in this account is primarily due to the increase in deposits increasing the amount of excess liquidity in the Bank.

SECURITIES AVAILABLE FOR SALE.  Securities available for sale were $53.0 million at March 31, 2016, a decrease of $2.2 million or 3.9 % from December 31, 2015 due to calls and maturities outpacing purchase activity.

LOANS.  Loans, net of allowance for loan losses, were $445.1 million at March 31, 2016, reflecting an increase of $2.4 million from $442.7 million at December 31, 2015.  

DEPOSITS. For the three months ended March 31, 2016, total deposits increased by $1.8 million or 0.3% when compared with total deposits at December 31, 2015. Non-interest-bearing deposits decreased $1.8 million to $95.2 million, while interest-bearing deposits increased by $3.7 million to $431.0 million at March 31, 2016 from December 31, 2015. Included in interest-bearing deposits at March 31, 2016 and December 31, 2015 were $20.4 million and $20.5 million, respectively, of brokered deposits as defined by the Federal Reserve.  Of the $20.4 million in brokered deposits, $12.7 million represent deposits of Bank customers, exchanged through the CDARS' network.  With the CDARS' program, funds are placed into certificate of deposits issued by other banks in the network, in increments of less than $250,000, to ensure both principal and interest are eligible for complete FDIC coverage.  These deposits are exchanged with other member banks on a dollar-for-dollar basis, bringing the full amount of our customers' deposits back to the Bank and making these funds fully available for lending in our community. The decrease in non-interest-bearing deposits and the increase in the Bank's interest-bearing deposits during the first three months of 2016 was the result of many factors difficult to segregate and quantify, and equally difficult to use as factors for future projections. The economy, local competition, retail customer preferences, changes in seasonal cash flows by both commercial and retail customers, changes in business cash management practices by Bank customers, the relative pricing from wholesale funding sources, the in-and-outflow of local government tax receipts, and the Bank's funding needs all contributed to the change in deposit balances. The Bank projects to increase its transaction accounts and other deposits during the remainder of 2016 and beyond by fully leveraging its branch network, as well as by offering value-added interest checking and demand deposit products, and selective rate premiums on its interest-bearing deposits.

ASSET QUALITY
Non-performing assets primarily consist of loans that are 90 days or more past due and for which the accrual of interest has been discontinued. Management evaluates all loans that are 90 days or more past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on non-accrual status. Factors considered by management include the net realizable value of collateral, if any, and other resources of the borrower that may be available to satisfy the delinquency.

Loans are placed on non-accrual status when principal or interest is delinquent for 90 days or more, unless the loans are well secured and in the process of collection. Any unpaid interest previously accrued on such loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other non-accrual loans is recognized only to the extent of interest payments received.

Non-performing assets totaled $3.2 million or 0.54% of total assets at March 31, 2016, compared with $3.2 million or 0.53% of total assets at December 31, 2015, and $3.0 million or 0.50% of total assets at March 31, 2015. Non-performing assets were comprised of $1.4 million of OREO and $1.9 million of non-accrual loans at March 31, 2016. Non-accrual loans as a percentage of total loans were 0.42% at March 31, 2016, as compared with 0.41% and 0.36% at December 31, 2015 and March 31, 2015, respectfully.

38

Student loans that were past due 90 days or more and still accruing interest totaled $2.2 million at March 31, 2016, $2.8 million at December 31, 2015 and $2.7 million at March 31, 2015.  These loans continue to accrue interest when past due because repayment of both principal and accrued interest are 98% guaranteed by the U.S. Department of Education.  There were no other loans that were past due 90 days or more and still accruing interest at March 31, 2016, December 31, 2015 and March 31, 2015.  During the quarter ended March 31, 2016, there were no loans newly identified as TDRs.  At the end of the quarter, 12 TDRs, totaling $7.0 million, were in the loan portfolio.  Eight of the loans, totaling $5.5 million, were on accrual status and performing in accordance with the modified terms. The remaining four loans, totaling $1.6 million, remained in nonaccrual status due to irregular payments.  Appropriate specific reserves have been established.  Restructured loans are included in the specific reserve calculation in the allowance for loan losses and are included in impaired loans.

For additional information regarding non-performing assets and potential loan problems, see "Loans and Allowance for Loan Losses" in Note 3 of the Notes to Consolidated Financial Statements contained herein.

Based on regulatory guidelines, the Bank is required to monitor the commercial investment real estate loan portfolio for: (a) concentrations above 100% of risk-based capital and (b) 300% of risk-based capital for permanent investor commercial real estate loans. As of March 31, 2016, commercial construction and land loans were $39.2 million or 65.9% of the concentration limit. Commercial investor real estate loans, including commercial construction and land loans, were $131.8 million or 221.7% of the concentration guideline.

At March 31, 2016, no concentration of loans and loan commitments to commercial borrowers engaged in similar activities (excluding commercial real estate investment) exceeded 5% of total gross loans. The largest industry concentration of loans and loan commitments at March 31, 2016 was approximately $17.7 million of loans to customers in the childcare industry, or 3.9% of total gross loans.

CONTRACTUAL OBLIGATIONS
As of March 31, 2016, there have been no other material changes outside the ordinary course of business to the contractual obligations disclosed in "Management's Discussion and Analysis and Results of Operations" in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.

OFF-BALANCE SHEET ARRANGEMENTS
As of March 31, 2016, there have been no material changes to the off-balance sheet arrangements disclosed in "Management's Discussion and Analysis and Results of Operations" in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.

CAPITAL

The Company meets the eligibility criteria of a small bank holding company in accordance with the Federal Reserve Board's Small Bank Holding Company Policy Statement issued in February 2015, and is no longer obligated to report consolidated regulatory capital.  The Bank continues to be subject to various capital requirements administered by banking agencies. Failure to meet minimum capital requirements can trigger certain mandatory and discretionary actions by regulators that could have a direct material effect on the Company's 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 their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. In July 2013, the Federal Reserve issued final rules that make technical changes to its capital rules to align them with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules maintain the general structure of the prompt corrective action framework in effect at such time while incorporating certain increased minimum requirements.  Effective January 1, 2015, the final rules require the Bank to comply with the following minimum capital ratios: (i) a new common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets (increased from the prior requirement of 4.0%); (iii) a total capital ratio of 8.0% of risk-weighted assets (unchanged from the prior requirement); and (iv) a leverage ratio of 4.0% of total assets (unchanged from the prior requirement). These are the initial capital requirements, which will be phased in over a four-year period. When fully phased in on January 1, 2019, the rules will require the Bank to maintain such minimum ratios plus a 2.5% "capital conservation buffer" (other than for the leverage ratio). The capital conservation buffer requirement will be phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increasing by the same amount each year until fully implemented at 2.5% on January 1, 2019. Management believes the Bank will be compliant with the fully phased-in requirements when they become effective January 1, 2019.

39

The following table provides information on the regulatory capital ratios for the Bank at March 31, 2016 and December 31, 2015. Management believes that the Bank exceeds all capital adequacy requirements of Basel III, including the conservation buffer, as of March 31, 2016.

Risk Based Capital Ratios
 
   
March 31, 2016
   
December 31, 2015
 
Tier 1 Capital:
           
Common Equity
 
$
55,206
   
$
54,699
 
 
               
Plus: Unrealized loss on securities available for sale, net
   
(12
)
   
(229
)
Plus: Unrealized benefit obligation for supplemental retirement plans
   
(41
)
   
(41
)
Total Tier 1 Capital
   
55,259
     
54,969
 
 
               
Tier 2 Capital:
               
Allowable allowance for loan losses
   
4,376
     
4,193
 
Unrealized loss on equity securities, net
   
4
     
-
 
 
               
Total Capital:
 
$
59,639
   
$
59,162
 
 
               
Risk Weighted Assets:
 
$
474,533
   
$
472,268
 
 
               
Regulatory Capital Ratios:
               
Leverage Ratio
   
9.33
%
   
9.13
%
Common Equity Tier 1 Capital Ratio
   
11.64
%
   
11.64
%
Tier 1 Capital Ratio
   
11.64
%
   
11.64
%
Total Capital Ratio
   
12.57
%
   
12.53
%

CAPITAL RESOURCES AND LIQUIDITY

Shareholders' equity totaled $53.1 million at March 31, 2016 compared with $52.6 million at December 31, 2015 and $55.7 million at March 31, 2015. The amount of equity reflects management's desire to increase shareholders' return on equity while maintaining a strong capital base.  On January 21, 2016, the Company's Board of Directors authorized the Company to repurchase up to 112,336 shares (3% of common stock outstanding on January 1, 2016) beginning January 1, 2016 and continuing until the next Board reset.  No shares were repurchased during the three months ended March 31, 2016. Accumulated other comprehensive income/loss was an unrealized loss, net of tax benefit, of $300,000 at March 31, 2016 compared with an unrealized income, net of tax benefit, of $460,000 at December 31, 2015 and an unrealized income, net of tax benefit, of $37,000 at March 31, 2015.

As discussed in "Junior Subordinated Debt" in Note 4 of the Notes to Consolidated Financial Statements contained herein, during 2006, the Company established a subsidiary trust that issued $4.0 million of capital securities as part of a separate pooled trust preferred security offering with other financial institutions. Under current applicable regulatory guidelines, the capital securities are treated as Tier 1 capital for purposes of the Federal Reserve's capital guidelines for bank holding companies, as long as the capital securities and all other cumulative preferred securities of the Company together do not exceed 25% of Tier 1 capital. As discussed above under "Capital," banking regulations have established minimum capital requirements for financial institutions, including risk-based capital ratios and leverage ratios. As of March 31, 2016, the Bank falls into the "well capitalized" category as defined by the appropriate regulatory authorities.

40

The primary sources of funds are deposits, repayment of loans, maturities of investments, funds provided from operations, federal funds lines of credit with the Federal Reserve and other banks, and advances from the FHLB. While scheduled repayments of loans and maturities of investment securities are predictable sources of funds, deposit flows and loan repayments are greatly influenced by the general level of interest rates, economic conditions and competition. The Bank uses its sources of funds to fund existing and future loan commitments, to fund maturing certificates of deposit and demand deposit withdrawals, to invest in other interest-earning assets, to maintain liquidity, and to meet operating expenses. Management monitors projected liquidity needs and determines the desirable funding level based in part on the Bank's commitments to make loans and management's assessment of the Bank's ability to generate funds. Management is not aware of any market or institutional trends, events or uncertainties that are expected to have a material effect on the liquidity, capital resources or operations of the Company or the Bank. Nor is management aware of any current recommendations by regulatory authorities that would have a material effect on liquidity, capital resources or operations. The Bank's internal sources of such liquidity are deposits, loan and investment repayments, and securities available for sale. The Bank's primary external sources of liquidity are federal funds lines of credit with the Federal Reserve Bank of Richmond and other banks and advances from the FHLB.

Cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold totaled $55.7 million at March 31, 2016 compared with $53.2 million at December 31, 2015. These assets provide a primary source of liquidity for the Bank. In addition, management has designated the entire investment portfolio as available for sale, of which approximately $5.3 million was unpledged and readily salable at March 31, 2016. Furthermore, the Bank has an available line of credit with the FHLB with a borrowing limit of approximately $102.1 million at March 31, 2016 to provide additional sources of liquidity, as well as available federal funds purchased lines of credit with the Federal Reserve and various other commercial banks totaling approximately $59.7 million. At March 31, 2016, $13.0 million of the FHLB line of credit and no federal funds purchased lines of credit were in use.

The following table sets forth information relating to the Company's sources of liquidity and the outstanding commitments for use of liquidity at March 31, 2016 and December 31, 2015. The liquidity coverage ratio is derived by dividing the total sources of liquidity by the outstanding commitments for use of liquidity.

Liquidity Sources and Uses

 
 
March 31, 2016
   
December 31, 2015
 
(Dollars in thousands)
 
Total
   
In Use
   
Available
   
Total
   
In Use
   
Available
 
Sources:
                                   
Federal funds borrowing lines of credit
 
$
59,714
   
$
-
   
$
59,714
   
$
59,842
   
$
-
   
$
59,842
 
Federal Home Loan Bank advances
   
102,072
     
12,989
     
89,083
     
102,172
     
13,007
     
89,165
 
Federal funds sold and interest-bearing deposits in other banks, excluding requirements
                   
31,408
                     
28,112
 
Securities, available for sale and unpledged at fair value
                   
5,308
                     
7,540
 
Total short-term funding sources
                 
$
185,513
                   
$
184,659
 
 
                                               
Uses:
                                               
Unfunded loan commitments and lending lines of credit
                 
$
68,138
                   
$
66,698
 
Letters of credit
                   
2,238
                     
2,516
 
Total potential short-term funding uses
                 
$
70,376
                   
$
69,214
 
 
                                               
Ratio of short-term funding sources to potential short-term funding uses
                   
263.6
%
                   
266.8
%

41

IMPACT OF INFLATION AND CHANGING PRICES

The consolidated financial statements and the accompanying notes presented elsewhere in this document have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of the Company and the Bank are monetary in nature. The impact of inflation is reflected in the increased cost of operations. As a result, interest rates have a greater impact on our performance than inflation does. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

CHANGES IN ACCOUNTING PRINCIPLES

For information regarding recent accounting pronouncements and their effect on the Company, see "Recent Accounting Pronouncements" in Note 1 of the Notes to Consolidated Financial Statements contained herein.

ITEM 3QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

An important component of both earnings performance and liquidity is management of interest rate sensitivity. Interest rate sensitivity reflects the potential effect on net interest income and economic value of equity from a change in market interest rates. The Bank is subject to interest rate sensitivity to the degree that its interest-earning assets mature or reprice at different time intervals than its interest-bearing liabilities. However, the Bank is not subject to the other major categories of market risk such as foreign currency exchange rate risk or commodity price risk. The Bank uses a number of tools to manage its interest rate risk, including simulating net interest income under various scenarios, monitoring the present value change in equity under the same scenarios, and monitoring the difference or gap between rate sensitive assets and rate sensitive liabilities over various time periods. Management believes that rate risk is best measured by simulation modeling.
 
There have been no material changes to the quantitative and qualitative disclosures made in the Company's Annual Report on Form 10-K for the year ended December 31, 2015.

ITEM 4CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to provide assurance that the information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods required by the SEC. An evaluation of the effectiveness of the design and operations of the Company's disclosure controls and procedures at the end of the period covered by this report was carried out under the supervision and with the participation of the management of Fauquier Bankshares, Inc., including the Chief Executive Officer and the Chief Financial Officer. Based on such an evaluation, the Chief Executive Officer and the Chief Financial Officer concluded the Company's disclosure controls and procedures were effective as of the end of such period.

The Company regularly assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations.  There have not been any significant changes in the Company's internal control over financial reporting or in other factors that have materially affected or are reasonably likely to materially affect, such controls during the quarter ended March 31, 2016.

42

Part II.  OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

There are no pending or threatened legal proceedings to which the Company or the Bank is a party or to which the property of either the Company or the Bank is subject to that, in the opinion of management, may materially impact the financial condition of either the Company or the Bank.

ITEM 1A.  RISK FACTORS

Not required for smaller reporting companies.

ITEM 2UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

On January 21, 2016, the Company's Board of Directors authorized the Company to repurchase up to 112,336 shares (3% of common stock outstanding on January 1, 2016) beginning January 1, 2016 and continuing until the next Board reset.  No shares were repurchased during the three month period ended March 31, 2016.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.  MINE SAFETY DISCLOSURES
 
Not applicable.

ITEM 5OTHER INFORMATION

None.

43

Exhibit
Exhibit
Number
Description
 
 
3.1
Articles of Incorporation of Fauquier Bankshares, Inc., as amended, incorporated by reference to Exhibit 3.1 to Form 10-K filed March 15, 2010.
 
 
3.2
By-laws of Fauquier Bankshares, Inc., as amended and restated, incorporated by reference to Exhibit 3.2 to Form 8-K filed February 22, 2016.
 
 
31.1
Certification of CEO pursuant to Rule 13a-14(a).
 
 
31.2
Certification of CFO pursuant to Rule 13a-14(a).
 
 
32.1
Certification of CEO pursuant to 18 U.S.C. Section 1350.
 
 
32.2
Certification of CFO pursuant to 18 U.S.C. Section 1350.
 
 
101.00
The following materials from the Company's Form 10-Q Report for the quarterly period ended March 31, 2016, formatted in XBRL: (1) Consolidated Balance Sheets, (2) Consolidated Statements of Income, (3) Consolidated Statements of Comprehensive Income, (4) Consolidated Statements of Changes in Shareholders' Equity, (5) Consolidated Statements of Cash Flows and (6) the Notes to Consolidated Financial Statements.
 
44

SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
FAUQUIER BANKSHARES, INC.
(Registrant)
 
/s/ Marc J. Bogan
Marc J. Bogan
President & Chief Executive Officer
Dated:  May 13, 2016
 
/s/ Eric P. Graap
Eric P. Graap
Executive Vice President & Chief Financial Officer
Dated:  May 13, 2016
 
45