Report on Consolidated Financial Statements
Contents Page Independent Auditor's Report... 1-2 Consolidated Financial Statements Consolidated Balance Sheets... 3 Consolidated Statements of Income... 4 Consolidated Statements of Comprehensive Income... 5 Consolidated Statements of Changes in Shareholders' Equity... 6 Consolidated Statements of Cash Flows... 7... 9-41
Independent Auditor s Report To the Board of Directors and Shareholders Raleigh, North Carolina Report on the Financial Statements We have audited the accompanying consolidated financial statements of and Subsidiaries, which comprise the consolidated balance sheets as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income, changes in shareholders equity and cash flows for the years then ended and the related notes to the consolidated financial statements (collectively, the financial statements). Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. 5410 Trinity Road, Suite 320, Raleigh, North Carolina 27607 Phone: 919.783.7073 Fax: 919.783.7138 www.elliottdavis.com
Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of and Subsidiaries as of December 31, 2017 and 2016, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Raleigh, North Carolina March 16, 2018
Consolidated Balance Sheets As of December 31, 2017 and 2016 2017 2016 Assets Cash and due from banks $ 2,985,561 $ 2,475,870 Interest-bearing deposits with other institutions 40,961,222 23,356,276 Total cash and cash equivalents 43,946,783 25,832,146 Securities available for sale, at fair value 7,119,026 5,042,937 Loans held for sale 66,706,280 58,923,484 Loans held for investment 378,551,801 170,111,550 Allowance for loan losses (3,426,859) (2,318,256) Net loans held for investment 375,124,942 167,793,296 Premises and equipment, net 11,562,969 6,780,523 Foreclosed assets 0 873,497 Servicing assets 5,236,515 5,569,171 Bank owned life insurance 8,796,110 4,648,301 Accrued interest receivable 1,544,150 1,055,407 Goodwill 7,015,703 0 Core deposit intangible 2,272,498 0 Investment in Windsor Advantage, LLC 6,880,446 0 Other assets 7,928,691 3,639,144 Total assets $ 544,134,113 $ 280,157,906 Liabilities and Shareholders Equity Liabilities Deposits: Noninterest-bearing $ 84,178,186 $ 20,820,351 Interest-bearing 308,555,834 195,999,387 Total deposits 392,734,020 216,819,738 Short term borrowings 72,100,000 30,000,000 Long term borrowings 6,802,570 0 Accrued interest payable 295,705 102,234 Other liabilities 6,622,402 5,281,570 Total liabilities 478,554,697 252,203,542 Shareholders equity Preferred stock, $100.00 par value, 1,000,000 shares authorized, none issued or outstanding at December 31, 2017 and 2016, respectively 0 0 Common stock, voting, $1.00 par value, 9,000,000 shares authorized, 2,622,968 and 1,463,105 shares issued and outstanding at December 31, 2017 and 2016, respectively 2,622,968 1,463,105 Common stock, non-voting, $1.00 par value, 1,000,000 shares authorized, 329,120 and 0 shares issued and outstanding at December 31, 2017 and 2016, respectively 329,120 0 Additional paid-in capital 44,184,289 10,895,786 Retained earnings 18,447,361 15,555,686 Accumulated other comprehensive income (loss) (4,322) 39,787 Total shareholders equity 65,579,416 27,954,364 Total liabilities and shareholders equity $ 544,134,113 $ 280,157,906 See 3
Consolidated Statements of Income As of December 31, 2017 and 2016 2017 2016 Interest income Interest and fees on loans $ 16,945,488 $ 11,895,173 Investment securities & deposits 448,377 208,710 Total interest income 17,393,865 12,103,883 Interest expense Interest on deposits 2,865,260 2,352,680 Interest on borrowed funds 441,355 117,489 Total interest expense 3,306,615 2,470,169 Net interest income 14,087,250 9,633,714 Provision for loan losses 2,176,804 1,318,957 Net interest income after provision for loan losses 11,910,446 8,314,757 Noninterest income Government lending revenue 4,426,265 5,830,593 Mortgage revenue 4,709,188 8,538,767 Service charge revenue 323,583 104,997 Loan servicing rights (332,656) 1,298,080 Income from Windsor Advantage, LLC 1,500,446 0 Loss on sale of securities available-for-sale (7,270) 0 Other noninterest income 906,986 796,632 Total noninterest income 11,526,542 16,569,069 Noninterest expense Compensation 11,341,898 12,291,126 Occupancy and equipment 1,416,632 1,336,682 Loan expenses 1,154,249 1,361,551 Data processing expense 853,667 914,912 Advertising expense 368,728 665,831 Insurance expense 292,292 167,648 Professional fees 1,129,647 2,444,052 Foreclosed asset expense, net (67,394) 234,268 Transaction-related expenses 587,883 297,826 Intangible amortization expense 237,502 0 Other noninterest expense 2,263,296 1,939,171 Total noninterest expense 19,578,400 21,653,067 Income before income taxes 3,858,588 3,230,759 Income tax expense 966,913 1,430,936 Net income $ 2,891,675 $ 1,799,823 Basic earnings per common share $ 1.60 $ 1.31 Diluted earnings per common share $ 1.54 $ 1.24 Weighted average common shares outstanding 1,804,297 1,374,732 Diluted average common shares outstanding 1,880,845 1,448,563 See 4
Consolidated Statements of Comprehensive Income 2017 2016 Net income $ 2,891,675 $ 1,799,823 Other comprehensive loss: Unrealized loss during the period on available for sale securities, net of tax $25,983 and $7,002, respectively (39,719) (16,012) Less: Reclassification adjustment for loss included in net income, net of tax $2,880 and $0, respectively (4,390) 0 Other comprehensive loss (44,109) (16,012) Comprehensive income $ 2,847,566 $ 1,783,811 See 5
Consolidated Statements of Changes in Shareholders Equity 2017 2016 Preferred stock, $100.00 par value Balance, beginning of year $ 0 $ 0 Issuance of preferred stock, par value $100.00 per share 3,291,200 0 Conversion of preferred stock to non-voting common stock (10:1) (3,291,200) 0 Balance, end of year $ 0 $ 0 Common stock, voting, $1.00 par value Balance, beginning of year $ 1,463,105 $ 1,364,948 Stock options exercised 7,272 11,200 Issuance of common stock in connection with secondary offering 454,011 86,957 Issuance of common stock, Sound Banking Company acquisition 698,580 0 Balance, end of year $ 2,622,968 $ 1,463,105 Common stock, non-voting, $1.00 par value Balance, beginning of year $ 0 $ 0 Conversion of preferred stock to non-voting common stock (10:1) 329,120 0 Balance, end of year $ 329,120 $ 0 Additional paid-in capital Balance, beginning of year $ 10,895,786 $ 8,970,213 Stock options exercised 42,658 72,978 Issuance of preferred stock 4,278,560 0 Issuance of common stock in connection with secondary offering, net of issuance costs 8,812,710 1,757,982 Issuance of common stock, Sound Banking Company acquisition 16,209,172 0 Stock-based compensation 153,659 94,613 Conversion of preferred stock, paid in capital 2,962,080 0 Call option for remaining ownership in Windsor Advantage, LLC 829,664 0 Balance, end of year $ 44,184,289 $ 10,895,786 Retained earnings Balance, beginning of year $ 15,555,686 $ 13,755,863 Net income 2,891,675 1,799,823 Balance, end of year $ 18,447,361 $ 15,555,686 Accumulated Other Comprehensive Income (Loss) Balance, beginning of year $ 39,787 $ 55,799 Other comprehensive income (loss), net of tax (44,109) (16,012) Balance, end of year $ (4,322) $ 39,787 Total shareholders equity $ 65,579,416 $ 27,954,364 See 6
Consolidated Statements of Cash Flows 2017 2016 Cash flows from operating activities Net income $ 2,891,675 $ 1,799,823 Adjustments to reconcile net income to net cash from operating activities: Depreciation expense 493,283 459,545 Provision for loan losses 2,176,804 1,318,957 Amortization of premium on securities, net of accretion 40,496 53,938 Amortization of intangible assets 237,502 0 Accretion of acquired loan discount (359,821) 0 Originations of loans held for sale (217,604,284) (576,597,245) Proceeds from sales of loans held for sale 195,030,675 544,943,876 Net gains on sale of loans held for sale (9,133,714) (14,369,360) Income from investment in Windsor Advantage, LLC (1,500,446) 0 Distributions received from investment in Windsor Advantage LLC 1,580,000 0 Net loss (gain) on disposal of property and equipment (106,700) 72,320 Net loss (gain) on sale of foreclosed assets (159,551) 37,537 Net loss on sale of securities available-for-sale 7,270 0 Impairment of foreclosed assets 0 119,924 Stock-based compensation expense 153,659 94,613 Earnings on bank-owned life insurance (169,604) (138,895) Changes in assets and liabilities: Other assets (357,757) 673,688 Other liabilities (1,522,010) 1,338,698 Net cash used in operating activities $ (28,302,523) $ (40,192,581) Cash flows from investing activities Purchases of securities available-for-sale $ (2,803,708) 0 Proceeds from sales of securities available-for-sale 46,753 0 Proceeds from maturities and principal paydowns of securities available-for-sale 811,121 1,258,102 Increase in loans, net (35,420,022) (7,726,152) Increase in FHLB stock (1,779,400) (459,728) Proceeds from sale of foreclosed assets 1,033,048 70,463 Purchases of premises and equipment, net (211,881) (1,375,838) Proceeds from disposal of premises and equipment 179,350 0 Investment in Windsor Advantage, LLC (6,960,000) 0 Net cash received from acquisition 21,420,377 0 Net cash used in investing activities $ (23,684,362) $ (8,233,153) Cash flows from financing activities Net increase in deposits $ 4,312,541 $ 38,883,123 Net increase in short-term borrowings 42,100,000 21,100,000 Net increase in long-term debt 6,802,570 0 Issuance of preferred stock 7,569,760 0 Preferred stock redeemed (7,569,760) 0 Stock option exercises 49,930 84,178 Sale of voting common stock, net of issuance costs 13,545,281 1,844,939 Sale of non-voting common stock, net of issuance costs 3,291,200 0 Net cash provided by financing activities $ 70,101,522 $ 61,912,240 Net change in cash and cash equivalents 18,114,637 13,486,506 Cash and cash equivalents, beginning 25,832,146 12,345,640 Cash and cash equivalents, ending $ 43,946,783 $ 25,832,146 See 7
Consolidated Statements of Cash Flows Supplemental Disclosures of Cash Flow Information Cash paid during the period for interest $ 3,113,144 $ 2,288,473 Cash paid during the period for taxes $ 1,897,567 $ 1,411,774 Supplemental Disclosure of Non-Cash Transactions Transfer of loans held for investment to other real estate owned $ 0 $ 831,822 Transfer of loans from held to sale to held for investment $ 23,924,527 $ 0 Transactions related to acquisition Assets acquired $ 192,155,770 $ 0 Liabilities assumed 174,269,353 0 Net assets $ 17,886,417 $ 0 Goodwill and fair value adjustments $ 7,015,703 $ 0 See 8
Note 1. Summary of Significant Accounting Policies Organization: (individually referred to herein as the Parent Company and together with all of its wholly-owned subsidiaries, collectively referred to as the Company ) is a bank holding company headquartered in Raleigh, North Carolina that provides a wide range of banking services tailored to the particular banking needs of the communities it serves. The Company is principally engaged in the business of attracting deposits from the general public and using those deposits, together with other funding from its lines of credit, to make consumer and commercial loans. The Company s wholly-owned subsidiaries include West Town Bank & Trust, an Illinois state-chartered bank whose banking offices are located in Illinois and North Carolina, and Sound Bank, a North Carolina state-chartered bank acquired by the Company on August 31, 2017 as detailed in Note 2, whose banking offices are located in North Carolina. West Town Bank & Trust also has a wholly owned subsidiary, West Town Insurance Agency, Inc., which offers insurance products. The Company is regulated by federal and state agencies and is subject to periodic examinations by those agencies. The Company s primary deposit products are checking, savings, and time certificate accounts, and its primary lending products are residential mortgage, real estate, commercial, and consumer loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans are expected to be repaid from cash flow from operations of businesses. Additionally, the West Town Bank & Trust engages in mortgage banking activities and, as such, originates and sells one-to-four family residential mortgage loans in multiple states. West Town Bank & Trust also lends in multiple states through its government-guaranteed lending program, which focuses on Small Business Administration ( SBA ) and United States Department of Agriculture ( USDA ) guaranteed loans. There are no significant concentrations of loans to any one industry or customer. However, the customers ability to repay their loans is dependent on the real estate and general economic conditions in the area. Basis of Presentation The accompanying consolidated financial statements includes the accounts and transactions of the Company and all significant intercompany transactions and balances have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in conformity with generally accepted accounting principles ( GAAP ) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. On an ongoing basis, the Company evaluates its estimates, including those relating to the allowance for loan losses, determination of fair value of acquired assets and assumed liabilities, and valuation of goodwill and intangible assets. Reclassifications Certain amounts in the 2016 consolidated financial statements have been reclassified to conform to the 2017 presentation. The reclassifications had no effect on net income or shareholders equity as previously reported. Business Combinations The Company accounts for its acquisitions under FASB ASC Topic 805, Business Combinations, which requires the use of the acquisition method of accounting. This method requires the use of fair values in determining the carrying values of the purchased assets and assumed liabilities, which are recorded at fair value at acquisition date, and identifiable intangible assets are recorded at fair value. Costs directly related to the business combinations are recorded as expenses as they are incurred. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Cash and Cash Equivalents For the purposes of presentation in the statements of cash flows, cash and cash equivalents include cash and due from banks and interest bearing deposits in other banks. 9
Note 1. Summary of Significant Accounting Policies, Continued Investment Securities Securities available for sale are carried at fair value, with unrealized holding gains and losses reported in other comprehensive income, net of tax. Interest income includes amortization of purchase premium or discount. Premiums and discounts on securities are amortized on the level-yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. The Company evaluates securities for other-than-temporary impairment ("OTTI") on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, the Company considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. The Company also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings. Investment in Windsor Advantage, LLC The Company accounts for its investment in Windsor Advantage, LLC using the equity method. See Note 17 for further discussion. Loans Held for Sale Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Gains and losses on sales of loans are based on the difference between the selling price and the carrying value of the related loan sold. Loans Originated Loans Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments. The Company classifies all loans past due when the payment of principal and/or interest based upon contractual terms is greater than 30 days delinquent. When commercial loans are placed on nonaccrual status as described below, a charge-off is recorded, as applicable, to decrease the carrying value of such loans to the estimated fair value of the collateral securing the loan. Consumer loans are placed on nonaccrual status at a specified delinquency date consistent with regulatory guidelines. As such, consumer loans are subject to collateral valuation and charge-off, as applicable, when they are moved to nonaccrual status. The accrual of interest income for commercial loans is discontinued when there is a clear indication that the borrower s cash flow may not be sufficient to meet payments as they become due, while the accrual of interest income for consumer loans is discontinued when loans reach specific delinquency levels. All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned 10
Note 1. Summary of Significant Accounting Policies, Continued Loans, continued to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Acquired Loans Acquired loans are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan losses is not recorded at the acquisition date. Acquired loans are evaluated upon acquisition and classified as either purchased impaired or purchased non-impaired. Purchased credit impaired ( PCI ) loans reflect credit deterioration since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. For purchased impaired loans, expected cash flows at the acquisition date in excess of the fair value of loans are recorded as interest income over the life of the loans using a level yield method if the timing and amount of the future cash flows is reasonably estimable. Subsequent to the acquisition date, increases in cash flows over those expected at the acquisition date are recognized prospectively as interest income. Decreases in expected cash flows after the acquisition date are recognized immediately through the provision for loan losses. For purchased non-impaired loans, the difference between the fair value and unpaid principal balance of the loan at the acquisition date is amortized or accreted to interest income over the economic life of the loans using a method that approximates the interest method. Nonperforming Loans The Company considers a loan impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. All impaired loans are measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price, or at the fair value of the collateral if the loan is collateral dependent. The Company uses several factors in determining if a loan is impaired. Internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payment status and the borrowers' financial data, cash flows, operating income or loss, and other factors. These discounted cash flow analyses incorporate adjustments to future cash flows that reflect management s best estimate based on a combination of historical experience and management judgment. Loans are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than ninety (90) days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than ninety (90) days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance (generally, a minimum of six months) by the borrower in accordance with the contractual terms of interest and principal. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are applied as a reduction to principal outstanding. When future collection of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. 11
Note 1. Summary of Significant Accounting Policies, Continued Loans, continued Restructurings Modifications to a borrower s debt agreement is considered a troubled debt restructuring ( TDR ) if a concession is granted for economic or legal reasons related to a borrower s financial difficulties that otherwise would not be considered. TDRs are undertaken in order to improve the likelihood of recovery on the loan and may take the form of modifications made with the stated interest rate lower than the current market rate for new debt with similar risk, modifications to the terms and conditions of the loan that fall outside of normal underwriting policies and procedures, or a combination of these modifications. Modifications of covered and other acquired loans that are part of a pool accounted for as a single asset are not considered TDRs. TDRs can involve loans remaining on nonaccrual, moving to nonaccrual, or continuing on accruing status, depending on the individual facts and circumstances of the borrower. Allowance for Loan Losses The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations, estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management s judgment, should be charged off. Originated Loans The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan s existing rate or at the fair value of collateral, less estimated selling costs, if repayment is expected solely from the collateral. The general component covers loans that are collectively evaluated for impairment. The general allowance component also includes loans that are not individually identified for impairment evaluation, such as commercial loans as well as those loans that are individually evaluated but are not considered impaired. The general component is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans (including troubled debt restructurings); levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; industry conditions; and effects of changes in credit concentration. 12
Note 1. Summary of Significant Accounting Policies, Continued Allowance for Loan Losses, continued Originated Loans, continued The following portfolio segments have been identified: commercial, real estate and consumer. The following provides a summary of the risks associated with the various segments of the Company s loan portfolio, which are factors management regularly considers when evaluating the adequacy of the allowance: Commercial loans are dependent on the strength of the industries of the related borrowers and the success of their businesses. Commercial loans are advanced for equipment purchases or to provide working capital to meet other financing needs of the business. These loans may be secured by accounts receivable, inventory, equipment or other business assets. Financial information is obtained from the borrower to evaluate the debt service coverage and ability to repay the loans. Commercial real estate loans are dependent on the industries tied to these loans as well as the local commercial real estate market, including available commercial real estate inventories, market demand and time to sell. The loans are secured by the real estate, and appraisals are obtained to support the loan amount. An evaluation of the entities cash flows is performed to evaluate the borrower s ability repay the loan. Residential real estate and home equity loans are affected by the local residential real estate market, the local economy, and movement in interest rates. The Company evaluates the borrower s repayment ability through a review of credit scores and debt to income ratios. Appraisals are obtained to support the loan amount. Consumer loans are dependent on the local economy. Consumer loans are generally secured by consumer assets, but may be unsecured. The Company evaluates the borrower s repayment ability through a review of credit scores and an evaluation of debt to income ratios. Acquired Loans Acquired loans are recorded at their fair value at acquisition date without carryover of the acquiree s previously established Allowance for Loan Losses, as credit discounts are included in the determination of fair value. The fair value of the loans is determined using market participant assumptions in estimating the amount and timing of both principal and interest cash flows expected to be collected on the loans and then applying a market-based discount rate to those cash flows. During evaluation upon acquisition, acquired loans are also classified as either acquired impaired (or PCI ) or acquired performing. Acquired impaired loans reflect credit quality deterioration since origination, as it is probable at acquisition that the Company will not be able to collect all contractually required payments. These PCI loans are accounted for under ASC 310-30, Receivables Loans and Debt Securities Acquired with Deteriorated Credit Quality. The PCI loans are segregated into pools based on loan type and credit risk. Loan type is determined based on collateral type, purpose, and lien position. Credit risk characteristics include risk rating groups, nonaccrual status, and past due status. For valuation purposes, these pools are further disaggregated by maturity, pricing characteristics, and re-payment structure. PCI loans are written down at acquisition to fair value using an estimate of cash flows deemed to be collectible. Accordingly, such loans are no longer classified as nonaccrual even though they may be contractually past due because the Company expects to fully collect the new carrying values of such loans, which is the new cost basis arising from purchase accounting. A loan will be removed from a pool (at its carrying value) only if the loan is sold, foreclosed, or assets are received in full satisfaction of the loan. For purposes of removing the loan from the pool, the carrying value is deemed to equal the amount of principal cash flows received in lieu of the loan balance. This treatment ensures that the percentage yield calculation used to recognize accretable yield on the pool of loans is not affected. 13
Note 1. Summary of Significant Accounting Policies, Continued Allowance for Loan Losses, continued Acquired Loans, continued Semi-annually, management performs a recast of PCI loans based on updated future expected cash flows, which are updated through reassessment of default rates, loss severity, and prepayment speed assumptions. The excess of the cash flows expected to be collected over a pool s carrying value is considered to be the accretable yield and is recognized as interest income over the estimated life of the loan or pool using the effective yield method. The accretable yield may change due to changes in the timing and amounts of expected cash flows; these changes are disclosed in Note 4 Loans and Allowance for Loan Losses. The excess of the undiscounted contractual balances due over the cash flows expected to be collected is considered to be the nonaccretable difference, which represents the estimate of credit losses expected to occur and was considered in determining the fair value of loan at the acquisition date. Any subsequent increases in expected cash flows over those expected at the acquisition date in excess of fair value are adjusted through an increase in the accretable yield on a prospective basis; any decreases in expected cash flows attributable to credit deterioration are recognized by recording a provision for loan losses. The Company s policy is to remove an individual loan from a pool based on comparing the amount received from its resolution with its contractual amount. Any difference between these amounts is absorbed by the nonaccretable difference for the entire pool. This removal method assumes that the amount received from resolution approximates pool performance expectations. The remaining accretable yield balance is unaffected and any material change in remaining effective yield caused by this removal method is addressed by the quarterly cash flow evaluation process for each pool. For loans that are resolved by payment in full, there is no release of the nonaccretable difference for the pool because there is no difference between the amount received at resolution and the contractual amount of the loan. The PCI loans are and will continue to be subject to the Company s internal and external credit review and monitoring. If further credit deterioration is experienced, such deterioration will be measured and the provision for loan losses will be increased. At acquisition, loans with active revolving privileges are excluded from the PCI accounting; however, PCI loans do occasionally draw additional funds from the Company. These advances will increase the recorded investment of the PCI loan and will be accounted for with the other PCI loans. Acquired performing loans are accounted for under ASC 310-20, Receivables Nonrefundable Fees and Other Costs. The difference between the fair value and unpaid principal balance of the loan at acquisition date (premium or discount) is amortized or accreted into interest income over the life of the loans. If the acquired performing loan has revolving privileges, it is accounted for using the straight-line method; otherwise, the effective interest method is used. Restructurings Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses. Servicing Rights When loans are sold with servicing retained, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on market prices for comparable servicing contracts, when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. Under the fair value measurement method, the Company measures servicing rights at fair value at each reporting date and reports changes in fair value of servicing assets in earnings in the period in which the changes occur, and are included with noninterest income on the income statement. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses. 14
Note 1. Summary of Significant Accounting Policies, Continued Servicing Rights, continued Servicing fee income, which is reported in the consolidated statements of income as other income, is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal; or a fixed amount per loan and are recorded as income when earned. Late fees and ancillary fees related to loan servicing are not material. Transfers of Financial Assets Transfers of financial assets are accounted for as sales, when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation and amortization. Land is carried at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the respective assets, which are 40 years for buildings and 3 to 10 years for furniture, fixtures and equipment. Leasehold improvements are amortized over the terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Repairs and maintenance costs are recorded as a component of non-interest expense as incurred. Foreclosed Assets Foreclosed assets are held for sale and are initially recorded at estimated fair value less cost of disposal at the date of foreclosure, establishing a new cost basis. When property is acquired, the excess, if any, of the loan balance over estimated fair value is charged to the allowance for loan losses. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in valuation are included in foreclosed asset expenses as a component of noninterest expense. Federal Home Loan Bank ( FHLB ) Stock West Town Bank & Trust is a member of the FHLB of Chicago and Sound Bank is a member of the FHLB of Atlanta. As members, the Company is are required to own a certain amount of stock based upon the amount of outstanding FHLB borrowings. This stock does not have a readily determinable fair value and is carried at cost. Bank Owned Life Insurance The Company has purchased life insurance policies on certain current and past key employees where the insurance policy benefits and ownership are retained by the employer. These policies are recorded at their cash surrender value. Income from these policies and changes in the net cash surrender value are recorded in non-interest income as earnings on bank-owned life insurance. The cash value accumulation is permanently tax deferred if the policy is held to the insured person s death and certain other conditions are met. Loan Commitments and Related Financial Instruments Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Goodwill and Other Intangible Assets The excess of the cost of an acquisition over the fair value of the net assets acquired consists primarily of goodwill and core deposit intangibles. The core deposit intangible arising from whole bank acquisitions are amortized on an accelerated method over its estimated useful life. The Company reviews long-lived assets and other intangible assets for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, in which case an impairment charge would be recorded. 15
Note 1. Summary of Significant Accounting Policies, Continued Goodwill and Other Intangible Assets, continued Goodwill is not amortized and is tested for impairment at least annually in November, or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. The impairment testing process is conducted by assigning net assets and goodwill to each reporting unit. An initial qualitative evaluation is made to assess the likelihood of impairment and determine whether further quantitative testing to calculate the fair value is necessary. When the qualitative evaluation indicates that impairment is more likely than not, quantitative testing is required whereby the fair value of each reporting unit is calculated and compared to the recorded book value. If the calculated fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired and no further testing is considered necessary. If the carrying value of a reporting unit exceeds its calculated fair value, the impairment test continues by comparing the carrying value of the reporting unit s goodwill to the implied fair value of goodwill. The implied fair value is computed by adjusting all assets and liabilities of the reporting unit to current fair value with the offset adjustment to goodwill. The adjusted goodwill balance is the implied fair value of the goodwill. An impairment charge is recognized if the carrying value of goodwill exceeds the implied fair value of goodwill. Mortgage Banking Derivatives The Company issues rate lock commitments to borrowers on prices quoted by secondary market investors. Derivatives related to these commitments are recorded as either assets or liabilities in the balance sheet and are measured at fair value. Changes in the fair value of the derivatives are reported in earnings or other comprehensive income depending on the purpose for which the derivative is held and whether the derivative qualifies for hedge accounting. The Company does not currently engage in any activities that qualify for hedge accounting. Accordingly, changes in fair value of these derivative instruments are included in noninterest income in the consolidated statements of income. Stock-Based Compensation Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award. Earnings Per Share Basic earnings per common share is computed using the weighted average number of common shares and participating securities outstanding during the reporting period. Diluted earnings per common share is the amount of earnings available to each share of common stock during the reporting period adjusted to include the effect of potentially dilutive common shares. Potentially dilutive common shares are excluded from the computation of dilutive earnings per share in the periods in which the effect would be anti-dilutive. Income Taxes Deferred income taxes are recognized for the tax consequences of temporary differences between financial statement carrying amounts and the tax bases of existing assets and liabilities that will result in taxable or deductible amounts in future years. These temporary differences are multiplied by the enacted income tax rate expected to be in effect when the taxes become payable or receivable. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based on available evidence. Comprehensive Income Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, which are also recognized as separate components of equity. 16
Note 1. Summary of Significant Accounting Policies, Continued Loss Contingencies Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. See Note 12 for further discussion on loss contingencies. Dividend Restriction Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Company to shareholders. There were no dividend restrictions on the Company as of December 31, 2017 and December 31, 2016. Fair Value of Financial Instruments Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 16. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates. Advertising expenses Advertising costs are expensed as incurred. Recent Accounting Pronouncements In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company s revenue is comprised of net interest income and noninterest income. The scope of the guidance explicitly excludes net interest income as well as many other revenues for financial assets and liabilities including loans, leases, securities, and derivatives. Accordingly, the majority of the Company s revenues will not be affected. The Company has performed an assessment of its revenue contracts related to revenue streams that are within the scope of the standard. The Company s accounting policies will not change materially since the principles of revenue recognition from the ASU are largely consistent with existing guidance and current practices applied by our businesses. The Company has not identified material changes to the timing or amount of revenue recognition. Based on the updated guidance, The Company anticipates changes in disclosures associated with the Company s revenues. The Company will provide qualitative disclosures of its performance obligations related to revenue recognition and the Company continues to evaluate disaggregation for significant categories of revenue in the scope of the guidance. In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a full retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements. In January 2016, the FASB amended the Financial Instruments topic of the Accounting Standards Codification to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements. In February 2016, the FASB amended the Leases topic of the Accounting Standards Codification to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. 17