AUBURN NATIONAL BANCORPORATION, INC 10-K

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index Page Report of Independent Registered Public Accounting Firm (PCAOB ID: 149 ) 83 Consolidated Balance Sheets 85 Consolidated Statements of Earnings 86 Consolidated Statements of Comprehensive Income 87 Consolidated Statements of Stockholders’ Equity 88 Consolidated Statements of Cash Flows 89 Notes To Consolidated Financial Statements 90 Table of Contents 83 Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of Auburn National Bancorporation, Inc. and Subsidiary Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Auburn National Bancorporation, Inc. and Subsidiary (the “Company”) as of December 31, 2022 and 2021, the related consolidated statements of earnings, comprehensive income, stockholders’ equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2022 and 2021, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Table of Contents 84 Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Allowance for Loan Losses As described in Note 5 to the Company’s consolidated financial statements, the Company has a gross loan portfolio of $504.5 million and related allowance for loan losses of $5.8 million as of December 31, 2022. As described by the Company in Note 1, the evaluation of the allowance for loan losses is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. The allowance for loan losses is evaluated on a regular basis and is based upon the Company’s review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. We identified the Company’s estimate of the allowance for loan losses as a critical audit matter. The principal considerations for our determination of the allowance for loan losses as a critical audit matter related to the high degree of subjectivity in the Company’s judgments in determining the qualitative factors. Auditing these complex judgments and assumptions by the Company involves especially challenging auditor judgment due to the nature and extent of audit evidence and effort required to address these matters, including the extent of specialized skill or knowledge needed. The primary procedures we performed to address this critical audit matter included the following: ● We evaluated the relevance and the reasonableness of assumptions related to evaluation of the loan portfolio, current economic conditions, and other risk factors used in development of the qualitative factors for collectively evaluated loans. ● We evaluated the reasonableness of assumptions and data used by the Company in developing the qualitative factors by comparing these data points to internally developed and third-party sources, and other audit evidence gathered. /s/ Elliott Davis, LLC We have served as the Company's auditor since 2015. Greenville, South Carolina March 17, 2023 Table of Contents 85 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31 (Dollars in thousands, except share data) 2022 2021 Assets: Cash and due from banks $ 11,608 $ 11,210 Federal funds sold 9,300 77,420 Interest bearing bank deposits 6,346 67,629 Cash and cash equivalents 27,254 156,259 Securities available-for-sale 405,304 421,891 Loans held for sale — 1,376 Loans, net of unearned income 504,458 458,364 Allowance for loan losses ( 5,765 ) ( 4,939 ) Loans, net 498,693 453,425 Premises and equipment, net 46,575 41,724 Bank-owned life insurance 19,952 19,635 Other assets 26,110 10,840 Total assets $ 1,023,888 $ 1,105,150 Liabilities: Deposits: Noninterest-bearing $ 311,371 $ 316,132 Interest-bearing 638,966 678,111 Total deposits 950,337 994,243 Federal funds purchased and securities sold under agreements to repurchase 2,551 3,448 Accrued expenses and other liabilities 2,959 3,733 Total liabilities 955,847 1,001,424 Stockholders' equity: Preferred stock of $ 0.01 par value; authorized 200,000 shares; issued shares - none — — Common stock of $ 0.01 par value; authorized 8,500,000 shares; issued 3,957,135 shares 39 39 Additional paid-in capital 3,797 3,794 Retained earnings 116,600 109,974 Accumulated other comprehensive (loss) income, net ( 40,920 ) 891 Less treasury stock, at cost - 453,683 shares and 436,650 shares at December 31, 2022 and 2021, respectively ( 11,475 ) ( 10,972 ) Total stockholders’ equity 68,041 103,726 Total liabilities and stockholders’ equity $ 1,023,888 $ 1,105,150 See accompanying notes to consolidated financial statements Table of Contents 86 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Earnings Year ended December 31 (Dollars in thousands, except share and per share data) 2022 2021 Interest income: Loans, including fees $ 20,241 $ 20,473 Securities: Taxable 6,576 4,107 Tax-exempt 1,716 1,772 Federal funds sold and interest bearing bank deposits 1,012 155 Total interest income 29,545 26,507 Interest expense: Deposits 2,319 2,500 Short-term borrowings 60 17 Total interest expense 2,379 2,517 Net interest income 27,166 23,990 Provision for loan losses 1,000 ( 600 ) Net interest income after provision for loan losses 26,166 24,590 Noninterest income: Service charges on deposit accounts 598 566 Mortgage lending 650 1,547 Bank-owned life insurance 317 403 Gain on sale of premises and equipment 3,234 — Other 1,695 1,757 Securities gains, net 12 15 Total noninterest income 6,506 4,288 Noninterest expense: Salaries and benefits 12,307 11,710 Employee retention credit ( 1,569 ) — Net occupancy and equipment 2,742 1,743 Professional fees 975 995 FDIC and other regulatory assessments 404 426 Other 4,964 4,559 Total noninterest expense 19,823 19,433 Earnings before income taxes 12,849 9,445 Income tax expense 2,503 1,406 Net earnings $ 10,346 $ 8,039 Net earnings per share: Basic and diluted $ 2.95 $ 2.27 Weighted average shares outstanding: Basic and diluted 3,510,869 3,545,310 See accompanying notes to consolidated financial statements Table of Contents 87 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income Year ended December 31 (Dollars in thousands) 2022 2021 Net earnings $ 10,346 $ 8,039 Other comprehensive loss, net of tax: Unrealized net holding loss on securities ( 41,802 ) ( 6,697 ) Reclassification adjustment for net gain on securities recognized in net earnings ( 9 ) ( 11 ) Other comprehensive loss ( 41,811 ) ( 6,708 ) Comprehensive (loss) income $ ( 31,465 ) $ 1,331 See accompanying notes to consolidated financial statements Table of Contents 88 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders’ Equity Accumulated Common Additional other Shares Common paid-in Retained comprehensive Treasury (Dollars in thousands, except share data) Outstanding Stock capital earnings (loss) income stock Total Balance, December 31, 2020 3,566,276 $ 39 3,789 105,617 7,599 ( 9,354 ) $ 107,690 Net earnings — — — 8,039 — — $ 8,039 Other comprehensive loss — — — — ( 6,708 ) — ( 6,708 ) Cash dividends paid ($ 1.04 per share) — — — ( 3,682 ) — — ( 3,682 ) Stock repurchases ( 45,946 ) — — — — ( 1,619 ) ( 1,619 ) Sale of treasury stock 155 — 5 — — 1 6 Balance, December 31, 2021 3,520,485 $ 39 $ 3,794 $ 109,974 $ 891 $ ( 10,972 ) $ 103,726 Net earnings — — — 10,346 — — 10,346 Other comprehensive loss — — — — ( 41,811 ) — ( 41,811 ) Cash dividends paid ($ 1.06 per share) — — — ( 3,720 ) — — ( 3,720 ) Stock repurchases ( 17,183 ) — — — — ( 504 ) ( 504 ) Sale of treasury stock 150 — 3 — — 1 4 Balance, December 31, 2022 3,503,452 $ 39 $ 3,797 $ 116,600 $ ( 40,920 ) $ ( 11,475 ) $ 68,041 See accompanying notes to consolidated financial statements Table of Contents 89 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Year ended December 31 (In thousands) 2022 2021 Cash flows from operating activities: Net earnings $ 10,346 $ 8,039 Adjustments to reconcile net earnings to net cash provided by operating activities: Provision for loan losses 1,000 ( 600 ) Depreciation and amortization 1,528 1,244 Premium amortization and discount accretion, net 3,091 3,979 Deferred tax expense 686 278 Net gain on securities available for sale ( 12 ) ( 15 ) Net gain on sale of loans held for sale ( 309 ) ( 1,417 ) Net gain on other real estate owned ( 162 ) — Loans originated for sale ( 8,850 ) ( 47,937 ) Proceeds from sale of loans 10,424 50,901 Net gain on disposition of premises and equipment (3,234) — Increase in cash surrender value of bank owned life insurance ( 317 ) ( 403 ) Net (increase) decrease in other assets ( 2,441 ) 1,235 Net decrease in accrued expenses and other liabilities ( 770 ) ( 2,984 ) Net cash provided by operating activities $ 10,980 $ 12,320 Cash flows from investing activities: Proceeds from sales of securities available-for-sale 4,860 — Proceeds from maturities, paydowns and calls of securities available-for-sale 45,921 73,607 Purchase of securities available-for-sale ( 93,106 ) ( 173,243 ) (Increase) decrease in loans, net ( 46,268 ) 2,883 Net purchases of premises and equipment ( 7,049 ) ( 20,175 ) (Increase) decrease in FHLB stock ( 74 ) 267 Purchase of New Markets Tax Credit investment — ( 2,181 ) Proceeds from sale of premises and equipment 4,222 — Proceeds from sale of other real estate owned 536 — Net cash used in investing activities $ ( 90,958 ) $ ( 118,842 ) Cash flows from financing activities: Net (decrease)increase in noninterest-bearing deposits ( 4,761 ) 70,734 Net (decrease) increase in interest-bearing deposits ( 39,145 ) 83,717 Net (decrease) increase in federal funds purchased and securities sold under agreements to repurchase ( 897 ) 1,056 Stock repurchases ( 504 ) ( 1,619 ) Dividends paid ( 3,720 ) ( 3,682 ) Net cash (used in) provided by financing activities $ ( 49,027 ) $ 150,206 Net change in cash and cash equivalents $ ( 129,005 ) $ 43,684 Cash and cash equivalents at beginning of period 156,259 112,575 Cash and cash equivalents at end of period $ 27,254 $ 156,259 Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 2,341 $ 2,560 Income taxes 1,351 2,760 Supplemental disclosure of non-cash transactions: Real estate acquired through foreclosure — 374 See accompanying notes to consolidated financial statements Table of Contents 90 AUBURN NATIONAL BANCORPORATION, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business Auburn National Bancorporation, Inc. (the “Company”) is a bank holding company whose primary business is conducted by its wholly-owned subsidiary, AuburnBank (the “Bank”). AuburnBank is a commercial bank located in Auburn, Alabama. The Bank provides a full range of banking services in its primary market area, Lee County, which includes the Auburn-Opelika Metropolitan Statistical Area. Basis of Presentation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Significant intercompany transactions and accounts are eliminated in consolidation. Revenue Recognition On January 1, 2018, the Company implemented ASU 2014-09, Revenue from Contracts with Customers , codified at ASC 606. The Company adopted ASC 606 using the modified retrospective transition method. The majority of the Company’s revenue stream is generated from interest income on loans and deposits which are outside the scope of ASC 606. The Company’s sources of income that fall within the scope of ASC 606 include service charges on deposits, investment services, interchange fees and gains and losses on sales of other real estate, all of which are presented as components of noninterest income. The following is a summary of the revenue streams that fall within the scope of ASC 606: Service charges on deposits, investment services, ATM and interchange fees – Fees from these services are either transaction-based, for which the performance obligations are satisfied when the individual transaction is processed, or set periodic service charges, for which the performance obligations are satisfied over the period the service is provided. Transaction-based fees are recognized at the time the transaction is processed, and periodic service charges are recognized over the service period. Gains on sales of other real estate – A gain on sale should be recognized when a contract for sale exists and control of the asset has been transferred to the buyer. ASC 606 lists several criteria required to conclude that a contract for sale exists, including a determination that the institution will collect substantially all of the consideration to which it is entitled. In addition to the loan-to-value, the analysis is based on various other factors, including the credit quality of the borrower, the structure of the loan, and any other factors that may affect collectability. Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the balance sheet date and the reported amounts of income and expense during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses, fair value measurements, valuation of other real estate owned, and valuation of deferred tax assets. Change in Accounting Estimate During the fourth quarter of 2019, the Company reassessed its estimate of the useful lives of certain fixed assets. The Company revised its original useful life estimate for certain land improvements, buildings and improvements and furniture, fixtures and equipment, with a carrying value of $ 0.5 million at December 31, 2019, to correspond with estimated demolition dates planned as part of the redevelopment project for its main campus. This is considered a change in accounting estimate, per ASC 250-10, where adjustments should be made prospectively. The effects of this change in accounting estimate for the year ended December 31, 2021 was a decrease in net earnings of $ 29 thousand, or $ 0.01 per share. Table of Contents 91 Reclassifications Certain amounts reported in the prior period have been reclassified to conform to the current -period presentation. These reclassifications had no impact on the Company’s previously reported net earnings or total stockholders’ equity. Subsequent Events The Company has evaluated the effects of events or transactions through the date of this filing that have occurred subsequent to December 31, 2022. The Company does not believe there are any material subsequent events that would require further recognition or disclosure. Accounting Standards Adopted in 2022 In 2022, the Company did not adopt any new accounting guidance. Issued not yet effective accounting standards The following ASUs have been issued by the FASB but are not yet effective. ● ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments; and ● ASU 2022-02, Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures. Information about these pronouncements are described in more detail below. ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , amends guidance on reporting credit losses for assets held at amortized cost basis and available for sale debt securities. For assets held at amortized cost basis, the new standard eliminates the probable initial recognition threshold incurrent GAAP and, instead, requires an entity to reflect its current estimate of all expected credit losses using a broader range of information regarding past events, current conditions and forecasts assessing the collectability of cash flows. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. For available for sale debt securities, credit losses should be measured in a manner similar to current GAAP, however the new standard will require that credit losses be presented as an allowance rather than as a write-down. The new guidance affects entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. The amendments affect loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash. For public business entities, the new guidance was originally effective for annual and interim periods in fiscal years beginning after December 15, 2019. On October 16, 2019, the FASB approved a previously issued proposal granting smaller reporting companies a postponement of the required implementation date for ASU 2016-13. This standard became effective for the Company on January 1, 2023. The Company adopted ASU 2016-13 in the first quarter of 2023 and will apply the standard’s provisions as a cumulative- effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. The Company is finalizing implementation efforts through its implementation team. The team has worked with an advisory consultant and has finalized and documented the methodologies that will be utilized. The team is currently finalizing controls, processes, policies and disclosures and has completed full end-to-end parallel runs. Based on the Company’s portfolio composition as of December 31, 2022, and current expectations of future economic conditions, the reserve for credit losses is expected to increase from 1.14 % as a percentage of total loans at December 31, 2022 to a range between 1.32 % and 1.36 % of total loans upon adoption of this standard, primarily resulting from the impact of adjusting from the incurred loss model to the expected loss model, which provides for expected credit losses over the life of the loan portfolio. The Company does not expect to record an allowance for available-for-sale securities as the investment portfolio consists primarily of debt securities explicitly or implicitly backed by the U.S. Government for which credit risk is deemed minimal. The impact of ASU 2016-13 is not expected to have a material impact on the allowance for unfunded commitments. The Company continues to finalize its day-one adjustment and will record the after-tax impact as a cumulative-effect adjustment to retained earnings as of January 1, 2023. This estimate is subject to change as key assumptions are refined. The impact going forward will depend on the composition, characteristics, and credit quality of the loan and securities portfolios as well as the economic conditions at future reporting periods. Table of Contents 92 ASU 2022-02 Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures , eliminates the accounting guidance for troubled debt restructurings (“TDRs”), while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2022. The new standard is not expected to have a material impact on the Company’s consolidated financial statements. Cash Equivalents Cash equivalents include cash on hand, cash items in process of collection, amounts due from banks, including interest bearing deposits with other banks, and federal funds sold. Securities Securities are classified based on management’s intention at the date of purchase. At December 31, 2022, all of the Company’s securities were classified as available-for-sale. Securities available-for-sale are used as part of the Company’s interest rate risk management strategy, and they may be sold in response to changes in interest rates, changes in prepayment risks or other factors. All securities classified as available-for-sale are recorded at fair value with any unrealized gains and losses reported in accumulated other comprehensive income (loss), net of the deferred income tax effects. Interest and dividends on securities, including the amortization of premiums and accretion of discounts are recognized in interest income using the effective interest method. Premiums are amortized to the earliest call date while discounts are accreted over the estimated life of the security. Realized gains and losses from the sale of securities are determined using the specific identification method. On a quarterly basis, management makes an assessment to determine whether there have been events or economic circumstances to indicate that a security on which there is an unrealized loss is other-than-tempor arily impaired. For debt securities with an unrealized loss, an other-than-temporary impairment write-down is triggered when (1) the Company has the intent to sell a debt security, (2) it is more likely than not that the Company will be required to sell the debt security before recovery of its amortized cost basis, or (3) the Company does not expect to recover the entire amortized cost basis of the debt security. If the Company has the intent to sell a debt security or if it is more likely than not that it will be required to sell the debt security before recovery, the other-than-temporary write-down is equal to the entire difference between the debt security’s amortized cost and its fair value. If the Company does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the other-than-temporary impairment write- down is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings, as a realized loss in securities gains (losses), and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes. Loans held for sale Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate. Loan sales are recognized when the transaction closes, the proceeds are collected, and ownership is transferred. Continuing involvement, through the sales agreement, consists of the right to service the loan for a fee for the life of the loan, if applicable. Gains on the sale of loans held for sale are recorded net of related costs, such as commissions, and reflected as a component of mortgage lending income in the consolidated statements of earnings. In the course of conducting the Bank’s mortgage lending activities of originating mortgage loans and selling those loans in the secondary market, the Bank makes various representations and warranties to the purchaser of the mortgage loans. Every loan closed by the Bank’s mortgage center is run through a government agency automated underwriting system. Any exceptions noted during this process are remedied prior to sale. These representations and warranties also apply to underwriting the real estate appraisal opinion of value for the collateral securing these loans. Failure by the Company to comply with the underwriting and/or appraisal standards could result in the Company being required to repurchase the mortgage loan or to reimburse the investor for losses incurred (make whole requests) if such failure cannot be cured by the Company within the specified period following discovery. Table of Contents 93 Loans Loans are reported at their outstanding principal balances, net of any unearned income, charge-offs, and any deferred fees or costs on originated loans. Interest income is accrued based on the principal balance outstanding. Loan origination fees, net of certain loan origination costs, are deferred and recognized in interest income over the contractual life of the loan using the effective interest method. Loan commitment fees are generally deferred and amortized on a straight-line basis over the commitment period, which results in a recorded amount that approximates fair value. The accrual of interest on loans is discontinued when there is a significant deterioration in the financial condition of the borrower and full repayment of principal and interest is not expected or the principal or interest is more than 90 days past due, unless the loan is both well-collateralized and in the process of collection. Generally, all interest accrued but not collected for loans that are placed on nonaccrual status is reversed against current interest income. Interest collections on nonaccrual loans are generally applied as principal reductions. The Company determines past due or delinquency status of a loan based on contractual payment terms. A loan is considered impaired when it is probable the Company will be unable to collect all principal and interest payments due according to the contractual terms of the loan agreement. Individually identified impaired loans are measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. If the recorded investment in the impaired loan exceeds the measure of fair value, a valuation allowance may be established as part of the allowance for loan losses. Changes to the valuation allowance are recorded as a component of the provision for loan losses. Impaired loans also include troubled debt restructurings (“TDRs”). In the normal course of business, management may grant concessions to borrowers who are experiencing financial difficulty. The concessions granted most frequently for TDRs involve reductions or delays in required payments of principal and interest for a specified time, the rescheduling of payments in accordance with a bankruptcy plan or the charge-off of a portion of the loan. In most cases, the conditions of the credit also warrant nonaccrual status, even after the restructuring occurs. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructuring. TDR loans may be returned to accrual status if there has been at least a six-month sustained period of repayment performance by the borrower. The Company offered short-term loan modifications to assist borrowers during the COVID-19 pandemic. If the modification meets certain conditions, the modification does not need to be accounted for as a TDR. For more information, please refer to Note 5, Loans and Allowance for Loan Losses. Allowance for Loan Losses The allowance for loan losses is maintained at a level that management believes is adequate to absorb probable losses inherent in the loan portfolio. Loan losses are charged against the allowance when they are known. Subsequent recoveries are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, growth, composition of the loan portfolio, homogeneous pools of loans, risk ratings of specific loans, historical loan loss factors, identified impaired loans and other factors related to the portfolio. This evaluation is performed quarterly and is inherently subjective, as it requires various material estimates that are susceptible to significant change, including the amounts and timing of future cash flows expected to be received on any impaired loans. In addition, regulatory agencies, as an integral part of their examination process, will periodically review the Company’s allowance for loan losses, and may require the Company to record additions to the allowance based on their judgment about information available to them at the time of their examinations. Premises and Equipment Land is carried at cost. Land improvements, buildings and improvements, and furniture, fixtures, and equipment are carried at cost, less accumulated depreciation computed on a straight-line method over the useful lives of the assets or the expected terms of the leases, if shorter. Expected terms include lease option periods to the extent that the exercise of such options is reasonably assured. Table of Contents 94 Nonmarketable equity investments Nonmarketable equity investments include equity securities that are not publicly traded and securities acquired for various purposes. The Bank is required to maintain certain minimum levels of equity investments with certain regulatory and other entities in which the Bank has an ongoing business relationship based on the Bank’s common stock and surplus (with regard to the relationship with the Federal Reserve Bank) or outstanding borrowings (with regard to the relationship with the Federal Home Loan Bank of Atlanta). These nonmarketable equity securities are accounted for at cost which equals par or redemption value. These securities do not have a readily determinable fair value as their ownership is restricted and there is no market for these securities. These securities can only be redeemed or sold at their par value and only to the respective issuing government supported institution or to another member institution. The Company records these nonmarketable equity securities as a component of other assets, which are periodically evaluated for impairment. Management considers these nonmarketable equity securities to be long-term investments. Accordingly, when evaluating these securities for impairment, management considers the ultimate recoverability of the par value rather than by recognizing temporary declines in value. Mortgage Servicing Rights The Company recognizes as assets the rights to service mortgage loans for others, known as MSRs. The Company determines the fair value of MSRs at the date the loan is transferred. An estimate of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of MSRs is analyzed monthly and is adjusted to reflect changes in prepayment speeds, as well as other factors. MSRs are evaluated for impairment based on the fair value of those assets. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established through a charge to earnings. The valuation allowance is adjusted as the fair value changes. MSRs are included in the other assets category in the accompanying consolidated balance sheets. Transfers of Financial Assets Transfers of an entire financial asset (i.e. loan sales), a group of entire financial assets, or a participating interest in an entire financial asset (i.e. loan participations sold) are accounted for as sales when control over the assets have been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Subsequent to the date of transfer, the Company has elected to measure its retained rights to service the sold mortgage loans, or MSRs, under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income. The amortization of MSRs is analyzed monthly and is adjusted to reflect changes in prepayment speeds, as well as other factors. MSRs are evaluated for impairment based on the fair value of those assets. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established through a charge to earnings. The valuation allowance is adjusted as the fair value changes. MSRs are included in the other assets category in the accompanying consolidated balance sheets. Securities sold under agreements to repurchase Securities sold under agreements to repurchase generally mature less than one year from the transaction date. Securities sold under agreements to repurchase are reflected as a secured borrowing in the accompanying consolidated balance sheets at the amount of cash received in connection with each transaction. Table of Contents 95 Income Taxes Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The net deferred tax asset is reflected as a component of other assets in the accompanying consolidated balance sheets. Income tax expense or benefit for the year is allocated among continuing operations and other comprehensive income (loss), as applicable. The amount allocated to continuing operations is the income tax effect of the pretax income or loss from continuing operations that occurred during the year, plus or minus income tax effects of (1) changes in certain circumstances that cause a change in judgment about the realization of deferred tax assets in future years, (2) changes in income tax laws or rates, and (3) changes in income tax status, subject to certain exceptions. The amount allocated to other comprehensive income (loss) is related solely to changes in the valuation allowance on items that are normally accounted for in other comprehensive income (loss) such as unrealized gains or losses on available-for -sale securities. In accordance with ASC 740, Income Taxes , a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. The Company and its wholly-owned subsidiaries file a consolidated income tax return . Fair Value Measurements ASC 820, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in U.S. generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 applies only to fair-value measurements that are already required or permitted by other accounting standards. The definition of fair value focuses on the exit price, i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not the entry price, i.e., the price that would be paid to acquire the asset or received to assume the liability at the measurement date. The statement emphasizes that fair value is a market-based measurement; not an entity-specific measurement. Therefore, the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. For more information related to fair value measurements, please refer to Note 14, Fair Value. NOTE 2: BASIC AND DILUTED NET EARNINGS PER SHARE Basic net earnings per share is computed by dividing net earnings by the weighted average common shares outstanding for the year. Diluted net earnings per share reflect the potential dilution that could occur upon exercise of securities or other rights for, or convertible into, shares of the Company’s common stock. As of December 31, 2022 and 2021, respectively, the Company had no such securities or other rights issued or outstanding, and therefore, no dilutive effect to consider for the diluted net earnings per share calculation. The basic and diluted net earnings per share computations for the respective years are presented below. Year ended December 31 (Dollars in thousands, except share and per share data) 2022 2021 Basic and diluted: Net earnings $ 10,346 $ 8,039 Weighted average common shares outstanding 3,510,869 3,545,310 Net earnings per share $ 2.95 $ 2.27 NOTE 3: VARIABLE INTEREST ENTITIES Generally, a variable interest entity (“VIE”) is a corporation, partnership, trust or other legal structure that does not have equity investors with substantive or proportional voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. Table of Contents 96 At December 31, 2022, the Company did not have any consolidated VIEs to disclose but did have one nonconsolidated VIE, discussed below. New Markets Tax Credit Investment The New Markets Tax Credit (“NMTC”) program provides federal tax incentives to investors to make investments in distressed communities and promotes economic improvement through the development of successful businesses in these communities. The NMTC is available to investors over seven years and is subject to recapture if certain events occur during such period. The Company had one investment with a balance of $2.1 million and $2.2 million at December 31, 2022 and 2021, respectively, and is included in other assets in the consolidated balance sheets. The Company’s equity investment meets the definition of a VIE. While the Company’s investment exceeds 50% of the outstanding equity interests, the Company does not consolidate the VIE because it does not meet the characteristics of a primary beneficiary since the Company lacks the power to direct the activities of the VIE. (Dollars in thousands) Maximum Loss Exposure Asset Recognized Classification Type: New Markets Tax Credit investment $ 2,110 $ 2,110 Other assets NOTE 4: SECURITIES At December 31, 2022 and 2021, respectively, all securities within the scope of ASC 320, Investments – Debt and Equity Securities were classified as available-for-sale. The fair value and amortized cost for securities available-for-sale by contractual maturity at December 31, 2022 and 2021, respectively, are presented below. 1 year 1 to 5 5 to 10 After 10 Fair Gross Unrealized Amortized (Dollars in thousands) or less years years years Value Gains Losses Cost December 31, 2022 Agency obligations (a) $ 4,935 50,746 69,936 — 125,617 — 15,826 $ 141,443 Agency MBS (a) — 7,130 27,153 183,877 218,160 — 33,146 251,306 State and political subdivisions 300 642 15,130 45,455 61,527 11 5,681 67,197 Total available-for-sale $ 5,235 58,518 112,219 229,332 405,304 11 54,653 $ 459,946 December 31, 2021 Agency obligations (a) $ 5,007 49,604 69,802 — 124,413 1,080 2,079 $ 125,412 Agency MBS (a) — 680 35,855 186,836 223,371 1,527 2,680 224,524 State and political subdivisions 170 647 15,743 57,547 74,107 3,611 270 70,766 Total available-for-sale $ 5,177 50,931 121,400 244,383 421,891 6,218 5,029 $ 420,702 (a) Includes securities issued by U.S. government agencies or government sponsored entities. Expected lives of these securities may differ from contractual maturities because issues may have the right to call or repay obligations with or without prepayment penalties. Securities with aggregate fair values of $ 208.3 million and $ 172.3 million at December 31, 2022 and 2021, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, FHLB advances, and for other purposes required or permitted by law. Included in other assets on the accompanying consolidated balance sheets are nonmarketable equity investments. The carrying amounts of nonmarketable equity investments were $ 1.2 million at December 31, 2022 and 2021, respectively. Nonmarketable equity investments include FHLB stock, Federal Reserve Bank stock, and stock in a privately held financial institution. Table of Contents 97 Gross Unrealized Losses and Fair Value The fair values and gross unrealized losses on securities at December 31, 2022 and 2021, respectively, segregated by those securities that have been in an unrealized loss position for less than 12 months and 12 months or more are presented below. Less than 12 Months 12 Months or Longer Total Fair Unrealized Fair Unrealized Fair Unrealized (Dollars in thousands) Value Losses Value Losses Value Losses December 31, 2022: Agency obligations $ 55,931 4,161 69,687 11,665 125,618 $ 15,826 Agency MBS 70,293 5,842 147,867 27,304 218,160 33,146 State and political subdivisions 44,777 2,176 13,043 3,505 57,820 5,681 Total $ 171,001 12,179 230,597 42,474 401,598 $ 54,653 December 31, 2021: Agency obligations $ 49,799 1,025 26,412 1,054 76,211 $ 2,079 Agency MBS 130,110 1,555 38,611 1,125 168,721 2,680 State and political subdivisions 7,960 109 3,114 161 11,074 270 Total $ 187,869 2,689 68,137 2,340 256,006 $ 5,029 For the securities in the previous table, the Company does not have the intent to sell and has determined it is not more likely than not that the Company will be required to sell the security before recovery of the amortized cost basis, which may be maturity. On a quarterly basis, the Company assesses each security for credit impairment. For debt securities, the Company evaluates, where necessary, whether credit impairment exists by comparing the present value of the expected cash flows to the securities’ amortized cost basis. In determining whether a loss is temporary, the Company considers all relevant information including: ● the length of time and the extent to which the fair value has been less than the amortized cost basis; ● adverse conditions specifically related to the security, an industry, or a geographic area (for example, changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, in the financial condition of the underlying loan obligors, including changes in technology or the discontinuance of a segment of the business that may affect the future earnings potential of the issuer or underlying loan obligors of the security or changes in the quality of the credit enhancement); ● the historical and implied volatility of the fair value of the security; ● the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future; ● failure of the issuer of the security to make scheduled interest or principal payments; ● any changes to the rating of the security by a rating agency; and ● recoveries or additional declines in fair value subsequent to the balance sheet date. Agency obligations The unrealized losses associated with agency obligations were primarily driven by changes in market interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government- sponsored entities and did not have any credit losses given the explicit government guarantee or other government support. Agency mortgage-backed securities (“MBS”) The unrealized losses associated with agency MBS were primarily driven by changes in market interest rates and not due to the credit quality of the securities. These securities were issued by U.S. government agencies or government-sponsored entities and did not have any credit losses given the explicit government guarantee or other government support. Table of Contents 98 Securities of U.S. states and political subdivisions The unrealized losses associated with securities of U.S. states and political subdivisions were primarily driven by changes in market interest rates and were not due to the credit quality of the securities. Some of these securities are guaranteed by a bond insurer, but management did not rely on the guarantee in making its investment decision. These securities will continue to be monitored as part of the Company’s quarterly impairment analysis, but are expected to perform even if the rating agencies reduce the credit rating of the bond insurers. As a result, the Company expects to recover the entire amortized cost basis of these securities. The carrying values of the Company’s investment securities could decline in the future if the financial condition of an issuer deteriorates and the Company determines it is probable that it will not recover the entire amortized cost basis for the security. As a result, there is a risk that other-than-temporary impairment charges may occur in the future. Other-Than-Temporarily Impaired Securities Credit-impaired debt securities are debt securities where the Company has written down the amortized cost basis of a security for other-than-temporary impairment and the credit component of the loss is recognized in earnings. At December 31, 2022 and 2021, respectively, the Company had no credit-impaired debt securities and there were no additions or reductions in the credit loss component of credit-impaired debt securities during the years ended December 31, 2022 and 2021, respectively. Realized Gains and Losses The following table presents the gross realized gains and losses on sales related to securities. Year ended December 31 (Dollars in thousands) 2022 2021 Gross realized gains $ 48 15 Gross realized losses ( 36 ) — Realized gains, net $ 12 15 NOTE 5: LOANS AND ALLOWANCE FOR LOAN LOSSES December 31 (In thousands) 2022 2021 Commercial and industrial $ 66,179 $ 83,977 Construction and land development 66,479 32,432 Commercial real estate: Owner occupied 61,265 63,375 Hotel/motel 33,457 43,856 Multifamily 41,181 42,587 Other 129,278 108,553 Total commercial real estate 265,181 258,371 Residential real estate: Consumer mortgage 45,410 29,781 Investment property 52,325 47,880 Total residential real estate 97,735 77,661 Consumer installment 9,546 6,682 Total loans 505,120 459,123 Less: unearned income ( 662 ) ( 759 ) Loans, net of unearned income $ 504,458 $ 458,364 Loans secured by real estate were approximately 85.0 % of the total loan portfolio at December 31, 2022. At December 31, 2022, the Company’s geographic loan distribution was concentrated primarily in Lee County, Alabama and surrounding areas. Table of Contents 99 In accordance with ASC 310, Receivables , a portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for loan losses. As part of the Company’s quarterly assessment of the allowance, the loan portfolio is disaggregated into the following portfolio segments: commercial and industrial, construction and land development, commercial real estate, residential real estate and consumer installment. Where appropriate, the Company’s loan portfolio segments are further disaggregated into classes. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity’s method for monitoring and determining credit risk. The following describe the risk characteristics relevant to each of the portfolio segments and classes. Commercial and industrial (“C&I”) — includes loans to finance business operations, equipment purchases, or other needs for small and medium-sized commercial customers. Also included in this category are loans to finance agricultural production. Generally, the primary source of repayment is the cash flow from business operations and activities of the borrower. We were a participating lender in the PPP. PPP loans are forgivable in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP. As of December 31, 2022, the Company had one PPP loan with an aggregate outstanding principal balance of $ 0.1 million included in this category. The Company had 138 PPP loans with an aggregate outstanding principal balance of $ 8.1 million included in this category at December 31, 2021. Construction and land development (“C&D”) — includes both loans and credit lines for the purpose of purchasing, carrying and developing land into commercial developments or residential subdivisions. Also included are loans and lines for construction of residential, multi-family and commercial buildings. Generally the primary source of repayment is dependent upon the sale or refinance of the real estate collateral. Commercial real estate (“CRE”) — includes loans disaggregated into three classes: (1) owner occupied (2) multi-family and (3) other. Owner occupied – includes loans secured by business facilities to finance business operations, equipment and owner-occupied facilities primarily for small and medium-sized commercial customers. Generally the primary source of repayment is the cash flow from business operations and activities of the borrower, who owns the property. Hotel/motel – includes loans for hotels and motels. Generally, the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates, as well as the financial health of the borrower. Multifamily – primarily includes loans to finance income-producing multi-family properties. Loans in this class include loans for 5 or more unit residential property and apartments leased to residents. Generally, the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates, as well as the financial health of the borrower. Other – primarily includes loans to finance income-producing commercial properties. Loans in this class include loans for neighborhood retail centers, hotels, medical and professional offices, sing le retail stores, industrial buildings, and warehouses leased generally to local businesses and residents. Generally, the primary source of repayment is dependent upon income generated from the real estate collateral. The underwriting of these loans takes into consideration the occupancy and rental rates as well as the financial health of the borrower. Residential real estate (“RRE”) — includes loans disaggregated into two classes: (1) consumer mortgage and (2) investment property. Consumer mortgage – primarily includes first or second lien mortgages and home equity lines to consumers that are secured by a primary residence or second home. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history and property value. Investment property – primarily includes loans to finance income-producing 1-4 family residential properties. Generally, the primary source of repayment is dependent upon income generated from leasing the property securing the loan. The underwriting of these loans takes into consideration the rental rates as well as the financial health of the borrower. Table of Contents 100 Consumer installment — includes loans to individuals both secured by personal property and unsecured. Loans include personal lines of credit, automobile loans, and other retail loans. These loans are underwritten in accordance with the Bank’s general loan policies and procedures which require, among other things, proper documentation of each borrower’s financial condition, satisfactory credit history, and if applicable, property value. The following is a summary of current, accruing past due and nonaccrual loans by portfolio class as of December 31, 2022 and 2021. Accruing Accruing Total 30-89 Days Greater than Accruing Non- Total (In thousands) Current Past Due 90 days Loans Accrual Loans December 31, 2022: Commercial and industrial $ 65,731 5 — 65,736 443 $ 66,179 Construction and land development 66,479 — — 66,479 — 66,479 Commercial real estate: Owner occupied 61,265 — — 61,265 — 61,265 Hotel/motel 33,457 — — 33,457 — 33,457 Multifamily 41,181 — — 41,181 — 41,181 Other 127,162 — — 127,162 2,116 129,278 Total commercial real estate 263,065 — — 263,065 2,116 265,181 Residential real estate: Consumer mortgage 45,200 38 — 45,238 172 45,410 Investment property 52,325 — — 52,325 — 52,325 Total residential real estate 97,525 38 — 97,563 172 97,735 Consumer installment 9,506 40 — 9,546 — 9,546 Total $ 502,306 83 — 502,389 2,731 $ 505,120 December 31, 2021: Commercial and industrial $ 83,974 3 — 83,977 — $ 83,977 Construction and land development 32,228 204 — 32,432 — 32,432 Commercial real estate: Owner occupied 63,375 — — 63,375 — 63,375 Hotel/motel 43,856 — — 43,856 — 43,856 Multifamily 42,587 — — 42,587 — 42,587 Other 108,366 — — 108,366 187 108,553 Total commercial real estate 258,184 — — 258,184 187 258,371 Residential real estate: Consumer mortgage 29,070 516 — 29,586 195 29,781 Investment property 47,818 — — 47,818 62 47,880 Total residential real estate 76,888 516 — 77,404 257 77,661 Consumer installment 6,657 25 — 6,682 — 6,682 Total $ 457,931 748 — 458,679 444 $ 459,123 The gross interest income which would have been recorded under the original terms of those nonaccrual loans had they been accruing interest, amounted to approximately $ 26 thousand and $ 27 thousand for the years ended December 31, 2022 and 2021, respectively. Table of Contents 101 Allowance for Loan Losses The allowance for loan losses as of and for the years ended December 31, 2022 and 2021, is presented below. Year ended December 31 (In thousands) 2022 2021 Beginning balance $ 4,939 $ 5,618 Charged-off loans (292) (294) Recovery of previously charged-off loans 118 215 Net charge-offs (174) (79) Provision for loan losses 1,000 (600) Ending balance $ 5,765 $ 4,939 The Company assesses the adequacy of its allowance for loan losses prior to the end of each calendar quarter. The level of the allowance is based upon management’s evaluation of the loan portfolio, past loan loss experience, current asset quality trends, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay (including the timing of future payment), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, industry and peer bank loan loss rates and other pertinent factors, including regulatory recommendations. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. Loans are charged off, in whole or in part, when management believes that the full collectability of the loan is unlikely. A loan may be partially charged-off after a “confirming event” has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. The Company deems loans 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. Collection of all amounts due according to the contractual terms means that both the interest and principal payments of a loan will be collected as scheduled in the loan agreement. An impairment allowance is recognized if the fair value of the loan is less than the recorded investment in the loan. The impairment is recognized through the allowance. Loans that are impaired are recorded at the present value of expected future cash flows discounted at the loan’s effective interest rate, or if the loan is collateral dependent, impairment measurement is based on the fair value of the collateral, less estimated disposal costs. The level of allowance maintained is believed by management to be adequate to absorb probable losses inherent in the portfolio at the balance sheet date. The allowance is increased by provisions charged to expense and decreased by charge- offs, net of recoveries of amounts previously charged-off. In assessing the adequacy of the allowance, the Company also considers the results of its ongoing internal, independent loan review process. The Company’s loan review process assists in determining whether there are loans in the portfolio whose credit quality has weakened over time and evaluating the risk characteristics of the entire loan portfolio. The Company’s loan review process includes the judgment of management, the input from our independent loan reviewers, and reviews that may have been conducted by bank regulatory agencies as part of their examination process. The Company incorporates loan review results in the determination of whether or not it is probable that it will be able to collect all amounts due according to the contractual terms of a loan. As part of the Company’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial and industrial, construction and land development, commercial real estate, residential real estate, and consumer installment loans. The Company analyzes each segment and estimates an allowance allocation for each loan segment. The allocation of the allowance for loan losses begins with a process of estimating the probable losses inherent for these types of loans. The estimates for these loans are established by category and based on the Company’s internal system of credit risk ratings and historical loss data. The estimated loan loss allocation rate for the Company’s internal system of credit risk grades is based on its experience with similarly graded loans. For loan segments where the Company believes it does not have sufficient historical loss data, the Company may make adjustments based, in part, on loss rates of peer bank groups. At December 31, 2022 and 2021, and for the years then ended, the Company adjusted its historical loss rates for the commercial real estate portfolio segment based, in part, on loss rates of peer bank groups. Table of Contents 102 The estimated loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several “qualitative and environmental” factors. The allocation for qualitative and environmental factors is particularly subjective and does not lend itself to exact mathematical calculation. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and are based upon quarterly trend assessments in delinquent and nonaccrual loans, credit concentration changes, prevailing economic conditions, changes based on lending personnel experience, changes in lending policies or procedures and other influencing factors. These qualitative and environmental factors are considered for each of the five loan segments and the allowance allocation, as determined by the processes noted above, is increased or decreased based on the incremental assessment of these factors. The Company regularly re-evaluates its practices in determining the allowance for loan losses. Since the fourth quarter of 2016, the Company has increased its look-back period each quarter to incorporate the effects of at least one economic downturn in its loss history. The Company believes the extension of its look-back period is appropriate due to the risks inherent in the loan portfolio. Absent this extension, the early cycle periods in which the Company experienced significant losses would be excluded from the determination of the allowance for loan losses and its balance would decrease. For the year ended December 31, 2022, the Company increased its look-back period to 55 quarters to continue to include losses incurred by the Company beginning with the first quarter of 2009. During 2021, the Company adjusted certain qualitative and economic factors to reflect improvements in economic conditions in our primary market area that had previously been observed as a result of the COVID-19 pandemic. No changes were made to qualitative and economic factors during 2022. The following table details the changes in the allowance for loan losses by portfolio segment for the years ended December 31, 2022 and 2021. (in thousands) Commercial and industrial Construction and land Development Commercial Real Estate Residential Real Estate Consumer Installment Total Balance, December 31, 2020 $ 807 594 3,169 944 104 $ 5,618 Charge-offs — — ( 254 ) ( 3 ) ( 37 ) ( 294 ) Recoveries 140 — — 55 20 215 Net recoveries (charge-offs) 140 — ( 254 ) 52 ( 17 ) ( 79 ) Provision ( 90 ) ( 76 ) ( 176 ) ( 257 ) ( 1 ) (600) Balance, December 31, 2021 $ 857 518 2,739 739 86 $ 4,939 Charge-offs ( 222 ) — — — ( 70 ) ( 292 ) Recoveries 7 — 23 26 62 118 Net (charge-offs) recoveries ( 215 ) — 23 26 ( 8 ) ( 174 ) Provision 105 431 347 63 54 1,000 Balance, December 31, 2022 $ 747 949 3,109 828 132 $ 5,765 Table of Contents 103 The following table presents an analysis of the allowance for loan losses and recorded investment in loans by portfolio segment and impairment methodology as of December 31, 2022 and 2021. Collectively evaluated (1) Individually evaluated (2) Total Allowance Recorded Allowance Recorded Allowance Recorded for loan investment for loan investment for loan investment (In thousands) losses in loans losses in loans losses in loans December 31, 2022: Commercial and industrial $ 688 65,736 59 443 747 66,179 Construction and land development 949 66,479 — — 949 66,479 Commercial real estate 2,663 263,065 446 2,116 3,109 265,181 Residential real estate 828 97,735 — — 828 97,735 Consumer installment 132 9,546 — — 132 9,546 Total $ 5,260 502,561 505 2,559 5,765 505,120 December 31, 2021: Commercial and industrial $ 857 83,977 — — 857 83,977 Construction and land development 518 32,432 — — 518 32,432 Commercial real estate 2,739 258,184 — 187 2,739 258,371 Residential real estate 739 77,599 — 62 739 77,661 Consumer installment 86 6,682 — — 86 6,682 Total $ 4,939 458,874 — 249 4,939 459,123 (1) Represents loans collectively evaluated for impairment in accordance with ASC 450-20, Loss Contingencies (formerly FAS 5), and pursuant to amendments by ASU 2010-20 regarding allowance for unimpaired loans. (2) Represents loans individually evaluated for impairment in accordance with ASC 310-30, Receivables (formerly FAS 114), and pursuant to amendments by ASU 2010-20 regarding allowance for impaired loans. Credit Quality Indicators The credit quality of the loan portfolio is summarized no less frequently than quarterly using categories similar to the standard asset classification system used by the federal banking agencies. The following table presents credit quality indicators for the loan portfolio segments and classes. These categories are utilized to develop the associated allowance for loan losses using historical losses adjusted for qualitative and environmental factors and are defined as follows: ● Pass – loans which are well protected by the current net worth and paying capacity of the obligor (or guarantors, if any) or by the fair value, less cost to acquire and sell, of any underlying collateral. ● Special Mention – loans with potential weakness that may, if not reversed or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans are not adversely classified and do not expose an institution to sufficient risk to warrant an adverse classification. ● Substandard Accruing – loans that exhibit a well-defined weakness which presently jeopardizes debt repayment, even though they are currently performing. These loans are characterized by the distinct possibility that the Company may incur a loss in the future if these weaknesses are not corrected. ● Nonaccrual – includes loans where management has determined that full payment of principal and interest is in doubt. Table of Contents 104 (In thousands) Pass Special Mention Substandard Accruing Nonaccrual Total loans December 31, 2022 Commercial and industrial $ 65,517 7 212 443 $ 66,179 Construction and land development 66,479 — — — 66,479 Commercial real estate: Owner occupied 60,866 238 161 — 61,265 Hotel/motel 33,457 — — — 33,457 Multifamily 41,181 — — — 41,181 Other 126,992 170 — 2,116 129,278 Total commercial real estate 262,496 408 161 2,116 265,181 Residential real estate: Consumer mortgage 44,212 439 587 172 45,410 Investment property 52,034 43 248 — 52,325 Total residential real estate 96,246 482 835 172 97,735 Consumer installment 9,498 1 47 — 9,546 Total $ 500,236 898 1,255 2,731 $ 505,120 December 31, 2021 Commercial and industrial $ 83,725 26 226 — $ 83,977 Construction and land development 32,212 2 218 — 32,432 Commercial real estate: Owner occupied 61,573 1,675 127 — 63,375 Hotel/motel 36,162 7,694 — — 43,856 Multifamily 39,093 3,494 — — 42,587 Other 107,426 911 29 187 108,553 Total commercial real estate 244,254 13,774 156 187 258,371 Residential real estate: Consumer mortgage 27,647 452 1,487 195 29,781 Investment property 47,459 98 261 62 47,880 Total residential real estate 75,106 550 1,748 257 77,661 Consumer installment 6,650 20 12 — 6,682 Total $ 441,947 14,372 2,360 444 $ 459,123 Impaired loans The following table presents details related to the Company’s impaired loans. Loans which have been fully charged-off do not appear in the following table. The related allowance generally represents the following components which correspond to impaired loans: ● Individually evaluated impaired loans equal to or greater than $500 thousand secured by real estate (nonaccrual construction and land development, commercial real estate, and residential real estate). ● Individually evaluated impaired loans equal to or greater than $250 thousand not secured by real estate (nonaccrual commercial and industrial and consumer loans). The following table sets forth certain information regarding the Company’s impaired loans that were individually evaluated for impairment at December 31, 2022 and 2021. Table of Contents 105 December 31, 2022 (In thousands) Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance With no allowance recorded: Commercial and industrial $ 210 ( 1 ) $ 209 Commercial real estate: Owner occupied 858 ( 3 ) 855 Total commercial real estate 858 ( 3 ) 855 Total $ 1,068 (4) $ 1,064 With allowance recorded: Commercial and industrial $ 234 — 234 $ 59 Commercial real estate: Owner occupied 1,261 — 1,261 446 Total commercial real estate 1,261 — 1,261 446 Total 1,495 — 1,495 505 Total impaired loans $ 2,563 ( 4 ) 2,559 $ 505 (1) Unpaid principal balance represents the contractual obligation due from the customer. (2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance. (3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses. December 31, 2021 (In thousands) Unpaid principal balance (1) Charge-offs and payments applied (2) Recorded investment (3) Related allowance With no allowance recorded: Commercial real estate: Other $ 205 ( 18 ) 187 Total commercial real estate 205 ( 18 ) 187 Residential real estate: Investment property 68 ( 6 ) 62 Total residential real estate 68 ( 6 ) 62 Total $ 273 (24) $ 249 With allowance recorded: Total impaired loans $ 273 ( 24 ) 249 $ — (1) Unpaid principal balance represents the contractual obligation due from the customer. (2) Charge-offs and payments applied represents cumulative charge-offs taken, as well as interest payments that have been applied against the outstanding principal balance. (3) Recorded investment represents the unpaid principal balance less charge-offs and payments applied; it is shown before any related allowance for loan losses. Table of Contents 106 The following table provides the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class. Year ended December 31, 2022 Year ended December 31, 2021 Average Total interest Average Total interest recorded income recorded income (In thousands) investment recognized investment recognized Impaired loans: Commercial and industrial $ 34 — $ — — Commercial real estate: Owner occupied 163 — — — Other $ 153 — $ 199 — Total commercial real estate 316 — 199 — Residential real estate: Investment property 5 — 96 — Total residential real estate 5 — 96 — Total $ 355 — $ 295 — Troubled Debt Restructurings Impaired loans also include troubled debt restructurings (“TDRs”). Section 4013 of the CARES Act, “Temporary Relief From Troubled Debt Restructurings,” provides banks the option to temporarily suspend certain requirements under ASC 340-10 TDR classifications for a limited period of time to account for the effects of COVID-19. Section 4013 of the CARES Act was extended to January 1, 2022 by Section 541 of the Consolidated Appropriations Act of 2021. The Interagency Statement on COVID-19 Loan Modifications, encourages banks to work prudently with borrowers and describes the agencies’ interpretation of how accounting rules under ASC 310-40, “Troubled Debt Restructurings by Creditors,” apply to certain COVID-19-related modifications. The Interagency Statement on COVID-19 Loan Modifications was supplemented on June 23, 2020 by the Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions. If a loan modification was eligible, a bank may elect to account for the loan under Section 4013 of the CARES Act. If a loan modification is not eligible under section 4013, or if the bank elects not to account for the loan modification under section 4013, the Revised Statement includes criteria when a bank may presume a loan modification is not a TDR in accordance with ASC 310-40. The Company evaluates loan extensions or modifications not qualified under Section 4013 of the CARES Act or under the Interagency Statement on COVID-19 Loan Modifications in accordance with FASB ASC 340-10 with respect to the classification of the loan as a TDR. In the normal course of business, management may grant concessions to borrowers that are experiencing financial difficulty. A concession may include, but is not limited to, delays in required payments of principal and interest for a specified period, reduction of the stated interest rate of the loan, reduction of accrued interest, extension of the maturity date, or reduction of the face amount or maturity amount of the debt. A concession has been granted when, as a result of the restructuring, the Bank does not expect to collect, when due, all amounts owed, including interest at the original stated rate. A concession may have also been granted if the debtor is not able to access funds elsewhere at a market rate for debt with similar risk characteristics as the restructured debt. In making the determination of whether a loan modification is a TDR, the Company considers the individual facts and circumstances surrounding each modification. As part of the credit approval process, the restructured loans are evaluated for adequate collateral protection in determining the appropriate accrual status at the time of restructure. Similar to other impaired loans, TDRs are measured for impairment based on the present value of expected payments using the loan’s original effective interest rate as the discount rate, or the fair value of the collateral, less selling costs if the loan is collateral dependent. If the recorded investment in the loan exceeds the measure of fair value, impairment is recognized by establishing a valuation allowance as part of the allowance for loan losses or a charge -off to the allowance for loan losses. In periods subsequent to the modification, all TDRs are evaluated individually, including those that have payment defaults, for possible impairment. Table of Contents 107 The Company had no TDRs at December 31, 2022. The following is a summary of accruing and nonaccrual TDRs and the related allowance for loan losses, by portfolio segment and class at December 31, 2021. TDRs Related (In thousands) Accruing Nonaccrual Total Allowance December 31, 2021 Commercial real estate: Other $ — 187 187 $ — Total commercial real estate — 187 187 — Residential real estate: Investment property — 62 62 — Total residential real estate — 62 62 — Total $ — 249 249 $ — At December 31, 2022 there were no significant outstanding commitments to advance additional funds to customers whose loans had been restructured. There were no loans modified in a TDR in 2022 and 2021, respectively. During the years ended December 31, 2022 and 2021, respectively, the Company had no loans modified in a TDR within the previous 12 months for which there was a payment default (defined as 90 days or more past due). NOTE 6: PREMISES AND EQUIPMENT Premises and equipment at December 31, 2022 and 2021 is presented below. December 31 (Dollars in thousands) 2022 2021 Land and improvements $ 12,788 9,830 Buildings and improvements 35,241 16,124 Furniture, fixtures, and equipment 3,861 3,096 Construction in progress 39 19,277 Total premises and equipment 51,929 48,327 Less: accumulated depreciation ( 5,354 ) ( 6,603 ) Premises and equipment, net $ 46,575 41,724 Depreciation expense was approximately $ 1.2 million and $ 0.6 million for the years ended December 31, 2022 and 2021, respectively, and is a component of net occupancy and equipment expense in the consolidated statements of earnings. For more information related to depreciation expense, please refer to “Change in Accounting Estimate” in Note 1, Summary of Significant Accounting Policies. NOTE 7: MORTGAGE SERVICING RIGHTS, NET MSRs are recognized based on the fair value of the servicing rights on the date the corresponding mortgage loans are sold. An estimate of the Company’s MSRs is determined using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Subsequent to the date of transfer, the Company has elected to measure its MSRs under the amortization method. Under the amortization method, MSRs are amortized in proportion to, and over the period of, estimated net servicing income. Servicing fee income is recorded net of related amortization expense and recognized in earnings as part of mortgage lending income. The Company has recorded MSRs related to loans sold without recourse to Fannie Mae. The Company generally sells conforming, fixed-rate, closed-end, residential mortgages to Fannie Mae. MSRs are included in other assets on the accompanying consolidated balance sheets. Table of Contents 108 The Company evaluates MSRs for impairment on a quarterly basis. Impairment is determined by stratifying MSRs into groupings based on predominant risk characteristics, such as interest rate and loan type. If, by individual stratum, the carrying amount of the MSRs exceeds fair value, a valuation allowance is established. The valuation allowance is adjusted as the fair value changes. Changes in the valuation allowance are recognized in earnings as a component of mortgage lending income. The following table details the changes in amortized MSRs and the related valuation allowance for the years ended December 31, 2022 and 2021. Year ended December 31 (Dollars in thousands) 2022 2021 Beginning balance $ 1,309 1,330 Additions, net 111 495 Amortization expense ( 269 ) ( 516 ) Ending balance $ 1,151 1,309 Valuation allowance included in MSRs, net: Beginning of period $ — — End of period — — Fair value of amortized MSRs: Beginning of period $ 1,908 1,489 End of period 2,369 1,908 Data and assumptions used in the fair value calculation related to MSRs at December 31, 2022 and 2021, respectively, are presented below. December 31 (Dollars in thousands) 2022 2021 Unpaid principal balance $ 234,349 255,310 Weighted average prepayment speed (CPR) 7.6 % 13.3 Discount rate (annual percentage) 9.5 % 9.5 Weighted average coupon interest rate 3.4 % 3.4 Weighted average remaining maturity (months) 256 260 Weighted average servicing fee (basis points) 25.0 25.0 At December 31, 2022, the weighted average amortization period for MSRs was 6.8 years. Estimated amortization expense for each of the next five years is presented below. (Dollars in thousands) December 31, 2022 2023 $ 163 2024 142 2025 124 2026 107 2027 93 Table of Contents 109 NOTE 8: DEPOSITS At December 31, 2022, the scheduled maturities of certificates of deposit and other time deposits are presented below. (Dollars in thousands) December 31, 2022 2023 $ 94,561 2024 29,603 2025 8,663 2026 3,836 2027 13,521 Thereafter 191 Total certificates of deposit and other time deposits $ 150,375 Additionally, at December 31, 2022 and 2021, approximately $ 57.4 million and $ 58.0 million, respectively, of certificates of deposit and other time deposits were issued in denominations greater than $250 thousand. At December 31, 2022 and 2021, the amount of deposit accounts in overdraft status that were reclassified to loans on the accompanying consolidated balance sheets was not material. NOTE 9: LEASE COMMITMENTS We lease certain office facilities and equipment under operating leases. Rent expense for all operating leases totaled $ 0.2 million for both years ended December 31, 2022 and 2021. On January 1, 2019, we adopted a new accounting standard which required the recognition of certain operating leases on our balance sheet as lease right of use assets (reported as component of other assets ) and related lease liabilities (reported as a component of accrued expenses and other liabilities ). Aggregate lease right of use assets were $ 588 thousand and $ 687 thousand at December 31, 2022 and 2021, respectively. Aggregate lease liabilities were $ 611 thousand and $ 710 thousand at December 31, 2022 and 2021, respectively. Rent expense includes amounts related to items that are not included in the determination of lease right of use assets including expenses related to short-term leases totaling $ 0.1 million for the year ended December 31, 2022. Lease payments under operating leases that were applied to our operating lease liability totaled $ 120 thousand during the year ended December 31, 2022. The following table reconciles future undiscounted lease payments due under non- cancelable operating leases (those amounts subject to recognition) to the aggregate operating lease liability as of December 31, 2022. (Dollars in thousands) Future lease payments 2023 $ 123 2024 123 2025 114 2026 96 2027 96 Thereafter 122 Total undiscounted operating lease liabilities $ 674 Imputed interest 63 Total operating lease liabilities included in the accompanying consolidated balance sheets $ 611 Weighted-average lease terms in years 5.89 Weighted-average discount rate 3.12 % Table of Contents 110 NOTE 10: OTHER COMPREHENSIVE LOSS Comprehensive income is defined as the change in equity from all transactions other than those with stockholders, and it includes net earnings and other comprehensive loss. Other comprehensive loss for the years ended December 31, 2022 and 2021, is presented below. Pre-tax Tax benefit Net of (Dollars in thousands) amount (expense) tax amount 2022: Unrealized net holding loss on securities $ ( 55,819 ) 14,017 ( 41,802 ) Reclassification adjustment for net gain on securities recognized in net earnings ( 12 ) 3 ( 9 ) Other comprehensive loss $ ( 55,831 ) 14,020 ( 41,811 ) 2021: Unrealized net holding gain on securities $ ( 8,943 ) 2,246 ( 6,697 ) Reclassification adjustment for net gain on securities recognized in net earnings ( 15 ) 4 ( 11 ) Other comprehensive loss $ ( 8,958 ) 2,250 ( 6,708 ) NOTE 11: INCOME TAXES For the years ended December 31, 2022 and 2021 the components of income tax expense from continuing operations are presented below. Year ended December 31 (Dollars in thousands) 2022 2021 Current income tax expense: Federal $ 1,461 833 State 356 295 Total current income tax expense 1,817 1,128 Deferred income tax benefit: Federal 556 220 State 130 58 Total deferred income tax expense 686 278 Total income tax expense $ 2,503 1,406 Table of Contents 111 Total income tax expense differs from the amounts computed by applying the statutory federal income tax rate of 21% to earnings before income taxes. A reconciliation of the differences for the years ended December 31, 2022 and 2021, is presented below. 2022 2021 Percent of Percent of pre-tax pre-tax (Dollars in thousands) Amount earnings Amount earnings Earnings before income taxes $ 12,849 9,445 Income taxes at statutory rate 2,698 21.0 % 1,983 21.0 % Tax-exempt interest ( 523 ) ( 4.1 ) ( 514 ) ( 5.4 ) State income taxes, net of federal tax effect 346 2.7 352 3.7 New Markets Tax Credit ( 356 ) ( 2.8 ) ( 356 ) ( 3.8 ) Bank-owned life insurance 141 1.1 ( 85 ) ( 0.9 ) Other 197 1.6 26 — Total income tax expense $ 2,503 19.5 % 1,406 14.9 % At December 31, 2022 and 2021, the Company had a net deferred tax asset of $13.8 million and $0.4 million, respectively, included in other assets on the consolidated balance sheet. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2022 and 2021 are presented below. December 31 (Dollars in thousands) 2022 2021 Deferred tax assets: Allowance for loan losses $ 1,448 1,240 Unrealized loss on securities 13,722 — Accrued bonus 228 192 Right of use liability 153 178 Other 70 77 Total deferred tax assets 15,621 1,687 Deferred tax liabilities: Premises and equipment 767 200 Unrealized gain on securities — 298 Originated mortgage servicing rights 289 329 Right of use asset 148 173 New Markets Tax Credit investment 179 89 Other 469 163 Total deferred tax liabilities 1,852 1,252 Net deferred tax asset $ 13,769 435 A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely- than-not that some portion of the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projection for future taxable income over the periods which the temporary differences resulting in the remaining deferred tax assets are deductible, management believes it is more-likely-than -not that the Company will realize the benefits of these deductible differences at December 31, 2022. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income are reduced. Table of Contents 112 The change in the net deferred tax asset for the years ended December 31, 2022 and 2021, is presented below. Year ended December 31 (Dollars in thousands) 2022 2021 Net deferred tax asset (liability): Balance, beginning of year $ 435 ( 1,537 ) Deferred tax expense related to continuing operations ( 686 ) ( 278 ) Stockholders' equity, for accumulated other comprehensive income 14,020 2,250 Balance, end of year $ 13,769 435 ASC 740, Income Taxes, defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. This section also provides guidance on the de- recognition, measurement, and classification of income tax uncertainties in interim periods. As of December 31, 2022, the Company had no unrecognized tax benefits related to federal or state income tax matters. The Company does not anticipate any material increase or decrease in unrecognized tax benefits during 2023 relative to any tax positions taken prior to December 31, 2022. As of December 31, 2022, the Company has accrued no interest and no penalties related to uncertain tax positions. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. The Company and its subsidiaries file consolidated U.S. federal and State of Alabama income tax returns. The Company is currently open to audit under the statute of limitations by the Internal Revenue Service and the State of Alabama for the years ended December 31, 2019 through 2022. NOTE 12: EMPLOYEE BENEFIT PLAN The Company sponsors a qualified defined contribution retirement plan, the Auburn National Bancorporation, Inc. 401(k) Plan (the "Plan"). Eligible employees may contribute up to 100% of eligible compensation, subject to statutory limits upon completion of 2 months of service. Furthermore, the Company allows employer Safe Harbor contributions. Participants are immediately vested in employer Safe Harbor contributions. The Company's matching contributions on behalf of participants were equal to $1.00 for each $1.00 contributed by participants, up to 3% of each participant's eligible compensation, and $0.50 for every $1.00 contributed by participants, above 3% up to 5% of each participant's eligible compensation, for a maximum matching contribution of 4% of the participants' eligible compensation. Company matching contributions to the Plan were approximately $ 0.3 million for the years ended December 31, 2022 and 2021, respectively, and are included in salaries and benefits expense. NOTE 13: COMMITMENTS AND CONTINGENT LIABILITIES Credit-Related Financial Instruments The Company is party to credit related financial instruments with off -balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments. At December 31, 2022 and 2021, the following financial instruments were outstanding whose contract amount represents credit risk. December 31 (Dollars in thousands) 2022 2021 Commitments to extend credit $ 87,657 $ 70,933 Standby letters of credit 1,041 1,455 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have fixed expiration dates or other termination clauses and may Table of Contents 113 require payment of a fee. The commitments for lines of credit may expire without being drawn upon. Therefore, total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer. The Company maintained a reserve for unfunded commitments of $ 0.2 million at December 31, 2022 and 2021, respectively. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds various assets as collateral, including accounts receivable, inventory, equipment, marketable securities, and property to support those commitments for which collateral is deemed necessary. The Company has recorded a liability for the estimated fair value of these standby letters of credit in the amount of $ 16 thousand and $ 23 thousand at December 31, 2022 and 2021, respectively. Contingent Liabilities The Company and the Bank are involved in various legal proceedings, arising in connection with their business. In the opinion of management, based upon consultation with legal counsel, the ultimate resolution of these proceeding will not have a material adverse effect upon the consolidated financial condition or results of operations of the Company and the Bank. NOTE 14: FAIR VALUE Fair Value Hierarchy “Fair value” is defined by ASC 820, Fair Value Measurements and Disclosures , as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for an asset or liability at the measurement date. GAAP establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: Level 1—inputs to the valuation methodology are quoted prices, unadjusted, for identical assets or liabilities in active markets. Level 2—inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs that are observable for the asset or liability, either directly or indirectly. Level 3—inputs to the valuation methodology are unobservable and reflect the Company’s own assumptions about the inputs market participants would use in pricing the asset or liability. Level changes in fair value measurements Transfers between levels of the fair value hierarchy are generally recognized at the end of the reporting period. The Company monitors the valuation techniques utilized for each category of financial assets and liabilities to ascertain when transfers between levels have been affected. The nature of the Company’s financial assets and liabilities generally is such that transfers in and out of any level are expected to be infrequent. For the years ended December 31, 2022 and 2021, there were no transfers between levels and no changes in valuation techniques for the Company’s financial assets and liabilities. Table of Contents 114 Assets and liabilities measured at fair value on a recurring basis Securities available-for-sale Fair values of securities available for sale were primarily measured using Level 2 inputs. For these securities, the Company obtains pricing from third party pricing services. These third-party pricing services consider observable data that may include broker/dealer quotes, market spreads, cash flows, market consensus prepayment speeds, benchmark yields, reported trades for similar securities, credit information and the securities’ terms and conditions. On a quarterly basis, management reviews the pricing received from the third-party pricing services for reasonableness given current market conditions. As part of its review, management may obtain non-binding third party broker quotes to validate the fair value measurements. In addition, management will periodically submit pricing provided by the third-party pricing services to another independent valuation firm on a sample basis. This independent valuation firm will compare the price provided by the third-party pricing service with its own price and will review the significant assumptions and valuation methodologies used with management. The following table presents the balances of the assets and liabilities measured at fair value on a recurring as of December 31, 2022 and 2021, respectively, by caption, on the accompanying consolidated balance sheets by ASC 820 valuation hierarchy (as described above). Quoted Prices in Significant Active Markets Other Significant for Observable Unobservable Identical Assets Inputs Inputs (Dollars in thousands) Amount (Level 1) (Level 2) (Level 3) December 31, 2022: Securities available-for-sale: Agency obligations $ 125,617 — 125,617 — Agency MBS 218,160 — 218,160 — State and political subdivisions 61,527 — 61,527 — Total securities available-for-sale 405,304 — 405,304 — Total assets at fair value $ 405,304 — 405,304 — December 31, 2021: Securities available-for-sale: Agency obligations $ 124,413 — 124,413 — Agency MBS 223,371 — 223,371 — State and political subdivisions 74,107 — 74,107 — Total securities available-for-sale 421,891 — 421,891 — Total assets at fair value $ 421,891 — 421,891 — Assets and liabilities measured at fair value on a nonrecurring basis Loans held for sale Loans held for sale are carried at the lower of cost or fair value. Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Loans held for sale are classified within Level 2 of the fair value hierarchy. Impaired Loans Loans considered impaired under ASC 310-10-35, Receivables , are loans for which, based on current information and events, it is probable that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent. Table of Contents 115 The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. The Company determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above. Other real estate owned Other real estate owned, consisting of properties obtained through foreclosure or otherwise in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less costs to sell when the loan is transferred to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, a loss is recognized in noninterest expense. Mortgage servicing rights, net Mortgage servicing rights, net, included in other assets on the accompanying consolidated balance sheets, are carried at the lower of cost or estimated fair value. MSRs do not trade in an active market with readily observable prices. To determine the fair value of MSRs, the Company engages an independent third party. The independent third party’s valuation model calculates the present value of estimated future net servicing income using assumptions that market participants would use in estimating future net servicing income, including estimates of prepayment speeds, discount rate, default rates, cost to service, escrow account earnings, contractual servicing fee income, ancillary income, and late fees. Periodically, the Company will review broker surveys and other market research to validate significant assumptions used in the model. The significant unobservable inputs include prepayment speeds or the constant prepayment rate (“CPR”) and the weighted average discount rate. Because the valuation of MSRs requires the use of significant unobservable inputs, all of the Company’s MSRs are classified within Level 3 of the valuation hierarchy. Table of Contents 116 The following table presents the balances of the assets and liabilities measured at fair value on a nonrecurring basis as of December 31, 2022 and 2021, respectively, by caption, on the accompanying consolidated balance sheets and by ASC 820 valuation hierarchy (as described above): Quoted Prices in Active Markets Other Significant for Observable Unobservable Identical Assets Inputs Inputs (Dollars in thousands) Amount (Level 1) (Level 2) (Level 3) December 31, 2022: Loans, net (1) $ 2,054 — — 2,054 Other assets (2) 1,151 — — 1,151 Total assets at fair value $ 3,205 — — 3,205 December 31, 2021: Loans held for sale $ 1,376 — 1,376 — Loans, net (1) 249 — — 249 Other assets (2) 1,683 — — 1,683 Total assets at fair value $ 3,308 — 1,376 1,932 (1) Loans considered impaired under ASC 310-10-35 Receivables. This amount reflects the recorded investment in impaired loans, net of any related allowance for loan losses. (2) Represents other real estate owned and MSRs, net both of which are carried at lower of cost or estimated fair value. At December 31, 2022 and 2021 and for the years then ended, the Company had no Level 3 assets measured at fair value on a recurring basis. For Level 3 assets measured at fair value on a non-recurring basis as of December 31, 2022 and 2021, the significant unobservable inputs used in the fair value measurements are presented below. Weighted Carrying Significant Average (Dollars in thousands) Amount Valuation Technique Unobservable Input Range of Input December 31, 2022: Impaired loans $ 2,054 Appraisal Appraisal discounts 10.0 - 10.0 % 10.0 % Mortgage servicing rights, net 1,151 Discounted cash flow Prepayment speed or CPR 5.2 - 18.6 % 7.5 % Discount rate 9.5 - 11.5 % 9.5 % December 31, 2021: Impaired loans $ 249 Appraisal Appraisal discounts 10.0 - 10.0 % 10.0 % Other real estate owned 374 Appraisal Appraisal discounts 55.0 - 55.0 % 55.0 % Mortgage servicing rights, net 1,309 Discounted cash flow Prepayment speed or CPR 6.8 - 16.5 % 13.3 % Discount rate 9.5 - 11.5 % 9.5 % Fair Value of Financial Instruments ASC 825, Financial Instruments , requires disclosure of fair value information about financial instruments, whether or not recognized on the face of the balance sheet, for which it is practicable to estimate that value. The assumptions used in the estimation of the fair value of the Company’s financial instruments are explained below. Where quoted market prices are not available, fair values are based on estimates using discounted cash flow analyses. Discounted cash flows can be significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The following fair value estimates cannot be substantiated by comparison to independent markets and should not be considered representative of the liquidation value of the Company’s financial instruments, but rather are good faith estimates of the fair value of financial instruments held by the Company. ASC 825 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Table of Contents 117 The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: Loans, net Fair values for loans were calculated using discounted cash flows. The discount rates reflected current rates at which similar loans would be made for the same remaining maturities. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments. The fair value of loans was measured using an exit price notion. Loans held for sale Fair values of loans held for sale are determined using quoted market secondary market prices for similar loans. Time Deposits Fair values for time deposits were estimated using discounted cash flows. The discount rates were based on rates currently offered for deposits with similar remaining maturities. Fair Value Hierarchy Carrying Estimated Level 1 Level 2 Level 3 (Dollars in thousands) amount fair value inputs inputs Inputs December 31, 2022: Financial Assets: Loans, net (1) $ 498,693 $ 484,007 $ — $ — $ 484,007 Financial Liabilities: Time Deposits $ 150,375 $ 150,146 $ — $ 150,146 $ — December 31, 2021: Financial Assets: Loans, net (1) $ 453,425 $ 449,105 $ — $ — $ 449,105 Loans held for sale 1,376 1,410 — 1,410 — Financial Liabilities: Time Deposits $ 159,650 $ 160,581 $ — $ 160,581 $ — (1) Represents loans, net of unearned income and the allowance for loan losses. The fair value of loans was measured using an exit price notion. NOTE 15: RELATED PARTY TRANSACTIONS The Bank has made, and expects in the future to continue to make in the ordinary course of business, loans to directors and executive officers of the Company, the Bank, and their affiliates. In management’s opinion, these loans were made in the ordinary course of business at normal credit terms, including interest rate and collateral requirements, and do not represent more than normal credit risk. An analysis of such outstanding loans is presented below. (Dollars in thousands) Amount Loans outstanding at December 31, 2021 $ 1,564 New loans/advances 961 Repayments ( 879 ) Loans outstanding at December 31, 2022 $ 1,646 During 2022 and 2021, certain executive officers and directors of the Company and the Bank, including companies with which they are affiliated, were deposit customers of the bank. Total deposits for these persons at December 31, 2022 and 2021 amounted to $ 22.8 million and $ 19.3 million, respectively. Table of Contents 118 NOTE 16: REGULATORY RESTRICTIONS AND CAPITAL RATIOS As required by the Economic Growth, Regulatory Relief, and Consumer Protection Act, the Federal Reserve Board issued an interim final rule that expanded applicability of the Board’s small bank holding company policy statement (the “Small BHC Policy Statement”) and its Regulation Q capital and Regulation Y holding company rules in August 2018. The interim final rule raised the Small BHC Policy Statement’s asset limit from $1 billion to $3 billion in total consolidated assets for a bank holding company or savings and loan holding company that: (1) is not engaged in significant nonbanking activities; (2) does not conduct significant off-balance sheet activities; and (3) does not have a material amount of debt or equity securities, other than trust-preferred securities, outstanding that are registered with the SEC. The interim final rule provides that, if warranted for supervisory purposes, the Federal Reserve may exclude a company from this asset level increase. The Federal Reserve has treated the Company as a small bank holding company for purposes of the Small BHC Policy Statement and therefore has considered only the Bank’s capital and not the Company’s consolidated capital. The Bank remains subject to regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the 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 capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. As of December 31, 2022, the Bank is “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum common equity Tier 1, total risk-based, Tier 1 risk- based, and Tier 1 leverage ratios as set forth in the table. Management has not received any notification from the Bank's regulators that changes the Bank’s regulatory capital status. The actual capital amounts and ratios for the Bank and the aforementioned minimums as of December 31, 2022 and 2021 are presented below. Minimum for capital Minimum to be Actual adequacy purposes well capitalized (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio At December 31, 2022: Tier 1 Leverage Capital $ 106,886 10.01 % $ 42,716 4.00 % $ 53,394 5.00 % Common Equity Tier 1 Capital 106,886 15.39 31,252 4.50 45,142 6.50 Tier 1 Risk-Based Capital 106,886 15.39 41,669 6.00 55,559 8.00 Total Risk-Based Capital 112,851 16.25 55,559 8.00 69,449 10.00 At December 31, 2021: Tier 1 Leverage Capital $ 100,059 9.35 % $ 42,808 4.00 % $ 53,509 5.00 % Common Equity Tier 1 Capital 100,059 16.23 27,742 4.50 40,072 6.50 Tier 1 Risk-Based Capital 100,059 16.23 36,990 6.00 49,320 8.00 Total Risk-Based Capital 105,163 17.06 49,320 8.00 61,649 10.00 Dividends paid by the Bank are a principal source of funds available to the Company for payment of dividends to its stockholders and for other needs. Applicable federal and state statutes and regulations impose restrictions on the amounts of dividends that may be declared by the subsidiary bank. State law and Federal Reserve policy restrict the Bank from declaring dividends in excess of the sum of the current year’s earnings plus the retained net earnings from the preceding two years without prior approval. In addition to the formal statutes and regulations, regulatory authorities also consider the adequacy of the Bank’s total capital in relation to its assets, deposits, and other such items. Capital adequacy considerations could further limit the availability of dividends from the Bank. At December 31, 2022, the Bank could have declared additional dividends of approximately $ 13.9 million without prior approval of regulatory authorities. As a result of this limitation, approximately $ 54.1 million of the Company’s investment in the Bank was restricted from transfer in the form of dividends. Table of Contents 119 NOTE 17: AUBURN NATIONAL BANCORPORATION (PARENT COMPANY) The Parent Company’s condensed balance sheets and related condensed statements of earnings and cash flows are as follows. CONDENSED BALANCE SHEETS December 31 (Dollars in thousands) 2022 2021 Assets: Cash and due from banks $ 1,700 2,705 Investment in bank subsidiary 65,967 100,951 Other assets 522 630 Total assets $ 68,189 104,286 Liabilities: Accrued expenses and other liabilities $ 148 560 Total liabilities 148 560 Stockholders' equity 68,041 103,726 Total liabilities and stockholders' equity $ 68,189 104,286 CONDENSED STATEMENTS OF EARNINGS Year ended December 31 (Dollars in thousands) 2022 2021 Income: Dividends from bank subsidiary $ 3,719 3,682 Noninterest income 78 665 Total income 3,797 4,347 Expense: Noninterest expense 326 189 Total expense 326 189 Earnings before income tax expense and equity in undistributed earnings of bank subsidiary 3,471 4,158 Income tax (benefit) expense ( 48 ) 82 Earnings before equity in undistributed earnings of bank subsidiary 3,519 4,076 Equity in undistributed earnings of bank subsidiary 6,827 3,963 Net earnings $ 10,346 8,039 Table of Contents 120 CONDENSED STATEMENTS OF CASH FLOWS Year ended December 31 (Dollars in thousands) 2022 2021 Cash flows from operating activities: Net earnings $ 10,346 8,039 Adjustments to reconcile net earnings to net cash provided by operating activities: Net decrease in other assets 108 1 Net decrease in other liabilities ( 408 ) ( 120 ) Equity in undistributed earnings of bank subsidiary ( 6,827 ) ( 3,963 ) Net cash provided by operating activities 3,219 3,957 Cash flows from financing activities: Dividends paid ( 3,720 ) ( 3,682 ) Stock repurchases ( 504 ) ( 1,619 ) Net cash used in financing activities ( 4,224 ) ( 5,301 ) Net change in cash and cash equivalents ( 1,005 ) ( 1,344 ) Cash and cash equivalents at beginning of period 2,705 4,049 Cash and cash equivalents at end of period $ 1,700 2,705 Table of Contents 121 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable.