Financial Statement Analysis: Loan Losses and Allowances, Study notes of Accounting

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SURREY

BANCORP

A NNUAL R EPOR T

2020 Annual Report

________________________________

Financial Highlights Summary

Summary of Operations

Interest income Interest expense Net interest income Provision for loan losses Noninterest income Noninterest expense Income taxes Net income Preferred stock dividends declared Net income available to common stockholders

Per Common Share Data

Net income: Basic Diluted Cash dividends declared Book value per common share

Balance Sheet

Loans, net Investment securities available for sale Total assets Deposits Stockholders’ equity Interest-earning assets Interest-bearing liabilities

Selected Ratios

Return on average assets Return on average equity Dividends declared on common stock as a percent of net income available to common stockholders

1. In thousands of dollars, except for per share data

Management’s Discussion and Analysis of Operations

Management’s Discussion and Analysis is provided to assist in the understanding and evaluation of the Company’s financial condition and its results of operations. The following discussion should be read in conjunction with the Company’s financial statements and related notes.

Management’s Discussion and Analysis

General

Surrey Bancorp was formed on May 1, 2003 and was created for the purpose of acquiring all the outstanding shares of common stock of Surrey Bank & Trust.

Surrey Bank & Trust was incorporated on July 15, 1996, as a North Carolina banking corporation and opened for business on July 22, 1996. The Company operates for the primary purpose of serving the banking needs of individuals and small to medium sized businesses in Surry County, North Carolina and Patrick County, Virginia and the surrounding area, while developing personal, hometown associations with these customers. The Company offers a wide range of banking services including checking and savings accounts; commercial, consumer and mortgage loans; safe deposit boxes; and other associated services. Through its subsidiary, Surrey Investment Services, Inc., the Company offers insurance products. The Company’s primary sources of revenue are interest income from its commercial and real estate lending activities and, to a lesser extent, from its investment portfolio. The Company also earns fees from lending and deposit activities. The major expenses of the Company are interest on deposit accounts and general and administrative expenses, such as salaries, occupancy and related expenses.

Primary Market Area

The Company’s market area consists of an area extending from Surry and Wilkes Counties, with branches in Mount Airy, Pilot Mountain, Elkin and North Wilkesboro, North Carolina, north into the southern portions of Carroll and Patrick Counties, Virginia. Mount Airy is the industrial and trading center of Surry County with a population of approximately 10,500 people living in the city limits and 30,000 in the metropolitan area. The total population of Surry County is approximately 73,000 people. Mount Airy is served by Interstate Highways 77 and 74 and U.S. Highways 52 and 601. Surry County has a civilian labor force of over 33,000. Major industries include manufacturing, construction, fabricated metals, and lumber and wood. North Wilkesboro is the largest town in Wilkes County with a population of approximately 4,300 people. The total population of Wilkes County is approximately 69,000 people. North Wilkesboro is served by U.S. Highways 21 and 421 Business. Wilkes County has a civilian labor force of over 26,000. Major industries include manufacturing, retail trade, agriculture and healthcare and social assistance. The Company has a branch office in Stuart, Virginia, which is located in Patrick County, Virginia. The primary industries found in Patrick County are lumber and wood, textiles and agricultural.

Forward Looking Statements

Information in this annual report contains “forward-looking statements.” These statements reflect management's current beliefs as to the expected outcomes of future events and are not guarantees of future performance. These statements involve certain risks, uncertainties and assumptions that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. As such, actual results and outcomes may materially differ from what may be expressed or forecast in such forward-looking statements. Factors that could cause a difference include, among others: changes in the national and local economies or market conditions; changes in interest rates, deposit levels, loan demand and asset quality, including real estate and other collateral values; changes in banking regulations and accounting principles, policies or guidelines; and the impact of competition from traditional or new sources. These and other factors that may emerge could cause decisions and actual results to differ materially from current expectations. Surrey Bancorp takes no obligation to revise, update, or clarify forward-looking statements to reflect events or conditions after the date of this annual report.

Critical Accounting Policies

Management believes the policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity. Management must make difficult and subjective judgments, assumptions or estimates that could cause reported results to differ materially. This critical policy and its application are periodically reviewed with the Audit Committee and Board of Directors.

Management’s Discussion and Analysis

Net Interest Income and Average Balances

Net interest income is the Company’s principal source of earnings. Net interest income is the amount of income generated by earning assets (primarily loans and investment securities) less the interest expense incurred on interest-bearing liabilities (primarily deposits and FHLB Advances used to fund earning assets). Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Changes in the interest rate environment and the Company’s cost of funds also affect net interest income. Table 1 summarizes the major components of net interest income for the years ended December 31, 2020, 2019 and 2018.

Table 1. Net Interest Income and Average Balances (dollars in thousands)

Periods Ended December 31, 2020 2019 2018 Interest Interest Interest Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ Balance Expense Cost Balance Expense Cost Balance Expense Cost

Interest-earning assets Deposits in other banks $ 91,491 $ 304 0.33% $ 47,152 $ 983 2.08% $ 39,718 $ 744 1.87% Taxable investment securities 10,804 126 1.17% 7,773 175 2.25% 6,297 109 1.73% Federal funds sold 1,353 5 0.35% 1,217 26 2.14% 1,228 22 1.79% Loans 1 2 262,874 13,453 5.12% 238,700 13,578 5.69% 231,707 12,771 5.51% Total interest-earning assets 366,522 13,888 294,842 14,762 278,950 13, Yield on average interest-earning assets 3.79% 5.01% 4.89%

Noninterest-earning assets Cash and due from banks 8,844 9,668 9, Property and equipment 6,207 6,458 6, Foreclosed assets - - 92 Interest receivable and other 11,358 10,846 10, Allowance for loan losses (4,443) (4,277) (3,961) Total noninterest-earning assets 21,966 22,695 22, Total assets $388,489 $317,537 $301,

Interest-bearing liabilities Demand deposits $ 63,387 $ 101 0.16% $ 49,928 $ 113 0.23% $ 43,006 $ 95 0.22% Savings deposits 80,963 192 0.24% 66,130 313 0.47% 68,949 308 0.45% Time deposits 68,673 802 1.17% 62,841 873 1.39% 63,925 595 0.93% Fed funds purchased/repurchase agreements 1 - 2.17% - - - % - - - % Short-term debt - - - % - - - % - - - % Long-term debt - - - % - - - % - - - % Total interest-bearing liabilities 213,024 1,095 178,899 1,299 175,880 998 Cost of average interest bearing liabilities 0.33% 0.73% 0.57%

Noninterest-bearing liabilities Demand deposits 119,764 86,552 77, Interest payable and other 6,392 5,249 4, Total noninterest-bearing liabilities 126,156 91,801 81, Total liabilities 339,180 270,700 257, Stockholders' equity 49,308 46,837 43, Total liabilities and stockholders' equity $388,488 $317,537 $301, Net interest income $ 12,793 $ 13,463 $ 12, Net yield on interest-earning assets 3.49% 4.57% 4.53%

1. Includes non-accrual loans.
2. Amortization of deferred loan fees are included in interest income.

Yields on interest-earning assets decreased 122 basis points during the year ended December 31, 2020, primarily due to a general decrease in interest rates. The cost of interest-bearing liabilities decreased by 40 basis points in 2020. As a result, the net yield on interest earning assets decreased from 4.57% for the year ended December 31, 2019 to 3.49% in 2020.

Analysis of Financial Condition

Average interest earning assets increased from December 31, 2019, to December 31, 2020. Average earning assets amounted to $366,521,800 for 2020, up from a total of $294,842,277 for 2019. Total earning assets represented 94.3% of total average assets at December 31, 2020, up from the 92.9% at the end of 2019. The mix of average earning assets

Management’s Discussion and Analysis

Analysis of Financial Condition, continued

changed from December 31, 2019, to December 31, 2020. Average net loans decreased in relationship to total average assets and as a percent of average earning assets in 2020. Average loans as a percentage of average earning assets decreased from 80.9% in 2019 to 71.7% in 2020. The yield on loans decreased from 5.69% in 2019 to 5.12% in 2020. The average cost of funds decreased 16 basis points, including noninterest bearing deposits, during 2020. The decrease in asset yields coupled with small decrease in the cost of funds resulted in a 108 basis point decrease in the net yield on average earning assets from 2019 to 2020 as shown in Table 1.

Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulation also influence interest rates.

Provision for Loan Losses

The allowance for loan losses is established to provide for expected losses in the Company’s loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. Management determines the provision for loan losses required to maintain an allowance adequate to provide for probable losses. Management regularly reviews asset quality and re-evaluates the allowance for loan losses. However, no assurance can be given as to unforeseen adverse economic conditions or other circumstances that could result in increased provisions in the future. Additionally, regulatory examiners may require the Company to recognize additions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations.

The provision for loan losses increased from $123,652 in 2019 to a provision of $689,853 in 2020. The net provision increase is due to the economic uncertainty surrounding the Covid 19 pandemic. Net charge offs recoveries amounted to $94,009 in 2020 compared to net charge offs of $196,691 in 2019, a $290,700 difference. The guaranteed portion of the loan portfolio increased from $48,827,025 at December 31, 2019 to $74,913,864 at December 31, 2020.

The allowance for loan losses was $4,905,431 or 1.90% of total loans outstanding at December 31, 2020. This compares to an allowance for loan losses of $4,121,569, or 1.74% of total loans outstanding at December 31, 2019. The reserve increased as a percentage of total loans outstanding is due the pandemic.

When the guaranteed portion of the loans (Table 2) for which the Company has no credit exposure, is removed from the equation the loan loss reserve is approximately 2.56% of outstanding loans. At December 31, 2019 the loan loss reserve percentage was 2.32% of loans net of government guarantees.

The level of reserve is established based upon management's evaluation of historical loss data and the effects of certain environmental factors on the loan portfolio. The historical loss portion of the reserve is computed using the average loss data from the past three years applied to its corresponding category of loans. However, historical losses only reflect a portion of the Company’s loan loss reserve. The environmental factors represent risk from external economic influences on the credit quality of the loan portfolio. These factors include the movement of interest rates, unemployment rates, past due and charge off trends, loan grading migrations, movement in collateral values, the economic impact of the pandemic and the Company’s exposure to certain loan concentrations. Positive or negative movements in any of these factors have an effect on the credit quality of the loan portfolio. As a result, management continues to actively monitor the Company's asset quality affected by these environmental factors

Management believes that its loan portfolio is diversified so that a downturn in a particular market or industry will not have a significant impact on the loan portfolio or the Company's financial condition. Management believes that its provision and reserve offer an adequate allowance for loan losses.

Government Guaranteed Loans

Management recognizes the inherent risk associated with commercial real estate and commercial lending, including a borrower's actual results of operations not corresponding to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and increases in interest rates, etc.; depression of collateral values; and completion of projects within the original cost and time estimates. The Company mitigates some of that risk by actively seeking government guarantees on these loans. Loan guarantees by loan class are shown in Table 3.

Management’s Discussion and Analysis

COVID- 19

The spread of highly infectious or contagious diseases could cause, and the spread of COVID-19 has caused, severe disruptions in the U.S. economy at large, and for small businesses in particular, which could disrupt the Company’s operations. COVID-19 continues to spread through the United States and the world. The resulting concerns on the part of the U.S. and global populations have created a recession and reduced economic activity. We expect that we could experience significant disruptions across our business due to these effects, possibly leading to decreased earnings, significant slowdowns in our loan collections or increased loan defaults.

COVID-19 has and may continue to impact businesses’ and consumers’ desire or financial ability to borrow money, which would negatively impact loan volumes. In addition, certain of our borrowers are in or have exposure to the various industries impacted by COVID-19 and COVID-19 may also have an adverse effect on our commercial real estate and consumer loan portfolios. Prolonged spread of COVID-19 and the related suppression of business activities would have a negative adverse impact on these borrowers and their revenue streams, which consequently impacts their ability to meet their financial obligations and could result in loan defaults.

The outbreak of COVID-19 or an outbreak of other highly infectious or contagious diseases has resulted in and may continue to result in a decrease in our customers’ businesses, a decrease in consumer confidence and business generally, an increase in unemployment or a disruption in the services provided by the Company’s vendors. Disruptions to our customers could result in increased risk of delinquencies, defaults, foreclosures and losses on our loans, negatively impact regional economic conditions, result in declines in local loan demand, liquidity of loan guarantors, loan collateral (particularly in real estate), loan originations and deposit availability and negatively impact the implementation of our growth strategy.

The Company relies upon its third-party vendors to conduct business and to process, record, and monitor transactions. If any of these vendors are unable to continue to provide the Company with these services, it could negatively impact the Company’s ability to serve its customers. Furthermore, the outbreak could negatively impact the ability of the Company’s employees and customers to engage in banking and other financial transactions in the geographic areas in which the Company operates and could create widespread issues for the Company. The Company also could be adversely affected if key personnel or a significant number of employees were to become unavailable due to the effects and restrictions of a COVID-19 outbreak in our market areas. Although the Company has business continuity plans and other safeguards in place, there is no assurance that such plans and safeguards will be effective.

We believe that the economic impact from COVID-19 could have an adverse impact on our business and could result in losses in our loan portfolio, all of which would impact our earnings and capital. Given the ongoing and dynamic nature of the circumstances, it is difficult to predict the full impact of the COVID-19 pandemic on the Company’s business. We do not yet know the full extent of the COVID-19 pandemic’s effects on our business, operations, or the global economy as a whole. Any future development will be highly uncertain and cannot be predicted, including the scope and duration of the pandemic, the effectiveness of our work from home arrangements, third party providers’ ability to support our operation, and any actions taken by governmental authorities and other third parties in response to the pandemic. We are continuing to monitor the COVID-19 pandemic and related risks, although the rapid development and fluidity of the situation precludes any specific prediction as to its ultimate impact on the Company. However, if the COVID-19 outbreak continues to spread or otherwise results in a continuation or worsening of the current economic and commercial environments, our business, financial condition, results of operations and cash flows as well as our regulatory capital and liquidity ratios could be materially adversely affected.

Management’s Discussion and Analysis

PPP Lending

On March 27, 2020, President Trump signed the CARES Act, which included a loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals could apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. The Bank is participating as a lender in the PPP. The PPP opened on April 3, 2020; however, because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP.

Since the opening of the PPP, several other larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. The Company and the Bank may be exposed to the risk of similar litigation, from both customers and non-customers that approached the Bank regarding PPP loans, regarding its process and procedures used in processing applications for the PPP and loan forgiveness applications. If any such litigation is filed against the Company or the Bank and is not resolved in a manner favorable to the Company or the Bank, it may result in significant financial liability or adversely affect the Company’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.

The Bank also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Company, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Company.

Consolidated Balance Sheets

December 31, 2020 and 2019

2020 2019

Assets

Cash and due from banks Interest-bearing deposits with banks Federal funds sold Investment securities available for sale Restricted equity securities Loans, net of allowance for loan losses of $4,905, in 2020 and $4,121,569 in 2019 Property and equipment, net Accrued interest and other income Goodwill Bank owned life insurance Other assets Total assets

Liabilities and Stockholders’ Equity

Liabilities Deposits: Noninterest-bearing Interest-bearing Total deposits

Dividends payable Accrued interest payable Other liabilities Total liabilities

Commitments and contingencies – Note 14

Stockholders’ equity Common stock, 9,000,000 shares authorized at no par value; 4,081,738 and 4,080,838 shares issued and outstanding at December 31, 2020 and 2019, respectively Common stock, Class A, 1,000,000 shares authorized at no par value; 87,095 shares issued and outstanding at December 31, 2020 and 2019 Retained earnings Accumulated other comprehensive loss Total stockholders’ equity Total liabilities and stockholders’ equity $

See Notes to Consolidated Financial Statements

Consolidated Statements of Income

• Letter to Stockholders Table of Contents
• Financial Highlights Summary.................................................................................................................................
• Management’s Discussion and Analysis
• Report of Independent Registered Public Accounting Firm......................................................................................
• Consolidated Balance Sheets
• Consolidated Statements of Income........................................................................................................................
• Consolidated Statements of Comprehensive Income
• Consolidated Statements of Changes in Stockholders’ Equity
• Consolidated Statements of Cash Flows
• Notes to Consolidated Financial Statements............................................................................................................
• Board of Directors and Officers
• Stockholder Information
• For the years ended December 31, 2020 and
• Loans and fees on loans $ 13,453,630 $ 13,577, Interest income
• Federal funds sold 4,743 26,
• Investment securities, taxable 126,054 175,
• Interest-bearing deposits with banks 303,817 982,
• Total interest income 13,888,244 14,762,
• Deposits 1,094,662 1,299, Interest expense
• sold under agreements to repurchase Federal funds purchased and securities
• Total interest expense 1,094,686 1,299,
• Net interest income 12,793,558 13,462,
• Provision for loan losses 689,853 123,
• for loan losses 12,103,705 13 ,338, Net interest income after provision
• Service charges on deposit accounts 533,554 651, Noninterest income
• Fees on loans delivered to correspondents 238,020 147,
• Other service charges and fees 1,018,695 800,
• Gain on the sale of foreclosed assets - 4,
• Income from bank owned life insurance 171,584 177,
• Insurance commissions 777,130 725,
• Brokerage commissions and gain on sale of business - 1,
• Other operating income 175,918 137,
• Total noninterest income 2,914,90 1 2,646,
• Salaries and employee benefits 5,153,502 5,201, Noninterest expense
• Occupancy expense 502,773 521,
• Equipment expense 405,681 388,
• Data processing 785,549 711,
• Foreclosed assets, net -
• Postage, printing and supplies 189,451 174,
• Professional fees 194,452 341,
• FDIC insurance premiums 60,205 40,
• Other expense 1,905,04 1 1,938,
• Total noninterest expense 9,196,65 4 9,317,
• Net income before income taxes 5,821,952 6,667,
• Income tax expense 1,243,791 1,753,
• Net income $ 4,578,161 $ 4,913,
• Basic earnings per common share $ 1.10 $ 1.
• Diluted earnings per common share $ 1.10 $ 1.
• Basic weighted average common shares outstanding 4,168,651 4,167,
• Diluted weighted average common shares outstanding 4,168,651 4,167,
• Dividends declared per common share $ 0.52 $ 0.

Consolidated Statements of Changes in Stockholders’ Equity

For the years ended December 31, 2020 and 2019

Accumulated Other Common Stock Class A Common Stock Retained Comprehensive Shares Amount Shares Amount Earnings Loss Total

Balance December 31, 2018 4,080,538^ $^ 14,653,165^ 87,095^ $^ 1,085,461^ $^ 29,455,150^ $^ (43,411)^ $^ 45,150, Net income - - - - 4,913,391 - 4,913, Other comprehensive income - - - - - 39,988 39, Issuance of restricted common stock 300 3,960 - - - - 3, Dividends declared on Class A common stock ($0.67 per share) - - - - (58,354) - (58,354) Dividends declared on common stock ($ 0. per share) - - - - (2,122,038) - (2,122,038) Balance, December 31, 2019^4 ,080,838^ 14,657,125^ 87,095^ 1,085,461^ 32,188,149^ (3,423)^ 47,927, Net income - - - - 4,578,161 - 4,578, Other comprehensive loss - - - - - (8,647) (8,647) Issuance of restricted common stock 900 12,762 - - - - 12, Dividends declared on Class A common stock ($0.67 per share) - - - - (58,354) - (58,354) Dividends declared on common stock ($ 0. per share) - - - - (2,122,515) - (2,122,515) Balance, December 31, 2020 4,081,738 $ 14,669,887 87 , 095 $ 1,085,461 $ 34,585,441 $ (12,070) $ 50,328,

See Notes to Consolidated Financial Statements

Consolidated Statements of Cash Flows

For the years ended December 31, 2020 and 2019

2020 2019

Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operations: Depreciation and amortization Provision for loan losses Gain on the sale of foreclosed assets Deferred income taxes Amortization of premiums on securities, net of accretion of discounts Changes in assets and liabilities: Accrued interest and other income Increase in cash surrender value of life insurance Other assets Accrued interest payable Other liabilities Net cash provided by operating activities

Cash flows from investing activities Net increase in interest-bearing deposits with banks Net increase in federal funds sold Purchases of investment securities Maturities of investment securities Purchases of restricted equity securities Net increase in loans Proceeds from the sale of foreclosed assets Purchases of property and equipment Net cash used in investing activities

Cash flows from financing activities Net increase in deposits Dividends paid on common stock Issuance of restricted stock rewards Net cash provided by financing activities Net increase (decrease) in cash and due from banks

Cash and due from banks, beginning Cash and due from banks, ending $

Supplemental disclosures Interest paid Income taxes paid Cash dividends declared but not paid Change in unrealized losses on investment securities available for sale, net

See Notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements............................................................................................................

Note 1. Organization and Summary of Significant Accounting Policies, continued

Use of Estimates, continued

Substantially, all of the Company’s loan portfolio consists of loans in its market area. Accordingly, the ultimate collectability of a substantial portion of the Company’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions. The regional economy is diverse but influenced to an extent by the manufacturing and agricultural segments.

While management uses available information to recognize loan and foreclosed real estate losses, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as a part of their routine examination process, periodically review the Company’s allowances for loan and foreclosed real estate losses. Such agencies may require the Company to recognize additions to the allowances based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the allowances for loan and foreclosed real estate losses may change materially in the near term.

Cash and Due from Banks

For the purpose of presentation in the statement of cash flows, cash and cash equivalents are defined as those amounts included in the consolidated balance sheet caption “cash and due from banks.” The Company maintains due from accounts with correspondent banks. During the normal course of business, the Company may have cash deposits with these banks that are in excess of federally insured limits.

Interest-bearing Deposits with Banks

Interest-bearing deposits with banks mature within one year and are carried at cost. These deposits are primarily at the Federal Reserve Bank and the Federal Home Loan Bank of Atlanta, which sweeps excess funds out nightly and invests the funds in accounts that pay a daily rate that mirrors the federal funds rate. Other deposits included in this category are money market accounts and short-term certificates of deposit issued through the Certificate of Deposit Account Registry Service (“CDARS”).

Investment Securities Available for Sale

Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held to maturity securities.

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders’ equity. Realized gains and losses on the sale of available for sale securities are determined using the specific-identification method and are recorded on a trade-date basis. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates. Declines in the fair value of individual held to maturity and available for sale securities below cost that are other than temporary are reflected as write- downs of the individual securities to fair value.

Related write-downs are included in earnings as realized losses. In determining whether other than temporary impairment exists, management considers many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and the ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

Loans Receivable

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay- off are reported at their outstanding principal amount adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.

Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan using the interest method. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method.

Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When the interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. Payments received on nonaccrual loans are first applied to principal and any residual amounts are then applied to interest. When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status. Past due loans are determined on the basis of contractual terms.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the 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. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and qualitative components. The specific component relates to loans that are classified as impaired. For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. A qualitative component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.