ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Management’s discussion and analysis is intended to assist in understanding the financial condition and results of operations of the Company. The information in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes contained in this Form 10-K.
EXECUTIVE SUMMARY
The Company is focused on providing core banking products and services, including customized and innovative banking and lending solutions, designed to cater to the unique needs of its diverse communities, businesses and entrepreneurs through over 50 locations throughout Maine, New Hampshire and Vermont. Through over 500 dedicated professionals, the Company is committed to servicing and building enduring relationships by providing a higher standard of banking. The Company offers a variety of financial products and services designed around our target clients in order to serve all of their banking and financial needs. The Company continues to focus on three main initiatives designed to improve its franchise and profitability on an ongoing basis: attracting noninterest-bearing deposits and reducing our cost of deposits, optimizing the balance sheet to focus on higher-margin products while managing credit risk, and appropriately managing down expenses to the size and complexity of the business. Through these efforts, the Company continues to transform its franchise into a relationship-focused business bank within its footprint.
Financial Highlights
Bar Harbor Bankshares recorded 2020 net income of $33 million, or $2.18 per diluted share, compared to $23 million, or $1.45 per diluted share, in 2019. Adjusted income (non-GAAP measure) in 2020 was $35 million, or $2.26 per diluted share, and $30 million, or $1.91 per diluted share, for the same period of 2019. Non-recurring expenses in 2020 included swap termination costs and profitability initiative costs while 2019 included acquisition, conversion and balance sheet optimization costs.
Non-interest income reached record levels in 2020 driven by mortgage banking income, gains on sold securities and other fee income. The Company sold fixed rate residential mortgage production in the secondary market in lieu of taking interest rate and credit risk on the balance sheet, producing $7 million in fee revenue. The Company also took advantage of unrealized gains in the securities portfolio by selling certain investments for a net gain of $5 million. Customer service fees increased 12% on an expanded customer base from the prior year acquisition and a significant number of organic accounts opened throughout 2020. Additionally, the Company’s continued focus on commercial customers generated higher derivative and treasury income in 2020, and produced cross-sell opportunities within the retail and wealth management lines.
Wealth management remains a significant contributor to fee income in 2020; increasing 11% and serving as a foundation for deepening customer relationships with $2.3 billion in assets under management. During the year the Company consolidated leadership and combined operations onto a common platform in its wealth management business. This consolidation allowed for unified policies under one environment driven by best practices.
In 2020, the Company maintained its earning assets through commercial loan growth of $212 million or 17% through its strategy to grow variable rate loans. Non-maturity deposits grew $445 million or 25% through new accounts and the impacts of government stimulus. Excess liquidity generated from deposits was used to further delever the Company’s balance sheet by reducing wholesale funding $520 million or 49%. The reduction in wholesale funding consisted of repayments of $195 million in senior borrowings and maturities of $325 million in brokered deposits. These collective actions reduced the Company’s overall loan to deposit ratio to 88% at year-end 2020 compared to 98% in the prior year.
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The Company maintains a strong capital position; building tangible equity excluding security adjustments (non-GAAP measure) in 2020 to a higher level than before the branch acquisition in the fourth quarter of 2019. The Company furthered its return on capital programs in 2020 in the form of stock purchases and dividend payments. Stock repurchases during the year totaled 720 thousand shares at a cost of $13.9 million. An additional 61 thousand shares remain available to be repurchased before the plan expires in 2021. The Company distributed regular cash dividends on its common stock in the aggregate amount of $13 million representing a payout ratio of 40%.
Return on assets in 2020 was 0.88% compared to 0.62% in 2019, while adjusted return on assets (non-GAAP measure) was 0.92% in 2020 compared to 0.82% in 2019. In a similar trend, return on equity was 8.17% in 2020 from 5.82% in 2019 and adjusted return on equity (non-GAAP measure) was 8.48% in 2020 from 7.65% in 2019.
COVID-19 Pandemic
On March 13, 2020, a national emergency was announced related to the COVID-19 pandemic, which has since been extended. The COVID-19 pandemic has resulted in significant economic uncertainties that have had, and could continue to have, an adverse impact on the Company's operating income, financial condition and cash flows. The extent to which the COVID-19 pandemic will impact the Company's operations and financial results during 2021 cannot be reasonably or reliably estimated at this time. The Company has taken careful measures in an effort to ensure the safety of its employees and customers. That includes restricting nonessential employee travel, expanding remote access availability, distancing work stations, professional cleaning of its facilities, and signs and distancing reminders for customers in the banking centers. Further, the Company remains committed to providing uninterrupted and reliable banking service and has business continuity plans and protocols in place to ensure critical operations are able to continue without disruption. See further discussion in Item 1A – Risk Factors of this Form 10-K.
Credit Quality
The Company has experienced continuous positive trends in credit quality in 2020. Disciplined risk management has guided the Company through volatility created by the pandemic while also allowing the Company to focus on long-term goals. The Company had low levels of non-performing assets at 0.33% and past dues at 0.58% by year end 2020 including a 34% decrease in commercial loan delinquencies.
Starting in the second quarter 2020, the Company began stress testing the loan portfolio in addition to normal migration analysis. The stress testing of commercial loans included the most affected industries by COVID-19 within the Company’s footprint, specifically hospitality. However, the Company’s customers in the hospitality industry benefited from a better than expected summer tourism season for Northern New England. Testing results throughout the year affirm the Company’s risk-based credit philosophy with no significant risk-rating downgrades or changes to reserves.
Paycheck Protection Program Loans
In response to the COVID-19 pandemic the CARES Act went into law on March 27, 2020, which provides assistance for American workers, families and small businesses. The Paycheck Protection Program ("PPP"), established by the CARES Act and implemented by the Small Business Administration ("SBA") provides small businesses with funds to pay payroll costs, pay interest on mortgages, rent, and utilities and are 100% guaranteed by the SBA. PPP loans have a two year term, carry an interest rate at 1% and earn an amortizing SBA fee between 1 to 5% depending of the size of the loan. These loans are recorded on the Company’s balance sheet as commercial and industrial loans. In 2020, the Company obtained SBA approvals on approximately $132 million with $5 million of fees on 1,900 PPP loans. As of December 31, 2020, the Company had an outstanding balance of loans totaling $54 million and $1 million of deferred fees. The Company expects the majority of remaining forgiveness to occur by the end of the second quarter 2021.
On December 27, 2020, the Consolidated Appropriations Act of 2021 ("CAA") was signed into law, which extended certain provisions of the CARES Act and provided additional funding. The CAA extended the PPP application period to March 31, 2021 and permits eligible companies to obtain a second PPP loan with a maximum amount of $2.0 million. This second round of loans carry similar terms and conditions as the first round and lenders are eligible for the same range of SBA processing fees. The Company plans to continue the PPP program into the first quarter of 2021.
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Loan Modifications
Also in response to the COVID-19 pandemic the Company has supported its customers through loan deferrals. Under the CARES Act and the CAA Act, banks may deem that loan modifications do not result in troubled debt restructurings if they are (1) related to COVID-19; (2) executed on a loan that was not more than 30 days past due as of December 31, 2019; and (3) executed between March 1, 2020, and the earlier of (A) 60 days after the date of termination of the COVID-19 national emergency declaration by the President of the United States or (B) January 1, 2022. Additionally, other short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings under ASC Subtopic 310-40 and federal banking agencies' interagency guidance.
Over the course of the year the Company modified over 800 loans totaling about $400 million, which were mostly temporary principal deferrals with normal interest accruals. The loans modified under deferment plans are still accruing interest and all contractual principal and interest is expected to be collected. As of December 31, 2020, the Company had 69 COVID-19 modified loans totaling $69 million.
CECL
In 2020, the Company implemented the CECL methodology and ran it concurrently with the historical incurred method. Under a provision provided by the CARES Act of 2020, the Company elected to delay the adoption of the CECL standard. On December 27, 2020, the Consolidated Appropriations Act, 2021 was signed into law. This law extended relief for troubled debt restructurings and provided for further delay of the current expected credit losses adoption under the CARES Act to January 1, 2022, with early adoption permitted. The Company elected to remain on the incurred loan loss methodology for 2020 and will adopt the CECL standard during the first quarter of 2021, effective January 1, 2021. Had the Company adopted CECL at year end 2020, the loan loss reserve as a percentage of total loans would have been 95 basis points compared to 74 basis points reported under the incurred loss model. The 95 basis points may change in the first quarter of 2021 based primarily on any changes in economic forecasts.
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2020 AND 2019
Summary
The Company offers a competitive mix of loan and deposit products to serve the retail and commercial markets in its footprint. Loans and investment securities are the Company’s primary earning assets and net interest income from these products is its primary revenue source. Funding of the Company’s earning assets is achieved through its management of liabilities, attempting to provide stable and flexible sources of funding within well-defined credit, investment, interest rate and liquidity guidelines. The Company’s objective is to optimize its balance sheet position and enhance profitability with controlled risk. The Company maintains adequate liquidity under both prevailing and forecasted economic conditions achieved primarily through an appropriate mix of deposits and borrowed funds. Total assets were $3.7 billion in 2020, remaining steady with 2019.
Cash and Cash Equivalents
The Company maintains cash vaults and teller drawers to service customers along with transactional cash accounts to service the needs of the Company and its subsidiaries that are non-interest bearing. Interest-bearing deposits are maintained with other banks such as the Federal Reserve Bank, Federal Home Loan Bank, and other correspondent banks. These accounts are used to fund reserve requirements, debt service on senior borrowings, and serve as collateral for correspondent bank relationships. In addition, these accounts hold any excess liquidity used to fund higher earning assets. The Company continuously monitors cash levels to ensure compliance with applicable regulatory requirements, including liquidity and reserve requirements.
Total cash and cash equivalents at December 31, 2020 were $226 million, compared to $57 million at December 31, 2019. The increase in cash and cash equivalent balances of $169 million between periods was driven by unanticipated extensive growth in non-maturity deposits from new accounts and government stimulus outpacing the growth in other earning assets. The biggest portion of the growth is in Federal Reserve balances reflected in interest bearing deposits with other banks that grew by $168 million. The average earning yield on interest bearing deposits in 2020 is 0.15% compared to 0.96% in 2021, which reduces net interest margin 16 basis points and one basis point, respectively from excess liquidity.
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Securities
The Company maintains a relatively high quality and liquid securities portfolio primarily consisting of US Government-sponsored enterprises and US Government agency mortgage-backed securities, obligations of states and political subdivisions, corporate bonds, and to a much lesser extent other asset backed securities and non-agency mortgage securities. The securities portfolio is managed in accordance with achieving the Company’s asset-liability objectives which includes managing liquidity, funding, capital, and structural interest rate risks. Investments are evaluated within this framework and policy guidelines which have been established by the Company’s Board of Directors. The Company continuously evaluates and monitors the securities portfolio tied to credit, liquidity, duration, suitability and other metrics. Included in the Company’s total securities is FHLB stock which is a non-marketable equity security and, therefore, is reported at cost.
Securities in 2020 decreased $85 million as the Company focused on meeting overall asset-liability objectives when interest rates increase from their current low levels. Securities activity during the year included purchases of $216 million offset by maturities, calls and pay downs of $152 million and sales of $153 million. The proceeds from sales and amortizing securities supported asset-liability objectives to increase liquidity, reduce prepayment and reinvestment risk, and improve risk adjusted returns.
The Company monitors our securities portfolio to ensure adequate credit support. As of December 31, 2020, the Company has identified no credit impairment. There is no current intent to sell securities with a fair value below amortized cost at December 31, 2020, and it is more likely than not that the Company will not be required to sell such securities prior to the recovery of their amortized cost basis. We consider the lowest credit rating and industrial analysis for identification of potential credit impairment.
In 2020, the Company sold securities of $153 million with a net gain of $5 million. The sales strategy took advantage of favorable market conditions with attractive prices allowing the Company to sell securities projected to have sub-optimal returns and lower liquidity profiles at sizable gains. The Company was then able to repurchase more liquid securities with reduced prepayment risk and improved risk adjusted returns. The execution of the fourth quarter trades led to slight increase in profitability metrics and availability to pledge additional securities with the FHLB. Although the sales generating realized gains the Company still improved December 31, 2020 unrealized gains, net of tax to $10 million compared to $6 million at December 31, 2019.
The weighted average yield on the Company’s securities portfolio was 2.96% in 2020 compared to 3.42% in the prior year. The weighted average life of the securities portfolio at December 31, 2020 was estimated to be 4.8 years, with a duration of approximately 4.3 years. These metrics compare with an estimated weighted average life of 5.0 years, with a duration of approximately 3.6 years for the portfolio at December 31, 2019.
Loans Held For Sale
Held for sale loans increased by $18 million to $24 million at December 31, 2020 from $6 million at December 31, 2019 as a result of strong mortgage refinancing demand in response to the low interest rate environment. This asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. In 2020, the Company’s strategy was to sell most of its residential mortgage originations on the secondary market. Proceeds from sales totaled $223 million in 2020, $63 million in 2019 and $58 million in 2018.
Loans
The Company’s loan portfolio is comprised of the following segments: commercial real estate, commercial and industrial, residential real estate, and consumer loans. Commercial real estate loans include multi-family, commercial construction and land development, and other commercial real estate classes. Commercial and industrial loans include loans to commercial businesses and tax exempt entities including PPP loans to small businesses. Residential real estate loans consist of mortgages for 1-4 family housing. Consumer loans include home equity loans, lines of credit and auto and other installment lending.
During 2020 total loans decreased $72 million to $2.6 billion. Given the current economic environment, the Company selectively grew total commercial loans to $1.5 billion or at a pace of 17%. Commercial and industrial loans grew 18%
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during the year, and 2% excluding PPP loans as the Company closely monitored risk associated with growth prospects in the portfolio. Commercial loan growth was offset by a decline in residential loan balances of $221 million or 20% as the Company strategically moved a majority of production to the secondary market platform to generate fee income. Residential loan production was led by refinancing activity given the lower interest rate environment and originations totaled $246 million in 2020 compared to $67 million in 2019.
The Company offered PPP loans in an effort to assist its business partners and communities. The Company will continue the program with the second round of PPP loans authorized by the new stimulus bill in 2021. The Company originated over 1,900 first-round PPP loans totaling $132 million, of which many have been submitted for forgiveness by the SBA. The remaining first round PPP loans total $54 million with an associated $1 million of deferred fees not yet recognized in income and are expected to be forgiven by the end of the second quarter 2021. The Company also offered borrowers COVID-19 loan modifications consisting mostly of temporary deferrals with normal interest accruals. The modifications totaled over 800 loans or about $400 million over the course of the year.
The Company’s loan portfolio remains diverse among many different industries over several geographies. However, commercial loans represent 60% of the total portfolio and typically involve larger balances and gives rise to concentration risk.
All commercial loans are assigned Standard Industrial Classification codes, North American Industry Classification System codes, and state and county codes. The following table summarizes the major industries of the Company’s commercial loan portfolio as of December 31, 2020:
(in thousands) Amount Percent of Portfolio
Real estate rental and leasing $ 644,994 42 %
Health care and social assistance 91,989 6
Agriculture, forestry, fishing and hunting 41,271 3
Arts, entertainment, and recreation 22,137 1
Professional, scientific, and technical services 16,463 1
Management of companies and enterprises 15,324 1
Transportation and warehousing 15,038 1
The largest concentrations in the commercial loan portfolio are commercial real estate and hospitality representing 42% and 18%, respectively. Concentrations are managed through a serious of loan policy limits and stringent underwriting requirements to minimize exposures. Loan policy limits are based on Tier 1 Risk Based Capital (TRBC) as computed in quarterly regulatory reporting. At December 31, 2020, none of these TRBC thresholds were exceeded. In regard to stringent underwriting requirements the Company has established minimum thresholds for loan to value ratios, debt service coverage rations, and requirements for personal guarantees. The Company also performs a borrower revenue/margin sensitively analysis on current financials to determine the impact of decreases in borrower revenues on cash flow and ability to cover debt service.
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Allowance for loan losses
The determination of the allowance for loan losses is a critical accounting estimate. The Company’s methodologies for determining the loan loss allowance are discussed in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements.
The year-end 2020 allowance for loan losses increased to $19 million from $15 million in 2019 largely due to commercial loan growth and increased qualitative economic factors associated with the pandemic. The allowance for loan losses to total loans ratio expanded at year-end 2020 to 0.74% from 0.58% at year-end 2019. As noted above the Company has adopted CECL as of January 1, 2021 which will result in a higher allowance coverage ratio. Non-accruing loans in 2020 decreased primarily due to $2 million in commercial and residential payoffs during the fourth quarter.
Due to the impacts of the pandemic the Company began and expanded quarterly stress testing of its commercial loan portfolio throughout 2020. Fourth quarter testing covered 54% of the portfolio including the top 50 relationships, all criticized loans greater than $1.0 million, hospitality loans greater than $250 thousand, all loans over $150 thousand with a pandemic modification and any seasonal payment, restaurant, or 2021 maturing term loans greater than $500 thousand. Results of the stress testing led to no significant downgrades or changes to reserves.
Other Assets
The Company identifies on its balance sheet premises and equipment, other real estate owned, goodwill, other intangible assets, bank-owned life insurance, net deferred tax assets and other assets consisting of derivative fair values, right of use asset, community investments, and receivables. These collective assets totaled $333 million at the end of 2020 compared to $303 million as of December 31, 2019. The increase is primarily from the $26 million gross up of the fair value in customer loan derivatives and $3 million in community limited partnership investments made during 2020 reflected in the cash flow from investing activities. Community limited partnership investments provide affordable loans or equity funding typically for multifamily or residential real estate in qualified community reinvestment areas, some of which may involve low income housing tax credits. Partnerships can also include loans for commercial purposes used in economic development in qualified community reinvestment areas.
Deposits
The Company views its customer relationships as key to building its core funding platform. The Company offers competitive deposit products with local convenience including accounts with cash-back rewards. Historically, the Company’s deposit market experiences some seasonality, with lower deposits in the winter and spring months and higher deposits in the summer and autumn months.
Total deposits increased $210 million to $2.9 billion in 2020 from $2.7 billion in 2019. Non-maturity deposits grew by $445 million or 25%, with the Company’s retail team opening 13,250 new accounts for the year and impacts of government stimulus. Time deposits decreased $235 million given a $325 million reduction in brokered deposits offset by $90 million of growth in customer time deposits. Lower interest rates and the divergence in brokered deposit spreads provided an opportunity to lock into favorable rates with longer maturities in early 2020. The Company improved its loan-to-deposit ratio to 88% at year-end from 98% at the end of 2019 primarily as a result of deposit growth and residential loan sales.
Borrowings
Borrowed funds provide a means to help manage balance sheet interest rate risk, given the Company’s ability to select desired amounts, terms and maturities on a daily basis. Senior borrowings principally consist of advances from the FHLB and, to a lesser extent, securities sold under agreements to repurchase. Advances from the FHLB are secured by stock in the FHLB, investment securities, certain commercial real estate loans, and blanket liens on qualifying mortgage loans and home equity loans. Subordinated borrowings consist of notes issued to accredited investors and provides a stable source of funding and capital to the Company. Contingency lines of credit are also maintained with the Federal Reserve Bank of Boston and a correspondent bank.
At December 31, 2020 total borrowings were $336 million with a weighted average rate of 1.41% compared to $531 million with a weighted average rate of 2.11% at year-end 2019. Prior to the pandemic the Company’s borrowings strategy centered around managing seasonal drops in core deposit funding while neutralizing fixed rate asset growth which involved locking into favorable rates on longer maturities. As a result 2020 long-term borrowings increased by $59 million with a
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weighted average rate of 2.37% at December 31, 2020 compared to 2.87% at December 31, 2019. Following the onset of the pandemic the Company changed strategy to leverage funds from strong core deposit growth to offset maturing short-term borrowings. Overall borrowings decreased $195 million or 37% from year-end 2019 primarily as excess liquidity was used to pay down borrowings. Short-term borrowings were reduced during the year by $254 million to $93 million with a weighted average rate of 0.44% compared to 1.73% at December 31, 2019.
Derivative Financial Instruments and Hedging Activities
The Company utilizes derivative instruments to minimize fluctuations in earnings and cash flows caused by interest rate volatility. The notional balance of derivative financial instruments increased to $877 million at the end of 2020 from $580 million at year-end 2019. The increase is primarily due to $300 million in customer loan derivatives sold on commercial loans with matching hedges using a national bank counterparty. The net fair value of total derivatives was a net asset of $52 thousand at the end of 2020 compared to a net liability of $743 thousand at year-end 2019.
Cash flow hedges reflected a new $25 million notional amount hedge on wholesale funding in April 2020. Based on direct and indirect events resulting from COVID-19 pandemic, the Company determined that $50 million of wholesale funding was no longer necessary. A hedge the Company placed in March 2019 with a $50 million notional amount and fixed rate of 2.46% was terminated in October 2020. As a result of the termination a $4 million loss recognized in acquisition, conversion, and other expenses as a result of the reclassification of the unrealized loss from other comprehensive income.
Stockholders’ Equity
Total equity was $411 million at year-end 2020, compared with $396 million at year-end 2019. The Company’s book value per share increased $2.10 to $27.58 from year-end 2019. The increase was primarily due to strong net income of $33 million and a $7 million improvement in other comprehensive income offset by $13 million in dividends and $14 million in stock repurchases. The Company evaluates changes in tangible book value, a non-GAAP financial measure that is a commonly used valuation metric in the investment community, which parallels some regulatory capital measures. Tangible book value per share increased to $19.05 per share at year-end 2020 up from $17.30 per share at year-end 2019.
During 2020 and 2019, the Company declared and distributed regular cash dividends on its common stock in the aggregate amount of $13 million for both periods. The Company’s 2020 dividend payout ratio amounted to 40%, compared with 59% in 2019. Total cash dividends paid in 2020 was $0.88 per common share of stock, compared with $0.86 in 2019.
On March 12, 2020, the Company’s Board of Directors authorized a share repurchase plan (the “Plan”). Under the terms of the Plan, the Company is authorized to repurchase up to 5% of its outstanding common stock, representing approximately 781,000 shares. The Plan is authorized for twelve months expiring on March 20, 2021 and authorized based on the strength of the Company’s balance sheet and capital position, and the Company’s belief in the intrinsic value of the Company’s common stock. Given the current market for bank stock prices, the Company believes this program is another tool to enhance long-term shareholder value. As of December 31, 2020, the Company has purchased 720,043 shares.
The Company and the Bank remained well-capitalized under regulatory guidelines at period end as further described in Note 13 - Shareholders’ Equity and Earnings Per Common Share on the Consolidated Financial Statements.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2020 AND 2019
Summary
Net income in 2020 was $33 million compared to $23 million in 2019. The non-GAAP measure of adjusted earnings in 2020 was $35 million compared to $30 million in 2019 and included acquisition, conversion and other expense charges of $6 million and $8 million, respectively. Net income and adjusted earnings benefited from an expanded net interest margin and higher non-interest income.
Net Interest Income
Net interest income is the principal component of the Company’s income stream and represents the difference or spread between interest generated from earning assets and the interest expense paid on deposits and borrowed funds. Fluctuations
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in market interest rates as well as volume and mix changes in earning assets and interest-bearing liabilities can materially impact net interest income.
Net interest income for 2020 was $99 million compared with $90 million in 2019 primarily due to a lower cost of funds resulting from increased liquidity from growth in non-maturity deposits. The net interest margin expanded to 2.97% in 2020 compared to 2.77% in the prior year. Purchase loan accretion contributed 11 and 10 basis points to the margin in 2020 and 2019, respectively. Cost of deposits and borrowings also benefited from the Federal Reserve rate cuts in 2020 and changes in other key indexes in response to the pandemic. In total cost of funds decreased 65 basis points to 0.96% compared to 1.61% in 2019 due to the shift in funding sources to core deposits. Total interest-bearing deposit rates improved to 0.78% compared to 1.27% in 2019 from growth in core deposits and reductions in time deposits during 2020. Borrowing costs improved to 1.75% from 2.61% in 2019, on reduced borrowing levels and interest rates.
The yield on earning assets was 3.87% compared to 4.14% in 2019 reflecting loan originations and repricing of variable rate products in a lower interest rate environment. Both securities yields and loan yields dropped 22 basis points to 3.20% and 4.16%, respectively for 2020. The 2020 adjusted net interest margin (non-GAAP measure), which excludes PPP loans was 2.93% compared to 2.77% for 2019, which included a drag of 16 basis points and one basis point, respectively from excess liquidity reflected in interest-bearing deposits with other banks.
Loan Loss Provision
The level of the allowance is a critical accounting estimate, which is subject to uncertainty. The provision for loan losses is a charge to earnings in an amount sufficient to maintain the allowance for loan losses at a level deemed adequate by the Company. The provision was $6 million in 2020 compared to $2 million in 2019. Credit quality metrics improved with decreases in non-accruing and past due loans. Overall credit quality remains strong, the increase in the provision is indicative of commercial loan growth and higher economic adjustments reflecting elevated risk from COVID-19.
Non-Interest Income
Non-interest income are fees that are fundamental to the Company’s profitability through revenue diversification in the forms of trust and treasury management services, customer service fees, customer loan derivatives, and secondary market mortgage sales.
Non-interest income in 2020 increased to $43 million from $29 million in 2019 driven primarily by increases in mortgage banking income and gains on sold securities. The $5 million increase in mortgage banking income is associated with secondary market sales of $223 million compared to $63 million in 2019. The Company took advantage of unrealized gains in the securities portfolio in 2020 by selling certain investments for a net gain of $5 million. Customer loan derivative income also contributed to non-interest income as demand for these products remained strong within the commercial loan pipeline throughout the year. Customer services fees increased by over $1 million to $11 million resulting from expanded operations into Central Maine offset by impacts of the pandemic on these services. Wealth management income grew over $1 million to $13 million in 2020. The increase reflects a full year of having assets under management acquired in the fourth quarter of 2019 totaling $218 million.
Non-Interest Expense
Non-interest expense was $95 million in 2020 compared to $90 million in 2019. The increase is primarily a result of a $4 million higher salary and benefit expense due to the expanded branch model and wealth management business. Salary and benefit expense was also impacted by larger accruals for incentives on improved performance metrics and post-retirement plan costs based on lower discount rates. Additionally, occupancy and equipment costs increased by $3 million based on the expanded footprint in central Maine. Operating expenses remained controlled as the efficiency ratio (non-GAAP) improved to 61.71% in 2020 from 64.95% in 2019. Non-recurring expenses in 2020 primarily consisted of a $4 million loss on termination of a $50.0 million swap on wholesale borrowings and a $1 million loss on extinguishment of debt on longer-term and higher cost FHLB borrowings. The remaining represents costs for profitability initiatives including trust system conversion and consolidation. Non-recurring expenses in 2019 included a $3 million loss on interest rate cap terminations, $3 million related to the branch acquisition, and $2 million related to branch optimization and other strategic initiatives.
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Income Tax Expense
The amount of federal and state income tax expense is influenced by the amount of pre-tax income, the amount of tax-exempt income and the amount of other nondeductible expenses. Income tax expense was $8 million for the year ended December 31, 2020, compared with $4 million for the year ended December 31, 2019. The effective tax rate increased to 20.2% in 2020 from 15.7% in 2019, reflecting the higher level of taxable income and lower level of non-tax advantaged income in 2020. This reflects higher income in 2020 from the Company’s expanded customer base in the state of Maine along with higher core deposits that carry a lower cost of funds.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2019 AND 2018
Summary
Net income in 2019 was $23 million compared to $33 million in 2018 and included acquisition, restructuring and other expense charges of $8 million and $2 million, respectively. The non-GAAP measure of adjusted earnings in 2019 was $30 million compared to $35 million in 2018. Net income and adjusted earnings in 2019 benefited from expanded yields on earning assets and non-interest income growth, offset by higher cost of funds. Results for 2019 include operations from the branch acquisition as of the October 25, 2019 effective date.
Net Interest Income
Net interest income for 2019 was $90 million compared with $91 million in 2018. Interest income was $135 million, up 6% from $127 million in 2018 as average earning assets grew $70 million. The net interest margin was 2.78% in 2019 compared to 2.87% in the prior year. Purchase loan accretion contributed 10 and 11 basis points to the margin in 2019 and 2018, respectively. Yields expanded across all loan categories as variable rate products in the first half of 2019 repriced to higher rates driven by the 2018 short-term hikes. The 2019 yield on securities improved by 19 basis points reflecting the benefit of portfolio remix strategies and associated security sales in the second half of 2019. These improvements in interest from earning assets were offset by a higher cost of interest bearing liabilities, especially in the first half of 2019, which was also driven by short-term rate hikes in late 2018. While the cost of interest bearing liabilities increased 30 basis points to 1.61% on a year-over-year basis, the same costs improved to 1.42% in the fourth quarter due to executing deleveraging strategies associated with the branch acquisition and securities sales.
Loan Loss Provision
The level of the allowance is a critical accounting estimate, which is subject to uncertainty. The provision for loan losses is a charge to earnings in an amount sufficient to maintain the allowance for loan losses at a level deemed adequate by the Company. The provision was $2 million in 2019 compared to $3 million in 2018. The decrease is primarily due to lower charge-offs in 2019 as compared to prior year reflecting continued improvement in credit quality.
Non-Interest Income
Non-interest income for 2019 increased to $29 million from $28 million in 2018 driven primarily by customer loan derivative income, which increased to $2 million in 2019 compared to $860 thousand in 2018. The increase in these fees is attributable to the Company’s continued focus on the complexity of the financial needs of its customers and related commercial loan growth in 2019. Customer service fees also contributed to the overall increase in non-interest income growing by $589 thousand in 2019. The increase is due to higher transaction volume principally from the deposit base obtained through the branch acquisition. Trust and investment management fee income in 2019 was relatively flat with 2018. However, assets under management increased to $2.0 billion in 2019 compared to $1.7 billion in 2018 primarily due wealth management accounts that were obtained through the branch acquisition.
Non-Interest Expense
Non-interest expense was $90 million in 2019 compared to $76 million in 2018. The increase in 2019 includes $3 million related to the branch acquisition, a $3 million reclassification of losses on the interest rate cap derivative from other comprehensive income and $3 million related to branch optimization and other strategic review expenses. Salary and employee benefits expenses increased by $4 million due to postretirement benefit revaluations on lower discount rates and an increase in full time equivalent employees (“FTEs”). FTEs totaled 531 at the end of 2019 compared with 445 at the end of 2018, which includes employees from the branch acquisition.
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Income Tax Expense
The effective tax rate decreased to 15.7% in 2019 from 18.7% in 2018 due to a higher proportion of tax-advantaged income to taxable income, which was driven by overall lower net income in 2019 as compared to 2018.
Expected Replacement of London Interbank Offered Rate
The Alternative Reference Rates Committee continues its work in finding suitable replacements for LIBOR. It is expected that a transition away from the widespread use of LIBOR to alternative reference rates and other potential interest rate benchmark reforms will occur beginning potentially in 2022. Although the full impact of such reforms and actions, together with any transition away from LIBOR remains unclear, the Company is preparing to transition from the LIBOR to an alternative reference rate.
The Company’s transition plan includes a number of key steps, including engagement with central bank and industry working groups and regulators, active client engagement, internal operational readiness, and risk management, among other things, to promote the transition to alternative reference rates. The Company is identifying on-balance sheet and off-balance sheet references to LIBOR, determining appropriate language to replace the LIBOR index language, and determining disclosures necessary for customers, with appropriate procedures and schedules to complete the LIBOR transition.
However, there is a number of unknown factors regarding the transition from LIBOR or interest rate benchmark reforms that could impact the Company’s business, including, for example, the pace of the transition to replacement or reformed rates, the specific terms and parameters for and market acceptance of the alternative reference rates, prices of and the liquidity of trading markets for products based on the alternative reference rates, and ability to transition to and develop appropriate systems and analytics for one or more alternative reference rates.
For a further discussion of the various risks the Company faces in connection with the expected replacement of LIBOR and reform of interest rate benchmarks on operations, see Item 1A of this Form 10K – “Risk Factors,” paragraph for “Reforms to London Interbank Offered Rate ("LIBOR") and other indices, and related uncertainty, may adversely affect our business, financial condition or results of operations.”
LIQUIDITY AND CASH FLOWS
Liquidity is measured by the Company’s ability to meet short-term cash needs at a reasonable cost or minimal loss. The Company seeks to obtain favorable sources of liabilities and to maintain prudent levels of liquid assets in order to satisfy varied liquidity demands. Besides serving as a funding source for maturing obligations, liquidity provides flexibility in responding to customer initiated needs. Many factors affect the Company’s ability to meet liquidity needs, including variations in the markets served by its network of offices, its mix of assets and liabilities, reputation and credit standing in the marketplace, and general economic conditions.
The Bank actively manages its liquidity position through target ratios established under its Asset Liability Management Policy. Continual monitoring of these ratios, by using historical data and through forecasts under multiple rate and stress scenarios, allows the Bank to employ strategies necessary to maintain adequate liquidity. The Bank’s policy is to maintain a liquidity position of at least 4% of total assets. A portion of the Bank’s deposit base has been historically seasonal in nature, with balances typically declining in the winter months through late spring, during which period the Bank’s liquidity position tightens.
The Bank maintains a liquidity contingency plan approved by the Bank’s Board of Directors. This plan addresses the steps that would be taken in the event of a liquidity crisis, and identifies other sources of liquidity available to the Company. Company management believes that the level of liquidity is sufficient to meet current and future funding requirements. However, changes in economic conditions, including consumer savings habits and availability or access to the brokered deposit market could potentially have a significant impact on the Company’s liquidity position.
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The Company believes the existing cash and cash equivalents (including an interest-bearing deposit at the FRB Boston), securities available for sale and cash flows from operating activities will be sufficient to meet anticipated cash needs for at least the next twelve months. Future working capital needs will depend on many factors, including the rate of business and revenue growth. To the extent cash and cash equivalents, securities available for sale and cash flows from operating activities are insufficient to fund future activities, the Company may need to raise additional funds through debt arrangements or public or private debt or equity financings. The Company also may need to raise additional funds in the event it is determined in the future to effect one or more acquisitions of banks or businesses. If additional funding is required, the Company may not be able to obtain debt arrangements or to effect an equity or debt financing on terms acceptable to the Company or at all.
Capital Resources
Consistent with its long-term goal of operating a sound and profitable organization, at December 31, 2020, the Company maintained its strong capital position and continued to be a “well-capitalized” financial institution according to applicable regulatory standards. Management believes this to be vital in promoting depositor and investor confidence and providing a solid foundation for future growth.
The Company’s liquidity position remains strong. During the quarter we initiated pandemic-specific liquidity stress tests to analyze potential impacts from payment deferrals, unanticipated use of committed lines of credit, as well as the possibility of required servicer advances on sold loans. At December 31, 2020, available same-day liquidity totaled approximately $1.1 billion, including cash, borrowing capacity at FHLB and the Federal Reserve Discount Window and various lines of credit. Additional sources of liquidity include cash flows from operations, wholesale deposits, cash flow from the Company's amortizing securities and loan portfolios. The Company had unused borrowing capacity at the FHLB of $511.9 million, unused borrowing capacity at the Federal Reserve of $81.1 million and unused lines of credit totaling $71.9 million, in addition to over $200.0 million in unencumbered, liquid investment portfolio assets. The Company has also utilized the Federal Reserve's Paycheck Protection Program Liquidity Facility to provide liquidity to fund PPP loans.
Contractual Obligations
The Company is a party to certain contractual obligations under which it is obligated to make future payments. These principally include borrowings from the FHLB, consisting of short-term and long-term fixed rate borrowings, and collateralized by all stock in the FHLB; a blanket lien on qualified collateral consisting primarily of loans with first and second mortgages secured by one-to-four family properties; and certain pledged investment securities. The Company has an obligation to repay all borrowings from the FHLB.
In the normal course of conducting its banking and financial services business, and in connection with providing products and services to its customers, the Company has entered into a variety of traditional third-party contracts for support services. Examples of such contractual agreements include, but are not limited to: services providing core banking systems, ATM and debit card processing, trust services software, accounting software and the leasing of T-1 telecommunication lines and other technology infrastructure supporting the Company’s network.
The following table summarizes the Company’s contractual obligations at December 31, 2020:
Less than One One to Three Three to Five After Five
(in thousands) Total Year Years Years Years
EFFECTS OF INFLATION
Inflation and changing prices have not had a material effect on the Company’s business, and the Company does not expect that they will materially affect the business in the foreseeable future. Any impact of inflation on cost of revenue and
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operating expenses, especially employee compensation costs, may not be readily recoverable in the price of the Company product offerings.
OFF-BALANCE SHEET ARRANGEMENTS
The Company is a party to certain off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that may be material to investors.
At December 31, 2020 and 2019, the Company’s off-balance sheet arrangements were limited to customer obligations, in the normal course of business to meet customer’s financing needs. These financial arrangements include commitments to extend credit, unused or unadvanced loan funds, and letters of credit. The Company uses the same lending policies and procedures to make such commitments as it uses for other lending products. Customers’ creditworthiness is evaluated on a case-by-case basis.
Commitments to originate loans, including unused or unadvanced loan funds, are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the customer to pay a fee. Since many of the commitments are expected to expire without being fully drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Standby letters of credit generally become payable upon the failure of the customer to perform according to the terms of the underlying contract with the third party, while commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and a third party. The contractual amount of these letters of credit represents the maximum potential future payments guaranteed by the Company. Typically these letters of credit expire if unused; therefore the total amounts do not necessarily represent future cash requirements. For further detail see Note 12 - Other Commitments, Contingencies and Off-Balance Sheet Activities of the Consolidated Financial Statements.
IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
Please refer to the notes on Recently Adopted Accounting Principles and Future Application of Accounting Pronouncements in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ACCOUNTING ESTIMATES, AND RECENT ACCOUNTING PRONOUNCEMENTS
The Company’s significant accounting policies are described in Note 1 - Summary of Significant Accounting Policies of the Consolidated Financial Statements in this Annual Report on Form 10-K. The preparation of the consolidated financial statements in accordance with GAAP and practices generally applicable to the financial services industry requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and to disclose contingent assets and liabilities. Actual results could differ from those estimates.
Management has identified the Company’s most critical accounting policies as related to:
● Allowance for Loan Losses
● Acquired Loans
● Income Taxes
● Goodwill and Identifiable Intangible Assets
● Determination of Other-Than-Temporary Impairment of Securities
● Fair Value of Financial Instruments
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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates/prices, such as interest rates, foreign currency exchange rates, commodity prices and equity prices. Interest rate risk is the most significant market risk affecting the Company. Other types of market risk do not arise in the normal course of the Company’s business activities.
The responsibility for interest rate risk management oversight is the function of the Bank’s Asset and Liability Committee (“ALCO”), chaired by the Chief Financial Officer and composed of various members of senior management. ALCO meets regularly to review balance sheet structure, formulate strategies in light of current and expected economic conditions, adjust product prices as necessary, implement policy, monitor liquidity, and review performance against guidelines established to control exposure to the various types of inherent risk.
Interest Rate Risk: Interest rate risk can be defined as an exposure to movement in interest rates that could have an adverse impact on the Bank's net interest income. Interest rate risk arises from the imbalance in the re-pricing, maturity and/or cash flow characteristics of assets and liabilities. Management's objectives are to measure, monitor and develop strategies in response to the interest rate risk profile inherent in the Bank's balance sheet. The objectives in managing the Bank's balance sheet are to preserve the sensitivity of net interest income to actual or potential changes in interest rates, and to enhance profitability through strategies that promote sufficient reward for understood and controlled risk.
The Bank's interest rate risk measurement and management techniques incorporate the re-pricing and cash flow attributes of balance sheet and off-balance sheet instruments as each relate to current and potential changes in interest rates. The level of interest rate risk, measured in terms of the potential future effect on net interest income, is determined through the use of modeling and other techniques under multiple interest rate scenarios. Interest rate risk is evaluated in depth on a quarterly basis and reviewed by ALCO and the Company’s Board of Directors.
The Bank's Asset Liability Management Policy, approved annually by the Bank’s Board of Directors, establishes interest rate risk limits in terms of variability of net interest income under rising, flat, and decreasing rate scenarios. It is the role of the ALCO to evaluate the overall risk profile and to determine actions to maintain and achieve a posture consistent with policy guidelines.
Interest Rate Sensitivity Modeling: The Bank utilizes an interest rate risk model widely recognized in the financial industry to monitor and measure interest rate risk. The model simulates the behavior of interest income and expense for all balance sheet and off-balance sheet instruments, under different interest rate scenarios together with a dynamic future balance sheet. Interest rate risk is measured in terms of potential changes in net interest income based upon shifts in the yield curve.
The interest rate risk sensitivity model requires that assets and liabilities be broken down into components as to fixed, variable, and adjustable interest rates, as well as other homogeneous groupings, which are segregated as to maturity and type of instrument. The model includes assumptions about how the balance sheet is likely to evolve through time and in different interest rate environments. The model uses contractual re-pricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposit accounts, such as money market accounts, that are subject to re-pricing based on current market conditions. Re-pricing margins are also determined for adjustable rate assets and incorporated in the model. Investment securities and borrowings with option provisions are examined on an individual basis in each rate environment to estimate the likelihood of exercise. Prepayment assumptions for mortgage loans are calibrated using specific Bank experience while mortgage-backed securities are developed from industry standard models of prepayment speeds, based upon similar coupon ranges and degree of seasoning. Cash flows and maturities are then determined, and for certain assets, prepayment assumptions are estimated under different interest rate scenarios. Interest income and interest expense are then simulated under several hypothetical interest rate conditions including:
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Changes in net interest income based upon the foregoing simulations are measured against the flat interest rate scenario and actions are taken to maintain the balance sheet interest rate risk within established policy guidelines.
In 2020, behavioral assumptions regarding both core deposits and residential loans were modified to incorporate the results of a third party model to better reflect the Bank’s unique position and geographic footprint. As of December 31, 2020, interest rate sensitivity modeling results indicate that the Bank’s balance sheet was asset sensitive over the one- and two-year horizons.
The following table presents the changes in sensitivities on net interest income for the years ended December 31, 2020 and 2019:
(in thousands, except ratios) $ Change % Change $ Change % Change
Assuming short-term and long-term interest rates decline 100 basis points from current levels (i.e., a parallel yield curve shift) and the Bank’s balance sheet structure and size remain at current levels, management believes net interest income will deteriorate over the one year horizon while deteriorating further from that level over the two-year horizon.
Assuming the Bank’s balance sheet structure and size remain at current levels and the Federal Reserve increases short-term interest rates by 200 basis points with the balance of the yield curve shifting in parallel with these increases, management believes net interest income will improve over both the one and two-year horizons.
As compared to December 31, 2019, the year-one sensitivity in the down 100 basis points scenario is down with the year-two sensitivities in the down 100 basis points scenario lower as well. In the year-one and year-two up 200 basis points scenario, results are meaningfully improved on a year-over-year basis.
The preceding sensitivity analysis does not represent a Company forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions including: the nature and timing of interest rate levels and yield curve shape, prepayment speeds on loans and securities, deposit rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cash flows, and renegotiated loan terms with borrowers. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
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As market conditions vary from those assumed in the sensitivity analysis, actual results may also differ due to: prepayment and refinancing levels deviating from those assumed; the impact of interest rate changes, caps or floors on adjustable rate assets; the potential effect of changing debt service levels on customers with adjustable rate loans; depositor early withdrawals and product preference changes; and other such variables. The sensitivity analysis also does not reflect additional actions that the Bank’s Senior Executive Team and Board of Directors might take in responding to or anticipating changes in interest rates, and the anticipated impact on the Bank’s net interest income.
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ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors of Bar Harbor Bankshares and Subsidiaries
Opinion on the Internal Control Over Financial Reporting
We have audited the accompanying consolidated balance sheets of Bar Harbor Bankshares and Subsidiaries (the Company) as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2020, 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, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 2013, and our report dated March 10, 2021 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
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 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. 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.
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.
Qualitative Reserve in the Allowance for Loan Losses
As described in Notes 1 and 4 of the consolidated financial statements, the Company’s allowance for loan losses totaled $19.1 million as of December 31, 2020. The allowance is comprised of four distinct reserve components: (1) specific reserves related to loans individually evaluated; (2) quantitative reserves related to loans collectively evaluated; (3) qualitative reserves related to loans collectively evaluated; and (4) an estimate is made for losses incurred during the loss emergence period for each loan category within the collectively evaluated pools. As of December 31, 2020, specific reserves related to loans individually evaluated totaled $730 thousand and the reserve associated with loans collectively evaluated, including the quantitative, qualitative and loss emergence period estimates, totaled, $18.4 million.
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For loans that are collectively evaluated, the Company segregates loans into two general loan pools: substandard and pass rated by loan type. The reserve for loans collectively evaluated is established through historical loss experience of the loan pools over their respective loss emergence periods which are then adjusted for potential risks factors that could result in actual losses deviating from prior loss experience. The Company has considered these qualitative risk factors to be: (1) lending policies and procedures, (2) business conditions, (3) volume and nature of the loan portfolio, (4) experience, ability and depth of lending management, (5) problem loan trends, (6) quality of the Company’s loan review system, (7) concentrations in the loan portfolio, (8) competition, legal, and regulatory environment, and (9) collateral coverage and loan to value. Arriving at an appropriate level of allowance for loan losses, specifically the qualitative reserve, involves a high degree of judgment by management and future adjustments may be necessary if there are significant changes in conditions.
We identified the qualitative reserve for loans collectively evaluated in the allowance for loan losses as a critical audit matter due to the high degree of auditor judgment required in order to evaluate the subjective assumptions made by management within the reserve. Our audit procedures related to management’s evaluation and establishment of the qualitative reserve for loans collectively evaluated in the allowance for loan losses include the following, among others:
Goodwill Impairment Assessment
As described in Notes 1 and 6 of the consolidated financial statements, the Company’s goodwill balance was $119.5 million as of December 31, 2020. The Company performs a goodwill impairment test annually as of September 30, or whenever certain triggering events occur or there are circumstances that would more likely than not reduce the fair value of the reporting unit below its carrying amount are identified. Management estimates the fair value of the reporting unit by considering multiple valuation techniques, which include the income approach (discounted cash flow method) and the market approach (combination of comparable public companies and acquisition transactions). These valuation techniques consider various assumptions about projected financial results, business plans, discount rates, valuation multiples, and growth rates, among others.
We identified the impairment assessment of goodwill as a critical audit matter due to the high degree of auditor judgement, subjectivity, and effort in order to evaluate the fair value of the reporting unit due to the judgements made by management in the estimation of the Company’s future cash flows (including consideration of projected financial results and business plans), the components used in determining the discount and growth rates, the valuation multiples used, and the market data used. In addition, the audit effort involved the use of internal professionals with specialized skill and knowledge in the field of business valuation.
Our audit procedures related to the goodwill impairment assessments performed throughout the year included the following:
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/s/ RSM US LLP
We have served as the Company's auditor since 2015.
Boston, Massachusetts
March 10, 2021
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) December 31, 2020 December 31, 2019
Assets
Cash and cash equivalents:
Interest-bearing deposits with other banks 198,441 30,425
Securities:
Less: Allowance for loan losses (19,082) (15,353)
Other real estate owned — 2,236
Cash surrender value of bank-owned life insurance 77,870 75,863
Liabilities
Deposits:
Borrowings:
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(in thousands, except share data) December 31, 2020 December 31, 2019
Shareholders’ equity
Accumulated other comprehensive income 11,016 3,911
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31,
(in thousands, except earnings per share data) 2020 2019 2018
Interest and dividend income
Interest expense
Net interest income after provision for loan losses 93,555 87,493 88,103
Non-interest income
Gain (loss) on sales of securities, net 5,445 237 (924)
Non-interest expense
(Gain) loss on premises and equipment, net (32) 18 —
Amortization of intangible assets 1,024 861 828
Loss on debt extinguishment 1,351 1,096 —
Acquisition, conversion and other expenses 5,801 8,317 1,728
Earnings per share:
Weighted average common shares outstanding:
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31,
Other comprehensive income, before tax:
Changes in unrealized gain on hedging derivatives 3,772 2,216 654
Changes in unrealized loss on pension (338) (350) (216)
Income taxes related to other comprehensive income:
Changes in unrealized gain on hedging derivatives (880) (448) (168)
Changes in unrealized loss on pension 77 83 47
Total other comprehensive income (loss) 7,105 15,713 (6,268)
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Accumulated
Common Additional other
stock paid-in Retained comprehensive Treasury
Other comprehensive income — — — (6,268) — (6,268)
Treasury stock purchased (10,899 shares) — — — — (324) (324)
Recognition of stock based compensation — 1,346 — — — 1,346
Other comprehensive income — — — 15,713 — 15,713
Cash dividends declared ($0.86 per share) — — (13,366) — — (13,366)
Treasury stock purchased (9,195 shares) — — — — (239) (239)
Recognition of stock based compensation — 1,373 — — — 1,373
Other comprehensive income — — — 7,105 — 7,105
Cash dividends declared ($0.88 per share) — — (13,417) — — (13,417)
Recognition of stock based compensation — 1,570 — — — 1,570
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
Cash flows from operating activities:
Deferred tax benefit (38) 1,020 (443)
Change in unamortized net loan costs and premiums 1,104 (555) (600)
Accretion of purchase accounting entries, net (1,975) (3,806) (3,512)
Amortization of other intangibles 1,025 861 828
(Gain) loss on sales of securities, net (5,445) (237) 924
Increase in right-of-use lease assets (578) (632) —
Increase in lease liabilities 625 660 —
(Gain) loss on other real estate owned (355) 166 —
(Gain) loss on premises and equipment, net (32) 18 —
Net change in other assets and liabilities (2,728) 7,174 (2,366)
Cash flows from investing activities:
Purchase of premises and equipment, net (6,776) (9,185) (4,793)
Proceeds from premises held for sale 903 — —
Net investment in community limited partnerships (2,750) (22) (585)
Purchase of bank-owned life insurance — — (14,000)
Acquisitions, net of cash acquired (340) (18,383) —
Proceeds from sale of other real estate owned 2,205 — 153
Cash flows from financing activities:
Net change in short-term other borrowings (17,053) 8,621 (4,495)
Proceeds from subordinated debt issuance — 40,000 —
Repayments of subordinated debt — (22,000) —
Payment of subordinated debt issuance costs — (700) —
Exercise of stock options 620 (273) 615
Purchase of treasury and common stock (14,188) (239) (324)
Net cash (used in) provided by financing activities (11,823) 6,734 14,311
(continued)
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Years Ended December 31,
Supplemental cash flow information:
Acquisition of non-cash assets and liabilities:
Liabilities acquired (343) 261,814 —
Other non-cash changes:
Real estate owned acquired in settlement of loans — 250 2,380
Initial recognition of operating lease right-of-use assets — 8,991 —
Initial recognition of operating lease liabilities — 8,991 —
The accompanying notes are an integral part of these consolidated financial statements.
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BAR HARBOR BANKSHARES AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of presentation: The consolidated financial statements (the “financial statements”) of Bar Harbor Bankshares and its subsidiaries (the “Company” or “Bar Harbor”) have been prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Bar Harbor Bankshares is a Maine Financial Institution Holding Company for the purposes of the laws of the state of Maine, and as such, is subject to the jurisdiction of the Superintendent of the Maine Bureau of Financial Institutions. These financial statements include the accounts of the Company, its wholly-owned subsidiary Bar Harbor Bank & Trust (the "Bank") and the Bank’s consolidated subsidiaries. The results of operations of companies or assets acquired are included only from the dates of acquisition. All material wholly-owned and majority-owned subsidiaries are consolidated unless U.S. GAAP requires otherwise.
Consolidation: The accompanying consolidated financial statements have been prepared in accordance with U.S. GAAP. The consolidated financial statements include the accounts of Bar Harbor Bankshares and its wholly-owned subsidiaries, Bar Harbor Bank & Trust, Bar Harbor Trust Services, Charter Trust Company and Cottage Street Corporation. All significant inter-company balances and transactions have been eliminated in consolidation. Assets held in a fiduciary capacity are not assets of the Company, but assets of customers, and therefore, are not included in the consolidated balance sheets.
Reclassifications: Whenever necessary, amounts in the prior years’ financial statements are reclassified to conform to current presentation. The reclassifications had no impact on net income in the Company’s consolidated income statement.
Use of estimates: In preparing financial statements in conformity with U.S. GAAP, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change in the near term relate to the determination of the allowance for loan losses, other-than-temporary impairment on securities, income tax estimates, reviews of goodwill for impairment, and accounting for post-retirement plans.
Cash and Cash Equivalents: For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks, interest-bearing deposits with other banks, federal funds sold, and other short-term investments with maturities less than 90 days. The Federal Reserve Bank requires the Bank to maintain certain reserve requirements of vault cash and/or deposits. On March 15, 2020, the Federal Reserve Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirement for all depository institutions. The reserve requirement at December 31, 2019 was $23.1 million.
Securities: All securities held at December 31, 2020 and 2019 were classified as available-for-sale (“AFS”). Available for sale securities primarily consist of mortgage-backed securities, obligations of state and political subdivisions thereof, and corporate bonds and are carried at estimated fair value. Changes in estimated fair value of AFS securities, net of applicable income taxes, are reported in accumulated other comprehensive income (loss) as a separate component of shareholders’ equity unless deemed to be other-than-temporarily impaired (“OTTI”) as discussed below. The Company does not have any securities classified as trading or held-to-maturity.
Premiums and discounts on securities are amortized and accreted over the term of the securities using the interest method. Gains and losses on the sale of securities are recognized at the trade date using the specific-identification method and are shown separately in the Consolidated Statements of Income.
Other-Than-Temporary Impairments on Securities: The Company conducts an OTTI analysis of investment securities on a quarterly basis or more often if a potential loss-triggering event occurs. A write-down of a debt security is recorded when fair value is below amortized cost in circumstances where: (1) the Company has the intent to sell a security; (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost basis; or (3) the Company does not expect to recover the entire amortized cost basis of the security. If the Company intends to sell
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a security or if it is more likely than not that the Company will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the entire difference between the security’s amortized cost basis 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 OTTI write-down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income. To determine the amount related to credit loss on a debt security, the Company applies a methodology similar to that used for evaluating the impairment of loans.
Federal Home Loan Bank Stock: The Bank is a member of the Federal Home Loan Bank of Boston (“FHLB”). The Bank uses the FHLB for most of its wholesale funding needs. As a requirement of membership in the FHLB, the Bank must own a minimum required amount of FHLB stock, based primarily on its level of obligations with the FHLB. FHLB stock is a non-marketable equity security and therefore is reported at cost, which generally equals par value. Shares held in excess of the minimum required amount are generally redeemable at par value. Dividends from FHLB stock are reported in interest and dividend income.
The Company periodically evaluates FHLB stock for impairment based on the capital adequacy of the FHLB and its overall financial condition. Based on the capital adequacy, liquidity position and sustained profitability of the FHLB, management believes there is no impairment related to the carrying amount of the Bank’s FHLB stock as of December 31, 2020.
Loans Held for Sale: Residential loans originated with the intent to be sold in the secondary market are accounted for at the lower of cost or market (fair value). Fair value is primarily determined based on quoted prices for similar loans in active markets. Residential loans held for sale are generally sold with servicing rights retained. The carrying value of loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of residential loans (sales proceeds minus carrying value) are recorded in non-interest income.
Loans: Loans are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, the unamortized balance of any deferred fees or costs on originated loans and the unamortized balance of any premiums or discounts on loans purchased or acquired through mergers.
Interest on loans is accrued and credited to income based on the principal amount of loans outstanding.
Loan origination and commitment fees and direct loan origination costs are deferred, and the net amount is amortized as an adjustment of the related loans’ yield, using the level-yield method over the estimated lives of the related loans.
Acquired Loans: Loans acquired in acquisitions are initially recorded at fair value with no carryover of the related allowance for credit losses. Determining the fair value of the loans involves estimating the amount and timing of principal and interest cash flows initially expected to be collected on the loans and discounting those cash flows at an appropriate market rate of interest.
For loans that meet the criteria stipulated in ASC 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality,” the Company recognizes the accretable yield, which is defined as the excess of all cash flows expected at acquisition over the initial fair value of the loan, as interest income on a level-yield basis over the expected remaining life of the loan. The excess of the loan’s contractually required payments over the cash flows expected to be collected is the non-accretable difference. The non-accretable difference is not recognized as an adjustment of yield, a loss accrual, or a valuation allowance. The Company evaluates quarterly whether the timing and cash to be collected are reasonably expected. Subsequent significant increases in cash flows the Company expects to collect will first reduce any previously recognized valuation allowance and then be reflected prospectively as an increase to the level yield. Subsequent decreases in expected cash flows may result in the loan being considered impaired. Interest income is not recognized to the extent that the net investment in the loan would increase to an amount greater than the estimated payoff amount.
For loans that do not meet the ASC 310-30 criteria, the Company accretes interest income based on the contractually required cash flows. The Company subjects loans that do not meet the ASC 310-30 criteria to ASC 450, “Contingencies” by collectively evaluating these loans for an allowance for loan loss.
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Acquired loans that met the criteria for non-accrual of interest prior to the acquisition are considered performing upon acquisition, regardless of whether the customer is contractually delinquent, if the Company can reasonably estimate the timing and amount of the expected cash flows on such loans and if the Company expects to fully collect the new carrying value of the loans. As such, the Company may no longer consider the loan to be non-accrual or nonperforming and may accrue interest on these loans, including the impact of any accretable yield.
Non-performing loans: Residential real estate and home equity loans are generally placed on non-accrual status when reaching 90 days past due, or in process of foreclosure, or sooner if considered appropriate by management. Consumer loans are generally placed on non-accrual when reaching 90 days or more past due, or sooner if considered appropriate by management. Secured consumer loans are written down to net realizable value and unsecured consumer loans are charged-off upon reaching 120 days past due. Commercial real estate loans and commercial business loans that are 90 days or more past due are generally placed on non-accrual status, unless secured by sufficient cash or other assets immediately convertible to cash, and the loan is in the process of collection. Commercial real estate and commercial business loans may be placed on non-accrual status prior to the 90 days delinquency date if considered appropriate by management.
When a loan has been placed on non-accrual status, previously accrued and uncollected interest is reversed against interest on the loan. The interest on non-accrual loans is accounted for using the cash-basis or cost-recovery method depending on corresponding credit risk, until qualifying for return to accrual status. A loan can be returned to accrual status when collectability of principal is reasonably assured and the loan has performed for a period of time, generally six months.
Impaired loans: A loan is considered impaired when, based on current information and events, it is probable that the Company will not be able to collect all amounts due from the borrower in accordance with the contractual terms of the loan, including scheduled interest payments.
Factors considered by management in determining impairment include payment status and collateral value. In considering loans for evaluation of impairment, management generally excludes smaller balance, homogeneous loans; residential mortgage loans, home equity loans, and all consumer loans, unless such loans were restructured in a troubled debt restructuring. These loans are collectively evaluated for risk of loss.
When a loan has been identified as being impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the estimated fair value of the collateral, less any selling costs, if the loan is collateral-dependent. If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees or costs, and unamortized premiums or discounts), impairment is recognized by establishing or adjusting an existing allocation of the allowance for loan losses, or by recording a partial charge-off of the loan to its fair value. Interest payments made on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case, interest income may be accrued or recognized on a cash basis.
Loans Modified in a Troubled Debt Restructuring: Loans are considered to have been modified in a troubled debt restructuring when, due to a borrower’s financial difficulties, the Company makes certain concessions to the borrower that it would not otherwise consider. Modifications may include interest rate reductions, principal or interest forgiveness, forbearance, and other actions intended to minimize economic loss and to avoid foreclosure or repossession of collateral. Generally, a non-accrual loan that has been modified in a troubled debt restructuring remains on non-accrual status for a period of at least 6 months to demonstrate that the borrower is able to meet the terms of the modified loan.
However, performance prior to the modification, or significant events that coincide with the modification, are included in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status at the time of loan modification or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains on non-accrual status.
Loan Modifications under the CARES Act: The CARES Act provides that a financial institution may elect to suspend (1) the requirements under GAAP for certain loan modifications that may otherwise be categorized as a troubled debt restructuring (“TDR”) and (2) any determination that such loan modifications would be considered a TDR, including the related impairment for accounting purposes.
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Allowance for Loan Losses: The allowance for loan losses (the “allowance”) is a significant accounting estimate used in the preparation of the Company’s consolidated financial statements. The allowance is available to absorb losses inherent in the current loan portfolio and is maintained at a level that, in management’s judgment, is appropriate for the amount of risk inherent in the loan portfolio, given past and present conditions. The allowance is increased by provisions charged to operating expense and by recoveries on loans previously charged off, and is decreased by loans charged off as uncollectible.
The allowance is calculated in accordance with ASC 310 - Receivables and ASC 450 - Contingencies. Under the guidance of ASC 310, specific allowances are established in cases where management has identified significant conditions or circumstances related to individual loans where the probability of a loss may be incurred. Credit loss estimates for loans without specific allowances are determined under the guidance of ASC 450, which includes portfolio segmentation based on similar risk characteristics, determination of estimated historical loss rates, calculation of a time-based loss emergence and confirmation periods, and adjustments for certain qualitative risk factors.
Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The determination of the adequacy of the allowance and provisioning for estimated losses is evaluated regularly based on review of loans, with particular emphasis on non-performing and other loans that management believes warrant special consideration.
While management uses available information to recognize losses on loans, changing economic conditions and the economic prospects of the borrowers may necessitate future additions or reductions to the allowance. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance, which also may necessitate future additions or reductions to the allowance, based on information available to them at the time of their examination.
Refer to Note 4 - Allowance for Loan Losses, for further information, including the Company’s loan loss estimation methodology.
Reserve for Unfunded Commitments: The unfunded reserve is a component of other liabilities and represents the estimate for probable credit losses inherent in unfunded commitments to extend credit. Unfunded commitments to extend credit include banker’s acceptances, and standby and commercial letters of credit. The process used to determine the unfunded reserve is consistent with the process for determining the allowance, as adjusted for estimated funding probabilities or loan and lease equivalency factors. The level of the unfunded reserve is adjusted by recording on an expense or recovery in other noninterest expense. Reserve for unfunded commitments are classified in other liabilities on the Company’s Consolidated Balance Sheet.
Premises and Equipment: Land is carried at cost. Premises and equipment and related improvements are stated at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the lesser of the lease term or estimated useful lives of related assets; generally 5 to 39 years for premises and three to seven years for furniture and equipment. Software costs are stated at cost less accumulated depreciation within other assets on the Consolidated Statements of Condition. Amortization expense on software is calculated using the straight-line method over the estimated useful lives of the related assets.
Transfers of Financial Assets: Transfers of an entire financial asset, group of entire financial assets, or a participating interest in an entire financial asset are accounted for as sales when control over the assets has 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 to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets.
Other Real Estate Owned: Other real estate owned consists of properties acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure. These properties are recorded at fair value less estimated costs to sell the property. Initially at transfer if the recorded investment in the loan exceeds the property’s fair value at the time of acquisition, a charge-off is recorded against the allowance. If the fair value of the property initially at transfer exceeds the carrying amount of the loan, the excess is recorded either as a recovery to the allowance if a charge-off had previously been recorded, or as a gain on initial transfer in other non-interest income. Subsequent decreases in the property’s fair
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value and operating expenses of the property are recognized through charges to other non-interest expense. The fair value of the property acquired and ongoing valuation is based on third-party appraisals, broker price opinions, recent sales activity, or a combination thereof, subject to management judgment. Due to changing market conditions the amount ultimately realized on the other real estate owned may differ from the amounts reflected in the financial statements.
Goodwill: In connection with acquisitions, the Company generally records as assets on its consolidated financial statements both goodwill and other intangible assets, such as core deposit and acquired customer relationship intangibles.
Goodwill represents the excess of the purchase price over the fair value of net assets acquired in accordance with the purchase method of accounting for business combinations. Goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis, or more frequently, if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. The impairment testing process is conducted by assigning assets and goodwill to each reporting unit. Currently, the Company’s goodwill is evaluated at the entity level as there is only one reporting unit. The Company, at our discretion, assesses certain qualitative factors to determine if it is more likely than not that the fair value of the reporting unit is less than its carrying value. An impairment charge is recognized if the carrying fair value of goodwill exceeds the implied fair value of goodwill.
Refer to Note 6 – Goodwill and Other Intangibles, for further information, including the Company’s loan loss estimation methodology
Other Intangible Assets: Intangible assets are acquired assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. The fair value of these assets are generally determined based on appraisals and management assesses the recoverability of these intangible assets whenever events or changes in circumstances indicate that their carrying value may not be recoverable. These other intangible assets primarily consist of core deposit and acquired customer relationship intangible assets arising from the whole bank and branch acquisitions are amortized on an accelerated method over their estimated useful lives.
Bank-Owned Life Insurance: Bank-owned life insurance (“BOLI”) represents life insurance on the lives of certain current and retired employees who had provided positive consent allowing the Bank to be the beneficiary of such policies. Increases in the cash value of the policies, as well as insurance proceeds received in excess of the cash value, are recorded in other non-interest income, and are not subject to income taxes.
Capitalized Servicing Rights: Capitalized servicing rights are recognized as assets when residential loans are sold and the rights to service those loans are retained.
The Company’s capitalized servicing rights are initially recorded at fair value. Fair values are established by using a discounted cash flow model to calculate the present value of estimated future net servicing income. Changes in the fair value of capitalized servicing rights are primarily due to changes in valuation inputs, assumptions, and the collection and realization of expected cash flows. However, these capitalized servicing rights are amortized in proportion to and over the period of estimated net servicing income, which includes prepayment assumptions. An impairment analysis is prepared on a quarterly basis by estimating the fair value of the capitalized servicing rights and comparing that value to the carrying amount. A valuation allowance is established when the carrying amount of these capitalized servicing rights exceeds fair value. The capitalized servicing rights are included in other assets on the Company’s consolidated balance sheet.
Derivative Financial Instruments: The Company recognizes all derivative instruments on the consolidated balance sheet at fair value. On the date the derivative instrument is entered into, the Company designates whether the derivative is part of a hedging relationship (i.e., cash flow or fair value hedge). The Company formally documents relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking hedge transactions. The Company also assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting the changes in cash flows or fair values of hedged items. The fair value of the derivative is reflected on the Consolidated Balance Sheet in either other assets or liabilities.
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Changes in the fair value of derivative instruments that are highly effective and qualify as cash flow hedge are recorded in other comprehensive income (loss). Any ineffective portion is recorded in earnings. For fair value hedges that are highly effective, the gain or loss on the derivative and the loss or gain on the hedged item attributable to the hedged risk are both recognized in earnings, with the differences (if any) representing hedge ineffectiveness. The Company discontinues hedge accounting when it is determined that the derivative is no longer highly effective in offsetting changes of the hedged risk on the hedged item, or management determines that the designation of the derivative as a hedging instrument is no longer appropriate.
Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense based on the item being hedged. Net cash settlements on derivatives that do not quality for hedge accounting are reporting in non-interest income. Cash flows on hedges are classified in the cash flow statement the same as cash flows of the items being hedged.
The Company enters into commitments to fund mortgage loans with borrowers (interest rate locks) and forward commitments for the future delivery of these mortgage loans for sale on the secondary market. These mortgage banking derivatives are classified as free standing derivatives to hedge against inherent interest rate and pricing risk associated with selling loans. The commitments to lend generally terminate once the loan is funded, the lock period expires or the borrower decides not to contract for the loan. The forward commitments generally terminate once the loan is sold or the commitment period expires. These commitments are considered derivatives which are accounted for by recognizing their estimated fair value on the Consolidated Balance Sheets in either other assets or other liabilities.
Senior and Subordinated Borrowings: The Company’s senior borrowings include retail and wholesale repurchase agreements, FHLB overnight, FHLB short-term and long-term advances, federal funds purchased, credit facilities, and line of credit advances. Subordinated borrowings consist of subordinated notes issued to investors. The Company is required to post collateral for certain borrowings, for which it, generally, posts loans and/or investment securities as collateral.
Off-Balance Sheet Financial Instruments: In the ordinary course of business, the Company has entered into off- balance sheet financial instruments consisting of commitments to extend credit, unused or unadvanced loan funds and letters of credit. Such financial instruments are recorded in the consolidated financial statements when they are funded or related fees are incurred or received.
Stock Based Compensation: The Company has equity award plans that include stock options, restricted stock awards restricted stock units and performance stock units, which are described more fully in Note 14 - Stock Based Compensation Plans of the Consolidated Financial Statements. The Company recognizes expenses for stock options and restricted awards based on the fair value of these awards as of the grant date. For restricted stock units and performance stock units the expense is recognized over the vesting periods of the grants. The Company uses its treasury shares for issuing shares upon option exercises, restricted stock awards, restricted stock unit vesting and performance stock unit vesting.
Employee Stock Purchase Plan: The Company recognizes expense based difference between the market price of shares and the discounted price of the plan from participant enrollment over each six month enrollment period.
Employee Benefit Plans: The Company has non-qualified supplemental executive retirement agreements with certain retired officers. The agreements provide supplemental retirement benefits payable in installments over a period of years upon retirement or death. The Company recognized the net present value of payments associated with the agreements over the service periods of the participating officers. Interest costs continue to be recognized on the benefit obligations. The Company also has a supplemental executive retirement agreement with a certain current executive officer. This agreement provides a stream of future payments in accordance with individually defined vesting schedules upon retirement, termination, or in the event that the participating executive leaves the Company following a change of control event. The Company recognizes the net present value of payments associated with these agreements over the service periods of the participating executive officers. Upon retirement, interest costs will continue to be recognized on the benefit obligation.
The Company recognizes the over-funded or under-funded status of post-retirement benefit plans as a liability or asset on the balance sheet in other liabilities or other assets and recognizes changes in that funded status through other
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comprehensive income (loss). Gains and losses, prior service costs and credits, and any remaining transition amounts that have not yet been recognized through net periodic benefit costs are recognized in accumulated other comprehensive income/(loss), net of tax effects, until they are amortized as a component of net periodic cost. The measurement date, which is the date at which the benefit obligation and plan assets are measured, is the Company’s fiscal year end.
Employee 401(k) expenses are recognized for the amount of the Company’s matching contributions.
Income Taxes: The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If current available information indicates that it is more likely than not that deferred tax assets will not be realized, a valuation allowance is established. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Treasury Stock: Shares of the Company’s common stock that are repurchased are recorded in treasury stock at cost. On the date of subsequent re-issuance, the treasury stock account is reduced by the cost of such stock on an average cost basis.
Earnings Per Share: Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company, such as the Company’s dilutive stock options.
Revenue Recognition: The Company recognizes revenue in accordance with ASC 606, "Revenue from Contracts with Customers." ASC 606 requires the Company to follow a five step process: (1) identify the contract(s) with a customer, (2) identify the performance obligations in the contract, (3) determine the transaction price, (4) allocate the transaction price to the performance obligations in the contract, and (5) recognize revenue when (or as) the Company satisfies a performance obligation. Revenue recognition under ASC 606 depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or service. See Note 16 - Revenue from Contracts with Customers of the Company’s Consolidated Financial Statements for additional information on revenue recognition.
Wealth Management:Wealth management assets held in a fiduciary or agent capacity are not included in the accompanying Consolidated Balance Sheets because they are not assets of the Company. Trust and investment management fees is primarily comprised of fees earned from consultative investment management, trust administration, tax return preparation, and financial planning. The Company’s performance obligation is generally satisfied over time and the resulting fees are recognized monthly, based on the daily accrual of the market value of the investment accounts and the applicable fee rate.
Marketing Costs: Marketing costs are expensed as incurred.
Segment Reporting: An operating segment is defined as a component of a business for which separate financial information is available that is evaluated regularly by the chief operating decision-maker in deciding how to allocate resources and evaluate performance. The Company has determined that its operations are solely in the community banking industry and include traditional community banking services, including lending activities, acceptance of demand, savings and time deposits, business services, investment management, trust and third-party brokerage services. These products and services have similar distribution methods, types of customers and regulatory responsibilities. Accordingly, segment information is not presented in the Consolidated Financial Statements.
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Recent Accounting Pronouncements
The following table provides a brief description of accounting standards that could have a material impact to the Company’s consolidated financial statements upon adoption:
Standard Description Required Date of Adoption Effect on financial statements
Standards Adopted in 2020
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Standard Description Required Date of Adoption Effect on financial statements
Standards Not Yet Adopted
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Standard Description Required Date of Adoption Effect on financial statements
Standards Not Yet Adopted (continued)
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1
NOTE 2. SECURITIES AVAILABLE FOR SALE
The following is a summary of securities available for sale:
Gross Gross
Unrealized Unrealized
(in thousands) Amortized Cost Gains Losses Fair Value
Mortgage-backed securities:
Gross Gross
Unrealized Unrealized
(in thousands) Amortized Cost Gains Losses Fair Value
Mortgage-backed securities:
The amortized cost and estimated fair value of available for sale (“AFS”) securities segregated by contractual maturity at December 31, 2020 are presented below. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mortgage-backed securities are shown in total, as their maturities are highly variable.
Available for sale
(in thousands) Amortized Cost Fair Value
Within 1 year $ — $ —
The following table summarizes proceeds from the sale of AFS securities and realized gains and losses:
Proceeds from Sale
of Securities
(in thousands) Available for Sale Realized Gains Realized Losses Net
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Securities with unrealized losses, segregated by the duration of their continuous unrealized loss positions, are summarized as follows:
Less Than Twelve Months Over Twelve Months Total
Gross Gross Gross
Unrealized Fair Unrealized Fair Unrealized Fair
(in thousands) Losses Value Losses Value Losses Value
Mortgage-backed securities:
Less Than Twelve Months Over Twelve Months Total
Gross Gross Gross
Unrealized Fair Unrealized Fair Unrealized Fair
(in thousands) Losses Value Losses Value Losses Value
Mortgage-backed securities:
A summary of securities pledged as collateral for certain deposits and borrowing arrangements as of the years ended December 31, 2020 and December 31, 2019 is as follows:
Carrying Estimated Carrying Estimated
(in thousands) Value Fair Value Value Fair Value
Securities Impairment
As a part of the Company’s ongoing security monitoring process, the Company identifies securities in an unrealized loss position that could potentially be other-than-temporarily impaired. For the twelve months ended December 31, 2020, 2019 and 2018 the Company did not record any other-than-temporary impairment (“OTTI”) losses.
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The following table presents the remaining amount of historical credit losses on debt securities and changes reflected in the statement of income: