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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

The purpose of this discussion is to focus on the important factors affecting the financial condition, results of operations, liquidity and capital resources of Eagle Financial Services, Inc. (the “Company”). This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.

GENERAL

The Company is a bank holding company which owns 100% of the stock of Bank of Clarke (the “Bank”). Accordingly, the results of operations for the Company are dependent upon the operations of the Bank. The Bank conducts a commercial banking business which consists of attracting deposits from the general public and investing those funds in commercial, consumer and real estate loans and corporate, municipal and U.S. government agency securities. The Bank also conducts a marine lending business as well as a wealth management division. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation to the extent permitted by law. At December 31, 2022, the Company had total assets of $1.62 billion, net loans of $1.31 billion, total deposits of $1.26 billion and shareholders’ equity of $101.7 million. The Company’s net income was $14.5 million for the year ended December 31, 2022.

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The following table presents selected financial data, which was derived from the Company’s audited financial statements for the periods indicated.

As of or for the Years Ended

December 31,

(dollars in thousands, except per share amounts)

Income Statement Data:

Performance Ratios:

Share and Per Share Data:

Balance Sheet Data:

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MANAGEMENT’S STRATEGY

The Company strives to be an outstanding financial institution in its market by building solid sustainable relationships with: (1) its customers, by providing highly personalized customer service, a network of conveniently placed branches and ATMs, a competitive variety of products/services and courteous, professional employees, (2) its employees, by providing generous benefits, a positive work environment, advancement opportunities and incentives to exceed expectations, (3) its communities, by participating in local concerns, providing monetary support, supporting employee volunteerism and providing employment opportunities, and (4) its shareholders, by providing sound profits and returns, sustainable growth, regular dividends and committing to our local, independent status.

OPERATING STRATEGY

The Bank is a locally owned and managed financial institution. This allows the Bank to be flexible and responsive in the products and services it offers. The Bank grows primarily by lending funds to local residents and businesses at a competitive price that reflects the inherent risk of lending. The Bank attempts to fund these loans through deposits gathered from local residents and businesses. The Bank prices its deposits by comparing alternative sources of funds and selecting the lowest cost available. When deposits are not adequate to fund asset growth, the Bank relies on borrowings, both short and long term. The Bank’s primary source of borrowed funds is the Federal Home Loan Bank of Atlanta which offers numerous terms and rate structures to the Bank.

As interest rates change, the Bank attempts to maintain its net interest margin. This is accomplished by changing the price, terms, and mix of its financial assets and liabilities. The Bank also earns fees on services provided through the Bank of Clarke Wealth Management Division, which is the Bank’s investment management division that offers both trust services and investment sales, mortgage originations and deposit operations. The Bank also incurs noninterest expenses associated with compensating employees, maintaining and acquiring fixed assets, and purchasing goods and services necessary to support its daily operations.

The Bank has a marketing department which seeks to develop new business. This is accomplished through an ongoing calling program whereby account officers contact existing and potential customers to discuss the products and services offered. The Bank conducts advertising through television commercials, radio ads, newspaper ads, printed materials, electronic materials, billboards, emails, and social media posts.

LENDING POLICIES

Administration and supervision over the lending process is provided by the Bank’s Credit Administration Department. The principal risk associated with the Bank’s loan portfolio is the creditworthiness of its borrowers. In an effort to manage this risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. Credit risk is increased or decreased, depending on the type of loan and prevailing economic conditions. In consideration of the different types of loans in the portfolio, the risk associated with real estate mortgage loans, commercial loans and consumer loans varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay debt.

The Company has written policies and procedures to help manage credit risk. The Company utilizes a loan review process that includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with the Company’s policies.

The Bank uses a tiered approach to approve credit requests consisting of individual lending authorities, joint approval of Co-Approval officers (Executive, Regional Credit Officer, Small Business Credit Officer), and a director loan committee. Lending limits for individuals are set by the Board of Directors and are determined by loan purpose, collateral type, and internal risk rating of the borrower. The highest individual authority (Executive) is assigned to the Bank’s President/ Chief Executive Officer, Chief Banking Officer and Chief Credit Officer (approval authority only). Two Executive officers may combine their authority to approve loan requests to borrowers with credit exposure up to $10.0 million on a secured basis and $6.0 million unsecured. Three Executive officers may combine to approve loan requests to borrowers with credit exposure up to $15.0 million on a secured basis and $9.0 million unsecured. Consumer Central Lenders can co-approve consumer, home equity lines of credit and home equity loan requests up to their stated authorities. Officers in Categories A through F have lesser authorities and with approval of an Executive officer may extend loans to borrowers with exposure of $5.0 million on a secured basis and $3.0 million unsecured. Officers in Categories A through F can also utilize the co-approval of the Regional and Small Business Credit Officers to extend loans with exposures up to $2.5 million and $1.5 million respectively on a secured basis, and up to $1 million and $750 thousand respectively on an unsecured basis. Loans exceeding $15.0 million and up to the Bank’s legal lending limit can be approved by the Director Loan Committee consisting of four directors (three directors

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constituting a quorum). The Director’s Loan Committee also reviews and approves changes to the Bank’s Loan Policy as presented by management. The following sections discuss the major loan categories within the total loan portfolio:

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if applicable, flood insurance. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. In its underwriting of commercial real estate, the Bank’s loan to original appraised value ratio is generally 80% or less. Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners.

Construction and Land Development Lending

The Bank makes local construction loans and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of most construction loans is less than one year and the Bank offers both fixed and variable rate interest structures. The interest rate structure offered to customers depends on the total amount of these loans outstanding and the impact of the interest rate structure on the Bank’s overall interest rate risk. There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished property. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners. Finally, the Bank performs inspections of the construction projects to ensure that the percentage of construction completed correlates with the amount of draws on the construction line of credit.

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Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate. Refer to the Marine Lending section below for discussion of additional commercial and industrial lending.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, which include personal installment loans, personal lines of credit, automobile loans, and credit card loans. The Bank generally originates its consumer loans within its geographic market area and these loans are largely made to customers with whom the Bank has an existing relationship. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and from any verifiable secondary income. Although creditworthiness of the applicant is the primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Refer to the Marine Lending section below for discussion of additional consumer lending.

Marine Lending

The Bank’s marine lending unit, which includes originated retail loans, which are classified as commercial and industrial loans or consumer loans depending on borrower, and dealer floorplan loans, which are classified as commercial and industrial loans. The Company’s relationships are limited to well established dealers of global premium brand manufacturers. The Company’s top three manufacturer customers have been in business between 30 and 100 years. The Company primarily has secured agreements with premium manufacturers to support dealer floor plan loans which reduces the Company’s credit exposure to the dealer, despite its underwriting of each respective dealer. The Company has developed incentive retail pricing programs with the dealers to drive retail dealer flow. In addition to the repurchase agreements associated with floor plan lending, manufacturers will often support secondary resale values which can have the effect of reducing losses from non-performing retail marine loans. Retail borrowers generally have very high credit scores, substantial down payments, substantial net worth, personal liquidity, and excess cash flow.

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CRITICAL ACCOUNTING POLICIES

The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within these statements is, to a significant extent, based on measurements of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of the transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the probable losses inherent in the Company’s loan portfolio. As required by GAAP, the allowance for loan losses is accrued when the occurrence of losses is probable and losses can be estimated. Impairment losses are accrued based on the differences between the loan balance and the value of its collateral, the present value of future cash flows, or the price established in the secondary market. The Company’s allowance for loan losses has three basic components: the general allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when actual events occur. The general allowance uses historical experience and other qualitative factors to estimate future losses and, as a result, the estimated amount of losses can differ significantly from the actual amount of losses which would be incurred in the future. However, the potential for significant differences is mitigated by continuously updating the loss history and qualitative factor analyses of the Company. The specific allowance is based upon the evaluation of specific impaired loans on which a loss may be realized. Factors such as past due history, ability to pay, and collateral value are used to identify those loans on which a loss may be realized. Each of these loans is then evaluated to determine how much loss is estimated to be realized on its disposition. The sum of the losses on the individual loans becomes the Company’s specific allowance. This process is inherently subjective and actual losses may be greater than or less than the estimated specific allowance. The unallocated allowance accounts for a measure of imprecision in the estimate. Note 1 to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of the 2022 Form 10-K, provides additional information related to the allowance for loan losses.

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FORWARD LOOKING STATEMENTS

The Company makes forward looking statements in this report that are subject to risks and uncertainties. These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements. These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

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difficult market conditions in our industry;

•

effects of soundness of other financial institutions;

•

potential impact on us of existing and future legislation and regulations;

•

the ability to successfully manage growth or implement growth strategies if the Bank is unable to identify attractive markets, locations or opportunities to expand in the future, expand into new markets, or successfully implement new product lines;

•

competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

•

the successful management of interest rate risk;

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risks inherent in making loans such as repayment risks and fluctuating collateral values;

•

changes in general economic and business conditions in the market area;

•

reliance on the management team, including the ability to attract and retain key personnel;

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changes in interest rates and interest rate policies;

•

maintaining capital levels adequate to support growth;

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maintaining cost controls and asset qualities as new branches are opened or acquired;

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demand, development and acceptance of new products and services;

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deposit flows;

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problems with technology utilized by the Bank;

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changing trends in customer profiles and behavior;

•

geopolitical conditions, including acts or threats of terrorism, international hostilities, or actions taken by the U.S. or other governments in response to acts or threats of terrorism and/or military conflicts, which could impact business and economic conditions in the U.S. and abroad;

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the Company’s potential exposure to fraud, negligence, computer theft, and cyber-crime

•

changes in accounting policies and banking and other laws and regulations; and

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other factors described in Item 1A., “Risk Factors,” above.

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward looking statements. In addition, past results of operations do not necessarily indicate future results.

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RESULTS OF OPERATIONS

Net Income

Net income for 2022 was $14.5 million, a increase of $3.5 million or 31.76% from 2021’s net income of $11.0 million. Basic and diluted earnings per share were $4.17 and $3.20 for 2022 and 2021, respectively.

Return on average assets (“ROA”) measures how efficiently the Company uses its assets to produce net income. Some issues reflected within this efficiency include the Company’s asset mix, funding sources, pricing, fee generation, and cost control. The ROA of the Company, on an annualized basis, was 1.02% and 0.90% for 2022 and 2021, respectively.

Return on average equity (“ROE”) measures the utilization of shareholders’ equity in generating net income. This measurement is affected by the same factors as ROA with consideration to how much of the Company’s assets are funded by the shareholders. The ROE for the Company was 14.06% and 10.28% for 2022 and 2021, respectively.

Net Interest Income

Net interest income, the difference between total interest income and total interest expense, is the Company’s primary source of earnings. Net interest income was $49.2 million for 2022 and $41.0 million for 2021, which represents an increase of $8.2 million or 20.03%. Net interest income is derived from the volume of earning assets and the rates earned on those assets as compared to the cost of funds. Total interest income was $54.7 million for 2022 and $42.7 million for 2021, which represents an increase of $12.0 million or 28.14% for 2022. Total interest expense was $5.5 million for 2022 and $1.7 million for 2021, which represents an increase of $3.8 million or 226.36% in 2022. The increase in total interest income, total interest expense and net interest income during 2022 was driven by the growth in interest-earning assets, interest-bearing liabilities and the rising interest rate environment. Refer to the table titled “Volume and Rate Analysis” for further detail.

The table titled “Average Balances, Income and Expenses, Yields and Rates” displays the composition of interest earnings assets and interest bearing liabilities and their respective yields and rates for the years ended December 31, 2022 and 2021.

The net interest margin was 3.68% for 2022 and 3.59% for 2021. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earnings assets. Tax-equivalent net interest income is calculated by adding the tax benefit on certain securities and loans, whose interest is tax-exempt, to total interest income then subtracting total interest expense. The tax rate used to calculate the tax benefit was the federal statutory rate of 21%. The table titled “Tax-Equivalent Net Interest Income” reconciles net interest income to tax-equivalent net interest income, which is not a measurement under GAAP, for the years ended December 31, 2022 and 2021.

Net interest income and net interest margin may experience some decline due to additional deposit pricing pressure as interest rates continue to increase and increased competition for new deposits is experienced. These combined also could result in the Company having to borrow wholesale funding to fund asset growth which is more expensive than deposits.

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Average Balances, Income and Expenses, Yields and Rates

(dollars in thousands)

Years Ended

Average InterestIncome/ Average Average InterestIncome/ Average

Balance Expense Rate Balance Expense Rate

Assets:

Securities:

Loans: (2)

Allowance for loan losses (9,852 ) (7,980 )

Liabilities and Shareholders' Equity:

Interest-bearing deposits:

Time deposits:

Noninterest-bearing liabilities:

Net interest spread 3.42 % 3.47 %

Interest expense as a percent of average earning assets 0.41 % 0.15 %

Net interest margin 3.68 % 3.59 %

(1)

Income and yields are reported on a tax-equivalent basis using the federal tax rate of 21%.

(2)

Interest and yields on loans include the amortization/accretion of origination costs/fees as well as any purchase premiums or discounts.

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Tax-Equivalent Net Interest Income

(dollars in thousands)

Twelve Months Ended

December 31,

(in thousands)

GAAP Financial Measurements:

Interest Income - Securities and Other Interest-Earnings Assets 4,004 2,805

Interest Expense - Other Borrowings 2,532 —

Non-GAAP Financial Measurements:

Add: Tax Benefit on Tax-Exempt Interest Income - Loans (1) $ 45 $ 61

Add: Tax Benefit on Tax-Exempt Interest Income - Securities (1) 59 111

Total Tax Benefit on Tax-Exempt Interest Income $ 104 $ 172

Tax-Equivalent Net Interest Income $ 49,317 $ 41,171

(1)

Tax benefit was calculated using the federal statutory tax rate of 21%.

The tax-equivalent yield on earning assets increased 35 basis points from 2021 to 2022. The tax-equivalent yield on securities increased 45 basis points from 2021 to 2022. The tax-equivalent yield on loans increased five basis points from 2021 to 2022. The increase in the tax-equivalent yield on earning assets resulted mostly from the increase in the tax-equivalent yield on securities. The increase in the tax-equivalent yield on securities as compared to the corresponding period in the prior year was due to a combination of increase of volume of securities and the rising interest rate environment.

The average rate on interest-bearing liabilities increased 41 basis points from 2021 to 2022. The average rate on total interest-bearing deposits increased 13 basis points from 2021 to 2022. The Federal Reserve interest rate increases during early 2022 heightened interest rates paid on deposit accounts. In general, deposit pricing is done in response to monetary policy actions and yield curve changes. Local competition for funds also affects the cost of time deposits, which are primarily comprised of certificates of deposit. The Company prefers to rely most heavily on non-maturity deposits, which include NOW accounts, money market accounts, and savings accounts. The average balance of non-maturity interest-bearing deposits increased $95.8 million or 18.13% from $528.5 million during 2021 to $624.3 million in 2022. The cost of interest bearing liabilities was also higher during 2022 due to the subordinated notes that the Company issued on March 31, 2022, which are currently paying a 4.5% fixed rate, and FHLB advances totaling $175.0 million at December 31, 2022, with interest rates ranging between 3.79% and 4.57%.

The table titled “Volume and Rate Analysis” provides information about the effect of changes in financial assets and liabilities and changes in rates on net interest income.

Tax-equivalent net interest income increased $8.1 million during 2022. The increase in tax-equivalent net interest income during 2022 is comprised of an increase due to volume of $7.6 million and a increase due to rate of $530 thousand. The increase in tax-equivalent net interest income during 2022 was largely affected by the increased volume of taxable loans, as well as increases in rates earned from interest-earning assets. This increase was partially offset by the increased volume in borrowing and increases in rates paid on interest bearing liabilities.

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Volume and Rate Analysis (Tax-Equivalent Basis)

(dollars in thousands)

2022 vs 2021Increase (Decrease)Due to Changes in:

Volume Rate Total

Earning Assets:

Securities:

Loans:

Federal funds sold 25 5 30

Interest-bearing deposits in other banks (15 ) 298 283

Interest-Bearing Liabilities:

Time deposits:

Federal funds purchased $ 169 $ 1 $ 170

Federal Home Loan Bank advances 1,295 — 1,295

Provision for Loan Losses

The provision for loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses as discussed within the Critical Accounting Policies section above. The provision for loan losses was $1.8 million for 2022 and $1.5 million for 2021. The amount of provision for loan losses during each period reflects the results of the Company’s analysis used to determine the adequacy of the allowance for loan losses. The provision for loan losses in 2022 reflects loan growth in the portfolio during the year partially offset by net recoveries of $601 thousand. The provision for loan losses in 2021 reflects loan growth in the portfolio during. The Company is committed to maintaining an allowance that adequately reflects the risk inherent in the loan portfolio. This commitment is more fully discussed in the “Asset Quality” section.

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Noninterest Income

Total noninterest income was $13.3 million and $11.3 million during 2022 and 2021, respectively. This represents an increase of $2.0 million or 17.89% for 2022. Management reviews the activities which generate noninterest income on an ongoing basis.

The following table provides the components of noninterest income for the twelve months ended December 31, 2022 and 2021, which are included within the respective Consolidated Statements of Income headings. The following paragraphs provide information about activities which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

December 31,

(dollars in thousands) 2022 2021 $ Change % Change

(Loss)on the sale and disposal of bank premises and equipment (11 ) — (11 ) NM

NM - Not Meaningful

Wealth management fees increased from 2021 to 2022. Wealth management fee income is comprised of income from fiduciary activities as well as commissions from the sale of non-deposit investment products. The amount of income from wealth management fees is determined by the number of active accounts and total assets under management. With the addition of several new key employees, total assets under management have seen an increase during the year.

Services charges on deposit accounts increased when comparing the year ended December 31, 2022 to 2021. This increase is mainly due to increases in overdraft charges. Overdraft charges can fluctuate based on changes in customer activity.

During 2022, the Company sold $12.2 million in mortgage loans on the secondary market and $155.0 million of loans from the commercial and consumer loan portfolios. During the third quarter of 2022, the Company sold $3.0 million in Small Business Association ("SBA") loans. During the last three quarters of 2021, the Company sold $18.1 million in mortgage loans on the secondary market and $99.2 million of loans from the commercial and consumer loan portfolios. These loan sales resulted in gains of $1.9 million and $1.7 million during the years ended December 31, 2022 and 2021, respectively.

Bank owned life insurance ("BOLI") fee income increased during 2022 when compared to 2021 as a result of investment of $10 million into BOLI by the Company during the second quarter of 2021.

Other operating income increased during 2022. The fluctuation from 2021 to 2022 is mostly attributed to adjustments to the investment in Banker’s Insurance as well as cash distributions received from investments in Small Business Investment Companies and derivative fee income.

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Noninterest Expenses

Total noninterest expenses were $43.1 million and $38.0 million during 2022 and 2021, respectively. This represents an increase of $5.0 million or 13.16% during 2022.

The following table provides the components of noninterest expense for the twelve months ended December 31, 2022 and 2021, which are included within the respective Consolidated Statements of Income headings. The following paragraphs provide information about activities which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

December 31,

(dollars in thousands) 2022 2021 $ Change % Change

Other real estate owned expense 34 41 (7 ) (17.07 )%

Loss on other real estate owned — 201 (201 ) NM

NM - Not Meaningful

The Company’s growth has had an impact on noninterest expenses. Total assets have grown by $313.7 million or 24.1% from December 31, 2021 to December 31, 2022. This growth has required investments to be made in the Company’s infrastructure, causing increases in salaries and employee benefits, occupancy expenses, equipment expenses, advertising and marketing expenses, stationary and supplies, and other operating expenses. In addition, increases in asset size and capital levels have impacted both the FDIC assessment and bank franchise tax amounts.

Salaries and employee benefits expense increased during 2022. Annual pay increases, newly hired employees, increasing insurance costs and enhanced employee incentive plans have attributed to these increases. The number of full-time equivalent employees (FTEs) has increased from 221 at December 31, 2021 to 241 at December 31, 2022.

Professional fees decreased during 2022. Significant expansion costs of the Company's wealth management business line and buildout of the marine lending division were incurred and completed in 2021, resulting in lower professional fees in 2022.

Data processing fees increased in 2022 due to the fees associated to the new general ledger system implemented in late 2021, the implementation of a new budgeting system and a new loan end-to-end platform system.

Other operating expenses increased during 2022. This increase is due primarily to increased loan related expenses due to a higher loan volume.

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The efficiency ratio of the Company was 67.90% and 72.14% for 2022 and 2021, respectively. The efficiency ratio is calculated by dividing total noninterest expenses by the sum of tax-equivalent net interest income and total noninterest income, excluding gains and losses on the investment portfolio and other gains/losses from OREO, repossessed vehicles, disposals of bank premises and equipment, etc. The tax rate utilized is 21%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency. A reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income is presented within the Net Interest Income section above.

The calculation of the efficiency ratio for the twelve months ended December 31, 2022 and 2021 were as follows:

December 31,

(in thousands)

Summary of Operating Results:

Less: Loss on other real estate owned — 201

Less: (Loss) gain on sales of securities (737 ) 24

Less: (Loss) on the sale and disposal of premises and equipment (11 ) —

Tax equivalent adjustment (1) 104 172

Total net interest income and noninterest income, adjusted $ 63,410 $ 52,467

(1)

Includes tax-equivalent adjustments on loans and securities using the federal statutory tax rate of 21%.

Income Taxes

Income tax expense was $3.2 million and $1.8 million for the years ended December 31, 2022 and 2021, respectively. These amounts correspond to an effective tax rate of 17.83% and 13.81% for 2022 and 2021, respectively. The effective tax rate is below the statutory rate of 21%, due primarily to tax credits on qualified affordable housing project investments as discussed in Note 25 to the Consolidated Financial Statements as well as qualified rehabilitation credits. During 2021, one of the Company's rehabilitation tax credit investments was finalized and the total amount of credits to be received was determined and certified. The effective tax rate is also impacted by tax-exempt income on investment securities and loans. Note 9 to the Consolidated Financial Statements provides a reconciliation between income tax expense computed using the federal statutory income tax rate and the Company’s actual income tax expense during 2022 and 2021.

Business Segments

The Company has two reportable operating segments: community banking and marine lending. Revenue from community banking operations consist primarily of net interest income related to investments in loans and securities and outstanding deposits and borrowings, fees earned on deposit accounts and debit card interchange activity. Revenue from marine lending operations consist primarily of net interest income related to commercial and consumer marine loans and gains on sales of loans.

Financial information for the parent company and the Bank of Clarke Wealth Management Division is included in the "All Other" category. The parent company's operating results are comprised primarily of interest expense associated with subordinated debt. The wealth management division's net recenues are comprised primarily of income from offering wealth management services and insurance products through third-party service providers. Refer to Notes 1 and 27 of the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K for additional information.

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Marine lending was identified as a newly reportable segment in 2022 and as such, the Company has included the prior period financial information for comparative purposes. The following table provides income and asset information as of and for the twelve months ended December 31, 2022 and 2021, which are included within the Consolidated Balance Sheets and Consolidated Statements of Income. Variances that the Company believes require explanation are discussed below the table.

Twelve Months Ended

Community Banking Marine Lending All Other Eliminations Consolidated

(in thousands)

Other data:

Capital expenditures $ 829 $ 9 $ — $ — $ 838

Twelve Months Ended

Community Banking Marine Lending All Other Eliminations Consolidated

(in thousands)

Other data:

Capital expenditures $ 520 $ — $ — $ — $ 520

Community Banking Marine Lending All Other Eliminations Consolidated

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The increase in community banking segment net income for the year ended December 31, 2022 compared to the year ended December 31, 2021 was primarily due to higher interest income resulting from higher average balances of interest-earning assets, including loans and securities, and the effects of rising interest rates on asset yields. This increase was partially offset by the increase in noninterest expense. The increase in noninterest expense is largely due to the Bank's growth and an increase in the allocated cost of funding. This growth has required investments to be made in the Bank’s infrastructure, causing increases in salaries and employee benefits, occupancy expenses, equipment expenses, advertising and marketing expenses, stationary and supplies, and other operating expenses. In addition, increases in asset size and capital levels have impacted both the FDIC assessment and bank franchise tax amounts.

The increase in marine lending segment net income for the year ended December 31, 2022 compared to the year ended December 31, 2021 was also primarily due to higher interest income resulting from higher average balances of interest-earning assets, including loans, and the effects of rising interest rates on asset yields. This increase was partially offset by higher salaries and employee benefits expense, including adding new talent to the marine lending team.

FINANCIAL CONDITION

Assets, Liabilities and Shareholders’ Equity

The Company’s total assets were $1.62 billion at December 31, 2022, an increase of $313.7 million or 24.07% from $1.30 billion at December 31, 2021. Securities decreased $43.2 million or 22.44% between 2021 and 2022. Loans, net of the allowance for loan losses, increased by $335.6 million or 34.36% from 2021 to 2022. Total liabilities were $1.51 billion at December 31, 2022, compared to $1.19 billion at December 31, 2021. Total shareholders’ equity at year end 2022 and 2021 was $101.7 million and $110.3 million, respectively.

Securities

Total securities, excluding restricted stock, were $149.2 million and $192.3 million for the years ended December 31, 2022 and December 31, 2021, respectively. The Company purchased $26.8 million in securities during 2022. This amount includes $23.1 million or 86.04% in mortgage-backed securities, $1.5 million or 5.57% in U.S. government corporations and agencies and $2.3 million or 8.39% in subordinated debt. The Company had $27.6 million in maturities, calls, and principal repayments on securities during 2022. This amount includes $3.6 million or 12.90% in obligations of U.S. government corporations and agencies, $19.0 million or 68.86% in mortgage-backed securities, $2.0 million or 7.24% in U.S. Treasuries, and $3.0 million or 11.00% in obligations of states and political subdivisions. Note 2 to the Consolidated Financial Statements provides additional details about the Company’s securities portfolio as of December 31, 2022 and 2021.

The ability to dispose of available for sale securities prior to maturity provides management more options to react to future rate changes and provides more liquidity, when needed, to meet short-term obligations. The Company had net unrealized losses on available for sale securities of $25.9 million and $218 thousand at December 31, 2022 and 2021, respectively. Unrealized gains or losses on available for sale securities are reported within shareholders’ equity, net of the related deferred tax effect, as accumulated other comprehensive income (loss).

The table titled “Maturity Distribution and Yields of Securities” shows the maturity period and average yield for the different types of securities in the portfolio at December 31, 2022. The weighted average yield is calculated based on the relative amortized costs of the securities. Although mortgage-backed securities have definitive maturities, they provide monthly principal curtailments which can be reinvested at a prevailing rate and for a different term.

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Maturity Distribution and Yields of Securities

Securities available for sale:

Mortgage-backed securities — % — % 1.06 % 1.75 % 1.71 %

Subordinated debt — % — % 4.28 % — % 4.28 %

(1)

Yields on tax-exempt securities have been computed on a tax-equivalent basis using a federal tax rate of 21%.

Loan Portfolio

The Company’s primary use of funds is supporting lending activities from which it derives the greatest amount of interest income. Gross loans net of net deferred costs and premiums were $1.32 billion and $985.7 million at December 31, 2022 and 2021, respectively. This represents an increase of $338.1 million or 34.30% for 2022. The ratio of net loans to deposits increased during the year from 82.99% to 104.72% at December 31, 2021 and December 31, 2022, respectively.

Loans secured by real estate were $938.9 million or 70.92% and $754.8 million or 76.57% of total loans at December 31, 2022 and 2021, respectively. This represents an increase of $184.1 million or 24.39% for 2022. Consumer installment loans were $117.1 million or 8.85% and $67.3 million or 6.83% of total loans at December 31, 2022 and 2021, respectively. This represents an increase of $49.8 million or 74.06% for 2022. Commercial and industrial loans were $247.7 million or 18.71% and $143.4 million or 14.55% of total loans at December 31, 2022 and 2021. This represents an increase of $104.3 million or 72.73% for 2022. All other loans were $12.7 million and $16.8 million at December 31, 2022 and 2021. This represents an decrease of $4.1 million or 24.27%. During the year ended December 31, 2022, loan growth was mainly concentrated in commercial real estate loans and commercial and industrial loans, net of PPP forgiveness. Loan growth was also strong in consumer installment loans. Loan growth in commercial and industrial loans and consumer installment loans was mainly due to the marine loan lending. Loan growth was also driven by the expansion into new market areas.

The table titled “Maturity Schedule of Selected Loans” shows the different loan categories and the period during which they mature. For loans maturing in more than one year, the table also shows a breakdown between fixed rate loans and floating rate loans. The table indicates that $464.5 million or 35.29% of the loan portfolio matures within five years. The floating rate loans maturing after five years are primarily comprised of loans secured by 1-4 family residential properties.

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Maturity Schedule of Selected Loans

(dollars in thousands)

Loans secured by real estate:

For maturities over one year:

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Asset Quality

The Company has policies and procedures designed to control credit risk and to maintain the quality of its loan portfolio. These include underwriting standards for new originations and ongoing monitoring and reporting of asset quality and adequacy of the allowance for loan losses. There were $2.6 million in total non-performing assets, which consist of nonaccrual loans, loans 90 days or more past due and still accruing, other real estate owned, and repossessed assets at December 31, 2022. This is a decrease of $178 thousand when compared to the December 31, 2021 balance of $2.8 million. This decrease resulted mostly from a decrease in nonaccrual loans.

Nonaccrual loans were $2.2 million at December 31, 2022 and $2.7 million at the end of 2021. The gross amount of interest income that would have been recognized on nonaccrual loans was $93 thousand for 2022 and $133 thousand for 2021. None of this interest income was included in net income for 2022 or 2021. A total of 12 loans totaling $544 thousand were placed on nonaccrual during 2022. The balance of these loans added to nonaccrual status during 2022 ranged from $1 thousand to $300 thousand with the average outstanding balance being $45 thousand. In addition, five loans totaling $688 thousand were removed from nonaccrual status during 2022. Of the $688 thousand in loans removed from nonaccrual status between December 31, 2021 and December 31, 2022, two loans were paid off, one loan was discharged in bankruptcy, one loan was charged off and one loan was returned to accrual status. The remainder of the decrease in nonaccrual loans was due to paydowns of loans that remained in nonaccrual status between December 31, 2021 and December 31, 2022. Management evaluates the financial condition of these borrowers and the value of any collateral on these loans. The results of these evaluations are used to estimate the amount of losses which may be realized on the disposition of these nonaccrual loans. Nonaccrual loans that were evaluated for impairment at December 31, 2022 totaled $2.2 million and had $73 thousand in specific allocations assigned.

Other real estate owned increased from zero at December 31, 2021 to $108 thousand at December 31, 2022. One property was foreclosed on during 2022. The difference between the amount of other real estate owned and the settlement proceeds is recognized as a gain or loss on the sale of other real estate owned. A net loss of $201 thousand was recognized on other real estate owned during 2021.

Nonperforming and Other Assets

Nonperforming assets consist of nonaccrual loans, loans past due 90 days and accruing interest, other real estate owned (foreclosed properties), and repossessed assets. The table titled “Nonperforming Assets and Credit Ratios” shows the amount of nonperforming assets and loans past due 90 days and accruing interest outstanding for the past two years. The table also shows the ratios for the allowance for loan losses as a percentage of nonperforming assets and nonperforming assets as a percentage of loans outstanding and other real estate owned.

Loans are placed on non-accrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on non-accrual status. First, all interest accrued but unpaid at the date that the loan is placed on non-accrual status is either deducted from interest income or written off as a loss. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Finally, there may be actual losses that require additional provisions for loan losses to be charged against earnings.

For real estate loans, upon foreclosure, the properties are recorded at the fair value of the property based on current appraisals and other current market trends, less selling costs. If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off against the allowance for loan losses. A review of the recorded property value is performed in conjunction with normal loan reviews, and if market conditions indicate that the recorded value exceeds the fair value, additional write downs of the property value are charged directly to operations. Gains on properties acquired through foreclosure where the fair value less costs to sell exceeds the related loan balance and there have been no prior charge-offs are recorded to current earnings.

In addition, the Company may, under certain circumstances, restructure loans in troubled debt restructurings as a concession to a borrower when the borrower is experiencing financial distress. Each loan considered for restructuring is evaluated based on customer circumstances and may include modifications to one or more loan provisions. Such restructured loans are included in impaired loans. At December 31, 2022 and 2021, the Company had $4.6 million and $2.7 million in restructured loans, respectively.

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Nonperforming Assets and Credit Ratios

(dollars in thousands)

December 31,

Loans past due 90 days and accruing interest 318 43

Other real estate owned and repossessed assets 108 —

Total nonperforming assets $ 2,588 $ 2,766

Allowance for loan losses to nonperforming assets 433 % 318 %

Allowance for loan losses to total loans 0.85 % 0.89 %

Allowance for loan losses to nonaccrual loans 519 % 323 %

Nonaccrual loans to total loans 0.19 % 0.28 %

Other potential problem loans are defined as performing loans that possess certain risks that management has identified that could result in the loans not being repaid in accordance with their terms. Accordingly, these loans are risk rated at a level of substandard or lower. At December 31, 2022, other potential problem loans totaled $9.6 million. Of the total other potential problem loans, $4.5 million are currently considered impaired and are disclosed in Note 4 to the Consolidated Financial Statements.

Allowance for Loan Losses

The purpose and the methods for measuring the allowance for loans are discussed in the Critical Accounting Policies section above.

Charged-off loans were $659 thousand and $110 thousand for 2022 and 2021, respectively. Recoveries were $1.3 million and $318 thousand for 2022 and 2021, respectively. Net recoveries were $601 thousand for 2022. Net recoveries were $208 thousand for 2021. This represents a increase in net recoveries of $393 thousand or 189% for 2022. The allowance for loan losses as a percentage of loans was 0.85% and 0.89% at the end of 2022 and 2021, respectively. Excluding outstanding PPP loans of $74 thousand and $15.9 million as of December 31, 2022 and 2021, respectively, the allowance for loan losses as a percentage of total loans was 0.85% and 0.91% as of December 31, 2022 and 2021, respectively. The slight decline in the allowance percentage year over year was attributable in large part to the concentration of loan growth during the period in segments which carry lower reserves. Despite a significant increase in classified loans, the allowance for loan losses as a percentage of loans excluding PPP loans declined slightly. The majority of the increase in classified loans was due to the downgrade of loans where current financial information has not been provided, per loan policy. These loans have not been identified as impaired or nonperforming loans. The ratio of net (recoveries) to average loans was (0.05%) for 2022 and (0.02%) for 2021.

The provision for loan losses for the years ended December 31, 2022 and 2021 was $1.8 million and $1.5 million, respectively. The provision for loan losses in 2022 and 2021 reflected mainly loan growth in the portfolio.

The table titled “Allocation of Allowance for Loan Losses” shows the amount of the allowance for loan losses which is allocated to the indicated loan categories, along with that category’s percentage of total loans, at December 31, 2022 and 2021. The amount of allowance for loan losses allocated to each loan category is based on the amount of delinquent loans in that loan category, the status of nonperforming assets in that loan category, the historical losses for that loan category, the evaluation of qualitative factors impacting the portfolio and the financial condition of certain borrowers whose financial conditional is monitored on a periodic basis. Management believes that the allowance for loan losses is adequate based on the loan portfolio’s current risk characteristics.

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Analysis of Allowance for Loan Losses

(dollars in thousands)

Years Ended December 31,

(1)

Averages as disclosed are based on the outstanding balances of the loans in each segment. These averages do not include net deferred costs and premiums

Allocation of Allowance for Loan Losses

(dollars in thousands)

During June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The ASU, as amended, requires an entity to measure expected credit losses for financial assets carried at amortized cost based on historical experience, current conditions, and reasonable and supportable forecasts. Among other things, the ASU also amended the impairment model for available for sale securities and addressed purchased financial assets with deterioration. Refer to Note 1 of the consolidated financial statements in Item 8 of this report for additional information.

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Deposits

Total deposits were $1.26 billion and $1.18 billion at December 31, 2022 and 2021, respectively, which represents an increase of $86.8 million or 7.38% during 2022. The table titled “Average Deposits and Rates Paid” shows the average deposit balances and average rates paid for 2022 and 2021.

Average Deposits and Rates Paid

(dollars in thousands)

Years Ended December 31,

Amount Rate Amount Rate

Interest-bearing:

Time deposits:

Noninterest-bearing demand deposits, which are comprised of checking accounts, increased $8.4 million or 1.78% from $470.4 million at December 31, 2021 to $478.8 million at December 31, 2022. Interest-bearing deposits, which include NOW accounts, money market accounts, regular savings accounts and time deposits, increased $78.4 million or 11.10% from $706.9 million at December 31, 2021 to $785.3 million at December 31, 2022. Total money market account balances decreased $31.4 million or 12.45% from $251.9 million at December 31, 2021 to $220.5 million at December 31, 2022; however, regular savings accounts increased $71.0 million or 42.07% from $168.7 million at December 31, 2021 to $239.7 million at December 31, 2022. Reciprocal deposit accounts balances (included in total money market account and NOW account balances) increased from $42.2 million to $59.5 million at December 31, 2021 and December 31, 2022, respectively. The reciprocal deposits balance at December 31, 2022 and December 31, 2021 consists of money market and NOW accounts obtained through the ICS network. The growth in deposits was mainly organic growth as we expand and grow into newer market areas. Time deposits increased $34.3 million or 27.76% from $123.6 million at December 31, 2021 to $157.9 million at December 31, 2022. Total estimated uninsured deposits at December 31, 2022 and December 31, 2021 were $322.5 million and $356.3 million, respectively.

The Company attempts to fund asset growth with deposit accounts and focus upon core deposit growth as its primary source of funding. Core deposits consist of checking accounts, NOW accounts, money market accounts, regular savings accounts, and time deposits of less than $250,000. Core deposits totaled $1.19 billion or 93.88% and $1.11 billion or 94.47% of total deposits at December 31, 2022 and 2021, respectively.

The table titled “Maturities of Certificates of Deposit and Other Time Deposits of $250,000 and Greater” shows the amount of certificates of deposit of $250,000 and more maturing within the time periods indicated at December 31, 2022. The total amount maturing within one year is $66.1 million or 93.96% of the total amount outstanding.

Maturities of Certificates of Deposit and Other Time Deposits of $250,000 and Greater

(dollars in thousands)

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The table titled “Certificates of Deposit and Other Time Deposits Otherwise Uninsured" shows the balances of certificates of deposit that were in excess of the FDIC insurance limit at December 31, 2022. The total amount maturing within one year is $54.6 million or 97.33% of the total amount outstanding.

Certificates of Deposit and Other Time Deposits Otherwise Uninsured

(dollars in thousands)

CAPITAL RESOURCES

Total shareholders’ equity on December 31, 2022 was $101.7 million, reflecting a percentage of total assets of 6.29% as compared to $110.3 million and 8.46% at December 31, 2021. The common stock’s book value per share decreased $2.78 or 8.70% to $29.15 per share at December 31, 2022 from $31.93 per share at December 31, 2021. During 2022, the Company paid $1.15 per share in dividends as compared to $1.10 per share for 2021. The Company has a Dividend Investment Plan that allows participating shareholders to reinvest the dividends in Company stock. During 2022, the Company purchased 4,442 shares of its Common Stock under its stock repurchase program at an average price of $34.79. During 2021, the Company purchased 4,479 shares of its Common Stock under its stock repurchase program at an average price of $31.26. At December 31, 2022, and 2021, Management believes the Bank met all capital adequacy requirements to which it was subject. Additionally, at December 31, 2022, the most recent notification from the Federal Reserve categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank’s category.

Federal regulatory risk-based capital guidelines require percentages to be applied to various assets, including off-balance sheet assets, based on their perceived risk in order to calculate risk-weighted assets. Tier 1 capital consists of total shareholders’ equity plus qualifying trust preferred securities outstanding less net unrealized gains and losses on available for sale securities, goodwill and other intangible assets. Total capital is comprised of Tier 1 capital plus the allowable portion of the allowance for loan losses and any excess trust preferred securities that do not qualify as Tier 1 capital.

Effective January 1, 2015, the Federal Reserve issued final risk-based capital rules to align with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules require the Bank to comply with the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (iii) a total capital ratio of 8.0% of risk-weighted assets; and (iv) a leverage ratio of 4.0% of total assets. In addition, a capital conservation buffer requirement was phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increased by the same amount each year until it was fully implemented at 2.5% effective January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with any ratio (excluding the leverage ratio) above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. As fully phased in effective January 1, 2019, the rules require the Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% common equity Tier 1 ratio, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7.0%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio, effectively resulting in a minimum Tier 1 capital ratio of 8.5%), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio, effectively resulting in a minimum total capital ratio of 10.5%), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets.

Pursuant to the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement, qualifying bank holding companies with total consolidated assets of less than $3 billion, such as the Company, are not subject to consolidated regulatory capital requirements.

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In 2019, the federal banking agencies jointly issued a final rule that provides for an optional, simplified measure of capital adequacy, the Community Bank Leverage Ratio framework (CBLR), for qualifying community banking organizations, consistent with Section 201 of the Economic Growth, Regulatory Relief, and Consumer Protection Act. The final rule became effective on January 1, 2020. The CBLR removes the requirement for qualifying banking organizations to calculate and report risk-based capital but rather only requires a Tier 1 to average assets (leverage) ratio. Qualifying banking organizations that elect to use the CBLR and that maintain a leverage ratio of greater than the required minimum will be considered to have satisfied the generally applicable risk-based and leverage capital requirements in the agencies’ capital rules and, if applicable, will be considered to have met the well-capitalized ratio requirements for purposes of section 38 of the Federal Deposit Insurance Act. Under the regulatory capital rules, an institution electing to use the CBLR must maintain a minimum leverage ratio of 9%. Qualifying institutions are allowed a two-quarter grace period to correct a ratio that falls below the required amount, provided the institution maintains a ratio of more than 8%. At December 31, 2022, the Bank was a qualifying institution and elected to utilize the CBLR to measure capital adequacy. As such, the related amounts and ratios for December 31, 2022, are presented below using the CLBR. As the Bank did not elect to utilize the CBLR at December 31, 2021, the amounts and ratios are presented using the risk-based capital framework.

Analysis of Bank Capital

(dollars in thousands)

Tier 1 Capital:

Common equity tier 1 capital $ 107,570

Tier 2 Capital:

Allowance for loan losses and reserves for off-balance sheet commitments $ 8,850

Total Tier 2 capital $ 8,850

Total risk-based capital $ 116,420

Capital Ratios:

Common equity Tier 1 capital ratio n/a 10.44 %

Tier 1 risk-based capital ratio n/a 10.44 %

Total risk-based capital ratio n/a 11.30 %

Note 15 to the Consolidated Financial Statements provides additional discussion and analysis of regulatory capital requirements.

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LIQUIDITY

Liquidity management involves meeting the present and future financial obligations of the Company with the sale or maturity of assets or with the occurrence of additional liabilities. Liquidity needs are met with cash on hand, deposits in banks, federal funds sold, securities classified as available for sale and loans maturing within one year. At December 31, 2022 liquid assets totaled $317.1 million as compared to $365.1 million at December 31, 2021. These amounts represent 20.93% and 30.61% of total liabilities at December 31, 2022 and 2021, respectively. Securities provide a constant source of liquidity through paydowns and maturities. Also, the Company maintains short-term borrowing arrangements, namely federal funds lines of credit, with larger financial institutions as an additional source of liquidity. The Bank’s membership with the Federal Home Loan Bank of Atlanta also provides a source of borrowings with numerous rate and term structures. At December 31, 2022 and 2021, the Company had remaining credit availability in the amounts of $105.7 million and $244.3 million, respectively, with the Federal Home Loan Bank of Atlanta. The Company also had unused lines of credit with financial institutions of $78.0 million at December 31, 2022 and 2021. The Company’s senior management monitors the liquidity position regularly and attempts to maintain a position which utilizes available funds most efficiently. As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

Note 18 to the Consolidated Financial Statements provides information about the off-balance sheet arrangements which arise through the lending activities of the Company. These arrangements increase the degree of both credit and interest rate risk beyond that which is recognized through the financial assets and liabilities on the consolidated balance sheets.

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Item 7A. Quantitative and Qualitative Disclosures about Market Risk

As the holding company of the Bank, the Company’s primary component of market risk is interest rate volatility. Interest rate fluctuations will impact the amount of interest income and expense the Bank receives or pays on almost all of its assets and liabilities and the market value of its interest-earning assets and interest-bearing liabilities, excluding those which have a very short term until maturity. Interest rate risk exposure of the Company is, therefore, experienced at the Bank level. Asset / liability management attempts to maximize the net interest income of the Company by adjusting the volume and price of rate sensitive assets and liabilities. The Company does not subject itself to foreign currency exchange or commodity price risk due to prohibition through policy and the current nature of operations. Derivative instruments and hedging activities of the Company have historically been minimal.

The Bank’s interest rate management strategy is designed to maximize net interest income and preserve the capital of the Company. The Bank’s financial instruments are periodically subjected to various simulations whose results are discussed in the following paragraphs. These models are based on actual data from the Bank’s financial statements and assumptions about the performance of certain financial instruments. Prepayment assumptions are applied to all mortgage related assets, which includes real estate loans and mortgage-backed securities. Prepayment assumptions are based on a median rate at which principal payments are received on these assets over their contractual term. The rate of principal payback is assumed to increase when rates fall and decrease when rates rise. Term assumptions are applied to non-maturity deposits, which includes demand deposits, NOW accounts, savings accounts, and money market accounts. Demand deposits and NOW accounts are generally assumed to have a term greater than one year since the total amount outstanding does not fluctuate with changes in interest rates. Savings accounts and money market accounts are assumed to be more interest rate sensitive, therefore, a majority of the amount outstanding is assumed to have a term of less than one year.

The simulation analysis evaluates the potential effect of upward and downward changes in market interest rates on future net interest income. The Bank views the immediate shock of rates as a more effective measure of interest rate risk exposure. The analysis assesses the impact on net interest income over a 12 month period after an immediate increase or “shock” in rates, of 100 basis points up to 400 basis points. The simulation analysis results are presented in the table below:

Year 1 Net Interest Income Simulation

(dollars in thousands)

Change inNet Interest Income

Assumed Market Interest Rate Shock Dollars Percent Change

The Bank uses simulation analysis to assess earnings at risk and economic value of equity ("EVE") analysis to assess economic value at risk. This analysis method allows management to regularly monitor the direction and magnitude of the Bank’s interest rate risk exposure. The modeling techniques cannot be measured with complete precision. Maturity and repricing characteristics of assets and liabilities, prepayments on amortizing assets, non-maturity deposit sensitivity and loan and deposit pricing are key assumptions used in acquiring this analysis. There is a realm of uncertainty in using these assumptions but the analysis does provide the Bank with the ability to estimate interest rate risk position over time.

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The table below examines the EVE. The EVE of the balance sheet is defined as the discounted present value of expected asset cash flows minus the discounted present value of the expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The model indicates an exposure to falling interest rates. These results are driven primarily by the relative change in value of the Bank’s core deposit base as rates rise.

Static EVE Change

(dollars in thousands)

Change in EVE

Assumed Market Interest Rate Shift Dollars Percent Change

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Item 8. Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders

Eagle Financial Services, Inc.

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of Eagle Financial Services, Inc. and its subsidiary (the Company) as of December 31, 2022 and 2021, the related consolidated statements of income, comprehensive income (loss), changes in shareholders’ equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2022 and 2021, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion

These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

Critical Audit Matter

The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates 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 matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.

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Allowance for Loan Losses – General Allowance – Qualitative Factors

As described in Note 1 (Nature of Banking Activities and Significant Accounting Policies) and Note 4 (Allowance for Loan Losses) to the consolidated financial statements, the Company has established an allowance for loan losses to provide for probable loan losses which are estimated to have occurred as of the balance sheet date, which totaled $11.22 million at December 31, 2022. The Company’s allowance for loan losses consists of three components: the specific allowance; the general allowance; and the unallocated allowance. The general component relates to loans that are not considered impaired and is based on historical loss experience adjusted for qualitative factors and totaled $11.12 million at December 31, 2022. The qualitative portion of the general allowance is based on management’s evaluation of specific factors which are used to develop loss percentages applied to the loan portfolio, by loan pool, based on management’s assessment of shared risk characteristics within groups of similar loans. The qualitative factors assessed include: national and local economic trends and conditions; the quality of the Company’s loan review system; changes in lending policies; the experience, ability, and depth of management; concentrations of credit; trends in volume and terms of loans; levels and trends in delinquencies and nonperforming loans; changes in collateral values; and competition and regulatory requirements.

Management exercised significant judgment when assessing the considerations which serve as the basis for the qualitative factors used to adjust the Company’s historical loss experience in the general component of the allowance for loan losses estimate. We identified the assessment of the qualitative factors as a critical audit matter as auditing the qualitative factors involved especially complex and subjective auditor judgment in evaluating management’s assessment of the inherently subjective estimates.

How We Addressed the Matter in Our Audit

The primary audit procedures we performed to address this critical audit matter included:

•

Evaluating the completeness and accuracy of data inputs used as the basis for the qualitative factors.

•

Evaluating the reasonableness of management’s judgments related to the determination of qualitative factors.

•

Evaluating the qualitative factors for directional consistency and for reasonableness.

•

Testing the mathematical accuracy of the allowance calculation, including the application of the qualitative factors.

/s/ Yount, Hyde & Barbour, P.C.

We have served as the Company's auditor since 2015.

Winchester, Virginia

March 29, 2023

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EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARY

Consolidated Balance Sheets

December 31, 2022 and 2021

(dollars in thousands, except per share amounts)

Assets

Interest-bearing deposits with other institutions 49,902 49,304

Other real estate owned, net of allowance 108 —

Liabilities and Shareholders’ Equity

Liabilities

Deposits:

Federal funds purchased 32,980 —

Federal Home Loan Bank advances 175,000 —

Subordinated debt 29,377 —

Commitments and contingencies

Shareholders’ Equity

Preferred stock, $10 par value; 500,000 shares authorized and unissued $ — $ —

Accumulated other comprehensive (loss) (20,446 ) (155 )

See Notes to Consolidated Financial Statements

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EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARY

Consolidated Statements of Income

Years Ended December 31, 2022 and 2021

(dollars in thousands, except per share amounts)

Interest and Dividend Income

Interest and dividends on securities:

Interest income exempt from federal income taxes 221 419

Interest on deposits in banks 352 69

Interest on federal funds sold 30 —

Total interest and dividend income $ 54,686 $ 42,676

Interest Expense

Interest on federal funds purchased 170 —

Interest on Federal Home Loan Bank advances 1,295 —

Interest on subordinated debt 1,067 —

Net interest income after provision for loan losses $ 47,383 $ 39,516

Noninterest Income

Service charges on deposit accounts 1,618 1,235

Other service charges and fees 3,943 3,941

(Loss) on the sale and disposal of bank premises and equipment (11 ) —

(Loss) gain on sale of securities (737 ) 24

Bank owned life insurance income 626 527

Noninterest Expenses

Advertising and marketing expenses 770 408

Stationery and supplies 199 155

Other real estate owned expense 34 41

Loss on other real estate owned — 201

Computer software expense 960 996

Earnings Per Share

Net income per common share, basic $ 4.17 $ 3.20

Net income per common share, diluted $ 4.17 $ 3.20

See Notes to Consolidated Financial Statements

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EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARY

Consolidated Statements of Comprehensive Income (Loss)

Years Ended December 31, 2022 and 2021

(dollars in thousands)

Other comprehensive (loss):

Total other comprehensive (loss) (20,291 ) (3,434 )

Total comprehensive (loss) income $ (5,770 ) $ 7,587

See Notes to Consolidated Financial Statements

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EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Shareholders’ Equity

Years Ended December 31, 2022 and 2021

(dollars in thousands, except per share amounts)

Other comprehensive (loss) (3,434 ) (3,434 )

Restricted stock awards, stock incentive plan (21,261 shares) 53 (53 ) —

Stock-based compensation expense 850 850

Issuance of common stock, dividend investment plan (16,194 shares) 41 479 520

Issuance of common stock, employee benefit plan (5,577 shares) 14 165 179

Retirement of common stock (4,749 shares) (12 ) (137 ) (149 )

Restricted stock awards, stock incentive plan (23,079 shares) 58 (58 ) —

Stock-based compensation expense 1,017 1,017

Issuance of common stock, dividend investment plan (5,582 shares) 14 185 199

Issuance of common stock, employee benefit plan (4,697 shares) 12 152 164

Retirement of common stock (4,442 shares) (11 ) (143 ) (154 )

See Notes to Consolidated Financial Statements

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EAGLE FINANCIAL SERVICES, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

Years Ended December 31, 2022 and 2021

(dollars in thousands)

Cash Flows from Operating Activities

Amortization of other assets 931 672

Origination of loans held for sale (14,276 ) (19,015 )

Proceeds from sale of loans held for sale 15,486 18,775

Net (gains) on sales of loans (1,875 ) (1,658 )

Loss (gain) on other real estate owned — 201

Loss on the sale and disposal of premises and equipment 11 —

Loss (gain) on the sale of securities 737 (24 )

Amortization of subordinated debt issuance costs 51 —

Stock-based compensation expense 1,017 850

Premium amortization on securities, net 562 1,239

Bank owned life insurance (income) (626 ) (527 )

Deferred tax (benefit) (86 ) (1,437 )

Changes in assets and liabilities:

(Increase) decrease in other assets (4,742 ) 6

(Decrease) increase in other liabilities (706 ) 3,877

Net cash provided by operating activities $ 13,814 $ 16,459

Cash Flows from Investing Activities

Proceeds from the sale of securities available for sale 15,370 15,885

Purchases of securities available for sale (26,819 ) (100,824 )

Proceeds from the sale of restricted investments — 222

Purchase of restricted investments (8,184 ) (4 )

Proceeds for the sale of bank premises and equipment 33 —

Purchases of bank premises and equipment (838 ) (520 )

Proceeds from the sale of other real estate owned — 672

Changes in collateral posted with other financial institutions, net (700 ) —

Purchase of bank-owned life insurance — (10,000 )

Origination of loans net of prinicpal collected (492,592 ) (248,598 )

Funding of capital commitments related to other investments (761 ) (2,238 )

Net cash (used in) investing activities $ (331,336 ) $ (193,217 )

Cash Flows from Financing Activities

Net increase (decrease) in certificates of deposit 34,310 (5,074 )

Net increase in federal funds purchased 32,980 —

Net increase in Federal Home Loan Bank advances 175,000 —

Issuance of subordinated debt, net of issuance costs 29,326 —

Issuance of common stock, employee benefit plan 164 179

Retirement of common stock (154 ) (149 )

Net cash provided by financing activities $ 320,348 $ 160,906

Increase (decrease) in cash and cash equivalents $ 2,826 $ (15,852 )

Cash and Cash Equivalents

Supplemental Disclosures of Cash Flow Information

Cash payments for:

Supplemental Schedule of Noncash Investing and Financing Activities:

Unrealized (loss) on securities available for sale $ (25,685 ) $ (4,346 )

Issuance of common stock, dividend investment plan $ 199 $ 520

Lease liabilities arising from right-of-use assets $ - $ 1,404

See Notes to Consolidated Financial Statements

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NOTE 1. Nature of Banking Activities and Significant Accounting Policies

Eagle Financial Services, Inc. (the “Company” or “Corporation”) and Bank of Clarke (the “Bank”) grant commercial, financial, agricultural, residential and consumer loans to customers in Virginia, Maryland and the Eastern Panhandle of West Virginia. The loan portfolio is well diversified and generally is collateralized by assets of the customers. The loans are expected to be repaid from cash flows or proceeds from the sale of selected assets of the borrowers. In addition, the Bank of Clarke Wealth Management Division, a division of the Bank, provides both a full-service Trust Department and a separate brokerage area.

The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to accepted practices within the banking industry.

Principles of Consolidation

The Company owns 100% of the Bank. The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant intercompany accounts and transactions between the Company and the Bank have been eliminated.

Wealth Management Assets

The Bank of Clarke Wealth Management Division provides both a full-service Trust Department and a separate brokerage area. The Trust Department features a full range of fiduciary expertise, including service as Trustee of personal trusts, service as guardian or conservator by court appointment, fiduciary investment management, estate settlement, and agency for trustees. The brokerage area offers advisory services and a broad selection of investment products, including Individual Retirement Accounts, mutual funds, tax-deferred annuities, 529 college savings plans, life insurance, long term care insurance, brokerage certificates of deposit, among other brokerage services. Securities and other property held by the Bank of Clarke Wealth Management Division in a fiduciary or agency capacity are not assets of the Bank and are not included in the accompanying consolidated financial statements.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The material estimate that is particularly susceptible to significant change in the near term relates to the determination of the allowance for loan losses.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold, and interest bearing deposits. Generally, federal funds are purchased and sold for one-day periods.

Securities

Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Debt securities not classified as held to maturity are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. Equity securities with readily determinable fair values are carried at fair value, with changes in fair value reported in income. Equity securities without readily determinable fair values are carried at cost, minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be “other than temporary” are reflected in earnings as realized losses. In estimating “other than temporary” impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery of fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

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The Bank is required to maintain an investment in the capital stock of certain correspondent banks. No readily available market exists for this stock and it has no quoted market value. The investment in these securities is recorded at cost and they are reported on the Company’s consolidated balance sheet as restricted investments.

Loans Held for Sale

Mortgage loans originated with the intent to sell in the secondary market are classified as loans held for sale and carried at the lower of cost or fair value as determined by commitments from investors. Mortgage loans that are sold in the secondary market are sold servicing released. The Company may also classify other loans as loans held for sale as part of its ongoing portfolio management strategies. Such other loans are generally not originated with the intent to sell. Once a decision is made to sell loans not previously classified as held for sale, such loans are transferred into the held-for-sale classification and carried at the lower of cost or fair value. In 2022, the Company sold non-mortgage loans totaling approximately $156 million as part of its portfolio management strategies that were previously classified as held for investment. Gains and losses on sales of loans are recorded based on the differential between the sales proceeds and carrying value of the underlying loans.

Loan Servicing Rights

Loan servicing rights are separate from the underlying loan and may be retained or sold by the Company when the related loan is sold.In connection with sale of certain loans, the Company has recognized assets for retained loan servicing rights. Capitalized loan servicing rights represent the economic benefits associated with contracts to service loans under which the benefits of servicing are expected to more than adequately compensate the Company for performing the servicing. Assets for retained loan servicing rights are initially recognized as a component of the gain recognized on the sale of the underlying loan(s) and are recorded at fair value on the consolidated balance sheets. Loan servicing rights are subsequently accounted for using the amortization method. The amortization method requires the servicing assets to be amortized in proportion to and over the period of estimated net servicing income. Additionally, the recorded balances are evaluated for impairment each reporting period and are reported at the lower of amortized cost or fair value. Assets for loan servicing rights are recorded in other assets in the consolidated balance sheets. Servicing fee income, net of amortization and impairment, if any, is reported in other service charges and fees in the consolidated statements of income.

Loans

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout the Counties of Clarke, Frederick, Loudoun and Fairfax, Virginia as well as the Towns of Leesburg and Purcellville and the Cities of Winchester and Frederick, Maryland. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan fees collected and certain costs incurred related to loan originations are deferred and amortized as an adjustment to interest income over the life of the related loans. Deferred fees and costs are recorded as an adjustment to interest income using a method that approximates a constant yield.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 120 and 90 days delinquent, respectively, unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 180 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Troubled Debt Restructurings ("TDR")

In situations where, for economic or legal reasons related to a borrower’s financial condition, management may grant a concession to the borrower that it would not otherwise consider, the related loan is classified as a TDR. TDRs are considered impaired loans. Upon designation as a TDR, the Company evaluates the borrower’s payment history, past due status and ability to make payments based on the revised terms of the loan. If a loan was accruing prior to being modified as a TDR and if the Company concludes that the borrower is able to make such payments, and there are no other factors or circumstances that would cause it to conclude otherwise, the loan will remain on an accruing status. If a loan was on non-accrual status at the time of the TDR, the loan will remain on non-accrual status following the modification and may be returned to accrual status based on the policy for returning loans to accrual status as noted above.

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Risks by Loan Portfolio Segments

One-to-Four-Family Residential Real Estate Lending

Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee.

Commercial Real Estate Lending

Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general.

Construction and Land Development Lending

There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished home.

Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans, but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of the borrower. Commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as accounts receivable, equipment, inventory and boats. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate.

Consumer Lending

Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. A portion of the Company’s consumer loans are also secured by boats. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.

Marine Lending

The Bank’s marine lending unit, which includes originated retail loans, which are classified as commercial and industrial loans or consumer loans depending on borrower, and dealer floorplan loans, which are classified as commercial and industrial loans. The Company’s relationships are limited to well established dealers of global premium brand manufacturers. The Company’s top three manufacturer customers have been in business between 30 and 100 years. The Company primarily has secured agreements with premium manufacturers to support dealer floor plan loans which reduces the Company’s credit exposure to the dealer, despite its underwriting of each respective dealer. The Company has developed incentive retail pricing programs with the dealers to drive retail dealer flow. In addition to the repurchase agreements associated with floor plan lending, manufacturers will often support secondary resale values which can have the effect of reducing losses from non-performing retail marine loans. Retail borrowers generally have very high credit scores, substantial down payments, substantial net worth, personal liquidity, and excess cash flow.

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Paycheck Protection Program Loans

In both 2021 and 2020, the Company participated in the Paycheck Protection Program ("PPP"). As of December 31, 2022, the Company had 1 PPP loan with an outstanding balance of $74 thousand. As of December 31, 2021, the Company had 152 PPP loans with outstanding balances totaling $15.9 million. Net origination fees related to PPP loans were recognized in earnings over the lives of the loans or until forgiveness by the SBA.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for (recovery of) loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are impaired. An allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. Qualitative factors considered in the general component include the levels and trends in delinquencies and nonperforming loans, trends in volume and terms of loans, the effects of any changes in lending policies, the experience, ability, and depth of management, national and local economic trends and conditions, changes in collateral values, concentrations of credit, the quality of the Company’s loan review system, competition and regulatory requirements. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair market value less estimated liquidation costs of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer loans for impairment disclosures, unless such loans are the subject of a restructuring agreement or are in a nonaccrual status.

Bank Premises and Equipment

Land is carried at cost. Buildings and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives of the assets. Estimated useful lives range from 10 to 39 years for buildings and 3 to 10 years for furniture and equipment. Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation balances are cleared the differential between the proceeds, if any, and the carrying value is recorded as a gain or loss in the Company's results of operations.

Leases

The Company accounts for its leasing arrangements in accordance with ASC 842 "Leases". Refer to Note 13 for further discussion of the Company's accounting for its leasing arrangements.

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Other Real Estate Owned

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the fair value of the property, less estimated selling costs at the date of foreclosure. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, valuations are periodically performed by management and property held for sale is carried at the lower of the new cost basis or fair value less estimated cost to sell. Impairment losses on property to be held and used are measured as the amount by which the carrying amount of a property exceeds its fair value. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in the (gain) loss on other real estate owned line item in the consolidated statements of income.

Bank Owned Life Insurance

The Company has purchased life insurance on certain key individuals. Bank owned life insurance is recorded at the amount that may be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or amounts due that are probable at settlement.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Loan Swaps

The Company enters into interest rate swaps with certain qualifying commercial loan customers to meet their interest rate risk management needs. The Company simultaneously enters into interest rate swaps with dealer counterparties, with identical notional amounts and offsetting terms. The net result of these interest rate swaps is that the customer pays a fixed rate of interest and the Company receives a floating rate. These back-to-back loan swaps are derivative financial instruments and are reported at fair value in “other assets” and “other liabilities” in the Consolidated Balance Sheets. Changes in the fair value of loan swaps are recorded in other noninterest income and sum to zero because of the offsetting terms of swaps with borrowers and swaps with dealer counterparties.

Retirement Plans

The Company sponsors a 401(k) savings plan under which eligible employees may defer a portion of their compensation on a pretax basis. The Company also provides a match to participants in this plan, as described more fully in Note 11.

Stock-Based Compensation Plan

During 2014, the Company’s shareholders approved a stock incentive plan which allows key employees and directors to increase their personal financial interest in the Company. This plan permits the issuance of incentive stock options and non-qualified stock options and the award of stock appreciation rights, common stock, restricted stock, and phantom stock. The plan, as adopted, authorized the issuance of up to 500,000 shares of common stock. This plan is discussed more fully in Note 10.

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Income Taxes

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various assets and liabilities and gives current recognition to changes in tax rates and laws.

When tax returns are filed, it is likely that some positions taken would be sustained upon examination by the applicable taxing authority, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, the Company believes it is “more likely than not” that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the “more likely than not” recognition threshold are measured as the largest amount of tax benefit that is more than fifty percent (50%) likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the balance sheet along with any associated interest and penalties that would be payable to the applicable taxing authority upon examination. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statement of income. The Company has no uncertain tax positions.

Advertising

The Company follows the policy of charging the costs of advertising to expense as incurred.

Reclassifications

Certain reclassifications have been made to the 2021 financial statements to conform to reporting for 2022. The results of the reclassifications are not considered material and had no effect on prior years' net income or shareholders' equity.

Earnings Per Common Share

Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Nonvested restricted shares are included in the weighted average number of common shares used to compute basic earnings per share because of dividend participation and voting rights. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. The number of potential common shares is determined using the treasury method.

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

Twelve Months Ended

December 31,

Effect of dilutive common stock — —

There were no potentially dilutive securities outstanding in 2022 or 2021.

Comprehensive (Loss) Income

Accounting principles generally accepted in the United States of America require that recognized revenue, expenses, gains and losses be included in net income. Certain changes in assets and liabilities, net of income taxes, are reported within the balance sheet as a separate component of shareholders’ equity. These changes, along with net income, are components of comprehensive income and are reported in the statement of comprehensive income. In addition to net income, the Company’s comprehensive income includes changes in the benefit obligations and plan assets for postretirement benefit plans and unrealized gains or losses on available for sale securities.

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Business Segments

The Company operates in two reportable business segments through the Bank: community banking and marine lending. The Company’s business segments are determined based on the products and services provided, as well as the nature of the related business activities, and they reflect the manner in which financial information is regularly reviewed for the purpose of allocating resources and evaluating performance of the Company’s businesses. The results for these business segments are based on management’s accounting process, which assigns income statement items and assets to each operating segment. Given the Company's reportable segments are contained within the Bank, management must make certain allocations of expenses, which may not be representative of the costs expected to be incurred if the specific business segments operated as stand-alone entities. For additional information, refer to Note 27. “Business Segments.”

Stock Repurchase Program

On July 11, 2022, the Corporation renewed the stock repurchase program to repurchase up to 150,000 shares of its common stock prior to June 30, 2023. During 2022, the Company purchased 4,442 shares of its Common Stock under its stock repurchase program at an average price of $34.79. During 2021, the Company purchased 4,749 shares of its Common Stock under its stock repurchase program at an average price of $31.26. The maximum number of shares that may yet be purchased under the June 2022 plan as of December 31, 2022 are 148,969.

Recent Accounting Pronouncements

During June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The ASU, as amended, requires an entity to measure expected credit losses for financial assets carried at amortized cost based on historical experience, current conditions, and reasonable and supportable forecasts. Among other things, the ASU also amended the impairment model for available for sale securities and addressed purchased financial assets with deterioration. The Company adopted ASU 2016-13 as of January 1, 2023 in accordance with the required implementation date. Transition adjustments during the first quarter of 2023, will include increases in the allowance for credit losses and the reserve for credit losses on unfunded commitments to extend credit as well as a reduction of total equity, net of taxes. This reduction of equity capital may, at the Bank's election, be phased-in over a three year period in accordance with regulatory guidelines. The final cumulative effect of the transition adjustments is still subject to completion by the Company but is estimated to reduce opening retained earnings on January 1, 2023 by a reasonable range of $1.5 million to $2.5 million.Subsequent to adoption, the Company will record adjustments to its allowances for credit losses through the provision for credit losses in the consolidated statements of income.

The Company is utilizing a third-party model to tabulate its estimate of current expected credit losses, using a cohort methodology. In accordance with ASC 326, the Company has segmented its loan portfolio based on similar risk characteristics which included call report coding and various other factors. The Company primarily utilizes unemployment, inflation, as well as the consumer price index, and may also consider other factors to support its reasonable and supportable forecasting of current expected credit losses. To further adjust the allowance for credit losses for expected losses not already included within the quantitative component of the calculation, the Company may consider the following qualitative adjustment factors: economic conditions, problem loan trends, legal/regulatory environment, lending policy and procedures, credit admin and lending staff, loan review, nature, term and volume of the portfolio, collateral values and concentrations of credit. The Company’s CECL implementation process was overseen by the CFO and Controller and included an assessment of data availability and gap analysis, data collection, consideration and analysis of multiple loss estimation methodologies, an assessment of relevant qualitative factors and correlation analysis of multiple potential loss drivers and their impact on the Company’s historical loss experience. During 2022, the Company calculated its current expected credit losses model in parallel to its incurred loss model in order to further refine the methodology and model. In addition, the Company engaged a third-party to perform a comprehensive model validation.

Effective November 25, 2019, the SEC adopted Staff Accounting Bulletin ("SAB") 119. SAB 119 updated portions of SEC interpretative guidance to align with FASB ASC 326, “Financial Instruments – Credit Losses.” It covers topics including (1) measuring current expected credit losses; (2) development, governance, and documentation of a systematic methodology; (3) documenting the results of a systematic methodology; and (4) validating a systematic methodology.

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In March 2022, FASB issued ASU No. 2022-02, “Financial Instruments-Credit Losses (Topic 326), Troubled Debt Restructurings and Vintage Disclosures.” ASU 2022-02 addresses areas identified by the FASB as part of its post-implementation review of the credit losses standard (ASU 2016-13) that introduced the CECL model. The amendments eliminate the accounting guidance for troubled debt restructurings by creditors that have adopted the CECL model and enhance the disclosure requirements for loan refinancings and restructurings made with borrowers experiencing financial difficulty. In addition, the amendments require a public business entity to disclose current-period gross write-offs for financing receivables and net investment in leases by year of origination in the vintage disclosures. The amendments in this ASU should be applied prospectively, except for the transition method related to the recognition and measurement of TDRs, an entity has the option to apply a modified retrospective transition method, resulting in a cumulative-effect adjustment to retained earnings in the period of adoption. ASU 2022-02 is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2022-02 will have on its consolidated financial statements.

In March 2020, FASB issued ASU No. 2020-04 “Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.” These amendments provide temporary optional guidance to ease the potential burden in accounting for reference rate reform. The ASU provides optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. It is intended to help stakeholders during the global market-wide reference rate transition period. The guidance is effective for all entities as of March 12, 2020 through December 31, 2022. Subsequently, in January 2021, FASB issued ASU No. 2021-01 “Reference Rate Reform (Topic 848): Scope.” This ASU clarifies that certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting apply to derivatives that are affected by the discounting transition. The ASU also amends the expedients and exceptions in Topic 848 to capture the incremental consequences of the scope clarification and to tailor the existing guidance to derivative instruments affected by the discounting transition. An entity may elect to apply ASU No. 2021-01 on contract modifications that change the interest rate used for margining, discounting, or contract price alignment retrospectively as of any date from the beginning of the interim period that includes March 12, 2020, or prospectively to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued. An entity may elect to apply ASU No. 2021-01 to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020. The Company has identified impacted loans and is currently working with individual borrowers to modify loans that are directly or indirectly influenced by LIBOR. The Company is assessing ASU 2020-04 and its impact on the Company’s transition away from LIBOR for its loan and other financial instruments.

In December 2022, FASB issued ASU 2022-06, “Reference Rate Reform (Topic 848): Deferral of the Sunset Date of Topic 848”. ASU 2022-06 extends the period of time preparers can utilize the reference rate reform relief guidance in Topic 848. The objective of the guidance in Topic 848 is to provide relief during the temporary transition period, so the FASB included a sunset provision within Topic 848 based on expectations of when the London Interbank Offered Rate ("LIBOR") would cease being published. In 2021, the UK Financial Conduct Authority delayed the intended cessation date of certain tenors of USD LIBOR to June 30, 2023.

To ensure the relief in Topic 848 covers the period of time during which a significant number of modifications may take place, the ASU defers the sunset date of Topic 848 from December 31, 2022, to December 31, 2024, after which entities will no longer be permitted to apply the relief in Topic 848. The ASU is effective for all entities upon issuance. The Company is assessing ASU 2022-06 and its impact on the Company’s transition away from LIBOR for its loan and other financial instruments.

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NOTE 2. Securities

Amortized costs and fair values of securities available for sale at December 31, 2022 and 2021 were as follows:

AmortizedCost GrossUnrealizedGains GrossUnrealized(Losses) FairValue

(in thousands)

Obligations of states and political subdivisions 7,027 2 (422 ) 6,607