UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
for the quarterly period ended September 30, 2015

TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
For the transition period from ____________ to ___________

COMMISSION FILE NO. 000-50313

SURREY BANCORP

(Exact name of registrant as specified in its charter)

North Carolina
 
59-3772016
(State or other jurisdiction of incorporation or organization)
 
(IRS Employer Identification No.)

145 North Renfro Street, Mount Airy, NC  27030
 (Address of principal executive offices)

(336) 783-3900
 (Registrant's telephone number)
 
Check whether the registrant: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   ☒     No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes   ☒      No   ☐

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

 
Large accelerated filer
Accelerated filer
         
 
Non-accelerated filer
Smaller reporting company

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ☐     No   ☒

State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practical date:

On November 12, 2015 there were 3,549,665 common shares issued and outstanding.
 


PART I – FINANCIAL INFORMATION

Item 1.
Consolidated Financial Statements
 
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
 
8
     
 
9-23
     
Item 2.
24-31
     
Item 3.
32
     
Item 4.
32
     
PART II – OTHER INFORMATION
 
     
Item 1.
32
     
Item 1A.
32
     
Item 2.
32
     
Item 3.
32
     
Item 4.
32
     
Item 5.
32
     
Item 6.
32
     
33
     
CERTIFICATIONS
34-36
 

Consolidated Balance Sheets
September 30, 2015 (Unaudited) and December 31, 2014 (Audited)

   
September
2015
   
December
2014
 
         
Assets
       
Cash and due from banks
 
$
5,040,193
   
$
6,236,749
 
Interest-bearing deposits with banks
   
54,449,791
     
37,315,779
 
Federal funds sold
   
1,217,554
     
1,212,776
 
Investment securities available for sale
   
5,343,021
     
4,363,805
 
Restricted equity securities
   
524,939
     
618,109
 
Loans, net of allowance for loan losses of $3,567,517 at September 30, 2015 and $3,554,664 at December 31, 2014
   
195,175,423
     
189,549,072
 
Property and equipment, net
   
5,061,728
     
4,368,589
 
Foreclosed assets
   
421,491
     
280,821
 
Accrued income
   
1,124,759
     
997,681
 
Goodwill
   
120,000
     
120,000
 
Bank owned life insurance
   
5,087,372
     
5,623,087
 
Other assets
   
3,349,697
     
2,514,855
 
Total assets
 
$
276,915,968
   
$
253,201,323
 
                 
Liabilities and Stockholders’ Equity
               
Liabilities
               
Deposits:
               
Noninterest-bearing
 
$
60,441,761
   
$
52,969,691
 
Interest-bearing
   
169,507,737
     
153,696,890
 
Total deposits
   
229,949,498
     
206,666,581
 
                 
Long-term debt
   
4,250,000
     
6,250,000
 
Dividends payable
   
46,233
     
827,159
 
Accrued interest payable
   
147,932
     
110,261
 
Other liabilities
   
3,641,905
     
2,576,668
 
Total liabilities
   
238,035,568
     
216,430,669
 
                 
Commitments and contingencies (Note 4)
               
                 
Stockholders’ equity
               
Preferred stock, 1,000,000 shares authorized,
               
189,356 shares of Series A issued and outstanding with no par value 4.5% convertible non-cumulative, perpetual, with a liquidation value of $14 per share;
   
2,620,325
     
2,620,325
 
181,154 shares of Series D issued and outstanding with no par value 5.0% convertible non-cumulative, perpetual; with a liquidation value of $7.08 per share;
   
1,248,482
     
1,248,482
 
Common stock, 10,000,000 shares authorized at no par value; 3,549,665 shares issued and outstanding
   
12,101,480
     
12,101,480
 
Retained earnings
   
22,938,076
     
20,808,309
 
Accumulated other comprehensive loss
   
(27,963
)
   
(7,942
)
Total stockholders’ equity
   
38,880,400
     
36,770,654
 
Total liabilities and stockholders’ equity
 
$
276,915,968
   
$
253,201,323
 

See Notes to Consolidated Financial Statements
 
3

Consolidated Statements of Income
Nine months ended September 30, 2015 and 2014 (Unaudited)

   
2015
   
2014
 
Interest income
       
Loans and fees on loans
 
$
8,096,051
   
$
7,908,742
 
Federal funds sold
   
2,046
     
2,036
 
Investment securities available for sale, taxable
   
54,184
     
45,837
 
Investment securities available for sale, dividends
   
11,782
     
10,656
 
Deposits with banks
   
74,108
     
69,381
 
Total interest income
   
8,238,171
     
8,036,652
 
                 
Interest expense
               
Deposits
   
702,058
     
816,409
 
Fed funds purchased
   
3
     
19
 
Long-term debt
   
162,591
     
218,019
 
Total interest expense
   
864,652
     
1,034,447
 
Net interest income
   
7,373,519
     
7,002,205
 
                 
Provision for loan losses
   
85,717
     
132,952
 
Net interest income after provision for loan losses
   
7,287,802
     
6,869,253
 
                 
Noninterest income
               
Service charges on deposit accounts
   
592,842
     
598,988
 
Gain on the sale of government guaranteed loans
   
-
     
127,362
 
Fees on loans delivered to correspondents
   
71,583
     
18,464
 
Other service charges and fees
   
543,378
     
499,856
 
Gain (loss) on the sale of investment securities
   
5,244
     
(1,670
)
Income from bank owned life insurance
   
111,190
     
119,720
 
Insurance commissions
   
374,972
     
388,778
 
Brokerage commissions
   
135,374
     
139,911
 
Other operating income
   
83,030
     
51,176
 
Total noninterest income
   
1,917,613
     
1,942,585
 
                 
Noninterest expense
               
Salaries and employee benefits
   
2,914,354
     
2,869,549
 
Occupancy expense
   
338,881
     
339,324
 
Equipment expense
   
206,926
     
204,098
 
Data processing
   
336,903
     
341,079
 
Foreclosed assets, net
   
119,015
     
12,770
 
Postage, printing and supplies
   
148,879
     
143,987
 
Professional fees
   
371,484
     
323,384
 
FDIC insurance premiums
   
87,228
     
89,503
 
Other expense
   
1,146,040
     
1,094,460
 
Total noninterest expense
   
5,669,710
     
5,418,154
 
Net income before income taxes
   
3,535,705
     
3,393,684
 
                 
Income tax expense
   
1,268,748
     
1,234,817
 
Net income
   
2,266,957
     
2,158,867
 
                 
Preferred stock dividends
   
(137,190
)
   
(137,190
)
Net income available to common stockholders
 
$
2,129,767
   
$
2,021,677
 
                 
Basic earnings per common share
 
$
0.60
   
$
0.57
 
Diluted earnings per common share
 
$
0.54
   
$
0.52
 
Basic weighted average common shares outstanding
   
3,549,665
     
3,542,984
 
Diluted weighted average common shares outstanding
   
4,186,647
     
4,178,933
 
 
See Notes to Consolidated Financial Statements
 
4

Consolidated Statements of Income
Three months ended September 30, 2015 and 2014 (Unaudited)

 
   
2015
   
2014
 
Interest income
       
Loans and fees on loans
 
$
2,739,903
    $
2,684,694
 
Federal funds sold
   
683
     
682
 
Investment securities available for sale, taxable
   
20,099
     
13,430
 
Investment securities available for sale, dividends
   
5,663
     
3,525
 
Deposits with banks
   
26,111
     
22,137
 
Total interest income
   
2,792,459
     
2,724,468
 
                 
Interest expense
               
Deposits
   
234,890
     
269,901
 
Long-term debt
   
44,127
     
73,472
 
Total interest expense
   
279,017
     
343,373
 
Net interest income
   
2,513,442
     
2,381,095
 
                 
Provision for loan losses
   
129,213
     
139,527
 
Net interest income after provision for loan losses
   
2,384,229
     
2,241,568
 
                 
Noninterest income
               
Service charges on deposit accounts
   
193,177
     
197,443
 
Fees on loans delivered to correspondents
   
43,775
     
12,347
 
Other service charges and fees
   
183,890
     
177,806
 
Gain on the sale of investment securities
   
868
     
873
 
Income from bank owned life insurance
   
37,621
     
40,236
 
Insurance commissions
   
159,657
     
134,552
 
Brokerage commissions
   
32,914
     
50,260
 
Other operating income
   
15,462
     
15,254
 
Total noninterest income
   
667,364
     
628,771
 
                 
Noninterest expense
               
Salaries and employee benefits
   
922,424
     
920,537
 
Occupancy expense
   
110,303
     
115,069
 
Equipment expense
   
79,670
     
70,981
 
Data processing
   
105,695
     
130,002
 
Foreclosed assets, net
   
33,404
     
5,466
 
Postage, printing and supplies
   
42,238
     
47,039
 
Professional fees
   
123,479
     
115,523
 
FDIC insurance premiums
   
30,689
     
30,320
 
Other expense
   
351,758
     
318,085
 
Total noninterest expense
   
1,799,660
     
1,753,022
 
Net income before income taxes
   
1,251,933
     
1,117,317
 
                 
Income tax expense
   
453,346
     
402,629
 
Net income
   
798,587
     
714,688
 
                 
Preferred stock dividends
   
(46,233
)
   
(46,233
)
Net income available to common stockholders
 
$
752,354
   
$
668,455
 
                 
Basic earnings per common share
 
$
0.21
   
$
0.19
 
Diluted earnings per common share
 
$
0.19
   
$
0.17
 
Basic weighted average common shares outstanding
   
3,549,665
     
3,542,984
 
Diluted weighted average common shares outstanding
   
4,185,109
     
4,180,983
 

See Notes to Consolidated Financial Statements
 
5

Consolidated Statements of Comprehensive Income
Three and Nine months ended September 30, 2015 and 2014 (Unaudited)

   
Three Months
Ended September 30,
   
Nine Months
Ended September 30,
 
   
2015
   
2014
   
2015
   
2014
 
                 
Net income
 
$
798,587
   
$
714,688
   
$
2,266,957
   
$
2,158,867
 
                                 
Other comprehensive income (loss):
                               
Investment securities available for sale:
                               
Unrealized holding gains (losses)
   
(32,904
)
   
(4,561
)
   
(22,693
)
   
65,750
 
Tax effect
   
10,597
     
1,492
     
6,133
     
(24,030
)
Reclassification of (gains) losses recognized in net income
   
(868
)
   
(873
)
   
(5,244
)
   
1,670
 
Tax effect
   
295
     
296
     
1,783
     
(568
)
     
(22,880
)
   
(3,646
)
   
(20,021
)
   
42,822
 
Comprehensive income
 
$
775,707
   
$
711,042
   
$
2,246,936
   
$
2,201,689
 

See Notes to Consolidated Financial Statements
 
6

Consolidated Statements of Cash Flows
Nine months ended September 30, 2015 and 2014 (Unaudited)

   
2015
   
2014
 
Cash flows from operating activities
       
Net income
 
$
2,266,957
   
$
2,158,867
 
Adjustments to reconcile net income to net cash provided by operations:
               
Depreciation and amortization
   
202,084
     
203,536
 
Gain on sale of property and equipment
   
(50
)
   
(3,406
)
Gain on the sale of government guaranteed loans
   
-
     
(127,362
)
(Gain) loss on the sale of securities
   
(5,244
)
   
1,670
 
(Gain) loss on the sale of foreclosed assets
   
21,248
     
(3,466
)
Provision for of loan losses
   
85,717
     
132,952
 
Deferred income taxes
   
1,868
     
(3,828
)
(Accretion) of discount on securities, net of amortization of premiums
   
(505
)
   
21
 
Increase in cash surrender value of life insurance
   
(111,190
)
   
(119,719
)
Life insurance proceeds
   
1,001,320
     
-
 
Changes in assets and liabilities:
               
Accrued income
   
(127,078
)
   
(79,743
)
Other assets
   
(1,247,944
)
   
(1,595,392
)
Accrued interest payable
   
37,671
     
76,734
 
Other liabilities
   
1,129,972
     
1,418,609
 
Net cash provided by operating activities
   
3,254,826
     
2,059,473
 
                 
Cash flows from investing activities
               
Net increase in interest-bearing deposits with banks
   
(17,134,012
)
   
(2,234,562
)
Net (increase) decrease in federal funds sold
   
(4,778
)
   
99,166
 
Purchases of investment securities
   
(3,024,364
)
   
(1,137,854
)
Maturities of investment securities
   
2,004,016
     
1,255,282
 
Redemption of restricted equity securities
   
104,400
     
59,000
 
Purchase of restricted equity securities
   
(11,230
)
   
(170
)
Net increase in loans
   
(6,185,511
)
   
(9,088,199
)
Proceeds from the sale of investment securities
   
18,944
     
131,403
 
Proceeds from the sale of foreclosed assets
   
311,525
     
39,591
 
Purchases of property and equipment
   
(895,223
)
   
(192,537
)
Proceeds from the sale of property and equipment
   
50
     
5,575
 
Net cash used in investing activities
   
(24,816,183
)
   
(11,063,305
)
                 
Cash flows from financing activities
               
Net increase in deposits
   
23,282,917
     
8,919,589
 
Maturities of long-term debt
   
(2,000,000
)
   
-
 
Dividends paid
   
(918,116
)
   
(881,216
)
Net cash provided by financing activities
   
20,364,801
     
8,038,373
 
Net decrease in cash and cash equivalents
   
(1,196,556
)
   
(965,459
)
Cash and due from banks, beginning
   
6,236,749
     
7,424,593
 
Cash and due from banks, ending
 
$
5,040,193
   
$
6,459,134
 
                 
Supplemental disclosures of cash flow information
               
Interest paid
 
$
826,981
   
$
957,713
 
Taxes paid
 
$
1,292,479
   
$
1,486,722
 
Supplemental disclosures of non-cash transactions
               
Loans transferred to foreclosed properties
 
$
473,443
   
$
177,461
 
Cash dividends declared but not paid
 
$
46,233
   
$
46,233
 

See Notes to Consolidated Financial Statements
 
7

Consolidated Statements of Changes in Stockholders’ Equity
Nine months ended September 30, 2015 and 2014 (Unaudited)

    
Preferred
Stock
   
Common Stock
   
Retained
   
Accumulated
Other
Comprehensive
     
   
Amount
   
Shares
   
Amount
   
Earnings
   
Income (Loss)
   
Total
 
                         
Balance, January 1, 2014
 
$
3,868,807
     
3,542,984
   
$
12,061,153
   
$
18,329,089
   
$
(41,423
)
 
$
34,217,626
 
                                                 
Net income
   
-
     
-
     
-
     
2,158,867
     
-
     
2,158,867
 
Other comprehensive income
   
-
     
-
     
-
     
-
     
42,822
     
42,822
 
                                                 
Dividends declared and accrued on convertible Series A preferred stock ($.47 per share)
   
-
     
-
     
-
     
(89,225
)
   
-
     
(89,225
)
Dividends declared and accrued on convertible Series D preferred stock ($.26 per share)
   
-
     
-
     
-
     
(47,965
)
   
-
     
(47,965
)
Balance, September 30, 2014
 
$
3,868,807
     
3,542,984
   
$
12,061,153
   
$
20,350,766
   
$
1,399
   
$
36,282,125
 
                                                 
Balance, January 1, 2015
 
$
3,868,807
     
3,549,665
   
$
12,101,480
   
$
20,808,309
   
$
(7,942
)
 
$
36,770,654
 
                                                 
Net income
   
-
     
-
     
-
     
2,266,957
     
-
     
2,266,957
 
Other comprehensive income
   
-
     
-
     
-
     
-
     
(20,021
)
   
(20,021
)
                                                 
Dividends declared and accrued on convertible Series A preferred stock ($.47 per share)
   
-
     
-
     
-
     
(89,225
)
   
-
     
(89,225
)
Dividends declared and accrued on convertible Series D preferred stock ($.26 per share)
   
-
     
-
     
-
     
(47,965
)
   
-
     
(47,965
)
Balance, September 30, 2015
 
$
3,868,807
     
3,549,665
   
$
12,101,480
   
$
22,938,076
   
$
(27,963
)
 
$
38,880,400
 

See Notes to Consolidated Financial Statements
 
8

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 
NOTE 1.
BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore, do not include all disclosures required by generally accepted accounting principles for a complete presentation of financial statements. In the opinion of management, the consolidated financial statements contain all adjustments necessary to present fairly the financial condition of Surrey Bancorp, (the “Company), as of September 30, 2015, the results of its operations and comprehensive income for the nine and three months ended September 30, 2015 and 2014, and its changes in stockholders’ equity and cash flows for the nine months ended September 30, 2015 and 2014.  These adjustments are of a normal and recurring nature. The results of operations for the nine months ended September 30, 2015, are not necessarily indicative of the results expected for the full year. These consolidated financial statements should be read in conjunction with the Company’s audited financial statements and related disclosures for the year ended December 31, 2014, included in the Company’s Form 10-K. The balance sheet at December 31, 2014, has been taken from the audited financial statements at that date.

Organization

Surrey Bancorp began operation on May 1, 2003 and was created for the purpose of acquiring all the outstanding shares of common stock of Surrey Bank & Trust (“the Bank”). Stockholders of the bank received six shares of Surrey Bancorp common stock for every five shares of Surrey Bank & Trust common stock owned. The Company is subject to regulation by the Federal Reserve.

Surrey Bank & Trust was organized and incorporated under the laws of the State of North Carolina on July 15, 1996 and commenced operations on July 22, 1996. The Bank currently serves Surry County, North Carolina and Patrick County, Virginia and surrounding areas through five banking offices. As a state chartered bank, which is not a member of the Federal Reserve, the Bank is subject to regulation by the State of North Carolina Banking Commission and the Federal Deposit Insurance Corporation.

Surrey Investment Services, Inc., (“Subsidiary”) was organized and incorporated under the laws of the State of North Carolina on February 10, 1998. The subsidiary provides insurance services through SB&T Insurance and investment advice and brokerage services through LPL Financial.

On July 31, 2000, Surrey Bank & Trust formed Freedom Finance, LLC, a subsidiary operation specializing in the purchase of sales finance contracts from local automobile dealers.

The accounting and reporting policies of the Company, the Bank, and its subsidiaries follow generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.

Critical Accounting Policies

The notes to the audited consolidated financial statements for the year ended December 31, 2014 contain a summary of the significant accounting policies.  The Company believes our policies with respect to the methodology for the determination of the allowance for loan losses, and asset impairment judgments, including the recoverability of intangible assets involve a higher degree of complexity and require management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters.  Changes in these judgments, assumptions or estimates could cause reported results to differ materially.  These critical policies and their application are periodically reviewed with the Audit Committee and our Board of Directors.  See our Annual Report on Form 10-K for full details on critical accounting policies.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company, the Bank and the subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation.
 
SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.
BASIS OF PRESENTATION, CONTINUED

Presentation of Cash Flows

For purposes of reporting cash flows, cash and cash equivalents includes cash and amounts due from depository institutions (including cash items in process of collection). Overnight interest bearing deposits and federal funds sold are shown separately.  Federal funds purchased are shown with securities sold under agreements to repurchase.

Investment Securities

Investments classified as available for sale are intended to be held for indefinite periods of time and include those securities that management may employ as part of asset/liability strategy or that may be sold in response to changes in interest rates, prepayments, regulatory capital requirements or similar factors. These securities are carried at fair value and are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments or significant other observable inputs.

Investment securities classified as held to maturity are those debt securities that the Bank has the ability and intent to hold to maturity. Accordingly, these securities are carried at cost adjusted for amortization of premiums and accretion of discount, computed by the interest-method over their contractual lives. At September 30, 2015 and December 31, 2014, the Bank had no investments classified as held to maturity.

Loans Held for Sale

The Bank originates and holds Small Business Administration (SBA) and United States Department of Agriculture (USDA) guaranteed loans in its portfolio in the normal course of business. Occasionally, the Bank sells the guaranteed portions of these loans into the secondary market. The loans are generally variable rate loans, which eliminates the market risk to the Bank and are therefore carried at cost. Fixed rate loans are carried at the lower of cost or market. The Bank recognizes gains on the sale of the guaranteed portion upon the consummation of the transaction. The Bank plans to continue to originate guaranteed loans for sales, however no such loans were funded and held for sale at September 30, 2015 and December 31, 2014.

Loans Receivable

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

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

Interest is accrued and credited to income based on the principal amount outstanding.  The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due.  When the interest accrual is discontinued, all unpaid accrued interest is reversed.  Interest income is subsequently recognized only to the extent cash payments are received.  Payments received on nonaccrual loans are first applied to principal and any residual amounts are then applied to interest.  When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status.  Past due loans are determined on the basis of contractual terms.
 
10

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1.
BASIS OF PRESENTATION, CONTINUED

Allowance for Loan Losses

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

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components.  The specific component relates to loans that are classified as impaired.  For loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan.  The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors.  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 value 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 and residential loans for impairment disclosures.

Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In January 2014, the FASB amended Receivables topic of the Accounting Standards Codification. The amendments are intended to resolve diversity in practice with respect to when a creditor should reclassify a collateralized consumer mortgage loan to other real estate owned (OREO). In addition, the amendments require a creditor reclassify a collateralized consumer mortgage loan to OREO upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. The amendments became effective for the Company on January 1, 2015. In implementing this guidance, assets that are reclassified from real estate to loans are measured at the carrying value of the real estate at the date of adoption. Assets reclassified from loans to real estate are measured at the lower of the net amount of the loan receivable or the fair value of the real estate less costs to sell at the date of adoption. The Company will apply the amendments prospectively. The Company does not expect these amendments to have a material effect on its financial statements.
 
11

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
NOTE 1.
BASIS OF PRESENTATION, CONTINUED

Recent Accounting Pronouncements, continued

In May 2014, the FASB issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements. In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.

In January 2015, the FASB issued guidance to eliminate from U.S. GAAP the concept of an extraordinary item, which is an event or transaction that is both (1) unusual in nature and (2) infrequently occurring. Under the new guidance, an entity will no longer (1) segregate an extraordinary item from the results of ordinary operations; (2) separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; or (3) disclose income taxes and earnings-per-share data applicable to an extraordinary item. The amendments will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015, with early adoption permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. The Company will apply the guidance prospectively. The Company does not expect these amendments to have a material effect on its financial statements.

In February 2015, the FASB issued guidance which amends the consolidation requirements and significantly changes the consolidation analysis required under U.S. GAAP. Although the amendments are expected to result in the deconsolidation of many entities, the Company will need to reevaluate all its previous consolidation conclusions. The amendments will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015, with early adoption permitted (including during an interim period), provided that the guidance is applied as of the beginning of the annual period containing the adoption date. The Company does not expect these amendments to have a material effect on its financial statements

In June 2015, the FASB issued amendments to clarify the Accounting Standards Codification (ASC), correct unintended application of guidance, and make minor improvements to the ASC that are not expected to have a significant effect on current accounting practice or create a significant administrative cost to most entities. The amendments were effective upon issuance (June 12, 2015) for amendments that do not have transition guidance. Amendments that are subject to transition guidance will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted, including adoption in an interim period. The Company does not expect these amendments to have a material effect on its financial statements.
 
In August 2015, the FASB issued amendments to the Interest topic of the Accounting Standards Codification to clarify the SEC staff’s position on presenting and measuring debt issuance costs incurred in connection with line-of-credit arrangements. The amendments were effective upon issuance. The Company does not expect these amendments to have a material effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Subsequent Events

Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued.  Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.  Non-recognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date.  Management has reviewed events occurring through the date the financial statements were issued and no subsequent events have occurred requiring accrual or disclosure.
 
SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2.
SECURITIES

Debt and equity securities have been classified in the balance sheets according to management’s intent.  The amortized costs of securities available for sale and their approximate fair values at September 30, 2015 and December 31, 2014 follow:

   
Amortized
Cost
   
Unrealized
Gains
   
Unrealized
Losses
   
Fair
Value
 
                 
September 30, 2015
               
Government-sponsored enterprises
 
$
4,498,020
   
$
6,335
   
$
720
   
$
4,503,635
 
Mortgage-backed securities
   
21,561
     
601
     
-
     
22,162
 
Corporate bonds
   
300,000
     
-
     
6,000
     
294,000
 
Equities and mutual funds
   
565,799
     
16,824
     
59,399
     
523,224
 
   
$
5,385,380
   
$
23,760
   
$
66,119
   
$
5,343,021
 
                                 
December 31, 2014
                               
Government-sponsored enterprises
 
$
3,500,000
   
$
1,170
   
$
4,640
   
$
3,496,530
 
Mortgage-backed securities
   
25,592
     
715
     
-
     
26,307
 
Corporate bonds
   
300,000
     
-
     
45,000
     
255,000
 
Equities and mutual funds
   
552,635
     
42,900
     
9,567
     
585,968
 
   
$
4,378,227
   
$
44,785
   
$
59,207
   
$
4,363,805
 

At September 30, 2015 and December 31, 2014, approximately $3,931,000 of the government-sponsored enterprises securities were pledged as collateral on public deposits and for other purposes as required or permitted by law.  The mortgage-backed securities were pledged to the Federal Home Loan Bank.

Maturities of mortgage-backed bonds are stated based on contractual maturities.  Actual maturities of these bonds may vary as the underlying mortgages are prepaid.  The investment in equities and mutual funds by nature have no maturity date and are classified as due in one year or less. The scheduled maturities of securities (all available for sale) at September 30, 2015, were as follows:
 
   
Amortized
Cost
   
Fair
Value
 
Due in one year or less
 
$
565,799
   
$
523,224
 
Due after one year through five years
   
4,805,983
     
4,805,782
 
Due after five years through ten years
   
4,950
     
5,078
 
Due after ten years
   
8,648
     
8,937
 
   
$
5,385,380
   
$
5,343,021
 

The following table shows investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position, at September 30, 2015 and December 31, 2014. These unrealized losses on investment securities are a result of volatility in interest rates which relate to government-sponsored enterprises and corporate bonds issued by other banks and market volatility as it relates to equity and mutual fund investments at September 30, 2015 and December 31, 2014.

   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
   
Fair
Value
   
Unrealized
Losses
 
                         
September 30, 2015
                       
Government-sponsored enterprises
 
$
999,280
   
$
720
   
$
-
   
$
-
   
$
999,280
   
$
720
 
Corporate bonds
   
-
     
-
     
294,000
     
6,000
     
294,000
     
6,000
 
Equities and mutual funds
   
252,350
     
48,458
     
141,657
     
10,941
     
394,007
     
59,399
 
   
$
1,251,630
   
$
49,178
   
$
435,657
   
$
16,941
   
$
1,687,287
   
$
66,119
 
                                                 
December 31, 2014
                                               
Government-sponsored enterprises
 
$
1,995,360
   
$
4,640
   
$
-
   
$
-
   
$
1,995,360
   
$
4,640
 
Corporate bonds
   
-
     
-
     
255,000
     
45,000
     
255,000
     
45,000
 
Equities and mutual funds
   
69,129
     
5,592
     
107,999
     
3,975
     
177,128
     
9,567
 
   
$
2,064,489
   
$
10,232
   
$
362,999
   
$
48,975
   
$
2,427,488
   
$
59,207
 
 
13

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2.
SECURITIES, CONTINUED

Management considers the nature of the investment, the underlying causes of the decline in the market value and the severity and duration of the decline in market value in determining if impairment is other than temporary. Consideration is given to (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 in fair value. Based upon this evaluation, there are seven securities in the portfolio at September 30, 2015, with unrealized losses for a period greater than 12 months. Two of these securities also had unrealized losses for a period greater than 12 months at December 31, 2014. We have analyzed each individual security for Other Than Temporary Impairment (“OTTI”) purposes by reviewing delinquencies, loan-to-value ratios, and credit quality and concluded that all unrealized losses presented in the tables above are not related to an issuer’s financial condition but are due to changes in the level of interest rates and market fluctuations. No declines are deemed to be other than temporary in nature.

The Company had realized gains of $5,244 from the sales of equity and mutual fund investment securities for the nine month period ended September 30, 2015, and realized losses of $1,670 from the sales of equity and mutual fund investment securities for the nine month periods ended September 30, 2014. Total proceeds from the sales amounted to $18,944 and $131,403 in 2015 and 2014, respectively.
 
NOTE 3.
EARNINGS PER COMMON SHARE

Basic earnings per common share for the nine and three months ended September 30, 2015 and 2014 were calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period.

The computation of diluted earnings per common share is similar to the computation of basic earnings per common share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. The potential dilutive shares are represented by common stock options and by the Series A and D convertible preferred stock. Each share of the Series A preferred is convertible into 2.2955 shares of common stock. Each share of Series D preferred is convertible into 1.10 shares of common stock.

NOTE 4.
COMMITMENTS AND LETTERS OF CREDIT

At September 30, 2015, the Company had commitments to extend credit, including unused lines of credit of approximately $49,729,000 and letters of credit outstanding of $2,370,151.

NOTE 5.
LOANS

The major components of loans in the balance sheets at September 30, 2015 and December 31, 2014 are below.

   
2015
   
2014
 
         
Commercial
 
$
52,651,131
   
$
56,602,425
 
Real estate:
               
Construction and land development
   
6,484,974
     
10,061,249
 
Residential, 1-4 families
   
41,938,912
     
41,824,806
 
Residential, 5 or more families
   
1,178,251
     
1,109,586
 
Farmland
   
3,360,755
     
3,486,002
 
Nonfarm, nonresidential
   
83,725,388
     
74,275,793
 
Agricultural
   
4,846,125
     
675,474
 
Consumer, net of discounts of $12,872 in 2015 and $11,950 in 2014
   
4,373,523
     
4,997,023
 
     
198,559,059
     
193,032,358
 
Deferred loan origination costs, net of (fees)
   
183,881
     
71,378
 
     
198,742,940
     
193,103,736
 
Allowance for loan losses
   
(3,567,517
)
   
(3,554,664
)
   
$
195,175,423
   
$
189,549,072
 
 
14

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 5.
LOANS, CONTINUED

Residential, 1-4 family loans pledged as collateral against FHLB advances approximated $12,351,000 and $18,124,000 at September 30, 2015 and December 31, 2014, respectively.

NOTE 6.
ALLOWANCE FOR LOAN LOSSES

The activity of the allowance for loan losses by loan components during the nine months ended September 30, 2015 and 2014 was as follows:

   
Construction
&
Development
   
1-4 Family
Residential
   
Nonfarm,
Nonresidential
   
Commercial
&
Industrial
   
Consumer
   
Other
   
Total
 
                             
September 30, 2015
                           
                             
Allowance for credit losses:
                           
Beginning balance
 
$
160,100
   
$
798,199
   
$
1,067,315
   
$
1,301,900
   
$
158,750
   
$
68,400
   
$
3,554,664
 
Charge-offs
   
-
     
(153,023
)
   
(8,481
)
   
(198,523
)
   
(95,503
)
   
-
     
(455,530
)
Recoveries
   
-
     
1,645
     
761
     
351,320
     
28,940
     
-
     
382,666
 
Provision
   
(57,200
)
   
119,448
     
(65,395
)
   
(50,097
)
   
75,161
     
63,800
     
85,717
 
Ending balance
 
$
102,900
   
$
766,269
   
$
994,200
   
$
1,404,600
   
$
167,348
   
$
132,200
   
$
3,567,517
 
                                                         
Ending balance: individually evaluated for impairment
 
$
-
   
$
4,869
   
$
-
   
$
-
   
$
-
   
$
-
   
$
4,869
 
Ending balance: collectively evaluated for impairment
 
$
102,900
   
$
761,400
   
$
994,200
   
$
1,404,600
   
$
167,348
   
$
132,200
   
$
3,562,648
 
                                                         
Loans Receivable:
                                                       
Ending balance
 
$
6,484,974
   
$
41,938,912
   
$
83,725,388
   
$
52,651,131
   
$
4,373,523
   
$
9,385,131
   
$
198,559,059
 
                                                         
Ending balance: individually evaluated for impairment
 
$
11,729
   
$
1,107,891
   
$
2,582,894
   
$
644,828
   
$
-
   
$
11,585
   
$
4,358,927
 
Ending balance: collectively evaluated for impairment
 
$
6,473,245
   
$
40,831,021
   
$
81,142,494
   
$
52,006,303
   
$
4,373,523
   
$
9,373,546
   
$
194,200,132
 
                                                         
September 30, 2014
                                                       
                                                         
Allowance for credit losses:
                                                       
Beginning balance
 
$
73,000
   
$
617,629
   
$
753,050
   
$
1,708,962
   
$
181,309
   
$
41,400
   
$
3,375,350
 
Charge-offs
   
-
     
(76,891
)
   
(1,778
)
   
(3,506
)
   
(41,118
)
   
-
     
(123,293
)
Recoveries
   
-
     
1,463
     
80,314
     
153,121
     
33,319
     
-
     
268,217
 
Provision
   
79,100
     
157,076
     
(10,304
)
   
(81,778
)
   
(22,042
)
   
10,900
     
132,952
 
Ending balance
 
$
152,100
   
$
699,277
   
$
821,282
   
$
1,776,799
   
$
151,468
   
$
52,300
   
$
3,653,226
 
                                                         
Ending balance: individually evaluated for impairment
 
$
-
   
$
86,377
   
$
120,382
   
$
257,699
   
$
-
   
$
-
   
$
464,458
 
Ending balance: collectively evaluated for impairment
 
$
152,100
   
$
612,900
   
$
700,900
   
$
1,519,100
   
$
151,468
   
$
52,300
   
$
3,188,768
 
                                                         
Loans Receivable:
                                                       
Ending balance
 
$
10,988,313
   
$
40,577,088
   
$
61,894,643
   
$
69,456,737
   
$
5,009,585
   
$
4,486,996
   
$
192,413,362
 
                                                         
Ending balance: individually evaluated for impairment
 
$
243,827
   
$
632,885
   
$
2,779,367
   
$
1,547,309
   
$
-
   
$
-
   
$
5,203,388
 
Ending balance: collectively evaluated for impairment
 
$
10,744,486
   
$
39,944,203
   
$
59,115,276
   
$
67,909,428
   
$
5,009,585
   
$
4,486,996
   
$
187,209,974
 
 
15

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6.
ALLOWANCE FOR LOAN LOSSES, CONTINUED

The following table presents impaired loans individually evaluated by class of loan as of September 30, 2015 and December 31, 2014 and the recognized interest income per the related period:

   
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
   
Average
Recorded
Investment
   
Interest
Income
Recognized
 
September 30, 2015
                   
With no related allowance recorded:
                   
Construction and development
 
$
11,729
   
$
11,729
   
$
-
   
$
12,684
   
$
774
 
1-4 family residential
   
1,088,402
     
1,088,402
     
-
     
1,097,425
     
29,983
 
Nonfarm, nonresidential
   
2,582,894
     
2,582,894
     
-
     
2,739,901
     
82,669
 
Commercial and industrial
   
644,828
     
644,828
     
-
     
796,205
     
8,123
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
11,585
     
11,585
     
-
     
13,546
     
503
 
     
4,339,438
     
4,339,438
     
-
     
4,659,761
     
122,052
 
                                         
With an allowance recorded:
   
-
     
-
     
-
     
-
     
-
 
Construction and development
   
19,489
     
19,489
     
4,869
     
20,272
     
-
 
1-4 family residential
   
-
     
-
     
-
     
-
     
-
 
Nonfarm, nonresidential
   
-
     
-
     
-
     
-
     
-
 
Commercial and industrial
   
-
     
-
     
-
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
19,489
     
19,489
     
4,869
     
20,272
     
-
 
                                         
                                         
Combined:
                                       
Construction and development
   
11,729
     
11,729
     
-
     
12,684
     
774
 
1-4 family residential
   
1,107,891
     
1,107,891
     
4,869
     
1,117,697
     
29,983
 
Nonfarm, nonresidential
   
2,582,894
     
2,582,894
     
-
     
2,739,901
     
82,669
 
Commercial and industrial
   
644,828
     
644,828
     
-
     
796,205
     
8,123
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
11,585
     
11,585
     
-
     
13,546
     
503
 
   
$
4,358,927
   
$
4,358,927
   
$
4,869
   
$
4,680,033
   
$
122,052
 
                                         
December 31, 2014
                                       
With no related allowance recorded:
                                       
Construction and development
 
$
13,536
   
$
13,536
   
$
-
   
$
13,788
   
$
2,710
 
1-4 family residential
   
174,314
     
174,314
     
-
     
174,882
     
7,269
 
Nonfarm, nonresidential
   
1,806,013
     
1,806,013
     
-
     
1,826,306
     
94,953
 
Commercial and industrial
   
844,682
     
844,682
     
-
     
986,462
     
9,452
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
228,111
     
228,111
     
-
     
228,884
     
15,244
 
     
3,066,656
     
3,066,656
     
-
     
3,230,322
     
129,628
 
                                         
With an allowance recorded:
                                       
Construction and development
   
-
     
-
     
-
     
-
     
-
 
1-4 family residential
   
399,764
     
399,764
     
97,799
     
402,691
     
8,141
 
Nonfarm, nonresidential
   
852,925
     
852,925
     
117,215
     
852,872
     
358
 
Commercial and industrial
   
554,787
     
554,787
     
162,900
     
552,865
     
72
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
-
     
-
     
-
     
-
     
-
 
     
1,807,476
     
1,807,476
     
377,914
     
1,808,428
     
8,571
 
                                         
Combined:
                                       
Construction and development
   
13,536
     
13,536
     
-
     
13,788
     
2,710
 
1-4 family residential
   
574,078
     
574,078
     
97,799
     
577,573
     
15,410
 
Nonfarm, nonresidential
   
2,658,938
     
2,658,938
     
117,215
     
2,679,178
     
95,311
 
Commercial and industrial
   
1,399,469
     
1,399,469
     
162,900
     
1,539,327
     
9,524
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
228,111
     
228,111
     
-
     
228,884
     
15,244
 
   
$
4,874,132
   
$
4,874,132
   
$
377,914
   
$
5,038,750
   
$
138,199
 
 
SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6.
ALLOWANCE FOR LOAN LOSSES, CONTINUED

The following presents by class, an aging analysis of the recorded investment in loans.

   
30-59 Days
Past Due
   
60-89 Days
Past Due
   
90 Days Plus
Past Due
   
Total
Past Due
   
Current
   
Total Loans
   
Recorded
Investment
> 90 Days
and
Accruing
 
September 30, 2015
                           
                             
Construction and development
 
$
-
   
$
-
   
$
-
   
$
-
   
$
6,484,974
   
$
6,484,974
     
-
 
1-4 family residential
   
426,321
     
345,031
     
413,710
     
1,185,062
     
40,753,850
     
41,938,912
     
66,793
 
Nonfarm, nonresidential
   
533,724
     
71,648
     
317,421
     
922,793
     
82,802,595
     
83,725,388
     
-
 
Commercial and industrial
   
90,150
     
680,430
     
185,300
     
955,880
     
51,695,251
     
52,651,131
     
-
 
Consumer
   
127,833
     
17,368
     
44,467
     
189,668
     
4,183,855
     
4,373,523
     
43,345
 
Other loans
   
-
     
-
     
-
     
-
     
9,385,131
     
9,385,131
     
-
 
Total
 
$
1,178,028
   
$
1,114,477
   
$
960,898
   
$
3,253,403
   
$
195,305,656
   
$
198,559,059
   
$
110,138
 
Percentage of total loans
   
0.59
%
   
0.56
%
   
0.48
%
   
1.64
%
   
98.36
%
   
100.00
%
       
                                                         
Non-accruals included above
                                                       
Construction and development
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
   
$
-
         
1-4 family residential
   
-
     
-
     
346,917
     
346,917
     
252,324
     
599,241
         
Nonfarm, nonresidential
   
116,473
     
-
     
317,421
     
433,894
     
94,516
     
528,410
         
Commercial and industrial
   
-
     
-
     
185,300
     
185,300
     
-
     
185,300
         
Consumer
   
-
     
-
     
1,122
     
1,122
     
948
     
2,070
         
Other loans
   
-
     
-
     
-
     
-
     
-
     
-
         
   
$
116,473
   
$
-
   
$
850,760
   
$
967,233
   
$
347,788
     
1,315,021
         
                                                         
December 31, 2014
                                                       
                                                         
Construction and development
 
$
94,736
   
$
-
   
$
-
   
$
94,736
   
$
9,966,513
   
$
10,061,249
   
$
-
 
1-4 family residential
   
362,406
     
274,595
     
172,981
     
809,982
     
41,014,824
     
41,824,806
     
-
 
Nonfarm, nonresidential
   
137,733
     
105,473
     
663,902
     
907,108
     
73,368,685
     
74,275,793
     
-
 
Commercial and industrial
   
63,744
     
20,476
     
1,271,937
     
1,356,157
     
55,246,268
     
56,602,425
     
-
 
Consumer
   
169,895
     
48,785
     
54,306
     
272,986
     
4,724,037
     
4,997,023
     
53,184
 
Other loans
   
-
     
-
     
-
     
-
     
5,271,062
     
5,271,062
     
-
 
Total
 
$
828,514
   
$
449,329
   
$
2,163,126
   
$
3,440,969
   
$
189,591,389
   
$
193,032,358
   
$
53,184
 
Percentage of total loans
   
0.43
%
   
0.23
%
   
1.12
%
   
1.78
%
   
98.22
%
   
100.00
%
       
                                                         
Non-accruals included above
                                                       
Construction and development
 
$
-
   
$
-
   
$
-
   
$
-
   
$
-
   
$
-
         
1-4 family residential
   
162,027
     
56,664
     
172,981
     
391,672
     
112,752
     
504,424
         
Nonfarm, nonresidential
   
133,147
     
-
     
663,902
     
797,049
     
395,558
     
1,192,607
         
Commercial and industrial
   
18,859
     
-
     
1,271,937
     
1,290,796
     
-
     
1,290,796
         
Consumer
   
-
     
-
     
1,122
     
1,122
     
-
     
1,122
         
Other loans
   
-
     
-
     
-
     
-
     
-
     
-
         
   
$
314,033
   
$
56,664
   
$
2,109,942
   
$
2,480,639
   
$
508,310
   
$
2,988,949
         

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. Loans classified as substandard or special mention are reviewed quarterly by the Company for further impairment or improvement to determine if appropriately classified. All other loans greater than $500,000, commercial lines greater than $250,000 and personal lines of credit greater than $100,000, and unsecured loans greater than $100,000 are specifically reviewed at least annually to determine the appropriate loan grading. In addition, during the renewal process of any loan, as well as when a loan becomes past due, the Company will evaluate the loan grade.
 
17

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6.
ALLOWANCE FOR LOAN LOSSES, CONTINUED

Loans excluded from the scope of the annual review process above are generally classified as pass credits until: (a) they become past due; (b) management becomes aware of deterioration in the credit worthiness of the borrower; or (c) the customer contacts the Company for a modification. In these circumstances, the loan is specifically evaluated for potential classification as to special mention, substandard or even charged off. The Company uses the following definitions for risk ratings:

Special Mention. Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.

Substandard. Loans classified as substandard are inadequately protected by the current net worth and payment capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans by credit quality indicator are provided in the following table.

   
Total
   
Pass Credits
   
Special
Mention
   
Substandard
   
Doubtful
 
September 30, 2015
                   
                     
Construction and development
 
$
6,484,974
   
$
6,484,974
   
$
-
   
$
-
   
$
-
 
1-4 family residential
   
41,938,912
     
41,525,418
     
413,494
     
-
     
-
 
Nonfarm, nonresidential
   
83,725,388
     
82,729,531
     
995,857
     
-
     
-
 
Commercial and industrial
   
52,651,131
     
52,090,158
     
560,973
     
-
     
-
 
Consumer
   
4,373,523
     
4,367,593
     
4,982
     
948
     
-
 
Other loans
   
9,385,131
     
9,385,131
     
-
     
-
     
-
 
   
$
198,559,059
   
$
196,582,805
   
$
1,975,306
   
$
948
   
$
-
 
                                         
Percentage of total loans
   
100.0
%
   
99.0
%
   
1.0
%
   
-
%
   
-
%
                                         
Guaranteed portion of loans
                                       
                                         
Construction and development
 
$
14,649
   
$
14,649
   
$
-
   
$
-
   
$
-
 
1-4 family residential
   
587,856
     
587,856
     
-
     
-
     
-
 
Nonfarm, nonresidential
   
36,717,790
     
36,164,290
     
553,500
     
-
     
-
 
Commercial and industrial
   
11,640,206
     
11,521,859
     
118,347
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
752,397
     
752,397
     
-
     
-
     
-
 
   
$
49,712,898
   
$
49,041,051
   
$
671,847
   
$
-
   
$
-
 
 
   
Total
   
Pass Credits
   
Special
Mention
   
Substandard
   
Doubtful
 
                                         
December 31, 2014
                                       
                                         
Construction and development
 
$
10,061,249
   
$
10,061,249
   
$
-
   
$
-
   
$
-
 
1-4 family residential
   
41,824,806
     
41,009,963
     
641,862
     
172,981
     
-
 
Nonfarm, nonresidential
   
74,275,793
     
72,657,724
     
1,618,069
     
-
     
-
 
Commercial and industrial
   
56,602,425
     
55,274,007
     
1,328,418
     
-
     
-
 
Consumer
   
4,997,023
     
4,996,479
     
544
     
-
     
-
 
Other loans
   
5,271,062
     
5,254,896
     
16,166
     
-
     
-
 
   
$
193,032,358
   
$
189,254,318
   
$
3,605,059
   
$
172,981
   
$
-
 
                                         
     
100.0
%
   
98.0
%
   
1.9
%
   
0.1
%
   
-
%
 
18

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6.
ALLOWANCE FOR LOAN LOSSES, CONTINUED

   
Total
   
Pass Credits
   
Special
Mention
   
Substandard
   
Doubtful
 
Guaranteed portion of loans
                   
                     
Construction and development
 
$
15,604
   
$
15,604
   
$
-
   
$
-
   
$
-
 
1-4 family residential
   
584,842
     
306,212
     
278,630
     
-
     
-
 
Nonfarm, nonresidential
   
29,914,244
     
29,082,499
     
831,745
     
-
     
-
 
Commercial and industrial
   
13,858,258
     
12,877,497
     
980,761
     
-
     
-
 
Consumer
   
-
     
-
     
-
     
-
     
-
 
Other loans
   
768,869
     
760,786
     
8,083
     
-
     
-
 
   
$
45,141,817
   
$
43,042,598
   
$
2,099,219
   
$
-
   
$
-
 

NOTE 7.
TROUBLED DEBT RESTRUCTURINGS

For the nine and three months ended September 30, 2015 and 2014, the following table presents loans modified during the period that were considered to be troubled debt restructurings.

 
For the three months ended
September 30,
    For the nine months ended
September 30,
 
   
Number
of
Contracts
   
Pre-
Modification
Outstanding
Recorded
Investment
   
Post-
Modification
Outstanding
Recorded
Investment
   
Number
of
Contracts
   
Pre-
Modification
Outstanding
Recorded
Investment
   
Post-
Modification
Outstanding
Recorded
Investment
 
2015
                       
1-4 Family residential
   
1
   
$
82,787
   
$
85,278
     
1
   
$
82,787
   
$
85,278
 
                                                 
2014                                                
1-4 Family residential
   
1
     
167,797
     
167,797
     
4
     
327,724
     
327,724
 

During the nine and three months ended September 30, 2015 and 2014, no loans that had previously been restructured were in default.

In the determination of the allowance for loan losses, management considers troubled debt restructurings and subsequent defaults in these restructurings by adjusting the loan grades of such loans, which figure into the environmental factors associated with the allowance. Defaults resulting in charge-offs affect the historical loss experience ratios which are a component of the allowance calculation. Additionally, specific reserves may be established on restructured loans evaluated individually.
 
NOTE 8.
NORTH CAROLINA TAX RATE CHANGE

On July 23, 2013, North Carolina Governor Pat McCrory signed a major tax reform bill into law that lowered the North Carolina corporate income tax rate among other things.  Specifically, the corporate income tax rate was reduced from 6.9% to 6% in 2014 and to 5% in 2015. The rate will be further reduced to 4% during the 2016 tax year and to 3% for post-2016 tax years provided that specified revenue growth targets are reached.

On July 28, 2015, McCrory announced the final revenue figures for the fiscal year ended on June 30, 2015 revealed that North Carolina had a $445 million revenue surplus.  Thus, the state met the necessary revenue target for fiscal year 2014-2015 to lower the corporate income tax rate from 5 percent to 4 percent effective for tax years beginning on or after January 1, 2016.  As of September 30, the Company estimates the rate reduction trigger will result in a $22,680 reduction in deferred income taxes. The Company has recorded the impact of this legislation as a reduction in deferred income taxes as of September 30, 2015.
 
19

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 9.
FAIR VALUE

The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale, trading securities and derivatives, if present, are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

Under the Fair Value Measurements and Disclosures Topic of the FASB ASC, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 Valuation is based upon quoted prices for identical instruments traded in active markets.

Level 2 Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with the Receivables Topic of the FASB ASC. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2015, substantially all of the total impaired loans were evaluated based on the fair value of the collateral and discounted cash flows. In accordance with the Fair Value and Measurement Topic of the FASB ASC, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3.
 
20

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9.
FAIR VALUE, CONTINUED

Servicing Assets

A valuation of loan servicing rights is performed on an individual basis due to the small number of loans serviced. Loans are evaluated on a discounted earnings basis to determine the present value of future earnings. The present value of the future earnings is the estimated market value for the loan, calculated using consensus assumptions that a first party purchaser would utilize in evaluating a potential acquisition of the servicing. As such, the Company classifies loan servicing rights as Level 3.

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the foreclosed asset as nonrecurring Level 3.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

The table below presents the recorded amount of assets and liabilities measured at fair value on a recurring basis.

(in thousands)
               
September 30, 2015
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Government-sponsored enterprises
 
$
4,504
   
$
-
   
$
4,504
   
$
-
 
Mortgage-backed securities
   
22
     
-
     
22
     
-
 
Corporate bonds
   
294
     
-
     
-
     
294
 
Equities and mutual funds
   
523
     
523
     
-
     
-
 
Total assets at fair value
 
$
5,343
   
$
523
   
$
4,526
   
$
294
 
 
(in thousands)
               
December 31, 2014
 
Total
   
Level 1
   
Level 2
   
Level 3
 
Government-sponsored enterprises
 
$
3,497
   
$
-
   
$
3,497
   
$
-
 
Mortgage-backed securities
   
26
     
-
     
26
     
-
 
Corporate bonds
   
255
     
-
     
-
     
255
 
Equities and mutual funds
   
586
     
586
     
-
     
-
 
Total assets at fair value
 
$
4,364
   
$
586
   
$
3,523
   
$
255
 

For the nine months ended September 30, 2015 and 2014, the changes in Level 3 assets and liabilities measured at fair value on a recurring basis were as follows:

   
Level 3
 
   
2015
   
2014
 
(in thousands)
 
Fair Value
   
Fair Value
 
Corporate Bonds – Available for Sale
       
Balance, January 1
 
$
255
   
$
451
 
Total unrealized gain (loss) included in income
   
-
      -  
Total unrealized gain (loss) included in other comprehensive income
   
39
      51  
Bonds called
   
-
      (250 )
Balance, September 30
 
$
294
   
$
252
 
 
21

SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9.
FAIR VALUE, CONTINUED

The change in the fair value of corporate bond assets for the nine and three month periods ended September 30, 2015 was $39,000 and $9,000, respectively. The change in the fair value of corporate bond assets for the nine and three month periods ended September 30, 2014 was $6,000, except for the call of a $250,000 corporate bond with a recorded fair valued of $205,000.

Assets and Liabilities Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets or liabilities at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets and liabilities that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets and liabilities measured at fair value on a nonrecurring basis are included in the table below.

(in thousands)
               
September 30, 2015
 
Total
   
Level 1
   
Level 2
   
Level 3
 
                 
Impaired loans:
               
1-4 family residential
 
$
15
   
$
-
   
$
-
   
$
15
 
Foreclosed assets
   
421
     
-
     
-
     
421
 
Servicing assets
   
344
     
-
     
-
     
344
 
Total assets at fair value
 
$
780
   
$
-
   
$
-
   
$
780
 
 
(in thousands)
               
December 31, 2014
               
   
Total
   
Level 1
   
Level 2
   
Level 3
 
Impaired loans:
               
Commercial and industrial
 
$
392
   
$
-
   
$
-
   
$
392
 
Nonfarm, non-residential
   
736
     
-
     
-
     
736
 
1-4 family residential
   
302
     
-
     
-
     
302
 
Foreclosed assets
   
281
     
-
     
-
     
281
 
Servicing assets
   
350
     
-
     
-
     
350
 
Total assets at fair value
 
$
2,061
   
$
-
   
$
-
   
$
2,061
 

Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and due from banks:  The carrying amounts reported in the balance sheet for cash and due from banks approximate their fair values.

Interest-bearing deposits with banks:  Fair values for time deposits are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

Federal funds sold:  Due to the short-term nature of these assets, the carrying value approximates fair value.

Securities:  Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available.  If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions.  The carrying values of restricted equity securities approximate fair values.
 
22

 SURREY BANCORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9.
FAIR VALUE, CONTINUED

Loans receivable:  For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying amounts.  The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.

Bank owned life insurance:  The carrying amount reported in the balance sheet approximates the fair value as it represents the cash surrender value of the life insurance.

Deposit liabilities:  The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date.  The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits.

Federal funds purchased, securities sold under agreements to repurchase and short-term debt:  The carrying amounts of federal funds purchased, securities sold under agreements to repurchase and short-term debt approximate their fair values.

Long-term debt:  The fair value of long-term debt is estimated using a discounted cash flow calculation that applies interest rates currently available on similar instruments.

Other liabilities:  For fixed-rate loan commitments, fair value considers the difference between current levels of interest rates and the committed rates.  The carrying amounts of other liabilities approximate fair value.

The following presents the carrying amount, fair value, and placement in the fair value hierarchy of the Company’s financial instruments as of September 30, 2015 and December 31, 2014.  This table excludes financial instruments for which the carrying amount approximates fair value.

           
Fair Value Measurements
 
(dollars in thousands)
 
Carrying
Amount
   
Fair Value
   
Quoted
Prices in
Active
Markets for
Identical
Assets or
Liabilities
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
September 30, 2015
                   
Financial Instruments – Assets
                   
Loans, net
 
$
195,175
   
$
203,431
   
$
-
   
$
-
   
$
203,431
 
                                         
Financial Instruments-Liabilities
                                       
Deposits
   
229,949
     
222,945
     
-
     
81,862
     
141,083
 
Long-Term Debt
   
4,250
     
4,406
     
-
     
-
     
4,406
 
                                         
December 31, 2014
                                       
Financial Instruments – Assets
                                       
Loans, net
 
$
189,549
   
$
195,254
     
-
     
-
   
$
195,254
 
                                         
Financial Instruments-Liabilities
                                       
Deposits
   
206,667
     
202,750
     
-
     
61,925
     
140,825
 
Long-Term Debt
   
6,250
     
6,486
     
-
     
-
     
6,486
 
 
23

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

This discussion, analysis and related financial information are presented to explain the significant factors which affected Surrey Bancorp's financial condition and results of operations for the three and nine months ended September 30, 2015 and 2014. This discussion should be read in conjunction with the financial statements and related notes contained within this report.

Surrey Bancorp (“Company”) is a North Carolina corporation, located in Mount Airy, North Carolina. The Company was incorporated on February 6, 2003, and began business on May 1, 2003.

Surrey Bank & Trust ("Bank") is a North Carolina state chartered bank, located in Mount Airy, North Carolina. The Bank was chartered on July 15, 1996, and began operations on July 22, 1996. The Bank has two operating subsidiaries: Surrey Investment Services, Inc. and Freedom Finance, LLC.

Effective March 5, 1998, the Bank became a member of the Federal Home Loan Bank.

Highlights

Certain information contained in this discussion may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  These forward-looking statements are generally identified by phrases such as “the Company expects,” “the Company believes” or words of similar import.  Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company.  Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

Net income available for common stockholders for the three months ended September 30, 2015, was $752,354 or $0.19 per diluted share outstanding, compared to a $668,455 or $0.17 per diluted share outstanding, for the same period in 2014. Earnings for the three months ended September 30, 2015, are approximately 12.6% higher than for the same period in 2014. The increase in earnings results from an increase in net interest income. Net interest income increased from $2,381,095 in the third quarter of 2014 to $2,513,442 in 2015. Most of this increase is due to loan growth. Average loans outstanding increased 3.8% from the third quarter of 2014 to the third quarter of 2015, or approximately $7,125,000. The net interest margin decreased from 4.15% to 4.00% from 2014 to 2015 due to a change in the average asset mix. Higher yielding loans averaged 80.7% of total interest earning assets in the third quarter of 2014 but only averaged 78.2% in the third quarter of 2015. As a result overall asset yields dropped from 4.75% in 2014 to 4.44% in 2015. The cost of funds decreased from 0.66% in the third quarter of 2014 to 0.49% in the third quarter of 2015 but was not enough to offset the reduction in asset yields. The provision for loan loss reserves decreased from $139,527 in the third quarter of 2014 to a provision of $129,213 in 2015. The decrease in the provision is partially due to a decrease in specific reserves on impaired loans. Noninterest expenses increased from $1,753,022 in the third quarter of 2014 to $1,799,660 in 2015, a 2.7% increase.

Net income available for common stockholders for the nine months ended September 30, 2015, was $2,129,767 or $0.54 per diluted share outstanding, compared to a $2,021,677 or $0.52 per diluted share outstanding, for the same period in 2014. Earnings for the nine months ended September 30, 2015, are approximately 5.4% higher than for the same period in 2014. The increase in earnings results from an increase in net interest income and a decrease in the provision for loan loss reserves.  Net interest income increased from $7,002,205 in the first nine months of 2014 to $7,373,519 in 2015. Most of this increase is due to loan growth. Average loans outstanding increased 4.3% from the first nine months of 2014 to the same period in 2015, or approximately $7,850,000. The net interest margin increased from 4.07% to 4.09% from 2014 to 2015 due to lower deposit costs. Asset yields dropped from 4.67% in
 
24

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED
 
2014 to 4.57% in 2015 but the reduction was offset by a reduction in the cost of funds. The cost of funds decreased from 0.66% in the first nine months of 2014 to 0.53% in 2015. The provision for loan losses decreased from  $132,952 in 2014 to  $85,717 in 2015. Gross loans increased approximately $5,526,000 from December 31, 2014 to September 30, 2015. However, the percentage of loans carrying government guarantees increased from $45,141,818, or 23.4% of gross loans at the end of 2014 to $49,712,898, or 25.0% of gross loans at September 30, 2015. The decreased credit exposure resulted in lower reserves. Noninterest income decreased from $1,942,585 in the first nine months of 2014 to $1,917,613 in 2015. The decrease primarily results a reduction in gains from the sale of government guaranteed loans. The Company had no gains for the first nine months of 2015, down from the $127,362 reported in 2014. Noninterest expenses increased 4.6% from $5,418,154 in 2014, to $5,669,710 in 2015. This increase was due increases in salaries and benefits and to expenses associated with foreclosed assets. Salaries and benefits increased 1.6% from 2,869,549 in 2014 to 2,914,354 in 2015. Increases in foreclosed assets expense, professional fees and other expense all rose as a result of cost required to take possession and dispose of foreclosed properties.

On September 30, 2015, Surrey Bancorp's assets totaled $276,915,968 compared to $253,201,323 on December 31, 2014. Net loans were $195,175,423 compared to $189,549,072 on December 31, 2014. This net increase was the result of a $5,639,204 increase in loans and net deferred fees and a $12,853 net increase in the loan loss reserve. Nonfarm, nonresidential loans represent most of the growth in the loan portfolio increasing $9,449,595 or 12.7% since the end of 2014. There was a 35.5% decrease in construction loans while other real estate loans collectively grew 7.9%. Commercial loans decreased by 7.0%. Overall gross loans increased 2.9%

Total deposits on September 30, 2015, were $229,949,498 compared to $206,666,581 at the end of 2014. This increase is attributable to an increase in demand deposit accounts, interest-bearing demand deposits accounts and savings accounts which increased collectively from $126,665,409 at December 31, 2014 to $158,410,691 at September 30, 2015. Large individual deposits account for much of the increase. These deposits are expected to reduce over the coming months. Overall, noninterest-bearing and interest-bearing demand deposits increased 35.9% from 2014 totals, while savings deposits, including money market accounts, increased 4.4%. Certificates of deposit decreased 10.6% from December 31, 2014 totals, or $8,462,365.

Common stockholders’ equity increased by $2,109,746, or 6.41%, during the nine months ended September 30, 2015. The net increase is comprised of net income of $2,266,957, a reduction in other comprehensive income of $20,021 and the declaration and accrual of preferred dividends of $137,190. The net increase resulted in a common stock book value of $9.86 per share, up from $9.27 on December 31, 2014.

The book value per common share is calculated by taking total stockholders’ equity, subtracting all preferred equity, and then dividing by the total number of common shares outstanding at the end of the reporting period.

Preferred stockholders’ equity remained the same during the period ended September 30, 2015.
 
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Financial Condition, Liquidity and Capital Resources

Investments

The Bank maintains a portfolio of securities as part of its asset/liability and liquidity management programs which emphasize effective yields and maturities to match its needs. The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest rate sensitivity needs for the Bank. The Company also invests funds in a brokerage account made up of selected equities and mutual funds. The investments were made to increase income in the holding company and improve yields.

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

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders' equity. Realized gains and losses on the sale of available for sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.

Declines in the fair value of individual held to maturity and available for sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value.  Related write-downs are included in earnings as realized losses.

Investments in available for sale securities of $5,343,021 consisted of Government-sponsored enterprise obligations with maturities ranging from 17 to 34 months, corporate bonds with maturities of 3.0 years, that reprice quarterly, GNMA adjustable rate mortgage securities, which adjust annually, and equity securities and mutual funds.

Loans

Net loans outstanding on September 30, 2015, were $195,175,423 compared to $189,549,072 on December 31, 2014. The Bank maintains a loan portfolio dominated by real estate and commercial loans diversified among various industries. Approximately 63.4% of the Bank's loans as of September 30, 2015, are fixed rate loans with 36.6% floating with the Bank's prime rate or other appropriate internal or external indices.
 
26

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Deposits

Deposits on September 30, 2015, were $229,949,498, compared to $206,666,581 on December 31, 2014. The September total consists of a base of approximately 12,795 accounts compared to 12,690 accounts at December 31, 2014. Interest-bearing accounts represent 73.7% of September 30, 2015 period end deposits versus 74.4% at December 31, 2014.

Stockholders' Equity

Surrey Bancorp and Surrey Bank & Trust are subject to various regulatory capital requirements administered by federal banking agencies. The Company and the Bank maintain strong capital positions which exceed all capital adequacy requirements of federal regulatory authorities. Common Equity Tier I Capital “CET1” is a new regulatory ratio resulting from BASEL III. CET1 primarily consist of the Company’s and the Bank’s common shares, common share surplus, retained earnings and accumulated other comprehensive income. The Company’s and the Bank’s capital ratios are presented in the following table.

   
Ratio
   
Minimum
Required
For Capital
Adequacy
Purposes
 
September 30, 2015:
       
Total Capital
       
(to Risk-Weighted Assets)
       
Surrey Bancorp (Consolidated)
   
21.61
%
   
8.0
%
Surrey Bank & Trust
   
21.50
%
   
8.0
%
Common Equity Tier I Capital
               
(to Risk-Weighted Assets)
               
Surrey Bancorp (Consolidated)
   
18.27
%
   
5.0
%
Surrey Bank & Trust
   
20.23
%
   
5.0
%
Tier I Capital
               
(to Risk-Weighted Assets)
               
Surrey Bancorp (Consolidated)
   
20.39
%
   
4.0
%
Surrey Bank & Trust
   
20.23
%
   
4.0
%
Tier I Capital
               
(to Average Assets)
               
Surrey Bancorp (Consolidated)
   
13.93
%
   
4.0
%
Surrey Bank & Trust
   
13.81
%
   
4.0
%
                 
December 31, 2014:
               
Total Capital
               
(to Risk-Weighted Assets)
               
Surrey Bancorp (Consolidated)
   
21.55
%
   
8.0
%
Surrey Bank & Trust
   
21.11
%
   
8.0
%
Common Equity Tier I Capital
               
(to Risk-Weighted Assets)
               
Surrey Bancorp (Consolidated)
   
n/a
 
   
n/a
 
Surrey Bank & Trust
   
n/a
 
   
n/a
 
Tier I Capital
               
(to Risk-Weighted Assets)
               
Surrey Bancorp (Consolidated)
   
20.29
%
   
4.0
%
Surrey Bank & Trust
   
19.85
%
   
4.0
%
Tier I Capital
               
(to Average Assets)
               
Surrey Bancorp (Consolidated)
   
13.93
%
   
4.0
%
Surrey Bank & Trust
   
13.65
%
   
4.0
%
 
27

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Asset Quality

The Company actively monitors delinquencies, nonperforming assets and potential problem loans. Unsecured loans past due more than 90 days are placed into nonaccrual status. Secured loans reach nonaccrual status when they surpass 120 days past due. When facts and circumstances indicate the borrower has regained the ability to meet the required payments, the loan is returned to accrual status.
 
Management reviews all criticized loans on a periodic basis for possible charge offs. Any unsecured loans that are 90 plus days past due must be charged off in full.  If secured, a reserve equal to the potential loss will be established. Any charge off must be reported to the Board of Directors within 30 days. On a monthly basis, a management report of recovery actions is provided to the Board of Directors.
 
Nonperforming assets are detailed below.

   
September 30,
2015
   
December 31,
2014
 
         
Nonaccrual loans
 
$
1,315,021
   
$
2,988,949
 
Loans past due 90 days and still accruing
   
110,139
     
53,184
 
Foreclosed assets
   
421,491
     
280,821
 
Total
 
$
1,846,651
   
$
3,322,954
 
Total assets
 
$
276,915,968
   
$
253,201,323
 
                 
Ratio of nonperforming assets to total assets
   
0.67
%
   
1.31
%

At September 30, 2015, the Bank had loans totaling $1,315,021 in nonaccrual status. Nonaccrual loans totaling $347,789 were current at the end of September. The guaranteed portion of nonaccrual loans at September 30, 2015 is $414,849. Foreclosed assets at September 30, 2015 primarily consist of 1-4 family residential and nonfarm, nonresidential properties. Loans that were considered impaired but were still accruing interest at September 30, 2015, including troubled debt restructurings, totaled $3,231,723. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due under the contractual terms of the loan agreement. Specific reserves on nonaccrual and impaired loans totaled $4,869 at September 30, 2015, or 0.1% of the balances outstanding.

Nonaccrual and impaired loans still accruing are summarized below:

   
September 30,
2015
   
December 31,
2014
 
         
Construction and development
 
$
11,729
   
$
13,536
 
1-4 family residential
   
1,293,638
     
601,587
 
Nonfarm, nonresidential
   
2,582,894
     
2,658,937
 
Commercial and industrial
   
644,828
     
1,399,470
 
Consumer
   
2,070
     
8,854
 
Other loans
   
11,585
     
228,111
 
Total impaired and nonaccrual
 
$
4,546,744
   
$
4,910,495
 
Guaranteed portion
 
$
1,279,212
   
$
2,090,348
 

 
At September 30, 2015, consumer loans totaling $186,695 are included above that were not individually evaluated for impairment in the determination of the allowance for loan loss reserve (See Note 6). These loans are primarily home equity loans collateralized by 1-4 family properties which are considered consumer loans. These loans are on nonaccrual status at September 30, 2015 and therefore considered impaired.
 
28

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

The loan portfolio is dominated by real estate and commercial loans. The general composition of the loan portfolio is as follows:

   
September 30, 2015
   
December 31, 2014
 
Construction and development
 
$
6,484,974
     
3.27
%
 
$
10,061,249
     
5.21
%
1-4 family residential
   
41,938,912
     
21.12
%
   
41,824,806
     
21.67
%
Multi-family
   
1,178,251
     
0.59
%
   
1,109,586
     
0.57
%
Farmland
   
3,360,755
     
1.69
%
   
3,486,002
     
1.81
%
Nonfarm, nonresidential
   
83,725,388
     
42.17
%
   
74,275,793
     
38.48
%
Total real estate
   
136,688,280
     
68.84
%
   
130,757,436
     
67.74
%
                                 
Agricultural
   
4,846,125
     
2.44
%
   
675,474
     
0.35
%
Commercial and industrial
   
52,651,131
     
26.52
%
   
56,602,425
     
29.32
%
Consumer
   
4,373,523
     
2.20
%
   
4,997,023
     
2.59
%
Total loans
 
$
198,559,059
     
100.00
%
 
$
193,032,358
     
100.00
%

The concentrations represented above do not, based on managements’ assessment, expose the Bank to any unusual concentration risk. Based on the Bank’s asset size, the concentrations that are above area peer group analysis are nonfarm nonresidential and commercial and industrial loans. Management recognizes the inherent risk associated with commercial real estate and commercial lending, including a borrower's actual results of operations not corresponding to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and increases in interest rates, etc.; depression of collateral values; and completion of projects within the original cost and time estimates. The Bank mitigates some of that risk by actively seeking government guarantees on these loans. Collectively, the Bank has approximately $62,186,279 in loans that carry government guarantees. The guaranteed portion of these loans amounts to $49,712,898 at September 30, 2015. Loan guarantees by loan class are below:

   
September 30,
2015
   
Guaranteed Portion
 
       
Amount
   
Percentage
 
Construction and development
 
$
6,484,974
   
$
14,649
     
0.23
%
1-4 family residential
   
41,938,912
     
587,856
     
1.40
%
Multi-family
   
1,178,251
     
5,792
     
0.49
%
Farmland
   
3,360,755
     
746,605
     
22.22
%
Nonfarm, nonresidential
   
83,725,388
     
36,717,790
     
43.86
%
Total real estate
   
136,688,280
     
38,072,692
     
27.85
%
                         
Agricultural
   
4,846,125
     
-
     
-
%
Commercial and industrial
   
52,651,131
     
11,640,206
     
22.11
%
Consumer
   
4,373,523
     
-
     
-
%
Total loans
 
$
198,559,059
   
$
49,712,898
     
25.04
%

Loans in higher risk categories, such as non-owner occupied nonfarm, non-residential property and commercial real estate construction represent a small segment of our loan portfolio. Commercial construction loans included in construction and development loans amounted to $1,826,771, or 0.92% of total loans at September 30, 2015. Non-owner occupied nonfarm, non-residential properties included in nonfarm, non-residential loans above amounted to $15,234,281, or 7.67% of total loans at September 30, 2015.

The consolidated provision for loan losses was $85,717 for the first nine months of 2015 compared to $132,952 for the same period in 2014. Gross loans increased $5,526,701 from December 31, 2014 to September 30, 2015. However, the percentage of loans carrying government guarantees increased from $45,141,818, or 23.4% of gross loans at the end of 2014 to $49,712,898, or 25.04% of gross loans at September 30, 2015. The decreased credit exposure resulted in lower reserves.

The reserve for loan losses on September 30, 2015, was $3,567,517 or 1.80% of period end loans. This percentage is derived from total loans. Approximately $62,186,000 of total loans outstanding at September 30, 2015, are government guaranteed loans which carry guarantees ranging from 49% to 100% of the outstanding loan balance. When the guaranteed portion of the loans, for which the Bank has no credit exposure, is removed from the equation the loan loss reserve is approximately 2.39% of outstanding loans.  At December 31, 2014 the loan loss reserve percentage was 1.83% of total loans and 2.40% of loans net of government guarantees.
 
29

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

The level of reserve is established based upon management's evaluation of historical loss data and the effects of certain environmental factors on the loan portfolio. The historical loss portion of the reserve is computed using the average loss data from the past applied to its corresponding category of loans. However, historical losses only reflect a small portion of the Bank’s loan loss reserve. The environmental factors represent risk from external economic influences on the credit quality of the loan portfolio. These factors include the movement of interest rates, unemployment rates, past due and charge off trends, loan grading migrations, movement in collateral values and the Bank’s exposure to certain loan concentrations. Positive or negative movements in any of these factors have an effect on the credit quality of the loan portfolio. As a result, management continues to actively monitor the Bank's asset quality affected by these environmental factors.  The following table is a summary of loans past due at September 30, 2015 and December 31, 2014.

   
September 30, 2015
   
December 31, 2014
 
   
30-89 Days
   
90 Days Plus
   
30-89 Days
   
90 Days Plus
 
                 
Construction and development
 
$
-
   
$
-
   
$
94,736
   
$
-
 
1-4 family residential
   
771,352
     
413,710
     
637,000
     
172,981
 
Nonfarm, non-residential
   
605,372
     
317,421
     
243,206
     
663,902
 
Commercial and industrial
   
770,580
     
185,300
     
84,221
     
1,271,937
 
Consumer
   
145,201
     
44,467
     
218,680
     
55,428
 
Other loans
   
-
     
-
     
-
     
-
 
   
$
2,292,505
   
$
960,898
   
$
1,277,843
   
$
2,164,248
 
Non-accrual loans included above
 
$
116,473
   
$
-
   
$
370,697
   
$
2,109,942
 
Guaranteed portion
 
$
1,103,256
   
$
356,612
   
$
100,869
   
$
1,935,839
 
                                 
Ratio to total loans
   
1.15
%
   
0.48
%
   
0.66
%
   
1.12
%
Ratio to total loans, net of guarantees
   
0.80
%
   
0.41
%
   
0.80
%
   
0.15
%

Past due loans are reviewed weekly and collection efforts assessed to determine potential problems arising in the loan portfolio. Proactive monitoring of past due accounts allows management to anticipate trends within the portfolio and make appropriate adjustments to collection efforts and to the allowance for loan losses. Collectively, past dues decreased from December 31, 2014 to September 30, 2015. The decrease is in the 90 day plus time frame, as the 30-89 day plus time frame increased. The largest decrease was in commercial and industrial loans 90 days past due. The largest increase was in commercial and industrial loans 30-89 days past due. Collectively commercial and industrial loans past due decreased $400,278.

Net of loan guarantees, total past dues have increased from $1,405,383 at December 31, 2014, to $1,793,535 at September 30, 2015, or 27.6%. Total past due loans at September 30, 2015 consist of fifty-nine loans with an average balance of $55,142, compared to fifty-seven loans at December 31, 2014, with an average balance of $60,388. Loans over $250,000 delinquent at September 30, 2015 and December 31, 2014 amounted to $1,441,436 and $1,223,882, respectively. The September 2015 and December 2014 totals consist of four and three loans, respectively, one of which is the same. The guaranteed portion of these loans at September 30, 2015 and December 31, 2014, is $835,507 and $1,072,042, respectively.

Management believes that its loan portfolio is sufficiently diversified such that a downturn in a particular market or industry will not have a significant impact on the loan portfolio or the Bank's financial condition. Management believes that its provision and reserve offer an adequate allowance for loan losses and provide an appropriate reserve for the loan portfolio. The Bank lends primarily in Surry County, North Carolina and Patrick Country, Virginia and surrounding counties.
 
30

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED

Interest Rate Sensitivity and Liquidity

One of the principal duties of the Bank's Asset/Liability Committee is management of interest rate risk. The Bank utilizes quarterly asset/liability reports prepared by a regional correspondent bank to project the impact on net interest income that might occur with hypothetical interest rate changes. The committee monitors and manages asset and liability strategies and pricing.

Another function of the Asset/Liability Committee is maintaining adequate liquidity and planning for future liquidity needs. Having adequate liquidity means the ability to meet current funding needs, including deposit withdrawals and commitments, in an orderly manner without sacrificing earnings. The Bank funds its investing activities, including making loans and purchasing investments, by attracting deposits and utilizing short-term borrowings when necessary.

At September 30, 2015, the liquidity position of the Company was excellent, in management’s opinion, with short-term liquid assets of $66,050,559 compared to $49,129,109 at December 31, 2014. To provide supplemental liquidity, the Bank has seven unsecured lines of credit with correspondent banks totaling $35,500,000. At September 30, 2015, there were no advances against these lines. Additionally, the Bank has a secured borrowing arrangement with the Federal Home Loan Bank (FHLB). The maximum credit available under this agreement approximates $9,374,000 of which $4,250,000 had been advanced at September 30, 2015.
 
31

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable as a “Smaller Reporting Company”.

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by the report, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15e. Based on the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. There have not been any changes in the Company’s internal control over financial reporting that occurred during the Company’s last quarter that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

None

Item 1A. Risk Factors

Not Applicable as a “Smaller Reporting Company”

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

Not Applicable

Item 4. Mine Safety Disclosures

Not Applicable

Item 5. Other Information

None

Item 6. Exhibits

31.1 Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act
31.2 Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act
32.1 Certification of PEO/PFO Pursuant to Section 906 of the Sarbanes Oxley Act
101 Interactive Data File
 
32

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized officers.

 
Surrey Bancorp
   
Date: November 12, 2015
/s/ Edward C. Ashby, III
   
 
Edward C. Ashby, III
 
President and Chief Executive Officer
 
(Principal Executive Officer)
   
Date: November 12, 2015
/s/ Mark H. Towe
   
 
Mark H. Towe
 
Sr. Vice President and Chief Financial Officer
 
(Principal Financial Officer)
 
 
33