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10-Q

Qnb Corp. (QNBC)

10-Q 2020-11-05 For: 2020-09-30
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Added on April 11, 2026
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended             September 30, 2020

OR

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from               to

Commission file number 0-17706

QNB Corp.

(Exact Name of Registrant as Specified in Its Charter)

Pennsylvania 23-2318082
(State or Other Jurisdiction of<br><br><br>Incorporation or Organization) (I.R.S. Employer<br><br><br>Identification No.)
15 North Third Street, P.O. Box 9005 Quakertown, PA 18951-9005
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(Address of Principal Executive Offices) (Zip Code)

(215) 538-5600

Registrant's Telephone Number, Including Area Code

Not Applicable

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.

Securities registered pursuant to Section 12(b) of the Act:  None.

Title of each class Trading<br><br><br>Symbol(s) Name of each exchange on which registered
Common Stock QNBC N/A

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐ Accelerated filer ☒
Non-accelerated filer ☐ Smaller Reporting Company ☒
Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class Outstanding at October 30, 2020
Common Stock, par value $0.625 3,550,602

QNB CORP. AND SUBSIDIARY

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2020

INDEX

PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) PAGE
Consolidated Balance Sheets at September 30, 2020 and December 31, 2019 2
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2020 and 2019 3
Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2020 and 2019 4
Consolidated Statement of Shareholders’ Equity for the Three and Nine Months Ended September 30, 2020 and 2019 5
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2020 and 2019 7
Notes to Consolidated Financial Statements 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 39
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 59
ITEM 4. CONTROLS AND PROCEDURES 59
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 60
ITEM 1A. RISK FACTORS 60
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 60
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 61
ITEM 4. MINE SAFETY DISCLOSURES 61
ITEM 5. OTHER INFORMATION 61
ITEM 6. EXHIBITS 62
SIGNATURES
CERTIFICATIONS

QNB Corp. and Subsidiary

CONSOLIDATED BALANCE SHEETS
December 31, 2019
Assets
Cash and due from banks 10,167 $ 12,398
Interest-bearing deposits in banks 27,353 5,210
Total cash and cash equivalents 37,520 17,608
Investments:
Available-for-sale (amortized cost 437,863 and 349,385) 444,616 349,710
Equity securities (cost of 12,726 and 9,053) 11,691 9,164
Restricted investment in stocks 1,041 1,073
Loans held-for-sale 9,077 977
Loans receivable 887,792 820,616
Allowance for loan losses (10,765 ) (9,887 )
Net loans 877,027 810,729
Bank-owned life insurance 11,703 11,490
Premises and equipment, net 15,625 15,608
Accrued interest receivable 4,674 2,828
Net deferred tax assets 583 1,441
Other assets 3,516 4,395
Total assets 1,417,073 $ 1,225,023
Liabilities
Deposits
Demand, non-interest bearing 205,492 $ 146,270
Interest-bearing demand 402,970 332,918
Money market 96,048 75,634
Savings 306,199 247,462
Time 110,279 120,917
Time of 100 or more 93,475 114,659
Total deposits 1,214,463 1,037,860
Short-term borrowings 52,406 55,931
Long-term debt 10,000 —
Accrued interest payable 447 909
Other liabilities 8,762 9,606
Total liabilities 1,286,078 1,104,306
Shareholders' Equity
Common stock, par value 0.625 per share;
authorized 10,000,000 shares; 3,715,171 shares and  3,684,336
shares issued; 3,550,602 and 3,519,767 shares outstanding 2,322 2,303
Surplus 22,113 21,261
Retained earnings 103,701 99,372
Accumulated other comprehensive gain, net of tax 5,335 257
Treasury stock, at cost; 164,569 shares (2,476 ) (2,476 )
Total shareholders' equity 130,995 120,717
Total liabilities and shareholders' equity 1,417,073 $ 1,225,023

All values are in US Dollars.

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data - unaudited)
For the Nine Months Ended September 30,
2019 2020 2019
Interest income
Interest and fees on loans 8,993 $ 9,767 $ 27,327 $ 28,627
Interest and dividends on investment securities (Available-for-sale & Equity):
Taxable 1,393 1,644 4,362 4,918
Tax-exempt 351 370 1,049 1,178
Interest on interest-bearing balances and other interest income 26 36 96 95
Total interest income 10,763 11,817 32,834 34,818
Interest expense
Interest on deposits
Interest-bearing demand 274 846 1,099 2,327
Money market 83 158 325 670
Savings 248 401 893 1,206
Time 380 507 1,252 1,405
Time of 100,000 or more 355 551 1,247 1,523
Interest on short-term borrowings 53 172 195 558
Interest on long-term debt 40 — 96 —
Total interest expense 1,433 2,635 5,107 7,689
Net interest income 9,330 9,182 27,727 27,129
Provision for loan losses 250 550 1,000 925
Net interest income after provision for loan losses 9,080 8,632 26,727 26,204
Non-interest income
Net gain on sales of  investments available-for-sale and equity securities 198 973 367 1,563
Unrealized (loss) gain on investment equity securities 627 (305 ) (1,147 ) 266
Fees for services to customers 299 432 952 1,247
ATM and debit card 598 533 1,602 1,522
Retail brokerage and advisory 141 145 423 419
Bank-owned life insurance 70 70 207 208
Merchant 110 87 298 261
Net gain on sale of loans 589 63 1,035 112
Other 177 146 318 509
Total non-interest income 2,809 2,144 4,055 6,107
Non-interest expense
Salaries and employee benefits 4,182 4,063 12,239 11,634
Net occupancy 555 500 1,602 1,511
Furniture and equipment 684 623 2,015 1,771
Marketing 155 285 632 785
Third party services 444 461 1,401 1,347
Telephone, postage and supplies 154 184 543 535
State taxes 243 171 645 549
FDIC insurance premiums 140 — 419 265
Other 640 668 1,848 2,075
Total non-interest expense 7,197 6,955 21,344 20,472
Income before income taxes 4,692 3,821 9,438 11,839
Provision for income taxes 914 731 1,506 2,227
Net income 3,778 $ 3,090 $ 7,932 $ 9,612
Earnings per share - basic 1.07 $ 0.88 $ 2.25 $ 2.75
Earnings per share - diluted 1.07 $ 0.88 $ 2.25 $ 2.75
Cash dividends per share 0.34 $ 0.33 $ 1.02 $ 0.99

All values are in US Dollars.

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands - unaudited)
2020 2019
For the Three Months Ended September 30, Before<br><br><br>tax<br><br><br>amount Tax<br><br><br>expense<br><br><br>(benefit) Net of<br><br><br>tax<br><br><br>amount Before<br><br><br>tax<br><br><br>amount Tax<br><br><br>expense<br><br><br>(benefit) Net of<br><br><br>tax<br><br><br>amount
Net income $ 4,692 $ 914 $ 3,778 $ 3,821 $ 731 $ 3,090
Other comprehensive income:
Net unrealized holding (losses) gains on available-for-sale securities:
Unrealized holding (losses) gains arising during the period (471 ) (99 ) (372 ) 1,189 250 939
Reclassification adjustment for gains included in net income (15 ) (3 ) (12 ) (3 ) — (3 )
Other comprehensive (loss) income (486 ) (102 ) (384 ) 1,186 250 936
Total comprehensive income $ 4,206 $ 812 $ 3,394 $ 5,007 $ 981 $ 4,026
For the Nine Months Ended September 30, 2020 2019
Before<br><br><br>tax<br><br><br>amount Tax<br><br><br>expense<br><br><br>(benefit) Net of<br><br><br>tax<br><br><br>amount Before<br><br><br>tax<br><br><br>amount Tax<br><br><br>expense<br><br><br>(benefit) Net of<br><br><br>tax<br><br><br>amount
Net income $ 9,438 $ 1,506 $ 7,932 $ 11,839 $ 2,227 $ 9,612
Other comprehensive income:
Net unrealized holding gains on available-for-sale securities:
Unrealized holding gains arising during the period 6,444 1,353 5,091 9,677 2,033 7,644
Reclassification adjustment for (gains) losses included in net income (16 ) (3 ) (13 ) 36 8 28
Other comprehensive income 6,428 1,350 5,078 9,713 2,041 7,672
Total comprehensive income $ 15,866 $ 2,856 $ 13,010 $ 21,552 $ 4,268 $ 17,284

The accompanying notes are an integral part of the consolidated financial statements.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

For the Three Months Ended September 30, 2020 and 2019
Accumulated
Other
(unaudited) Common Retained Comprehensive Treasury
(in thousands, except share and per share data) Stock Surplus Earnings Income (Loss) Stock Total
Balance, July 1, 2020 3,542,261 $ 2,317 $ 21,876 $ 101,127 $ 5,719 $ (2,476 ) $ 128,563
Net income — — 3,778 — — 3,778
Other comprehensive loss, net of tax — — — (384 ) — (384 )
Cash dividends declared (0.34 per share) — — (1,204 ) — — (1,204 )
Stock issued in connection with dividend<br>   reinvestment and stock purchase plan 8,341 5 213 — — — 218
Stock issued for employee stock purchase plan — — — — — — —
Stock issued for options exercised — — — — — — —
Stock-based compensation expense — 24 — — — 24
Balance, September 30, 2020 3,550,602 $ 2,322 $ 22,113 $ 103,701 $ 5,335 $ (2,476 ) $ 130,995
Accumulated
Other
(unaudited) Common Retained Comprehensive Treasury
(in thousands, except share and per share data) Stock Surplus Earnings Income (Loss) Stock Total
Balance, July 1, 2019 3,501,446 $ 2,291 $ 20,607 $ 95,852 $ (396 ) $ (2,476 ) $ 115,878
Net income — — 3,090 — — 3,090
Other comprehensive income. net of tax — — — 936 — 936
Cash dividends declared (0.33 per share) — — (1,155 ) — — (1,155 )
Stock issued in connection with dividend<br>   reinvestment and stock purchase plan 5,860 4 201 — — — 205
Stock issued for employee stock purchase plan — — — — — — —
Stock issued for options exercised 250 — 7 — — — 7
Stock-based compensation expense — 24 — — — 24
Balance, September 30, 2019 3,507,556 $ 2,295 $ 20,839 $ 97,787 $ 540 $ (2,476 ) $ 118,985

All values are in US Dollars.

The accompanying notes are an integral part of the consolidated financial statements.

For the Nine Months Ended September 30, 2020 and 2019
Accumulated
Other
(unaudited) Common Retained Comprehensive Treasury
(in thousands, except share and per share data) Stock Surplus Earnings Income (Loss) Stock Total
Balance, January 1, 2020 3,519,767 $ 2,303 $ 21,261 $ 99,372 $ 257 $ (2,476 ) $ 120,717
Net income — — 7,932 — — 7,932
Other comprehensive income, net of tax — — — 5,078 — 5,078
Cash dividends declared (1.02 per share) — — (3,603 ) — — (3,603 )
Stock issued in connection with dividend<br>   reinvestment and stock purchase plan 24,791 15 663 — — — 678
Stock issued for employee stock purchase plan 2,923 2 73 — — — 75
Stock issued for options exercised 3,121 2 35 — — — 37
Stock-based compensation expense — 81 — — — 81
Balance, September 30, 2020 3,550,602 $ 2,322 $ 22,113 $ 103,701 $ 5,335 $ (2,476 ) $ 130,995
Accumulated
Other
(unaudited) Common Retained Comprehensive Treasury
(in thousands, except share and per share data) Stock Surplus Earnings Income (Loss) Stock Total
Balance, January 1, 2019 3,484,080 $ 2,280 $ 20,041 $ 91,635 $ (7,132 ) $ (2,476 ) $ 104,348
Net income — — 9,612 — — 9,612
Other comprehensive income, net of tax — — — 7,672 — 7,672
Cash dividends declared (0.99 per share) — — (3,460 ) — — (3,460 )
Stock issued in connection with dividend<br>   reinvestment and stock purchase plan 18,150 12 626 — — — 638
Stock issued for employee stock purchase plan 1,617 1 53 — — — 54
Stock issued for options exercised 3,709 2 35 — — — 37
Stock-based compensation expense — 84 — — — 84
Balance, September 30, 2019 3,507,556 $ 2,295 $ 20,839 $ 97,787 $ 540 $ (2,476 ) $ 118,985

All values are in US Dollars.

QNB Corp. and Subsidiary

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, unaudited)
For the Nine Months Ended September 30, 2020 2019
Operating Activities
Net income $ 7,932 $ 9,612
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization 1,499 1,277
Provision for loan losses 1,000 925
Net gain on calls and sales of debt and equity securities (367 ) (1,563 )
Net unrealized loss (gain) on equity securities 1,147 (266 )
Net loss (gain) on sale of other real estate and premises and equipment 6 (58 )
Net gain on sale of loans (1,035 ) (112 )
Proceeds from sales of residential mortgages held-for-sale 21,756 4,043
Origination of residential mortgages held-for-sale (28,821 ) (4,171 )
Increase in cash surrender value of bank-owned life insurance (207 ) (208 )
Stock-based compensation expense 81 84
Deferred income tax (benefit) provision (492 ) 214
Net increase in income taxes payable 525 493
Net increase in accrued interest receivable (1,846 ) (424 )
Amortization of mortgage servicing rights and change in valuation allowance 116 44
Net amortization of premiums and discounts on investment securities 1,664 1,117
Net (decrease) increase in accrued interest payable (462 ) 341
Operating lease payments (488 ) (431 )
Decrease (increase) in other assets 385 (837 )
Decrease in other liabilities (1,610 ) (383 )
Net cash provided by operating activities 783 9,697
Investing Activities
Proceeds from payments, maturities and calls of investments available-for-sale 151,534 43,455
Proceeds from the sale of investments available-for-sale 6,931 30,294
Proceeds from the sale of equity securities 3,694 10,924
Purchases of investments available-for-sale (248,591 ) (82,126 )
Purchases of equity securities (7,017 ) (5,488 )
Proceeds from redemption of investment in restricted stock 1,495 7,399
Purchases of restricted stock (1,463 ) (8,683 )
Net increase in loans (67,298 ) (45,373 )
Net purchases of premises and equipment (421 ) (1,761 )
Proceeds from sales of other real estate owned — 58
Net cash used in investing activities (161,136 ) (51,301 )
Financing Activities
Net increase in non-interest bearing deposits 59,222 22,329
Net increase in interest-bearing deposits 117,381 10,262
Net (decrease) increase in short-term borrowings (3,525 ) 19,073
Increase in long-term debt 10,000 —
Cash dividends paid, net of reinvestment (3,163 ) (3,055 )
Proceeds from issuance of common stock 350 324
Net cash provided by financing activities 180,265 48,933
Increase in cash and cash equivalents 19,912 7,329
Cash and cash equivalents at beginning of year 17,608 13,458
Cash and cash equivalents at end of period $ 37,520 $ 20,787
Supplemental Cash Flow Disclosures
Interest paid $ 5,569 $ 7,348
Net income taxes paid 1,473 921
Non-cash transactions:
Unsettled trades to purchase securities — —
Right-of-use assets obtained in exchange for new operating lease liabilities 1,086 2,407

The accompanying notes are an integral part of the consolidated financial statements.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

  1. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of QNB Corp. and its wholly-owned subsidiary, QNB Bank (the “Bank”). The consolidated entity is referred to herein as “QNB” or the “Company”. All significant intercompany accounts and transactions are eliminated in the consolidated financial statements.

These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in QNB's 2019 Annual Report incorporated in the Form 10-K. Operating results for the nine-month period ended September 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020.

The unaudited consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of operations for the period and are of a normal and recurring nature.

Tabular information, other than share and per share data, is presented in thousands of dollars.

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from such estimates.

QNB has evaluated events and transactions occurring subsequent to the balance sheet date of September 30, 2020 for items that should potentially be recognized or disclosed in these consolidated financial statements.

Recent Developments

On March 11, 2020, the disease caused by the coronavirus was declared a pandemic by the World Health Organization (the “COVID-19 Pandemic”).   QNB, its employees, customers and shareholders are being impacted by the COVID-19 Pandemic.  QNB immediately activated portions of its business continuity program to prepare for possible alternate work arrangements and loss of staff due to illness.  QNB has provided several solutions to maintain the health and safety of its employees, customers and shareholders.   Initially, nine branches serviced customers primarily via drive-up window; customers also made appointments for in-branch service.  Drive-ups operated under normal or expanded hours.  Night Drops remained available 24/7.  Three of QNB’s twelve offices do not offer drive-up service.  Our Quakertown Commons Office in the GIANT Food Store was temporarily closed. Our Allentown and Warminster Offices remained available for restricted access (one customer at a time) during normal business hours.  Because banking was designated an essential service by Governor Wolf, access to safe deposit boxes or to conduct any other in-person transaction were arranged by appointment only.   Currently, all QNB office lobbies have reopened with their normal operating hours but are operating under limited capacities, our banking by appointment service remains available. Our Quakertown Commons office inside GIANT Food Store has also reopened; however, staff is limited due to social distancing requirements. Drive-ups are also operating under normal hours.  All visitors to any QNB office are required to wear face masks upon entering the building, in accordance with the state mandates. All QNB employees are required to wear face masks when working on company premises.  Employees with remote access are strongly encouraged to work from home.  QNB has not incurred any significant disruptions to its business continuity.

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was signed into law.  As permitted under Section 4013 of the CARES Act, QNB continues to provide customers experiencing financial hardship caused by the COVID-19 Pandemic, solutions to help them through this difficult period.  Upon requests from customers, QNB: has provided an interest only payment option, granted in 90 days increments; has provided payment deferment for mortgage and consumer loans with no late fee during the deferment period; has granted foreclosure and motor vehicle repossession reprieve; and will not adversely impact credit reporting for customers who were granted relief on mortgage or consumer loans.  None of these modifications are considered troubled-debt restructurings as the customers were not experiencing financial difficulty prior to the COVID-19 Pandemic.  Interest continues to be accrued on all COVID-19 modifications during the deferment period. QNB had modified a total 309 commercial loans or $160,681,000 and 63 retail loans or $8,951,000 during the year due to COVID-19.  As of September 30, 2020, QNB had modifications on approximately 8.4% of the September 30, 2020 commercial portfolio, consisting of 109 loan with an outstanding balance of $62,390,000, of which 101 loans totaling $62,119,000 had extended the initial modification period, and had modifications to approximately 2.6% of the September 30, 2020 retail portfolio, consisting of 18 loans with an outstanding balance of $3,758,000, of which 15 loans totaling $3,461,000 had extended the initial deferment period,  related to the COVID-19 Pandemic.   We will continue work with our borrowers during this difficult time.

As provided under the CARES Act, the U.S. Small Business Administration (“SBA”) and Treasury have implemented the Paycheck Protection Program (“PPP”) which is designed to assist small businesses and their employees during this crisis. This program provides small businesses with payroll assistance in the form of a 100% guaranteed loan from SBA. Eligible borrowers can receive up to 2.5 times their monthly average payroll expenses for the prior year.  Congress originally approved $349 billion for this program as part of the CARES Act. The first round of funding was quickly exhausted by April 16, 2020 and Congress worked to provide an additional $310 billion in funding which was approved on April 23, 2020.  The SBA reopened its portal to begin accepting PPP loans for approval on Monday, April 27, 2020.  As of August 13, 2020, QNB closed 660 loans totaling $82,475,000, of which all  were outstanding at September 30, 2020.   QNB received origination fees from the SBA ranging from one to five basis points which are recognized in interest income as a yield adjustment over the term of the loan.   Funds are primarily being transferred into the borrowers’ deposit  accounts, and disbursement on these PPP loan proceeds are being funded by cash held at the Federal Reserve and proceeds from calls and payments of investment securities.  QNB has ample resources to cover future disbursements through short-term Federal Home Loan Bank (“FHLB”) advances and participation in the Federal Reserve’s Paycheck Protection Program Liquidity Facility (“PPPLF”), if necessary.  On June 5, 2020, the Paycheck Protection Program Flexibility Act of 2020 was signed into law and amends the CARES Act.  The amended act eases rules on how and when small businesses can use the proceeds from PPP loans and still be eligible for loan forgiveness. The amended act made the following changes: (1) extended the covered period for loan forgiveness purposes to the earlier of 24 weeks or December 31, 2020; (2) lowered the amount required to be spent on payroll costs from 75% to 60%; (3) extended the loan maturity period from two to five years; and (4) revised the loan deferral period.

The full impact of the COVID-19 Pandemic is unknown and rapidly evolving.  Uncertainties exist related to the duration of the COVID-19 Pandemic and its potential effects on QNB’s customers and prospects, including impacts on national and local economies, unemployment, maintaining  a competent workforce, and disruptions in the supply chain.   There are no assurances as to how the COVID-19 Pandemic might affect QNB’s loan, investment and deposit portfolios.

  1. RECENT ACCOUNTING PRONOUNCEMENTS

On June 16, 2016, the FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326) (CECL). The new guidance requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts.

To that end, the new guidance:

• Eliminates the probable initial recognition threshold in current U.S. generally accepted accounting principles (“U.S. GAAP”) and, instead, reflects an organization’s current estimate of all expected credit losses over the contractual term of its financial assets
• Broadens the information an entity can consider when measuring credit losses to include forward-looking information
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• Increases usefulness of the financial statements by requiring timely inclusion of forecasted information in forming expectations of credit losses
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• Increases comparability of purchased financial assets with credit deterioration (PCD assets) with other purchased assets that do not have credit deterioration as well as originated assets because credit losses that are expected will be recorded through an allowance for credit losses for all assets
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• Increases users’ understanding of underwriting standards and credit quality trends by requiring additional information about credit quality indicators by year of origination (vintage)
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• For available-for-sale debt securities, aligns the income statement recognition of credit losses with the reporting period in which changes occur by recording credit losses (and subsequent changes in credit losses) through an allowance rather than a write down
--- ---

The new guidance affects organizations that hold financial assets and net investments in leases that are not accounted for at fair value with changes in fair value reported in net income.  The new guidance affects loans, debt securities, trade receivables, net investments in leases, off-balance-sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

On October 16, 2019, FASB adopted its August 15, 2019 proposal to delay the effective dates for certain smaller reporting companies for the implementation CECL. For public business entities that are U.S. Securities and Exchange Commission (SEC) filers, the new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019, except for smaller reporting companies, whose effective date is effective for fiscal years, and interim periods with those fiscal years, beginning after December 15, 2022. QNB continues to evaluate the impact of this new standard on its consolidated financial statements and currently anticipates a material change to its allowance for loan losses upon the eventual implementation of CECL.

On August 28, 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement. This ASU changes the fair value measurement disclosure requirements of ASC 820. The amendments in this ASU are the result of a broader disclosure project called FASB Concepts Statement, Conceptual Framework for Financial Reporting — Chapter 8: Notes to Financial Statements, which the FASB finalized on August 28, 2018. The FASB used the guidance in the Concepts Statement to improve the effectiveness of ASC 820’s disclosure requirements. New disclosure requirements include: 1) Changes in unrealized gains or losses included in other comprehensive income (OCI) for recurring Level 3 fair value measurements held at the end of the reporting period; and 2) Explicit requirement to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. Disclosures eliminated include: 1) Amount of and reasons for transfers between Level 1 and Level 2; 2) Valuation processes for Level 3 fair value measurements; and 3) Policy for timing of transfers between levels of the fair value hierarchy. The ASU was effective for all entities for fiscal years beginning after December 15, 2019, including interim periods therein. The adoption of this ASU had no material impact on QNB.

  1. STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY

QNB sponsors stock-based compensation plans, administered by a Board committee (the “Committee”), under which both qualified and non-qualified stock options may be granted periodically to certain employees. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period.

Stock-based compensation expense was $24,000 and $24,000 for the three months ended September 30, 2020 and 2019, respectively. Stock-based compensation expense was $81,000 and $84,000 for the nine months ended September 30, 2020 and 2019, respectively. As of September 30, 2020, there was approximately $104,000 of unrecognized compensation cost related to unvested share-based compensation award grants that is expected to be recognized over the next 29 months.

Options are granted to certain employees at prices equal to the market value of the stock on the date the options are granted. The 2005 Plan authorized the issuance of 200,000 shares. The time period during which any option is exercisable under the 2005 Plan is determined by the Committee but shall not commence before the expiration of six months after the date of grant or continue beyond the expiration of five years after the date the option is awarded. The granted options vest after a three-year period. As of June 30, 2020, there were 184,200 options granted, 65,850 options forfeited, 118,350 options exercised, and no options outstanding under this Plan. The 2005 Plan expired on March 15, 2015.

The 2015 Plan authorizes the issuance of 300,000 shares. The terms of the 2015 Plan are identical to the 2005 Plan. There were 123,200 options granted, 2,600 options forfeited, 1,800 options exercised and 118,800 options outstanding under the 2015 Plan as of June 30, 2020. The 2015 Plan expires on February 24, 2025.

The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimated the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of assumptions.

The following assumptions were used in the option pricing model in determining the fair value of options granted during the period:

For the Nine Months Ended September 30, 2020 2019
Risk free interest rate 1.52 % 2.52 %
Dividend yield 3.60 % 3.36 %
Volatility 13.46 % 16.44 %
Expected life (years) 4.03 4.17

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The risk-free interest rate was selected based upon yields of U.S. Treasury securities with a term approximating the expected life of the option being valued. Historical information was the basis for the selection of the expected dividend yield, expected volatility and expected lives of the options.

The fair market value of options granted in the nine months ended September 30, 2020 and 2019 was $2.42 and $3.96, respectively.

Stock option activity during the nine months ended September 30, 2020 and 2019 is as follows:

Number<br><br><br>of options Weighted<br><br><br>average<br><br><br>exercise<br><br><br>price Weighted<br><br><br>average<br><br><br>remaining<br><br><br>contractual term<br><br><br>(in years) Aggregate<br><br><br>intrinsic value
Outstanding at December 31, 2019 103,350 $ 36.96
Granted 25,000 36.50
Exercised (9,550 ) 29.39
Forfeited — —
Outstanding at September 30, 2020 118,800 $ 37.47 2.46 $ -
Exercisable at September 30, 2020 44,600 $ 34.27 0.92 $ -
Number<br><br><br>of options Weighted<br><br><br>average<br><br><br>exercise<br><br><br>price Weighted<br><br><br>average<br><br><br>remaining<br><br><br>contractual term<br><br><br>(in years) Aggregate<br><br><br>intrinsic value
--- --- --- --- --- --- --- --- --- ---
Outstanding at December 31, 2018 95,075 $ 35.11
Granted 24,700 38.15
Exercised (8,775 ) 25.64
Forfeited (1,500 ) 37.20
Outstanding at September 30, 2019 109,500 $ 36.53 2.34 $ 357
Exercisable at September 30, 2019 36,350 $ 29.95 0.72 $ 318
  1. EARNINGS PER SHARE & SHARE REPURCHASE PLAN

The following sets forth the computation of basic and diluted earnings per share:

For the Three Months Ended September 30, For the Nine Months Ended September 30,
2020 2019 2020 2019
Numerator for basic and diluted earnings per share - net income $ 3,778 $ 3,090 $ 7,932 $ 9,612
Denominator for basic earnings per share - weighted average<br><br><br>shares outstanding 3,542,805 3,501,771 3,532,555 3,494,471
Effect of dilutive securities - employee stock options — 6,546 122 7,036
Denominator for diluted earnings per share - adjusted<br><br><br>weighted average shares outstanding 3,542,805 3,508,317 3,532,677 3,501,507
Earnings per share - basic $ 1.07 $ 0.88 $ 2.25 $ 2.75
Earnings per share - diluted 1.07 0.88 2.25 2.75

There were 118,800 and 73,150  stock options that were anti-dilutive for the three-month periods ended September 30, 2020 and 2019, respectively. There were 98,150 and 73,150  stock options that were anti-dilutive for the nine-month periods ended September 30, 2020 and 2019, respectively. These stock options were not included in the above calculation.

QNB’s current stock repurchase plan was approved by the Board of Directors on January 21, 2008 and subsequently increased on  February 9, 2009 and has authorized the repurchase of up to 100,000 shares of its common stock in open market or privately

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

negotiated transactions. The repurchase authorization has no termination date. There were no shares repurchased during the nine months ended September 30, 2020 and 2019. As of September 30, 2020, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000.

  1. COMPREHENSIVE INCOME (LOSS)

The following shows the components of accumulated other comprehensive income (loss) at September 30, 2020 and December 31, 2019:

September 30, December 31,
2020 2019
Unrealized net holding gains on available-for-sale<br><br><br>securities $ 6,753 $ 325
Unrealized gains (losses) on available-for-sale securities<br><br><br>for which a portion of an other-than-temporary<br><br><br>impairment loss has been recognized in earnings — —
Accumulated other comprehensive income 6,753 325
Tax effect (1,418 ) (68 )
Accumulated other comprehensive gain, net of tax $ 5,335 $ 257

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following tables present amounts reclassified out of accumulated other comprehensive income (loss) for the three and nine months ended September 30, 2020 and 2019:

For the Three Months Ended September 30, Amount reclassified from<br><br><br>accumulated other<br><br><br>comprehensive loss
Details about accumulated other comprehensive income (loss) 2020 2019 Affected line item in statement of income
Unrealized net holding gains (losses) on available-for-sale<br><br><br>securities $ 15 $ 3 Unrealized net holding gains (losses) on investments available-for-sale
Other-than-temporary impairment gains (losses) on<br><br><br>investment securities — — Net other-than-temporary impairment<br><br><br>losses on investment securities
15 3
Tax effect (3 ) — Provision for income taxes
Total reclassification out of accumulated other<br><br><br>comprehensive income (loss), net of tax $ 12 $ 3 Net of tax
For the Nine Months Ended September 30, Amount reclassified from<br><br><br>accumulated other<br><br><br>comprehensive income
Details about accumulated other comprehensive income (loss) 2020 2019 Affected line item in statement of income
Unrealized net holding gains (losses) on available-for-sale<br><br><br>securities $ 16 $ (36 ) Unrealized net holding gains (losses) on investments available-for-sale
Other-than-temporary impairment gains (losses) on<br><br><br>investment securities — — Net other-than-temporary impairment<br><br><br>losses on investment securities
16 (36 )
Tax effect (3 ) 8 Provision for income taxes
Total reclassification out of accumulated other<br><br><br>comprehensive income (loss), net of tax $ 13 $ (28 ) Net of tax

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

  1. INVESTMENT SECURITIES

Available-For-Sale Securities

The amortized cost and estimated fair values of investment securities available-for-sale at September 30, 2020 and December 31, 2019 were as follows:

Gross Gross
unrealized unrealized
Fair holding holding Amortized
September 30, 2020 value gains losses cost
U.S. Government agency $ 81,533 $ 82 $ (152 ) $ 81,603
State and municipal 77,016 1,824 (140 ) 75,332
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed 176,982 3,232 (112 ) 173,862
Collateralized mortgage obligations (CMOs) 101,843 2,043 (9 ) 99,809
Pooled trust preferred 68 — (16 ) 84
Corporate debt 7,174 26 (25 ) 7,173
Total investment debt securities available-for-sale $ 444,616 $ 7,207 $ (454 ) $ 437,863
Gross Gross
--- --- --- --- --- --- --- --- --- ---
unrealized unrealized
Fair holding holding Amortized
December 31, 2019 value gains losses cost
U.S. Government agency $ 69,298 $ 8 $ (213 ) $ 69,503
State and municipal 50,781 860 (19 ) 49,940
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed 134,829 371 (504 ) 134,962
Collateralized mortgage obligations (CMOs) 86,610 260 (535 ) 86,885
Pooled trust preferred 79 — (6 ) 85
Corporate debt 8,113 103 — 8,010
Total investment debt securities available-for-sale $ 349,710 $ 1,602 $ (1,277 ) $ 349,385

The amortized cost and estimated fair value of securities available-for-sale by contractual maturity at September 30, 2020 are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities are assigned to categories based on contractual maturity except for mortgage-backed securities and CMOs which are based on the estimated average life of these securities and municipal securities that have been pre-refunded.

September 30, 2020 Fair value Amortized cost
Due in one year or less $ 13,589 $ 13,443
Due after one year through five years 273,528 268,416
Due after five years through ten years 104,683 104,154
Due after ten years 52,816 51,850
Total investment debt securities available-for-sale $ 444,616 $ 437,863

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Proceeds from sales of investment securities available-for-sale were approximately $0 and $9,511,000 for the three months ended September 30, 2020 and 2019, respectively. Proceeds from sales of investment securities available-for-sale were approximately $6,931,000 and $30,294,000 for the nine months ended September 30, 2020 and 2019, respectively.

At September 30, 2020 and December 31, 2019, investment securities available-for-sale totaling approximately $245,184,000 and $205,016,000, respectively, were pledged as collateral for repurchase agreements and deposits of public funds.

The following table presents information related to the Company’s gains and losses on the sales of securities available-for-sale, and losses recognized for the other-than-temporary impairment (“OTTI”) of these investments. Gains and losses on available-for-sale  securities are computed on the specific identification method and included in non-interest income. Gross realized losses on debt securities are net of other-than-temporary impairment charges:

For the Three Months Ended September 30, For the Nine Months Ended September 30,
2020 2019 2020 2019
Gross realized gains $ 15 $ 28 $ 21 $ 64
Gross realized losses — (25 ) (5 ) (100 )
Other-than-temporary impairment — — — —
Total net gains (losses) on AFS securities $ 15 $ 3 $ 16 $ (36 )

The tax expense applicable to the net realized gains for the three-month periods ended September 30, 2020 and 2019 was $3,000 and $0, respectively.  The tax applicable to the net realized gains/(losses) for the nine-month periods ended September 30, 2020 and 2019 was expense of $3,000 and a benefit of $8,000, respectively.

QNB recognizes OTTI for debt securities classified as available-for-sale in accordance with FASB ASC 320, Investments – Debt and Equity Securities, which requires that we assess whether we intend to sell or it is more likely than not that the Company will be required to sell a security before recovery of its amortized cost basis less any current-period credit losses. For debt securities that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell prior to recovery of our amortized cost basis, the amount of the impairment is separated into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the security’s amortized cost basis and the present value of its expected future cash flows discounted at the security’s effective yield. The remaining difference between the security’s fair value and the present value of future expected cash flows is due to factors that are not credit related and, therefore, is not required to be recognized as a loss in the statement of income but is recognized in other comprehensive income. QNB believes that we will fully collect the carrying value of securities on which we have recorded a non-credit related impairment in other comprehensive income. No credit impairments were recognized on debt securities during the nine months ended September 30, 2020 and 2019, respectively.

The following table indicates the length of time individual debt securities have been in a continuous unrealized loss position at September 30, 2020 and December 31, 2019:

Less than 12 months 12 months or longer Total
No. of Fair Unrealized Fair Unrealized Fair Unrealized
September 30, 2020 securities value losses value losses value losses
U.S. Government agency 17 $ 32,451 $ (152 ) $ — $ — $ 32,451 $ (152 )
State and municipal 24 13,828 (140 ) — — 13,828 (140 )
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed 10 32,864 (112 ) — — 32,864 (112 )
Collateralized mortgage obligations (CMOs) 4 5,361 (9 ) — — 5,361 (9 )
Pooled trust preferred 1 — — 68 (16 ) 68 (16 )
Corporate debt 1 2,975 (25 ) — — 2,975 (25 )
Total 57 $ 87,479 $ (438 ) $ 68 $ (16 ) $ 87,547 $ (454 )

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Less than 12 months 12 months or longer Total
No. of Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2019 securities value losses value losses value losses
U.S. Government agency 36 $ 28,857 $ (141 ) $ 20,427 $ (72 ) $ 49,284 $ (213 )
State and municipal 7 2,431 (14 ) 515 (5 ) 2,946 (19 )
U.S. Government agencies and sponsored enterprises (GSEs):
Mortgage-backed 66 28,482 (50 ) 52,398 (454 ) 80,880 (504 )
Collateralized mortgage obligations (CMOs) 64 24,412 (82 ) 27,625 (453 ) 52,037 (535 )
Pooled trust preferred 1 — — 79 (6 ) 79 (6 )
Corporate debt — — — — — — —
Total 174 $ 84,182 $ (287 ) $ 101,044 $ (990 ) $ 185,226 $ (1,277 )

Management evaluates debt securities, which are comprised of U.S. Government agencies, state and municipalities, mortgage-backed securities, CMOs and corporate debt securities, for other-than-temporary impairment and considers the current economic conditions, the length of time and the extent to which the fair value has been less than cost, interest rates and the bond rating of each security. The unrealized losses at September 30, 2020 in U.S. Government agency securities, state and municipal securities, mortgage-backed securities, and CMOs are primarily the result of interest rate fluctuations. If held to maturity, these bonds will mature at par, and QNB will not realize a loss. The Company has the intent to hold the securities and does not believe it will be required to sell the securities before recovery occurs.

QNB holds one pooled trust preferred security as of September 30, 2020. This security has a total amortized cost of approximately $84,000 and a fair value of $68,000.   The pooled trust preferred security is available-for-sale and is carried at fair value.

Marketable Equity Securities

The Company’s investment in marketable equity securities primarily consists of investments with readily determinable fair values in large cap stock companies. Changes in fair value is recorded in unrealized gain/(losses) in non-interest income.

At September 30, 2020 and December 31, 2019, the Company had $11,691,000 and $9,164,000, respectively, in equity securities recorded at fair value. The following is a summary of unrealized and realized gains and losses recognized in net income on equity securities during the three and nine months ended September 30, 2020 and 2019:

For the Three Months Ended September 30, For the Nine Months Ended September 30,
2020 2019 2020 2019
Net gains (loss) recognized during the period on equity securities $ 810 $ 665 $ (796 ) $ 1,865
Less:  Net gains recognized during the period on equity securities sold during the period 183 970 351 1,599
Net unrealized gains (losses) recognized during the reporting period on equity securities still held at the reporting date $ 627 $ (305 ) $ (1,147 ) $ 266

Tax expense applicable to the net gains recognized for the three months ended September 30, 2020 was $234,000. Tax expense applicable to the net gains recognized for the three months ended September 30, 2019 was $192,000. Tax benefit applicable to the net losses recognized for the nine months ended September 30, 2020 was $230,000. Tax expense applicable to the net gains recognized for the nine months ended September 30, 2019 was $539,000. Proceeds from sales of investment equity securities were approximately $2,266,000 and $6,404,000 for the three months ended September 30, 2020 and 2019, respectively. Proceeds from sales of investment

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

equity securities were approximately $3,694,000 and $10,924,000 for the nine months ended September 30, 2020 and 2019, respectively.

  1. RESTRICTED INVESTMENT IN STOCKS

Restricted investment in stocks includes Federal Home Loan Bank of Pittsburgh (“FHLB”) with a carrying cost of $1,029,000, Atlantic Community Bankers Bank (ACBB) stock with a carrying cost of $12,000 and VISA Class B stock with a carrying cost of $0 at September 30, 2020. FHLB and ACBB stock was issued to the Bank as a requirement to facilitate the Bank’s participation in borrowing and other banking services.  The Bank’s investment in FHLB stock may fluctuate, as it is based on the member banks’ use of FHLB’s services.

The Bank owns 6,502 shares of Visa Class B stock, which was necessary to participate in Visa services in support of the Bank’s credit card, debit card, and related payment programs (permissible activities under banking regulations) as a member institution.  Following the resolution of Visa’s covered litigation, shares of Visa’s Class B stock will be converted to Visa Class A shares using a conversion factor (1.6228 as of September 27, 2019), which is periodically adjusted to reflect VISA’s ongoing litigation costs. There is a very limited market for this stock, as only current owners of Class B shares are permitted to transact in Class B.  Due to the lack of orderly trades and public information of such trades, Visa Class B does not have a readily determinable fair value.

These restricted investments are carried at cost and evaluated for OTTI periodically. As of September 30, 2020, there was no OTTI associated with these shares.

  1. LOANS & ALLOWANCE FOR LOAN LOSSES

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at the principal amount outstanding, net of deferred loan fees and costs. Interest income is accrued on the principal amount outstanding. Loan origination and commitment fees and related direct costs are deferred and amortized to income over the term of the respective loan and loan commitment period as a yield adjustment.

Loans held-for-sale consists of residential mortgage loans that are carried at the lower of aggregate cost or fair value. Net unrealized losses, if any, are recognized through a valuation allowance charged to income. Gains and losses on residential mortgages held-for-sale are included in non-interest income.

QNB maintains an allowance for loan losses, which is intended to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continuing review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value) of the impaired loan is lower than the carrying value of that loan. The portion of the allowance that is allocated to internally criticized and non-accrual loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral. The general component covers pools of loans by loan class including commercial loans not considered impaired, as well as smaller balance homogeneous loans, such as residential real estate, home equity and other consumer loans. These pools of loans are evaluated for loss exposure based upon historical loss rates. These loss rates are based on a three-year history of charge-offs and are more heavily weighted for recent experience for each of these categories of loans, adjusted for qualitative factors. These qualitative risk factors include:

1. Lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices.
2. Effect of external factors, such as legal and regulatory requirements.
--- ---
3. National, regional, and local economic and business conditions as well as the condition of various market segments, including the value of underlying collateral for collateral dependent loans.
--- ---
4. Nature and volume of the portfolio including growth.
--- ---
5. Experience, ability, and depth of lending management and staff.
--- ---

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

6. Volume and severity of past due, classified and nonaccrual loans.
7. Quality of the Company’s loan review system, and the degree of oversight by the Company’s Board of Directors.
--- ---
8. Existence and effect of any concentrations of credit and changes in the level of such concentrations.
--- ---

Each factor is assigned a value to reflect improving, stable or declining conditions based on management’s best judgment using relevant information available at the time of the evaluation.  Factor 8 above includes adjustments for concentrations in COVID-19 modifications existing at September 30, 2020.

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.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collectability. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent firm reviews risk assessment and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments using information available to them at the time of their examination.

Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

Major classes of loans are as follows:

September 30, December 31,
2020 2019
Commercial:
Commercial and industrial $ 227,448 $ 168,031
Construction 50,187 56,209
Secured by commercial real estate 351,012 336,050
Secured by residential real estate 80,278 72,443
State and political subdivisions 34,489 38,376
Retail:
1-4 family residential mortgages 76,020 69,469
Home equity loans and lines 65,189 73,311
Consumer 5,490 6,530
Total loans 890,113 820,419
Net unearned (fees) costs (2,321 ) 197
Loans receivable $ 887,792 $ 820,616

Loans secured by commercial real estate include all loans collateralized at least in part by commercial real estate. These loans may not be for the expressed purpose of conducting commercial real estate transactions.

Overdrafts are reclassified as loans and are included in consumer loans above and total loans receivable on the Consolidated Balance Sheets. At September 30, 2020 and December 31, 2019, overdrafts were approximately $86,238 and $224,000, respectively.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

QNB generally lends in its trade area which is comprised of Quakertown and the surrounding communities. To a large extent, QNB makes loans collateralized at least in part by real estate. Its lending activities could be affected by changes in the general economy, the regional economy, or real estate values. Other than disclosed in the table above, at September 30, 2020, there was a concentration of loans to lessors of residential buildings and dwellings of 14.4% of total loans and to lessors of nonresidential buildings of 19.0% of total loans, compared with 16.6% and 18.3% of total loans, respectively, at December 31, 2019.  These concentrations were primarily within the commercial real estate categories.

Under the CARES Act, QNB continues to provide customers experiencing financial hardship caused by the COVID-19 Pandemic, solutions to help them through this difficult period. As of September 30, 2020, QNB had modifications to approximately 8.4% of the September 30, 2020 commercial portfolio and had modifications to approximately 2.6% of the September 30, 2020 retail portfolio,  related to the COVID-19 Pandemic. Loans modified one time included eight credits and totaled $568,000 with deferred interest and or principal payments between three and six months.  Loans modified two times included 102 credits and totaled $38,120,000 with deferred interest and or principal payments between five and six months.  Loans modified three times included 17 credits and totaled $27,460,000 with deferred interest and or principal payments between six and nine months.  The following table illustrates the modified loans by major loan class and total deferral by number of months.

September 30, 2020
Total Number of Months Deferred
0-3 Months 4-6 Months 7-9 Months Total
Commercial:
Commercial and industrial $ 33 $ 3,375 $ 37 $ 3,445
Construction — — — —
Secured by commercial real estate — 28,753 24,452 53,205
Secured by residential real estate — 5,475 113 5,588
State and political subdivisions 152 — — 152
Retail:
1-4 family residential mortgages — 404 2,111 2,515
Home equity loans and lines 39 453 747 1,239
Consumer 4 — — 4
Total COVID-19 Modified Loans $ 228 $ 38,460 $ 27,460 $ 66,148

At September 30, 2020, QNB had 660 PPP loans totaling $82,475,000 reported in commercial and industrial loans.  The PPP loans are 100% guaranteed by the SBA.  QNB received origination fees from the SBA ranging from one to five basis points which are recognized in interest income as a yield adjustment over the term of the loan.   Net unearned (fees) costs includes $2,406,000 in PPP loan origination fees net of costs

The Company engages in a variety of lending activities, including commercial, residential real estate and consumer transactions. The Company focuses its lending activities on individuals, professionals and small to medium sized businesses. Risks associated with lending activities include economic conditions and changes in interest rates, which can adversely impact both the ability of borrowers to repay their loans and the value of the associated collateral.

Commercial and industrial loans, commercial real estate loans, construction loans and residential real estate loans with a business purpose are generally perceived as having more risk of default than residential real estate loans with a personal purpose and consumer loans. These types of loans involve larger loan balances to a single borrower or groups of related borrowers and are more susceptible to a risk of loss during a downturn in the business cycle. These loans may involve greater risk because the availability of funds to repay these loans depends on the successful operation of the borrower’s business. The assets financed are used within the business for its ongoing operation. Repayment of these kinds of loans generally comes from the cash flow of the business or the ongoing conversions of assets, such as accounts receivable and inventory, to cash. Typical collateral for commercial and industrial loans includes the borrower’s accounts receivable, inventory and machinery and equipment. Commercial real estate and residential real estate loans secured for a business purpose are originated primarily within the eastern Pennsylvania market area at conservative loan-to-value ratios and often backed by the individual guarantees of the borrowers or owners. Repayment of this kind of loan is dependent upon either the ongoing cash flow of the borrowing entity or the resale or lease of the subject property. Commercial real estate loans may be affected to a greater extent than residential loans by adverse conditions in real estate markets or the economy because

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

commercial real estate borrowers’ ability to repay their loans depends on successful development of their properties, as well as the factors affecting residential real estate borrowers.

Loans to state and political subdivisions are tax-exempt or taxable loans to municipalities, school districts and housing and industrial development authorities. These loans can be general obligations of the municipality or school district repaid through their taxing authority, revenue obligations repaid through the income generated by the operations of the authority, such as a water or sewer authority, or loans issued to a housing and industrial development agency, for which a private corporation is responsible for payments on the loans.

The Company originates fixed-rate and adjustable-rate real estate-residential mortgage loans for personal purposes that are secured by first liens on the underlying 1-4 family residential properties. Credit risk exposure in this area of lending is minimized by the evaluation of the credit worthiness of the borrower, including debt-to-income ratios, credit scores and adherence to underwriting policies that emphasize conservative loan-to-value ratios of generally no more than 80%. Residential mortgage loans granted in excess of the 80% loan-to-value ratio criterion are generally insured by private mortgage insurance.

The real estate-home equity portfolio consists of fixed-rate home equity loans and variable-rate home equity lines of credit. Risks associated with loans secured by residential properties are generally lower than commercial loans and include general economic risks, such as the strength of the job market, employment stability and the strength of the housing market. Since most loans are secured by a primary or secondary residence, the borrower’s continued employment is the greatest risk to repayment.

The Company offers a variety of loans to individuals for personal and household purposes. Consumer loans are generally considered to have greater risk than first or second mortgages on real estate because they may be unsecured, or, if they are secured, the value of the collateral may be difficult to assess and is more likely to decrease in value than real estate. Credit risk in this portfolio is controlled by conservative underwriting standards that consider debt-to-income levels and the creditworthiness of the borrower and, if secured, collateral values.

The Company employs a ten-grade risk rating system related to the credit quality of commercial loans and loans to state and political subdivisions of which the first six categories are pass categories (credits not adversely rated). The following is a description of the internal risk ratings and the likelihood of loss related to each risk rating.

1 Excellent - no apparent risk
2 Good - minimal risk
--- ---
3 Acceptable - lower risk
--- ---
4 Acceptable - average risk
--- ---
5 Acceptable – higher risk
--- ---
6 Pass watch
--- ---
7 Special Mention - potential weaknesses
--- ---
8 Substandard - well defined weaknesses
--- ---
9 Doubtful - full collection unlikely
--- ---
10 Loss - considered uncollectible
--- ---

The Company maintains a loan review system, which allows for a periodic review of our loan portfolio and the early identification of potential problem loans. Each loan officer assigns a rating to all loans in the portfolio at the time the loan is originated. Loans with risk ratings of one through five are reviewed annually based on the borrower’s fiscal year. Loans with risk ratings of six are reviewed every six to twelve months based on the dollar amount of the relationship with the borrower. Loans with risk ratings of seven through ten are reviewed at least quarterly, and as often as monthly, at management’s discretion. The Company also utilizes an outside loan review firm to review the portfolio on a semi-annual basis to provide the Board of Directors and senior management an independent review of the Company’s loan portfolio on an ongoing basis. These reviews are designed to recognize deteriorating credits in their earliest stages in an effort to reduce and control risk in the lending function as well as identifying potential shifts in the quality of the loan portfolio. The examinations by the outside loan review firm include the review of lending activities with respect to underwriting and processing new loans, monitoring the risk of existing loans and to provide timely follow-up and corrective action for loans

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

showing signs of deterioration in quality. In addition, the outside firm reviews the methodology for the allowance for loan losses to determine compliance to policy and regulatory guidance.

The following tables present the classes of the loan portfolio summarized by the aggregate pass rating and the classified ratings of special mention, substandard and doubtful within the Company’s internal risk rating system as of September 30, 2020 and December 31, 2019:

September 30, 2020 Pass Special<br><br><br>mention Substandard Doubtful Total
Commercial:
Commercial and industrial $ 218,532 $ 481 $ 8,435 $ — $ 227,448
Construction 50,187 — — — 50,187
Secured by commercial real estate 336,079 8,202 6,731 — 351,012
Secured by residential real estate 78,728 — 1,550 — 80,278
State and political subdivisions 34,489 — — — 34,489
Total $ 718,015 $ 8,683 $ 16,716 $ — $ 743,414
December 31, 2019 Pass Special<br><br><br>mention Substandard Doubtful Total
--- --- --- --- --- --- --- --- --- --- ---
Commercial:
Commercial and industrial $ 158,247 $ 3,665 $ 6,119 $ — $ 168,031
Construction 56,209 — — — 56,209
Secured by commercial real estate 324,936 2,995 8,119 — 336,050
Secured by residential real estate 70,759 - 1,684 — 72,443
State and political subdivisions 38,376 — — — 38,376
Total $ 648,527 $ 6,660 $ 15,922 $ — $ 671,109

For retail loans, the Company evaluates credit quality based on the performance of the individual credits. The following tables present the recorded investment in the retail classes of the loan portfolio based on payment activity as of September 30, 2020 and December 31, 2019:

September 30, 2020 Performing Non-performing Total
Retail:
1-4 family residential mortgages $ 75,525 $ 495 $ 76,020
Home equity loans and lines 64,464 725 65,189
Consumer 5,342 148 5,490
Total $ 145,331 $ 1,368 $ 146,699
December 31, 2019 Performing Non-performing Total
--- --- --- --- --- --- ---
Retail:
1-4 family residential mortgages $ 68,833 $ 636 $ 69,469
Home equity loans and lines 72,774 537 73,311
Consumer 6,391 139 6,530
Total $ 147,998 $ 1,312 $ 149,310

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The performance and credit quality of the loan portfolio is also monitored by analyzing the age of the loans receivable as determined by the length of time a recorded payment is past due. The following table presents the classes of the loan portfolio summarized by the past due status as of September 30, 2020 and December 31, 2019:

September 30, 2020 30-59 days<br><br><br>past due 60-89 days<br><br><br>past due 90 days or<br><br><br>more past<br><br><br>due Total past<br><br><br>due loans Current Total loans<br><br><br>receivable
Commercial:
Commercial and industrial $ 2,428 $ — $ 1,608 $ 4,036 $ 223,412 $ 227,448
Construction — — — — 50,187 50,187
Secured by commercial real estate 344 — 39 383 350,629 351,012
Secured by residential real estate 67 — 186 253 80,025 80,278
State and political subdivisions — — — — 34,489 34,489
Retail:
1-4 family residential mortgages 310 305 140 755 75,265 76,020
Home equity loans and lines 299 — 8 307 64,882 65,189
Consumer 124 4 42 170 5,320 5,490
Total $ 3,572 $ 309 $ 2,023 $ 5,904 $ 884,209 $ 890,113
December 31, 2019 30-59 days<br><br><br>past due 60-89 days<br><br><br>past due 90 days or<br><br><br>more past<br><br><br>due Total past<br><br><br>due loans Current Total loans<br><br><br>receivable
--- --- --- --- --- --- --- --- --- --- --- --- ---
Commercial:
Commercial and industrial $ — $ 58 $ 2,006 $ 2,064 $ 165,967 $ 168,031
Construction — — — — 56,209 56,209
Secured by commercial real estate — — 1,527 1,527 334,523 336,050
Secured by residential real estate 208 79 142 429 72,014 72,443
State and political subdivisions — — — — 38,376 38,376
Retail:
1-4 family residential mortgages 1,486 573 432 2,491 66,978 69,469
Home equity loans and lines 271 23 55 349 72,962 73,311
Consumer 29 71 — 100 6,430 6,530
Total $ 1,994 $ 804 $ 4,162 $ 6,960 $ 813,459 $ 820,419

The following tables disclose the recorded investment in loans receivable that are either on non-accrual status or past due 90 days or more and still accruing interest as of September 30, 2020 and December 31, 2019:

September 30, 2020 90 days or more past<br><br><br>due (still accruing) Non-accrual
Commercial:
Commercial and industrial $ — $ 4,888
Construction — —
Secured by commercial real estate — 2,998
Secured by residential real estate — 747
State and political subdivisions — —
Retail:
1-4 family residential mortgages — 495
Home equity loans and lines — 725
Consumer — 148
Total $ — $ 10,001

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

December 31, 2019 90 days or more past<br><br><br>due (still accruing) Non-accrual
Commercial:
Commercial and industrial $ — $ 5,901
Construction — —
Secured by commercial real estate — 3,640
Secured by residential real estate — 851
State and political subdivisions — —
Retail:
1-4 family residential mortgages — 636
Home equity loans and lines — 537
Consumer — 139
Total $ — $ 11,704

Activity in the allowance for loan losses for the three and nine months ended September 30, 2020 and 2019 are as follows:

For the Three Months Ended September 30, 2020 Balance,<br><br><br>beginning of<br><br><br>period Provision for<br><br><br>(credit to)<br><br><br>loan losses Charge-offs Recoveries Balance, end<br><br><br>of period
Commercial:
Commercial and industrial $ 4,270 $ 540 $ — $ 10 $ 4,820
Construction 287 14 — — 301
Secured by commercial real estate 3,423 (154 ) — — 3,269
Secured by residential real estate 721 79 — 34 834
State and political subdivisions 120 1 — — 121
Retail:
1-4 family residential mortgages 586 (59 ) — — 527
Home equity loans and lines 266 20 — 1 287
Consumer 268 (7 ) (25 ) 31 267
Unallocated 523 (184 ) N/A N/A 339
Total $ 10,464 $ 250 $ (25 ) $ 76 $ 10,765
For the Three Months Ended September 30, 2019 Balance,<br><br><br>beginning of<br><br><br>period Provision for<br><br><br>(credit to)<br><br><br>loan losses Charge-offs Recoveries Balance, end<br><br><br>of period
--- --- --- --- --- --- --- --- --- --- --- --- ---
Commercial:
Commercial and industrial $ 3,302 $ 844 $ (207 ) $ 8 $ 3,947
Construction 675 (87 ) — — 588
Secured by commercial real estate 2,913 (60 ) — 8 2,861
Secured by residential real estate 722 (9 ) (15 ) 16 714
State and political subdivisions 201 45 — — 246
Retail:
1-4 family residential mortgages 433 (15 ) — — 418
Home equity loans and lines 294 21 — 3 318
Consumer 188 46 (49 ) 16 201
Unallocated 436 (235 ) N/A N/A 201
Total $ 9,164 $ 550 $ (271 ) $ 51 $ 9,494

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

For the Nine Months Ended September 30, 2020 Balance,<br><br><br>beginning of<br><br><br>period Provision for<br><br><br>(credit to)<br><br><br>loan losses Charge-offs Recoveries Balance, end<br><br><br>of period
Commercial:
Commercial and industrial $ 4,689 $ 176 $ (72 ) $ 27 $ 4,820
Construction 590 (289 ) — — 301
Secured by commercial real estate 2,519 738 — 12 3,269
Secured by residential real estate 629 147 — 58 834
State and political subdivisions 115 6 — — 121
Retail: —
1-4 family residential mortgages 549 (22 ) — — 527
Home equity loans and lines 310 (29 ) — 6 287
Consumer 230 190 (219 ) 66 267
Unallocated 256 83 N/A N/A 339
Total $ 9,887 $ 1,000 $ (291 ) $ 169 $ 10,765
For the Nine Months Ended September 30, 2019 Balance,<br><br><br>beginning of<br><br><br>period Provision for<br><br><br>(credit to)<br><br><br>loan losses Charge-offs Recoveries Balance, end<br><br><br>of period
--- --- --- --- --- --- --- --- --- --- --- --- ---
Commercial:
Commercial and industrial $ 3,092 $ 1,036 $ (207 ) $ 26 $ 3,947
Construction 551 37 — — 588
Secured by commercial real estate 2,824 29 — 8 2,861
Secured by residential real estate 754 (68 ) (51 ) 79 714
State and political subdivisions 153 93 — — 246
Retail:
1-4 family residential mortgages 497 (79 ) — — 418
Home equity loans and lines 338 (17 ) (17 ) 14 318
Consumer 164 154 (151 ) 34 201
Unallocated 461 (260 ) N/A N/A 201
Total $ 8,834 $ 925 $ (426 ) $ 161 $ 9,494

As previously discussed, the Company maintains a loan review system, which includes a continuous review of the loan portfolio by internal and external parties to aid in the early identification of potential impaired loans. 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 loans and loans to state and political subdivisions by using either the present value of expected future cash flows discounted at the loan’s effective interest rate 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 mortgage loans for impairment disclosures, unless such loans are part of a larger relationship that is impaired or are classified as a troubled debt restructuring or on non-accrual.

An allowance for loan losses is established for an impaired loan if its carrying value exceeds its estimated fair value. The estimated fair values of the majority of the Company’s impaired loans are measured based on the estimated fair value of the loan’s collateral.

For commercial loans secured by real estate, estimated fair values are determined primarily through third-party appraisals. When a real estate secured loan becomes impaired, a decision is made regarding whether an updated certified appraisal of the real estate is necessary. This decision is based on various considerations, including the age of the most recent appraisal, the loan-to-value ratio

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

based on the original appraisal and the condition of the property. Appraised values are discounted to arrive at the estimated selling price of the collateral, which is considered to be the estimated fair value. The discounts also include estimated costs to sell the property.

For commercial loans secured by non-real estate collateral, such as accounts receivable, inventory and equipment, estimated fair values are determined based on the borrower’s financial statements, inventory reports, accounts receivable agings or equipment appraisals or invoices. Indications of value from these sources are generally discounted based on the age of the financial information or the quality of the assets.

From time to time, QNB may extend, restructure, or otherwise modify the terms of existing loans, on a case-by-case basis, to remain competitive and retain certain customers, as well as assist other customers that may be experiencing financial difficulties. A loan is considered to be a troubled debt restructuring (“TDR”) loan when the Company grants a concession to the borrower because of the borrower’s financial condition that it would not otherwise consider. Such concessions include the reduction of interest rates, forgiveness of principal or interest, or other modifications of interest rates to less than the current market rate for new obligations with similar risk. Loans classified as TDRs are considered non-performing and are also designated as impaired.

The concessions made for TDRs involve lowering the monthly payments on loans through periods of interest only payments, a reduction in interest rate below a market rate or an extension of the term of the loan without a corresponding adjustment to the risk premium reflected in the interest rate, or a combination of these three methods. The restructurings rarely result in the forgiveness of principal or accrued interest. If the borrower has demonstrated performance under the previous terms and our underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. Non-accruing restructured loans may be returned to accrual status when there has been a sustained period of repayment performance (generally six consecutive months of payments) and both principal and interest are deemed collectible. TDR loans that are in compliance with their modified terms and that yield a market rate may be removed from the TDR status after a period of performance.

Performing TDRs (not reported as non-accrual or past due 90 days or more and still accruing) totaled $4,665,000 and $4,760,000 as of September 30, 2020 and December 31, 2019, respectively. Non-performing TDRs totaled $899,000 and $1,131,000 as of September 30, 2020 and December 31, 2019, respectively. All TDRs are included in impaired loans.

The following table illustrates the specific reserve for loan losses allocated to loans modified as TDRs. These specific reserves are included in the allowance for loan losses for loans individually evaluated for impairment.

September 30, 2020 December 31, 2019
Unpaid<br><br><br>principal<br><br><br>balance Related<br><br><br>allowance Unpaid<br><br><br>principal<br><br><br>balance Related<br><br><br>allowance
TDRs with no specific allowance recorded $ 2,208 $ — $ 2,957 $ —
TDRs with an allowance recorded 3,356 543 2,934 450
Total $ 5,564 $ 543 $ 5,891 $ 450

There were no newly identified TDRs during the nine months ended September 30, 2020.  As of September 30, 2020, QNB had $13,000 in commitments to lend additional funds to customers with loans whose terms have been modified in troubled debt restructurings and no commitments at December 31, 2019. There were no charge-offs during the three and nine months ended September 30, 2020 and 2019, resulting from loans previously modified as TDRs.

There were no loans modified as TDRs within 12 months prior to September 30, 2020 and 2019 for which there was a payment default (60 days or more past due) during the nine months ended September 30, 2020 and 2019.

The Company has three loans secured by residential real estate for which foreclosure proceedings are in process at September 30, 2020. The total recorded investment is $398,000.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following tables present the balance in the allowance for loan losses at September 30, 2020 and December 31, 2019 disaggregated on the basis of the Company’s impairment method by class of loans receivable along with the balance of loans receivable by class, excluding unearned fees and costs, disaggregated on the basis of the Company’s impairment methodology:

Allowance for Loan Losses Loans Receivable
September 30, 2020 Balance Balance related<br><br><br>to loans<br><br><br>individually<br><br><br>evaluated for<br><br><br>impairment Balance related<br><br><br>to loans<br><br><br>collectively<br><br><br>evaluated for<br><br><br>impairment Balance Balance<br><br><br>individually<br><br><br>evaluated for<br><br><br>impairment Balance<br><br><br>collectively<br><br><br>evaluated for<br><br><br>impairment
Commercial:
Commercial and industrial $ 4,820 $ 3,268 $ 1,552 $ 227,448 $ 5,025 $ 222,423
Construction 301 — 301 50,187 — 50,187
Secured by commercial real estate 3,269 375 2,894 351,012 6,459 344,553
Secured by residential real estate 834 52 782 80,278 1,940 78,338
State and political subdivisions 121 — 121 34,489 — 34,489
Retail:
1-4 family residential mortgages 527 — 527 76,020 810 75,210
Home equity loans and lines 287 3 284 65,189 739 64,450
Consumer 267 9 258 5,490 63 5,427
Unallocated 339 N/A N/A N/A N/A N/A
Total $ 10,765 $ 3,707 $ 6,719 $ 890,113 $ 15,036 $ 875,077
Allowance for Loan Losses Loans Receivable
--- --- --- --- --- --- --- --- --- --- --- --- ---
December 31, 2019 Balance Balance related<br><br><br>to loans<br><br><br>individually<br><br><br>evaluated for<br><br><br>impairment Balance related<br><br><br>to loans<br><br><br>collectively<br><br><br>evaluated for<br><br><br>impairment Balance Balance<br><br><br>individually<br><br><br>evaluated for<br><br><br>impairment Balance<br><br><br>collectively<br><br><br>evaluated for<br><br><br>impairment
Commercial:
Commercial and industrial $ 4,689 $ 3,307 $ 1,382 $ 168,031 $ 6,027 $ 162,004
Construction 590 — 590 56,209 — 56,209
Secured by commercial real estate 2,519 217 2,302 336,050 7,172 328,878
Secured by residential real estate 629 31 598 72,443 2,082 70,361
State and political subdivisions 115 — 115 38,376 — 38,376
Retail:
1-4 family residential mortgages 549 — 549 69,469 955 68,514
Home equity loans and lines 310 — 310 73,311 555 72,756
Consumer 230 11 219 6,530 69 6,461
Unallocated 256 N/A N/A N/A N/A N/A
Total $ 9,887 $ 3,566 $ 6,065 $ 820,419 $ 16,860 $ 803,559

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table summarizes additional information, in regards to impaired loans by loan portfolio class, as of September 30, 2020 and December 31, 2019:

September 30, 2020 December 31, 2019
Recorded<br><br><br>investment<br><br><br>(after<br><br><br>charge-offs) Unpaid<br><br><br>principal<br><br><br>balance Related<br><br><br>allowance Recorded<br><br><br>investment<br><br><br>(after<br><br><br>charge-offs) Unpaid<br><br><br>principal<br><br><br>balance Related<br><br><br>allowance
With no specific allowance recorded:
Commercial:
Commercial and industrial $ 799 $ 930 $ 901 $ 1,258
Construction — — — —
Secured by commercial real estate 3,125 3,747 3,735 4,362
Secured by residential real estate 1,371 1,557 1,936 2,110
Retail:
1-4 family residential mortgages 810 889 955 1,010
Home equity loans and lines 554 586 555 612
Consumer — — — —
Total $ 6,659 $ 7,709 $ 8,082 $ 9,352
With an allowance recorded:
Commercial:
Commercial and industrial $ 4,226 $ 5,811 $ 3,268 $ 5,126 $ 6,577 $ 3,307
Construction — — — — — —
Secured by commercial real estate 3,334 3,439 375 3,437 3,495 217
Secured by residential real estate 569 575 52 146 193 31
Retail:
1-4 family residential mortgages — — — — — —
Home equity loans and lines 185 194 3 — — —
Consumer 63 75 9 69 79 11
Total $ 8,377 $ 10,094 $ 3,707 $ 8,778 $ 10,344 $ 3,566
Total:
Commercial:
Commercial and industrial $ 5,025 $ 6,741 $ 3,268 $ 6,027 $ 7,835 $ 3,307
Construction — — — — — —
Secured by commercial real estate 6,459 7,186 375 7,172 7,857 217
Secured by residential real estate 1,940 2,132 52 2,082 2,303 31
Retail:
1-4 family residential mortgages 810 889 — 955 1,010 —
Home equity loans and lines 739 780 3 555 612 —
Consumer 63 75 9 69 79 11
Total $ 15,036 $ 17,803 $ 3,707 $ 16,860 $ 19,696 $ 3,566

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table presents additional information regarding the average recorded investment and interest income recognized on impaired loans:

For the Nine Months Ended September 30, 2020 2019
Average<br><br><br>recorded<br><br><br>investment Interest income<br><br><br>recognized Average<br><br><br>recorded<br><br><br>investment Interest income<br><br><br>recognized
Commercial:
Commercial and industrial $ 5,401 $ 4 $ 4,127 $ 1
Construction — — — —
Secured by commercial real estate 6,793 128 4,468 81
Secured by residential real estate 2,014 53 1,716 30
Retail:
1-4 family residential mortgages 849 8 1,060 9
Home equity loans and lines 661 1 198 1
Consumer 68 — 74 —
Total $ 15,786 $ 194 $ 11,643 $ 122
  1. FAIR VALUE MEASUREMENTS AND DISCLOSURES

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants (fair values are not adjusted for transaction costs). ASC 820 also establishes a framework (fair value hierarchy) for measuring fair value under U.S. GAAP and expands disclosures about fair value measurements.

ASC 820 establishes a fair value hierarchy that prioritizes the inputs to valuation methods used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are as follows:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
Level 2: Quoted prices in markets that are not active, or inputs that are observable either directly or indirectly, for substantially the full term of the asset or liability.
--- ---
Level 3: Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported with little or no market activity).
--- ---

An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The measurement of fair value should be consistent with one of the following valuation techniques: market approach, income approach, and/or cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities (including a business). For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables. Multiples might lie in ranges with a different multiple for each comparable. The selection of where within the range the appropriate multiple falls requires judgment, considering factors specific to the measurement (qualitative and quantitative). Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the security’s relationship to other benchmark quoted securities.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis and the fair value measurements by level within the fair value hierarchy as of September 30, 2020:

September 30, 2020 Quoted prices<br><br><br>in active<br><br><br>markets<br><br><br>for identical<br><br><br>assets<br><br><br>(Level 1) Significant<br><br><br>other<br><br><br>observable<br><br><br>inputs<br><br><br>(Level 2) Significant<br><br><br>unobservable<br><br><br>inputs<br><br><br>(Level 3) Balance at end<br><br><br>of period
Recurring fair value measurements
Available-for-sale securities:
U.S. Government agency securities $ — $ 81,533 $ — $ 81,533
State and municipal securities — 77,016 — 77,016
U.S. Government agencies and sponsored<br><br><br>enterprises (GSEs):
Mortgage-backed securities — 176,982 — 176,982
Collateralized mortgage obligations (CMOs) — 101,843 — 101,843
Pooled trust preferred securities — — 68 68
Corporate debt securities — 7,174 — 7,174
Total debt securities available-for-sale — 444,548 68 444,616
Equity securities 11,691 — — 11,691
Total recurring fair value measurements $ 11,691 $ 444,548 $ 68 $ 456,307
Nonrecurring fair value measurements*
Impaired loans $ — $ — $ 4,670 $ 4,670
Mortgage servicing rights — — 326 326
Total nonrecurring fair value measurements $ — $ — $ 4,996 $ 4,996
*Impairment

There were no transfers in and out of Level 1 and Level 2 fair value measurements during the three or nine months ended September 30, 2020. There were also no transfers in or out of Level 3 for the same periods. There were no losses included in earnings attributable to the change in unrealized gains or losses relating to the available-for-sale securities above with fair value measurements utilizing significant unobservable inputs for the three- or nine-month period ended September 30, 2020.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following table sets forth QNB’s financial assets measured at fair value on a recurring and nonrecurring basis, showing the fair value measurements by level within the fair value hierarchy, as of December 31, 2019:

December 31, 2019 Quoted prices<br><br><br>in active<br><br><br>markets<br><br><br>for identical<br><br><br>assets<br><br><br>(Level 1) Significant<br><br><br>other<br><br><br>observable<br><br><br>inputs<br><br><br>(Level 2) Significant<br><br><br>unobservable<br><br><br>inputs<br><br><br>(Level 3) Balance at end<br><br><br>of period
Recurring fair value measurements
Debt securities available-for-sale
U.S. Government agency securities $ — $ 69,298 $ — $ 69,298
State and municipal securities — 50,781 — 50,781
U.S. Government agencies and sponsored<br><br><br>enterprises (GSEs):
Mortgage-backed securities — 134,829 — 134,829
Collateralized mortgage obligations (CMOs) — 86,610 — 86,610
Pooled trust preferred securities — — 79 79
Corporate debt securities — 8,113 — 8,113
Total debt securities available-for-sale — 349,631 79 349,710
Equity securities 9,164 — — 9,164
Total recurring fair value measurements $ 9,164 $ 349,631 $ 79 $ 358,874
Nonrecurring fair value measurements*
Impaired loans $ — $ — $ 5,212 $ 5,212
Mortgage servicing rights — — 7 7
Total nonrecurring fair value measurements $ — $ — $ 5,219 $ 5,219
*Impairment

The following table presents additional quantitative information about assets measured at fair value on a nonrecurring basis and for which QNB has utilized Level 3 inputs to determine fair value:

Quantitative information about Level 3 fair value measurements
September 30, 2020 Fair value Valuation<br><br><br>techniques Unobservable<br><br><br>inputs Value or range<br><br><br>of values
Impaired loans $ 3,712 Appraisal of collateral (1) Appraisal adjustments (2) -10% to -30%
Liquidation expenses (3) -10 %
Impaired loans 922 Financial statement values for UCC collateral Financial statement value discounts (5) -20% to -100%
Impaired loans 36 Used commercial vehicle guides Guide value discounts (4) -30 %
Mortgage servicing rights 326 Discounted cash flow Remaining term 2 to 30 years
Discount rate 12.0% to 12.5%

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Quantitative information about Level 3 fair value measurements
December 31, 2019 Fair value Valuation<br><br><br>techniques Unobservable<br><br><br>inputs Value or range<br><br><br>of values
Impaired loans $ 4,655 Appraisal of collateral (1) Appraisal adjustments (2) -5% to -40%
Liquidation expenses (3) -10 %
Impaired loans 521 Financial statement values for UCC collateral Financial statement value discounts (5) -30% to -100%
Impaired loans 36 Used commercial vehicle guides Guide value discounts (4) -30 %
Mortgage servicing rights 7 Discounted cash flow Remaining term 2 to 27 years
Discount rate 12.0% to 12.5%
(1) Fair value is primarily determined through appraisals of the underlying collateral by independent parties, which generally includes various Level 3 inputs which are not always identifiable.
--- ---
(2) Appraisals may be adjusted by management for qualitative factors such as economic conditions and the age of the appraisal. The range is presented as a percent of the initial appraised value.
--- ---
(3) Appraisals and pending agreements of sale are adjusted by management for estimated liquidation expenses. The range is presented as a percent of the initial appraised value.
--- ---
(4) If lendable value (lower than wholesale) is utilized then no additional discounts are taken. If lendable value is not provided, additional discounts are applied.
--- ---
(5) Values obtained from financial statements for UCC collateral (fixed assets and inventory) are discounted to estimated realizable liquidation value.
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The following table presents additional information about the available-for-sale securities measured at fair value on a recurring basis and for which QNB utilized significant unobservable inputs (Level 3 inputs) to determine fair value for the nine months ended September 30, 2020 and 2019:

Fair value measurements<br><br><br>using significant<br><br><br>unobservable inputs<br><br><br>(Level 3)
2020 2019
Balance, January 1, $ 79 $ 116
Payments received (1 ) (36 )
Total gains or losses (realized/unrealized)
Included in earnings — —
Included in other comprehensive (loss) income (10 ) (2 )
Transfers in and/or out of Level 3 — —
Balance, September 30, $ 68 $ 78

The Level 3 securities consist of one collateralized debt obligation security, the PreTSL security, which is backed by trust preferred securities issued by banks. The market for this security at September 30, 2020 was not active and markets for similar securities also are not active.  The new issue market is also inactive and there are currently very few market participants who are willing and or able to transact for these securities.

Given conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:

• The few observable transactions and market quotations that are available are not reliable for purposes of determining fair value at September 30, 2020;
• An income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates; and
--- ---

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

• The PreTSL will be classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date.

QNB used an independent third party to value this security using a discounted cash flow analysis. Based on management’s review of the bond’s three underlying issuers, there are no expected credit losses or prepayments; cashflows used were contractual based on the Bloomberg YA screen.  The assumed cashflows have been discounted using an estimated market discount rate based on the 30-year swap rate.  The 30-year is used as the reference rate since it is indicative of market expectation for short-term rates in the future.  This is consistent with the 30-year nature of  the PreTSL security, which is priced using the 3-month LIBOR as a reference rate.  The discount rate of 5.83% includes the risk-free rate, a credit component and a spread for illiquidity.

The following information should not be interpreted as an estimate of the fair value of the entire Company since a fair value calculation is only provided for a limited portion of QNB’s assets and liabilities. Due to a wide range of valuation techniques and the degree of subjectivity used in making the estimates, comparisons between QNB’s disclosures and those of other companies may not be meaningful.

The following methods and assumptions were used to estimate the fair values of each major classification of financial instrument and non-financial asset at September 30, 2020 and December 31, 2019:

Cash and cash equivalents, accrued interest receivable and accrued interest payable (carried at cost):  The carrying amounts reported in the balance sheet approximate those assets’ fair value.

Investment securities (carried at fair value):  The fair value of securities are primarily determined by obtaining quoted market prices on nationally recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 debt securities are valued by a third-party pricing service commonly used in the banking industry. Level 2 fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution date, market consensus prepayment speeds, credit information and the security’s terms and conditions, among other things. For certain securities which are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence (Level 3). In the absence of such evidence, management’s best estimate is used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Cash flow models using a present value formula that includes assumptions market participants would use along with indicative exit pricing obtained from broker/dealers (where available) were used to support fair values of certain Level 3 investments.

Restricted investment in stocks (carried at cost):  The fair value of stock in Atlantic Community Bankers Bank, the Federal Home Loan Bank and VISA Class B is the carrying amount, based on redemption provisions, and considers the limited marketability of and restrictions on such securities.

Loans Held for Sale (carried at lower of cost or fair value):  The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted prices exist, the fair value of a loan is determined using quoted prices for a similar loan or loans, adjusted for the specific attributes of that loan.

Loans Receivable (carried at cost): The fair values of loans are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the liquidity, credit and interest rate-risk inherent in the loans. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. Generally, for variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values.

Impaired Loans (generally carried at fair value):  Impaired loans are loans for which the Company has measured impairment generally based on the fair value of the loan’s collateral. Fair value is generally determined based upon independent third-party appraisals of the properties, or discounted cash flows based upon the expected proceeds. These assets are included as Level 3 fair values, based upon the lowest level of input that is significant to the fair value measurements.

Mortgage Servicing Rights (carried at lower of cost or fair value):  The fair value of mortgage servicing rights is based on a valuation model that calculates the present value of estimated net servicing income. The mortgage servicing rights are stratified into tranches

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

based on predominant characteristics, such as interest rate, loan type and investor type. The valuation incorporates assumptions that market participants would use in estimating future net servicing income.

Deposit liabilities (carried at cost):  The fair value of deposits with no stated maturity (e.g. demand deposits, interest-bearing demand accounts, money market accounts and savings accounts) are by definition, equal to the amount payable on demand at the reporting date (i.e. their carrying amounts). This approach to estimating fair value excludes the significant benefit that results from the low-cost funding provided by such deposit liabilities, as compared to alternative sources of funding. Deposits with a stated maturity (time deposits) have been valued using the present value of cash flows discounted at rates approximating the current market for similar deposits.

Short-term borrowings (carried at cost):  The carrying amount of short-term borrowings approximates their fair values.

Long-term debt (carried at cost):  Long-term debt has stated maturities and have been valued using the present value of cash flows discounted at rates approximating the current market for similar debt instruments.

Off-balance-sheet instruments (disclosed at cost):  The fair values for QNB’s off-balance sheet instruments (lending commitments and letters of credit) are based on fees currently charged in the market to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.

Management uses its best judgment in estimating the fair value of the Company’s financial instruments; however, there are inherent weaknesses in any estimation technique. Therefore, for substantially all financial instruments, the fair value estimates herein are not necessarily indicative of the amounts the Company could have realized in sales transaction on the dates indicated. The estimated fair value amounts have been measured as of the respective period ends and have not been re-evaluated or updated for purposes of these financial statements subsequent to those respective dates. As such, the estimated fair values of these financial instruments subsequent to the respective reporting dates may be different than the amounts reported at each period end.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The estimated fair values and carrying amounts of the Company’s financial and off-balance sheet instruments are summarized as follows:

Fair value measurements
September 30, 2020 Carrying<br><br><br>amount Fair value Quoted<br><br><br>prices in<br><br><br>active<br><br><br>markets for<br><br><br>identical<br><br><br>assets<br><br><br>(Level 1) Significant<br><br><br>other<br><br><br>observable<br><br><br>inputs<br><br><br>(Level 2) Significant<br><br><br>unobservable<br><br><br>inputs<br><br><br>(Level 3)
Financial assets
Cash and cash equivalents $ 37,520 $ 37,520 $ 37,520 $ — $ —
Investment securities:
Equities 11,691 11,691 11,691 — —
Available-for-sale 444,616 444,616 — 444,548 68
Restricted investment in stocks 1,041 1,041 — 1,041 —
Loans held-for-sale 9,077 9,435 — 9,435 —
Net loans 877,027 888,952 — — 888,952
Mortgage servicing rights 475 491 — — 491
Accrued interest receivable 4,674 4,674 — 4,674 —
Financial liabilities
Deposits with no stated maturities $ 1,010,709 $ 1,010,709 $ 1,010,709 $ — $ —
Deposits with stated maturities 203,754 206,280 — 206,280 —
Short-term borrowings 52,406 52,406 52,406 — —
Long-term debt 10,000 10,292 — 10,292 —
Accrued interest payable 447 447 — 447 —
Off-balance sheet instruments
Commitments to extend credit $ — $ — $ — $ — $ —
Standby letters of credit — 86 — 86 —

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Fair value measurements
December 31, 2019 Carrying<br><br><br>amount Fair value Quoted<br><br><br>prices in<br><br><br>active<br><br><br>markets for<br><br><br>identical<br><br><br>assets<br><br><br>(Level 1) Significant<br><br><br>other<br><br><br>observable<br><br><br>inputs<br><br><br>(Level 2) Significant<br><br><br>unobservable<br><br><br>inputs<br><br><br>(Level 3)
Financial assets
Cash and cash equivalents $ 17,608 $ 17,608 $ 17,608 $ — $ —
Investment securities:
Equities 9,164 9,164 9,164 — —
Available-for-sale 349,710 349,710 — 349,631 79
Restricted investment in stocks 1,073 1,073 — 1,073 —
Loans held-for-sale 977 997 — 997 —
Net loans 810,729 825,295 — — 825,295
Mortgage servicing rights 441 551 — — 551
Accrued interest receivable 2,828 2,828 — 2,828 —
Financial liabilities
Deposits with no stated maturities $ 802,284 $ 802,284 $ 802,284 $ — $ —
Deposits with stated maturities 235,576 235,557 — 235,557 —
Short-term borrowings 55,931 55,931 55,931 — —
Accrued interest payable 909 909 — 909 —
Off-balance sheet instruments
Commitments to extend credit $ — $ — $ — $ — $ —
Standby letters of credit — 47 — 47 —
  1. COMMITMENTS AND CONTINGENCIES

Financial Instruments with off-balance sheet risk:

In the normal course of business there are various legal proceedings, commitments, and contingent liabilities which are not reflected in the consolidated financial statements. Management does not anticipate any material losses as a result of these transactions and activities. They include, among other things, commitments to extend credit and standby letters of credit. The maximum exposure to credit loss, which represents the possibility of sustaining a loss due to the failure of the other parties to a financial instrument to perform according to the terms of the contract, is represented by the contractual amount of these instruments. QNB uses the same lending standards and policies in making credit commitments as it does for on-balance sheet instruments. The activity is controlled through credit approvals, control limits, and monitoring procedures.

A summary of the Company's financial instrument commitments is as follows:

September 30, December 31,
2020 2019
Commitments to extend credit and unused lines of credit $ 318,955 $ 273,088
Standby letters of credit 24,122 11,704
Total financial instrument commitments $ 343,077 $ 284,792

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. QNB evaluates each customer’s creditworthiness on a case-by-case basis.

Standby letters of credit are conditional commitments issued by the Company to guarantee the financial or performance obligation of a customer to a third party. QNB’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

for standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making conditional obligations as it does for on-balance sheet instruments. Standby letters of credit of $18,556,000 will expire within one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending other loan commitments. The Company requires collateral and personal guarantees supporting these letters of credit as deemed necessary. Management believes that the proceeds obtained through a liquidation of such collateral and the enforcement of personal guarantees would be sufficient to cover the maximum potential amount of future payments required under the corresponding guarantees. The amount of the liability as of September 30, 2020 and December 31, 2019 for guarantees under standby letters of credit issued is not material.

The amount of collateral obtained for letters of credit and commitments to extend credit is based on management’s credit evaluation of the customer. Collateral varies, but may include real estate, accounts receivable, marketable securities, pledged deposits, inventory or equipment.

Other commitments:

QNB has committed to various operating leases for several of their branch and office facilities. Some of these leases include specific provisions relating to rent increases.  Some of the leases contain renewal options to extend the initial terms of the lease for periods ranging from five to ten years and certain leases allow for multiple extensions.  During the nine months ended September 30, 2020, QNB renewed one lease and recorded an additional right-of-use asset in exchange for an operating lease liability of $1,086,000.

  1. REGULATORY RESTRICTIONS

Dividends payable by QNB and the Bank are subject to various limitations imposed by statutes, regulations and policies adopted by bank regulatory agencies. Under Federal and Pennsylvania banking law, the Bank is subject to certain restrictions on the amount of dividends that it may declare without prior regulatory approval. Under Federal Reserve regulations, the Bank is limited as to the amount it may lend affiliates, including QNB, unless such loans are collateralized by specific obligations.

Both the QNB and the Bank are subject to regulatory capital requirements administered by Federal banking agencies. Failure to meet minimum capital requirements can initiate actions by regulators that could have an effect on the financial statements. Under the framework for prompt corrective action, the Bank must meet capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items. The capital amounts and classification are also subject to qualitative judgments by the regulators. Management believes, as of September 30, 2020, that the Company and the Bank met capital adequacy requirements to which they were subject.

As of the most recent notification, the primary regulator of the Bank considered it to be “well capitalized” under the regulatory framework. There are no conditions or events since that notification that management believes have changed the classification. To be categorized as well capitalized, bank holding companies and insured depository institutions must maintain minimum ratios as set forth in the following table below.

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The Company and the Bank’s actual capital amounts and ratios are presented as follows:

Capital levels
Actual Adequately capitalized Well capitalized
September 30, 2020 Amount Ratio Amount Ratio Amount Ratio
Total risk-based capital (to risk-weighted assets):
The Company $ 136,502 14.23 % $ 76,745 8.00 % $ 95,931 10.00 %
Bank 124,749 13.51 73,892 8.00 92,365 10.00
Tier I capital (to risk-weighted assets):
The Company 125,652 13.10 57,558 6.00 57,558 6.00
Bank 113,899 12.33 55,419 6.00 73,892 8.00
Common equity tier 1 capital (to risk-weighted<br><br><br>assets):
The Company 125,652 13.10 43,169 4.50 N/A N/A
Bank 113,899 12.33 41,564 4.50 60,037 6.50
Tier I capital (to average assets):
The Company 125,652 8.90 56,459 4.00 N/A N/A
Bank 113,899 8.14 55,947 4.00 69,933 5.00
Capital levels
--- --- --- --- --- --- --- --- --- --- --- --- --- --- --- ---
Actual Adequately capitalized Well capitalized
As of December 31, 2019 Amount Ratio Amount Ratio Amount Ratio
Total risk-based capital (to risk-weighted assets):
The Company $ 130,412 13.82 % $ 75,498 8.00 % $ 94,373 10.00 %
Bank 118,389 12.93 73,270 8.00 91,587 10.00
Tier I capital (to risk-weighted assets):
The Company 120,452 12.76 56,624 6.00 56,624 6.00
Bank 108,429 11.84 54,952 6.00 73,270 8.00
Common equity tier 1 capital (to risk-weighted<br><br><br>assets):
The Company 120,452 12.76 42,468 4.50 N/A N/A
Bank 108,429 11.84 41,241 4.50 59,532 6.50
Tier I capital (to average assets):
The Company 120,452 9.78 49,283 4.00 N/A N/A
Bank 108,429 8.89 48,804 4.00 61,005 5.00

QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

12.  REVENUE RECOGNITION FROM CONTRACTS WITH CUSTOMERS

The Company generally fully satisfies its performance obligations on its contracts with customers as services are rendered and the transaction prices are typically fixed; charged either on a periodic basis or based on activity. Because performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers.  The main types of revenue contracts included in non-interest income within the consolidated statements of operations are as follows:

• Fees for services to customers—fees include service charges on deposits which are included as liabilities in the consolidated statement of financial position and consist of transaction-based fees, stop payment fees, Automated Clearing House (ACH) fees, account maintenance fees, and overdraft services fees for various retail and business checking customers.  These fees are charged as earned on the day of the transaction or within the month of the service, with the exception of Enhanced Account Analysis Fees, which are calculated on the previous month’s activity and assessed on the following month.  The Enhanced Account Analysis Fees are currently being accrued; the revenue is currently being recorded in the month it is earned.   Service charges on deposits are withdrawn directly from the customer’s account balance.
• ATM and debit card – fees are recognized at the time the transaction is executed as that is the point in time the Company fulfills the customer’s request.
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• Retail brokerage and advisory—fee income and related expenses are accrued monthly to properly record the revenues in the month they are earned.  Advisory fees are collected in advance on a quarterly basis.  These advisory fees are recorded in the first month of the quarter for which the service is being performed.     Fees that are transaction based are recognized at the point in time that the transaction is executed (i.e. trade date).
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• Merchant – QNB earns interchange fees from credit/debit cardholder transactions conducted through VISA/MasterCard payment networks.  Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.
--- ---
• Other—includes credit card fees, sales of checks to depositors, miscellaneous fees and gain/losses on sale of OREO.
--- ---
• Credit card fees are recognized monthly, concurrently with the transaction processing services provided to the cardholder within the month.
--- ---
• Sales of checks to depositors are commissions earned from a third-party who provides checks to QNB’s customers.  There is a pre-paid incentive with the third party which is recognized over the term of the contract.  Other commissions on the sales of checks are recorded weekly.
--- ---
• Miscellaneous fees, such as wire, cashier check and garnishment fees, are charged as earned on the day of the transaction.
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• Gain (loss) on sales of OREO – QNB records a gain or loss from the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. When the QNB finances the sale of OREO to the buyer, QNB assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable.  Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer.  In determining the gain or loss on the sale, QNB adjusts the transaction prices and related gain (loss) on sale if a significant financing component is present.
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QNB CORP. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

QNB CORP. AND SUBSIDIARY

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

QNB Corp. is a bank holding company headquartered in Quakertown, Pennsylvania. QNB Corp., through its wholly-owned subsidiary, the Bank, has been serving the residents and businesses of upper Bucks, northern Montgomery and southern Lehigh counties in Pennsylvania since 1877. Due to its limited geographic area, growth is pursued through expansion of existing customer relationships and building new relationships by stressing a consistent high level of service at all points of contact.  The Bank is a locally managed community bank that provides a full range of commercial and retail banking and retail brokerage services. The consolidated entity is referred to herein as “QNB” or the “Company”.

Tabular information presented throughout management’s discussion and analysis, other than share and per share data, is presented in thousands of dollars.

FORWARD-LOOKING STATEMENTS

In addition to historical information, this document contains forward-looking statements. Forward-looking statements are typically identified by words or phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides safe harbor in regard to the inclusion of forward-looking statements in this document and documents incorporated by reference.

Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, and including the risk factors identified in Item 1A of QNB’s 2019 Form 10-K, could affect the future financial results of QNB Corp. and its subsidiary and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this document. These factors include, but are not limited, to the following:

• Volatility in interest rates and shape of the yield curve;
• Credit risk;
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• Liquidity risk;
--- ---
• Operating, legal and regulatory risks;
--- ---
• Economic, political and competitive forces affecting QNB’s business;
--- ---
• The effects of unforeseen external events, including acts of terrorism, natural disasters, and pandemics, including the COVID-19 Pandemic; and
--- ---
• The risk that the analysis of these risks and forces could be incorrect, and/or that the strategies developed to address them could be unsuccessful.
--- ---

QNB cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which change over time, and QNB assumes no duty to update forward-looking statements. Management cautions readers not to place undue reliance on any forward-looking statements. These statements speak only as of the date of this report on Form 10-Q, even if subsequently made available by QNB on its website or otherwise, and they advise readers that various factors, including those described above, could affect QNB’s financial performance and could cause actual results or circumstances for future periods to differ materially from those anticipated or projected. Except as required by law, QNB does not undertake, and specifically disclaims any obligation, to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of QNB, which are prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and predominant practices within the banking industry. The preparation of these consolidated financial statements requires QNB to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. QNB evaluates estimates on an on-going basis, including those related to the determination of the allowance for loan losses, the determination of the valuation of other real estate owned and foreclosed assets, other-than-temporary impairments on investment

securities, the valuation of deferred tax assets, stock-based compensation and income taxes. QNB bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Other-Than-Temporary Investment Security Impairment

Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, it indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. For equity securities that do not have readily-determinable fair values, once a decline in value is determined to be other-than-temporary, the value of the equity security is reduced and a corresponding charge to earnings is recognized.  There were no other-than-temporary impairment charges recorded during the nine months ended September 30, 2020 and 2019, respectively.

The Company follows accounting guidance related to the recognition and presentation of other-than-temporary impairment that specifies (a) if a company does not have the intent to sell a debt security prior to recovery and (b) it is more likely than not that it will not have to sell the debt security prior to recovery, the security would not be considered other-than-temporarily impaired unless there is a credit loss. When an entity does not intend to sell the security, and it is more likely than not the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income. There were no credit-related other-than-temporary impairment charges in the nine months ended September 30, 2020 or 2019, respectively.

Allowance for Loan Losses

The determination of the allowance for loan losses involves a higher degree of judgment and complexity than the Company’s other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a level believed by management to be sufficient to absorb probable known and inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charged to earnings to bring the total allowance for loan losses to a level considered necessary by management.

The allowance for loan losses is based on management’s continual review and evaluation of the loan portfolio. The level of the allowance is determined by assigning specific reserves to individually identified problem credits and general reserves to all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of underlying collateral or present value of future estimated cash flows. The general reserves are based on the composition and risk characteristics of the loan portfolio, including the nature of the loan portfolio, credit concentration trends, delinquency and loss experience, as well as other qualitative factors such as current economic trends.

Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized to assess and monitor the degree of risk in the loan portfolio. QNB’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of collection. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan. An independent loan review group tests risk assessments and evaluates the adequacy of the allowance for loan losses. Management meets monthly to review the credit quality of the loan portfolio and quarterly to review the allowance for loan losses.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for loan losses. Such agencies may require QNB to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance for loan losses may be necessary and results of

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

operations could be affected. Because future events affecting borrowers and collateral cannot be predicted with certainty, increases to the allowance may be necessary should the quality of any loans deteriorate as a result of the factors discussed above.

Foreclosed Assets

Assets acquired through, or in lieu of, loan foreclosure are held-for-sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses and changes in the valuation allowance are included in net expenses from foreclosed assets.

Stock-Based Compensation

QNB sponsors stock-based compensation plans, administered by a Board committee, under which both qualified and non-qualified stock options may be granted periodically to certain employees. QNB accounts for all awards granted under stock-based compensation plans in accordance with ASC 718, Compensation-Stock Compensation. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. QNB estimates the fair value of stock options on the date of the grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.

Income Taxes

QNB accounts for income taxes under the asset/liability method in accordance with income tax accounting guidance, ASC 740, Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become available. Because the judgment about the level of future taxable income is dependent on matters that may, at least in part, be beyond QNB’s control, it is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.

RESULTS OF OPERATIONS - OVERVIEW

QNB reported net income for the third quarter of 2020 of $3,778,000, or $1.07 per share on a diluted basis, compared to net income of $3,090,000, or $0.88 per share on a diluted basis, for the same period in 2019. For the nine-month period ended September 30, 2020, QNB reported net income of $7,932,000, or $2.25 per share on a diluted basis, compared to net income of $9,612,000, or $2.75 per share on a diluted basis, for the same period in 2019. The Bank contributed $8,543,000 to net income for the first nine months of 2020 compared to $8,372,000 for the first nine months of 2019; whereas the holding company contributed a net loss of  $611,000 to the first nine months of 2020 compared to net income of $1,240,000 for the first nine months of 2019.  The net loss at the holding company resulted primarily from a decrease in the fair value of the equity portfolio during the first nine months of 2020.

Net income expressed as an annualized rate of return on average assets and average shareholders’ equity was 1.06% and 11.94%, respectively, for the quarter ended September 30, 2020 compared with 1.00% and 10.39%, respectively, for the quarter ended September 30, 2019. For the nine months ended September 30, 2020, the annualized rate of return on average assets and average shareholders’ equity was 0.80% and 8.56%, respectively, compared with 1.07% and 11.11%, for the same period in 2019.

Total assets as of September 30, 2020 were $1,417,073,000, compared with $1,225,023,000 at December 31, 2019. Loans receivable at September 30, 2020 were $887,792,000, compared with $820,616,000 at December 31, 2019, an increase of $67,176,000, or 8.2%, with commercial lending as the largest contributor to the growth. To date, the Bank originated $82,475,000 in the Small Business Administration’s Paycheck Protection Program (“PPP”) loans, enabling 660 businesses to maintain their payrolls and stay in operation.  Excluding PPP loans net of deferred fees, loans receivable at September 30, 2020 would have decreased $12,893,000, or 1.6% since year-end 2019.  Total deposits of $1,214,463,000 at September 30, 2020 increased $176,603,000, or 17.0%, compared with total deposits of $1,037,860,000 at December 31, 2019.  Most of the PPP loans proceeds were deposited to deposit accounts at the Bank.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Results for the three and nine months ended September 30, 2020 include the following significant components:

• Net interest income increased $148,000, or 1.6%, to $9,330,000 and $598,000, or 2.2%, to $27,727,000 for the three and nine months ended September 30, 2020, respectively.
• Net interest margin on a tax-equivalent basis decreased 36 basis points for the quarter and 21 basis points for year-to-date, to 2.78% and 2.96%, respectively.
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• QNB recorded $250,000 in provision for loan losses for the quarter and $1,000,000 for the nine months ended September 30, 2020, compared with $550,000 and $925,000 for the same periods in 2019, respectively.
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• Non-interest income increased $665,000, to $2,809,000 for the third quarter and decreased $2,052,000, or 33.6% for the nine months ended September 30, 2020 compared with the same periods in 2019.  Excluding realized and unrealized gains (losses) on equity securities, non-interest income increased $520,000, or 35.2%, to $1,999,000 for the quarter and $609,000, or 14.4%, to $4,851,000 for the nine months ended September 30, 2020 compared with the same periods in 2019.
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• Non-interest expense increased $242,000, or 3.5%, to $7,197,000 for the quarter and $872,000, or 4.3%, to $21,344,000 for the nine months ended September 30, 2020 compared to the same periods in 2019.
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• Total non-performing loans were $14,666,000, or 1.65% of loans receivable at September 30, 2020, compared to $16,464,000, or 2.01% of loans receivable at December 31, 2019. Loans on non-accrual status were $10,001,000 at September 30, 2020 compared with $11,704,000 at December 31, 2019. Net charge-offs for the nine months ended September 30, 2020 were $122,000, compared with $265,000 for the same period in 2019.
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These items, as well as others, are explained more thoroughly in the next sections.

NET INTEREST INCOME

QNB earns its net income primarily through the Bank. Net interest income, or the spread between the interest, dividends and fees earned on loans and investment securities and the expense incurred on deposits and other interest-bearing liabilities, is the primary source of operating income for QNB. Management seeks to achieve sustainable and consistent earnings growth while maintaining adequate levels of capital and liquidity and limiting its exposure to credit and interest rate risk levels approved by the Board of Directors.

The following table presents the adjustment to convert net interest income to net interest income on a fully taxable-equivalent basis for the three- and nine-month periods ended September 30, 2020 and 2019.

For the Three Months Ended September 30, For the Nine Months Ended September 30,
2020 2019 2020 2019
Total interest income $ 10,763 $ 11,817 $ 32,834 $ 34,818
Total interest expense 1,433 2,635 5,107 7,689
Net interest income 9,330 9,182 27,727 27,129
Tax-equivalent adjustment 170 200 523 593
Net interest income (fully taxable-equivalent) $ 9,500 $ 9,382 $ 28,250 $ 27,722

Net interest income is the primary source of operating income for QNB. Net interest income is interest income, dividends, and fees on earning assets, less interest expense incurred for funding sources. Earning assets primarily include loans, investment securities, interest bearing balances at the Federal Reserve Bank (Fed) and Federal funds sold. Sources used to fund these assets include deposits and borrowed funds. Net interest income is affected by changes in interest rates, the volume and mix of earning assets and interest-bearing liabilities, and the amount of earning assets funded by non-interest-bearing deposits.

For purposes of this discussion, interest income and the average yield earned on loans and investment securities are adjusted to a tax-equivalent basis as detailed in the tables that appear above. This adjustment to interest income is made for analysis purposes only. Interest income is increased by the amount of savings of Federal income taxes, which QNB realizes by investing in certain tax-exempt state and municipal securities and by making loans to certain tax-exempt organizations. In this way, the ultimate economic impact of earnings from various assets can be more easily compared.

The net interest rate spread is the difference between average rates received on earning assets and average rates paid on interest-bearing liabilities, while the net interest rate margin, which includes interest-free sources of funds, is net interest income expressed as a percentage of average interest-earning assets. The Asset/Liability and Investment Management Committee works to manage and maximize the net interest margin for the Company.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Average Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)
September 30, 2019
Average Average Average
Rate Interest Balance Rate Interest
Assets
Investment securities (AFS & Equity):
U.S. Treasury — 0.00 % $ — $ 2,615 2.20 % $ 15
U.S. Government agencies 80,485 1.24 249 67,552 1.79 303
State and municipal 68,521 3.02 516 51,370 3.64 467
Mortgage-backed and CMOs 255,667 1.45 924 221,778 2.13 1,180
Pooled trust preferred securities 85 2.65 — 91 4.38 1
Corporate debt securities 6,753 3.79 64 8,016 3.73 75
Equities 12,564 2.97 94 8,127 3.90 80
Total investment securities 424,075 1.74 1,847 359,549 2.36 2,121
Loans:
Commercial real estate 482,094 4.38 5,314 475,396 4.87 5,833
Residential real estate 79,660 3.73 742 67,121 3.98 668
Home equity loans 60,548 3.56 541 67,400 4.76 808
Commercial and industrial 223,413 3.69 2,070 154,506 5.17 2,013
Consumer loans 5,802 5.12 75 6,759 5.92 101
Tax-exempt loans 34,451 3.66 317 51,683 3.35 437
Total loans, net of unearned income* 885,968 4.07 9,059 822,865 4.75 9,860
Other earning assets 49,130 0.22 27 3,289 4.35 36
Total earning assets 1,359,173 3.20 10,933 1,185,703 4.02 12,017
Cash and due from banks 24,772 15,377
Allowance for loan losses (10,572 ) (9,238 )
Other assets 38,104 33,934
Total assets 1,411,477 $ 1,225,776
Liabilities and Shareholders' Equity
Interest-bearing deposits:
Interest-bearing demand 263,099 0.22 % 146 $ 212,898 0.48 % 260
Municipals 138,587 0.37 128 128,140 1.82 586
Money market 96,062 0.34 83 80,543 0.78 158
Savings 301,415 0.33 248 240,431 0.66 401
Time 112,211 1.35 380 123,078 1.63 507
Time of 100,000 or more 94,080 1.50 355 112,110 1.95 551
Total interest-bearing deposits 1,005,454 0.53 1,340 897,200 1.09 2,463
Short-term borrowings 54,487 0.39 53 55,275 1.23 172
Long-term debt 10,000 1.57 40 — — —
Total interest-bearing liabilities 1,069,941 0.53 1,433 952,475 1.10 2,635
Non-interest-bearing deposits 206,272 146,894
Other liabilities 9,375 8,423
Shareholders' equity 125,889 117,984
Total liabilities and shareholders' equity 1,411,477 $ 1,225,776
Net interest rate spread 2.67 % 2.92 %
Margin/net interest income 2.78 % $ 9,500 3.14 % $ 9,382

All values are in US Dollars.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS
September 30, 2019
Average Average Average
Rate Interest Balance Rate Interest
Assets
Investment securities (AFS & Equity):
U.S. Treasury — 0.00 % $ — $ 1,526 2.33 % $ 27
U.S. Government agencies 61,412 1.49 687 69,991 1.81 949
State and municipal 61,796 3.21 1,487 56,081 3.54 1,491
Mortgage-backed and CMOs 233,483 1.75 3,056 214,768 2.18 3,519
Pooled trust preferred securities 85 3.32 2 112 4.86 4
Corporate debt securities 7,431 3.68 205 8,020 3.76 226
Equities 12,077 3.16 285 8,840 3.32 219
Total investment securities 376,284 2.03 5,722 359,338 2.39 6,435
Loans:
Commercial real estate 478,987 4.54 16,285 460,231 4.84 16,655
Residential real estate 74,569 3.84 2,147 67,273 3.96 1,997
Home equity loans 62,291 3.89 1,812 68,332 4.74 2,421
Commercial and industrial 200,220 4.04 6,049 155,773 5.40 6,296
Consumer loans 6,099 5.35 244 6,853 6.06 311
Tax-exempt loans 36,997 3.61 1,000 47,730 3.36 1,200
Total loans, net of unearned income* 859,163 4.28 27,537 806,192 4.79 28,880
Other earning assets 38,894 0.34 98 2,829 4.54 96
Total earning assets 1,274,341 3.50 33,357 1,168,359 4.05 35,411
Cash and due from banks 18,289 13,293
Allowance for loan losses (10,307 ) (9,088 )
Other assets 37,625 32,762
Total assets 1,319,948 $ 1,205,326
Liabilities and Shareholders' Equity
Interest-bearing deposits:
Interest-bearing demand 247,529 0.28 % 523 $ 211,558 0.47 % 750
Municipals 117,166 0.66 576 108,796 1.94 1,577
Money market 88,611 0.49 325 93,931 0.95 670
Savings 278,997 0.43 893 243,203 0.66 1,206
Time 115,123 1.45 1,252 120,750 1.56 1,405
Time of 100,000 or more 101,459 1.64 1,247 107,710 1.89 1,523
Total interest-bearing deposits 948,885 0.68 4,816 885,948 1.08 7,131
Short-term borrowings 50,830 0.51 195 57,441 1.30 558
Long-term debt 8,084 1.57 96 — — —
Total interest-bearing liabilities 1,007,799 0.68 5,107 943,389 1.09 7,689
Non-interest-bearing deposits 178,775 138,878
Other liabilities 9,572 7,430
Shareholders' equity 123,802 115,629
Total liabilities and shareholders' equity 1,319,948 $ 1,205,326
Net interest rate spread 2.82 % 2.96 %
Margin/net interest income 2.96 % $ 28,250 3.17 % $ 27,722

All values are in US Dollars.

Tax-exempt securities and loans were adjusted to a tax-equivalent basis and are based on the marginal Federal corporate tax rate of 21 percent for three and nine months ended September 30, 2020 and 2019.

Non-accrual loans are included in earning assets.

* Includes loans held-for-sale

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Rate/Volume Analysis. The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated to changes in volume.

For the Nine Months Ended
September 30, 2020 compared
to September 30, 2019
Due to change in: Total Due to change in:
Volume Rate Change Volume Rate
Interest income:
Investment securities (AFS & Equity):
U.S. Treasury (15 ) $ (15 ) $ — $ (27 ) $ (27 ) $ —
U.S. Government agencies (54 ) 58 (112 ) (262 ) (116 ) (146 )
State and municipal 49 156 (107 ) (4 ) 151 (155 )
Mortgage-backed and CMOs (256 ) 181 (437 ) (463 ) 306 (769 )
Pooled trust preferred securities (1 ) (1 ) — (2 ) (1 ) (1 )
Corporate debt securities (11 ) (12 ) 1 (21 ) (17 ) (4 )
Equities 14 43 (29 ) 66 81 (15 )
Total Investment securities (AFS & Equity) (274 ) 410 (684 ) (713 ) 377 (1,090 )
Loans:
Commercial real estate (519 ) 67 (586 ) (370 ) 695 (1,065 )
Residential real estate 74 124 (50 ) 150 217 (67 )
Home equity loans (267 ) (84 ) (183 ) (609 ) (212 ) (397 )
Commercial and industrial 57 889 (832 ) (247 ) 1,804 (2,051 )
Consumer loans (26 ) (14 ) (12 ) (67 ) (34 ) (33 )
Tax-exempt loans (120 ) (147 ) 27 (200 ) (269 ) 69
Total Loans (801 ) 835 (1,636 ) (1,343 ) 2,201 (3,544 )
Other earning assets (9 ) 501 (510 ) 2 1,225 (1,223 )
Total interest income (1,084 ) 1,746 (2,830 ) (2,054 ) 3,803 (5,857 )
Interest expense:
Interest-bearing deposits:
Interest-bearing demand (114 ) 60 (174 ) (227 ) 128 (355 )
Municipals (458 ) 47 (505 ) (1,001 ) 124 (1,125 )
Money market (75 ) 29 (104 ) (345 ) (38 ) (307 )
Savings (153 ) 100 (253 ) (313 ) 179 (492 )
Time (127 ) (46 ) (81 ) (153 ) (64 ) (89 )
Time of 100,000 or more (196 ) (90 ) (106 ) (276 ) (87 ) (189 )
Total interest-bearing deposits (1,123 ) 100 (1,223 ) (2,315 ) 242 (2,557 )
Short-term borrowings (119 ) (3 ) (116 ) (363 ) (63 ) (300 )
Long-term debt 40 — 40 96 — 96
Total interest expense (1,202 ) 97 (1,299 ) (2,582 ) 179 (2,761 )
Net interest income 118 $ 1,649 $ (1,531 ) $ 528 $ 3,624 $ (3,096 )

All values are in US Dollars.

Net Interest Income and Net Interest Margin – Quarterly Comparison

Average earning assets for the third quarter of 2020 were $1,359,173,000, an increase of $173,470,000 or 14.6%, from the third quarter of 2019, with average loans increasing $63,103,000, or 7.7%, and average investment securities increasing $64,526,000, or 17.9%, over the same period. Growth in the loan portfolio supports interest income and the net interest margin as loans generally earn a higher yield than investment securities. Average loans as a percent of average earning assets were 65.2% for the third quarter of 2020, compared with 69.4% for the third quarter of 2019. On the funding side, average deposits increased $167,632,000, or 16.1%, to $1,211,726,000 for the third quarter of 2020 primarily due to growth in non-interest-bearing and interest-bearing demand and savings deposits. Customers continue to reinvest funds into more liquid accounts. Average short-term borrowed funds for the third quarter of 2020 decreased $788,000, to $54,487,000, which consisted entirely of average commercial repurchase agreements during the third

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

quarter of 2020.  For the same period in 2019, borrowings consisted of average commercial repurchase agreements of $39,016,000 and average overnight borrowings of $16,259,000.

The net interest margin for the third quarter of 2020 decreased 36 basis points to 2.78% from 3.14% at the same period in 2019. While competition for quality loans in our local market continues to exert pressure on the net interest margin, prime rate fluctuations during 2019 and 2020 have provided increased competitive pricing pressure on deposits.

The Rate-Volume Analysis tables, as presented on a tax-equivalent basis, highlight the impact of changing rates and volumes on interest income and interest expense. Total interest income on a tax-equivalent basis decreased $1,084,000, or 9.0%, to $10,933,000 for the third quarter of 2020; total interest expense decreased $1,202,000, or 45.6%, to $1,433,000. Decrease in rates on earning assets contributed to the decrease in interest income. All categories of interest-bearing deposits, experienced lower rates in the third quarter of 2020 compared to third quarter of 2019, due to rate decreases for municipal deposits indexed to Fed Funds, a 45-basis point rate decrease to the eSavings, a 35-basis point decrease in Rewards products and a 15-basis point decrease in the top tiers of the Money Market product since September 30, 2019.

The yield on earning assets on a tax-equivalent basis decreased 82 basis points from 4.02% for the third quarter of 2019, to 3.20% for the third quarter of 2020. The cost of interest-bearing liabilities was 0.53% for the third quarter ended September 30, 2020, compared with 1.10% for the same period in 2019.

Interest income on investment securities (available-for-sale and equity) decreased $274,000 when comparing the quarters ended September 30, 2020 and 2019. The average yield on the investment portfolio was 1.74% for the third quarter of 2020 compared with 2.36% for the third quarter of 2019.

Income on U.S. Government agency securities decreased $54,000 as the rate decreased 55 basis points, partially offset by an increase in average balances of $12,933,000.

Interest income on municipal securities, which are primarily tax-exempt, increased due to a $17,151,000 increase in average balances.  Proceeds from matured, called securities and proceeds from deposits were invested back into the U.S. Government agency, municipal and mortgage-backed securities portfolios. Typically, QNB purchases municipal bonds with 10-20-year maturities and may have call dates between 2-10 years.

Interest income on mortgage-backed securities and CMOs decreased $256,000 due to a 68-basis point decline in yield partially offset by a $33,889,000 increase in average balances. This portfolio generally provides higher yields relative to agency bonds and also provides monthly cash flow which can be used for liquidity purposes or can be reinvested as interest rates increase. Since most of these securities were purchased at a premium, any prepayments result in a shorter amortization period of this premium and therefore a reduction in income.

Income on loans decreased $801,000 to $9,059,000 when comparing the third quarters of 2020 and 2019, with a 7.7% growth in average balances contributing an increase in interest income of $835,000. The yield on loans, at 4.07%, was 68 basis points lower than the third quarter of 2019, contributing to a $1,636,000 decrease in interest income.  Competitive pressures compressed the yields on new loans being originated.

The largest category of the loan portfolio is commercial real estate loans. This category of loans includes commercial purpose loans secured by either commercial properties such as office buildings, factories, warehouses, medical facilities and retail establishments, or residential real estate, usually the residence of the business owner. The category also includes construction and land development loans. Income on commercial real estate loans decreased $519,000 when comparing the third quarters of 2020 and 2019, primarily due to a 49-basis point decrease in rate from 4.87% in 2019 to 4.38% in 2020. Average balances increased $6,698,000, to $482,094,000 for the quarter ended September 30, 2020 compared with the same quarter in 2019.

Income on commercial and industrial loans increased $57,000 when comparing the third quarters of 2020 and 2019. The average yield on these loans decreased 148 basis points to 3.69% resulting in a decrease in income of $832,000; average balances increased $68,907,000, to $223,413,000 for the third quarter of 2020 resulting in an $889,000 increase in interest income. Many of the loans in this category are indexed to the prime interest rate, which decreased 25 basis points in August 2019 with an additional decrease of 25 basis points in September 2019, 25 basis points in October and a total of 150 basis points in March 2020.  Included in this category are the PPP loans which contributed $79,409,000 of the net volume increase.  The PPP loans yield one percent to the customer, however

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

QNB received origination fees from the SBA ranging from one to five basis points, resulting in a yield of approximately 2.92% for the third quarter of 2020.   The PPP loans contributed 41 basis points to the decline in the average yield.

Tax-exempt loan income was $317,000 for the third quarter of 2020, an increase of $31,000 from the same period in 2019. Average balances decreased $17,232,000, or 33.3%, to $34,451,000 for the third quarter of 2020, resulting in a decrease of $147,000 in income. The yield on municipal loans increased 31 basis points, to 3.66% for the third quarter of 2020, compared with the same period in 2019, resulting in an increase of $27,000 in interest income.   The decrease in volume during 2020 was a result of municipal loans being refinanced as bonds.

QNB desires to become the “local consumer lender of choice” and to effect this QNB refocused its retail lending efforts, adding new product offerings and increasing marketing and promotion.  Average residential mortgage loans secured by first lien 1-4 family residential mortgages increased by $12,539,000, or 18.7%, to $79,660,000 for the third quarter of 2020 compared to the same period in 2019. Over this same timeframe, the average yield on the portfolio decreased 25 basis points to 3.73% for the third quarter of 2020. The combined result was a net increase in interest income of $74,000. Average home equity loans decreased by $6,852,000, or 10.2%, to $60,548,000 and the average yield decreased 120 basis points to 3.56% resulting in a combined decrease in interest income of $267,000. The yield on the consumer portfolio decreased 80 basis points to 5.12% for the third quarter of 2020 and there was a slight decrease in average balances resulting in a combined $26,000 decrease in interest income.

Earning assets are funded by deposits and borrowed funds. Interest expense decreased $1,202,000, when comparing the third quarter of 2020 to the same period in 2019.  The growth in average deposits continues to be centered in accounts with greater liquidity, such as non-interest and interest-bearing demand deposits. Average non-interest-bearing demand accounts increased $59,378,000, or 40.4%, to $206,272,000 for the third quarter of 2020. Average interest-bearing demand accounts increased $50,201,000, or 23.6%, to $263,099,000 for the third quarter of 2020. Interest expense on interest-bearing demand accounts decreased $114,000 to $146,000 for the same period, as the average rate paid decreased 26 basis points to 0.22% for the third quarter 2020. Included in this category is QNB-Rewards checking, a higher-rate checking account product that pays 1.00% on balances up to $25,000 and 0.20% for balances over $25,000. In order to receive the high rate a customer must receive an electronic statement, have one direct deposit or other ACH transaction and have at least 12 check card purchase transactions post and clear per statement cycle. For the third quarter of 2020, the average balance in this product was $78,033,000 and the related interest expense was $78,000 for an average yield of 0.40%. In comparison, the average balance of the QNB-Rewards accounts for the third quarter of 2019 was $58,638,000 and the related interest expense was $99,000 for an average yield of 0.67%. This product also generates fee income through the use of the check card.

Interest expense on municipal interest-bearing demand accounts decreased $458,000 to $128,000 for the third quarter of 2020. The average interest rate paid on municipal interest-bearing demand accounts decreased 145 basis points to 0.37% for the third quarter of 2020 and average balances increased $10,447,000, or 8.2%, to $138,587,000. Many of these accounts are indexed to the Federal funds rate with rate floors between 0.25% and 0.50%; therefore the 150-basis point decrease in the Federal funds rate in March 2020, affected the yield of these deposits. Municipal deposits are seasonal in nature and are received during the third and third quarters as tax receipts are collected and are withdrawn over the course of the year.

Average money market accounts increased $15,519,000, or 19.3%, to $96,062,000 for the third quarter of 2020 compared with the same period in 2019. Interest expense on money market accounts decreased $75,000 to $83,000, and the average interest rate paid on money market accounts decreased 44 basis points to 0.34% for the third quarter of 2020. Most of the balances in this category are in a product that pays a tiered rate based on account balances.

Interest expense on savings accounts decreased $153,000 when comparing the third quarter of 2020 to the third quarter of 2019. The average interest rate paid on savings accounts decreased 33 basis points to 0.33% for the third quarter of 2020. When comparing these same periods, average savings accounts increased $60,984,000, or 25.4%, to $301,415,000 for the third quarter of 2020 primarily due to increases in the e-Savings product. QNB’s online e-Savings product is the largest category of savings deposits, with average balances for the third quarter of 2020 of $216,627,000 compared to $169,491,000 in the same period of 2019. The average yield paid on these accounts was 0.40% for the third quarter of 2020 and 0.86% for the same period in 2019. Traditional statement savings accounts, passbook savings and club accounts are also included in the savings category and average balances in these types of savings accounts increased $13,848,000 when comparing the third quarter of 2020 average to the same period in 2019.

Interest expense on time deposits totaled $735,000 for the third quarter of 2020 compared to $1,058,000 in 2019. Average total time deposits decreased $28,897,000 to $206,291,000 for the third quarter of 2020. As with fixed-rate loans and investment securities, these deposits reprice over time and, therefore, have less of an immediate impact on costs in either a rising or falling rate environment,

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

however, the maturity and repricing characteristics of time deposits tend to be shorter. The average rate paid on total time deposits decreased 36 basis points from 1.78% to 1.42% when comparing the third quarter of 2019 to the same period in 2020.

Approximately $134,853,000, or 66%, of time deposits at September 30, 2020 will mature over the next 12 months. The average rate paid on these time deposits is approximately 1.31%. The yield on the time deposit portfolio may change slightly in the next quarter as short-term time deposits reprice. However, given the short-term nature of these deposits, interest expense may increase if short-term time deposit rates were to increase suddenly or if customers select higher paying time deposits.

Short-term borrowings are primarily comprised of sweep accounts structured as repurchase agreements with our commercial customers and overnight FHLB borrowings. Interest expense on short-term borrowings decreased $119,000 for the third quarter of 2020 to $53,000 when compared to the same period in 2019. When comparing these same periods, average balances decreased from $788,000 to $54,487,000 due to a decrease in average FHLB borrowings of $16,256,000 partially offset by an increase in average repurchase agreement balances of $15,468,000, with a combined 84-basis point decrease in rate.    During 2020, QNB borrowed long-term debt of $10,000,000 to lock in at a low yield.

Net Interest Income and Net Interest Margin – Nine-Month Comparison

For the nine-month period ending September 30, 2020 average earning assets increased $105,982,000, or 9.1%, to $1,274,341,000, with average loans increasing 6.6% and average investment securities increasing 4.7%. Average total deposits increased $102,834,000, or 10.0%, to $1,127,660,000 for the nine-month period ended September 30, 2020 compared to the same period in 2019. The net interest margin on a tax-equivalent basis was 2.96% for the nine-month period ended September 30, 2020, a 21-basis point decrease from the same period in 2019.

Total interest income on a tax-equivalent basis decreased $2,054,000, or 5.8%, to $33,357,000 from $35,411,000, when comparing the nine-month periods ended September 30, 2020 and September 30, 2019 due to a decrease in the level of interest rates and therefore lower yields. Interest income increased $3,803,000 as a result of volume and decreased $5,857,000 as a result of lower yields. The analysis of the nine-month comparison periods is similar to what was described in the quarterly analysis.

The yield on earning assets decreased from 4.05% to 3.50% for the nine-month periods with the yield on loans down 51 basis points to 4.28%. QNB continues to experience pressure on yields due to historically low levels of interest rates over the past several years and competitive pressures on loan pricing. The yield on investments decreased 36 basis points from 2.39% to 2.03% when comparing the nine-month periods.

Total interest expense decreased $2,582,000 for the nine-month period ended September 30, 2020 compared with the same period in 2019, attributable to a decrease in rates.   The average rate paid on interest bearing deposits decreased 40 basis points to 0.68% for the nine-month period ended September 30, 2020 versus the same period in 2019. QNB funded growth in loans with net proceeds from growth in deposits; QNB was therefore able to reduce its short-term cash needs resulting in decreased FHLB borrowings in the first nine months of 2020 compared with the same period in 2019. The average balance of total short-term borrowing decreased $6,611,000 and the average borrowing rate decreased 79 basis points resulting in a net decrease in interest expense of $363,000. During 2020, QNB borrowed long-term debt of $10,000,000 from the FHLB to lock in at a low yield. Average long-term debt was $10,000,000 with an average yield of 1.52%, 137 basis points lower than the yield on short-term FHLB borrowings. The yield on interest-bearing liabilities decreased 41 basis points to 0.68% for the first nine months of 2020.

PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES

The provision for loan losses represents management's determination of the amount necessary to be charged to operations to bring the allowance for loan losses to a level that represents management’s best estimate of the known and inherent losses in the existing loan portfolio. Management believes that it uses the best information available to make determinations about the adequacy of the allowance and that it has established its existing allowance for loan losses in accordance with U.S. GAAP. The determination of an appropriate level for the allowance for loan losses is based upon an analysis of the risks inherent in QNB’s loan portfolio. Management, in determining the allowance for loan losses, makes significant estimates and assumptions. Since the allowance for loan losses is dependent, to a great extent, on conditions that may be beyond QNB’s control, it is at least reasonably possible that management’s estimates of the allowance for loan losses and actual results could differ. In addition, various regulatory agencies, as an integral part of their examination process, periodically review QNB’s allowance for losses on loans. Such agencies may require QNB to recognize changes to the allowance based on their judgments about information available to them at the time of their examination. Actual loan losses, net of recoveries, serve to reduce the allowance.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Management closely monitors the quality of its loan portfolio and performs a quarterly analysis of the appropriateness of the allowance for loan losses. This analysis considers several relevant factors including  specific impairment reserves, historical loan loss experience, general economic conditions, levels of and trends in delinquent and non-performing loans, levels of classified loans, trends in the growth rate of loans and concentrations of credit.

Based on this analysis, QNB recorded $250,000 and $1,000,000 in provision for loan losses in the three and nine months ended September 30, 2020, respectively, compared with $550,000 and $925,000 for the same periods in 2019. QNB's allowance for loan losses of $10,765,000 represents 1.21% of loans receivable at September 30, 2020 compared with an allowance for loan losses of $9,887,000, or 1.20% of loans receivable, at December 31, 2019, and $9,494,000, or 1.14% of loans receivable at September 30, 2019. Management believes the allowance for loan losses at September 30, 2020 is adequate as of that date based on its analysis of known and inherent losses in the portfolio.  Excluding PPP loans, the allowance for loan losses of $10,765,000 represents 1.33% of loans receivable at September 30, 2020.

Net recoveries were $51,000 and net charge-offs were $122,000 for the three and nine months ended September 30, 2020 compared to net charge-offs of $220,000 and $265,000 for the same periods in 2019. Charge-offs of approximately $291,000 during the nine months ended September 30, 2020 consisted of commercial and industrial charge-offs of $72,000, overdraft charge-offs of $51,000, student loans of $144,000 and other consumer loans of $24,000. These were partially offset by $169,000 in recoveries comprising $131,000 in repayments from borrowers of previously charged-off credits, and $38,000 related to overdraft recoveries. Annualized net (recoveries) charge-offs as a percentage of average loans receivable were (0.02)% and 0.02% for the three and nine months ended September 30, 2020 compared with annualized charge-offs as a percentage of average loans receivable of 0.11% and 0.14% for the same period in 2019.

Non-performing assets were $14,666,000 at September 30, 2020 compared to $16,464,000 as of December 31, 2019 and $14,088,000 at September 30, 2019. Total non-performing loans, which represent loans on non-accrual status, loans past due 90 days or more and still accruing interest and restructured loans, were 1.65% of loans receivable at September 30, 2020 compared with 2.01% of loans receivable at December 31, 2019 and 1.70% of loans receivable at September 30, 2019.  In cases where there is a collateral shortfall on non-accrual loans, specific impairment reserves have been established based on updated collateral values even if the borrower continues to pay in accordance with the terms of the agreement. At September 30, 2020, $4,961,000, or approximately 50% of the loans classified as non-accrual are current or past due less than 30 days. Commercial loans classified as substandard or doubtful totaled $16,716,000, an increase of $794,000, or 5.0%, from the $15,922,000 reported at December 31, 2019 and a decrease of $269,000, or 1.6%, from the $16,985,000 reported at September 30, 2019. The increase in classified loans since year-end is due to the downgrade of one large credit which is partially offset by repayments on existing substandard loans.

QNB had no loans past due 90 days or more and still accruing interest at September 30, 2020, December 31, 2019, or September 30, 2019. Total loans 30 days or more past due, which includes non-accrual loans by actual number of days delinquent, represented 0.67% of loans receivable at September 30, 2020 compared with 0.85% at December 31, 2019 and 0.80% at September 30, 2019.

Troubled debt restructured loans, not classified as non-accrual loans or loans past due 90 days or more and accruing, were $4,665,000 at September 30, 2020, compared with $4,760,000 at December 31, 2019, and $1,643,000 at September 30, 2019. There were no newly identified troubled debt restructurings during the nine months ended September 30, 2020. QNB had no other real estate owned or repossessed assets at September 30, 2020, December 31, 2019, or September 30, 2019.

A loan is considered impaired, based on current information and events, if it is probable that QNB 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 shortfalls on a case-by-case basis, taking into consideration all the circumstances surrounding the loan and the borrower, including 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 loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral, if the loan is collateral dependent.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The following table shows detailed information and ratios pertaining to the Company’s loan and asset quality:

September 30, December 31, September 30,
2020 2019 2019
Non-accrual loans $ 10,001 $ 11,704 $ 12,445
Loans past due 90 days or more and still accruing interest — — —
Troubled debt restructured loans (not already included above) 4,665 4,760 1,643
Total non-performing loans 14,666 16,464 14,088
Total non-performing assets $ 14,666 $ 16,464 $ 14,088
Total loans (excluding loans held-for-sale):
Average total loans (YTD) $ 856,370 $ 811,413 $ 806,126
Total loans 887,792 820,616 830,556
Allowance for loan losses 10,765 9,887 9,464
Allowance for loan losses to:
Non-performing loans 73.40 % 60.05 % 67.39 %
Total loans (excluding held-for-sale) 1.21 % 1.20 % 1.14 %
Average total loans (excluding held-for-sale) 1.26 % 1.22 % 1.18 %
Non-performing loans / total loans (excluding held-for-sale) 1.65 % 2.01 % 1.70 %
Non-performing assets / total assets 1.03 % 1.34 % 1.13 %

An analysis of net loan charge-offs for the three and nine months ended September 30, 2020 compared to 2019 is as follows:

For the Three Months Ended September 30, For the Nine Months Ended September 30,
2020 2019 2020 2019
Net charge-offs $ (51 ) $ 220 $ 122 $ 265
Net annualized charge-offs to:
Total loans (0.02 %) 0.11 % 0.02 % 0.04 %
Average total loans excluding held-for-sale (0.02 %) 0.11 % 0.02 % 0.04 %
Allowance for loan losses (1.88 %) 9.19 % 1.51 % 3.73 %

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

At September 30, 2020 and December 31, 2019, the recorded investment in loans for which impairment has been identified totaled $15,036,000 and $16,860,000 of which $6,659,000 and $8,082,000, respectively, required no specific allowance for loan loss. The recorded investment in impaired loans requiring an allowance for loan losses was $8,377,000 and $8,778,000 at September 30, 2020 and December 31, 2019, respectively, and the related allowance for loan losses associated with these loans was $3,707,000 and $3,566,000, respectively. Most of the loans that have been identified as impaired are collateral-dependent. See Note 8 to the Notes to Consolidated Financial Statements for additional detail of impaired loans.

NON-INTEREST INCOME

Non-Interest Income Comparison
For the Three Months Ended September 30, Change from prior year For the Nine Months Ended September 30, Change from prior year
2020 2019 Amount Percent 2020 2019 Amount Percent
Net gain on sales of investment securities $ 198 $ 973 $ (775 ) -79.7 % $ 367 $ 1,563 $ (1,196 ) -76.5 %
Unrealized gain (loss) on investment equity securities 627 (305 ) 932 N/M (1,147 ) 266 (1,413 ) N/M
Fees for services to customers 299 432 (133 ) (30.8 ) 952 1,247 (295 ) (23.7 )
ATM and debit card 598 533 65 12.2 1,602 1,522 80 5.3
Retail brokerage and advisory 141 145 (4 ) (2.8 ) 423 419 4 1.0
Bank-owned life insurance 70 70 — - 207 208 (1 ) (0.5 )
Merchant 110 87 23 26.4 298 261 37 14.2
Net gain on sale of loans 589 63 526 N/M 1,035 112 923 N/M
Other 177 146 31 21.2 318 509 (191 ) (37.5 )
Total $ 2,809 $ 2,144 $ 665 31.0 % $ 4,055 $ 6,107 $ (2,052 ) -33.6 %

Quarter to Quarter Comparison

Total non-interest income for the third quarter of 2020 was $2,809,000, an increase of $665,000, compared to $2,144,000 for the third quarter of 2019. Excluding net realized and unrealized gains (losses) on equity securities for both periods, total non-interest income was $1,999,000 and $1,479,000 for the quarters ended September 30, 2020 and 2019, respectively, an increase of $520,000 or 35.2%.

During the third quarter of 2020, unrealized gains of $627,000 were recorded compared to unrealized losses of $305,000 in the same period of 2019. The unrealized gains and losses for the three months ended September 30, 2020 and 2019 resulted from the change in the fair value of the equities portfolio, the performance of which was consistent with the overall performance of the U.S. stock market for the periods. The equities portfolio comprises blue-chip large-capitalized stocks, providing a taxable equivalent dividend yield of 2.97%.  The estimated cumulative contribution (realized and unrealized net gains (losses), plus dividends) of the equity portfolio to earnings per share from January 1, 2008 through September 30, 2020 is $1.50 per diluted share.  Details of the equity portfolio’s contribution to net income is detailed in the following table.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Net Income (Expense) on Equity Securities
For the Year Ended December 31, For the Nine Months Ended September 30,
2015 2016 2017 2018 2019 2020 2019
Equity Securities:
Tax-equivalent dividends* $ 244 $ 233 $ 249 $ 300 $ 274 $ 285 $ 219
Net gain (loss)  on sales 691 758 1,557 (79 ) 1,781 351 1,599
OTTI (55 ) (192 ) (80 ) N/A N/A N/A N/A
Unrealized (loss) gain N/A N/A N/A (336 ) 770 (1,147 ) 266
Tax-equivalent income before tax 880 799 1,726 (115 ) 2,825 (511 ) 2,084
Tax expense (benefit)* 357 324 700 (33 ) 816 (148 ) 602
Net income $ 523 $ 475 $ 1,026 $ (82 ) $ 2,009 $ (363 ) $ 1,482
Earnings per share - basic $ 0.16 $ 0.14 $ 0.30 $ (0.02 ) $ 0.57 $ (0.10 ) $ 0.42
Earnings per share - diluted $ 0.16 $ 0.14 $ 0.30 $ (0.02 ) $ 0.57 $ (0.10 ) $ 0.42
Tax-equivalent yield* 3.35 % 3.13 % 3.49 % 3.08 % 3.31 % 3.16 % 3.32 %
*Based on Federal tax rates of 34% for the 2015 and 2016 periods and 21% for all 2017, 2018, 2019 and 2020 periods.

QNB originates residential mortgage loans for sale in the secondary market. Net gain on sale of loans increased $526,000 when comparing the two periods. The net gain on residential mortgage sales is directly related to the volume of mortgages sold and the timing of the sales relative to the interest rate environment. Residential mortgage loans to be sold are identified at origination. Proceeds from the sale of residential mortgages were $11,563,000 and $2,179,000 for the third quarters of 2020 and 2019, respectively.

Fees for services to customers decreased $133,000 to $299,000 for the third quarter of 2020, due primarily to a decrease in net overdraft income. ATM and debit card income increased $65,000 to $598,000 for the third quarter of 2020, compared to the same period in 2019, due primarily to debit card interchange fee income.

QNB provides securities and advisory services under the name QNB Financial Services. Retail brokerage and advisory fees decreased slightly for the third quarter of 2020 compared to the same period in 2019. During 2019, there was a continued transition to move toward advanced advisory fees based on assets under management in lieu of fees per transaction. Advisory fees increased $6,000 for the third quarter of 2020 compared with the same period in 2019, while transactional fees declined $10,000 when comparing third quarters of 2020 and 2019.

Merchant income increased by $23,000 to $110,000 for the third quarter of 2020, compared to the same period in 2019. Other non-interest income increased $31,000, or 21.2%. Other non-interest income includes broker-dealer conversion cost reimbursements of $17,000 and $18,000 in the third quarter of 2020 and 2019, respectively.  Mortgage serving income increased $18,000 when comparing the two quarters primarily due to an increase in the fair value of servicing rights. There was an increase in title company income of $11,000 due to the increased volume of mortgage originations.

Nine-Month Comparison

Total non-interest income for the nine-month periods ended September 30, 2020 and 2019 was $4,055,000 and $6,107,000, respectively, a decrease of $2,052,000, or 33.6%. Excluding realized and unrealized gain and losses on equity securities for both periods total non-interest income was $4,851,000 and $4,242,000, respectively, an increase of $609,000.

Net investment securities gains decreased $1,196,000 to $367,000 for the nine months ended September 30, 2020 compared to $1,593,000 for the comparable nine months in 2019.  Market conditions in the equities market for the nine months ended September 30, 2019 versus the same period in 2020 resulted in greater opportunities for profitable sales in 2019.  QNB recorded realized gains of $351,000 compared to gains of $1,599,000  on equity securities for the nine months ended September 30, 2020 and 2019, respectively.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Net gains on sales of loans increased $923,000 from $112,000, when comparing the nine months ended September 30, 2020 to the same period in 2019.  Proceeds from the sale of residential mortgages were $21,756,000 and $4,043,000 for the nine-month periods ended September 30, 2020 and 2019, respectively.

Fees for services to customers decreased $295,000 to $952,000 for the first nine months of 2020, due primarily to a decrease in net overdraft income.  ATM and debit card and merchant income increased $80,000 and $37,000, respectively, for the first nine months of 2020 compared to 2019, for reasons detailed in the quarterly comparison.

Retail brokerage and advisory increased slightly by $4,000 for the nine months ended September 30, 2020 compared to the same period in 2019; advisory fees increased $5,000 and transaction-based fees decreased $1,000.

Other non-interest income decreased $191,000, or 37.5%. Other non-interest income included a $58,000 deferred gain on the sale of a bank-financed other real estate owned property in 2019.  Other non-interest income included broker-dealer conversion cost reimbursements of $51,000 and $65,000, respectively, for the first nine months of 2020 compared to 2019. Mortgage serving income declined $69,000 when comparing the two periods primarily due to a reduction in the fair value of servicing rights.

NON-INTEREST EXPENSE

Non-Interest Expense Comparison
For the Three Months Ended September 30, Change from prior year For the Nine Months Ended September 30, Change from prior year
2020 2019 Amount Percent 2020 2019 Amount Percent
Salaries and employee benefits $ 4,182 $ 4,063 $ 119 2.9 % $ 12,239 $ 11,634 $ 605 5.2 %
Net occupancy 555 500 55 11.0 1,602 1,511 91 6.0
Furniture and equipment 684 623 61 9.8 2,015 1,771 244 13.8
Marketing 155 285 (130 ) (45.6 ) 632 785 (153 ) (19.5 )
Third-party services 444 461 (17 ) (3.7 ) 1,401 1,347 54 4.0
Telephone, postage and supplies 154 184 (30 ) (16.3 ) 543 535 8 1.5
State taxes 243 171 72 42.1 645 549 96 17.5
FDIC insurance premiums 140 - 140 N/M 419 265 154 58.1
Other 640 668 (28 ) (4.2 ) 1,848 2,075 (227 ) (10.9 )
Total $ 7,197 $ 6,955 $ 242 3.5 % $ 21,344 $ 20,472 $ 872 4.3 %

Quarter to Quarter Comparison

Total non-interest expense was $7,197,000 for the third quarter of 2020, an increase of $242,000, or 3.5%, compared to the third quarter of 2019.

Salaries and benefits comprise the largest component of non-interest expense. QNB monitors, through the use of various surveys, the competitive salary and benefit information in its markets and makes adjustments when appropriate. Salaries and benefits expense increased $119,000, or 2.9%, to $4,182,000 when comparing the two quarters, in part due to the addition of branch staff in our new Allentown, Pennsylvania location. Salary expense and related payroll taxes decreased $42,000, or 1.2%, to $3,467,000 during the third quarter of 2020 compared to the same period in 2019 due to a reduction in bonus accrual and increased loan origination deferred costs of $71,000 and $88,000, respectively. Medical and dental premiums, net of employee contributions increased $147,000 to $438,000 when comparing the two quarters due to an increase in medical claims. Retirement plan increased $19,000 during the same period.

Net occupancy and furniture and equipment expenses increased $55,000, or 11.0%, and $61,000, or 9.8%, respectively. This is due primarily to increased depreciation of furniture and equipment and software maintenance expense of $33,000 and $69,000, respectively, when comparing the two periods. Marketing expense decreased $130,000, or 45.6%, to $155,000 for the quarter ended September 30, 2020 due to cancellation of events resulting from the COVID-19 pandemic.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Third party services are comprised of professional services, including legal, accounting, auditing and consulting services, as well as fees paid to outside vendors for support services of day-to-day operations. These support services include correspondent banking services, IT services, statement printing and mailing, investment security safekeeping and supply management services. Third party services expense decreased $17,000 when comparing the two periods, due primarily to decreases in fees paid to outside vendors for support services. Telephone, postage and supplies expenses decreased $8,000, $10,000 and $12,000, respectively. State taxes increased $72,000 due to an increase bank shares tax expense. FDIC insurance premiums increased $140,000 due to Small Institution Credits of $136,000 in 2019.

Other non-interest expense decreased $28,000, or 4.2%, primarily due to reduced travel and entertainment expense related to the cancellation of events, seminars and travel due the COVID-19 pandemic.

Nine-Month Comparison

Total non-interest expense was $21,344,000 for the nine-month period ended September 30, 2020, an increase of $872,000, or 4.3%, compared to the nine months ended September 30, 2019.

Salaries and benefits expense increased $605,000 to $12,239,000 for the nine months ended September 30, 2020 compared to the same period in 2019, for the same reasons described in the quarter comparison. Salary and related payroll tax expense increased $181,000, or 5.2%, during the period, to $10,092,000 while medical and dental premiums, net of employee contributions, increased $398,000, to $1,295,000.

Net occupancy and furniture and equipment expense increased $335,000, or 10.2%, to $3,617,000, for the same reasons described in the quarter comparison, and third-party services increased $54,000, or 4.0%, to $1,401,000 for the nine months ended September 30, 2020, due primarily to fees paid to outside vendors for support services.

Telephone, postage and supplies expenses increased $8,000 in the first nine months of 2020 compared to 2019, supplies expenses increased $19,000 due to required cleaning supplies, signage, personal protective equipment and plexiglass shields needed for customers and staff in response to the pandemic. FDIC insurance premiums increased $154,000 and marketing decreased $153,000, due to the reasons described in the quarter comparison.

Other expense decreased due to the reasons described above, and included the write-off of a receivable of $52,000 in 2019.

INCOME TAXES

QNB utilizes an asset and liability approach for financial accounting and reporting of income taxes. As of September 30, 2020, QNB’s net deferred tax asset was $583,000. The primary components of deferred taxes are deferred tax assets of which $2,261,000 relates to the allowance for loan losses. As of December 31, 2019, QNB’s net deferred tax asset was $1,441,000. The decrease in the balance of net deferred tax assets when comparing September 30, 2020 to December 31, 2019 is due to the increase in unrealized gains on available for sale securities at September 30, 2020 compared to December 31, 2019, contributing to $1,350,000 of the decline. This decline was partially offset by the deferred tax on unrealized losses at September 30, 2020 compared to gains at December 31, 2019 on equity securities, resulting in an increase of $331,000.

The realizability of deferred tax assets is dependent upon a variety of factors, including the generation of future taxable income, the existence of taxes paid and recoverable, the reversal of deferred tax liabilities and tax planning strategies. Based upon these and other factors, management believes it is more likely than not that QNB will realize the benefits of these remaining deferred tax assets.

Applicable income tax expense was $914,000 for the quarter and $1,506,000 for the nine months ended September 30, 2020, compared to expense of $731,000 and $2,227,000 for the same periods in 2019. The effective tax rate for third quarter and year-to-date 2020 was 19.5% and 16.0%, respectively, compared with 19.1% and 18.8%, respectively, for the same periods in 2019. The increase in effective tax rate in the third quarter of 2020 is due to the decline in the proportion of tax-exempt net interest income to income before taxes.  The decrease in the effective tax rate for the nine-month period of 2020 is due to the state income tax benefit at the parent company related to the unrealized losses on the equities portfolio and to the proportion of tax-exempt net interest income to income before taxes.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

FINANCIAL CONDITION ANALYSIS

Financial service organizations are challenged to demonstrate they can generate sustainable and consistent earnings growth in a dynamic operating environment. Rate competition for quality loans is anticipated to continue through 2020. It is also anticipated that the rate competition for attracting and retaining deposits may continue in 2020, which could result in a lower net interest margin and a decline in net interest income.

QNB’s primary business is accepting deposits and making loans to meet the credit needs of the communities it serves. Loans are the most significant component of earning assets and growth in loans to small businesses and residents of these communities has been a primary focus of QNB. Inherent within the lending function is the evaluation and acceptance of credit risk and interest rate risk. QNB manages credit risk associated with its lending activities through portfolio diversification, underwriting policies and procedures and loan monitoring practices. QNB is committed to make credit available to its customers.

Total assets at September 30, 2020 were $1,417,073,000 compared with $1,225,023,000 at December 31, 2019. Cash and cash equivalents increased $19,912,000 from $17,608,000 at December 31, 2019 to $37,520,000 at September 30, 2020, due primarily to increases in deposits during the nine months ended September 30, 2020.

The fixed-income securities portfolio represents a significant portion of QNB’s earning assets and is also a primary tool in liquidity and asset/liability management. QNB actively manages its fixed income portfolio to take advantage of changes in the shape of the yield curve and changes in spread relationships in different sectors and for liquidity purposes. Management continually reviews strategies that will result in an increase in the yield or improvement in the structure of the investment portfolio, including monitoring credit and concentration risk in the portfolio.

Loans receivable grew $67,176,000, or 8.2%, with commercial loans increasing $72,305,000, or 10.8%, to $743,414,000 at September 30, 2020, compared with $671,109,000 at year-end 2019. Retail loan balances declined $2,611,000 comparing September 30, 2020 to December 31, 2019. Under the CARES Act, QNB continues to provide customers experiencing financial hardship caused by the COVID-19 Pandemic, solutions to help them through this difficult period. As of September 30, 2020, QNB had modifications to approximately 8.4% of the commercial portfolio, with an outstanding balance of $62,390,000, and modifications to approximately 2.6% of the retail portfolio, with an outstanding balance of $3,758,000, related to the COVID-19 Pandemic. At September 30, 2020, QNB had 660 PPP loans totaling $82,475,000 reported in commercial and industrial loans.  PPP loan origination fees net of costs amounted to $2,406,000 at September 30, 2020 and are recognized in interest income as a yield adjustment over the term of the loans.  The PPP loans are 100% guaranteed by the SBA. To date, the Bank originated $82,475,000 in PPP loans, enabling 660 businesses to maintain their payrolls and stay in operation.  Excluding PPP loans net of deferred fees at September 30, 2020, loans receivable would have decreased $12,893,000, or 1.6% since year-end 2019.

Deposits grew $176,603,000, or 17.0%, from December 31, 2019 to September 30, 2020. Non-interest-bearing demand deposits increased $59,222,000, or 40.5%, with balances of $205,492,000 at September 30, 2020 compared with $146,270,000 at year-end 2019. Interest-bearing demand balances, excluding municipal deposits, increased $39,416,000, or 17.8%, to $260,417,000, with increases in all personal checking products and in the business checking product. The $58,737,000 increase in savings and $20,414,000 increase in money markets was partially offset by the decline in time deposits as balances were moved to more liquid accounts. Total time deposits declined $31,822,000 from December 31, 2019 to September 30, 2020. Municipal deposit balances increased $30,636,000, or 27.4%, to $142,553,000. Municipal deposits can be volatile depending on the timing of deposits and withdrawals, and the cash flow needs of the school districts or municipalities. Municipal deposits increase as tax money is received from the local school districts during second and third quarters and it is anticipated that these funds will flow out for the subsequent twelve months as the schools use the funds for operations. These deposits provide incremental income as they are invested in short-term investment securities but will further reduce the net interest margin as the spread earned is significantly less than the current net interest margin.

Short-term borrowings decreased 6.3%, from $55,931,000 at December 31, 2019 to $52,406,000 at September 30, 2020. Commercial sweep accounts increased $8,292,000, as these funds may be volatile based on businesses’ receipt and disbursement of funds and is offset by business non-interest-bearing demand accounts. Overnight borrowings from FHLB decreased $11,817,000. During the first nine months of 2020, QNB borrowed long-term debt from the FHLB of $10,000,000 to lock in a rate at a low yield; the average yield of 1.57% for the nine-month period was 137 basis points lower than the average rate paid on FHLB short-term borrowings during the same period.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

LIQUIDITY

Liquidity represents an institution’s ability to generate cash or otherwise obtain funds at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB attempts to manage its mix of cash and interest-bearing balances, Federal funds sold and investment securities to match the volatility, seasonality, interest sensitivity and growth trends of its loans and deposits. The Company manages its liquidity risk by measuring and monitoring its liquidity sources and estimated funding needs. Liquidity is provided from asset sources through repayments and maturities of loans and investment securities. The portfolio of investment securities classified as available for sale and QNB's policy of selling certain residential mortgage originations in the secondary market also provide sources of liquidity. Core deposits and cash management repurchase agreements have historically been the most significant funding source for QNB. These deposits and repurchase agreements are generated from a base of consumers, businesses and public funds primarily located in the Company’s market area.

Additional sources of liquidity are provided by the Bank’s membership in the FHLB. At September 30, 2020, the Bank had a maximum borrowing capacity with the FHLB of approximately $328,102,000, which is net of the $10,000,000 in long-term borrowings and a $350,000 letter of credit. The maximum borrowing depends upon qualifying collateral assets and the Bank’s asset quality and capital adequacy. In addition, the Bank maintains unsecured Federal funds lines with five correspondent banks totaling $101,000,000. At September 30, 2020 there were no outstanding borrowings under these lines. Future availability under these lines is subject to the policies of the granting banks and may be withdrawn.

Liquid sources of funds, including cash, available-for-sale and equity investment securities, and loans held-for-sale have increased $125,445,000 since December 31, 2019, totaling $502,904,000 at September 30, 2020. Growth in deposits since year-end 2019 has been used to fund loans, excess cash was invested in debt securities, primarily amortizing securities, and to cover operating expenses. Management expects these liquid sources will be adequate to meet normal fluctuations in loan demand or deposit withdrawals. The investment portfolio is expected to continue to provide sufficient liquidity, as municipal bonds are called or mature and cash flow on mortgage-backed and CMO securities continues to be steady.

Approximately $245,184,000 and $205,016,000 of available-for-sale debt securities at September 30, 2020 and December 31, 2019, respectively, were pledged as collateral for repurchase agreements and deposits of public funds. The level of pledged securities corresponds with the municipal deposit and repurchase agreement balances.

QNB is a member of the Certificate of Deposit Account Registry Services (CDARS) program offered by the Promontory Interfinancial Network, LLC. CDARS is a funding and liquidity management tool used by banks to access funds and manage their balance sheet. It enables financial institutions to provide customers with full FDIC insurance on time deposits over $250,000 that are placed in the program. QNB also has available Insured Cash Sweep (ICS), another program through Promontory Interfinancial Network, LLC, which is a product similar to CDARS, but one that provides liquidity like a money market or savings account.

CAPITAL ADEQUACY

A strong capital position is fundamental to support continued growth and profitability and to serve the needs of depositors. QNB's shareholders' equity at September 30, 2020 was $130,995,000, or 9.24% of total assets, compared with shareholders' equity of $120,717,000, or 9.85% of total assets, at December 31, 2019. Shareholders’ equity at September 30, 2020 and December 31, 2019 included a positive adjustment of $5,335,000 and $257,000, respectively, related to unrealized holding gains, net of taxes, on investment securities available-for-sale. Without these adjustments, shareholders' equity to total assets would have been 8.90% and 9.84% at September 30, 2020 and December 31, 2019, respectively.

Average shareholders' equity and average total assets were $123,802,000 and $1,319,948,000 for the nine months ended September 30, 2020, an increase of 7.1% and 9.5%, respectively, from the averages for the nine months ended September 30, 2019. The ratio of average total equity to average total assets was 9.38% for the nine months ended September 30, 2020 compared to 9.59% for the same period in 2019.

Retained earnings at September 30, 2020 were impacted by nine months of net income totaling $7,932,000 offset by dividends declared and paid of $3,603,000 for the same period. QNB offers a Dividend Reinvestment and Stock Purchase Plan (the “Plan”) to provide participants a convenient and economical method for investing cash dividends paid on the Company’s common stock in additional shares at a discount. The Plan also allows participants to make additional cash purchases of stock at a discount. Stock purchases under the Plan contributed $678,000 to capital during the nine months ended September 30, 2020.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The Board of Directors has authorized the repurchase of up to 100,000 shares of QNB common stock in open market or privately negotiated transactions. The repurchase authorization does not bear a termination date. As of September 30, 2020, 57,883 shares were repurchased under this authorization at an average price of $16.97 and a total cost of $982,000. There have been no additional shares repurchased under the plan since the first quarter of 2009.

QNB and the Bank are subject to various regulatory capital requirements as issued by Federal regulatory authorities. Regulatory capital is defined in terms of Tier 1 capital and Tier 2 capital. Risk-based capital ratios are expressed as a percentage of risk-weighted assets. Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet arrangements, such as letters of credit and loan commitments, based on associated risk. The final rules implementing the Basel Committee on Banking Supervision’s capital guidelines for U.S. banks (Basel III) were fully phased-in January 1, 2019.

Minimum requirements increased for both the quantity and quality of capital. The rules included a new common equity Tier 1 capital to risk-weighted assets minimum ratio of 4.5%, raised the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, required a minimum ratio of Total Capital to risk-weighted assets of 8.0%, and required a minimum Tier 1 leverage ratio of 4.0%.  A capital conservation buffer of 2.5% of risk-weighted assets also applies to avoid limitations on certain capital distributions. QNB and the Bank have sufficient capital to meet minimum regulatory capital requirements plus the fully phased-in capital conservation buffer.

The following table sets forth consolidated information for QNB:

September 30, December 31,
Capital Analysis 2020 2019
Regulatory Capital
Shareholders' equity $ 130,995 $ 120,717
Net unrealized securities losses, net of tax (5,335 ) (257 )
Deferred tax assets on net operating loss — —
Disallowed intangible assets (8 ) (8 )
Common equity tier I capital 125,652 120,452
Tier I capital 125,652 120,452
Allowable portion: Allowance for loan losses and reserve<br><br><br>for unfunded commitments 10,850 9,960
Total regulatory capital $ 136,502 $ 130,412
Risk-weighted assets $ 959,308 $ 943,725
Quarterly average assets for leverage capital purposes $ 1,411,469 $ 1,232,064
September 30, December 31,
--- --- --- --- --- --- ---
Capital Ratios 2020 2019
Common equity tier I capital / risk-weighted assets 13.10 % 12.76 %
Tier I capital / risk-weighted assets 13.10 12.76
Total regulatory capital / risk-weighted assets 14.23 13.82
Tier I capital / average assets (leverage ratio) 8.90 9.78

At September 30, 2020, common equity Tier I, Tier I capital, and total regulatory capital ratios improved compared with December 31, 2019. The Company remains well-capitalized by all applicable regulatory requirements as of September 30, 2020.

MARKET RISK MANAGEMENT

Market risk reflects the risk of economic loss resulting from changes in interest rates and market prices. QNB’s primary market risk exposure is interest rate risk and liquidity risk. QNB’s liquidity position was discussed in a prior section.

QNB’s largest source of revenue is net interest income, which is subject to changes in market interest rates. Interest rate risk management seeks to minimize the effect of interest rate changes on net interest margins and interest rate spreads and to provide growth in net interest income through periods of changing interest rates. QNB’s Asset/Liability and Investment Management

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Committee (ALCO) is responsible for managing interest rate risk and for evaluating the impact of changing interest rate conditions on net interest income.

QNB uses computer simulation analysis to measure the sensitivity of projected earnings to changes in interest rates. Simulation considers current balance sheet volumes and the scheduled repricing dates, instrument level optionality, and maturities of assets and liabilities. It incorporates assumptions for growth, changes in the mix of assets and liabilities, prepayments, and average rates earned and paid. Based on this information, management uses the model to project net interest income under multiple interest rate scenarios.

A balance sheet is considered liability sensitive when its liabilities (deposits and borrowings) reprice faster than its earning assets (loans and securities). A liability sensitive balance sheet will produce relatively less net interest income when interest rates rise and more net interest income when they decline. Based on our simulation analysis, management believes QNB’s interest sensitivity position at September 30, 2020 is liability sensitive. Management expects that market interest rates will remain level over the next 12 months, based on the economic environment and policy of the Board of Governors of the Federal Reserve System.

The following table shows the estimated impact of changes in interest rates on net interest income as of September 30, 2020 and 2019 assuming instantaneous rate shocks, and consistent levels of assets and liabilities. Net interest income for the subsequent twelve months is projected to decrease when interest rates are higher than current rates.

Estimated Change in Net Interest Income
Changes in Interest rates September 30,
(in basis points) 2020 2019
+300 -8.36 % -8.05 %
+200 -4.10 % -4.88 %
+100 -1.30 % -2.00 %
-100 -5.07 % -2.61 %

Computations of future effects of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results. Assets and liabilities may react differently than projected to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag changes in market interest rates. Interest rate shifts may not be parallel.

Changes in interest rates can cause substantial changes in the amount of prepayments of loans and mortgage-backed securities, which may in turn affect QNB’s interest rate sensitivity position. Additionally, credit risk may rise if an interest rate increase adversely affects the ability of borrowers to service their debt.

QNB is not subject to foreign currency exchange or commodity price risk. At September 30, 2020, QNB did not have any hedging transactions in place such as interest rate swaps, caps or floors.

QNB CORP. AND SUBSIDIARY

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The information required in response to this item is set forth in Item 2, above.

ITEM 4. CONTROLS AND PROCEDURES

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the consolidated financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report. No changes were made to our internal control over financial reporting during the fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

QNB CORP. AND SUBSIDIARY

PART II. OTHER INFORMATION

September 30, 2020

Item 1. Legal Proceedings

No material proceedings.

Item 1A. Risk Factors

The continuing COVID-19 pandemic may adversely impact our business and financial results, and the ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.

Since the beginning of January 2020, the coronavirus outbreak has disrupted global supply chains, lowered equity market valuations, created significant volatility and disruption in financial markets, increased unemployment levels, and decreased consumer confidence.   Additionally, the COVID-19 pandemic has resulted in temporary closures of many businesses and the institution of social distancing and sheltering in place requirements in many states and communities, including in our primary market areas. As a result, the demand for our products and services may be significantly impacted, which could adversely affect our revenue.  This may result in a significant decrease in business and/or cause QNB’s customers to be unable to meet existing payment or other obligations to QNB, particularly in in QNB’s market area. The continuing COVID-19 pandemic could result in the recognition of credit losses in our loan portfolios and increases in our allowance for credit losses, particularly if businesses remain closed, the impact on the global economy worsens, or more customers draw on their lines of credit or seek additional loans to help finance their businesses. Similarly, because of changing economic and market conditions affecting bond issuers, we may be required to recognize impairments on the securities we hold as well as reductions in other comprehensive income. Although the Company maintains contingency plans for pandemic outbreaks, a spread of COVID-19, or an outbreak of another contagious disease, could also negatively impact the availability of key personnel of QNB necessary to conduct the business of QNB.  Our business operations may be further disrupted if significant portions of our workforce are unable to work effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic.   Such a spread or outbreak could also negatively impact the business and operations of third-party service providers who perform critical services for QNB’s business.   Moreover, the pandemic has created additional operational and compliance risks, including the need to quickly implement and execute new programs and procedures for the products and services we offer our customers, provide enhanced safety measures for our employees and customers, comply with rapidly changing regulatory requirements, address any increased risk of fraudulent activity, and protect the integrity and functionality of our systems and networks as a larger number of our employees work remotely. The extent to which the COVID-19 pandemic impacts our business, results of operations, and financial condition, as well as our regulatory capital and liquidity ratios and our cost of capital, will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities and other third parties in response to the pandemic.

There were no other material changes to the Risk Factors described in Item 1A in QNB’s Annual Report on Form 10-K for the period ended December 31, 2019.

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

QNB did not repurchase any shares of its common stock during the quarter ended September 30, 2020. The following provides certain information relating to QNB's stock repurchase plan.

Period Total Number of<br><br><br>Shares Purchased Average Price<br><br><br>Paid per Share Total Number of<br><br><br>Shares<br><br><br>Purchased as<br><br><br>Part of Publicly<br><br><br>Announced<br><br><br>Plan Maximum<br><br><br>Number of<br><br><br>Shares that<br><br><br>may yet be<br><br><br>Purchased<br><br><br>Under the Plan
July 1, 2020 through July 31, 2020 — — — 42,117
August 1, 2020 through August 31, 2020 — — — 42,117
September 1, 2020 through September 30, 2020 — — — 42,117
Total — — — 42,117
(1) Transactions are reported as of settlement dates.
--- ---
(2) QNB’s current stock repurchase plan was approved by its Board of Directors and announced on January 24, 2008 and subsequently increased on February 9, 2009.
--- ---
(3) The total number of shares approved for repurchase under QNB’s current stock repurchase plan is 100,000.
--- ---
(4) QNB’s current stock repurchase plan has no expiration date.
--- ---
(5) QNB has no stock repurchase plan that it has determined to terminate or under which it does not intend to make further purchases.
--- ---

Item 3. Default Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

Item 6. Exhibits

Exhibit 3.1 Articles of Incorporation of Registrant, as amended. (Incorporated by reference to Exhibit 3(i) of Registrant’s Annual Report on Form 10-K, SEC File No. 0-17706, filed with the Commission on March 13, 2015).
Exhibit 3.2 Bylaws of Registrant, as amended May 5, 2020 (Incorporated by reference to Exhibit 3.2 of Registrant’s Quarterly Report on Form 10-Q, SEC File No. 0-17706, filed with the Commission on August 6, 2020).
Exhibit 31.1 Section 302 Certification of Chief Executive Officer
Exhibit 31.2 Section 302 Certification of Chief Financial Officer
Exhibit 32.1 Section 906 Certification of Chief Executive Officer
Exhibit 32.2 Section 906 Certification of Chief Financial Officer

The following Exhibits are being furnished* as part of this report:

No. Description
101.SCH iXBRL Taxonomy Extension Schema Document.*
101.CAL iXBRL Taxonomy Extension Calculation Linkbase Document.*
101.LAB iXBRL Taxonomy Extension Label Linkbase Document.*
101.PRE iXBRL Taxonomy Extension Presentation Linkbase Document.*
101.DEF iXBRL Taxonomy Extension Definitions Linkbase Document.*
104 Cover Page Interactive Data File (formatted as inline iXBRL and contained in Exhibit 101)
* These interactive data files are being furnished as part of this Quarterly Report, and, in accordance with Rule 402 of Regulation S-T, shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to liability under those sections.
--- ---

SIGNATURES

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

QNB Corp.
Date:         November 5, 2020 By: /s/ David W. Freeman
David W. Freeman
Chief Executive Officer
Date:         November 5, 2020 By: /s/ Janice McCracken Erkes
Janice McCracken Erkes
Chief Financial Officer
Date:         November 5, 2020 By: /s/ Mary E. Liddle
Mary E. Liddle
Chief Accounting Officer, QNB Bank

63

qnbc-ex311_6.htm

Exhibit 31.1

CERTIFICATION

I, David W. Freeman, certify that:

1. I have reviewed this quarterly report on Form 10-Q of QNB Corp.
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.
--- ---
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report.
--- ---
4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:
--- ---
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
--- ---
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles;
--- ---
(c) Evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
--- ---
(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and
--- ---
5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function):
--- ---
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and
--- ---
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal control over financial reporting.
--- ---
Date:                 November 5, 2020 By: /s/ David W Freeman
--- --- ---
David W. Freeman
Chief Executive Officer

qnbc-ex312_9.htm

Exhibit 31.2

CERTIFICATION

I, Janice McCracken Erkes, certify that:

1. I have reviewed this quarterly report on Form 10-Q of QNB Corp.
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report.
--- ---
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report.
--- ---
4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:
--- ---
(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
--- ---
(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles;
--- ---
(c) Evaluated the effectiveness of the Registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
--- ---
(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and
--- ---
5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function):
--- ---
(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant's ability to record, process, summarize and report financial information; and
--- ---
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal control over financial reporting.
--- ---
Date:                  November 5, 2020 By: /s/ Janice McCracken Erkes
--- --- ---
Janice McCracken Erkes
Chief Financial Officer

qnbc-ex321_8.htm

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350

AS ADDED BY

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of QNB Corp. (the Company) for the period ended September 30, 2020, as filed with the Securities and Exchange Commission (the Report), I, David W. Freeman, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. §1350, as added by § 906 of the Sarbanes-Oxley Act of 2002, that this periodic report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in this report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

Date:           November 5, 2020 By: /s/ David W. Freeman
David W. Freeman
Chief Executive Officer

qnbc-ex322_10.htm

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350

AS ADDED BY

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of QNB Corp. (the Company) for the period ended September 30, 2020, as filed with the Securities and Exchange Commission (the Report), I, Janice McCracken Erkes, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. §1350, as added by § 906 of the Sarbanes-Oxley Act of 2002, that this periodic report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in this report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

Date:           November 5, 2020 By: /s/ Janice McCracken Erkes
Janice McCracken Erkes
Chief Financial Officer

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