# CHOICEONE FINANCIAL SERVICES INC (COFS) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from CHOICEONE FINANCIAL SERVICES INC's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/803164/000143774923007584/cofs20221231_10k.htm
Accession: 0001437749-23-007584
Filing date: 2023-03-23
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/COFS/
All MD&A years: /company/COFS/mda/
Previous year: /company/COFS/mda/fy2021/ (FY 2021)
Next year: /company/COFS/mda/fy2023/ (FY 2023)

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne Financial Services, Inc. (“ChoiceOne” or the “Company”), and its wholly-owned subsidiaries. This discussion should be read in conjunction with the consolidated financial statements and related footnotes.

We have omitted discussion of 2021 results where it would be redundant to the discussion previously included in Part II, Item 7 of our 2021 Annual Report on Form 10-K.

Selected Financial Data

[[GREPCENT_TABLE]]
[["(Dollars in thousands, except per share data)"],["","","2022","","","2021","","","2020"],["For the year"],["Net interest income","","$","67,314","","","$","60,641","","","$","51,071"],["Provision for loan losses","","","250","","","","416","","","","4,000"],["Noninterest income","","","14,072","","","","19,194","","","","22,698"],["Noninterest expense","","","53,478","","","","52,921","","","","50,884"],["Income before income taxes","","","27,658","","","","26,498","","","","18,885"],["Income tax expense","","","4,018","","","","4,456","","","","3,272"],["Net income","","","23,640","","","","22,042","","","","15,613"],["Cash dividends declared","","","7,578","","","","7,200","","","","6,174"],["Per share"],["Basic earnings","","$","3.15","","","$","2.87","","","$","2.08"],["Diluted earnings","","","3.15","","","","2.86","","","","2.07"],["Cash dividends declared","","","1.01","","","","0.94","","","","0.82"],["Shareholders' equity (at year end)","","","22.47","","","","29.52","","","","29.15"],["Average for the year"],["Securities","","$","1,094,559","","","$","869,788","","","$","388,797"],["Gross loans","","","1,104,030","","","","1,040,430","","","","1,014,959"],["Deposits","","","2,133,790","","","","1,905,629","","","","1,421,168"],["Borrowings","","","13,537","","","","5,465","","","","16,712"],["Subordinated debt","","","35,211","","","","12,841","","","","1,532"],["Shareholders' equity","","","178,415","","","","225,120","","","","214,591"],["Assets","","","2,373,374","","","","2,156,774","","","","1,654,873"],["At year end"],["Securities","","$","972,802","","","$","1,116,265","","","$","585,687"],["Gross loans","","","1,194,616","","","","1,068,831","","","","1,117,798"],["Deposits","","","2,118,003","","","","2,052,294","","","","1,674,578"],["Borrowings","","","50,000","","","","50,000","","","","9,327"],["Subordinated debt","","","35,262","","","","35,017","","","","3,089"],["Shareholders' equity","","","168,874","","","","221,669","","","","227,268"],["Assets","","","2,385,915","","","","2,366,682","","","","1,919,342"],["Selected financial ratios"],["Return on average assets","","","1.00","%","","","1.02","%","","","0.94","%"],["Return on average shareholders' equity","","","13.25","","","","9.79","","","","7.28"],["Cash dividend payout as a percentage of net income","","","32.06","","","","32.67","","","","39.54"],["Shareholders' equity to assets (at year end)","","","7.08","","","","9.37","","","","11.84"]]
[[/GREPCENT_TABLE]]

Note - 2020 financial data includes the impact of the merger with Community Shores, which was effective July 1, 2020.

20

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Explanatory Note

On July 1, 2020, ChoiceOne completed the merger of Community Shores Bank Corporation ("Community Shores") with and into ChoiceOne with ChoiceOne surviving the merger. Accordingly, the reported consolidated financial condition and operating results as of and for the years ended December 31, 2020, December 31, 2021, and December 31, 2022 include the impact of the merger, which was effective as of July 1, 2020. 

On October 1, 2019, ChoiceOne completed the merger of County Bank Corp. ("County") with and into ChoiceOne with ChoiceOne surviving the merger. Accordingly, the reported consolidated financial condition and operating results as of and for the years ended December 31, 2020, December 31, 2021, and December 31, 2022 include the impact of the merger, which was effective as of October 1, 2019.

For additional details regarding the mergers with Community Shores and County, see Note 22 (Business Combinations) of the Notes to the Consolidated Financial Statements included in Item 8 of this report. 

RESULTS OF OPERATIONS

Summary

ChoiceOne's net income for
2022
was $23.6 million, compared to $22.0 million in
2021
.  Diluted earnings per share was $3.15 in the twelve months ended December 31, 2022, compared to $2.86 per share in the twelve months ended December 31, 2021.  

ChoiceOne's asset mix has shifted from loans held for investment of 51.6% at December 31, 2021 to 56.2% at December 31, 2022.
  Core loans, which exclude PPP loans, loans held for sale, and loans to other financial institutions, grew organically by $206.1 million or 21.0% during the full year 2022.  Loans to other financial institutions, consisting of a warehouse line of credit, were suspended at the end of the third quarter 2022 to preserve liquidity for loan growth. ChoiceOne continues to have ample on balance sheet liquidity to fund future loan growth, including an estimated $178.7 million of cash flow from securities over the next two years.  Overall, t
otal assets grew less than 1% or $19.2 million in 2022.  ChoiceOne saw deposits decline $38.7 million in the fourth quarter of 2022 due to some seasonality in municipal deposits and increased competition.  The cost of these deposits also increased by $940,000 in the fourth quarter of 2022 compared to the third quarter of 2022 and $1.8 million compared to the fourth quarter of 2021.  Deposits have increased by $65.7 million in the twelve months ended December 31, 2022; however, during that time deposit expense has increased $2.5 million.  Cost of interest-bearing deposits increased to 0.66% in the fourth quarter of 2022 primarily due to the increases in rates offered to retain clients and an increased customer interest in certificates of deposit. ChoiceOne is actively managing these costs while still retaining funds, and anticipates that deposit expense will continue to lag the cumulative increases in the federal funds rate.  Borrowing interest expense for the twelve months ended December 31, 2022, increased $1.2 million as compared to the same period in 2021 primarily due to the issuance of $32.5 million in subordinated debt that was completed in the third quarter of 2021 and the increase in rates on short-term borrowings.  

Interest income increased $10.4 million in the twelve months ended December 31, 2022, compared to the same period in 2021.  The increase was driven by a $6.3 million increase in securities interest income largely due to an increase in the average balance of securities of $190.1 million during 2022.  In 2022, ChoiceOne liquidated a total of $47.2 million in securities resulting in an $809,000 realized loss, in order to redeploy funds into higher yielding loans and securities, and to reduce the risk of extension on certain fixed income securities which include a call option.  Interest income on loans increased $4.2 million during 2022 and was primarily a result of higher loan balances and $919,000 of additional accretion income from acquired loans, partially offset by a decrease in PPP fee income of $3.9 million. 

ChoiceOne had $250,000 of provision for loan losses expense for the year ended December 31, 2022.  Management has seen declining deferrals and very few past due loans during 2022; however, the additional provision was deemed necessary due to increased loan growth in 2022.  On December 31, 2022, the allowance for loan losses represented 0.64% of total loans.  ChoiceOne adopted ASU 2016-13 current expected credit loss ("CECL") on January 1, 2023.  Due to the current economic environment, the nature of the new calculation, and purchase accounting with our recent mergers, we anticipate an increase in our current allowance for loan losses of between $6.5 million and $7.0 million, which will result in an expected allowance for loan losses to total loan coverage ratio between 1.15% and 1.25% on January 1, 2023.  Approximately 20% to 25% of this increase is related to the migration of purchased loans into the portfolio assessed by the CECL calculation.  Purchased loans carry approximately $4.0 million of accretable yield, which will be recognized into income over the remaining life of the loans.  ChoiceOne will also record a liability for expected credit losses on unfunded loans and other commitments of between $2.5 million to $3.0 million related to the adoption of CECL.  These unfunded loans and other commitments are open credit lines with current customers and loans approved by ChoiceOne but not yet funded.  The increase in the reserve and the cost of the liability will result in a decrease in retained earnings account on our Consolidated Balance Sheet equal to the after-tax impact, with the tax impact portion being recorded in deferred taxes in our Consolidated balance Sheet in accordance with FASB guidance.  Further discussion of the change in accounting policy can be found in Item 8 Note 1.

Noninterest Income

Total noninterest income declined $5.1 million during 2022 compared to 2021.  $4.4 million of this decline is due to the change in the mortgage sales environment from the prior year.  With the rapid rise in interest rates, refinancing activity has slowed, and demand has shifted toward adjustable-rate products, which ChoiceOne keeps in portfolio. Customer service charges increased $722,000 during 2022 compared to 2021 as prior year service charges were depressed by the effects of the COVID-19 pandemic.  The change in market value of equity securities declined $1.4 million during 2022 compared to 2021 consistent with general market conditions.  Equity investments include local community bank stocks and Community Reinvestment Act bond mutual funds.  

Noninterest Expense

Total noninterest expense increased $557,000, or 1.1%, in 2022 compared to 2021.  Expense management was a focus in 2022 and will continue to be a focus in 2023 given inflationary pressures.  The increase in total noninterest expense was related to an increase in salaries and wages due to annual wage increases and the addition of new commercial loan production and wealth management staff.   This increase was offset by decreases in other categories including professional fees and loan-driven incentive-based compensation.  ChoiceOne continues to monitor expenses and looks to improve our efficiency through automation and use of digital tools. 

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Paycheck Protection Program

ChoiceOne processed over $126 million in PPP loans in 2020, acquired an additional $37 million in PPP loans in the merger with Community Shores, and originated $89.1 million in PPP loans in 2021.  In the third quarter of 2022, the remaining $1.8 million of PPP loans were forgiven resulting in $68,000 of fee income.  For the full year 2022, $33.1 million of PPP loans were forgiven resulting in $1.2 million of fee income. At December 31, 2022, no PPP loans remain in ChoiceOne’s loan portfolio.

Dividends

Cash dividends of $7.6 million or $1.01 per common share were declared in 2022 compared to $7.2 million or $0.94 per common share in 2021.  The dividend yield for ChoiceOne’s common stock was 3.48% as of the end of 2022, compared to 3.55% as of the end of 2021. The cash dividend payout as a percentage of net income was 32% as of December 31, 2022, compared to 33% as of December 31, 2021.

Income Taxes

Income tax expense was $438,000 lower in
2022 than in
2021. The decline is related to additional tax-exempt interest income from securities and additional tax-exempt earnings on bank-owned life insurances in
2022 compared to
2021.  The effective tax rate was 15% in
2022 compared to 17% in
2021.  For further details, refer to Note 12 (Income Taxes) of the Notes to the Consolidated Financial Statements included in Item 8 of this report. 

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Table 1 – Average Balances and Tax-Equivalent Interest Rates

Tables 1 and 2 on the following pages provide information regarding interest income and expense for the years ended December 31, 2022, 2021, and 2020. Table 1 documents ChoiceOne’s average balances and interest income and expense, as well as the average rates earned or paid on assets and liabilities.  Table 2 documents the effect on interest income and expense of changes in volume (average balance) and interest rates. 

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["(Dollars in thousands)","","Average","","","","","","","","","","","Average","","","","","","","","","","","Average"],["","","Balance","","","Interest","","","Rate","","","Balance","","","Interest","","","Rate","","","Balance","","","Interest","","","Rate"],["Assets:"],["Loans (1) (3)(4)(5)","","$","1,104,030","","","$","52,861","","","","4.79","%","","$","1,040,430","","","$","48,672","","","","4.68","%","","$","1,014,959","","","$","46,893","","","","4.62","%"],["Taxable securities (2)","","","779,915","","","","15,583","","","","2.00","","","","599,902","","","","10,260","","","","1.71","","","","276,085","","","","5,891","","","","2.13"],["Nontaxable securities (1)","","","314,644","","","","7,790","","","","2.48","","","","269,886","","","","7,098","","","","2.63","","","","112,712","","","","3,402","","","","3.02"],["Other","","","34,255","","","","491","","","","1.43","","","","68,879","","","","84","","","","0.12","","","","71,417","","","","266","","","","0.37"],["Interest-earning assets","","","2,232,844","","","","76,725","","","","3.44","","","","1,979,097","","","","66,114","","","","3.34","","","","1,475,173","","","","56,452","","","","3.83"],["Noninterest-earning assets","","","140,530","","","","","","","","","","","","177,677","","","","","","","","","","","","179,699"],["Total assets","","$","2,373,374","","","","","","","","","","","$","2,156,774","","","","","","","","","","","$","1,654,872"],["Liabilities and Shareholders' Equity:"],["Interest-bearing demand deposits","","$","902,090","","","$","3,514","","","","0.39","%","","$","791,886","","","$","1,797","","","","0.23","%","","$","571,693","","","$","1,832","","","","0.32","%"],["Savings deposits","","","452,542","","","","711","","","","0.16","","","","398,969","","","","551","","","","0.14","","","","267,217","","","","300","","","","0.11"],["Certificates of deposit","","","196,166","","","","1,620","","","","0.83","","","","186,898","","","","957","","","","0.51","","","","183,836","","","","2,046","","","","1.11"],["Borrowings","","","13,537","","","","410","","","","3.02","","","","5,465","","","","101","","","","1.86","","","","16,712","","","","327","","","","1.96"],["Subordinated debentures","","","35,211","","","","1,491","","","","4.23","","","","12,841","","","","571","","","","4.45","","","","1,532","","","","139","","","","9.07"],["Interest-bearing liabilities","","","1,599,546","","","","7,746","","","","0.48","","","","1,396,059","","","","3,977","","","","0.28","","","","1,040,990","","","","4,644","","","","0.45"],["Demand deposits","","","582,992","","","","","","","","","","","","527,876","","","","","","","","","","","","398,422"],["Other noninterest-bearing liabilities","","","12,421","","","","","","","","","","","","7,719","","","","","","","","","","","","870"],["Total liabilities","","","2,194,959","","","","","","","","","","","","1,931,654","","","","","","","","","","","","1,440,282"],["Shareholders' equity","","","178,415","","","","","","","","","","","","225,120","","","","","","","","","","","","214,591"],["Total liabilities and shareholders' equity","","$","2,373,374","","","","","","","","","","","$","2,156,774","","","","","","","","","","","$","1,654,873"],["Net interest income (tax-equivalent basis) (Non-GAAP) (1)","","","","","","$","68,979","","","","","","","","","","","$","62,137","","","","","","","","","","","$","51,808"],["Net interest margin (tax-equivalent basis) (Non-GAAP) (1)","","","","","","","","","","","3.09","%","","","","","","","","","","","3.14","%","","","","","","","","","","","3.51","%"],["Reconciliation to Reported Net Interest Income"],["Net interest income (tax-equivalent basis) (Non-GAAP) (1)","","","","","","$","68,979","","","","","","","","","","","$","62,137","","","","","","","","","","","$","51,808"],["Adjustment for taxable equivalent interest","","","","","","","(1,665",")","","","","","","","","","","","(1,513",")","","","","","","","","","","","(737",")"],["Net interest income (GAAP)","","","","","","$","67,314","","","","","","","","","","","$","60,624","","","","","","","","","","","$","51,071"],["Net interest margin (GAAP)","","","","","","","","","","","3.01","%","","","","","","","","","","","3.08","%","","","","","","","","","","","3.38","%"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["(1)","Adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 21%. The presentation of these measures on a tax-equivalent basis is not in accordance with GAAP, but is customary in the banking industry. These non-GAAP measures ensure comparability with respect to both taxable and tax-exempt loans and securities."],["(2)","Interest on taxable securities includes dividends on Federal Home Loan Bank and Federal Reserve Bank stock."],["(3)","Loans include both loans to other financial institutions and loans held for sale."],["(4)","Non-accruing loan and PPP loan balances are included in the balances of average loans. Non-accruing loan average balances were $1.3 million, $3.3 million, and $5.0 million for the year ended 2022, 2021, and 2020, respectively. PPP loan average balances were $8.7 million, $95.9 million, and $84.2 million for the year ended 2022, 2021, and 2020, respectively. At December 31, 2022 no PPP loans remain in ChoiceOne\u2019s loan portfolio."],["(5)","Interest on loans included net origination fees, accretion income, and PPP fees. Accretion income was $2.0 million, $1.1 million, and $420,000 for the full year 2022, 2021 and 2020, respectively. PPP fees were approximately $1.2 million, $5.2 million, and $3.0 million for the full year 2022, 2021, and 2020, respectively."]]
[[/GREPCENT_TABLE]]

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Table 2 – Changes in Tax-Equivalent Net Interest Income

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["(Dollars in thousands)","","2022 Over 2021","","","2021 Over 2020"],["","","Total","","","Volume","","","Rate","","","Total","","","Volume","","","Rate"],["Increase (decrease) in interest income (1)"],["Loans (2)","","$","4,189","","","$","3,026","","","$","1,163","","","$","1,779","","","$","1,187","","","$","592"],["Taxable securities","","","5,323","","","","3,410","","","","1,913","","","","4,369","","","","5,737","","","","(1,368",")"],["Nontaxable securities (2)","","","692","","","","1,126","","","","(434",")","","","3,696","","","","4,185","","","","(489",")"],["Other","","","407","","","","(62",")","","","469","","","","(182",")","","","(9",")","","","(173",")"],["Net change in interest income","","$","10,611","","","$","7,500","","","$","3,111","","","$","9,662","","","$","11,099","","","$","(1,437",")"],["Increase (decrease) in interest expense (1)"],["Interest-bearing demand deposits","","$","1,717","","","$","279","","","$","1,438","","","$","(35",")","","$","588","","","$","(623",")"],["Savings deposits","","","159","","","","79","","","","80","","","","251","","","","171","","","","80"],["Certificates of deposit","","","664","","","","50","","","","614","","","","(1,089",")","","","34","","","","(1,123",")"],["Borrowings","","","309","","","","217","","","","92","","","","(226",")","","","(210",")","","","(16",")"],["Subordinated debentures","","","920","","","","948","","","","(28",")","","","432","","","","1,516","","","","(37",")"],["Net change in interest expense","","$","3,769","","","$","1,573","","","$","2,196","","","$","(667",")","","$","2,099","","","$","(1,719",")"],["Net change in tax-equivalent net interest income","","$","6,841","","","$","5,927","","","$","915","","","$","10,329","","","$","9,001","","","$","282"]]
[[/GREPCENT_TABLE]]

[[GREPCENT_TABLE]]
[["(1)","The volume variance is computed as the change in volume (average balance) multiplied by the previous year\u2019s interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year\u2019s volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each."],["(2)","Interest on tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 21% for 2022, 2021, and 2020."]]
[[/GREPCENT_TABLE]]

Net Interest Income

Tax-equivalent net interest income increased $6.8 million for the full year 2022, compared to the same period in 2021.  The Federal Reserve increased the federal funds rate by 4.0% during 2022 in response to published inflation rates.  This both increased rates on newly originated loans and increased the rates paid on deposits and led to a net decline in tax equivalent net interest margin of 5 basis points in 2022 compared to 2021.  GAAP based net interest margin declined 7 basis points in 2022 compared to 2021.

The following table presents the cost of deposits and the cost of funds for the years ended December 31, 2022, December 31, 2021, and December 31, 2020.

[[GREPCENT_TABLE]]
[["","","Year Ended December 31,"],["","","2022","","","2021","","","2020"],["Cost of deposits","","","0.27","%","","","0.17","%","","","0.29","%"],["Cost of funds","","","0.35","%","","","0.21","%","","","0.32","%"]]
[[/GREPCENT_TABLE]]

Net interest income increased $6.7 million in 2022 compared to 2021 due to the $224.8 million increase in the average balance of securities and a 14 basis point increase in the average rate earned on securities during the full year 2022 as ChoiceOne deployed excess deposit dollars into securities with the intent to transition to loans as good credits become available.  ChoiceOne has also experienced core loan growth during 2022 leading to an increase in interest income from loans of $4.2 million in the full year 2022, compared to the same period in the prior year.  Average core loans, which exclude PPP loans, loans held for sale, and loans to other financial institutions, grew $153.9 million during the full year 2022.  In addition, the average rate earned on loans increased 11 basis points in 2022 compared to 2021.  The increase in interest income from loans and the average rate increase on loans is muted by a $3.9 million decline in PPP fee income in the full year 2022 compared to 2021.  This decline was somewhat offset by a $919,000 increase in accretion income from acquired loans in 2022 compared to 2021.  

Interest expense increased $3.8 million for the full year 2022, compared to the same period in 2021.  Growth of $163.8 million in the average balance of interest-bearing demand deposits and savings deposits and a combined 11 basis point increase in the average rate paid, caused interest expense to increase $1.9 million in 2022 compared to the prior year.  The increase in the average balance of certificates of deposit of $9.3 million, combined with a 31 basis point increase in the rate paid on certificates of deposits in 2022 compared to 2021, led to an increase in interest expense of $664,000. In September 2021, ChoiceOne completed a private placement of $32.5 million in aggregate principal amount of 3.25% fixed-to-floating rate subordinated notes due 2031.  In addition, ChoiceOne holds certain subordinated debentures issued in connection with a trust preferred securities offering that were obtained as part of the merger with Community Shores.  These increased the average balance of subordinated debentures by $22.4 million in 2022 compared to the same period in the prior year and caused interest expense to increase by $920,000 over the same period. 

The rise in interest rates has led to ChoiceOne's cost of funds increasing 15 basis points from 0.21% in 2021 to 0.35% in 2022.  10 basis points of this increase is due to the rising cost of deposits, while the remainder is due to the increased cost of borrowing and a full year's expense of the subordinated notes completed in September of 2021.

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Provision and Allowance For Loan Losses

Table 3 – Provision and Allowance For Loan Losses

[[GREPCENT_TABLE]]
[["(Dollars in thousands)"],["","","2022","","","2021","","","2020"],["Allowance for loan losses at beginning of year","","$","7,688","","","$","7,593","","","$","4,057"],["Charge-offs:"],["Agricultural","","","-","","","","-","","","","15"],["Commercial and industrial","","","177","","","","195","","","","148"],["Consumer","","","496","","","","370","","","","329"],["Real estate - commercial","","","-","","","","111","","","","254"],["Real estate - construction","","","-","","","","-","","","","-"],["Real estate - residential","","","-","","","","-","","","","8"],["Total","","","673","","","","676","","","","754"],["Recoveries:"],["Agricultural","","","-","","","","-","","","","-"],["Commercial and industrial","","","143","","","","86","","","","57"],["Consumer","","","206","","","","214","","","","204"],["Real estate - commercial","","","3","","","","48","","","","10"],["Real estate - construction","","","-","","","","-","","","","-"],["Real estate - residential","","","2","","","","7","","","","19"],["Total","","","354","","","","355","","","","290"],["Net charge-offs (recoveries)","","","319","","","","321","","","","464"],["Provision for loan losses","","","250","","","","416","","","","4,000"],["Allowance for loan losses at end of year","","$","7,619","","","$","7,688","","","$","7,593"],["Allowance for loan losses as a percentage of:"],["Total loans as of year end","","","0.64","%","","","0.76","%","","","0.71","%"],["Nonaccrual loans, accrual loans past due 90 days or more and troubled debt restructurings","","","286","%","","","139","%","","","92","%"],["Ratio of net charge-offs during the period to average loans outstanding during the period","","","0.03","%","","","0.03","%","","","0.05","%"],["Loan recoveries as a percentage of prior year's charge-offs","","","52","%","","","47","%","","","29","%"]]
[[/GREPCENT_TABLE]]

25

Table of Contents

The provision for loan losses was $250,000 in 2022, compared to $416,000 in the prior year.  The provision for loan losses expense was deemed necessary to reserve for core loan growth of $206.1 million in 2022.  Our methodology for measuring the appropriate level of allowance for loan losses and related provision for loan losses involves specific allocations for loans considered impaired, and general allocations for homogeneous loans based on historical loss experience. 

Loans classified as impaired loans declined by $2.6 million during 2022 which led to a decline in the specific allowance for loan losses for impaired loans of $350,000 in 2022 compared to 2021.

The determination of our loss factors is based, in part, upon our actual loss history adjusted for significant qualitative factors that, in management's judgment, affect the collectability of the portfolio as of the analysis date.  ChoiceOne uses a rolling 20 quarter actual net charge-off history as the basis for the computation. 

Nonperforming loans were $2.7 million as of December 31, 2022 compared to $5.5 million as of December 31, 2021. The allowance for loan losses was 0.64% of total loans at December 31, 2022, compared to 0.76% at December 31, 2021. Loans acquired in the mergers with County and Community Shores were recorded at fair value and as a result do not have an allowance for loan losses allocated to them unless credit deteriorates subsequent to acquisition.   

Net charge-offs were $319,000 in 2022 compared to net charge-offs of $321,000 during the same period in 2021.  Net charge-offs on an annualized basis as a percentage of average loans were 0.03% in 2022 compared to 0.03% in 2021. Management is aware that the economic climate in Michigan will continue to affect business and individual borrowers.  

ChoiceOne adopted ASU 2016-13 current expected credit loss ("CECL") on January 1, 2023.  Due to the current economic environment, the nature of the new calculation, and purchase accounting with our recent mergers, we anticipate an increase in our current allowance for loan losses of between $6.5 million and $7.0 million, which will result in an expected allowance for loan losses to total loan coverage ratio between 1.15% and 1.25% on January 1, 2023.  Approximately 20% to 25% of this increase is related to the migration of purchased loans into the portfolio assessed by the CECL calculation.  ChoiceOne will also record a liability for expected credit losses on unfunded loans and other commitments of between $2.5 million to $3.0 million related to the adoption of CECL.  These unfunded loans and other commitments are open credit lines with current customers and loans approved by ChoiceOne but not yet funded.  The increase in the reserve and the cost of the liability will result in a decrease in retained earnings account on our Consolidated Balance Sheet equal to the after-tax impact, with the tax impact portion being recorded in deferred taxes in our Consolidated balance Sheet in accordance with FASB guidance.  Further discussion of the change in accounting policy can be found in Item 8 Note 1.

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Financial Condition

Summary

Total assets grew $19.2 million in the twelve months ended December 31, 2022.  Core loans grew $206.1 million or 21.0% and were offset by a decline in securities of $143.2 million, and a decline in loans to other financial institutions of $42.6 million.  ChoiceOne also grew deposits by $65.7 million during 2022.  Deposit costs rose steadily during the year with larger increases coming in the fourth quarter as competition and rate awareness has amplified.  

Securities

The Company’s securities balances as of December 31 were as follows:

[[GREPCENT_TABLE]]
[["(Dollars in thousands)"],["","","2022","","","2021"],["Equity securities","","$","8,566","","","$","8,492"],["Available for Sale Securities at fair value"],["U.S. Government and federal agency","","$","-","","","$","2,008"],["U.S. Treasury notes and bonds","","","78,204","","","","91,979"],["State and municipal","","","229,938","","","","534,847"],["Mortgage-backed","","","208,563","","","","433,115"],["Corporate","","","711","","","","20,642"],["Asset-backed securities","","","12,333","","","","16,294"],["Total","","$","529,749","","","$","1,098,885"],["Held to Maturity Securities at amortized cost"],["U.S. Government and federal agency","","$","2,966","","","$","-"],["U.S. Treasury notes and bonds","","","-","","","","-"],["State and municipal","","","201,890","","","","-"],["Mortgage-backed","","","200,473","","","","-"],["Corporate","","","19,603","","","","-"],["Asset-backed securities","","","974","","","","-"],["Total","","$","425,906","","","$","-"]]
[[/GREPCENT_TABLE]]

In the last two years ChoiceOne has grown its securities portfolio substantially. Total available for sale securities on December 31, 2020, amounted to $577.7 million and grew steadily to an available for sale balance on December 31, 2021, of $1.1 billion.  Many of the securities making up this balance include local municipals and other securities ChoiceOne has no intent to sell prior to maturity.  During the first quarter of 2022, ChoiceOne elected to move $428.4 million of the portfolio into a held to maturity status.  

Total investment securities declined $143.2 million from
December 31, 2021
to
December 31, 2022
.  ChoiceOne purchased $63.6 million of securities in 2022.  This was offset by the liquidation of $47.2 million in securities during 2022, resulting in an $809,000 realized loss and reduced the risk of extension on certain fixed income securities which included a call option.
  Securities totaling $19.6 million were called or matured in
2022
. ChoiceOne received principal payments for municipal and mortgage-backed securities totaling $40.1 million during
2022
. 

At December 31, 2022, the Company had $161.0 million in unrealized losses on its investment securities, including $89.0 million in unrealized losses on available for sale securities and $72.0 in unrealized losses on held to maturity securities.  Unrealized losses on corporate and municipal bonds have not been recognized into income because the issuers’ bonds are of high credit quality, and management does not intend to sell prior to their anticipated recovery, and the decline in fair value is largely due to changes in interest rates and other market conditions. The issuers continue to make timely principal and interest payments on the bonds. The fair value is expected to recover as the bonds approach maturity.

ChoiceOne utilizes interest rate derivatives as part of its asset liability management strategy to help manage its interest rate risk position.  In order to hedge the risk of rising rates and unrealized losses on securities resulting from the rising rates, ChoiceOne currently holds four interest rate swaps with a total notional value of $400.1 million. These derivative instruments increase in value as long-term interest rates rise, which offsets the reduction in equity due to unrealized losses on securities available for sale.  Refer to footnote 8 and 23 for more discussion on ChoiceOne’s derivative position. 

The Bank’s Investment Committee continues to monitor the portfolio and purchases securities as it considers prudent.

Equity securities included a money market preferred security ("MMP") of $1.0 million and common stock of $7.6 million as of
December 31, 2022
. As of
December 31, 2021
, equity securities included an MMP of $1.0 million and common stock of $7.5 million.

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Table of Contents

Loans

The Company’s loan portfolio as of December 31 was as follows:

[[GREPCENT_TABLE]]
[["(Dollars in thousands)"],["","","2022","","","2021"],["Agricultural","","$","64,159","","","$","64,819"],["Commercial and industrial","","","210,210","","","","203,024"],["Consumer","","","39,808","","","","35,174"],["Real estate - commercial","","","630,953","","","","525,884"],["Real estate - construction","","","14,736","","","","19,066"],["Real estate - residential","","","229,916","","","","168,881"],["Loans, gross","","$","1,189,782","","","$","1,016,848"]]
[[/GREPCENT_TABLE]]

Core loans, which exclude PPP loans, held for sale loans, and loans to other financial institutions, grew organically by $206.1 million in 2022.  Excluding PPP loans, ChoiceOne saw growth of $144.7 million in commercial loans and $56.7 million in retail loans in 2022.  Additions to our commercial lending staff in 2021 and 2022 as well as investments in the automation of our commercial loan process have helped drive our pipeline of commercial loans and corresponding growth.    

Loans to other financial institutions declined $42.6 million from December 31, 2021 to December 31, 2022, as management chose to suspend the program at the end of the third quarter 2022.  Additionally, the remaining $33.1 million of PPP loans were forgiven resulting in $1.2 million of fee income.  At December 31, 2022, all PPP loans have been fully forgiven, and the associated fee income has been recognized.

ChoiceOne recorded accretion income related to acquired loans in the amount of $2.0 million during 2022.  Remaining credit and yield mark on acquired loans from the recent mergers with County Bank Corp. and Community Shores will accrete into income as the acquired loans mature.  ChoiceOne estimates that roughly $4.0 million will accrete into income over the next two to four years.

Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. In addition to its review of the loan portfolio for impaired loans, management also monitors various nonperforming loans. Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or past due 90 days or more, which are considered troubled debt restructurings. Troubled debt restructurings consist of loans where the terms have been modified to assist the borrowers in making their payments. The modifications can include capitalization of interest onto the principal balance, reduction in interest rate, and extension of the loan term. 

The balances of these nonperforming loans as of December 31 were as follows:

[[GREPCENT_TABLE]]
[["(Dollars in thousands)"],["","","2022","","","2021"],["Loans accounted for on a nonaccrual basis","","$","1,263","","","$","1,727"],["Loans contractually past due 90 days or more as to principal or interest payments","","","-","","","","-"],["Loans considered troubled debt restructurings which are not included above","","","1,404","","","","3,816"],["Total","","$","2,667","","","$","5,543"]]
[[/GREPCENT_TABLE]]

Nonaccrual loans included $1.3 million in residential real estate loans as of December 31, 2022, compared to $313,000 in agricultural loans, $285,000 in commercial and industrial loans, $279,000 in commercial real estate loans, and $850,000 in residential real estate loans as of December 31, 2021.  Loans considered troubled debt restructurings which were not on a nonaccrual basis and were not 90 days or more past due as to principal or interest payments consisted of $3,000 in agricultural loans, $58,000 in commercial and industrial loans, $131,000 in commercial real estate loans and $1.2 million in residential real estate loans at December 31, 2022, compared to $1.8 million in agricultural loans, $73,000 in commercial and industrial loans, $601,000 in commercial real estate loans and $1.3 million in residential real estate loans at December 31, 2021.

Management also maintains a list of loans that are not classified as nonperforming loans but where some concern exists as to the borrowers’ abilities to comply with the original loan terms. There were 10 loans totaling $180,000 fitting this description as of
December 31, 2022
, and no loans fitting that description on 
December 31, 2021
.

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Table of Contents

Deposits and Other Funding Sources

The Company’s deposit balances as of December 31 were as follows:

[[GREPCENT_TABLE]]
[["(Dollars in thousands)"],["","","2022","","","2021"],["Noninterest-bearing demand deposits","","$","599,579","","","$","560,931"],["Interest-bearing demand deposits","","","638,641","","","","665,482"],["Money market deposits","","","214,026","","","","218,211"],["Savings deposits","","","427,583","","","","425,626"],["Local certificates of deposit","","","236,431","","","","182,044"],["Brokered certificates of deposit","","","1,743","","","","-"],["Total deposits","","$","2,118,003","","","$","2,052,294"]]
[[/GREPCENT_TABLE]]

Total deposits increased $65.7 million from
December 31, 2021
to
December 31, 2022
; however, most of this was in the first half of 2022.  ChoiceOne saw deposits decline $38.7 million in the fourth quarter of 2022 due to some seasonality in municipal deposits and increased competition. 
 The Federal Reserve increased the federal funds rate by 4.0% during 2022 in response to published inflation rates. In response, the cost of interest-bearing deposits increased to 0.66% in the fourth quarter of 2022 primarily due to the increases in rates offered to retain clients and an increased interest in certificates of deposit. ChoiceOne is actively managing these costs while still retaining funds, and anticipates that deposit expense will continue to lag the cumulative increases in the federal funds rate. The actual cost of deposits increased by $940,000 in the fourth quarter of 2022 compared to the third quarter of 2022 and $1.9 million compared to the fourth quarter of 2021. 

In September 2021, ChoiceOne completed a private placement of $32.5 million in aggregate principal amount of 3.25% fixed-to-floating rate subordinated notes due 2031. ChoiceOne used a portion of net proceeds from the private placement to redeem senior debt, fund common stock repurchases, and support bank-level capital ratios. ChoiceOne also holds $3.2 million in subordinated debentures issued in connection with a $4.5 million trust preferred securities offering, which were obtained in the merger with Community Shores, offset by the mark-to-market adjustment. 

At December 31, 2022, the aggregate balance of all deposits exceeding the FDIC insured limit of $250,000 totaled $823.2 million, or 39% of total deposits, compared to $889.2 million, or 43% of total deposits and $583.7 million, or 35% of total deposits at December 31, 2021 and 2020, respectively.

Core deposits, which we define as insured branch deposits less certificates of deposit, totaled $1.2 billion or 55.0% of total deposits at December 31, 2022. 

Shareholders’ Equity

Total shareholders' equity declined $52.8 million in 2022. Accumulated other comprehensive income declined $69.2 million in 2022 as a result of market value declines in ChoiceOne’s available for sale securities. The change was caused by increases in certain general market interest rates since the beginning of 2022.  ChoiceOne's derivative strategy implemented during the second quarter of 2022 and repositioned during the fourth quarter of 2022, is expected to better position the Bank should rates continue to rise.  The net impact on equity of the derivative strategy as of December 31, 2022, was $957,000 net of tax.  

For further details refer to Footnote 8 "Derivatives and Hedging Activities".  As permitted by U.S. generally accepted accounting principles, unrecognized losses on securities held to maturity do not reduce other comprehensive income and, as a result, are not reflected as a reduction to shareholders’ equity on our balance sheet. ChoiceOne Bank remains “well-capitalized” with a total risk-based capital ratio of 13.0% as of December 31, 2022, compared to 12.9% on December 31, 2021.  

ChoiceOne repurchased 25,899 shares for $683,000, or a weighted average all-in cost per share of $26.35, during the first quarter of 2022. This was part of the common stock repurchase program announced in April 2021 which authorized repurchases of up to 390,114 shares, representing 5% of the total outstanding shares of common stock as of the date the program was adopted.  No shares of common stock were repurchased for the remainder of 2022; however, ChoiceOne may strategically repurchase shares of common stock in the future depending on market and other conditions. 

Note 21 to the consolidated financial statements presents regulatory capital information for ChoiceOne and the Bank at the end of 2022 and 2021. Management will monitor these capital ratios during 2023 as they relate to asset growth and earnings retention. ChoiceOne’s Board of Directors and management do not plan to allow capital to decrease below those levels necessary to be considered "well capitalized" by regulatory guidelines. At December 31, 2022, the Bank was categorized as "well-capitalized" under regulatory guidelines. 

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Table of Contents

Table 4 – Contractual Obligations

The following table discloses information regarding the maturity of ChoiceOne’s contractual obligations at
December 31, 2022:

[[GREPCENT_TABLE]]
[["","","Payment Due by Period"],["","","","","","","Less","","","","","","","","","","","More"],["","","","","","","than","","","1 - 3","","","3 - 5","","","than"],["(Dollars in thousands)","","Total","","","1 year","","","Years","","","Years","","","5 Years"],["Time deposits","","$","238,174","","","$","210,989","","","$","22,113","","","$","5,072","","","$","-"],["Borrowings","","","50,000","","","","50,000","","","","-","","","","-","","","","-"],["Cumulative Preferred Securities (1)","","","3,795","","","","-","","","","-","","","","-","","","","3,795"],["ChoiceOne Subordinated Debenture (2)","","","32,500","","","","-","","","","-","","","","-","","","","32,500"],["Operating leases","","","1,012","","","","322","","","","459","","","","231","","","","-"],["Other obligations","","","164","","","","70","","","","62","","","","18","","","","14"],["Total","","$","325,645","","","$","261,381","","","$","22,634","","","$","5,321","","","$","36,309"]]
[[/GREPCENT_TABLE]]

(1) Cumulative preferred securities on the balance sheet include $504,000 of discount due to a mark to market adjustment which is not reflected in the table above.

(2) ChoiceOne subordinated debenture on the balance sheet includes $529,000 of capitalized issuance cost which is not reflected in the table above.  

Liquidity and Interest Rate Risk

Net cash provided by operating activities was $45.0 million in 2022 compared to $37.7 million in 2021.  The change was due to lower net proceeds from loan sales in 2022 compared to 2021, which was offset by the change in other assets and liabilities.  Net cash used in investing activities was $90.5 million in 2022 compared to $521.4 million in 2021. ChoiceOne purchased $63.6 million of securities and had maturities or sales of securities of $106.4 million in 2022 compared to $637.9 million in purchases and $83.9 million in maturities or sales in 2021, respectively.  An increase in net loan originations led to cash used of $130.6 million in 2022 compared to cash provided of $45.4 million in the prior year.  Net cash provided by financing activities was $57.5 million in 2022, compared to $436.0 million in 2021. ChoiceOne experienced growth of $65.7 million in deposits in 2022 compared to growth of $377.7 million in 2021, while also seeing a $73.2 million decrease in borrowings in 2022, which led to the change.

ChoiceOne's primary market risk exposure occurs in the form of interest rate risk. Liquidity risk also can have an impact but to a lesser extent. ChoiceOne's business is transacted in U.S. dollars with no foreign exchange risk exposure. Agricultural loans comprise a relatively small portion of ChoiceOne's total assets. Management believes that ChoiceOne's exposure to changes in commodity prices is insignificant.

Management believes that the current level of liquidity and sources of additional liquidity are sufficient to meet the Bank's future liquidity needs. This belief is based upon the availability of deposits from both the local and national markets, our core deposit base, maturities of and cash flows from securities, normal loan repayments, income retention, federal funds purchased and advances available from the FHLB. Liquidity risk deals with ChoiceOne's ability to meet its cash flow requirements. These requirements include depositors desiring to withdraw funds and borrowers seeking credit. The Bank also has a line of credit secured by ChoiceOne’s commercial loans with the Federal Reserve Bank of Chicago for $380.4 million, which is designated for nonrecurring short-term liquidity needs. Longer-term liquidity needs may be met through core deposit growth, maturities of and cash flows from securities, normal loan repayments, advances from the FHLB, brokered certificates of deposit, and income retention. ChoiceOne had $50.0 million in outstanding borrowings at FHLB as of December 31, 2022, and $39.6 million of additional borrowing capacity was available based on residential real estate loans pledged as collateral at the end of 2022. The acceptance of brokered certificates of deposit is not limited as long as the Bank is categorized as “well capitalized” under regulatory guidelines.

ChoiceOne continues to review its liquidity management and has taken steps in an effort to ensure adequacy.  These steps include limiting bond purchases in the first two months of 2023, moving safekeeping of securities to FHLB in order to increase borrowing capacity, if pledged, by an amount of roughly $300.0 million, and using alternative funding sources such as brokered deposits.  ChoiceOne is also investigating additional borrowing capacity by use of the new Bank Term Funding Program announced March 12, 2023.  As of February 28, 2023 ChoiceOne estimates that it has total borrowing capacity of $398.3 million, and if additional securities are pledged with the FHLB, will have the ability to borrow up to $716.3 million.

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Table of Contents

NON-GAAP FINANCIAL MEASURES

This report contains financial measures that are not defined in U.S. generally accepted accounting principles ("GAAP"). Management believes this non-GAAP financial measure provides additional information that is useful to investors in helping to understand the underlying financial performance of ChoiceOne.

Non-GAAP financial measures have inherent limitations. Readers should be aware of these limitations and should be cautious with respect to the use of such measures. To compensate for these limitations, we use non-GAAP measures as comparative tools, together with GAAP measures, to assist in the evaluation of our operating performance or financial condition. Also, we ensure that these measures are calculated using the appropriate GAAP or regulatory components in their entirety and that they are computed in a manner intended to facilitate consistent period-to-period comparisons. ChoiceOne’s method of calculating these non-GAAP financial measures may differ from methods used by other companies. These non-GAAP financial measures should not be considered in isolation or as a substitute for those financial measures prepared in accordance with GAAP or in-effect regulatory requirements.

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Table of Contents

Critical Accounting Policies And Estimates

Management’s discussion and analysis of financial condition and results of operations as well as disclosures found elsewhere in this report are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the market value of securities, the amount of the allowance for loan losses, loan servicing rights, carrying value of goodwill, and income taxes. Actual results could differ from those estimates.

Securities

Debt securities are classified as held to maturity and carried at amortized cost when management has the positive intent and ability to hold them to maturity.  Debt securities available for sale may be sold prior to maturity due to changes in interest rates, prepayment risks, yield, availability of alternative investments, liquidity needs, credit rating changes, or other factors. Debt securities classified as available for sale are reported at their fair value with changes flowing through other comprehensive income. Declines in the fair value of securities below their cost that are considered to be “other than temporary” are recorded as losses in the income statement. In estimating whether a fair value decline is considered to be “other than temporary,” management considers the length of time and extent that the security’s fair value has been less than its carrying value, the financial condition and near-term prospects of the issuer, and the Bank’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

Market values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the fair value of securities is recorded as a valuation adjustment and reported net of tax effect in other comprehensive income.

Equity securities are reported at their fair value with changes in market value flowing through net income. Prior to 2018, equity securities were accounted for in a manner similar to available for sale debt securities.

Allowance for Loan Losses

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance for loan losses is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios.

Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and current economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Company’s assets reported on the balance sheet as well as its net income.

Loan Servicing Rights

Loan servicing rights represent the estimated value of servicing loans that are sold with servicing retained by ChoiceOne and are initially recorded at estimated fair value. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Management’s accounting treatment of loan servicing rights is estimated based on current prepayment speeds that are typically market driven.

Management believes the accounting estimate related to loan servicing rights is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of significant changes within long-term interest rates affecting the prepayment speeds for current loans being serviced and (2) the impact of recognizing an impairment loss could have a material effect on ChoiceOne’s net income. Management has obtained a third-party valuation of its loan servicing rights to corroborate its current carrying value at the end of each reporting period.

Goodwill

Goodwill is not amortized but is evaluated annually for impairment and on an interim basis if events or changes in circumstances indicate that goodwill might be impaired. The goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount, and an impairment charge would be recognized for any amount by which the carrying amount exceeds the reporting unit's fair value.  Accounting pronouncements allow a company to first perform a qualitative assessment for goodwill prior to a quantitative assessment (Step 1 assessment). If the results of the qualitative assessment indicate that it is more likely than not that goodwill is impaired, then a quantitative assessment must be performed. If not, there is no further assessment required. The Company acquired Valley Ridge Financial Corp. in 2006, County in 2019, and Community Shores in 2020, which resulted in the recognition of goodwill of $13.7 million, $38.9 million and $7.3 million, respectively.

We conducted an annual assessment of goodwill as of June 30, 2022 and no impairment was identified. The Company used a qualitative assessment to determine goodwill was not impaired as of June 30, 2022.

Additionally, the Company engaged a third party valuation firm to assist in performing a quantitative analysis of goodwill as of November 30, 2022 ("the valuation date"). In deriving the fair value of the reporting unit (the Bank), the third-party firm assessed general economic conditions and outlook; industry and market considerations and outlook; the impact of recent events to financial performance; the market price of ChoiceOne’s common stock and other relevant events. In addition, the valuation relied on financial projections through 2027 and growth rates prepared by management. Based on the valuation prepared, it was determined that ChoiceOne's estimated fair value of the reporting unit at the valuation date was greater than its book value and impairment of goodwill was not required.

Management concurred with the conclusion derived from the quantitative goodwill analysis as of the valuation date and determined that there were no material changes and that no triggering events had occurred that indicated impairment from the valuation date through December 31, 2022, and as a result that it is more likely than not that there was no goodwill impairment as of December 31, 2022.

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Table of Contents

Deferred Tax Assets and Liabilities

Income taxes include both a current and deferred portion. Deferred tax assets and liabilities are recorded to account for differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. Generally accepted accounting principles require that deferred tax assets be reviewed to determine whether a valuation allowance should be established using a “more likely than not” standard. Based on its review of ChoiceOne’s deferred tax assets as of
December 31, 2022, management determined that no valuation allowance was necessary. The valuation of current and deferred income tax assets and liabilities is considered critical, as it requires management to make estimates based on provisions of the enacted tax laws. The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and the federal tax code.