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EXHIBIT 13 (NATIONAL BANCSHARES CORPORATION LOGO) With the growth we experienced during the past few years, weve been actively restructuring a
number of areas of the bank to support current growth, and better position the
organization for future growth.




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|                                                |  |  |  |  |  |  |  | 
|----------------------------------------------- |  |  |  |  |  |  |  | 
|EX-3.1 Amended Articles of Incorporation       
|EX-3.2 Code of Regulations                     
|EX-13 Annual Report                            
|EX-14 Code of Business Conduct and Ethics      
|EX-21 Subsidiaries of National Bancshares Corp.
|EX-23 Consent of Independent Auditors          
|EX-31.1 CEO 302 Cert                           
|EX-31.2 CFO 302 Cert                           
|EX-32 906 Certifications                       



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FINANCIAL HIGHLIGHTS These financial highlights are merely excerpts of and are not a substitute for
National Bancshares Corporations consolidated financial statements, including
notes, and other detailed financial information we provide elsewhere in this
document. You should read the entire document, including the Financial Review
and the consolidated financial statements and notes to the consolidated
financial statements. Financial Position (Year End Balances)
    
    2003
    
    2002
    
    Percentage ChangeTotal Assets
    
    $
    301,249,375
    
    
    $
    296,750,165
    
    
    
    1.52
    %Deposits
    
    
    242,847,291
    
    
    
    239,297,227
    
    
    
    1.48
    %Loans-Net
    
    
    187,056,241
    
    
    
    190,559,663
    
    
    
    -1.84
    %Investment Securities
    
    
    83,793,119
    
    
    
    70,806,397
    
    
    
    18.34
    %Shareholders Equity
    
    
    34,804,735
    
    
    
    33,190,050
    
    
    
    4.86
    %Summary of OperationsNet Interest Income
    
    $
    11,303,793
    
    
    $
    11,013,379
    
    
    
    2.64
    %Net Income
    
    
    2,643,551
    
    
    
    2,254,774
    
    
    
    17.24
    %Regular Cash Dividends
    
    
    1,296,004
    
    
    
    1,203,946
    
    
    
    7.65
    %Net Income Per Share
    
    
    1.18
    
    
    
    1.01
    
    
    
    16.83
    %Cash Dividends Per Share
    
    
    0.58
    
    
    
    0.54
    
    
    
    7.41
    %Book Value Per Share
    
    
    15.58
    
    
    
    14.85
    
    
    
    4.92
    %
 National Bancshares Corporation is a one-bank holding company with assets of
$301 million. First National Bank, its subsidiary, is headquartered in
Orrville, Ohio. Serving Wayne County, southern Medina County, western Stark
County and parts of Holmes County through fourteen banking offices, First
National Bank offers a variety of personal and commercial deposit and lending
services.




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(PHOTO) DEAR SHAREHOLDERS The year 2003 brought continued
growth for National Bancshares with
total assets reaching over $300
million. Total deposits increased
over $3.5 million while net loans
decreased $3.5 million, compared to the
end of the previous year. With the
low interest rate environment that
existed throughout the past year,
many customers elected to refinance
their home mortgage loans. During
this time, many fixed rate mortgage
loans were paid off, refinanced, or
sold into the secondary market.
Having acquired primarily fixed rate
residential mortgage loans from the
acquisition of Peoples Financial
Corporation in 2002, this mortgage
activity assisted us in repositioning
our balance sheet by shifting certain
loan exposure from fixed rate
mortgages to variable rate commercial
loans. This should have a positive
impact on our earnings in an
increasing interest rate environment.
Net income increased by over $388
thousand or 17.2% above the year
2002. THIS GROWTH EXEMPLIFIES THE LONG-TERM TREND OF
INCREASING CASH DIVIDENDS, WHICH HAS CONTINUED
FOR OVER 35 CONSECUTIVE YEARS. Total cash dividends declared
during 2003 amounted to 58¢ per
share. This is a 7.4% increase over
the total cash dividends declared in
2002. This growth exemplifies the
long-term trend of increasing cash
dividends, which has continued for
over 35 consecutive years. The market
value of our common stock has also
continued to increase during the past
year, finishing the year
approximately 10.2% above the end of
the previous year. The Over The
Counter (OTC) market, upon which our
stock is listed, did not dissolve
this past year as NASDAQ had planned.
NASDAQ operates the Over The Counter
market and has decided to embrace
this market for trading small company
stocks. We continue to trade on this
market since we have found good,
ongoing liquidity for our stock
there. With the growth we experienced
during the past few years, we have been actively restructuring
a number of areas of the bank to
support current growth, and better
position the organization for future
growth. Additional lending and
support staff have been hired. We
have also embarked upon extensive
staff training on sales and problem
solving. New systems are being put
into place to more




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effectively manage a larger and growing
organization. To gain operational
efficiencies while supporting an
expanding organization, we have
embraced the use of a number of
technological advancements
available in the industry.
Recently, we have upgraded
computers and added servers
within the organization. Deposit
documentation software has been
upgraded to keep in step with the
ever-changing regulatory
environment. In the fourth
quarter of this past year we
completed installation and
testing of check imaging. This
service is being introduced to
our customers in January of 2004.
The time efficiency for
information retrieval on checks
will be greatly enhanced with
this service. Check imaging also
positions us to more efficiently
meet the upcoming changes the
Federal Reserve will begin
implementing in 2004 regarding
check truncation. In order to
move check clearing information
across the country faster and
more efficiently, the Federal
Reserve will be implementing a
new system of capturing check
information electronically at the
first Federal Reserve Bank a
check is processed through. The
information will then be
forwarded through a clearing
system electronically while the
physical check is retained, and
eventually destroyed by the
Federal Reserve Bank that first processed
the paper check. Banks will then
receive and process incoming
checks electronically rather than
by paper. This new system should
help to speed the processing of
checks across the country. IN LOOKING AHEAD TO 2004, WE FACE THESE CHALLENGES, AND THE
OPPORTUNITIES THEY MAY CREATE FOR US, WITH OPTIMISM. As we enter 2004, the economy is showing definite signs of improvement.
Interest rates appear to have bottomed and stabilized. The Federal Open Market
Committee has given indications they will not move short-term rates early in
2004. Only time will tell if and when a rate movement will take place. We
remain optimistic that the economy will continue to improve throughout next
year. The challenges presented by a struggling economy, along with an
ever-increasing regulatory and competitive environment, created a rather
interesting year. In looking ahead to 2004, we face these challenges, and the
opportunities they may create for us, with optimism. We thank you for your
support and hope we may have the opportunity to serve your financial needs. Charles J. Dolezal President and Chairman




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NATIONAL BANCSHARES CORPORATION 112 West Market Street
Orrville, Ohio 44667 2003 ANNUAL REPORT December 31, 2003




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TABLE OF CONTENTS PAGESELECTED FINANCIAL DATA
    
    
    4FINANCIAL REVIEW
    
    
    6CONSOLIDATED BALANCE SHEETS
    
    
    29CONSOLIDATED STATEMENTS OF INCOME
    
    
    30CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
    
    
    31CONSOLIDATED STATEMENTS OF CASH FLOWS
    
    
    32NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
    
    
    33REPORT OF INDEPENDENT AUDITORS
    
    
    54PRICE RANGE OF COMMON STOCK
    
    
    57DIRECTORS AND OFFICERS
    
    
    58OFFICE LOCATIONS
    
    
    59
 3




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SELECTED FINANCIAL DATA The summary financial information to follow is not a substitute for
National Bancshares Corporations consolidated financial statements, notes to
the consolidated financial statements, and other detailed financial information
we provide elsewhere in this document. You should read the entire document,
including the consolidated financial statements, the notes to the consolidated
financial statements, and the Financial Review. We derived the following data
from National Bancshares consolidated financial statements for the fiscal
years ended December 31, 1999 through 2003. As of or For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Income Statement Data:Interest Income
    
    $
    15,043,809
    
    
    $
    15,941,153
    
    
    $
    13,556,747
    
    
    $
    14,214,579
    
    
    $
    13,382,607Interest Expense
    
    
    3,740,016
    
    
    
    4,927,774
    
    
    
    4,954,357
    
    
    
    5,410,266
    
    
    
    4,748,609Net Interest Income
    
    
    11,303,793
    
    
    
    11,013,379
    
    
    
    8,602,390
    
    
    
    8,804,313
    
    
    
    8,633,998Provision for Loan Losses
    
    
    245,000
    
    
    
    1,569,402
    
    
    
    40,000
    
    
    
    62,500
    
    
    
    120,000Net Interest Income After
Provision for Loan Losses
    
    
    11,058,793
    
    
    
    9,443,977
    
    
    
    8,562,390
    
    
    
    8,741,813
    
    
    
    8,513,998Noninterest Income
    
    
    1,532,020
    
    
    
    1,458,031
    
    
    
    1,145,238
    
    
    
    849,467
    
    
    
    836,598Noninterest Expense
    
    
    9,140,516
    
    
    
    7,998,774
    
    
    
    6,403,105
    
    
    
    6,318,759
    
    
    
    6,199,427Income Before Income Taxes
    
    
    3,450,297
    
    
    
    2,903,234
    
    
    
    3,304,523
    
    
    
    3,272,521
    
    
    
    3,151,169Income Tax Expense
    
    
    806,746
    
    
    
    648,460
    
    
    
    777,320
    
    
    
    717,250
    
    
    
    634,183Net Income
    
    $
    2,643,551
    
    
    $
    2,254,774
    
    
    $
    2,527,203
    
    
    $
    2,555,271
    
    
    $
    2,516,986Balance Sheet Data:Cash and Due from Banks
    
    $
    11,506,999
    
    
    $
    10,010,654
    
    
    $
    6,935,082
    
    
    $
    7,077,797
    
    
    $
    8,538,351Investment Securities
    
    
    83,793,119
    
    
    
    70,806,397
    
    
    
    60,843,655
    
    
    
    68,021,052
    
    
    
    70,214,050Loans-Net
    
    
    187,056,241
    
    
    
    190,559,663
    
    
    
    116,880,804
    
    
    
    107,551,674
    
    
    
    99,531,223Deposits
    
    
    242,847,291
    
    
    
    239,297,227
    
    
    
    159,519,295
    
    
    
    162,013,585
    
    
    
    160,435,348Borrowings
    
    
    20,140,702
    
    
    
    21,211,964
    
    
    
    5,741,697
    
    
    
    8,010,869
    
    
    
    8,663,682Shareholders Equity
    
    
    34,804,735
    
    
    
    33,190,050
    
    
    
    30,922,188
    
    
    
    28,939,329
    
    
    
    26,856,195Total Assets
    
    
    301,249,375
    
    
    
    296,750,165
    
    
    
    197,763,446
    
    
    
    200,792,706
    
    
    
    197,402,543Per Common Share Data:Net Income
    
    $
    1.18
    
    
    $
    1.01
    
    
    $
    1.13
    
    
    $
    1.14
    
    
    $
    1.12Cash Dividends
    
    
    0.58
    
    
    
    0.54
    
    
    
    0.52
    
    
    
    0.50
    
    
    
    0.48Book Value
    
    
    15.58
    
    
    
    14.85
    
    
    
    13.93
    
    
    
    12.93
    
    
    
    12.01Weighted Average Number
of Shares Outstanding
    
    
    2,234,488
    
    
    
    2,228,510
    
    
    
    2,230,013
    
    
    
    2,240,534
    
    
    
    2,253,650
 4




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As of or For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Selected Data:Return on Average Equity
    
    
    7.58
    %
    
    
    7.01
    %
    
    
    8.17
    %
    
    
    9.08
    %
    
    
    9.22
    %Return on Average Assets
    
    
    0.90
    %
    
    
    0.85
    %
    
    
    1.27
    %
    
    
    1.30
    %
    
    
    1.30
    %Dividend Payout Percentage
    
    
    49.03
    %
    
    
    53.40
    %
    
    
    45.85
    %
    
    
    43.82
    %
    
    
    42.84
    %Efficiency Ratio(1)
    
    
    71.21
    %
    
    
    64.14
    %
    
    
    65.69
    %
    
    
    65.45
    %
    
    
    65.46
    %Full Time Equivalent Staff
    
    
    133
    
    
    
    122
    
    
    
    103
    
    
    
    103
    
    
    
    101Average Total Assets to
Full Time Equivalent Staff
    
    $
    2,209,383
    
    
    $
    2,166,827
    
    
    $
    1,938,835
    
    
    $
    1,902,022
    
    
    $
    1,917,411Asset Quality Ratios:Allowance for Loan Losses to
Ending Total Loans
    
    
    0.85
    %
    
    
    0.83
    %
    
    
    1.12
    %
    
    
    1.23
    %
    
    
    1.29
    %Net Loan Charge-offs to
Average Loans
    
    
    0.13
    %
    
    
    0.89
    %
    
    
    0.06
    %
    
    
    0.03
    %
    
    
    0.11
    %Capital Ratios:Average Equity to
Average Assets
    
    
    11.86
    %
    
    
    12.17
    %
    
    
    15.49
    %
    
    
    14.36
    %
    
    
    14.10
    %Leverage Ratio(2)
    
    
    9.04
    %
    
    
    8.61
    %
    
    
    14.98
    %
    
    
    14.53
    %
    
    
    13.83
    %Total Risk-Based Capital Ratio(2)
    
    
    13.59
    %
    
    
    13.58
    %
    
    
    22.71
    %
    
    
    22.22
    %
    
    
    21.81
    %
  (1)
    
    The efficiency ratio is calculated by dividing noninterest expenses by
the sum of net interest income and non-interest income.(2)
    
    Computed in accordance with Comptroller of the Currency and FDIC
guidelines. The following table shows quarterly results of operations for 2003 and
2002. Income (Loss)Provision
    
    Before
    
    Net
    
    Basic and DilutedInterest
    
    Net Interest
    
    For Loan
    
    Income
    
    Income
    
    Earnings(Unaudited)
    
    Income
    
    Income
    
    Losses
    
    Taxes
    
    (Loss)
    
    (Loss) Per Share2003First quarter
    
    $
    3,974,571
    
    
    $
    2,992,145
    
    
    $
    35,000
    
    
    $
    1,073,950
    
    
    $
    806,646
    
    
    $
    0.36Second quarter
    
    
    3,926,619
    
    
    
    2,926,329
    
    
    
    50,000
    
    
    
    1,076,993
    
    
    
    799,626
    
    
    
    0.36Third quarter
    
    
    3,744,193
    
    
    
    2,839,220
    
    
    
    70,000
    
    
    
    826,683
    
    
    
    636,946
    
    
    
    0.28Fourth quarter
    
    
    3,398,426
    
    
    
    2,546,099
    
    
    
    90,000
    
    
    
    472,671
    
    
    
    400,333
    
    
    
    0.182002First quarter
    
    $
    3,007,388
    
    
    $
    2,153,796
    
    
    $
    20,000
    
    
    $
    933,340
    
    
    $
    729,777
    
    
    $
    0.33Second quarter
    
    
    4,397,461
    
    
    
    2,898,126
    
    
    
    95,000
    
    
    
    976,131
    
    
    
    680,516
    
    
    
    0.31Third quarter
    
    
    4,291,593
    
    
    
    2,943,490
    
    
    
    25,000
    
    
    
    1,175,006
    
    
    
    874,757
    
    
    
    0.39Fourth quarter
    
    
    4,244,711
    
    
    
    3,017,967
    
    
    
    1,429,402
    
    
    
    (181,243
    )
    
    
    (30,276
    )
    
    
    -0.02
 During the fourth quarter of 2002, management charged off one large
commercial credit and identified other losses in the portfolio, which required
an additional provision. This was the primary reason for the decline in 2002
fourth quarter income before income taxes, net income and earnings per share. During the fourth quarter of 2003, the Corporation accelerated the
purchase accounting adjustment on loans related to the acquisition in 2002 by
approximately $450,000. This impacted the Corporations net interest income,
income before income taxes, net income and earnings per share for the fourth
quarter of 2003. 5




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FINANCIAL REVIEW This financial review is intended to assist the reader in evaluating the
performance of National Bancshares Corporation for the years ended December 31,
2003, 2002 and 2001. This information should be read in conjunction with the
consolidated financial statements and accompanying notes to the financial
statements. Forward Looking Statement The Private Securities Litigation Reform Act of 1995 contains safe harbor
provisions regarding forward-looking statements. Forward-looking statements can
be identified by terminology such as believes, expects, anticipates,
estimates, intends, should, will, plans, potential and similar
words. Forward-looking statements are also statements that are not statements
of historical fact. Forward-looking statements necessarily involve risks and
uncertainties. They are merely predictive or statements of probabilities,
involving known and unknown risks, uncertainties and other factors. If one or
more of these risks or uncertainties occurs or if the underlying assumptions
prove incorrect, actual results in 2004 and beyond could differ materially from
those expressed in or implied by the forward-looking statements. Forward-looking statements are based upon a variety of estimates and
assumptions. The estimates and assumptions involve judgments about a number of
things, including future economic, competitive, and financial market conditions
and future business decisions. These matters are inherently subject to
significant business, economic, and competitive uncertainties, all of which are
difficult to predict and many of which are beyond National Bancshares
Corporations control. Although we believe the estimates and assumptions are
reasonable, actual results could vary materially from those shown. Inclusion of
forward-looking information does not constitute a representation by National
Bancshares or any other person that the indicated results will be achieved. You
are cautioned not to place undue reliance on forward-looking information. Financial Condition Loans. National Bancshares total assets increased by 1.5%, while net
loans decreased by 1.8% from 2002 to 2003, principally due to the $17.5 million
or 14.8% decrease in residential real estate loans. With low interest rates
during 2003, many customers elected to refinance their homes. The Bank
experienced a net decline in residential real estate mortgages due to payoffs,
pay downs and loan sales of approximately $5.4 million. At the end of 2002
residential mortgage loans secured by 1-4 family real estate constituted 62% of
First National Banks total loans, compared to 54% by the end of 2003. With the acquisition of Peoples Financial Corporation in 2002, and its
subsidiary, Peoples Federal Savings and Loan Association of Massillon (Peoples
Federal), located in Stark County, the Bank entered a new market. Peoples
Federals primary lending activity consisted of the origination of conventional
mortgage loans secured by one-to-four family homes. To diversify the loan
portfolio and take advantage of the opportunities in the market place, the Bank
hired seasoned commercial loan officers to focus on our current and new market
areas. By year-end 2003, commercial real estate loans increased $10.6 million
or 36.9% over year-end 2002. First National Banks loan policy provides that loans in any one of five
broad categories of lending products may constitute up to 60% of the total loan
portfolio: commercial loans, real estate loans, agricultural loans, commercial
real estate loans, and consumer loans. As noted above, the major changes in the
loan portfolio were an increase in commercial real estate loans, offset by a
decline in residential real estate loans. Home equity and construction loans
also increased; offset by declines in consumer, commercial, credit cards and
other loans. Home equity loans increased $1.5 million or 11.6% as we made
changes to this product to make it more competitive in the marketplace.
Construction loans, which are short term by nature, increased by $3.1 million
or 148.4%. At the end of the construction period a construction loan migrates
from the construction loan category to another, such as commercial real estate,
if First National Bank provides permanent financing. The sharp decline in real
estate construction loans by the end of the year 2002 is attributable
principally to a large commercial construction loan that was written off in
2002. Other loans, which consist mostly of tax-free industrial development bond
loans, decreased $0.7 million or 29.2% to $1.8 million due to paydowns. The
composition of the banks loan portfolio in dollar amounts and in percentages
at the end of each of the last five fiscal years was as follows. 6




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Loan Portfolio Composition at December 31,2003
    
    2002
    
    2001$
    
    %
    
    $
    
    %
    
    $
    
    %Type of Loan:Collateralized by real estate:Commercial
    
    $
    39,349,045
    
    
    
    21
    %
    
    $
    28,747,949
    
    
    
    15
    %
    
    $
    23,933,475
    
    
    
    20
    %Residential
    
    
    101,291,447
    
    
    
    54
    %
    
    
    118,834,883
    
    
    
    62
    %
    
    
    53,522,228
    
    
    
    45
    %Home equity
    
    
    14,008,018
    
    
    
    7
    %
    
    
    12,555,738
    
    
    
    6
    %
    
    
    9,426,924
    
    
    
    8
    %Construction
    
    
    5,131,685
    
    
    
    3
    %
    
    
    2,065,964
    
    
    
    1
    %
    
    
    4,769,337
    
    
    
    4
    %159,780,195
    
    
    
    85
    %
    
    
    162,204,534
    
    
    
    84
    %
    
    
    91,651,964
    
    
    
    77
    %Other:Consumer
    
    
    4,828,644
    
    
    
    3
    %
    
    
    4,847,264
    
    
    
    3
    %
    
    
    5,224,468
    
    
    
    5
    %Commercial
    
    
    21,374,911
    
    
    
    11
    %
    
    
    21,631,567
    
    
    
    11
    %
    
    
    18,050,801
    
    
    
    15
    %Credit cards - unsecured
    
    
    1,263,565
    
    
    
    0
    %
    
    
    1,276,587
    
    
    
    1
    %
    
    
    1,227,172
    
    
    
    1
    %Other
    
    
    1,821,016
    
    
    
    1
    %
    
    
    2,570,767
    
    
    
    1
    %
    
    
    2,249,271
    
    
    
    2
    %Total Loans
    
    
    189,068,331
    
    
    
    100
    %
    
    
    192,530,719
    
    
    
    100
    %
    
    
    118,403,676
    
    
    
    100
    %Less:Unearned and deferred income
    
    
    (408,522
    )
    
    
    
    
    
    
    (366,856
    )
    
    
    
    
    
    
    (201,720
    )Allowance for loan losses
    
    
    (1,603,568
    )
    
    
    
    
    
    
    (1,604,200
    )
    
    
    
    
    
    
    (1,321,152
    )Net Loans
    
    $
    187,056,241
    
    
    
    
    
    
    $
    190,559,663
    
    
    
    
    
    
    $
    116,880,804Net loans as a percent of
total assets
    
    
    62.09
    %
    
    
    
    
    
    
    64.22
    %
    
    
    
    
    
    
    59.10
    %
   [Continued from above table, first column(s) repeated] Loan Portfolio Composition at December 31,2000
    
    1999$
    
    %
    
    $
    
    %Type of Loan:Collateralized by real estate:Commercial
    
    $
    27,005,236
    
    
    
    25
    %
    
    $
    25,030,907
    
    
    
    25
    %Residential
    
    
    42,063,386
    
    
    
    38
    %
    
    
    39,206,446
    
    
    
    39
    %Home equity
    
    
    8,612,004
    
    
    
    8
    %
    
    
    6,334,052
    
    
    
    6
    %Construction
    
    
    1,011,188
    
    
    
    1
    %
    
    
    1,225,265
    
    
    
    1
    %78,691,814
    
    
    
    72
    %
    
    
    71,796,670
    
    
    
    71
    %Other:Consumer
    
    
    7,151,394
    
    
    
    7
    %
    
    
    7,847,553
    
    
    
    8
    %Commercial
    
    
    19,850,559
    
    
    
    18
    %
    
    
    17,851,661
    
    
    
    18
    %Credit cards - unsecured
    
    
    1,188,297
    
    
    
    1
    %
    
    
    1,207,352
    
    
    
    1
    %Other
    
    
    2,273,180
    
    
    
    2
    %
    
    
    2,452,641
    
    
    
    2
    %Total Loans
    
    
    109,155,244
    
    
    
    100
    %
    
    
    101,155,877
    
    
    
    100
    %Less:Unearned and deferred income
    
    
    (260,446
    )
    
    
    
    
    
    
    (316,024
    )Allowance for loan losses
    
    
    (1,343,124
    )
    
    
    
    
    
    
    (1,308,630
    )Net Loans
    
    $
    107,551,674
    
    
    
    
    
    
    $
    99,531,223Net loans as a percent of
total assets
    
    
    53.56
    %
    
    
    
    
    
    
    50.42
    %
 At the end of 2003 total agricultural loans were not significant,
amounting to approximately $4.6 million. About $4.4 million of that amount
consists of loans collateralized by farmland, which is included in the $39.3
million commercial loans secured by real estate. The remainder, slightly less
than $200 thousand, consists of loans for agricultural production and other
loans to farmers, and that figure is included in the $21.4 million figure for
commercial loans (not collateralized by real estate). Ranked by Standard
Industry Classification  or SIC  codes, the industries most represented among
First National Banks commercial borrowers include the restaurant, real estate
agent, and holding company industries, in that order, accounting for
approximately 2.83%, 2.36%, and 1.90% of the total loans at year-end 2003,
respectively. Conventional mortgage loans secured by 1-4 family real estate are
long-term assets and in many cases have a fixed interest rate. The vast
majority of loans added to First National Banks portfolio by the acquisition
of Peoples Federal were fixed-rate residential mortgage loans, but their number
has declined since the merger as these fixed-rate loans have steadily been sold
into the secondary market, have been refinanced elsewhere or paid off.
Approximately 37% of the portfolio of conventional mortgage loans secured by
1-4 family and multifamily real estate at year-end 2003 was adjustable rate.
First National Banks fixed-rate conventional mortgage loans are originated
with loan documentation that permits their sale to Freddie Mac. However, the
banks policy is generally to retain mortgage loans in its portfolio unless the
banks loan-to-deposit ratio exceeds 90% or unless the banks fixed mortgages
exceed 35% of total gross loans. The first table to follow presents maturity information for the loan
portfolio at year-end 2003, without taking account of prepayments or
unscheduled principal repayments. Loans are shown as maturing based on
contractual maturities. The second table shows the dollar amount of all loans
due after December 31, 2003 that have pre-determined interest rates and the
dollar amount of all loans due after December 31, 2003 that have floating or
adjustable rates. 7




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##### Table of Contents



Loan Portfolio Maturity at December 31, 20035 years0 to 1 year *
    
    1 to 5 years
    
    or more
    
    TotalAmount due:Collateralized by real estate:Commercial
    
    $
    3,689,843
    
    
    $
    10,581,002
    
    
    $
    25,078,200
    
    
    $
    39,349,045Residential
    
    
    8,728,895
    
    
    
    18,707,237
    
    
    
    73,855,315
    
    
    
    101,291,447Home equity
    
    
    146,660
    
    
    
    32,131
    
    
    
    13,829,227
    
    
    
    14,008,018Construction
    
    
    3,144,569
    
    
    
    1,235,888
    
    
    
    751,228
    
    
    
    5,131,685Consumer
    
    
    1,717,897
    
    
    
    3,074,754
    
    
    
    35,993
    
    
    
    4,828,644Commercial
    
    
    15,921,934
    
    
    
    4,761,752
    
    
    
    691,225
    
    
    
    21,374,911Credit cards
    
    
    1,263,565
    
    
    
    0
    
    
    
    0
    
    
    
    1,263,565Other
    
    
    572,398
    
    
    
    601,952
    
    
    
    646,666
    
    
    
    1,821,016Total amount due
    
    $
    35,185,761
    
    
    $
    38,994,716
    
    
    $
    114,887,854
    
    
    $
    189,068,331
 *  Loans due on demand and overdrafts are included in the amount due in one
year or less. Fixed Rate
    
    Adjustable Rate
    
    TotalCollateralized by real estate:Commercial
    
    $
    5,726,621
    
    
    $
    33,622,424
    
    
    $
    39,349,045Residential
    
    
    63,374,047
    
    
    
    37,917,400
    
    
    
    101,291,447Home equity
    
    
    0
    
    
    
    14,008,018
    
    
    
    14,008,018Construction
    
    
    4,050,901
    
    
    
    1,080,784
    
    
    
    5,131,685Consumer
    
    
    4,532,962
    
    
    
    295,682
    
    
    
    4,828,644Commercial
    
    
    3,649,177
    
    
    
    17,725,734
    
    
    
    21,374,911Credit cards
    
    
    1,008,744
    
    
    
    254,821
    
    
    
    1,263,565Other
    
    
    1,552,249
    
    
    
    268,767
    
    
    
    1,821,016Total
    
    $
    83,894,701
    
    
    $
    105,173,630
    
    
    $
    189,068,331
 Allowance for Loan Losses. As explained in Note 1 of the consolidated
financial statements, the allowance for loan losses is a valuation allowance
for probable incurred credit losses that have not yet been confirmed, increased
by the provision for credit losses and decreased by charge-offs less
recoveries. The allowance for loan losses is the sum of components recognized
and measured either: (1) according to Statement of Financial Accounting
Standards (SFAS) 5, Accounting for Contingencies, for pools of homogenous
loans, or (2) according to SFAS 114, Accounting by Creditors for Impairment of
a Loan, for loans the bank considers impaired based upon individual loan
review. Management determines the necessary allowance balance using the banks
loan loss experience, the nature and volume of the portfolio, information about
specific borrower situations and estimated collateral values, economic
conditions, and other factors. Loan losses are charged against the allowance
when management believes the uncollectibility of a loan balance is confirmed. Loans Analyzed Individually. Determining the loan loss allowance begins
with the banks assessment of credit risk for loans analyzed individually.
Individual loans are assigned credit-risk grades based on the banks assessment
of conditions affecting a borrowers ability to satisfy its contractual
obligation under the loan agreement. The assessment process includes reviewing
a borrowers current financial information, historical payment experience,
credit documentation, public information, and other information specific to
each borrower. Loans reviewed individually are reviewed at least annually, or
more frequently if management becomes aware of information affecting a
borrowers ability to fulfill its obligation. All loans over $200 thousand or
to customers whose aggregate total loans exceed $200 thousand are reviewed
individually, except for first mortgage loans on a borrowers personal
residence. Loans or customers with balances under $200 thousand may also be
reviewed individually if considered necessary by the board or management.
Likewise, all commercial lending relationships over $200 thousand are ranked
according to risk at least annually, but a risk ranking may change at any point
during the year if the credit relationship changes. Loans analyzed individually
are ranked as follows  8




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##### Table of Contents



Passloans are loans that are
considered satisfactory, with lower
than average risk and low probability
of serious financial deterioration on
the borrowers part Special-Mentionloans have more than
average risk, with identified
potential weaknesses that deserve
managements close attention. Left
uncorrected, the potential weaknesses
could result in deterioration of
repayment prospects. In the case of a
commercial borrower for example,
potential weaknesses could include
adverse trends in the borrowers
operations or adverse economic or
market conditions that could affect
the borrower in the future Doubtfulloans have all the weaknesses
inherent in those classified as
substandard, with the added
characteristic that existing facts,
conditions, and values make collection
or liquidation in full highly
questionable and improbable. The
possibility of loss is extremely high,
but because of factors that could work
to the borrowers advantage
classification of the doubtful loan
as loss is deferred Watchloans are loans that are
performing according to the terms of the
loan agreement but that nevertheless
require enhanced management supervision
because of factors such as an unusual
payment history or a weakened financial
condition on the borrowers part Substandardloans are inadequately
protected by the current financial
condition and paying capacity of the
borrower or by any collateral securing
the loan. Substandard loans have a
well-defined weakness or weaknesses
jeopardizing collection of the debt in
full, with a distinct possibility of
loss if the weakness or weaknesses are
not corrected. Although a loan may be
classified substandard even if payments
are not 90 days or more past due, if
payments are 90 days or more past due
the loan will be classified as
substandard at best, if not ranked even
lower Loans classified as Lossare those
considered uncollectible and of such
little value that their continuance as
assets without the establishment of a
specific loss reserve is not warranted.
When a bank classifies an asset as
loss, the bank is required either to
establish an allowance for losses equal
to 100% of that portion of the asset so
classified or to charge off that amount If it is probable that the bank will be unable to collect all principal
and interest due on a loan  and that the loan is therefore impaired 
management measures the amount of impairment using the loans expected future
cash flows (discounted at the loans effective interest rate), or the fair
value of the underlying collateral if loan repayment is expected to come from
the sale or operation of the collateral. First National Bank considers larger
loans ranked doubtful or loss to be impaired. Substandard, special mention, and
watch loans are not considered impaired. Impairment is evaluated in total for
smaller-balance loans of similar nature  such as residential mortgage,
consumer, and credit card loans  and on an individual loan basis for other
loans. If a loan is impaired, a portion of the loan loss allowance is allocated
so that the loan is reported net, at the present value of estimated future cash
flows using the loans existing rate or at the fair value of collateral if
repayment is expected solely from the collateral. Increases in the allowance for loan losses are made by charges to the
provision for loan losses. No specific provision for loan losses results if an
individually reviewed loan is ranked pass or watch, but they are included
in the pools of loans analyzed under SFAS 5. Loans classified special mention
or
substandard, and smaller-balance loans classified doubtful are assigned a
provision based upon a historical migration analysis performed on classified
loans. The migration analysis identifies the percentage of classified loans by
category that has historically been ultimately charged-off. The migration
percentages are reviewed and adjusted by management to reflect various factors
such as the growth and change in mix of the loan portfolio and the regulators
guidelines. Loans ranked loss are of course charged off in their entirety
because at that point the unconfirmed loss that the loan loss allowance is
intended to approximate is considered to be confirmed. 9




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##### Table of Contents



As of December 31, 2003, 2002, and 2001 classified assets were as follows  Classified assets at December 31,2003
    
    2002
    
    2001Percent of
    
    
    
    
    
    Percent of
    
    
    
    
    
    Percent ofAmount
    
    total loans
    
    Amount
    
    total loans
    
    Amount
    
    total loansClassified loans:Special mention
    
    $
    3,126,131
    
    
    
    1.7
    %
    
    $
    2,333,281
    
    
    
    1.2
    %
    
    $
    
    
    
    
    0.0
    %Substandard
    
    
    3,994,474
    
    
    
    2.1
    %
    
    
    4,351,773
    
    
    
    2.3
    %
    
    
    3,762,681
    
    
    
    3.2
    %Doubtful
    
    
    383,495
    
    
    
    0.2
    %
    
    
    9,878
    
    
    
    0.0
    %
    
    
    92,144
    
    
    
    0.1
    %Loss
    
    
    
    
    
    
    0.0
    %
    
    
    6,512
    
    
    
    0.0
    %
    
    
    1,665
    
    
    
    0.0
    %Total classified loans
    
    $
    7,504,100
    
    
    
    4.0
    %
    
    $
    6,701,444
    
    
    
    3.5
    %
    
    $
    3,856,490
    
    
    
    3.3
    %Other classified assets
    
    
    
    
    
    
    0.0
    %
    
    
    
    
    
    
    0.0
    %
    
    
    
    
    
    
    0.0
    %Total classified assets
    
    $
    7,504,100
    
    
    
    4.0
    %
    
    $
    6,701,444
    
    
    
    3.5
    %
    
    $
    3,856,490
    
    
    
    3.3
    %
 Pools of Homogenous Loans Analyzed under SFAS 5. The total loan loss
allowance is derived both from analysis of individual impaired loans under SFAS
114 and analysis of aggregated pools of loans under SFAS 5. Smaller balance
loans (such as automobile or home equity loans, for example), homogenous groups
of loans (such as residential mortgage loans), and less severely classified
loans reviewed individually may be analyzed on an aggregated or pooled basis
under SFAS 5. Under SFAS 5, loans are segmented into groups of loans having similar risk
characteristics based on purpose, loan type, and collateral, for example
commercial loans, residential mortgage loans, home equity loans, and consumer
loans. Losses inherent in pools of loans are estimated using average historical
losses over a period of years for loans of those types, but with adjustments to
account for changes in loan policies, changes in underwriting or loan recovery
practices, changes in prevailing economic conditions, changes in the nature or
volume of the loan portfolio, and changes in other internal and external
factors. Loans secured by real estate  particularly residential mortgage loans
 generally have less credit risk than other types of loans. Representing a
significant portion of the banks loan portfolio before the acquisition of
Peoples Financial, loans secured by real estate are still a dominant portion of
the portfolio. Changes in the Allowance for Loan Losses and Classified Assets. A proper
loan review function is vital to establishment of an appropriate loan loss
allowance. Loan officers and the banks credit analysts are responsible for the
assignment of risk ratings for loans reviewed individually. The banks internal
auditor provides another level of review for selected loans of $200 thousand or
more, annually reviewing the credit assignments and the financial analyses
performed by credit analysts. Each month a committee consisting of the banks
President, Controller, and Chief Loan Officer evaluates the loan loss allowance
and reports the results of its evaluation to the banks board. Finally, the
bank adjusts its loan loss allowance methodologies retrospectively as well,
making adjustments in its estimates and assumptions as necessary to account for
variances of estimated loan losses from actual loan loss experience. The banks
determination about classification of its assets and the amount of its
allowances is subject to review by the Office of the Comptroller of the
Currency (OCC), which may order the establishment of additional loss
allowances. First National Banks allowance for loan losses as a percentage of total
loans declined significantly in 2002, and increased slightly in 2003. The ratio
of the loan loss allowance to loan losses also declined in 2002 with an
increase in 2003. The ratio of classified assets to the sum of tier 1 capital
plus the
allowance for loans losses increased in 2002 and 2003. The reduction in the
allowance for loan losses as a percentage of total loans from 1.12% at year-end
2001 to 0.83% at year-end 2002 and 0.85% at year-end 2003 was due mainly to the
63% increase in total loans arising out of the acquisition of Peoples Financial
in 2002, which maintained a relatively small loan loss allowance because the
vast majority of its loan assets consisted of residential mortgage loans. The
ratio of the loan loss allowance to loan losses declined from about 15:1 at the
end of 2001 to almost 1:1 by the end of 2002, then increased to approximately
6:1 at the end of 2003. The ratio dropped significantly in 2002 because of a
$1.5 million charge-off of a commercial real estate construction loan, which
occurred in the fourth quarter of 2002. During 2003 the ratio was impacted by a
$200 thousand commercial loan that was charged-off. The ratio of classified
assets to the sum of tier 1 capital plus the allowance for loans losses
increased from about 12% at the end of 2001 to 25% at the end of 2002, and 26%
at the end of 2003 for two principal reasons. First, continued weakness in the
local 10




---



##### Table of Contents



economy and deterioration in the financial circumstances of some of the banks
commercial borrowers has led to more loans being classified. Secondly, the
acquisition of Peoples Federal reduced the banks capital ratios. First National Bank modified its methodology for analyzing loans under
SFAS 5 in 2001. Until 2001 the bank used peer group loan loss experience to
estimate the loan loss allowance for this portion of the portfolio. But as the
bank accumulated more loan loss experience during periods of strong loan
growth, management felt by 2001 that it was appropriate to start using its own
loan loss experience to assess the adequacy of the loan loss reserve. This
resulted in a lower required reserve balance at year-end 2001 compared to prior
periods because First National Banks loss rates were lower than peer loss
rates. However, the ending reserve balance in 2001 was comparable to 2000 due
to additional specific reserves on problem loans. Taking into account the
banks rapid growth resulting from the April 2002 acquisition of Peoples
Financial, the banks expansion in the Stark County market, the growing
financial stress on borrowers that can result from deteriorating economic
conditions such as occurred in 2001 through 2003, and the late 2002 charge off
of a large construction loan, the bank is taking actions to improve and make
more systematic its loan administration functions, including loan review and
monitoring. Loan review and monitoring is vital not only to establishment of an
appropriate loan loss allowance but also to proper credit administration and
risk management generally. Bank growth outpaced the evolution of the banks
credit administration and oversight functions, which developed over time in a
somewhat informal way as many community banking organizations functions do.
Until the Peoples Financial acquisition, First National Bank was a community
banking organization in the truest sense, with many of the banks customers
known to the banks management by name. In a typical community bank, management
is personally familiar with the credit factors that support customers loans,
including the financial circumstances of commercial borrowers organizations,
the quality of real estate collateral supporting loans, and similar factors.
Although First National Bank remains a community banking organization,
management recognizes that  as a significantly larger institution having a
broader geographic reach than its historical core market in Orrville  the bank
must make more formal and systematic its credit administration, loan review,
and associated functions. As part of this ongoing effort, an additional credit
analyst was engaged in 2003, and loan reporting and documentation processes are
being enhanced to instill greater discipline into the credit administration and
oversight functions Loans deemed uncollectible are charged against the allowance for loan
losses. But even after a loan is charged off, the bank nevertheless attempts
recovery when possible. Recoveries of previously charged-off amounts are
credited to the allowance for loan losses. Transactions in the allowance for
loan losses are summarized as follows  11




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##### Table of Contents



Year Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Loan loss allowance, beginning of period
    
    $
    1,604,200
    
    
    $
    1,321,152
    
    
    $
    1,343,124
    
    
    $
    1,308,630
    
    
    $
    1,296,513Loans charged off:Collateralized by real estate:Commercial
    
    
    
    
    
    
    
    
    
    
    20,007
    
    
    
    
    
    
    
    Residential
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Home equity
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Construction
    
    
    
    
    
    
    1,475,906
    
    
    
    
    
    
    
    
    
    
    
    Consumer
    
    
    9,923
    
    
    
    21,943
    
    
    
    21,006
    
    
    
    34,510
    
    
    
    83,039Commercial
    
    
    237,526
    
    
    
    23,431
    
    
    
    38,730
    
    
    
    8,720
    
    
    
    57,568Credit cards
    
    
    20,036
    
    
    
    24,706
    
    
    
    6,439
    
    
    
    13,507
    
    
    
    5,352Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total loans charged off
    
    
    267,485
    
    
    
    1,545,986
    
    
    
    86,182
    
    
    
    56,737
    
    
    
    145,959Recoveries of loans previously charged off:Collateralized by real estate:Commercial
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Residential
    
    
    
    
    
    
    
    
    
    
    1,451
    
    
    
    707
    
    
    
    6,407Home equity
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Construction
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Consumer
    
    
    8,840
    
    
    
    12,151
    
    
    
    20,937
    
    
    
    24,986
    
    
    
    16,894Commercial
    
    
    7,320
    
    
    
    2,300
    
    
    
    1,218
    
    
    
    2,002
    
    
    
    13,263Credit cards
    
    
    5,693
    
    
    
    652
    
    
    
    604
    
    
    
    1,036
    
    
    
    1,512Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total recoveries
    
    
    21,853
    
    
    
    15,103
    
    
    
    24,210
    
    
    
    28,731
    
    
    
    38,076Net loans recovered (charged off)
    
    
    (245,632
    )
    
    
    (1,530,883
    )
    
    
    (61,972
    )
    
    
    (28,006
    )
    
    
    (107,883
    )Provision charged to operations
    
    
    245,000
    
    
    
    1,569,402
    
    
    
    40,000
    
    
    
    62,500
    
    
    
    120,000Allowance of acquired institution
    
    
    
    
    
    
    244,529
    
    
    
    
    
    
    
    
    
    
    
    Loan loss allowance, end of period
    
    $
    1,603,568
    
    
    $
    1,604,200
    
    
    $
    1,321,152
    
    
    $
    1,343,124
    
    
    $
    1,308,630Loans outstanding:Average
    
    
    187,180,000
    
    
    
    172,159,000
    
    
    
    110,418,000
    
    
    
    104,856,000
    
    
    
    97,438,000End of period
    
    
    189,068,331
    
    
    
    192,530,719
    
    
    
    118,403,676
    
    
    
    109,155,244
    
    
    
    101,155,877Ratio of allowance for loan losses to total loans
outstanding at end of period
    
    
    0.85
    %
    
    
    0.83
    %
    
    
    1.12
    %
    
    
    1.23
    %
    
    
    1.29
    %Net recoveries (charge offs) to average loans
    
    
    -0.13
    %
    
    
    -0.89
    %
    
    
    -0.06
    %
    
    
    -0.03
    %
    
    
    -0.11
    %
 The allowance for loan losses is allocated among loan categories as shown
in the table to follow. The allocation of the allowance to each category is not
necessarily indicative of future loss in a particular category. Although a bank
considers inherent losses in individual loans and categories of similar loans
when it establishes the loan loss allowance, the allowance is a general reserve
available to absorb all credit losses in the portfolio. No part of the
allowance is segregated for or dedicated to any particular asset or group of
assets. 12




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##### Table of Contents



Allocation of the Allowance for Loan Losses at December 31,2003
    
    2002
    
    2001Percent of
    
    
    
    
    
    Percent of
    
    
    
    
    
    Percent ofloans in
    
    
    
    
    
    loans in
    
    
    
    
    
    loans ineach
    
    
    
    
    
    each
    
    
    
    
    
    eachcategory to
    
    
    
    
    
    category to
    
    
    
    
    
    category toAmount
    
    total loans
    
    Amount
    
    total loans
    
    Amount
    
    total loansCollateralized by
real estate:Commercial
    
    $
    462,667
    
    
    
    21
    %
    
    $
    277,776
    
    
    
    15
    %
    
    $
    171,388
    
    
    
    20
    %Residential
    
    
    56,624
    
    
    
    54
    %
    
    
    258,377
    
    
    
    62
    %
    
    
    74,396
    
    
    
    45
    %Home equity
    
    
    5,592
    
    
    
    7
    %
    
    
    14,623
    
    
    
    6
    %
    
    
    13,103
    
    
    
    8
    %Construction
    
    
    
    
    
    
    3
    %
    
    
    40,789
    
    
    
    1
    %
    
    
    763,783
    
    
    
    4
    %Consumer
    
    
    7,976
    
    
    
    3
    %
    
    
    20,497
    
    
    
    3
    %
    
    
    58,732
    
    
    
    5
    %Commercial
    
    
    964,121
    
    
    
    11
    %
    
    
    967,182
    
    
    
    11
    %
    
    
    177,538
    
    
    
    15
    %Credit cards
    
    
    21,760
    
    
    
    0
    %
    
    
    24,956
    
    
    
    1
    %
    
    
    51,691
    
    
    
    1
    %Other
    
    
    
    
    
    
    1
    %
    
    
    
    
    
    
    1
    %
    
    
    
    
    
    
    2
    %Unallocated
    
    
    84,828
    
    
    
    N/A
    
    
    
    
    
    
    
    N/A
    
    
    
    10,521
    
    
    
    N/ATotal
    
    $
    1,603,568
    
    
    
    100
    %
    
    $
    1,604,200
    
    
    
    100
    %
    
    $
    1,321,152
    
    
    
    100
    %
   [Continued from above table, first column(s) repeated] Allocation of the Allowance for Loan Losses at December 31,2000
    
    1999Percent of
    
    
    
    
    
    Percent ofloans in
    
    
    
    
    
    loans ineach
    
    
    
    
    
    eachcategory to
    
    
    
    
    
    category toAmount
    
    total loans
    
    Amount
    
    total loansCollateralized by
real estate:Commercial
    
    $
    354,665
    
    
    
    25
    %
    
    $
    270,161
    
    
    
    25
    %Residential
    
    
    139,598
    
    
    
    38
    %
    
    
    137,223
    
    
    
    39
    %Home equity
    
    
    52,900
    
    
    
    8
    %
    
    
    22,169
    
    
    
    6
    %Construction
    
    
    6,067
    
    
    
    1
    %
    
    
    12,253
    
    
    
    1
    %Consumer
    
    
    95,309
    
    
    
    7
    %
    
    
    119,568
    
    
    
    8
    %Commercial
    
    
    227,919
    
    
    
    18
    %
    
    
    273,354
    
    
    
    18
    %Credit cards
    
    
    148,562
    
    
    
    1
    %
    
    
    20,309
    
    
    
    1
    %Other
    
    
    
    
    
    
    2
    %
    
    
    
    
    
    
    2
    %Unallocated
    
    
    318,104
    
    
    
    N/A
    
    
    
    453,593
    
    
    
    N/ATotal
    
    $
    1,343,124
    
    
    
    100
    %
    
    $
    1,308,630
    
    
    
    100
    %
 Management reviews problem loans for unfavorable collectibility factors
and assesses the requirement for specific reserves on those credits. Management
considers any loan past due 90 days or more and any loan on non-accrual to be a
problem loan. Any loan 90 days or more past due that is not both adequately
collateralized and in a positive cash-flow position and any loan of a borrower
experiencing serious financial deterioration may be placed on non-accrual by
the Chief Lending Officer. Interest received on non-accrual loans
 also
referred to as nonperforming loans  is recorded as a reduction of principal.
The table to follow summarizes problem loans and other problem assets by
category. 13




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##### Table of Contents



Problem Assets at December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999Collateralized by real estate:Commercial:Non-accrual
    
    $
    
    
    
    $
    
    
    
    $
    142,803
    
    
    $
    93,007
    
    
    $
    90,739Past due 90 days or more
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    105,616
    
    
    
    138,268Residential:Non-accrual
    
    
    567,590
    
    
    
    171,482
    
    
    
    103,152
    
    
    
    40,137
    
    
    
    89,050Past due 90 days or more
    
    
    28,578
    
    
    
    76,752
    
    
    
    71,942
    
    
    
    
    
    
    
    57,786Home equity:Non-accrual
    
    
    
    
    
    
    
    
    
    
    12,823
    
    
    
    
    
    
    
    Past due 90 days or more
    
    
    23,172
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Construction:Non-accrual
    
    
    125,502
    
    
    
    140,000
    
    
    
    
    
    
    
    
    
    
    
    Past due 90 days or more
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Not collateralized by real estate:Consumer:Non-accrual
    
    
    
    
    
    
    4,964
    
    
    
    
    
    
    
    10,987
    
    
    
    27,384Past due 90 days or more
    
    
    
    
    
    
    
    
    
    
    13,232
    
    
    
    5,497
    
    
    
    8,560Commercial:Non-accrual
    
    
    677,777
    
    
    
    1,841,922
    
    
    
    
    
    
    
    
    
    
    
    42,697Past due 90 days or more
    
    
    
    
    
    
    252,331
    
    
    
    58,749
    
    
    
    
    
    
    
    20,011Credit cards:Non-accrual
    
    
    8,989
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Past due 90 days or more
    
    
    
    
    
    
    5,690
    
    
    
    4,012
    
    
    
    980
    
    
    
    1,279Total problem loans
    
    
    1,431,608
    
    
    
    2,493,141
    
    
    
    406,713
    
    
    
    256,224
    
    
    
    475,774Other real estate owned
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total problem assets
    
    $
    1,431,608
    
    
    $
    2,493,141
    
    
    $
    406,713
    
    
    $
    256,224
    
    
    $
    475,774Loans outstanding, net
    
    $
    187,056,241
    
    
    $
    190,559,663
    
    
    $
    116,880,804
    
    
    $
    107,551,674
    
    
    $
    99,531,223Problem loans to total net loans
    
    
    0.77
    %
    
    
    1.31
    %
    
    
    0.35
    %
    
    
    0.24
    %
    
    
    0.48
    %Problem loans to total assets
    
    
    0.48
    %
    
    
    0.84
    %
    
    
    0.21
    %
    
    
    0.13
    %
    
    
    0.24
    %Allowance for loan losses to total loans
    
    
    0.85
    %
    
    
    0.83
    %
    
    
    1.12
    %
    
    
    1.23
    %
    
    
    1.29
    %Allowance for loan losses to problem loans
    
    
    112.01
    %
    
    
    64.34
    %
    
    
    324.84
    %
    
    
    524.20
    %
    
    
    275.05
    %
 Securities. To assist in local development, the bank actively purchases
bonds issued by local municipalities, school systems, and other public entities
when opportunities arise. Other securities are primarily comprised of corporate
bonds and notes as well as equity securities of approximately $900 thousand.
Investment securities are classified either as held to maturity or as available
for sale. The bank does not hold any securities for trading purposes. If
management has the intent and the bank has the ability at the time of purchase
to hold a security until maturity or on a long-term basis, the security is
classified as held-to-maturity and it is reflected on the balance sheet at
historical cost. Securities to be held for indefinite periods and not intended
to be held to maturity or on a long-term basis are classified as
available-for-sale, and they are reflected on the balance sheet at their market
value. Management determines the appropriate classification at the time of
purchase. At year-end 2003, 2002 and 2001 there was no single issuer of
securities where the total book value of such securities exceeded 10% of
shareholders equity except for United States government and agency
obligations. 14




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##### Table of Contents



The following table shows the amortized cost and estimated fair value of the
banks investment portfolio at the dates indicated. Investment Portfolio Amortized Cost and Fair Value at December 31, 2003
    
    2002Gross
    
    Gross
    
    
    
    
    
    
    
    
    
    Gross
    
    GrossAmortized
    
    unrealized
    
    unrealized
    
    Fair
    
    Amortized
    
    unrealized
    
    unrealized
    
    Faircost
    
    gains
    
    tosses
    
    value
    
    cost
    
    gains
    
    losses
    
    valueAvailable
for Sale:U.S. Government
and federal agency
    
    $
    26,046,048
    
    
    $
    1,047,855
    
    
    $
    (19,375
    )
    
    $
    27,074,528
    
    
    $
    19,774,745
    
    
    $
    1,244,835
    
    
    $
    (317
    )
    
    $
    21,019,283State and municipal
    
    
    2,261,802
    
    
    
    175,194
    
    
    
    
    
    
    
    2,436,996
    
    
    
    2,273,996
    
    
    
    146,698
    
    
    
    
    
    
    
    2,420,694Corporate bonds and
notes
    
    
    34,981,032
    
    
    
    1,924,041
    
    
    
    (79,437
    )
    
    
    36,825,636
    
    
    
    25,471,382
    
    
    
    1,589,612
    
    
    
    (158,648
    )
    
    
    26,902,346Equity securities
    
    
    859,940
    
    
    
    26,013
    
    
    
    (33,550
    )
    
    
    852,403
    
    
    
    2,208,602
    
    
    
    85,673
    
    
    
    (271,766
    )
    
    
    2,022,409Total available
for sale
    
    
    64,148,822
    
    
    
    3,173,103
    
    
    
    (132,362
    )
    
    
    67,189,563
    
    
    
    49,728,725
    
    
    
    3,066,718
    
    
    
    (430,731
    )
    
    
    52,364,712Held to
Maturity:State and municipal
    
    
    16,603,556
    
    
    
    712,328
    
    
    
    (15,800
    )
    
    
    17,300,084
    
    
    
    18,441,685
    
    
    
    668,144
    
    
    
    (144,264
    )
    
    
    18,985,565Total Investment
Securities
    
    $
    80,752,378
    
    
    $
    3,885,431
    
    
    $
    (148,162
    )
    
    $
    84,489,647
    
    
    $
    68,170,410
    
    
    $
    3,754,862
    
    
    $
    (574,996
    )
    
    $
    71,350,277
   [Continued from above table, first column(s) repeated] 2001Gross
    
    GrossAmortized
    
    unrealized
    
    unrealized
    
    Faircost
    
    gains
    
    losses
    
    valueAvailable
for Sale:U.S. Government
and federal agency
    
    $
    16,030,295
    
    
    $
    540,133
    
    
    $
    (2,618
    )
    
    $
    16,567,812State and municipal
    
    
    2,285,595
    
    
    
    55,614
    
    
    
    
    
    
    
    2,341,209Corporate bonds and
notes
    
    
    25,848,708
    
    
    
    864,269
    
    
    
    (186,053
    )
    
    
    26,326,912Equity securities
    
    
    2,356,379
    
    
    
    144,125
    
    
    
    (227,133
    )
    
    
    2,273,371Total available
for sale
    
    
    46,320,975
    
    
    
    1,604,131
    
    
    
    (415,802
    )
    
    
    47,509,304Held to
Maturity:State and municipal
    
    
    13,334,351
    
    
    
    479,921
    
    
    
    (7,694
    )
    
    
    13,806,578Total Investment
Securities
    
    $
    59,655,326
    
    
    $
    2,084,052
    
    
    $
    (423,496
    )
    
    $
    61,315,882
 15




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##### Table of Contents



The contractual maturity of investment securities at December 31, 2003 is shown
below. December 31, 2003More than one to five
    
    More than five to tenOne year or less
    
    years
    
    yearsCarrying
    
    Average
    
    Carrying
    
    Average
    
    Carrying
    
    Averagevalue
    
    yield
    
    value
    
    yield
    
    value
    
    yieldAvailable for Sale:U.S. Government and federal agency
    
    $
    1,975,540
    
    
    
    8.50
    %
    
    $
    2,025,000
    
    
    
    4.21
    %
    
    $
    15,488,486
    
    
    
    5.37
    %State and political subdivisions:Tax-exempt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    221,358
    
    
    
    7.50
    %Mortgage-backed
    
    
    2,336
    
    
    
    10.05
    %
    
    
    65,382
    
    
    
    9.10
    %
    
    
    77,506
    
    
    
    8.90
    %Corporate bonds and notes
    
    
    2,295,391
    
    
    
    6.72
    %
    
    
    19,524,438
    
    
    
    5.54
    %
    
    
    14,855,013
    
    
    
    5.49
    %Total debt securities
    
    
    4,273,267
    
    
    
    7.55
    %
    
    
    21,614,820
    
    
    
    5.42
    %
    
    
    30,642,363
    
    
    
    5.45
    %Equity securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total available for sale
    
    
    4,273,267
    
    
    
    7.55
    %
    
    
    21,614,820
    
    
    
    5.42
    %
    
    
    30,642,363
    
    
    
    5.45
    %Held to Maturity:State and political subdivisions:Tax-exempt
    
    
    361,973
    
    
    
    9.03
    %
    
    
    2,601,577
    
    
    
    7.94
    %
    
    
    4,769,951
    
    
    
    7.02
    %Total investment securities
    
    $
    4,635,240
    
    
    
    7.66
    %
    
    $
    24,216,397
    
    
    
    5.69
    %
    
    $
    35,412,314
    
    
    
    5.66
    %
   [Continued from above table, first column(s) repeated] December 31, 2003Total investment securities andMore than ten years
    
    mortgage-backed securitiesCarrying
    
    Average
    
    Carrying
    
    Average
    
    Marketvalue
    
    yield
    
    value
    
    yield
    
    valueAvailable for Sale:U.S. Government and federal agency
    
    $
    5,463,036
    
    
    
    6.41
    %
    
    $
    24,952,062
    
    
    
    5.75
    %
    
    $
    24,952,062State and political subdivisions:Tax-exempt
    
    
    2,215,638
    
    
    
    7.84
    %
    
    
    2,436,996
    
    
    
    7.81
    %
    
    
    2,436,996Mortgage-backed
    
    
    1,977,242
    
    
    
    7.86
    %
    
    
    2,122,466
    
    
    
    7.94
    %
    
    
    2,122,466Corporate bonds and notes
    
    
    150,794
    
    
    
    7.47
    %
    
    
    36,825,636
    
    
    
    5.60
    %
    
    
    36,825,636Total debt securities
    
    
    9,806,710
    
    
    
    7.04
    %
    
    $
    66,337,160
    
    
    
    5.81
    %
    
    
    66,337,160Equity securities
    
    
    852,403
    
    
    
    3.37
    %
    
    
    852,403
    
    
    
    3.37
    %
    
    
    852,403Total available for sale
    
    
    10,659,113
    
    
    
    6.75
    %
    
    
    67,189,563
    
    
    
    5.78
    %
    
    
    67,189,563Held to Maturity:State and political subdivisions:
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Tax-exempt
    
    
    8,870,055
    
    
    
    6.70
    %
    
    
    16,603,556
    
    
    
    7.04
    %
    
    
    17,300,084Total investment securities
    
    $
    19,529,168
    
    
    
    6.72
    %
    
    $
    83,793,119
    
    
    
    6.03
    %
    
    $
    84,489,647
 Expected maturities of investment securities could differ from contractual
maturities because the borrower, or issuer, could have the right to call or
prepay obligations with or without call or prepayment penalties. At year-end
2003, approximately 28% of the banks securities portfolio was represented by
securities that could be called or prepaid without penalty. 16




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##### Table of Contents



Federal Bank Stock. As of December 31, 2003, the bank held 20,599 shares
of $100 par value Federal Home Loan Bank of Cincinnati stock, which are
restricted securities. FHLB stock represents an equity interest in the FHLB,
but it does not have a readily determinable market value. The stock can be sold
at its par value only, and only to the FHLB or to another member institution.
Member institutions are required to maintain a minimum stock investment in the
FHLB, based on total assets, total mortgages, and total mortgage-backed
securities. Deposits. Deposits increased 1.5% during 2003, with growth concentrated in
demand and savings deposits, offset by a decline in time deposits. First
National Banks savings accounts include passbook and statement savings, as
well as Preferred Savings accounts tiered to pay higher rates for higher
balances. First National Bank does not solicit brokered deposits. Savings
accounts increased $4.5 million or 5.5% from the end of 2002 to the end of
2003. Noninterest bearing demand deposits, consisting of regular checking
accounts, increased $3.0 million or 8.3% and interest bearing demand deposits,
which includes Negotiable Order of Withdrawal accounts and Money Market Deposit
Accounts, increased $4.5 million or 13.2% during 2003. With certificates of
deposit rates declining during 2003, customers moved funds from time deposits
into demand and savings accounts. Time deposits under $100,000 decreased $7.9
million or 10.6% during 2003. Time deposits of $100,000 and more decreased by
$549 thousand or 4.7% by the end of 2003. The table below shows the amount of
time deposits (certificates of deposit) of $100,000 or more by time remaining
until maturity as of December 31, 2003. Maturity of Time Deposits of$100,000 or More atDecember 31, 2003Percent ofTime Remaining to Maturity
    
    Amount
    
    totalThree months or less
    
    $
    3,676,071
    
    
    
    32.8
    %Over three through 12 months
    
    
    4,790,196
    
    
    
    42.7
    %Over one year through 3 years
    
    
    2,104,573
    
    
    
    18.8
    %Over 3 years
    
    
    640,044
    
    
    
    5.7
    %Total
    
    $
    11,210,884
    
    
    
    100.0
    %
 Deposits are the primary sources of funds for lending activities and other
general business purposes. Our core deposits at year-end 2003 were
approximately $164 million, consisting of demand and savings deposits. This
represented 61% of total long-term assets, compared to 59% at year-end 2002.
Our net non-core funding dependence ratio was 9.3% at year-end 2003 and 7.9% at
year-end 2002. We use the net non-core funding dependence ratio to measure the
banks dependence on high-cost funding sources to support long-term assets,
meaning funding sources other than core funding sources like retail customer
deposits. The net non-core funding dependence ratio is calculated as noncore
liabilities, such as time deposits over $100,000, repurchase agreements and
Federal Home Loan Bank advances, less short-term investments, divided by total
long-term investments. One of our goals is to increase the percentage of core
or nonmaturity deposits relative to the banks long-term assets, enhancing the
banks liquidity and management of interest-rate risk by increasing the level
of low-cost and stable funding sources for the banks long-term assets. Liquidity and Capital Resources. A banks liquidity risk is the risk
associated with having to satisfy current and future financial obligations in a
timely manner. The bank considers core earnings, strong capital ratios, and
credit quality essential for maintaining high credit ratings, which allow the
bank cost-effective access to market-based liquidity. Both short- and long-term
liquidity needs are addressed by maturities and sales of unpledged investment
securities, loan repayments and maturities, sales of loans that are not pledged
as security for FHLB borrowings, and transactions in cash and cash equivalents,
such as federal funds sold. The use of these resources, combined with access to
credit, provide funds for satisfying depositor, borrower, and creditor needs.
Management considers the bank to have satisfactory liquidity, with the ability
to satisfy the demands of customers and the local economy. Liquidity may be
adversely affected by unexpected deposit outflows, excessive interest rates
paid by competitors, and similar factors. Management monitors projected
liquidity needs and establishes a desirable level based in part on the banks
commitment to make loans as well as managements assessment of the banks
ability to generate funds. The most liquid assets are cash and cash equivalents, which at year-end
2003 consisted of $11.5 million in cash and due from banks. At year-end 2002
cash and cash equivalents consisted of $10.0 million in cash and due from banks
and $6.3 million in federal funds sold. Federal funds sold are overnight
investments with correspondent 17




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##### Table of Contents



banks, an investment and liquidity tool that are
used to maximize earning assets. Investment securities classified as available
for sale that are not pledged are another source of liquidity. In addition to
the net non-core funding dependence ratio, we also consider the banks
loans-to-deposits ratio to assess liquidity, seeking to cap the ratio of loans
to deposits at 90%. The ratio of total loans to deposits at year-end 2003 was
78%. At the end of 2003 the fair value of securities available for sale was
approximately $67 million, while the total carrying value of securities pledged
was approximately $26 million, representing securities pledged to secure public
deposits and repurchase agreements. In 2001, securities with a fair value of
approximately $30.7 million were transferred from the held to maturity category
to available for sale, with the result that most of the banks securities,
which were once held to maturity, are now available for sale. A new accounting
standard that became effective for National Bancshares in 2001 requires
companies to record derivatives on the balance sheet as assets and liabilities
measured at fair value. The new accounting standard also prohibits classifying
as held to maturity any security held for hedging purposes, but companies were
permitted to reclassify any security from held to maturity upon adoption of the
pronouncement if they desired to be able to hedge the security in the future.
In January 2001, National Bancshares adopted the new standard and transferred
securities with an amortized cost of approximately $30.5 million and a fair
value of approximately $30.7 million from the held to maturity to the available
for sale category to take advantage of the flexibility provided by this
classification. Operating activities provided net cash of $3.4 million in 2003, $3.2
million in 2002, and $2.4 million in 2001, generated principally from net
income in those years, but the unusually large $1.6 million provision for loan
losses taken in 2002 also contributed to net cash from operations because the
provision is a non-cash charge against earnings. Investing activities consist
primarily of loan originations, sales, and repayments, along with investment
securities purchases, sales, and maturities. In 2001 the approximately $22
million of proceeds from securities maturities and repayments was nearly
equally offset by additional securities purchases and net loan originations in
that year. After the acquisition of Peoples Federal in 2002, interest rates
continued the decline that began in 2000. As mortgage borrowers did nationwide,
many of Peoples Federals mortgage borrowers took advantage of historically low
interest rates to refinance their debt. However, more so than other First
National Bank mortgage customers, these former Peoples Federal customers tended
to refinance their mortgage borrowings at other institutions. As a consequence,
although new loan originations remained robust, loan repayments and maturities
exceeded loan originations in 2002 by about $4.6 million. In 2003 investing
activities used cash of $9.5 million as investment purchases exceeded
investment maturities, repayments and sales and proceeds from sale of loans by
approximately $7.0 million. Loan originations by category in the last three
years were as follows  2003
    
    2002
    
    2001Collateralized by real estate:Commercial
    
    $
    11,406,806
    
    
    $
    7,424,626
    
    
    $
    6,424,502Residential
    
    
    42,976,105
    
    
    
    33,609,861
    
    
    
    23,139,725Home equity
    
    
    2,288,240
    
    
    
    1,696,849
    
    
    
    2,011,281Construction
    
    
    2,567,017
    
    
    
    968,832
    
    
    
    2,013,334Consumer
    
    
    3,447,668
    
    
    
    3,315,190
    
    
    
    2,851,082Commercial
    
    
    9,478,041
    
    
    
    11,786,741
    
    
    
    8,101,818Credit cards
    
    
    504,700
    
    
    
    291,900
    
    
    
    217,850Other
    
    
    317,891
    
    
    
    948,473
    
    
    
    578,947Total
    
    $
    72,986,468
    
    
    $
    60,042,472
    
    
    $
    45,338,539
 Financing activities include the solicitation and repayment of customer
deposits, borrowings and repayments, treasury stock activity, and the payment
of dividends. The bank had $17 million of borrowings outstanding with the
Federal Home Loan Bank (FHLB) of Cincinnati at the end of 2003, maturing in
2010 and 2011. We had assumed $19.4 million in FHLB advances when we acquired
Peoples Financial Corporation in April 2002. First National Bank has
approximately $57 million available in short-term funding arrangements with its
correspondent banks and the FHLB. Additional information concerning FHLB
borrowings and bank obligations under repurchase agreements is contained in
Notes 7 and 8 of the consolidated financial statements of National Bancshares.
The outstanding balances and related information about short-term borrowings,
which consists almost entirely of securities sold under agreements to
repurchase are summarized as follows  18




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##### Table of Contents



Year Ended December 31,2003
    
    2002
    
    2001Balance at year end
    
    $
    2,786,848
    
    
    $
    3,006,221
    
    
    $
    3,422,657Average balance outstanding
    
    
    2,845,520
    
    
    
    3,919,776
    
    
    
    3,649,427Maximum month-end balance
    
    
    3,385,869
    
    
    
    4,775,461
    
    
    
    4,700,114Weighted-average rate at year end
    
    
    0.10
    %
    
    
    0.12
    %
    
    
    0.25
    %Weighted-average rate during the year
    
    
    0.13
    %
    
    
    0.17
    %
    
    
    2.22
    %
 National Bancshares and the bank are subject to federal regulations
imposing minimum capital requirements. We monitor total risk-based, tier I
risk-based, and tier I leverage capital ratios to assure compliance with
regulatory capital requirements. At December 31, 2003 both National Bancshares
and the bank exceeded minimum risk-based and leverage capital ratio
requirements. The banks ratio of total capital to risk-based assets was 13.09%
on December 31, 2003. The minimum required ratio is 8%. Additional information
concerning capital ratios at year-end 2003 and 2002 is contained in Note 12 of
the consolidated financial statements. Contractual Obligations. As discussed in the notes to National Bancshares
consolidated financial statements, we have obligations to make payments under
contracts, including borrowings. At December 31, 2003, the aggregate
contractual obligations are  Payment due by periodLess than 1
    
    
    
    
    
    
    
    
    
    More thanContractual Obligations
    
    Total
    
    year
    
    1 - 3 years
    
    3 - 5 years
    
    5 yearsLong-term obligations
    
    $
    17,034,291
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    17,034,291Capital lease obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating lease obligations
    
    
    205,916
    
    
    
    63,322
    
    
    
    86,694
    
    
    
    31,200
    
    
    
    24,700Purchase obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other long-term liabilities reflected on National
Bancshares Corporations balance sheet
under GAAP
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    17,240,207
    
    
    $
    63,322
    
    
    $
    86,694
    
    
    $
    31,200
    
    
    $
    17,058,991
 Off-Balance Sheet and Contingent Liabilities. Some financial instruments,
such as loan commitments, credit lines, and letters of credit are issued to
satisfy customers financing needs. Ordinarily having fixed expiration dates,
these are agreements to provide credit or to
support the credit of others, as long as conditions established in the contract
are satisfied. Off-balance-sheet risk in the form of potential credit loss
exists up to the face amount of these instruments, although we do not expect
material losses. We use the same credit policies to make these commitments that
we use to make loans, including obtaining collateral at exercise of the
commitment. Funding commitments by expiration period were as follows at
year-end 2003  Expiration of Funding CommitmentsOne year
    
    Over oneand less
    
    year
    
    TotalUnused loan commitments
    
    $
    25,837,109
    
    
    $
    20,479,191
    
    
    $
    46,316,300Letters of credit
    
    
    821,000
    
    
    
    
    
    
    
    821,000Total
    
    $
    26,658,109
    
    
    $
    20,479,191
    
    
    $
    47,137,300
 Of the unused loan commitments, approximately $5.0 million pertain to
fixed-rate commitments and approximately $41.3 million pertain to variable-rate
commitments. Rates on unused loan commitments range from 3.0% to 16.9%. Because
our experience demonstrates that a large percentage of funding commitments
expire unused or only partially used, we believe that the total funding
commitments shown in the table above do not necessarily represent actual future
cash requirements. The bank earns fees when it issues funding commitments,
which are recorded in the consolidated statements of income as interest on
loans, including fees. The bank also earns fees from customer overdrafts, which
fees are included in checking account fees. 19




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##### Table of Contents



The bank is required by reserve regulations of the Federal Reserve Board
to maintain cash on hand or on deposit with the Federal Reserve Bank. Reserve
requirements vary according to the amount of a banks transaction accounts,
checking accounts principally. Reserve balances do not earn interest. First
National Bank was required to have cash on hand or on deposit with the Federal
Reserve Bank of $3.0 million at year-end 2003 and $2.7 million at year-end
2002. The bank occasionally sells loans it originates, particularly conventional
residential mortgage loans. These loans are not sold with recourse. The bank
has retained mortgage-servicing rights on approximately $5.7 million of
residential mortgage loans sold. Shareholders Equity. The 4.9% increase in shareholders equity from
year-end 2002 to year-end 2003 is attributable to retained earnings and
increased accumulated other comprehensive income, which benefited from the
general improvement in the market value of investments available for sale.
Accumulated other comprehensive income represents the unrealized appreciation
or depreciation (net of taxes) in the market value of debt and equity
investments available for sale. Because of interest rate volatility,
accumulated other comprehensive income could materially fluctuate for each
interim and year-end period, depending on economic and interest rate
conditions. Because National Bancshares is dependent on the bank for earnings and
funds necessary to pay dividends, the ability of National Bancshares to pay
dividends to its shareholders is subject to bank regulatory restrictions.
According to the National Bank Act and Office of the Comptroller of the
Currency (OCC) Rule 5.64, a national bank may never pay a cash dividend without
advance OCC approval if the amount of the dividend exceeds retained net income
for the year and for the two preceding years (after any required transfers to
surplus). To provide funds to National Bancshares for the April 2002
acquisition of Peoples Financial Corporation, First National Bank obtained OCC
approval to pay a $12 million special dividend, which exceeded the Rule 5.64
formula amount. As a result, First National Bank may pay no additional cash
dividends to National Bancshares through the end of 2004 without additional OCC
approval. We believe National Bancshares cash resources will allow National
Bancshares to continue paying its regular quarterly cash dividend to
shareholders through the first half of 2004 without having to obtain OCC
approval of a cash dividend from First National Bank. But we expect that OCC
approval of one or more dividends from the bank to the holding company will be
necessary to continue the regular quarterly cash dividend to shareholders
during the second half of 2004. Although we expect that OCC approval can be
obtained, taking the banks capital position and its continued earnings into
account, we cannot assure that the OCC will approve the bank dividend. Assuming
First National Bank continues to achieve net earnings in 2004 and into 2005;
the requirement to obtain OCC approval for bank dividends should lapse
beginning in 2005. Interest-Rate Sensitivity. Like other financial institutions, the bank is
subject to interest rate risk, which management considers to be the banks most
significant market risk. Interest rate sensitivity, or interest rate risk,
relates to the effect of changing interest rates on net interest income.
Interest-earning assets with interest rates tied to the prime rate for example,
or that mature in relatively short time periods, are considered interest-rate
sensitive. Interest-bearing liabilities with interest rates that can be
repriced in a discretionary manner, or that mature in relatively short periods
of time, are also considered interest-rate sensitive. The differences between
interest-sensitive assets and interest-sensitive liabilities over various time
horizons are commonly referred to as sensitivity gaps. As interest rates
change, a sensitivity gap will have either a favorable effect or an adverse
effect on net interest income. A negative gap  with liabilities repricing more
rapidly than assets  generally has a favorable
effect when interest rates are falling, and an adverse effect when rates are
rising. A positive gap  with assets repricing more rapidly than liabilities 
generally has the opposite effect: an adverse effect when rates are falling and
a favorable effect when rates are rising. National Bancshares and the bank do
not own any trading assets and are not subject to foreign currency exchange or
commodity price risk. Interest rate risk in total is a product of risks such as repricing risk,
option risk, and basis risk. Repricing risk results from differences in the
maturity, or repricing, of asset and liability portfolios. Most residential
mortgage and consumer loans give consumers the right to prepay with little or
no prepayment penalty, and because of competitive pressures commercial lenders
might choose not to enforce prepayment penalties on commercial loans. Although
First National Banks fixed-rate conventional mortgage loans are originated
with loan documentation that permits their sale to Freddie Mac, the banks
policy is generally to retain mortgage loans in its portfolio. A loan
prepayment right is, like the right of a depositor to early withdrawal without
penalty, a form of embedded option giving the customer the opportunity to
benefit when market interest rates change, ordinarily at a banks expense in
the form of higher costs or lower revenue. Because of the acquisition of
Peoples Federal and its loan portfolio dominated by conventional residential
mortgage loans, First National Banks option risk increased significantly in
2002. This risk declined during 2003 as a substantial number of the mortgage
loans acquired from Peoples Federal were refinanced or paid off. Although
residential mortgage loans tend to have lower credit risk than other forms of 20




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##### Table of Contents



lending, they tend also to have higher option risk and interest rate risk
because of this prepayment feature and their long-term nature. Option risk in
the form of prepayments also affects the value of mortgage-backed securities.
Basis risk refers to the potential for changes in the underlying relationship
between market rates and indices, which can result in a narrowing of the profit
spread on an earning asset or liability. Basis risk also exists in administered
rate liabilities, such as NOW accounts, savings accounts, and money market
accounts, whose historical pricing relationships to market rates may change due
to the level or directional change in market interest rates. Managements goal is to manage interest rate risk by maintaining the
one-year ratio of interest-earning assets to interest-bearing liabilities
within a range between 50% and 150%. At year-end 2003 the bank had a negative
one-year cumulative gap of -30% of total assets, and a ratio of
interest-earning assets to interest-bearing liabilities of 50%. During 2003 the
bank changed its classification of savings accounts from repricing in the over
one year category to repricing within three months. This created a large
negative one-year GAP, but more accurately reflected the banks ability to
reprice savings accounts. After adjusting prior years saving accounts
classification, this compares to a negative one-year cumulative gap of -26% of
total assets at December 31, 2002. The April 2002 acquisition of Peoples
Financial and its portfolio of residential mortgage loans increased the
percentage of First National Banks long-term assets relative to total assets,
meaning assets repricing in five or more years. At year-end 2003 long-term
interest-earning assets represent 34% of total assets, compared to 32% at
year-end 2002. This increases the exposure to interest rate risk. We are taking
actions to shorten the maturities of the banks assets and lengthen the
maturities of the banks liabilities, including offering attractive rates on
variable rate loans and offering certificate of deposit specials maturing in
longer than twelve months. The table below shows the maturities or repricing of the banks assets and
liabilities at year-end 2003 based upon the contractual maturity or contractual
repricing dates of loans and the contractual maturities of time deposits.
Demand loans, loans having no stated schedule of repayments and no stated
maturity, and overdrafts are reported as due in one year or less. Allocation of
deposits other than time deposits to the various maturity and repricing periods
is based upon managements best estimate. 21




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##### Table of Contents



Maturing or Repricing PeriodsWithin
    
    4 - 12
    
    1 - 5
    
    Over 53 Months
    
    Months
    
    Years
    
    Years
    
    TotalInterest-earning assets:Interest-bearing deposits in other institutions
    
    $
    
    
    
    $
    999,048
    
    
    $
    
    
    
    $
    
    
    
    $
    999,048Investment securities
    
    
    1,816,405
    
    
    
    5,442,092
    
    
    
    27,007,655
    
    
    
    49,526,967
    
    
    
    83,793,119Federal bank stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,771,350
    
    
    
    2,771,350Loans collateralized by real estate:Commercial (1)
    
    
    9,417,501
    
    
    
    8,223,114
    
    
    
    18,725,133
    
    
    
    2,983,297
    
    
    
    39,349,045Residential (1)
    
    
    7,911,092
    
    
    
    17,846,465
    
    
    
    29,124,041
    
    
    
    46,409,849
    
    
    
    101,291,447Home equity (1)
    
    
    14,008,018
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    14,008,018Construction (1)
    
    
    2,728,636
    
    
    
    244,274
    
    
    
    1,755,447
    
    
    
    403,328
    
    
    
    5,131,685Consumer loans (1)
    
    
    593,051
    
    
    
    1,300,046
    
    
    
    2,934,275
    
    
    
    1,272
    
    
    
    4,828,644Commercial (1)
    
    
    16,365,830
    
    
    
    2,074,933
    
    
    
    2,928,148
    
    
    
    6,000
    
    
    
    21,374,911Credit cards (1)
    
    
    315,891
    
    
    
    947,674
    
    
    
    
    
    
    
    
    
    
    
    1,263,565Other (1)
    
    
    354,993
    
    
    
    325,483
    
    
    
    520,519
    
    
    
    620,021
    
    
    
    1,821,016Total interest-earning assets
    
    $
    53,511,417
    
    
    $
    37,403,129
    
    
    $
    82,995,218
    
    
    $
    102,722,084
    
    
    $
    276,631,848Interest-bearing liabilities:Interest-bearing demand
    
    $
    31,223,878
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    31,223,878Money market
    
    
    7,699,095
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,699,095Savings
    
    
    86,636,381
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    86,636,381Time
    
    
    16,805,721
    
    
    
    35,780,649
    
    
    
    25,774,606
    
    
    
    105,675
    
    
    
    78,466,651Short-term borrowings
    
    
    3,106,411
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,106,411Other borrowings
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,034,291
    
    
    
    17,034,291Total interest-bearing liabilities
    
    $
    145,471,486
    
    
    $
    35,780,649
    
    
    $
    25,774,606
    
    
    $
    17,139,966
    
    
    $
    224,166,707Interest-sensitivity gap
    
    $
    (91,960,069
    )
    
    $
    1,622,480
    
    
    $
    57,220,612
    
    
    $
    85,582,118
    
    
    $
    52,465,141Cumulative interest sensitivity gap
    
    $
    (91,960,069
    )
    
    $
    (90,337,589
    )
    
    $
    (33,116,977
    )
    
    $
    52,465,141Cumulative interest sensitivity gap as a percent
of total equity
    
    
    -264.22
    %
    
    
    -259.56
    %
    
    
    -95.15
    %
    
    
    150.74
    %Cumulative interest sensitivity gap as a percent
of total assets
    
    
    -30.53
    %
    
    
    -29.99
    %
    
    
    -10.99
    %
    
    
    17.42
    %
  (1)
    
    For purposes of the gap analysis, loans are not reduced by the allowance
for loan losses. One way to minimize interest rate risk is to maintain a balanced or
matched interest-rate sensitivity position. However, profits are not always
maximized by matched funding. To increase net interest income, the bank
selectively mismatches asset and liability repricing to take advantage of
short-term interest rate movements. The magnitude of the mismatch depends on
managements assessment of the risks presented by forecasted interest rate
movements. Interest rates change daily on federal funds purchased and sold. Federal
funds are therefore the most sensitive to the market and have the most stable
fair values. Loans and deposits tied to indices such as the prime rate or
federal discount rate are also market sensitive, with stable fair values. The
least sensitive instruments include long-term, fixed-rate loans and securities,
which have the least stable fair value. Management of maturity distributions of
assets and liabilities between these extremes is as important as the balances
maintained.
Management of maturity distributions involves matching interest rate maturities
as well as principal maturities, which can influence net interest income
significantly. In periods of rapidly changing interest rates, a negative or
positive gap can cause major fluctuations in net interest income and earnings.
Managing asset and liability sensitivities to enhance growth regardless of
changes in market conditions is one of the objectives of the banks
asset/liability management strategy. 22




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##### Table of Contents



Management attempts to maintain consistent growth in net interest income
and net income while managing interest rate risk within board-approved policy
limits. Evaluating the banks exposure to changes in interest rates is the
responsibility of the Asset/Liability Management Committee, a committee of bank
officers meeting monthly and reporting directly to the board. The
Asset/Liability Management Committee assesses both the adequacy of the
management process used to control interest rate risk and the quantitative
level of exposure, monitoring and managing interest rate risk to control the
effect of changing interest rates on net interest income and net income.
Evaluating the quantitative level of interest rate risk exposure requires
assessment of existing and potential effects of changes in interest rates on
the banks financial condition, including capital adequacy, earnings,
liquidity, and asset quality. The Asset/Liability Management Committee also
monitors the banks liquidity levels. Interest rate risk exposure is reviewed
in monthly meetings of the Asset/Liability Committee. Risk is mitigated by
matching maturities or repricing opportunities. Gap analysis has limitations because it cannot measure the effect of
interest rate movements and competitive pressures on the repricing and maturity
characteristics of interest-earning assets and interest-bearing liabilities.
The static gap analysis is based on assumptions concerning such matters as when
assets and liabilities will reprice in a changing interest rate environment.
The model assumes that certain assets and liabilities of similar maturity or
repricing opportunities will react the same to changes in interest rates.
However, certain assets and liabilities indicated as maturing or repricing
within a stated period might actually mature or reprice at different times and
at different volumes from those estimated. Actual results can differ
significantly from simulated results if, for example, market conditions and
management strategies vary from the assumptions used in the analysis. The
actual prepayments and withdrawals experienced by the bank after a change in
interest rates could deviate significantly from those assumed in calculating
the data shown in the table. Adjustable-rate loans, for example, commonly have
provisions limiting changes in interest rates each time the interest rate
changes and on a cumulative basis over the life of the loan. Also, the renewal
or repricing of some assets and liabilities can be discretionary and subject to
competitive and other pressures. The ability of borrowers to service their debt
could diminish after an interest rate increase. Therefore, the gap table above
does not and cannot necessarily indicate the actual future impact of general
interest movements on net interest income. Management also uses an earnings simulation model to assess interest rate
sensitivity, which estimates the effect on net interest income and net income
assuming various interest rate changes  or rate shocks  such as changes of
plus or minus 100 basis points or plus 200 basis points. As noted above, during
2003 the bank changed its classification of savings accounts from repricing in
the over the one year category to repricing within three months. This change
moved the bank from an assetsensitive position to a liability-sensitive
position in the one-year time frame. The bank also incorporated caps and floors
on rates into the simulation model to more accurately reflect interest rate
movements. Consequently, at year-end 2003 the earnings simulation model
predicts a decrease in net interest income and net income assuming interest
rates increase, and a slight increase if rates decrease. Being in a
liability-sensitive position would dictate an earnings decrease if rates rise.
With interest rates at historical lows, and floors set on deposit rates, the
model predicts a slight earnings increase if rates drop 100 basis points. Prior
years model did not incorporate caps and floors and considered savings rates
as non-sensitive within a one-year time frame. The banks goal is to limit
earnings at risk to 15% of projected net income over a one year time period
assuming a plus or minus shift of 100 basis points in interest rates. The table
to follow shows the predicted effect on net income over one year under the
earnings simulation model assuming interest rate changes of plus or minus 100
and plus 200 basis points. This analysis is based on numerous assumptions,
including relative levels of market interest rates, loan prepayments, and
reactions of depositors to changes in interest rates. The earnings simulation
models predictions of the effect of rate changes on net income must not be
relied upon as being indicative of actual results. Further, it does not
necessarily contemplate all actions we might undertake in response to interest
rate changes. Management continues to seek non-interest income opportunities
and seeks to control expenses in an effort to offset these possible
fluctuations in net income. Effect of a Change in Interest Rates on NetIncome Over a 12-Month Period(Dollars in thousands)
    
    2003
    
    2002+ 200 basis points
    
    $
    (364
    )
    
    
    -11.8
    %
    
    $
    286
    
    
    
    9.7
    %+ 100 basis points
    
    $
    (239
    )
    
    
    -7.7
    %
    
    $
    187
    
    
    
    6.3
    %- 100 basis points
    
    $
    6
    
    
    
    0.2
    %
    
    $
    (208
    )
    
    
    -7.0
    %
 23




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##### Table of Contents



First National Bank also has longer-term interest rate risk exposure,
which may not be appropriately measured by earnings sensitivity analysis.
Longer-term interest rate risk exposure can be measured using an economic
value of equity sensitivity analysis. The economic value of equity sensitivity
analysis involves discounting cash flows on the balance sheet to present value
assuming various interest rate levels. The discounted present value of all cash
flows represents the banks economic value of equity. The analysis requires
modifying the expected cash flows in each interest rate scenario, which affects
the discounted present value. We have not performed economic value of equity
sensitivity analyses in the past. We are in the process of establishing limits
for economic value of equity at risk, and we expect to incorporate this
sensitivity analysis into our asset/liability function in 2004 and beyond. Results of Operations First National Bank derives substantially all of its income from banking
and bank-related services, including interest earnings on residential real
estate, commercial real estate, commercial, and consumer loans and investment
securities along with fee income from deposit services. National Bancshares
Corporations business consists almost exclusively of acting as holding company
for the bank. First National Banks business is not complex: the bank gathers
deposits and it makes loans, principally in Wayne, Stark, and Medina Counties,
Ohio. With the acquisition of Peoples Financial completed in April 2002, First
National Bank is now solidly established in Stark County. Net income declined 10.8% from 2001 to 2002, and increased 17.2% from 2002
to 2003. The principal difference between 2001 and 2002 was the continued
decline in interest rates and the acquisition of Peoples Federal in April 2002,
which has already been discussed at length. These factors also affected the
bank in 2003. The acquisition of Peoples Federal not only increased First
National Banks total assets and its total loans and deposits, it also
contributed to an increase in many expense categories, including salary and
benefits for the additional staff, data processing fees and net occupancy
expenses, and depreciation expense, as well as increased professional fees
included in the other expense category. The other most noteworthy factor
about 2002 was the write off a large commercial construction credit, which
occurred in the fourth quarter of 2002. That accounts for the increase in the
provision for loan losses from $40 thousand in 2001 to $1.6 million in 2002. Interest and fees on loans increased $2.9 million or 32.5% in 2002 because
of the higher average loan volumes attributable to the April 2002 addition of
Peoples Federals loan portfolio to First National Banks. Despite higher
average volume in 2003, interest and fees on loans decreased $1.1 million or
9.5% as average yields dropped from 6.96% to 5.79%. Interest and fees on loans
in 2003 was also negatively impacted by a $450 thousand acceleration of a
purchase accounting adjustment (PAA) related to Peoples Federals loans. A PAA
was made at the time of the acquisition to adjust the loans acquired from
Peoples Federal to market. The PAA is amortized over the average life of the
acquired loans. As more Peoples Federals loans were paid off or refinanced
during 2003 than expected, the PAA was adjusted. Interest on taxable investment
securities declined 5.7% in 2002 and increased 6.9% in 2003. The decline in
2002 was due to a decrease in average volume. The increase in 2003
was due principally to higher average volume. Interest on nontaxable
obligations of states and political subdivisions also declined in 2002 and
increased in 2003. While rates continued to fall during 2002 and 2003, the
average volume of nontaxable obligations increased during 2003. The steady
decline of interest rates to historically low levels in 2002 and 2003 also
affected the banks interest expense on deposits, which declined in both of
those years. Interest expense on borrowings increased by 197% in 2002 and 35%
in 2003 because of the FHLB advances assumed by First National Bank in the
April 2002 acquisition of Peoples Federal. Net interest income increased 28% in
2002 and 2.6% in 2003. The Peoples Federal acquisition contributed greatly to
the 28% increase in net interest income in 2002. Continued decreases in rates
in 2002 and 2003 contributed to the reduction in net yield on interest-earning
assets from 4.89% in 2001 to 4.69% in 2002 and 4.34% in 2003. Average Balances, Interest Rates and Yields. The average balances of our
interest-earning assets and interest-bearing liabilities, interest earned on
assets and interest cost of liabilities for the periods indicated, and the
average yields earned and rates paid are presented in the table to follow.
Yields are derived by dividing income or expense by the average balance of
assets or liabilities, respectively, for the periods presented. Average
balances are daily averages. 24




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##### Table of Contents



Year Ended December 31,2003
    
    2002
    
    2001Daily
    
    
    
    
    
    
    
    
    
    Daily
    
    
    
    
    
    
    
    
    
    DailyAverage
    
    
    
    
    
    Average
    
    Average
    
    
    
    
    
    Average
    
    Average
    
    
    
    
    
    Average(Dollars in Thousands)
    
    Balance
    
    Interest
    
    Yield/cost (3)
    
    Balance
    
    Interest
    
    Yield/cost (3)
    
    Balance
    
    Interest
    
    Yield/cost (3)AssetsInterest earning assets:Investment securities:Taxable
    
    $
    55,445
    
    
    $
    3,124
    
    
    
    5.94
    %
    
    $
    46,075
    
    
    $
    2,893
    
    
    
    6.52
    %
    
    $
    47,532
    
    
    $
    3,039
    
    
    
    6.53
    %Nontaxable (tax equivalent basis)
    
    
    19,742
    
    
    
    1,421
    
    
    
    7.26
    %
    
    
    15,826
    
    
    
    1,288
    
    
    
    8.19
    %
    
    
    18,253
    
    
    
    1,523
    
    
    
    8.37
    %Federal funds sold
    
    
    8,233
    
    
    
    86
    
    
    
    1.04
    %
    
    
    8,614
    
    
    
    136
    
    
    
    1.58
    %
    
    
    8,469
    
    
    
    354
    
    
    
    4.18
    %Interest bearing deposits
    
    
    998
    
    
    
    62
    
    
    
    6.21
    %
    
    
    1,434
    
    
    
    88
    
    
    
    6.14
    %
    
    
    1,991
    
    
    
    122
    
    
    
    6.13
    %Net loans (including
nonaccrual loans)
    
    
    187,180
    
    
    
    10,834
    
    
    
    5.79
    %
    
    
    172,159
    
    
    
    11,974
    
    
    
    6.96
    %
    
    
    110,418
    
    
    
    9,037
    
    
    
    8.18
    %Total interest
earning assets
    
    
    271,598
    
    
    
    15,527
    
    
    
    5.72
    %
    
    
    244,108
    
    
    
    16,379
    
    
    
    6.71
    %
    
    
    186,663
    
    
    
    14,075
    
    
    
    7.54
    %All other assets
    
    
    22,250
    
    
    
    
    
    
    
    
    
    
    
    20,245
    
    
    
    
    
    
    
    
    
    
    
    13,037Total Assets
    
    $
    293,848
    
    
    
    
    
    
    
    
    
    
    $
    264,353
    
    
    
    
    
    
    
    
    
    
    $
    199,700Liabilities and Shareholders EquityInterest bearing liabilitiesDeposits:Interest bearing checking
    
    $
    35,072
    
    
    $
    207
    
    
    
    0.59
    %
    
    $
    32,431
    
    
    $
    366
    
    
    
    1.13
    %
    
    $
    29,163
    
    
    $
    427
    
    
    
    1.46
    %Savings
    
    
    84,620
    
    
    
    844
    
    
    
    1.00
    %
    
    
    68,618
    
    
    
    1,348
    
    
    
    1.96
    %
    
    
    44,117
    
    
    
    1,119
    
    
    
    2.54
    %Time, $100,000 and over
    
    
    11,286
    
    
    
    362
    
    
    
    3.21
    %
    
    
    12,895
    
    
    
    464
    
    
    
    3.60
    %
    
    
    12,581
    
    
    
    654
    
    
    
    5.20
    %Time, other
    
    
    70,699
    
    
    
    1,603
    
    
    
    2.27
    %
    
    
    68,125
    
    
    
    2,207
    
    
    
    3.24
    %
    
    
    48,092
    
    
    
    2,477
    
    
    
    5.15
    %Other funds purchased
    
    
    20,342
    
    
    
    724
    
    
    
    3.56
    %
    
    
    17,432
    
    
    
    543
    
    
    
    3.11
    %
    
    
    6,917
    
    
    
    277
    
    
    
    4.00
    %Total interest
bearing liabilities
    
    
    222,019
    
    
    
    3,740
    
    
    
    1.68
    %
    
    
    199,501
    
    
    
    4,928
    
    
    
    2.47
    %
    
    
    140,870
    
    
    
    4,954
    
    
    
    3.52
    %Demand deposits
    
    
    33,807
    
    
    
    
    
    
    
    
    
    
    
    29,675
    
    
    
    
    
    
    
    
    
    
    
    26,344Other liablities
    
    
    3,165
    
    
    
    
    
    
    
    
    
    
    
    3,004
    
    
    
    
    
    
    
    
    
    
    
    1,543Shareholders equity
    
    
    34,857
    
    
    
    
    
    
    
    
    
    
    
    32,173
    
    
    
    
    
    
    
    
    
    
    
    30,943Total Liabilities and
Shareholders Equity
    
    $
    293,848
    
    
    
    
    
    
    
    
    
    
    $
    264,353
    
    
    
    
    
    
    
    
    
    
    $
    199,700Net interest income (tax
equivalent basis)
    
    
    
    
    
    $
    11,787
    
    
    
    
    
    
    
    
    
    
    $
    11,451
    
    
    
    
    
    
    
    
    
    
    $
    9,121Interest rate spread (1)
    
    
    
    
    
    
    
    
    
    
    4.04
    %
    
    
    
    
    
    
    
    
    
    
    4.24
    %
    
    
    
    
    
    
    
    
    
    
    4.02
    %Net yield on interest-earning assets (2)
    
    
    
    
    
    
    
    
    
    
    4.34
    %
    
    
    
    
    
    
    
    
    
    
    4.69
    %
    
    
    
    
    
    
    
    
    
    
    4.89
    %Ratio of average interest-earning assets
to average interest-bearing liabilities
    
    
    
    
    
    
    
    
    
    
    122.33
    %
    
    
    
    
    
    
    
    
    
    
    122.36
    %
    
    
    
    
    
    
    
    
    
    
    132.51
    %
  (1)
    
    Interest rate spread represents the difference between the average yield on
interest-earning assets and the average cost of interest-bearing liabilities.  (2)
    
    Net yield on interest-earning assets represents net interest income as a
percentage of average interest-earning assets.  (3)
    
    Average yields are computed using annualized interest income and expense
for the periods. 25




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##### Table of Contents



Rate/Volume Analysis. Changes in interest income and interest expense
attributable to (1) changes in volume (changes in average volume multiplied by
prior year rate), and (2) changes in rates (changes in rate multiplied by prior
year average volume) are shown in the table to follow. Increases and decreases
due to both rate and volume have been allocated proportionally to the change
due to volume and the change due to rate. Changes in net interest income
    
    Changes in net interest incomefor the year ended
    
    for the year endedDecember 31,2003
    
    December 31,20022003 versus 2002
    
    2002 versus 2001Increase (Decrease)
    
    Increase (Decrease)Due to Changes In
    
    Due to Changes InNet
    
    
    
    
    
    
    
    
    
    Net(Dollars in thousands)
    
    Volume
    
    Rate
    
    Change
    
    Volume
    
    Rate
    
    ChangeInterest IncomeInvestment securities:Taxable
    
    $
    588
    
    
    ($
    357
    )
    
    $
    231
    
    
    ($
    93
    )
    
    ($
    53
    )
    
    ($
    146
    )Nontaxable
(tax equivalent basis)*
    
    
    319
    
    
    
    (186
    )
    
    
    133
    
    
    
    (203
    )
    
    
    (32
    )
    
    
    (235
    )Federal funds sold
    
    
    (6
    )
    
    
    (44
    )
    
    
    (50
    )
    
    
    6
    
    
    
    (224
    )
    
    
    (218
    )Interest bearing deposits
    
    
    (27
    )
    
    
    1
    
    
    
    (26
    )
    
    
    (34
    )
    
    
    0
    
    
    
    (34
    )Loans (including
nonaccrual loans)
    
    
    1,045
    
    
    
    (2,185
    )
    
    
    (1,140
    )
    
    
    5,053
    
    
    
    (2,116
    )
    
    
    2,937Total interest Income
(tax equivalent basis)*
    
    $
    1,919
    
    
    ($
    2,771
    )
    
    ($
    852
    )
    
    $
    4,729
    
    
    ($
    2,425
    )
    
    $
    2,304Interest ExpenseDepositsInterest bearing checking
    
    $
    30
    
    
    ($
    189
    )
    
    ($
    159
    )
    
    $
    48
    
    
    ($
    109
    )
    
    ($
    61
    )Savings
    
    
    314
    
    
    
    (818
    )
    
    
    (504
    )
    
    
    621
    
    
    
    (392
    )
    
    
    229Time, $100,000
and over
    
    
    (58
    )
    
    
    (44
    )
    
    
    (102
    )
    
    
    16
    
    
    
    (206
    )
    
    
    (190
    )Time, other
    
    
    83
    
    
    
    (687
    )
    
    
    (604
    )
    
    
    1,032
    
    
    
    (1,302
    )
    
    
    (270
    )Other funds purchased
    
    
    91
    
    
    
    90
    
    
    
    181
    
    
    
    421
    
    
    
    (155
    )
    
    
    266Total interest
Expense
    
    $
    460
    
    
    ($
    1,648
    )
    
    ($
    1,188
    )
    
    $
    2,138
    
    
    ($
    2,164
    )
    
    ($
    26
    )Changes in net
interest income (tax
equivalent basis)*
    
    $
    1,459
    
    
    ($
    1,123
    )
    
    $
    336
    
    
    $
    2,591
    
    
    ($
    261
    )
    
    $
    2,330
 * Tax equivalence based on
highest statutory tax rates of 34% Noninterest income grew both in 2002 and in 2003, but at a significantly
lower rate in 2003. Occasional sales of investment securities and loans
contribute to noninterest income, but in First National Banks case the largest
consistent contributors to noninterest income are fees charged on checking
accounts and other noninterest income, which includes safety deposit box
rents and other miscellaneous fees and collections. 26




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##### Table of Contents



Noninterest expenses are the cost of doing business. They include salaries
and employee benefits, data processing fees, occupancy and depreciation and
maintenance expenses, along with miscellaneous other expenses. Noninterest
expenses grew 23.4% in 2002 compared to 2001, attributable to higher salary and
employee benefit, data processing, net occupancy, and other expenses related to
the acquisition of Peoples Financial Corporation. Noninterest expenses grew by
14.3% in 2003 compared to 2002, due mainly to higher salaries and benefits,
amortization of intangibles and other miscellaneous expenses. The bank
restructured a number of areas during 2003 to support current growth, and
better position the organization for future growth. This involved hiring
additional lending and support staff. Our efficiency ratio for 2001 was 65.7%,
improving slightly to 64.1% in 2002 and increasing to 71.2% in 2003. The
efficiency ratio is essentially a measurement of how much it costs to produce
an additional dollar of net income. A bank can manage interest rate changes but
it cannot control them. A bank can, however, exercise some control over its
noninterest expenses. Although there isnt universal agreement about how an
efficiency ratio should be calculated, with slight variations from one user to
the next, we calculate our efficiency ratio simply by dividing noninterest
expenses by the sum of net interest income and non-interest income. An
efficiency ratio of 71% means it costs about 71 cents to produce an additional
dollar of net income. Achieving the optimal efficiency ratio (the lower the
better) requires careful control of noninterest expenses, but perhaps even more
importantly it requires active capitalization on the banking franchise those
noninterest expenses support, including robust loan growth and accumulation of
low-cost deposits. Critical Accounting Policies National Bancshares consolidated financial statements are prepared in
accordance with accounting principles generally accepted in the United States
of America  GAAP  and follow general practices within the industry in which
it operates. Application of these principles requires management to make
estimates, assumptions, and judgments based on information available as of the
date of the consolidated financial statements, affecting the amounts reported
in the financial statements and accompanying notes. Certain policies
necessarily require greater reliance on the use of estimates, assumptions, and
judgments. Estimates, assumptions, and judgments are necessary when assets and
liabilities are required to be recorded at fair value, when a decline in the
value of an asset not carried on the consolidated financial statements at fair
value warrants an impairment write-down or valuation reserve to be established,
or when an asset or liability needs to be recorded contingent upon a future
event. Carrying assets and liabilities at fair value inherently results in more
financial statement volatility. The fair values and the information used to
record valuation adjustments for certain assets and liabilities are based
either on quoted market prices or are provided by other third-party sources,
when available. When third-party information is not available, valuation
adjustments are estimated in good faith by management, including the use of
internal cash-flow modeling techniques. National Bancshares most significant
accounting policies are presented in Note 1 of the consolidated financial
statements. Management considers the allowance for loan losses and the
valuation of securities to be the most subjective and the most susceptible to
change as circumstances and economic conditions change. Allowance for Loan Losses. An allowance for loan losses recorded under
GAAP is an institutions best estimate within a range of the probable amount of
loans that  based on current information and events  the institution will be
unable to collect. The amount of the allowance is a product of managements
judgment and it is inevitably imprecise. Estimating the allowance requires
significant judgment and the use of estimates related to many factors,
including the amount and timing of future cash flows on problem loans,
estimated losses on pools of homogeneous loans based on historical loss
experience, and consideration of current economic trends and conditions, all of
which are susceptible to significant change. Although management believes that
the allowance for loan losses was adequate at December 31, 2003, future
adjustments could be necessary if circumstances or economic conditions differ
substantially from the assumptions used in making the initial determinations. A
downturn in the local economy and employment could result in increased levels
of nonperforming assets and charge-offs, increased loan loss provisions, and
reductions in income. Additionally, as an integral part of the examination
process bank regulatory agencies periodically review a banks loan loss
allowance. The Office of the Comptroller of the Currency (OCC)
could require the recognition of additions to the loan loss allowance based on
the OCCs judgment of information available to it at the time of its
examination of First National Bank. Valuation of Securities. The portfolio of available-for-sale securities is
reported at fair value. The fair value of a security is determined based on
quoted market prices. If quoted market prices are not available, fair value is
determined based on quoted prices of similar instruments. Available-for-sale
and held-to-maturity securities are reviewed quarterly for possible
other-than-temporary impairment. The review includes an analysis of the facts
and circumstances of each individual investment, such as the length of time the
fair value has been below cost, the expectation for that securitys
performance, the credit worthiness of the issuer, and the banks ability to
hold the security to maturity. A decline in value that is considered to be
other-than-temporary would be recorded as a loss within noninterest income in
the consolidated statements of income. 27




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##### Table of Contents



New Accounting Pronouncements Adoption of New Accounting Standards: During 2003, the Company adopted
FASB Statement 149, Amendment of Statement 133 on Derivative Instruments
and Hedging Activities, FASB Statement 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and
Equities, FASB Statement 132 (revised 2003), Employers Disclosures about
Pensions and Other Postretirement Benefits, FASB Interpretation 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, and
FASB Interpretation 46, Consolidation of Variable Interest Entities.
Adoption of the new standards did not materially affect the Companys
operating results or financial condition. Statement 149 indicates that commitments to make mortgage loans should be
accounted for as derivatives if the loans are to be held for sale, because the
commitment represents a written option and accordingly is recorded at the fair
value of the option liability. Statement 150 requires reporting mandatorily redeemable shares as
liabilities, as well as obligations not in the form of shares to repurchase
shares that may require cash payment and some obligations that may be settled
by issuing a variable number of equity shares. Statement 132 (revised 2003) requires additional disclosures about the
assets, obligations, cash flows of defined benefit pension and post-retirement
plans, as well as the expense recorded for such plans. Interpretation 45 requires recognizing the fair value of guarantees made
and information about the maximum potential payments that might be required,
as well as the collateral or other recourse obtainable.Interpretation 45
covers guarantees such as standby letters of credit, performance guarantees,
and direct or indirect guarantees of the indebtedness of others, but not
guarantees of funding. Interpretation 46, as revised in December 2003, changes the accounting
model for consolidation from one based on consideration of control through
voting interests. Whether to consolidate an entity will now also consider
whether that entity has sufficient equity at risk to enable it to operate
without additional financial support, whether the equity owners in that entity
lack the obligation to absorb expected losses or the right to receive residual
returns of the entity, or whether voting rights in the entity are not
proportional to the equity interest and substantially all the entitys
activities are conducted for an investor with few voting rights. 28




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##### Table of Contents



CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002 2003
    
    2002ASSETSCash and due from the banks
    
    $
    11,506,999
    
    
    $
    10,010,654Federal funds sold
    
    
    
    
    
    
    6,315,000Total cash and cash equivalents
    
    
    11,506,999
    
    
    
    16,325,654Interest-bearing time deposits with other banks
    
    
    999,048
    
    
    
    997,185Securities available for sale
    
    
    67,189,563
    
    
    
    52,364,712Securities held to maturity (fair
value: 2003 - $17,300,084; 2002 -
$18,985,565)
    
    
    16,603,556
    
    
    
    18,441,685Federal bank stock
    
    
    2,771,350
    
    
    
    2,689,450Loans, net of allowance for loan
losses: 2003 - $1,603,568; 2002 -
$1,604,200
    
    
    187,056,241
    
    
    
    190,559,663Premises and equipment, net
    
    
    4,737,018
    
    
    
    4,816,253Goodwill
    
    
    4,723,075
    
    
    
    4,723,075Identified intangible assets
    
    
    1,654,086
    
    
    
    1,929,734Accrued interest receivable
    
    
    1,622,090
    
    
    
    1,495,506Other assets
    
    
    2,386,349
    
    
    
    2,407,248$
    301,249,375
    
    
    $
    296,750,165LIABILITIES AND SHAREHOLDERS EQUITYDepositsNoninterest-bearing
    
    $
    38,821,286
    
    
    $
    35,852,184Interest-bearing
    
    
    204,026,005
    
    
    
    203,445,043Total deposits
    
    
    242,847,291
    
    
    
    239,297,227Repurchase agreements
    
    
    2,786,848
    
    
    
    3,006,221Federal Reserve note account
    
    
    319,563
    
    
    
    1,000,000Federal Home Loan Bank advances
    
    
    17,034,291
    
    
    
    17,205,743Accrued expenses and other liabilities
    
    
    3,456,647
    
    
    
    3,050,924Total liabilities
    
    
    266,444,640
    
    
    
    263,560,115Shareholders equityCommon stock, no par value; 6,000,000 shares authorized;
2,289,528 shares issued
    
    
    11,447,640
    
    
    
    11,447,640Additional paid-in capital
    
    
    4,689,800
    
    
    
    4,689,800Accumulated other comprehensive income
    
    
    2,006,889
    
    
    
    1,739,751Retained earnings
    
    
    17,849,899
    
    
    
    16,502,352Treasury stock, at cost (55,040 shares)
    
    
    (1,189,493
    )
    
    
    (1,189,493
    )Total shareholders equity
    
    
    34,804,735
    
    
    
    33,190,050$
    301,249,375
    
    
    $
    296,750,165
 See accompanying notes to consolidated financial statements. 29




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##### Table of Contents



CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001Interest and dividend incomeLoans, including fees
    
    $
    10,833,688
    
    
    $
    11,974,356
    
    
    $
    9,036,841Federal funds sold
    
    
    85,635
    
    
    
    136,263
    
    
    
    353,756Securities:Taxable
    
    
    3,186,618
    
    
    
    2,980,610
    
    
    
    3,160,784Nontaxable
    
    
    937,868
    
    
    
    849,924
    
    
    
    1,005,366Total interest and dividend income
    
    
    15,043,809
    
    
    
    15,941,153
    
    
    
    13,556,747Interest expenseDeposits
    
    
    3,016,172
    
    
    
    4,384,154
    
    
    
    4,677,652Short-term borrowings
    
    
    6,996
    
    
    
    13,551
    
    
    
    98,275Federal Home Loan Bank advances
    
    
    716,848
    
    
    
    530,069
    
    
    
    178,430Total interest expense
    
    
    3,740,016
    
    
    
    4,927,774
    
    
    
    4,954,357Net interest income
    
    
    11,303,793
    
    
    
    11,013,379
    
    
    
    8,602,390Provision for loan losses
    
    
    245,000
    
    
    
    1,569,402
    
    
    
    40,000Net interest income after provision for loan losses
    
    
    11,058,793
    
    
    
    9,443,977
    
    
    
    8,562,390Noninterest incomeChecking account fees
    
    
    752,833
    
    
    
    754,341
    
    
    
    656,441Gain on sale of loans
    
    
    115,982
    
    
    
    8,409
    
    
    
    43,750Securities gains, net
    
    
    72,290
    
    
    
    182,324
    
    
    
    97,003Other
    
    
    590,915
    
    
    
    512,957
    
    
    
    348,044Total noninterest income
    
    
    1,532,020
    
    
    
    1,458,031
    
    
    
    1,145,238Noninterest expenseSalaries and employee benefits
    
    
    4,844,909
    
    
    
    4,338,987
    
    
    
    3,517,438Data processing fees
    
    
    794,932
    
    
    
    738,643
    
    
    
    627,799Net occupancy expense
    
    
    404,489
    
    
    
    345,858
    
    
    
    216,709Depreciation
- furniture and fixtures
    
    
    353,601
    
    
    
    327,634
    
    
    
    237,967Franchise taxes
    
    
    321,824
    
    
    
    302,880
    
    
    
    314,869Maintenance and repairs
    
    
    267,261
    
    
    
    238,735
    
    
    
    197,234Amortization of intangibles
    
    
    275,647
    
    
    
    145,227
    
    
    
    52,330Other
    
    
    1,877,853
    
    
    
    1,560,810
    
    
    
    1,238,759Total noninterest expense
    
    
    9,140,516
    
    
    
    7,998,774
    
    
    
    6,403,105Income before income taxes
    
    
    3,450,297
    
    
    
    2,903,234
    
    
    
    3,304,523Income tax expense
    
    
    806,746
    
    
    
    648,460
    
    
    
    777,320Net income
    
    $
    2,643,551
    
    
    $
    2,254,774
    
    
    $
    2,527,203Weighted average common shares outstanding
    
    
    2,234,488
    
    
    
    2,228,510
    
    
    
    2,230,013Basic and diluted earnings per common share
    
    $
    1.18
    
    
    $
    1.01
    
    
    $
    1.13
 See accompanying notes to consolidated financial statements. 30




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##### Table of Contents



CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
Years ended December 31, 2003, 2002 and 2001 AccumulatedAdditional
    
    Other
    
    
    
    
    
    
    
    
    
    TotalCommon
    
    Paid-in
    
    Comprehensive
    
    Retained
    
    Treasury
    
    ShareholdersStock
    
    Capital
    
    Income
    
    Earnings
    
    Stock
    
    EquityBalance at January 1, 2001
    
    $
    11,447,640
    
    
    $
    4,689,800
    
    
    $
    (127,139
    )
    
    $
    14,292,805
    
    
    $
    (1,363,777
    )
    
    $
    28,939,329Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,527,203
    
    
    
    
    
    
    
    2,527,203Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    911,436
    
    
    
    
    
    
    
    
    
    
    
    911,436Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,438,639Cash dividends declared ($.52 per
share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,158,687
    )
    
    
    
    
    
    
    (1,158,687
    )Shares issued under dividend
reinvestment plan (2,905 shares)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (40,386
    )
    
    
    87,738
    
    
    
    47,352Purchase of 20,856 treasury shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (344,445
    )
    
    
    (344,445
    )Balance at December 31, 2001
    
    
    11,447,640
    
    
    
    4,689,800
    
    
    
    784,297
    
    
    
    15,620,935
    
    
    
    (1,620,484
    )
    
    
    30,922,188Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,254,774
    
    
    
    
    
    
    
    2,254,774Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    955,454
    
    
    
    
    
    
    
    
    
    
    
    955,454Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,210,228Cash dividends declared ($.54 per
share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,203,946
    )
    
    
    
    
    
    
    (1,203,946
    )Shares issued under dividend
reinvestment plan (14,295 shares)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (169,411
    )
    
    
    430,991
    
    
    
    261,580Balance at December 31, 2002
    
    
    11,447,640
    
    
    
    4,689,800
    
    
    
    1,739,751
    
    
    
    16,502,352
    
    
    
    (1,189,493
    )
    
    
    33,190,050Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,643,551
    
    
    
    
    
    
    
    2,643,551Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    267,138
    
    
    
    
    
    
    
    
    
    
    
    267,138Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,910,689Cash dividends declared ($.58 per
share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,296,004
    )
    
    
    
    
    
    
    (1,296,004
    )Balance at December 31, 2003
    
    $
    11,447,640
    
    
    $
    4,689,800
    
    
    $
    2,006,889
    
    
    $
    17,849,899
    
    
    $
    (1,189,493
    )
    
    $
    34,804,735
 See accompanying notes to consolidated financial statements 31




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##### Table of Contents



CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001Cash flows from operating activitiesNet income
    
    $
    2,643,551
    
    
    $
    2,254,774
    
    
    $
    2,527,203Adjustments to reconcile net income to net
cash from operating activitiesProvision for loan losses
    
    
    245,000
    
    
    
    1,569,402
    
    
    
    40,000Depreciation, amortization and accretion
    
    
    685,769
    
    
    
    443,887
    
    
    
    160,688Federal Home Loan Bank stock dividend
    
    
    (81,900
    )
    
    
    (64,300
    )
    
    
    (51,500
    )Gain on sale of loans
    
    
    (115,982
    )
    
    
    (8,409
    )
    
    
    (43,750
    )Net security gains
    
    
    (72,290
    )
    
    
    (182,324
    )
    
    
    (97,003
    )Change in other assets and liabilities
    
    
    140,078
    
    
    
    (771,589
    )
    
    
    (108,410
    )Net cash from operating activities
    
    
    3,444,226
    
    
    
    3,241,441
    
    
    
    2,427,228Cash flows from investing activitiesNet change in interest-bearing deposits
with banks
    
    
    (1,863
    )
    
    
    996,826
    
    
    
    (4,571
    )Securities held to maturityProceeds from maturities and repayments
    
    
    2,412,599
    
    
    
    3,610,036
    
    
    
    4,581,349Purchases
    
    
    (636,911
    )
    
    
    (7,917,091
    )
    
    
    (504,500
    )Securities available for saleProceeds from maturities and repayments
    
    
    8,442,092
    
    
    
    9,881,758
    
    
    
    17,576,405Proceeds from sales
    
    
    2,071,143
    
    
    
    5,317,609
    
    
    
    134,171Purchases
    
    
    (24,668,182
    )
    
    
    (13,587,788
    )
    
    
    (12,902,383
    )Purchase of Federal Bank Stock
    
    
    
    
    
    
    (450,550
    )
    
    
    Cash paid for acquisition, net of cash received
    
    
    
    
    
    
    (1,123,425
    )
    
    
    Capital expenditures
    
    
    (461,306
    )
    
    
    (580,424
    )
    
    
    (691,077
    )Proceeds from sale of loans
    
    
    5,432,154
    
    
    
    1,195,026
    
    
    
    1,598,277Net change in loans to customers
    
    
    (2,057,750
    )
    
    
    4,558,543
    
    
    
    (10,923,657
    )Net cash from investing activities
    
    
    (9,468,024
    )
    
    
    1,900,520
    
    
    
    (1,135,986
    )Cash flow from financing activitiesNet change in deposits
    
    
    3,550,064
    
    
    
    5,782,993
    
    
    
    (2,494,290
    )Net change in short-term borrowings
    
    
    (899,810
    )
    
    
    472,331
    
    
    
    (1,030,893
    )Repayments of Federal Home Loan Bank
advances
    
    
    (171,452
    )
    
    
    (4,413,550
    )
    
    
    (1,238,279
    )Dividends paid
    
    
    (1,273,659
    )
    
    
    (1,179,743
    )
    
    
    (1,183,402
    )Dividends reinvested
    
    
    
    
    
    
    261,580
    
    
    
    47,352Purchase of treasury shares
    
    
    
    
    
    
    
    
    
    
    (344,445
    )Net cash from financing activities
    
    
    1,205,143
    
    
    
    923,611
    
    
    
    (6,243,957
    )Net change in cash and cash equivalents
    
    
    (4,818,655
    )
    
    
    6,065,572
    
    
    
    (4,952,715
    )Beginning cash and cash equivalents
    
    
    16,325,654
    
    
    
    10,260,082
    
    
    
    15,212,797Ending cash and cash equivalents
    
    $
    11,506,999
    
    
    $
    16,325,654
    
    
    $
    10,260,082Supplemental disclosuresCash paid for interest
    
    $
    3,817,233
    
    
    $
    4,964,995
    
    
    $
    5,329,612Cash paid for income taxes, net of refunds
    
    
    940,000
    
    
    
    591,091
    
    
    
    770,000Non-cash items:Securities transferred from held to
maturity to available for sale
    
    $
    
    
    
    $
    
    
    
    $
    30,661,985
 See accompanying notes to consolidated financial statements. 32




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations and Principles of Consolidation: The consolidated
financial statements include National Bancshares Corporation and its
wholly-owned subsidiary, First National Bank, Orrville, Ohio, together referred
to as the Corporation. Intercompany transactions and balances are eliminated
in consolidation. The Corporation provides financial services through its offices in Orrville,
Ohio, and surrounding communities. Its primary deposit products are checking,
savings, and term certificate accounts, and its primary lending products are
commercial and residential mortgage, commercial and consumer installment loans.
Most loans are secured by specific items of collateral including business
assets, consumer assets and real estate. Commercial loans are expected to be
repaid from cash flow from operations of businesses. Real estate loans are
secured by both residential and commercial real estate. Other financial
instruments, which potentially represent concentrations of credit risk, include
deposit accounts in other financial institutions and federal funds sold. Segments: As noted above, the Corporation provides a broad range of financial
services to individuals and companies in northern Ohio. While the Corporations
chief decision makers monitor the revenue streams of the various products and
services, operations are managed and financial performance is evaluated on a
Corporation-wide basis. Accordingly, all of the Corporations banking
operations are considered by management to be aggregated in one reportable
operating segment. Use of Estimates: To prepare financial statements in conformity with accounting
principles generally accepted in the United States of America, management makes
estimates and assumptions based on available information. These estimates and
assumptions affect the amounts reported in the financial statements and the
disclosures provided, and future results could differ. The allowance for loan
losses, fair values of financial instruments, carrying value of intangible
assets and fair values of certain securities are particularly subject to
change. Cash Flows: Cash and cash equivalents include cash, deposits with other
financial institutions with original maturities under 90 days, and federal
funds sold. Net cash flows are reported for customer loan and deposit
transactions, short-term borrowings and deposits with other banks. Securities: 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. Securities are classified as available for sale when they might be
sold before maturity. Securities available for sale are carried at fair value,
with unrealized holding gains and losses reported in other comprehensive
income. Federal bank stock in the consolidated financial statements consists of Federal
Reserve Bank and Federal Home Loan Bank stock. These securities are carried at
cost. (Continued) 33




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued) Interest income includes amortization of purchase premium or discount. Gains
and losses on sales are based on the amortized cost of the security sold.
Securities are written down to fair value when a decline in fair value is not
temporary. Loans: Loans are reported at the principal balance outstanding, net of unearned
interest, deferred loan fees and costs, and an allowance for loan losses. Loans
held for sale are reported at the lower of cost or fair value, on an aggregate
basis. Interest income is reported on the interest method and includes amortization of
net deferred loan fees and costs over the loan term. Interest income is not
reported when full loan repayment is in doubt, typically when the loan is
impaired or payments are past due over 90 days unless the credit is
well-secured and in process of collection. Payments received on such loans are
reported as principal reductions. All interest accrued but not received for loans placed on nonaccrual is
reversed against income. Interest received on such loans is accounted for on
the cash-basis or cost-recovery method, until qualifying for return to accrual.
Loans are returned to accrual status when all the principal and interest
amounts contractually due are brought current and future payments are
reasonably assured. Allowance for Loan Losses: The allowance for loan losses is a valuation
allowance for probable incurred credit losses, increased by the provision for
loan losses and decreased by charge-offs less recoveries. Management estimates
the allowance balance required using past loan loss experience, the nature and
volume of the portfolio, information about specific borrower situations and
estimated collateral values, economic conditions, and other factors.
Allocations of the allowance may be made for specific loans, but the entire
allowance is available for any loan that, in managements judgment, should be
charged-off. Loan losses are charged against the allowance when management
believes the uncollectibility of a loan balance is confirmed. A loan is impaired when full payment under the loan terms is not expected.
Impairment is evaluated in total for smaller-balance loans of similar nature
such as residential mortgage, consumer, and credit card loans, and on an
individual loan basis for other loans. If a loan is impaired, a portion of the
allowance is allocated so that the loan is reported net, at the
present value of estimated future cash flows using the loans existing rate or
at the fair value of collateral if repayment is expected solely from the
collateral. Foreclosed Assets: Assets acquired through or instead of loan foreclosure are
initially recorded at fair value when acquired, establishing a new cost basis.
If fair value declines, a valuation allowance is recorded through expense.
Costs after acquisition are expensed. (Continued) 34




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE
1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued) Premises and Equipment: Land is carried at cost. Premises and equipment are
stated at cost less accumulated depreciation. Buildings and related components
are depreciated using the straight-line method with useful lives ranging from 7
to 39 years. Furniture, fixtures and equipment are depreciated using the
straight-line method with useful lives ranging from 3 to 7 years. Bank Owned Life Insurance: The Corporation has purchased life insurance
policies on its directors. Life insurance is recorded at its cash surrender
value, or the amount that can be realized. Goodwill and Other Intangible Assets: Goodwill results from business
acquisitions and represents the excess of the purchase price over the fair
value of acquired tangible assets and liabilities and identifiable assets.
Under a new accounting pronouncement that became effective in 2002, goodwill is
not amortized but rather is assessed at least annually for impairment and any
such impairment will be recognized in the period identified. Other intangible assets consist of core deposit and acquired customer
relationship intangible assets arising from whole bank and branch acquisitions.
They are initially measured at fair value and then are amortized on an
accelerated method over their estimated useful lives which is 10 years. The Corporation also has intangible assets associated with a prior branch
acquisition, including unidentified intangibles of $173,000 and $203,000 and
core deposit value of $14,000 and $31,000 at year-end 2003 and 2002. Management
does not believe that this purchase constituted a business combination and
therefore is continuing to amortize the unidentified intangible asset. Long-term Assets: These assets are reviewed for impairment when events indicate
their carrying amount may not be recoverable from future undiscounted cash
flows. If impaired, the assets are recorded at fair value. Repurchase Agreements: Substantially all repurchase agreement liabilities
represent amounts advanced by various customers. Securities are pledged to
cover these liabilities, which are not covered by federal deposit insurance. Benefit Plans: Retirement plan expense is the amount of required matching
contributions plus any discretionary contributions to the Corporations 401(k)
plan as determined by Board decision. Deferred compensation plan expense
allocates the benefits over the estimated years of service. (Continued) 35




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued) Income Taxes: Income tax expense is the total of the current-year income tax
due or refundable and the change in deferred tax assets and liabilities.
Deferred tax assets and liabilities are the expected future tax amounts for the
temporary differences between carrying amounts and tax bases of assets and
liabilities, computed using enacted tax rates. A valuation allowance, if
needed, reduces deferred tax assets to the amount expected to be realized. Financial Instruments: Financial instruments include credit instruments, such
as commitments to make loans and standby letters of credit, issued to meet
customer financing needs. The face amount for these items represents the
exposure to loss, before considering customer collateral or ability to repay. Earnings Per Common Share: Earnings per common share are calculated based on
the weighted average number of shares outstanding during the period. There are
no potentially dilutive instruments. Comprehensive Income: Comprehensive income consists of net income and other
comprehensive income. Other comprehensive income includes unrealized gains and
losses on securities available for sale, which is also recognized as a separate
component of equity. Loss Contingencies: Loss contingencies, including claims and legal actions
arising in the ordinary course of business, are recorded as liabilities when
the likelihood of loss is probable and an amount or range of loss can be
reasonably estimated. Management does not believe there now are such matters
that will have a material effect on the financial statements. Dividend Restriction: Banking regulations require maintaining certain capital
levels and limit the dividends paid by the bank to the holding company.
Dividends paid by the bank
to the holding company are the primary source of funds for dividends by the
holding company to its shareholders. Fair Value of Financial Instruments: Fair values of financial instruments are
estimated using relevant market information and other assumptions, as more
fully disclosed in a separate note. Fair value estimates involve uncertainties
and matters of significant judgment regarding interest rates, credit risk,
prepayments, and other factors, especially in the absence of broad markets for
particular items. Changes in assumptions or in market conditions could
significantly affect the estimates. (Continued) 36




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued) Adoption of New Accounting Standards: During 2003, the Company adopted FASB
Statement 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities, FASB Statement 150, Accounting for Certain Financial Instruments
with Characteristics of both Liabilities and Equities, FASB Statement 132
(revised 2003), Employers Disclosures about Pensions and Other Postretirement
Benefits, FASB Interpretation 45, Guarantors Accounting and Disclosure
Requirements for Guarantees, and FASB Interpretation 46, Consolidation of
Variable Interest Entities. Adoption of the new standards did not materially
affect the
Companys operating results or financial condition. Statement 149 indicates that commitments to make mortgage loans should be
accounted for as derivatives if the loans are to be held for sale, because the
commitment represents a written option and accordingly is recorded at the fair
value of the option liability. Statement 150 requires reporting mandatorily redeemable shares as liabilities,
as well as obligations not in the form of shares to repurchase shares that may
require cash payment and some obligations that may be settled by issuing a
variable number of equity shares. Statement 132 (revised 2003) requires additional disclosures about the assets,
obligations, cash flows of defined benefit pension and post-retirement plans,
as well as the expense recorded for such plans. Interpretation 45 requires recognizing the fair value of guarantees made and
information about the maximum potential payments that might be required, as
well as the collateral or other recourse obtainable. Interpretation 45 covers
guarantees such as standby letters of credit, performance guarantees, and
direct or indirect guarantees of the indebtedness of others, but not guarantees
of funding. Interpretation 46, as revised in December 2003, changes the accounting model
for consolidation from one based on consideration of control through voting
interests. Whether to consolidate an entity will now also consider whether that
entity has sufficient equity at risk to enable it to operate without additional
financial support, whether the equity owners in that entity lack the obligation
to absorb expected losses or the right to receive residual returns of the
entity, or whether voting rights in the entity are not proportional to the
equity interest and substantially all the entitys activities are conducted for
an investor with few voting rights. Reclassifications: Certain items in the prior year financial statements were
reclassified to conform to the current presentation. (Continued) 37




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##### Table of Contents



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 2 - ACQUISITION On October 2, 2001, the Company entered into an Agreement and Plan of Merger to
acquire Peoples Financial Corporation (Peoples Financial), located in
Massillon, Ohio. Under the terms of the agreement, the Corporation paid $12.25
in cash for each of the 1,234,085 outstanding shares of Peoples Financial. The
aggregate transaction value was $15.1 million. The merger was consummated on
April 3, 2002 and was accounted for as a purchase. As such, Peoples Financials
results of operations from the effective date of the acquisition are included
in the Corporations 2002 income statements. Peoples Federal Savings and Loan
Association, the wholly-owned subsidiary of Peoples Financial, was merged into
First National Bank, Orrville, the wholly-owned subsidiary of the Corporation. Identified intangible assets totaling $728,000 were recognized and have average
useful lives of 7 to 10 years and the amortization is not tax deductible.
Goodwill of $4,723,000 represents the acquisition cost in excess of book value
of $5,561,000, less adjustment to reflect fair values of $1,154,000 net of tax,
plus merger related expenses of $316,000. NOTE
3 - SECURITIES Year-end securities are as follows: Gross
    
    GrossUnrealized
    
    Unrealized
    
    FairGains
    
    Losses
    
    ValueAvailable for Sale2003U.S. Government and federal agency
    
    $
    730,120
    
    
    $
    (19,375
    )
    
    $
    24,952,062State and municipal
    
    
    175,194
    
    
    
    
    
    
    
    2,436,996Corporate bond and notes
    
    
    1,924,041
    
    
    
    (79,437
    )
    
    
    36,825,636Mortgage backed
    
    
    317,735
    
    
    
    
    
    
    
    2,122,466Total debt securities
    
    
    3,147,090
    
    
    
    (98,812
    )
    
    
    66,337,160Equity securities
    
    
    26,013
    
    
    
    (33,550
    )
    
    
    852,403Total
    
    $
    3,173,103
    
    
    $
    (132,362
    )
    
    $
    67,189,5632002U.S. Government and federal agency
    
    $
    1,244,835
    
    
    $
    (317
    )
    
    $
    21,019,263State and municipal
    
    
    146,698
    
    
    
    
    
    
    
    2,420,694Corporate bonds and notes
    
    
    1,589,612
    
    
    
    (158,648
    )
    
    
    26,902,346Total debt securities
    
    
    2,981,145
    
    
    
    (158,965
    )
    
    
    50,342,303Equity securities
    
    
    85,573
    
    
    
    (271,766
    )
    
    
    2,022,409Total
    
    $
    3,066,718
    
    
    $
    (430,731
    )
    
    $
    52,364,712
 (Continued) 38




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 3 - SECURITIES(Continued) Gross
    
    GrossCarrying
    
    Unrecognized
    
    Unrecognized
    
    FairValue
    
    Gains
    
    Losses
    
    ValueHeld to Maturity2003State and municipal
    
    $
    16,603,556
    
    
    $
    712,328
    
    
    $
    (15,800
    )
    
    $
    17,300,0842002State and municipal
    
    $
    18,441,685
    
    
    $
    688,144
    
    
    $
    (144,264
    )
    
    $
    18,985,565
 Sales of available for sale securities were as follows: 2003
    
    2002
    
    2001Proceeds
    
    $
    2,071,143
    
    
    $
    5,317,609
    
    
    $
    134,701Gross gains
    
    
    234,331
    
    
    
    227,679
    
    
    
    97,003Gross losses
    
    
    162,041
    
    
    
    45,355
    
    
    
    
 Contractual maturities of debt securities at year-end 2003 were as follows: Available for Sale
    
    Held to MaturityFair
    
    Carrying
    
    FairValue
    
    Value
    
    ValueDue in one year or less
    
    $
    4,380,096
    
    
    $
    361,973
    
    
    $
    368,920Due from one to five years
    
    
    21,616,532
    
    
    
    2,601,577
    
    
    
    2,755,716Due from five to ten years
    
    
    30,642,362
    
    
    
    4,769,947
    
    
    
    4,990,198Due after ten years
    
    
    9,698,170
    
    
    
    8,870,059
    
    
    
    9,185,250Total
    
    $
    66,337,160
    
    
    $
    16,603,556
    
    
    $
    17,300,084
 (Continued) 39




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 3 - SECURITIES(Continued) Securities with unrealized losses at year end 2003 not recognized in income are
as follows: Less than 12 Months
    
    12 Months or More
    
    TotalFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedDescription of Securities
    
    Value
    
    Loss
    
    Value
    
    Loss
    
    Value
    
    LossGovernment and
Federal Agency
    
    $
    1,979,375
    
    
    $
    (19,375
    )
    
    $
    
    
    
    $
    
    
    
    $
    1,979,375
    
    
    $
    (19,375
    )State and Municipal
    
    
    316,346
    
    
    
    (1,832
    )
    
    
    1,720,120
    
    
    
    (13,968
    )
    
    
    2,036,466
    
    
    
    (15,800
    )Corporate bonds and notes
    
    
    10,645,436
    
    
    
    (79,437
    )
    
    
    
    
    
    
    
    
    
    
    10,645,436
    
    
    
    (79,437
    )Equity securities
    
    
    
    
    
    
    
    
    
    
    213,642
    
    
    
    (33,550
    )
    
    
    213,642
    
    
    
    (33,550
    )Total temporarily impaired
    
    $
    12,941,157
    
    
    $
    (100,644
    )
    
    $
    1,933,762
    
    
    $
    (47,518
    )
    
    $
    14,874,919
    
    
    $
    (148,162
    )
 Unrealized losses have not been recognized into income because the issuer(s)
securities are of high credit quality, management has the intent and ability to
hold for the foreseeable future, and the decline in fair value is largely due
to increases in market interest rates or normally expected market pricing
fluctuations. The fair value of debt securities is expected to recover as the
bond(s) approach their maturity date and/or market rates decline. Securities pledged at year-end 2003 and 2002 had carrying values of
$25,811,397 and $26,654,000, and were pledged to secure public deposits and
repurchase agreements. (Continued) 40




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 4 - LOANS Loans at year-end were as follows: 2003
    
    2002Collateralized by real estate:Commercial
    
    $
    39,349,045
    
    
    $
    28,747,949Residential
    
    
    101,291,447
    
    
    
    118,834,883Home equity
    
    
    14,008,018
    
    
    
    12,555,738Construction
    
    
    5,131,685
    
    
    
    2,065,964159,780,195
    
    
    
    162,204,534Other:Consumer
    
    
    4,828,644
    
    
    
    4,847,264Commercial
    
    
    21,374,911
    
    
    
    21,631,567Credit cards
    
    
    1,263,565
    
    
    
    1,276,587Other
    
    
    1,821,016
    
    
    
    2,570,767189,068,331
    
    
    
    192,530,719Unearned and deferred income
    
    
    (408,522
    )
    
    
    (366,856
    )Allowance for loan losses
    
    
    (1,603,568
    )
    
    
    (1,604,200
    )Total
    
    $
    187,056,241
    
    
    $
    190,559,663
 Activity in the allowance for loan losses for the year was as follows: 2003
    
    2002
    
    2001Beginning balance
    
    $
    1,604,200
    
    
    $
    1,321,152
    
    
    $
    1,343,124Provision for loan losses
    
    
    245,000
    
    
    
    1,569,402
    
    
    
    40,000Loans charged-off
    
    
    (267,485
    )
    
    
    (1,545,986
    )
    
    
    (86,182
    )Recoveries
    
    
    21,853
    
    
    
    15,103
    
    
    
    24,210Allowance of acquired
institution
    
    
    
    
    
    
    244,529
    
    
    
    Ending balance
    
    $
    1,603,568
    
    
    $
    1,604,200
    
    
    $
    1,321,152
 Loans charged off in 2002 consisted primarily of one commercial relationship
which was determined to be uncollectible and charged off in the fourth quarter
of 2002. (Continued) 41




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 4 - LOANS(Continued) Impaired loans were as follows: 2003
    
    2002Year-end loans with no allocated allowance
for loan losses
    
    $
    125,502
    
    
    $
    Year-end loans with allocated allowance
for loan losses
    
    
    251,081
    
    
    
    1,436,332Amount of the allowance for loan losses allocated
    
    
    100,000
    
    
    
    215,450Average of impaired loans during the year
    
    $
    837,670
    
    
    $
    571,240Interest income recognized during impairment
    
    
    362
    
    
    
    26,104Cash-basis interest income recognized
    
    
    362
    
    
    
    26,104
 Loans past due over 90 days and still accruing interest at year-end 2003 and
2002 were $51,749 and $334,774. Nonaccrual loans for the same periods were
$1,379,857 and $1,612,778. Non-performing loans consist primarily of
residential real estate, commercial and consumer loans. NOTE 5 - PREMISES AND EQUIPMENT Year-end premises and equipment were as follows: 2003
    
    2002Land
    
    $
    1,114,306
    
    
    $
    1,114,306Buildings
    
    
    5,418,947
    
    
    
    5,355,995Furniture, fixtures and equipment
    
    
    4,525,832
    
    
    
    4,550,72911,059,085
    
    
    
    11,021,030Less: Accumulated depreciation
    
    
    6,322,067
    
    
    
    6,204,777$
    4,737,018
    
    
    $
    4,816,253
 Depreciation included in noninterest expense was $540,541, $493,649 and
$338,036 in 2003, 2002 and 2001. (Continued) 42




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 6 - DEPOSITS Year-end deposits were as follows: 2003
    
    2002Demand, noninterest-bearing
    
    $
    38,821,286
    
    
    $
    35,852,184Demand, interest-bearing
    
    
    38,922,973
    
    
    
    34,396,647Savings
    
    
    86,636,381
    
    
    
    82,091,395Time, $100,000 and over
    
    
    11,210,884
    
    
    
    11,760,381Time, other
    
    
    67,255,767
    
    
    
    75,196,620$
    242,847,291
    
    
    $
    239,297,227
 A summary of time deposits at year-end 2003 by maturity follows: 2004
    
    $
    52,586,3702005
    
    
    13,252,7012006
    
    
    8,433,7662007
    
    
    4,000,5982008 and thereafter
    
    
    193,216$
    78,466,651
 NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES At year-end, advances from the Federal Home Loan Bank were as follows: 2003
    
    2002Maturity in 2010, fixed rate at 6.26%, convertible
to variable rate if 3-month LIBOR is at or above
predetermined conversion rate level
    
    $
    1,000,000
    
    
    $
    1,000,000Maturities in 2010 and 2011, fixed rate at 4.60% to
5.79%, convertible to variable rates at the option
of the FHLB at various dates through 2004
    
    
    16,034,291
    
    
    
    16,205,743Total
    
    $
    17,034,291
    
    
    $
    17,205,743
 Each advance is payable at its maturity date; advances may be paid prior to
maturity with a prepayment penalty. As collateral for the advances, the Bank
has approximately $91,949,000 million of first mortgage loans available under a
blanket lien arrangement at year-end 2003. (Continued) 43




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES(Continued) Required principal payments are: Rate2010
    
    
    5.00 to 6.26
    %
    
    $
    11,022,1862011
    
    
    4.60 to 5.12
    %
    
    
    6,012,105$
    17,034,291
 NOTE 8 - REPURCHASE AGREEMENTS Repurchase agreements generally mature within thirty days from the
transaction date. Information concerning repurchase agreements is
summarized as follows: 2003
    
    2002Average balance during the year
    
    $
    2,845,520
    
    
    $
    3,919,776Average interest rate during the year
    
    
    0.13
    %
    
    
    0.17
    %Maximum month-end balance during the year
    
    
    3,385,869
    
    
    
    4,775,461
 NOTE 9 - BENEFIT PLANS The Corporation has a 401(k) retirement plan that covers substantially all
employees. The plan allows employees to contribute up to a predetermined
amount, subject to certain limitations, with the Corporation matching 50% of
contributions up to 6% of an employees pay. Discretionary contributions may
also be made to the plan. Total matching and discretionary contributions made
by the Corporation during 2003, 2002 and 2001 amounted to $137,656, $133,947
and $111,636. The Corporation has an Employee Stock Purchase Incentive Plan for full-time and
most part-time employees. Under the Plan, each employee is entitled to receive
a cash payment equal to 20% of the purchase price of Corporation common stock
acquired by the employee on the open market, up to a maximum of 100 shares per
calendar year. Expense recognized in 2003, 2002 and 2001 amounted to $4,755,
$2,256 and $3,011. The Corporation has a director retirement and death benefit plan for the
benefit of all members of the Board of Directors. The plan is designed to
provide an annual retirement benefit to be paid to each director upon
retirement from the Board and attaining age 70. The retirement benefit provided
to each director is an annual benefit equal to $1,000 for each year of service
on the Board from and after August 24, 1994. In addition, each director has the
option of deferring (Continued) 44




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 9 - BENEFIT PLANS(Continued)

any portion of directors fees to a maximum of $5,000 per month until
retirement. Expense recognized in 2003, 2002 and 2001 for the director
retirement and death benefit plan was $48,898, $ 47,088 and $36,804.

NOTE 10 - INCOME TAXES

The components of deferred taxes were as follows:

|                                     |                                        |       |            |           |           |      |            |         |           | 
|------------------------------------ | -------------------------------------- | ----- | ---------- | --------- | --------- | ---- | ---------- | ------- | --------- | 
|                                     |                                        |       |            | 2003      |           | 2002
|                                     |                                        |       |            |           |           |     
|Deferred tax assets:                 |                                        |       |            |           |           |      |            |        
|                                     | Bad debts                              |       | $          | 385,083   |           |      | $          | 360,332 |          
|                                     | Deferred loan fees                     |       |            | 136,631   |           |      |            | 122,036 |          
|                                     | Core deposit intangibles               |       |            | 38,251    |           |      |            | 39,473  |          
|                                     | Deferred compensation                  |       |            | 207,369   |           |      |            | 178,971 |          
|                                     | Investment in financial stock fund     |       |            | 19,900    |           |      |            |        |          
|                                     |                                        |       |            |           |           |      |            |         |          
|                                     |                                        | Total |            |           | 787,234   |      |            |         | 700,812   | 
|                                     |                                        |       |            |           |           |      |            |         |          
|Deferred tax liabilities:            |                                        |       |            |           |           |      |            |        
|                                     | Securities accretion                   |       |            | 57,305    |           |      |            | 65,726  |          
|                                     | Depreciation                           |       |            | 258,360   |           |      |            | 211,908 |          
|                                     | Federal Home Loan Bank stock dividends |       |            | 397,290   |           |      |            | 369,444 |          
|                                     | Investment in financial stock fund     |       |            |          |           |      |            | 30,436  |          
|                                     | Purchase accounting adjustments        |       |            | 717,083   |           |      |            | 820,687 |          
|                                     | Unrealized securities gains            |       |            | 1,033,851 |           |      |            | 896,236 |          
|                                     |                                        |       |            |           |           |      |            |         |          
|                                     |                                        | Total |            |           | 2,463,889 |      |            |         | 2,394,437 | 
|                                     |                                        |       |            |           |           |      |            |         |          
|Net deferred tax asset (liabilities) |                                        | $     | (1,676,655 | )         |           | $    | (1,693,625 | )      
|                                     |                                        |       |            |           |           |      |            |         |          

Federal income tax laws provided that the 2002 acquired entity could claim
additional bad debt deductions through 1987, totaling $1.9 million. Accounting
standards do not require a deferred tax liability to be recorded on this
amount, which liability otherwise would total $646,000 at December 31, 2003. If
First National were liquidated or otherwise ceases to be a bank or if tax laws
were to change, this amount would be expensed.

(Continued)

45



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 10 - INCOME TAXES(Continued)

The components of income tax expense are as follows:

|                  |       |   |          |         |      |   |         |         |  |   |         |         | 
|----------------- | ----- | - | -------- | ------- | ---- | - | ------- | ------- |  | - | ------- | ------- | 
|                  |       |   | 2003     |         | 2002 |   | 2001   
|                  |       |   |          |         |      |   |        
|Currently payable |       | $ | 961,331  |         |      | $ | 474,567 |         |  | $ | 760,750 |        
|Deferred          |       |   | (154,585 | )       |      |   | 173,893 |         |  |   | 16,570  |        
|                  |       |   |          |         |      |   |         |         |  |   |         |        
|                  | Total |   | $        | 806,746 |      |   | $       | 648,460 |  |   | $       | 777,320 | 
|                  |       |   |          |         |      |   |         |         |  |   |         |        

The following is a reconciliation of income tax at the federal statutory rate
to the effective rate of tax on the financial statements:

|                              |  |                          |     |        |  |      |           |        |  |      |    |        |  |   |          |   |  |  |     |   |  |   |           |  
|----------------------------- |  | ------------------------ | --- | ------ |  | ---- | --------- | ------ |  | ---- | -- | ------ |  | - | -------- | - |  |  | --- | - |  | - | --------- | -
|                              |  | Years Ended December 31,
|                              |  |                         
|                              |  | 2003                     |     | 2002   |  | 2001
|                              |  |                          |     |        |  |     
|                              |  | Rate                     |     | Amount |  | Rate |           | Amount |  | Rate |    | Amount
|                              |  |                          |     |        |  |      |           |        |  |      |    |       
|Tax at federal statutory
rate |  |                          | 34  | %      |  | $    | 1,173,101 |        |  |      | 34 | %      |  | $ | 987,100  |   |  |  | 34  | % |  | $ | 1,123,538 |  
|Tax-exempt income             |  |                          | (10 | )      |  |      | (331,423  | )      |  |      | (9 | )      |  |   | (300,078 | ) |  |  | (10 | ) |  |   | (339,366  | )
|Other                         |  |                          | (1  | )      |  |      | (34,932   | )      |  |      | (1 | )      |  |   | (38,562  | ) |  |  |    |   |  |   | (6,852    | )
|                              |  |                          |     |        |  |      |           |        |  |      |    |        |  |   |          |   |  |  |     |   |  |   |           |  
|Income tax expense            |  |                          | 23  | %      |  | $    | 806,746   |        |  |      | 24 | %      |  | $ | 648,460  |   |  |  | 24  | % |  | $ | 777,320   |  
|                              |  |                          |     |        |  |      |           |        |  |      |    |        |  |   |          |   |  |  |     |   |  |   |           |  

NOTE 11 - RELATED PARTY TRANSACTIONS

Loans to principal officers, directors, and their affiliates in 2003 were as
follows:

|                  |  |   |            |  
|----------------- |  | - | ---------- | -
|Beginning balance |  | $ | 3,418,557  |  
|New loans         |  |   | 1,648,847  |  
|Repayments        |  |   | (1,690,410 | )
|                  |  |   |            |  
|Ending balance    |  | $ | 3,376,994  |  
|                  |  |   |            |  

Unused commitments to these related parties totaled $2,255,000 at year-end
2003. Related party deposits totaled $4,347,000 and $5,327,000 at year-end 2003
and 2002.

(Continued)

46



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 12 - REGULATORY MATTERS

The Bank is restricted by regulation in the amount of dividends it may pay to
the holding company. As part of the acquisition of Peoples Financial in 2002,
the Bank paid a special $12 million dividend to the holding company. As a
result of this dividend, no additional Bank dividends to the parent company can
be paid through at least the end of 2004 without prior regulatory approval.

The Company and the Bank are subject to regulatory capital requirements
administered by federal banking agencies. Capital adequacy guidelines and
prompt corrective action regulations involve quantitative measures of assets,
liabilities, and certain off-balance-sheet items calculated under regulatory
accounting practices. Capital amounts and classifications are also subject to
qualitative judgments by regulators. Failure to meet capital requirements can
initiate regulatory action.

Prompt corrective action regulations provide five classifications: well
capitalized, adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized, although these terms are not
used to represent overall financial condition. If adequately capitalized,
regulatory approval is required to accept brokered deposits. If
undercapitalized, capital distributions, asset growth and expansion are limited
and capital restoration plans are required. The Corporation and the Bank are
considered well capitalized for regulatory purposes. Management is not aware of
any matters after December 31, 2003 that would cause its capital category to
change.

(Continued)

47



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 12 - REGULATORY MATTERS(Continued)

Actual and required capital amounts and ratios are presented below at year-end.

|                                       |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |       |   |  | 
|-------------------------------------- | ------------ | ------ | - | ------ | ------ | ------ | ----------------- | ----- | ----------------- | ------ | - | ------ | ----------- |  | ----------------- | ---- | - |  | - | ------ | ----------------- |  |  | ----- | - |  | 
|                                       |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        | To Be Well       
|                                       |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        | Capitalized Under
|                                       |              |        |   |        |        |        |                   |       |                   |        |   |        | For Capital |  | Prompt Corrective
|                                       |              |        |   |        | Actual |        | Adequacy Purposes |       | Action Provisions
|                                       |              |        |   |        |        |        |                   |       |                  
|(Dollars in thousands)                 |              | Amount |   | Ratio  |        | Amount |                   | Ratio |                   | Amount |   | Ratio 
|                                       |              |        |   |        |        |        |                   |       |                   |        |   |       
|2003                                   |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|Total capital to risk-weighted assets  |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        | $ | 28,013 |        |        |                   | 13.59 | %                 |        | $ | 16,487 |             |  |                   | 8.00 | % |  | $ | 20,609 |                   |  |  | 10.00 | %
|                                       | Bank         |        |   | 26,902 |        |        |                   | 13.09 |                   |        |   | 16,435 |             |  |                   | 8.00 |   |  |   | 20,544 |                   |  |  | 10.00 |  
|Tier 1 capital to risk-weighted assets |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        |   | 26,398 |        |        |                   | 12.81 |                   |        |   | 8,243  |             |  |                   | 4.00 |   |  |   | 12,365 |                   |  |  | 6.00  |  
|                                       | Bank         |        |   | 25,298 |        |        |                   | 12.31 |                   |        |   | 8,218  |             |  |                   | 4.00 |   |  |   | 12,327 |                   |  |  | 6.00  |  
|Tier 1 capital to
average assets       |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        |   | 26,398 |        |        |                   | 9.04  |                   |        |   | 11,685 |             |  |                   | 4.00 |   |  |   | 14,607 |                   |  |  | 5.00  |  
|                                       | Bank         |        |   | 25,298 |        |        |                   | 8.68  |                   |        |   | 11,657 |             |  |                   | 4.00 |   |  |   | 14,571 |                   |  |  | 5.00  |  
|2002                                   |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|Total capital to risk-weighted assets  |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        | $ | 26,527 |        |        |                   | 13.58 | %                 |        | $ | 15,628 |             |  |                   | 8.00 | % |  | $ | 19,535 |                   |  |  | 10.00 | %
|                                       | Bank         |        |   | 24,362 |        |        |                   | 12.59 |                   |        |   | 15,482 |             |  |                   | 8.00 |   |  |   | 19,353 |                   |  |  | 10.00 |  
|Tier 1 capital to risk-weighted assets |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        |   | 24,923 |        |        |                   | 12.76 |                   |        |   | 7,814  |             |  |                   | 4.00 |   |  |   | 11,721 |                   |  |  | 6.00  |  
|                                       | Bank         |        |   | 22,758 |        |        |                   | 11.76 |                   |        |   | 7,741  |             |  |                   | 4.00 |   |  |   | 11,612 |                   |  |  | 6.00  |  
|Tier 1 capital to
average assets       |              |        |   |        |        |        |                   |       |                   |        |   |        |             |  |                   |      |   |  |   |        |                   |  |  |      
|                                       | Consolidated |        |   | 24,923 |        |        |                   | 8.61  |                   |        |   | 11,574 |             |  |                   | 4.00 |   |  |   | 14,468 |                   |  |  | 5.00  |  
|                                       | Bank         |        |   | 22,758 |        |        |                   | 7.91  |                   |        |   | 11,503 |             |  |                   | 4.00 |   |  |   | 14,379 |                   |  |  | 5.00  |  

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 13 - COMMITMENTS, CONTINGENCIES AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK

Some financial instruments, such as loan commitments, credit lines, letters of
credit, and overdraft protection, are issued to meet customer financing needs.
These are agreements to provide credit or to support the credit of others, as
long as conditions established in the contract are met. These agreements
usually have fixed expiration dates. Commitments may expire without being used.
Off-balance-sheet risk to credit loss exists up to the face amount of these
instruments, although material losses are not anticipated. The same credit
policies are used to make such commitments as are used for loans, including
obtaining collateral at exercise of the commitment.

Financial instruments with off-balance-sheet risk were as follows at year-end:

|                       |  |      |            |      |  |   |            | 
|---------------------- |  | ---- | ---------- | ---- |  | - | ---------- | 
|                       |  | 2003 |            | 2002
|                       |  |      |            |     
|Unused lines of credit |  | $    | 46,316,300 |      |  | $ | 35,860,000 | 
|Letters of credit      |  |      | 821,000    |      |  |   | 998,000    | 

Of the above unused lines of credit for 2003, approximately $5,044,000 pertains
to fixed-rate commitments, and variable-rate commitments account for
approximately $41,273,000. In addition, rates on unused lines of credit range
from 3.00% to 16.90%.

The Corporation was required to have approximately $2,961,000 and $2,705,000 of
cash on hand or on deposit with the Federal Reserve Bank at year-end 2003 and
2002. These balances do not earn interest.

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 14 - FAIR VALUES OF FINANCIAL INSTRUMENTS

Carrying amount and estimated fair values of financial instruments were as
follows at year-end:

|                      |                                 |  |          |              |       |  |          |              |       |  |   |              |   |  |   |              |  
|--------------------- | ------------------------------- |  | -------- | ------------ | ----- |  | -------- | ------------ | ----- |  | - | ------------ | - |  | - | ------------ | -
|                      |                                 |  | 2003     |              | 2002 
|                      |                                 |  |          |              |      
|                      |                                 |  | Carrying |              | Fair  |  | Carrying |              | Fair 
|                      |                                 |  | Amount   |              | Value |  | Amount   |              | Value
|                      |                                 |  |          |              |       |  |          |              |      
|Financial assets      |                                 |  |          |              |       |  |          |              |       |  |   |              |   |  |   |             
|                      | Cash and cash equivalents       |  | $        | 11,506,999   |       |  | $        | 11,507,000   |       |  | $ | 16,325,654   |   |  | $ | 16,326,000   |  
|                      | Interest-bearing deposits       |  |          | 999,048      |       |  |          | 999,000      |       |  |   | 997,185      |   |  |   | 1,000,000    |  
|                      | Securities available for sale   |  |          | 67,189,563   |       |  |          | 67,190,000   |       |  |   | 52,364,712   |   |  |   | 52,365,000   |  
|                      | Securities held to maturity     |  |          | 16,603,556   |       |  |          | 17,300,000   |       |  |   | 18,441,685   |   |  |   | 18,986,000   |  
|                      | Federal bank stock              |  |          | 2,771,350    |       |  |          | 2,771,000    |       |  |   | 2,689,450    |   |  |   | 2,689,000    |  
|                      | Loans, net                      |  |          | 187,056,241  |       |  |          | 187,116,000  |       |  |   | 190,559,663  |   |  |   | 195,398,000  |  
|                      | Accrued interest receivable     |  |          | 1,622,090    |       |  |          | 1,622,000    |       |  |   | 1,495,506    |   |  |   | 1,496,000    |  
|Financial liabilities |                                 |  |          |              |       |  |          |              |       |  |   |              |   |  |   |             
|                      | Deposits                        |  |          | (242,847,291 | )     |  |          | (243,461,000 | )     |  |   | (239,297,227 | ) |  |   | (239,938,000 | )
|                      | Short-term borrowings           |  |          | (3,106,411   | )     |  |          | (3,106,000   | )     |  |   | (4,006,221   | ) |  |   | (4,006,000   | )
|                      | Federal Home Loan Bank
advances |  |          | (17,034,291  | )     |  |          | (18,373,000  | )     |  |   | (17,205,743  | ) |  |   | (17,546,000  | )
|                      | Accrued interest payable        |  |          | (454,790     | )     |  |          | (455,000     | )     |  |   | (532,007     | ) |  |   | (532,000     | )

The methods and assumptions used to estimate fair value are described as
follows.

Carrying amount is the estimated fair value for cash and cash equivalents,
short-term borrowings, Federal bank stock, accrued interest receivable and
payable, demand and savings deposits, short-term debt, and variable rate loans
or deposits that reprice frequently and fully. Security fair values are based
on market prices or dealer quotes, and if no such information is available, on
the rate and term of the security and information about the issuer. For fixed
rate loans or deposits and for variable rate loans or deposits with infrequent
repricing or repricing limits, fair value is based on discounted cash flows
using current market rates applied to the estimated life and credit risk. Fair
values for impaired loans are estimated using discounted cash flow analysis or
underlying collateral values. Fair value of loans held for sale is based on
market quotes. Fair value of debt is based on current rates for similar
financing. The fair value of off-balance-sheet items,
based on the current fees or cost that would be charged to enter into or
terminate such arrangements, is not material.

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 15  OTHER COMPREHENSIVE INCOME

Other comprehensive income components and related taxes were as follows.

|                                                                      |  |      |          |      |  |      |           |   |  |   |           |  
|--------------------------------------------------------------------- |  | ---- | -------- | ---- |  | ---- | --------- | - |  | - | --------- | -
|                                                                      |  | 2003 |          | 2002 |  | 2001
|                                                                      |  |      |          |      |  |     
|Unrealized holding gains
on available-for-sale
securities             |  | $    | 477,045  |      |  | $    | 1,629,982 |   |  | $ | 1,343,599 |  
|Cumulative effect of adopting
new accounting standard                 |  |      |         |      |  |      |          |   |  |   | 134,368   |  
|Less reclassification adjustment
for gains later
recognized in income |  |      | (72,290  | )    |  |      | (182,324  | ) |  |   | (97,003   | )
|                                                                      |  |      |          |      |  |      |           |   |  |   |           |  
|Net unrealized gains                                                  |  |      | 404,755  |      |  |      | 1,447,658 |   |  |   | 1,380,964 |  
|Tax effect                                                            |  |      | (137,617 | )    |  |      | (492,204  | ) |  |   | (469,528  | )
|                                                                      |  |      |          |      |  |      |           |   |  |   |           |  
|Other comprehensive income                                            |  | $    | 267,138  |      |  | $    | 955,454   |   |  | $ | 911,436   |  
|                                                                      |  |      |          |      |  |      |           |   |  |   |           |  

NOTE 16  PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION

Condensed financial statements for National Bancshares Corporation (parent
only) are as follows:

BALANCE SHEETS

|                                     |                               |                                            |   |              |            |      |   |            |            | 
|------------------------------------ | ----------------------------- | ------------------------------------------ | - | ------------ | ---------- | ---- | - | ---------- | ---------- | 
|                                     |                               |                                            |   | December 31,
|                                     |                               |                                            |   |             
|                                     |                               |                                            |   | 2003         |            | 2002
|                                     |                               |                                            |   |              |            |     
|Assets                               |                               |                                            |   |              |            |      |   |           
|                                     | Cash                          |                                            | $ | 781,087      |            |      | $ | 600,316    |           
|                                     | Investment in Bank subsidiary |                                            |   | 33,704,009   |            |      |   | 31,025,731 |           
|                                     | Securities available for sale |                                            |   | 660,711      |            |      |   | 1,817,490  |           
|                                     | Other assets                  |                                            |   |             |            |      |   | 59,341     |           
|                                     |                               |                                            |   |              |            |      |   |            |           
|                                     |                               | Total assets                               |   | $            | 35,145,807 |      |   | $          | 33,502,878 | 
|                                     |                               |                                            |   |              |            |      |   |            |           
|Liabilities and shareholders equity |                               |                                            |   |              |            |      |   |           
|                                     | Dividends payable             |                                            | $ | 335,173      |            |      | $ | 312,828    |           
|                                     | Other liabilities             |                                            |   | 5,899        |            |      |   |           |           
|                                     | Shareholders equity          |                                            |   | 34,804,735   |            |      |   | 33,190,050 |           
|                                     |                               |                                            |   |              |            |      |   |            |           
|                                     |                               | Total liabilities and shareholders equity |   | $            | 35,145,807 |      |   | $          | 33,502,878 | 
|                                     |                               |                                            |   |              |            |      |   |            |           

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 16 - PARENT COMPANY ONLY
CONDENSED FINANCIAL INFORMATION

(Continued)

STATEMENTS OF INCOME

|                                                                                   |                                |              |           |                          |         |      |             |            |            |  |          |           |           | 
|---------------------------------------------------------------------------------- | ------------------------------ | ------------ | --------- | ------------------------ | ------- | ---- | ----------- | ---------- | ---------- |  | -------- | --------- | --------- | 
|                                                                                   |                                |              |           | Years ended December 31,
|                                                                                   |                                |              |           | 2003                     |         | 2002 |             | 2001      
|                                                                                   |                                |              |           |                          |         |      |             |           
|Income                                                                             |                                |              |           |                          |         |      |             |            |            |  |          |          
|                                                                                   | Dividends from Bank subsidiary |              | $         |                         |         |      | $           | 12,200,000 |            |  | $        | 2,851,398 |          
|                                                                                   | Other dividends                |              |           | 25,210                   |         |      |             | 25,970     |            |  |          | 28,715    |          
|                                                                                   | Securities gains, net          |              |           | 110,607                  |         |      |             | 148,002    |            |  |          | 97,003    |          
|                                                                                   |                                |              |           |                          |         |      |             |            |            |  |          |           |          
|                                                                                   |                                | Total income |           |                          | 135,817 |      |             |            | 12,373,972 |  |          |           | 2,977,116 | 
|Expenses                                                                           |                                |              |           |                          |         |      |             |            |            |  |          |          
|                                                                                   | Miscellaneous expense          |              |           | (30,049                  | )       |      |             | (52,296    | )          |  |          | (33,100   | )        
|Undistributed equity in (distributions in excess
of) net income of Bank subsidiary |                                |              | 2,537,783 |                          |         |      | (10,066,902 | )          |            |  | (416,813 | )        
|                                                                                   |                                |              |           |                          |         |      |             |            |            |  |          |           |          
|                                                                                   | Net income                     |              | $         | 2,643,551                |         |      | $           | 2,254,774  |            |  | $        | 2,527,203 |          
|                                                                                   |                                |              |           |                          |         |      |             |            |            |  |          |           |          

STATEMENTS OF CASH FLOWS

|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |            |  
|------------------------------------ | -------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ------- | ------------------------ | ---------- | ---- | ---------- | ----------- | ----------- | - | --------- | ---------- | ---------- | -
|                                     |                                                                            |                                                                                    |         | Years ended December 31,
|                                     |                                                                            |                                                                                    |         | 2003                     |            | 2002 |            | 2001       
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |            
|Cash flows from operating activities |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |           
|                                     | Net income                                                                 |                                                                                    | $       | 2,643,551                |            |      | $          | 2,254,774   |             |   | $         | 2,527,203  |           
|                                     | Adjustments to reconcile net income to net
cash from operating activities: |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|                                     |                                                                            | Distributions in excess of (equity in
undistributed) net income of Bank
subsidiary |         |                          | (2,537,783 | )    |            |             | 10,066,902  |   |           |            | 416,813    |  
|                                     |                                                                            | Net security gains                                                                 |         |                          | (110,607   | )    |            |             | (148,002    | ) |           |            | (97,003    | )
|                                     |                                                                            | Change in other assets and liabilities                                             |         |                          |           |      |            |             | 141,192     |   |           |            | (141,192   | )
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|                                     |                                                                            | Net cash from operating activities                                                 |         |                          | (4,839     | )    |            |             | 12,314,866  |   |           |            | 2,705,821  |  
|Cash flows from investing activities |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |           
|                                     | Purchase of securities                                                     |                                                                                    |         |                         |            |      |            |            |             |   |           | (112,500   | )         
|                                     | Sales of securities                                                        |                                                                                    |         | 1,459,269                |            |      |            | 227,562     |             |   |           | 134,171    |           
|                                     | Cash paid for acquisition (net of cash received)                           |                                                                                    |         |                         |            |      |            | (14,733,013 | )           |   |           |           |           
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|                                     |                                                                            | Net cash from investing activities                                                 |         |                          | 1,459,269  |      |            |             | (14,505,451 | ) |           |            | 21,671     |  
|Cash flows from financing activities |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |           
|                                     | Dividends paid                                                             |                                                                                    |         | (1,273,659               | )          |      |            | (1,179,743  | )           |   |           | (1,183,402 | )         
|                                     | Dividends reinvested                                                       |                                                                                    |         |                         |            |      |            | 261,580     |             |   |           | 47,352     |           
|                                     | Purchase of treasury shares                                                |                                                                                    |         |                         |            |      |            |            |             |   |           | (344,445   | )         
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|                                     |                                                                            | Net cash from financing activities                                                 |         |                          | (1,273,659 | )    |            |             | (918,163    | ) |           |            | (1,480,495 | )
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|Net increase (decrease) in cash      |                                                                            |                                                                                    | 180,771 |                          |            |      | (3,108,748 | )           |             |   | 1,246,997 |           
|Cash, beginning of year              |                                                                            |                                                                                    | 600,316 |                          |            |      | 3,709,064  |             |             |   | 2,462,067 |           
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           
|Cash, end of year                    |                                                                            | $                                                                                  | 781,087 |                          |            | $    | 600,316    |             |             | $ | 3,709,064 |           
|                                     |                                                                            |                                                                                    |         |                          |            |      |            |             |             |   |           |            |           

(Continued)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001

NOTE 17 - QUARTERLY FINANCIAL DATA(UNAUDITED)

|     |                |  |          |           |              |  |        |           |           |  |   |         |   |  |           |       |  
|---- | -------------- |  | -------- | --------- | ------------ |  | ------ | --------- | --------- |  | - | ------- | - |  | --------- | ----- | -
|     |                |  |          |           |              |  |        |           |           |  |   |         |   |  | Basic and
|     |                |  |          |           |              |  |        |           |           |  |   |         |   |  | Diluted  
|     |                |  | Interest |           | Net Interest |  | Net    |           | Earnings 
|     |                |  | Income   |           | Income       |  | Income |           | per share
|     |                |  |          |           |              |  |        |           |          
|2003 |                |  |          |           |              |  |        |           |           |  |   |         |   |  |           |      
|     | First quarter  |  | $        | 3,974,571 |              |  | $      | 2,992,145 |           |  | $ | 806,646 |   |  | $         | 0.36  |  
|     | Second quarter |  |          | 3,926,619 |              |  |        | 2,926,329 |           |  |   | 799,626 |   |  |           | 0.36  |  
|     | Third quarter  |  |          | 3,744,193 |              |  |        | 2,839,220 |           |  |   | 636,946 |   |  |           | 0.28  |  
|     | Fourth quarter |  |          | 3,398,426 |              |  |        | 2,546,099 |           |  |   | 400,333 |   |  |           | 0.18  |  
|2002 |                |  |          |           |              |  |        |           |           |  |   |         |   |  |           |      
|     | First quarter  |  | $        | 3,007,388 |              |  | $      | 2,153,796 |           |  | $ | 729,777 |   |  | $         | 0.33  |  
|     | Second quarter |  |          | 4,397,461 |              |  |        | 2,898,126 |           |  |   | 680,516 |   |  |           | 0.31  |  
|     | Third quarter  |  |          | 4,291,593 |              |  |        | 2,943,490 |           |  |   | 874,757 |   |  |           | 0.39  |  
|     | Fourth quarter |  |          | 4,244,711 |              |  |        | 3,017,967 |           |  |   | (30,276 | ) |  |           | (0.02 | )

During the fourth quarter 2002, management charged off one large commercial
credit and identified other losses in the portfolio which required an
additional provision. This was the primary reason for the decline in 2002
fourth quarter net income and earnings per share.

During the fourth quarter of 2003, the Company accelerated the purchase
accounting adjustment on loans related to the acquisition in 2002 by
approximately $450,000. This impacted the Companys net interest income, net
income and earnings per share for the fourth quarter of 2003.

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REPORT OF INDEPENDENT AUDITORS

Board of Directors and Shareholders
National Bancshares Corporation
Orrville, Ohio

We have audited the accompanying consolidated balance sheets of National
Bancshares Corporation as of December 31, 2003 and 2002, and the related
consolidated statements of income, changes in shareholders equity and cash
flows for each of the three years in the period ended December 31, 2003. These
financial statements are the responsibility of the Corporations management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of National Bancshares
Corporation as of December 31, 2003 and 2002, and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
2003 in conformity with accounting principles generally accepted in the United
States of America.

| |  |                                    
| |  | -----------------------------------
| |  | (CROWE CHIZEK AND COMPANY LLC LOGO)
| |  |                                    
| |  | Crowe Chizek and Company LLC       

Columbus, Ohio
January 27, 2004

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Price Range of Common Stock

National Bancshares common stock is traded on the OTC Bulletin Board®
under the symbol NBOH. The OTC Bulletin Board® is a regulated quotation
service that displays real-time quotes, last-sale prices, and volume
information in over-the-counter equity securities. A summary of the high and
low prices of and cash dividends paid on National Bancshares common stock in
2002 and 2003 follows. This information does not reflect retail mark-up,
mark-down or commissions, and does not necessarily represent actual
transactions.

|               |  |      |       |     |  |                     |       |  |  |   |     | 
|-------------- |  | ---- | ----- | --- |  | ------------------- | ----- |  |  | - | --- | 
|2003           |  | High |       | Low |  | Dividends Per Share
|               |  |      |       |     |  |                    
|First Quarter  |  | $    | 23.00 |     |  | $                   | 21.75 |  |  | $ | .14 | 
|Second Quarter |  |      | 22.65 |     |  |                     | 21.85 |  |  |   | .14 | 
|Third Quarter  |  |      | 25.05 |     |  |                     | 23.00 |  |  |   | .15 | 
|Fourth Quarter |  |      | 25.00 |     |  |                     | 23.25 |  |  |   | .15 | 

|               |  |      |       |     |  |                     |       |  |  |   |     | 
|-------------- |  | ---- | ----- | --- |  | ------------------- | ----- |  |  | - | --- | 
|2002           |  | High |       | Low |  | Dividends Per Share
|               |  |      |       |     |  |                    
|First Quarter  |  | $    | 17.50 |     |  | $                   | 15.00 |  |  | $ | .13 | 
|Second Quarter |  |      | 21,00 |     |  |                     | 17.25 |  |  |   | .13 | 
|Third Quarter  |  |      | 20.50 |     |  |                     | 19.20 |  |  |   | .14 | 
|Fourth Quarter |  |      | 22.75 |     |  |                     | 19.85 |  |  |   | .14 | 

Information regarding the limitations on dividends available to be paid is
located in Note 12 to the Consolidated Financial Statements included herein.

Shareholder Information

Corporate Office
National Bancshares Corporation
112 West Market Street, P.O. Box 57Orrville, OH 44667
www.fnborrville.com

Stock Trading Information

The shares of common stock of National Bancshares Corporation are traded on the
OTC Bulletin Board® The ticker symbol for National Bancshares Corporation is
NBOH, The Corporation had 973 shareholders of record as of December 31, 2003.

Form 10-K

A copy of the Corporations 2003 Annual Report on Form 10-K as filed with the
SEC will be furnished free of charge to shareholders upon written request to
the company.

Shareholder Assistance

National Bancshares Corporation
Shareholder Services Department
(330) 682-1030
egerber@fnborrville.com

Transfer Agent
Registrar and Transfer Company
10 Commerce Drive
Cranford, NJ 07016
1-800-368-5948
invrelations@rtco.com
www.rtco.com

National Bancshares Corporation has a Dividend Reinvestment Plan and a
Dividend Direct Deposit Plan available at no cost. Please contact Registrar and
Transfer Company for enrollment.





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##### Table of Contents



DIRECTORS

Charles J. DolezalChairman, President,
Chief Executive Officer
National Bancshares
Corporation
First National Bank

Sara Steinbrenner BalzariniFormer Member of
Management Committee
Contours, Ltd.

Bobbi DouglasExecutive Director
STEPS at Liberty Center
Every Womans House

John W. KropfAttorney
Kropf., Wagner,
Hohenberger & Lutz, L.L.P.

Steve SchmidPresident
Smith Daily Products, Inc.

John E. SprungerPresident
Kidron Auction, Inc.

Howard J. WengerPresident
Wenger Excavating, Inc.
Lake Region Oil, Inc.
Northstar Asphalt, Inc.

James F. WoolleyChief Executive Officer
R.W. Screw Products, Inc.

Albert YeagleyDirector, Corporate
Quality Assurance
The J.M. Smucker Company

Robert F. GumzDirector Emeritus

OFFICERS

National Bancshares Corporation

Charles J. DolezalPresident

Kenneth R. VanSickleSenior Vice President, Secretary

Lawrence Cardinal, Jr.Vice President, Treasurer

First National Bank

Charles J. DolezalPresident

CONTROL
Lawrence Cardinal, Jr.Vice President & Controller

Jim HuntsbergerAssistant Vice President,
Asset/Liability Manager

Angela SmithAssistant Controller

LENDING
Scott HolmesAssistant Vice President,
Mortgage Loan
Department Manager

Suzanne HudsonCredit Analyst

Dean KarhanAssistant Vice President,
Commercial Loan Officer

Patty MassaroLoan Officer

Steve RiddickVice President,
Commercial Banking

Darrell SmuckerVice President,
Commercial Banking

Kenneth R. VanSickleSenior Vice President.
Chief Loan Officer

Carol YoderAssistant Vice President,
Consumer Loan
Department Manager

OPERATIONS
Robert WoodruffVice President & Cashier

Jan ZachariasOperations Officer

HUMAN RESOURCES
Jane MillerAdministrative Officer,
Human Resources

Jackie SamsaAssistant Vice President,
Manager of
Human Resources

SALES & BUSINESS
DEVELOPMENT

Harold D. BerkeyVice President of
Customer Services

Vanessa BrowerDirector of Sales Training
and Development

John D. Shultz, Jr.Vice President,
Commercial Banking
Downtown Massillon Office

Vicki SlaterDirector of Marketing

INTERNAL AUDIT
Tammy StarkeyAuditor

SECURITY/ COMPLIANCE

Ron ArmentroulAssistant Vice President,
Security Officer,
Compliance Officer

OFFICE
ADMINISTRATION

Kathy BarnesAssistant Vice President,
Mortgage Loan Originator
Midway Office

Paul BayusAssistant Vice President,
Manager Lodi Office

Carolyn ForrerAdministrative Officer,
Manager Main Office Lobby

Karen HaueterAssistant Vice President,
Manager Smithville and
Midway Offices

Michelle KieffaberLoan Officer, Dalton Office

James KuschmeaderAssistant Vice President,
Manager Seville Office

Susan KutzAdministrative Officer,
Manager West High Office

Betty LyonAssistant Vice President,
Manager Dalton Office

Matt MillerAssistant Vice President,
Manager Mt. Eaton Office

Linda RickerAssistant Vice President,
Loan Officer
Downtown Massillon Office

Jerry SchmidtLoan Officer
Downtown Massillon Office

Valerie SteinAssistant Vice President,
Manager Kidron Office

Cindy WagnerAssistant Vice President,
Manager Downtown
Massillon Office

Sue WeygandtAssistant Vice President,
Manager Mayflower Office



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OFFICES

Main Office
112 West Market St.
Orrville
(330) 682-1010

West High Office
1320 West High St.
Orrville
(330) 682-2881

Northside Office
1720 North Main St.
Orrville
(330) 682-2342

Cleveland Road Office
1725 Cleveland Rd.
Wooster
(330) 263-1725

Dalton Office
12 West Main St.
Dalton
(330) 828-2227

Kidron Office
4934 Kidron Rd.
Kidron
(330) 857-3101

Lodi Office
06 Ainsworth St.
Lodi
(330) 948-1414

Downtown Massillon Office
211 Lincoln Way East
Massillon
(330) 832-7441

Mayflower Office
2312 Lincoln Way N.W.
Massillon
(330) 833-1622

Massillon Marketplace Office
1 Massillon Marketplace Dr. S.W.
Massillon
(330) 837-2582

Midway Office
U.S. Rt. 30 at Co. Rd. 44
Apple Creek
(330) 264-8070

Mt. Eaton Office
15974 East Main St.
Mt. Eaton
(330) 857-4301 or
(330) 359-5476

Seville Office
121 Greenwich Rd.
Seville
(330) 769-3105

Smithville Office
153 East Main St.
Smithville
(330) 669-2611



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##### Table of Contents



| |                                       
| | --------------------------------------
| | (NATIONAL BANCSHARES CORPORATION LOGO)
| | 112 West Market Street                
| | Orrville, Ohio 44667                  
| | (330) 682-1010                        
| |                                       
| | www.fnborrville.com                   
| |                                       
| | Member FDIC
Equal Housing Lender