Table of Contents

**U.S. SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, DC 20549**
**FORM 10-QSB**
(Mark one)
x Quarterly report under Section 13 or 15(d) of the Securities Exchange Actof 1934
For the quarterly period ended June 30, 2004
o Transition report under Section 13 or 15(d) of the Exchange Act
For the transition period from _____________________ to ____________________
Commission file number 1-12707
**Pinnacle Bancshares, Inc.**(Exact Name of Small Business Issuer as Specified in Its Charter)   Delaware 72-1370314   (State or Other Jurisdiction of (I.R.S. EmployerIncorporation or Organization) Identification No.)
1811 Second Avenue, Jasper, Alabama 35502-1388(Address of Principal Executive Offices)
(205) 221-4111(Issuer’s Telephone Number, Including Area Code)
     Check whether the issuer: (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.
Yes x       No o
     The number of shares outstanding of each of the issuer’s classes ofcommon equity, as of August 14, 2004: 1,549,678 shares of common stock.
     Transitional Small Business Disclosure Format (check one):
Yes o       No x
 

Table of Contents

**CONTENTS**       **Page****PART I FINANCIAL INFORMATION**    **Item 1. Financial Statements**    ****Unaudited Condensed Consolidated Statements of Financial Condition at June 30, 2004and December 31, 2003.  3 ****Unaudited Condensed Consolidated Statements of Operations for the three and six-monthsended June 30, 2004 and 2003.  4 ****Unaudited Condensed Consolidated Statements of Stockholders’ Equity for the six-monthsended June 30, 2004 and 2003.  5 ****Unaudited Condensed Consolidated Statements of Cash Flows for the six-months endedJune 30, 2004 and 2003.  6 ****Notes to Unaudited Condensed Consolidated Financial Statements.  7 **Item 2. Management’s Discussion and Analysis**  10 **Item 3. Controls and Procedures**  14 **Part II OTHER INFORMATION**    **Item 2. Changes in Securities and Small Business Issuer Purchases of Equity Securities**  15 **Item 4. Submission of Matters to a Vote of Security Holders**  15 **Item 6. Exhibits and Reports on Form 8-K**  15 **Signatures**  16  EX-31.1 SECTION 302 CERTIFICATIONS OF THE CEO & CFO EX-32.1 SECTION 906 CERTIFICATIONS OF THE CEO & CFO
2

Table of Contents

**PART I  — FINANCIAL INFORMATION**
**Item 1. Financial Statements**
**PINNACLE BANCSHARES, INC.****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION**           **June 30,** **December 31,**  **2004** **2003**ASSETS:        Cash and cash equivalents $3,071,281  $3,519,377 Interest-bearing deposits in other banks  1,083,996   256,294 Securities available-for-sale  86,959,996   83,325,381 FHLB stock  557,500   732,400 Loans held for sale  967,697   1,428,190 Loans receivable, net of allowances for loan lossesof $1,315,772 and $1,467,128, respectively  103,597,600   105,477,419 Real estate owned, net  506,186   1,023,026 Premises and equipment  5,847,362   5,790,124 Goodwill  306,488   306,488 Bank owned life insurance  4,656,330   4,514,902 Accrued interest receivable  1,326,295   1,362,440 Other assets  1,619,008   838,150          Total assets $210,499,739  $208,574,191          LIABILITIES AND STOCKHOLDERS’ EQUITY:        Deposits $181,773,681  $179,939,397 Subordinated debt  3,093,000   3,093,000 Borrowed funds  4,080,000   3,465,000 Official checks outstanding  1,582,536   1,481,801 Accrued interest payable  515,089   439,729 Other liabilities  928,196   724,068          Total liabilities  191,972,502   189,142,995          STOCKHOLDERS’ EQUITY:        Common stock, par value $.01 per share; 2,400,000 authorized; 1,816,780and 1,800,813 issued at June 30, 2004 and December 31, 2003,respectively; 1,549,678 and 1,562,611 outstanding at June 30, 2004 andDecember 31, 2003, respectively.  18,168   18,008 Additional paid-in capital  8,374,884   8,219,941 Treasury shares, at cost (267,102 shares and 238,202 shares atJune 30, 2004 and December 31, 2003, respectively)  (3,207,162)  (2,743,245)Retained earnings  15,151,705   14,508,277 Accumulated other comprehensive loss, net of tax  (1,810,358)  (571,785)         Total stockholders’ equity  18,527,237   19,431,196          Total liabilities and stockholders’ equity $210,499,739  $208,574,191          
See accompanying notes to these condensed consolidated financial statements.
3

Table of Contents

**PINNACLE BANCSHARES, INC.****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**                   **Three Months ended** **Six Months Ended**  **June 30,** **June 30,**  **2004** **2003** **2004** **2003**INTEREST REVENUE:                Interest on loans $1,847,269  $2,145,981  $3,703,575  $4,351,026 Interest and dividends on securities  840,562   758,606   1,590,939   1,466,736 Other interest  4,793   5,381   15,439   15,636                     2,692,624   2,909,968   5,309,953   5,833,398 INTEREST EXPENSE:                Interest on deposits  778,888   982,349   1,556,778   2,045,719 Interest on borrowed funds  53,096   49,606   94,744   99,288 Interest on subordinated debentures  31,695   0   68,760   0                     863,679   1,031,955   1,720,282   2,145,007                  NET INTEREST INCOME BEFORE PROVISION FORLOAN LOSSES  1,828,945   1,878,013   3,589,671   3,688,391 PROVISION FOR LOAN LOSSES  147,000   267,500   294,000   535,000                  NET INTEREST INCOME AFTER PROVISION FORLOAN LOSSES  1,681,945   1,610,513   3,295,671   3,153,391                  NONINTEREST INCOME:                Fees and service charges on deposit accounts  260,297   249,104   489,241   460,141 Service fee income, net  41,352   40,495   82,245   80,015 Fees and charges on loans  61,658   21,598   115,036   71,124 Bank owned life insurance  70,714   71,406   141,428   142,811 Net gain (loss) on sale or write-down of:                Loans held for sale  191,308   245,301   326,863   493,044 Real estate owned  (7,571)  (44,932)  (17,406)  (50,738)Premises and equipment  0   13,500   0   13,500 Securities available-for-sale  0   91,054   (78,304)  376,240                     617,758   687,526   1,059,103   1,586,137                  NONINTEREST EXPENSE:                Compensation and benefits  864,361   788,141   1,720,806   1,583,607 Occupancy  257,958   268,468   513,932   521,668 Marketing and professional  59,313   56,073   117,391   109,199 Other  276,905   279,163   533,861   540,790                     1,458,537   1,391,845   2,885,990   2,755,264                  INCOME BEFORE INCOME TAXES  841,166   906,194   1,468,784   1,984,264 INCOME TAX EXPENSE  288,045   310,867   496,984   685,260                  NET INCOME $553,121  $595,327  $971,800  $1,299,004                  Basic earnings per share $0.35  $0.38  $0.62  $0.81 Diluted earnings per share $0.35  $0.37  $0.60  $0.80 Cash dividends per share $0.11  $0.10  $0.21  $0.20 Weighted average basic shares outstanding  1,564,744   1,575,838   1,565,336   1,608,126 Weighted average diluted shares outstanding  1,601,848   1,605,532   1,607,012   1,632,421 
See accompanying notes to these consolidated financial statements.
4

Table of Contents

**PINNACLE BANCSHARES, INC.****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY****FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003**                                                   **Accumulated** ** **  **Common Stock** **Additional**         **Other** **Total**   **Paid-in** **Treasury** **Retained** **Comprehensive** **Stockholders’**  **Shares** **Amount** **Capital** **Stock** **Earnings** **(Loss) Income** **Equity**BALANCE, December 31, 2002                            Comprehensive income:  1,792,086  $17,921  $8,131,746  $(1,497,777) $12,716,579  $587,009  $19,955,478 Net income  0   0   0   0   1,299,004   0   1,299,004 Change in fair value of securities available-for-sale, net of tax  0   0   0   0   0   (13,147)  (13,147)                             Comprehensive income                          1,285,857 Repurchase of common stock (87,000 shares at cost)  0   0   0   (1,070,939)  0   0   (1,070,939)Cash dividends declared ($.20 per share)  0   0   0   0   (321,837)  0   (321,837)                             BALANCE, June 30, 2003  1,792,086  $17,921  $8,131,746  $(2,568,716) $13,693,746  $573,862  $19,848,559                              BALANCE, December 31, 2003  1,800,813  $18,008  $8,219,941  $(2,743,245) $14,508,277  $(571,785) $19,431,196 Comprehensive income:                            Net income  0   0   0   0   971,800   0   971,800 Change in fair value of securities available-For-sale, net of tax  0   0   0   0   0   (1,238,573)  (1,238,573)                             Comprehensive income (loss)                          (266,773)Exercise of stock options  15,967   160   154,943   0   0   0   155,103 Repurchase of common stock (28,900 shares at cost)  0   0   0   (463,917)  0   0   (463,917)Cash dividends declared ($.21 per share)  0   0   0   0   (328,372)  0   (328,372)                             BALANCE, June 30, 2004  1,816,780  $18,168  $8,374,884  $(3,207,162) $15,151,705  $(1,810,358) $18,527,237                              
See accompanying notes to unaudited condensed consolidated financial statements.
5

Table of Contents

**PINNACLE BANCSHARES, INC,****UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**           **For the Six Months Ended**  **June 30,**  **2004** **2003****CASH FLOWS FROM OPERATING ACTIVITIES:**        Net income $971,800  $1,299,004 Adjustments to reconcile net income to net cash provided by operating activities:        Depreciation  244,428   229,571 Provision for loan losses  294,000   535,000 Accretion, net  (313,086)  (98,213)Increase in cash surrender value of Bank owned life insurance  (141,428)  (142,811)Net (gain) loss on sale or write down of:        Loans held for sale  (326,863)  (493,044)Securities available-for-sale  78,304   (376,240)Real estate owned and other assets  17,406   50,738 Premises and Equipment  0   (13,500)Proceeds from sale of loans  21,741,928   41,416,304 Loans originated for sale  (20,954,572)  (39,608,277)Decrease in accrued interest receivable  36,145   76,584 (Increase) decrease in other assets  (779,858)  37,651 Increase in accrued interest payable  75,360   26,959 Increase (decrease) in other liabilities  963,254   (66,657)         Net cash provided by operating activities  1,906,818   2,873,069          **CASH FLOWS FROM INVESTING ACTIVITIES:**        Net loan repayments  1,383,900   4,788,310 Net change in interest bearing deposits in other banks  (827,702)  (9,460,303)Purchase of securities available-for-sale  (53,670,854)  (75,200,000)Proceeds from the sale of securities available-for-sale  34,905,702   37,617,840 Proceeds from maturing, called, and payments received on securities available-for-sale  13,207,435   37,907,953 Proceeds from sale of FHLB stock  174,900   0 Purchase of premises and equipment  (301,666)  (277,476)Proceeds from sales of premises and equipment  0   26,210 Proceeds from sales of real estate owned  860,538   407,940          Net cash used in investing activities  (4,267,747)  (4,189,526)         **CASH FLOWS FROM FINANCING ACTIVITIES:**        Net increase in passbook, NOW and money market deposit accounts  2,066,903   2,141,728 Proceeds from sales of time deposits  10,619,777   12,620,932 Payments on maturing time deposits  (10,852,396)  (14,986,357)Increase in borrowed funds  615,000   3,825,000 Increase (decrease) in official checks outstanding  100,735   (822,875)Proceeds from the exercise of stock options  155,103   0 Repurchase of common stock  (463,917)  (1,070,939)Payments of cash dividends  (328,372)  (321,837)         Net cash provided by financing activities  1,912,833   1,385,652          **NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS**  (448,096)  69,195 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD  3,519,377   3,862,956          CASH AND CASH EQUIVALENTS AT END OF PERIOD $3,071,281  $3,932,151          SUPPLEMENTAL DISCLOSURES:        Cash payments for interest on deposits and borrowed funds $1,644,922  $2,118,048 Cash payments for income taxes  570,000   587,921 Real estate acquired through foreclosure  361,104   469,932 
See accompanying notes to unaudited condensed consolidated financial statements.
6

Table of Contents

**PINNACLE BANCSHARES, INC**.
**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
**1. BASIS OF PRESENTATION:**
The accompanying unaudited condensed consolidated financial statementsinclude the accounts of Pinnacle Bancshares, Inc. (the “Company”) andPinnacle Bank (the “Bank”), the Company’s wholly owned subsidiary. Allsignificant intercompany transactions and accounts have been eliminated inconsolidation.
In the opinion of management, all adjustments (none of which are other thannormal recurring accruals) necessary for a fair presentation of the resultsof such interim periods have been included. The results of operations for thethree month period ended June 30, 2004, are not necessarily indicative of theresults of operations which may be expected for the entire year.
These unaudited condensed consolidated financial statements should be read inconjunction with the audited financial statements and the notes theretoincluded in the Company’s Annual Report on Form 10-KSB for the year endedDecember 31, 2003. The accounting policies followed by the Company are setforth in the summary of Significant Accounting Policies in the Company’saudited consolidated financial statements.
7

Table of Contents

**2. EARNINGS PER SHARE:**
The following table represents the earnings per share calculations for thethree and six-month periods ended June 30, 2004 and 2003:                       **Per**          **Share****For The Three Months Ended** **Net Income** **Shares** **Amount****June 30, 2004**            Basic earnings per share $553,121   1,564,744  $0.35              Dilutive securities      37,104                  Diluted earnings per share $553,121   1,601,848  $0.35                                     **Per**          **Share****For The Three Months Ended** **Net Income** **Shares** **Amount****June 30, 2003**            Basic earnings per share $595,327   1,575,838  $0.38              Dilutive securities      29,694                  Diluted earnings per share $595,327   1,605,532  $0.37                                     **Per**          **Share****For The Six Months Ended** **Net Income** **Shares** **Amount****June 30, 2004**            Basic earnings per share $971,800   1,565,336  $0.62              Dilutive securities      41,676                  Diluted earnings per share $971,800   1,607,012  $0.60                                     **Per**          **Share****For The Six Months Ended** **Net Income** **Shares** **Amount****June 30, 2003**            Basic earnings per share $1,299,004   1,608,126  $0.81              Dilutive securities      24,295                  Diluted earnings per share $1,299,004   1,632,421  $0.80              
8

Table of Contents

**3. RECENT ACCOUNTING PRONOUNCEMENTS:**
In December 2003, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 46 (revised December 2003), *Consolidation of VariableInterest Entities*(“FIN 46R”)*,*which addresses how a business enterprise shouldevaluate whether it has controlling financial interest in an entity throughmeans other than voting rights and accordingly should consolidate the entity.FIN 46R replaces FASB Interpretation No. 46, *Consolidated of Variable InterestEntities (“FIN46”),*which was issued January 2003. Pinnacle Bancshares, Inc.will be required to apply FIN 46R to all entities subject to thisInterpretation no later than the end of the first reporting period that endsafter December 15, 2004. This interpretation must be applied to those entitiesthat are considered to be special-purpose entities no later than as of the endof the first reporting period that ends after December 15, 2003.
For any variable interest entities (VIEs) that must be consolidated under FIN46R that were created before January 1, 2004, the assets, liabilities andnon-controlling interest of the VIE initially would be measured at theircarrying amounts with any difference between the net amount added to thebalance sheet and any previously recognized interest being recognized as thecumulative effect of an accounting change. If determining the carrying amountsis not practicable, fair value at the date FIN 46R first applies may be used tomeasure the assets, liabilities and non-controlling interest of the VIE.
Pinnacle Bancshares, Inc. has applied FIN 46R in accounting for PinnacleCapital Trust I (“Trust”), established on December 22, 2003. Accordingly, inthe accompanying consolidated statement of financial condition the Company hasincluded in other assets, our investment in the Trust of $93,000 and alsoincluded, in subordinated debt, the balance owed the Trust of $3,093,000.Except as related to the Trust, the application of this Interpretation is notexpected to have a material effect on Pinnacle Bancshares, Inc.’s consolidatedfinancial statements.
In April 2003, the FASB issued Statement of Financial Accounting Standard(“SFAS”) No. 149, *Amendment of Statement 133 on Derivative Instruments andHedging Activities*. The Statement amends and clarifies accounting forderivative instruments, including certain derivatives instruments embedded inother contracts, and for hedging activities under SFAS No. 133, *Accounting forDerivative Instruments and Hedging Activities*. This Statement is effective forcontracts entered into or modified after June 30, 2003 and for hedgingrelationships designated after June 30, 2003. The adoption of this Statementdid not have a material impact on the Company’s consolidated financialposition or results of operations.
In May 2003, the FASB issued SFAS No. 150, *Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity*. ThisStatement establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. It requires that an issuer classify a financial instrument that iswithin its scope as a liability (or an asset in some circumstances). Many ofthose instruments were previously classified as equity. This Statement iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003. On November 7, 2003, the FASB deferredindefinitely the classification and measurement provisions related to mandatoryredeemable non controlling interest. The adoption of this Statement and theamendment did not have a material impact on the Company’s consolidatedfinancial position or results of operations.
In March 2004, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin (“SAB”) 105, *Application of Accounting Principles to LoanCommitments*, which summarizes the views of the staff regarding the applicationof generally accepted accounting principles to loan commitments accounted foras derivative instruments. The SAB requires that the fair value measurement ofa loan commitment that is accounted for as a derivative includes onlydifferences between the guaranteed interest rate in the loan commitment and amarket interest rate, excluding any expected future cash flows related to thecustomer relationship or loan servicing. This SAB is effective for loancommitments entered into after March 31, 2004. The Company adopted SAB 105 onApril 1, 2004, and the effect was not material.
In March 2004, the FASB’s Emerging Issues Task Force reached a consensus ofEITF Issue No. 03-1, *The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments.*The guidance prescribes a three-step modelfor determining whether an investment is other-than-temporarily impaired andrequires disclosures about unrealized losses on investments. The accountingguidance is effective for reporting periods beginning after June 15, 2004,while the disclosure requirements are effective for annual reporting periodsending after June 15, 2004. The Company has adopted the requirements of thisEITF.
9

Table of Contents

**Item 2. Management’s Discussion and Analysis or Plan of Operation**
**Forward-Looking Statements:**This Quarterly Report on Form 10-QSB containsforward-looking statements. Additional written or oral forward-lookingstatements may be made by the Company from time to time in filings with the SECor otherwise. The words “believe,” “expect,” “seek” and “intend,” and similarexpressions identify forward-looking statements, which speak only as of thedate the statement is made. Such forward-looking statements are within themeaning of that term in Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended. Suchstatements may include, but are not limited to, projections of income or loss,expenditures, acquisitions, plans for future operations, financing needs orplans relating to services of the Company, as well as assumptions relating tothe foregoing. Forward-looking statements are inherently subject to risk anduncertainties, some of which cannot be predicted or qualified. Future eventsand actual results could differ materially from those set forth in,contemplated by or underlying the forward-looking statements.
The Company does not undertake, and specifically disclaims, any obligation topublicly release the results of revisions, which may be made to forward-lookingstatements to reflect the occurrence of anticipated or unanticipated events orcircumstances after the date of such statements.
**Critical Accounting Policies:**The accounting principles followed by theCompany and the methods of applying these principles conform with United Statesgenerally accepted accounting principles and with general practices within thebanking industry. The Company’s critical accounting policies relate to theallowance for loan losses and real estate owned. These policies require the useof estimates, assumptions and judgments and are based on information availableas of the date of the financial statements. Accordingly, as this informationchanges, the financial statements could reflect different estimates,assumptions and judgments. Certain policies inherently have a greater result onthe use of estimates, assumptions and judgments and as such have a greaterpossibility of producing reliance that could be materially different thanoriginally reported. These policies require the use of subjective and complexestimates, assumptions and judgments that are important to the portrayal of theCompany’s financial condition and results.
The allowance for loan losses is maintained at a level which managementconsiders to be adequate to absorb losses inherent in the loan portfolio.Management’s estimation of the amount of the allowance is based on a continuingevaluation of the loan portfolio and includes such factors as economicconditions, analysis of individual loans, overall portfolio characteristics,delinquencies and the balance of any impaired loans (generally considered to benonperforming loans, excluding residential mortgages and other homogeneousloans).
Management reviews the adequacy of the allowance for loan losses on acontinuous basis by assessing the quality of the loan portfolio and adjustingthe allowance when appropriate. Management’s evaluation of certainspecifically identified loans includes a review of the financial condition andcapacity of the borrower, the value of the collateral, current economic trends,historical losses, workout and collection arrangements, and possibleconcentrations of credit. The loan review process also includes a collectiveevaluation of credit quality within the mortgage and installment loanportfolios. In establishing the allowance, loss percentages are applied togroups of loans with similar risk characteristics. These loss percentages aredetermined by historical experience, portfolio mix, regulatory influence, andother economic factors. Each quarter this review is quantified in a report tomanagement, which uses it to determine whether an appropriate allowance isbeing maintained. This report is then submitted to the Board of Directors andto the appropriate Board committee quarterly.
Changes in the allowance can result from changes in economic events, changes inthe creditworthiness of the borrowers, or changes in collateral values. Theeffect of these changes is reflected when known. Though management believesthe allowance for loan losses to be adequate as of June 30, 2004, ultimatelosses may vary from estimations.
Real estate owned acquired through foreclosure is carried at the lower of costor fair value less expected selling costs. Any excess of the recordedinvestment over fair value, less estimated costs of disposition of theproperty, is charged to the allowance for loan losses at the time offoreclosure. Subsequent to foreclosure, real estate owned is
10

Table of Contents

evaluated on an individual basis for changes in fair value. Declines in fairvalue of the asset, less costs of disposition below its carrying amount,require an increase in the valuation allowance account. Future increases infair value of the asset, less cost of disposition, may cause a reduction in thevaluation allowance account, but not below zero. Increases or decreases in thevaluation allowance account are charged or credited to income. Costs relatingto the development and improvement of property are capitalized, whereas costsrelating to the holding of property are expensed.
The recognition of gains and losses on the sale of real estate owned isdependent upon whether the nature and terms of the sale and future involvementof the Bank in the property meet certain requirements. If the transaction doesnot meet these requirements, income recognition is deferred and recognizedunder an alternative method in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 66, *Accounting for Sales of Real Estate.*
**Comparison of Financial Condition as of December 31, 2003 and June 30, 2004:**Total assets were $210.5 million at June 30, 2004, compared to $208.6 millionat December 31, 2003. Net loans receivable were $103.6 million at June 30,2004, compared to $105.5 million at December 31, 2003. Total securitiesavailable-for-sale were $87.0 million at June 30, 2004, compared to $83.3million at December 31, 2003.
At June 30, 2004, the investment portfolio of $87.0 million consisted primarilyof U. S. agency securities and mortgage-backed securities. The entireinvestment portfolio is classified as “available-for-sale,” which is carried atfair value with the unrealized gains/losses reflected directly in stockholders’equity, net of taxes. During the six months ended June 30, 2004, the Bank had$13.2 million in agency securities called. Also during the six month periodended June 30, 2004, the Bank sold $34.9 million in agency securities. Grosslosses of $78,000 were realized on these sales. The proceeds from these calls,and sales of securities available-for-sale, combined with the proceeds fromloan principal repayments and Federal Home Loan Bank (“FHLB”) of Atlantaadvances, were used by the Bank to purchase $53.7 million in agency securitieswith an average yield of 4.11%.
Total deposits increased approximately $1.8 million, from $180.0 million atDecember 31, 2003 to $181.8 million at June 30, 2004. This increase wasprimarily due to an increase in passbook, NOW and money market depositaccounts.
On December 22, 2003, the Company established Pinnacle Capital Trust I (the“Trust”), a wholly-owned statutory business trust. The Company is the solesponsor of the trust and owns $93,000 of the Trust’s common securities. TheTrust was created for the exclusive purpose of issuing 30-year capital trustpreferred securities (“Trust Preferred Securities”) in the aggregate amount of$3,000,000 and using proceeds from the issuance of the common and preferredsecurities to purchase $3,093,000 of junior subordinated debentures(“Subordinated Debentures”) issued by the Company. The sole assets of the Trustare the Subordinated Debentures. The Company’s investment in the Trust isincluded in other assets in the accompanying consolidated balance sheet at June30, 2004 and the $3,093,000 obligation of the Company is included insubordinated debt.
During the six-months ended June 30, 2004, the Bank periodically borrowed fundson a short-term basis from the FHLB of Atlanta. During the six-months endedJune 30, 2004, the Bank used proceeds from borrowed funds to purchase agencysecurities as part of managing the Bank’s investment portfolio. The maximumamount outstanding during the six-months ended June 30, 2004 was $10.0 million.The average amount outstanding during the six-months ended June 30, 2004 was$2.3 million.
Stockholders’ equity decreased from $19.4 million at December 31, 2003, to$18.5 million at June 30, 2004. This decrease was primarily attributable to a$1.2 million decrease in the market value of the Company’s available-for-salesecurities portfolio, which is marked to fair value based on prevailinginterest rates. The interest rate risk in the Company’s portfolio is monitoredclosely. The Company anticipates that it will restructure its portfolio in thethird and fourth quarters of 2004 and may incur some losses in connection withthese transactions.
Management evaluates securities for other-than-temporary impairment on a leasta quarterly basis, and more frequently when economic or market concerns warrantsuch evaluation. Consideration is given to (1) the length of time and theextent to which the fair value has been less than cost, (2) the financialcondition and near-term prospects of the issuer, and (3) the intent and abilityof the Company to retain its investment in the issuer for a period of timesufficient to allow for any anticipated recovery in fair value. Because thedeclines in fair value of $2.9 million were attributable to increases ininterest rates and not attributable to credit quality and because the
11

Table of Contents

Company has the ability and intent to hold all of these investments until amarket price recovery or maturity, these investments were not consideredother-than-temporary impaired.
**Results of Operations-Comparison of the Three and Six-Months Ended June 30,2004 and 2003:**For the three-months ended June 30, 2004, net income was$553,000, compared with net income of $595,000 for the three months ended June30, 2003. For the six months ended June 30, 2004, net income was $972,000,compared with net income of $1,299,000 for the six months ended June 30, 2003.
The net interest margin was 3.71% and 3.69% for the three and six months endedJune 30, 2004, compared to 3.69% and 3.65% for the three and six months endedJune 30, 2003, respectively. As market rates continued to stabilize at lowerlevels during the three and six months period ended June 30, 2004, theCompany’s cost of funds decreased more rapidly than rates on loans andinvestments, contributing to the improved margin. The yield on interest-earningassets decreased from approximately 5.72% and 5.77% in the three and six monthperiods ended June 30, 2003, respectively, to approximately 5.46% in both thethree and six month period ended at June 30, 2004. These decreases were due todecreases in market interest rates as well as a decrease in the average balanceof interest earning assets. The cost of funds decreased from approximately2.00% at June 30, 2003, to approximately 1.76% at June 30, 2004, due todecreases in market deposit rates.
Net interest income before the provision for loan losses for the three monthsended June 30, 2004, was $1,829,000, compared with $1,878,000 in the sameperiod last year. Net interest income before the provision for loan losses forthe six months ended June 30, 2004, was $3,590,000, compared with $3,688,000 inthe same period last year. The decreases were primarily due to decreases ininterest revenue of $217,000 and $523,000 for the three and six months endedJune 30, 2004, respectively, compared with the same periods last year.
Provisions for loan losses are made to maintain the allowance for loan lossesat adequate levels. The allowance for loan losses reflects management’sestimates, which take into account historical experience, the amount ofnon-performing loans, collateral values and general economic conditions. Theprovision for loan losses was $147,000 and $294,000 for the three and sixmonths ended June 30, 2004, respectively, compared to $267,500 and $535,000 forthe three and six months ended June 30, 2003, respectively. The decrease inthe provision for loan losses for the three and six month periods ended June30, 2004, as compared to the prior year period, was primarily the result of adecrease in charge-offs as well as a decrease in non-accrual loans. It ismanagement’s opinion that the allowance for loan losses at June 30, 2004 wasadequate to absorb losses related to the portfolio of loans. Management willcontinue to analyze the Bank’s exposure to losses. Although management believesthat it uses the best information available to make such determinations, futureadjustments to allowances may be necessary, and net earnings could besignificantly affected if circumstances differ substantially from theassumptions used in making the initial determinations.
Net interest income after the provision for loan losses for the three monthsended June 30, 2004, was $1,682,000, compared with $1,611,000 in the sameperiod last year. Net interest income after the provision for loan losses forthe six months ended June 30, 2004, was $3,296,000, compared with $3,153,000 inthe same period last year.
Non-interest income, which includes fees and service charges, income from realestate operations, the sale of loans, bank owned life insurance and otherincome, decreased $70,000 in the three-month period ended June 30, 2004, ascompared to the three-month period ended June 30, 2004. The decrease was dueprimarily to a decrease in the gain on sale of securities available-for-saleof $91,000**,**a decrease in net gain on sale of loans held for sale of $54,000and a decrease in all other non-interest income of $2,000. This decrease wasoffset by an increase in fees and service charges on loans of $40,000 and adecrease in the loss on sale of real estate owned of $37,000. Non-interestincome decreased $527,000 in the six-month period ended June 30, 2004, ascompared to the six-month period ended June 30, 2004. The decrease was dueprimarily to a decrease in the gain on sale of securities available-for-saleof $455,000**,**a decrease in net gain on sale of loans held for sale of$166,000. This decrease was offset by an increase in fees and service chargeson loans of $44,000, a decrease in the loss on sale of real estate owned of$33,000 and an increase in all other non-interest income of $17,000.
Non-interest expense increased $67,000 in the three-month period ended June30, 2004, as compared to the corresponding prior year period. This wasprimarily a result of an increase in compensation and benefits of $76,000.This increase was offset by a decrease in all other non-interest expense of$9,000. Non-interest expense increased $131,000 in the six-month period endedJune 30, 2004 as compared to the corresponding prior year
12

Table of Contents

period. This was primarily due to an increase in compensation and benefits of$137,000. This increase was offset by a decrease in all other non-interestexpense of $6,000.
**Asset/LiabilityManagement:**The modeling techniques used by the Companysimulate net interest income and impact on fair values under various ratescenarios. Important elements of these techniques include the mix of floatingversus fixed rate assets and liabilities, and the scheduled, as well asexpected, re-pricing and maturing volumes and rates of the existing balancesheet. Under scenarios simulating hypothetical 100, 200 and 300 basis pointrate increases applied to all fixed rate interest earning assets andinterest-bearing liabilities, the Company would expect net losses in fair valueof the underlying instruments of approximately ($1,239,000), ($2,465,000), and($3,752,000), respectively. Under scenarios simulating hypothetical 100, 200and 300 basis point rate decreases applied to all fixed rate interest earningassets and interest-bearing liabilities, the Company would expect net gains(losses) in fair value of the underlying instruments of approximately $664,000,($11,000), and ($673,000), respectively. These hypotheticals are not preciseindicators of future events. Instead, it is a reasonable estimate of theresults anticipated if the assumptions used in the modeling techniques were tooccur**.**
Changes in interest rates can affect loans and other interest-earning assets,including the Bank’s investment portfolio. A significant change in interestrates could have a negative impact on the Company’s operating income andportfolio market value.
On April 25, 2003, the Company announced a stock repurchase program to acquireup to 80,000 shares of common stock. As of July 31, 2004, the Company hadrepurchased 73,700 shares at an average price of $14.70 per share.
The following table details purchases under the Company’s stock repurchaseprogram during the six months ended June 30, 2004.                           **Total Number of** **Maximum Number**  **Total Number**     **Shares Purchased** **of Shares that May**  **of Shares** **Average Price** **As Part of Publicly** **Yet Be Purchased****Period** **Purchased** **Paid per Share** **Announced Programs** **Under the Programs**January 1-31, 2004  0   0   0   0                  February 1-29, 2004  9,900  $17.85   9,900   25,300                  March 1-31, 2004  0   0   0   0                  April 1-30, 2004  0   0   0   0                  May 1-31, 2004  5,000  $14.32   5,000   20,300                  June 1-30, 2004  14,000  $15.40   14,000   6,300                  **Total**  28,900  $16.05   28,900   6,300                  
On June 10, 2004, the Company announced a supplemental stock repurchase programto acquire an additional 5% of the Company’s outstanding shares outstandingupon completion of its current repurchase program, or 77,169 shares. Thisprogram supplements the Company’s current repurchase program. The repurchaseprograms are dependent upon market conditions and other requirements, and thereis no guarantee as to the exact number of shares to be repurchased by theCompany.
**Capital Resources:**Historically, funds provided by operations, mortgage loanprincipal repayments, deposits and short-term borrowings have been the Bank’sprincipal sources of funds. In addition, the Bank has the ability to obtainfunds through the sale of mortgage loans, through borrowings from the FHLB ofAtlanta and other borrowing sources. At June 30, 2004, the Bank’s total loancommitments, including construction loans in process, unused lines of creditand letter of credits, were approximately $24.3 million. Management believesthat the Bank’s liquidity and other sources of funds are sufficient to fund allcommitments outstanding and other cash needs. The Company and the Bank arerequired to maintain certain levels of regulatory capital. At June 30, 2004,the Company and the Bank exceeded all regulatory capital requirements.As of June 30, 2004, the $3.0 million of Trust Preferred Securities qualifiesas Tier I Capital under current regulators definitions. If these TrustPreferred Securities had not been included in the consolidated capitalcalculations, the Company would have still been classified as well capitalized.
13

Table of Contents

**Item 3. Controls and Procedures**
The Company carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Company’s PrincipalExecutive Officer and Principal Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures as ofJune 30, 2004. Based upon that evaluation, the Company’s Principal ExecutiveOfficer and Principal Financial Officer concluded that the Company’s disclosurecontrols and procedures, as designed and implemented, are effective in alertinghim in a timely manner to material information relating to the Company(including its consolidated subsidiaries) required to be included in theCompany’s periodic SEC filings.
In addition, the Company reviewed its internal controls under the supervisionof the audit committee. There has been no change in the Company’s internalcontrol over financial reporting during the last fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.
Disclosure controls and procedures are designed to ensure that informationrequired to be disclosed in reports filed by the Company under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms. Disclosure controls arealso designed with the objective of ensuring that such information isaccumulated and communicated to the Company’s management, including thePrincipal Executive Officer and Principal Financial Officer to allow timelydecisions regarding required disclosures. Disclosure controls include internalcontrols that are designed to provide reasonable assurance that transactionsare properly authorized, assets are safeguarded against unauthorized orimproper use and transactions are properly recorded and reported.
Any control system, no matter how well conceived and operated, can provide onlyreasonable assurance that its objectives are achieved. The design of a controlsystem inherently has limitations, including the controls’ cost relative totheir benefits. Additionally, controls can be circumvented. No cost-effectivecontrol system can provide absolute assurance that all control issues andinstances of fraud, if any, will be detected.
14

Table of Contents

**PART II — OTHER INFORMATION**
**ITEM 2. Changes in Securities and Small Business Issuer Purchases of Equity Securities**
Information regarding the Company’s purchases of equity securities is describedon pages 12 and 13 under Item 2. “Management’s Discussion and Analysis or Planof Operation.”
**ITEM 4. Submission of Matters to a Vote of Security Holders**
On May 26, 2004, the Company held its Annual Meeting of Stockholders at whichthe following matters were considered and voted on.
**PROPOSAL I- ELECTION OF DIRECTORS**             **NOMINEES** **FOR** **WITHHELD** **TERM**Greg Batchelor  1,396,437   802   2007 James T. Waggoner  1,391,537   5,702   2007 
There were no abstentions or broker non-votes.
**PROPOSAL II- RATIFICATION OF APPOINTMENT OF INDEPENDENT AUDITORS**
Ratification of the appointment of KPMG, LLP as independent auditors of theCompany for the fiscal Year ending December 31, 2004.         **FOR** **AGAINST** **ABSTAIN**1,388.971  4,954   3,314 
There were no broker non-votes.
**ITEM 6. Exhibits and Reports on Form 8-K**
(a) Exhibits
Exhibit 31.1- Certifications of Chief Executive Officer and Chief FinancialOfficer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1 Certifications of Chief Executive Officer and Chief FinancialOfficer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
Current Report on Form 8-K dated May 7, 2004, furnishing under Item 12announcement of the Company’s results of operations for the first quarter endedMarch 31, 2004.
15

Table of Contents

**SIGNATURES**
In accordance with the requirements of the Exchange Act, the registrant hascaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.          PINNACLE BANCSHARES, INC