<PAGE>   1
                                                                      EXHIBIT 13



TABLE OF CONTENTS


SELECTED FINANCIAL DATA                                                 2
FIVE YEAR FINANCIAL PERFORMANCE                                         3
LETTER TO SHAREHOLDERS                                                  4
MANAGEMENT'S REPORT                                                     5
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL INFORMATION                  11
COMMUNITY REINVESTMENT - JUNIOR ACHIEVEMENT                            12
CONSOLIDATED BALANCE SHEETS                                            13
CONSOLIDATED STATEMENTS OF SHAREHOLDER'S EQUITY                        14
CONSOLIDATED STATEMENTS OF INCOME                                      15
CONSOLIDATED STATEMENTS OF CASH FLOWS                                  16
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                             17
REPORT OF INDEPENDENT AUDITORS                                         29
BOARD OF DIRECTORS                                                     30
STRATEGIC MANAGEMENT TEAM                                              31
OFFICERS                                                               32
EMPLOYEES                                                              33



FACTS ABOUT SOUTHERN MICHIGAN BANCORP, INC. STOCK
The Trust Department of Southern Michigan Bank & Trust acts as transfer agent
for the Company's stock. For information concerning the transfer of the
Company's stock, call the Trust Department (517) 279-5503.

The Coldwater, Michigan office of Hilliard Lyons "makes the market" for the
Company's stock. For more information call (517) 278-4333 or (800) 211-5257.

Southern Michigan Bancorp, Inc. provides an automatic dividend reinvestment plan
that allows shareholders to increase their holdings without brokerage fees. For
more information call the Trust Department at (517) 279-5503.

ANNUAL MEETING
The Annual Meeting of Southern Michigan Bancorp, Inc. will be held on April 20,
1998 at 4:00 p.m. at Southern Michigan Bank & Trust, 51 W. Pearl Street,
Coldwater, Michigan.

10-K INFORMATION
To order Form 10-K, the Annual Report for 1997 to the Securities and Exchange
Commission, address request to Southern Michigan Bancorp, Inc., 51 West Pearl
Street, Coldwater, Michigan 49036, Attention: Secretary.


                                        1


<PAGE>   2
\


SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                            Year Ended December 31
                                           1997        1996        1995        1994         1993
                                        -----------------------------------------------------------
                                                  (In thousands, except per share amounts)
<S>                                     <C>         <C>         <C>         <C>         <C>     
Total interest income                   $ 18,865    $ 17,004    $ 15,476    $ 12,680    $ 11,863
Net interest income                       11,422      10,400       9,096       7,738       6,702
Provision for loan losses                    460         267         222         180           0
Net income                                 3,032       3,058       2,615       2,018       1,590
Per share data:
   Net income                               1.59        1.62        1.41        1.11         .90
   Cash dividends                            .58         .53         .50         .38         .35
Balance sheet data:
   Long-term borrowings                    3,000           0           0           0           0
   Capital note                                0           0       1,000       1,000       1,000
   Common stock subject to repurchase      4,899       3,555       2,232       1,464       1,187
   Equity                                 20,590      19,616      18,497      16,855      15,614
   Total assets                          238,531     235,562     209,977     195,625     178,453
Return on average assets                    1.30%       1.45%       1.31%       1.11%        .90%
Return on average equity                   14.96%      16.09%      14.64%      12.36%      10.56%
</TABLE>


COMMON STOCK MARKET PRICES AND DIVIDENDS
The Company's common stock, for which there is no established public trading
market, is traded infrequently in the local over-the-counter market. Market
prices are based on information provided by an established securities dealer.
There were 423 shareholders of record at December 31, 1997.


High and low market prices and dividends for the last two years were:

<TABLE>
<CAPTION>
                               1997                                 1996
                   ------------------------------    -------------------------------
                       MARKET PRICE          CASH        Market Price           Cash
                   -------------------- DIVIDENDS    --------------------  Dividends
                   HIGH BID     LOW BID  DECLARED    High Bid     Low Bid   Declared


Quarter Ended
-------------------------------------------------------------------------------------
<S>               <C>         <C>         <C>       <C>         <C>         <C>    
March 31          $   23.50   $   21.50   $   .12   $   17.00   $   15.00   $   .12
June 30               24.63       22.50       .13       17.50       16.50       .12
September 30          28.00       24.13       .13       19.75       17.50       .12
December 31           34.00       28.00       .20       22.50       19.75       .17
</TABLE>


There are restrictions that currently limit the Company's ability to pay cash
dividends. Information regarding dividend payment restrictions is described in
Note K to the consolidated financial statements for the year ended December 31,
1997.

All per share amounts have been adjusted for a 1997 stock split effected in the
form of a 100% stock dividend, a 2 for 1 stock split in 1995 and a 10 percent
stock dividend declared in 1993.


                                        2

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   3


CORNER MARK 41 MISSING



<PAGE>   4




LETTER TO SHAREHOLDERS

 [Photo of Towns and Grohalski]

To Our Shareholders: 

Every organization that is committed to growth and independence must, first of
all, be prepared and willing to adapt to change.  In 1997, Southern
Michigan Bancorp seized the opportunity, provided by years of increasing
profits, to invest in changes that will greatly strengthen long-term
shareholder value.  

Research into customer preferences and industry trends compelled us to
implement several strategic initiatives this year which, although they
had a dampening effect on 1997 profits, will strengthen Southern Michigan
Bancorp's market leadership. And when you look at where those investments were
made, technology continues at the top of the list.

In 1997, we made it much easier for customers to bank with us by adding 24-hour
telephone banking. It was also the year that we began to build a presence on the
Information Superhighway with our own page on the World Wide Web
(www.smb-t.com). But the biggest technological investments were behind the
scenes.

As we went through transition in 1997, changing from a reactive organization to
one which anticipates customer needs, we realized that changes would be needed
in our computers. The process of anticipating and filling customer needs by
using direct sales techniques increases the demand for timely information. Our
systems couldn't keep up.

In response, we literally overhauled every desktop with new machinery, linking
the computers together in networks to share information faster, improve
productivity and serve customers more completely. Significant technological
upgrades also were made in the processing end of our business. At the same time,
we invested heavily in employee training . . . in sales techniques, computer
operation and, of course, customer service.

What has emerged is a distinct way of doing business that we call CUSTOMER
SERVICE SOUTHERN STYLE. It's a unique blend of appropriate technology,
highly-trained employees and exciting products. And, because our work force rose
to the challenge and implemented these investments while minimizing the dilution
of our profits, we rewarded them with a year-end bonus, directly tied to their
contributions.

These types of investments will never end for independent companies committed to
growth. And, in 1998, we will continue to position ourselves as a strong,
independent financial services organization with the construction of a new
office in Hillsdale. Ground already has been broken; completion is scheduled for
this summer.

Creating profit and increasing shareholder value has been our goal for 125
years. Our work in 1997 promises to lay a strong foundation from which to
continue the pursuit of that vision.


Jerry L Towns                                 James T. Grohalski
---------------------------                   ------------------------------
Jerry L. Towns                                James T. Grohalski
President & C.E.O.                            Executive Vice-President
                                                             
                                       4

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   5



MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information about the Company's financial
condition which supplements the Consolidated Financial Statements included
elsewhere in this Annual Report. The analysis should be read in conjunction with
such financial statements and Five Year Performance and Selected Financial Data
presented in other sections of this Annual Report.

FINANCIAL CONDITION

The Company functions as a financial intermediary and, as such, its financial
condition should be examined in terms of trends in its sources and uses of
funds.

The Company uses its funds primarily to support its lending activities. Loans
increased by 4.0% in 1997 and 23.9% in 1996. The growth in 1997 occurred in all
loan categories and is the result of continued good economic conditions within
the Company's market area. The growth in 1996 also occurred in all loan
categories. The good economic conditions caused many businesses within the
market area to expand in 1996. This strong loan demand, along with more
competitive pricing techniques, caused the Bank's commercial loan portfolio to
grow significantly in 1996.

The Bank's real estate mortgage loan sales to the secondary market continued to
increase in 1997. Gains of $451,000 (after the capitalization of mortgage
servicing rights) were recognized in 1997 and gains of $236,000 were recognized
in 1996. There were no loans held for sale at December 31, 1997. The real estate
portfolio largely consists of residential mortgages within the local area with a
low risk of loss.

Despite the significant increase in secondary market loan sales, the Bank's
mortgage portfolio increased due to the offering of some attractive adjustable
rate mortgage products and the Bank's continued efforts to become a market
leader in the consumer lending area. The Bank anticipates that the sale of loans
in the secondary market will continue to increase, subject to the impact of
economic factors and levels of interest rates.

Loan commitments, consisting of unused credit card and home equity lines,
available amounts on revolving lines of credit and other approved loans which
have not been funded, were $23,049,000 and $26,429,000 at December 31, 1997 and
1996, respectively. All of these commitments, with the exception of unused
credit cards ($2,539,000 at December 31, 1997 and $1,892,000 at December 31,
1996), are priced at a variable interest rate thus minimizing the Bank's risk in
a changing interest rate environment.

There were no significant concentrations in any loan category as to borrower,
industry or location.

Another significant use of funds is the investment securities portfolio.
Investments decreased by 20.4% in 1997 and increased by 2.3% in 1996. The funds
received from maturing investments were used to fund the 1997 loan growth since
the Bank was not able to fund this growth with deposits. The 1996 increase
occurred during the month of December following the significant increase in
deposits associated with the acquisition of two branches from First of
America-Michigan.

The available-for-sale portfolio had net unrealized gains of $39,000 and $31,000
at December 31, 1997 and 1996, respectively. Net unrealized gains in the
investment portfolio classified as held to maturity totaled $351,000 and
$286,000 at December 31, 1997 and 1996, respectively. It is the Company's intent
to hold these investment securities to maturity with the available-for-sale
securities being available to sell should the Company's liquidity needs require
it. There is no concentration of investments in the portfolio which would
constitute an unusual risk.

Deposits traditionally represent the Company's principal source of funds. Total
deposits decreased 1.1% in 1997 and increased 12.9% in 1996. The 1997 decrease
is the result of the maturing of short-term municipal and school deposits that
were acquired late in 1996. The Company's deposit base was below 1996 levels for
most of the year, thus requiring the Company to seek other sources to fund loan
growth. The 1996 increase occurred as the result of the acquisition of
$18,635,000 in deposits from First of America, as well as an increase in
short-term municipal and school deposits.

Attracting and keeping traditional deposit relationships will continue to be a
challenge to the Bank, particularly with the increased competition from
nondeposit products. In order to have an alternate funding source, the Bank
obtained a $3,000,000 putable advance from the Federal Home Loan Bank (FHLB) in
December 1997. This advance carries a five year maturity and is secured by a
blanket collateral agreement with the FHLB giving the FHLB an unperfected
security interest in the Bank's one-to-four family whole mortgage loans,
government and agency securities and highly rated mortgage-backed securities.
The Bank obtained an additional $2,000,000 advance in February 1998. FHLB
advances will be a less expensive way to obtain longer term funds than paying a
premium for long term deposits.

Premises and equipment increased by 6.9% in 1997 and 31.9% in 1996. The 1997
increase was due to the continued upgrading of the Bank's technology. The 1996
increase was due to the completion of renovations for the two new retail loan
centers opened in 1996, and associated furniture and equipment purchases.

The Company has committed approximately $1,700,000 for the construction of a new
branch office in Hillsdale, Michigan. The office is expected to open in the
third quarter of 1998.



                                        5

1997 Annual Report to Shareholders

<PAGE>   6



MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

CAPITAL RESOURCES

The Company maintains a strong capital base to take advantage of business
opportunities while ensuring that it has resources to absorb the risk inherent
in the business.

The Federal Reserve Board (FRB) has imposed risk-based capital guidelines
applicable to the Company. These guidelines require that bank holding companies
maintain capital commensurate with both on and off balance sheet credit risks of
their operations. Under the guidelines, a bank holding company must have a
minimum ratio of total capital to risk-weighted assets of 8 percent. In
addition, a bank holding company must maintain a minimum ratio of Tier 1 capital
equal to 4 percent of risk-weighted assets. Tier 1 capital includes common
shareholders' equity, qualifying perpetual preferred stock and minority
interests in equity accounts of consolidated subsidiaries less goodwill.

As a supplement to the risk-based capital requirements, the FRB has also adopted
leverage capital ratio requirements. The leverage ratio requirements are
intended to insure that adequate capital is maintained against risk other than
credit risk. The leverage ratio requirements establish a minimum ratio of Tier 1
capital to total assets of 3 percent for the most highly rated bank holding
companies and banks that do not anticipate and are not experiencing significant
growth. All other bank holding companies are required to maintain a ratio of
Tier 1 capital to assets of 4 to 5 percent, depending on the particular
circumstances and risk profile of the institution.

Regulatory agencies have determined that the capital component created by the
adoption of Financial Accounting Standards Board (FASB) Statement No. 115 should
not be included in Tier 1 capital. As such, the net unrealized appreciation or
depreciation on available-for-sale securities is not included in the ratios
listed below. The ratios include the common stock subject to repurchase
obligation in the Company's employee stock ownership plan (ESOP).

The following table summarizes the Company's capital ratios as of December 31:


                                                         1997       1996
                                                         ---------------
          Tier 1 risk-based capital                      13.3%     11.9%
          Total risk-based capital ratio                 14.3%     12.9%
          Leverage ratio                                 10.1%      9.9%

The table above indicates that the Company's capital ratios are above the
regulatory minimum requirements.

In addition to these regulatory requirements, a certain level of capital growth
must be achieved to maintain appropriate levels of equity to total assets.
During 1997 and 1996, total average assets grew 10.8% and 5.7%, respectively. At
the same time, average equity (including common stock held by the ESOP)
increased 11.9% in 1997 and 11.1% in 1996. This indicates that the Company has
retained adequate capital to support its asset growth and has the ability to
continue growing. Future growth opportunities will focus on maintaining the
existing customer base and growing within the Calhoun and Hillsdale county
markets.

LIQUIDITY AND INTEREST RATE SENSITIVITY

The primary functions of asset/liability management are to assure adequate
liquidity and maintain an appropriate balance between interest-earning assets
and interest-bearing liabilities. Liquidity management involves the ability to
meet the cash flow requirements of customers who may be either depositors
wanting to withdraw funds or borrowers needing assurance that sufficient funds
will be available to meet their credit needs. Interest rate sensitivity
management seeks to avoid fluctuating net interest margins and enhance
consistent growth of net interest income through periods of changing interest
rates.

Maturing loans and investment securities are the principal sources of asset
liquidity. Securities maturing or callable within 1 year were $13,687,000 at
December 31, 1997 representing 30.4% of the amortized cost of the investment
securities portfolio, an increase from the 28.7% level of 1996. Loans maturing
within 1 year were $32,773,000 at December 31, 1997 representing 20.6% of the
loan portfolio, a slight increase from the 20.0% level of 1996.

Financial institutions are subject to prepayment risk in falling rate
environments. Prepayments of assets carrying higher rates reduce the Company's
interest income and overall asset yields. Certain portions of an institution's
liabilities may be short-term or due on demand, while most of its assets may be
invested in long-term loans or investments. Accordingly, the Company seeks to
have in place sources of cash to meet short-term demands. These funds can be
obtained by increasing deposits, borrowing, or selling assets. Also, Federal
Home Loan Bank advances and short-term borrowings provide additional sources of
liquidity for the Company.

During the year ended December 31, 1997, there was a net increase in cash and
cash equivalents of $3,328,000. The major sources of cash in 1997 were loan
sales and maturing securities. The major uses of cash in 1997 were loan growth
and loans originated for sale.

During the year ended December 31, 1996, there was a net decrease in cash and
cash equivalents of $3,660,000. The major source of cash in 1996 was the
increase in deposits resulting from growth in the existing deposit base and the
acquisition of two branches. The major use of cash in 1996 was the increase in
loans.

                                       6

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   7



MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

During the year ended December 31, 1995, there was a net increase in cash and
cash equivalents of $2,751,000. The major source of cash in 1995 was the growth
in the existing deposit base. The major uses of cash in 1995 were the growth in
loans, the investment of funds in the investment securities portfolio and the
increase in federal funds sold.

Federal law places restrictions on extensions of credit from banks to their
parent holding company and, with certain exceptions, to other affiliates, on
investments in stock or other securities thereof, and on taking of such
securities as collateral for loans. Note K to the Consolidated Financial
Statements discusses these limitations between the Company and its banking
subsidiary.

Interest rate risk arises when the maturity or repricing characteristics of
assets differ significantly from the maturity or the repricing characteristics
of liabilities. Accepting this risk can be an important source of profitability
and shareholder value, however, excessive levels of interest rate risk could
pose a significant threat to the Company's earnings and capital base.
Accordingly, effective risk management that maintains interest rate risk at
prudent levels is essential to the Company's safety and soundness.

The Company measures the impact of changes in interest rates on net interest
income through a comprehensive analysis of the Bank's interest rate sensitive
assets and liabilities. Interest rate sensitivity varies with different types of
interest-earning assets and interest-bearing liabilities. Overnight federal
funds and mutual funds on which rates change daily and loans which are tied to
the prime rate or a comparable index differ considerably from long-term
investment securities and fixed-rate loans. Similarly, certificates of deposit
and money market investment accounts are much more interest sensitive than
passbook savings accounts. The shorter term interest rate sensitivities are key
to measuring the interest sensitivity gap, or excess interest-earning assets
over interest-bearing liabilities. In addition to reviewing the interest
sensitivity gap, the Company also analyzes projected changes in market interest
rates and the resulting effect on net interest income.

The following table shows the interest sensitivity gaps for five different time
intervals as of December 31, 1997:

<TABLE>
<CAPTION>

                                      0-30        31-90      91-365       1-5     Over 5
                                      Days         Days       Days       Years     Years
                                    -----------------------------------------------------
                                                    (Dollars in thousands)
<S>                                 <C>        <C>         <C>        <C>        <C>     
     Interest-earning assets        $ 53,693   $  8,246    $ 53,366   $ 65,853   $ 27,581
     Interest-bearing liabilities     45,205     73,114      34,153     22,823        847
                                    -----------------------------------------------------
     Interest sensitivity gap       $  8,488   $(64,868)   $ 19,213   $ 43,030   $ 26,734
                                    =====================================================
</TABLE>

The primary interest sensitive assets in the one year repricing range are
commercial loans and adjustable rate mortgage loans. The primary interest
sensitive liabilities in the one year repricing range are money market
investment accounts, certificates of deposit and interest-bearing checking
accounts. This analysis indicates that growth in rate sensitive liabilities has
outpaced the growth in rate sensitive assets in the one year range. This has
occurred primarily as a result of the inclusion of interest-bearing checking
accounts and savings accounts in a repricing period of one year or less as these
accounts have become rate sensitive as interest rates have fluctuated. The
long-term interest sensitivity gap indicates that the Company's net interest
margin would improve with an increase in interest rates and decline with further
declines in interest rates. Trying to minimize the interest sensitivity gap is a
continual challenge in a changing rate environment and one of the objectives of
the Company's asset/liability strategy.

RESULTS OF OPERATIONS

Net interest income is an effective measurement of how well management has
balanced the Company's interest rate sensitive assets and liabilities. Net
interest income increased by 9.8% in 1997, 14.3% in 1996 and 17.6% in 1995. The
increases in all three years are due to improvements in the net interest margin.
The 1997 and 1996 net interest margin increased as a result of the reinvestment
of funds received from maturing investment securities into the higher yielding
loan portfolio, along with the stability of the Company's cost of funds. The
primary reason for the 1995 increase was the Company's ability to maintain or
decrease the interest rates paid on deposits, while loan interest rates remained
fairly steady.

The uncertain economic environment and potential fluctuations in interest rates
are expected to continue to impact the Company and the industry in 1998.
Depending on these interest rate fluctuations, there may be market pressure to
raise deposit rates in 1998. The Company monitors deposit rates on a weekly
basis and adjusts deposit rates as the market dictates. An increase in deposit
rates without loan rate increases would cause the Company's net interest margin
to decline.

The provision for loan losses is based on an analysis of the required additions
to the allowance for loan losses. The allowance for loan losses is maintained at
a level believed adequate by management to absorb potential losses in the loan
portfolio. Some factors considered by management in determining the level at
which the allowance is maintained include specific credit reviews, past loan
loss experience, current economic conditions and trends, results of examinations
by regulatory agencies and the volume, growth and composition of the loan
portfolio.





                                        7

1997 Annual Report to Shareholders


<PAGE>   8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Effective January 1, 1995, the Company adopted FASB Statement 114 as amended by
Statement 118. The Statement requires that impaired loans, as defined, be
reduced to the present value of expected cash flows discounted at the loan's
effective interest rate or to the fair value of collateral if the loan is
collateral dependent, by allocating a portion of the allowance for loan losses
to such loans. If these allocations cause the allowance for loan losses to
increase, such increase is included in the provision for loan losses. The effect
of adopting Statements 114 and 118 was included in the provision for loan losses
and was not material for 1995.

The provision for loan losses was $460,000 in 1997, $267,000 in 1996 and
$222,000 in 1995. The 1997 provision was increased to provide for loan growth
and the increase in charge-offs and delinquencies. Several customers, including
a large commercial borrower, declared bankruptcy during 1997 resulting in
increased charge-offs. Net charge-offs were $411,000 in 1997, $62,000 in 1996
and $110,000 in 1995. The provisions in 1996 and 1995 were increased to provide
for significant loan growth. The 1998 provision is expected to be approximately
the same as 1997 to provide for continued higher than normal losses and will be
adjusted quarterly, if necessary, to reflect actual charge-off experience and
any known future losses.

Non-interest income, excluding security gains and losses, increased by 21.2% in
1997, 15.8% in 1996 and 5.8% in 1995. The 1997 increase is due to increased
service charges on deposit accounts as a result of the additional deposits
purchased in connection with the acquisition of two branches late in 1996,
increased gains recognized on the sale of secondary market real estate mortgage
loans in 1997 due to an increase in activity, increased fees from the sale of
nondepository investment products in 1997 due to an increase in activity and
unrecognized losses on real estate mortgage loans held for sale recorded in
1996. These increases were partially offset by a decline in trust income due to
a decline in trust assets and a decline in earnings on Bank owned life insurance
policies due to an increase in premium payments.

The increase in 1996 was due to an increase in trust income, as a result of
increased trust assets, increased secondary market gains due to an increase in
activity and the capitalization of mortgage servicing rights, increased earnings
in Bank owned life insurance policies and increased rental income. These
increases were partially offset by a $61,000 unrealized loss on $1,200,000 in
real estate mortgage loans previously classified as held for sale and
transferred to the Bank's loan portfolio. This loss will be amortized through
the maturity dates of the loans.

The increase in 1995 was due to an increase in trust income, as a result of
increased trust assets, $41,000 in gains on the sale of real estate mortgages to
the secondary market and the receipt of life insurance proceeds.

Security gains of $5,000 in 1997, $10,000 in 1996 and $17,000 in 1995 were
recognized.

Non-interest expense increased by 16.8% in 1997, 10.6% in 1996 and 9.1% in 1995.
This increase is due to additional personnel costs, occupancy costs, marketing
and advertising expenditures, training costs and intangible asset amortization
as a result of the acquisition of two branches late in 1996. Trust department
expenses also increased in 1997 as professional consultants and new trust
administrators were added in order to increase the trust department's market
share. Equipment costs increased in 1997 as the Company invested in significant
technological upgrades.

The 1996 increase was due to increased salary and benefit costs associated with
an increase in the number of employees, increased occupancy and equipment costs
associated with the new retail loan centers and technology improvements made
throughout the Bank, increased training expenditures and increased marketing and
advertising expenditures to promote the new retail loan centers and the branches
acquired from First of America. These increases were partially offset by a
decline in legal fees and FDIC premiums.

The 1995 increase was due to increased salary and benefit costs associated with
an increase in the number of employees, increased legal fees, increased
marketing expenditures, increased postage costs and increased office supply
costs due to recent paper price increases. These increases were partially offset
by a refund received on the Company's FDIC insurance premium when the rate was
lowered to 4 cents per $100 of deposits from 23 cents per $100 of deposits.

A significant item that may impact the future results for many companies is the
year 2000. The concern is whether or not computers, elevators, telephone systems
and other electronic items will recognize the year 2000 as a valid date. For
banks, this is a concern not only for the bank's operations, but for those of
their customers and vendors. The Company has taken steps to insure that bank
operations are year 2000 compliant and that its customers and vendors are
addressing year 2000 issues. At this point, the year 2000 issues have not had a
material impact on the Company's operations but it is uncertain as to whether or
not they may be significant in the next two years.

Income tax expense was $1,085,000 in 1997, $1,150,000 in 1996 and $835,000 in
1995. Tax-exempt income continues to have a major impact on the Company's tax
expense. The benefit offsetting lower coupon rates on municipal instruments is
the nontaxable feature of the income earned on such instruments. This resulted
in a lower effective tax rate and reduced federal income tax expense by
approximately $254,000 in 1997, $227,000 in 1996 and $231,000 in 1995.

Results of operations can be measured by various ratio analyses. Two widely
recognized performance indicators are the return on equity and the return on
assets. The Company's return on equity was 14.96% in 1997, 16.09% in 1996 and
14.64% in 1995. The return on average assets was 1.30% in 1997, 1.45% in 1996
and 1.31% in 1995.

                                       8

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   9
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)


The majority of assets and liabilities of a financial institution are monetary
in nature and therefore differ greatly from most commercial and industrial
companies that have significant investments in fixed assets or inventories.
However, inflation does have an important impact on the growth of total assets
in the banking industry and the resulting need to increase equity capital at
higher than normal rates in order to maintain an appropriate equity-to-assets
ratio. Another significant effect of inflation is on other expenses, which tend
to rise during periods of general inflation.

Management believes the most significant impact on financial results is the
Company's ability to react to changes in interest rates. As discussed
previously, management is attempting to maintain an essentially balanced
position between interest sensitive assets and liabilities in order to protect
against wide interest rate fluctuations.

NONPERFORMING ASSETS

Nonperforming assets include nonaccrual loans, accruing loans past due 90 days
or more, and other real estate which includes foreclosures and deeds in lieu of
foreclosure.

A loan generally is classified as nonaccrual when full collectibility of
principal or interest is doubtful or a loan becomes 90 days past due as to
principal or interest, unless management determines that the estimated net
realizable value of the collateral is sufficient to cover the principal balance
and accrued interest. When interest accruals are discontinued, unpaid interest
credited to income in the current year is reversed, and unpaid interest accrued
in prior years is charged to the allowance for loan losses. Nonperforming loans
are returned to performing status when the loan is brought current and has
performed in accordance with contract terms for a period of time.

The following table sets forth the aggregate amount of nonperforming loans in
each of the following categories:

<TABLE>
<CAPTION>
                                                            December 31
                                                      1997       1996      1995
                                                   -----------------------------
                                                        (Dollars in thousands)
<S>                                                  <C>       <C>       <C> 
     Nonaccrual loans:
       Commercial, financial and agricultural        $1,026    $  448    $  380
       Real estate mortgage                               0         0        24
       Installment                                       61         2        40
                                                   -----------------------------
                                                      1,087       450       444
     Loans contractually past due 90 days or more:
       Commercial, financial and agricultural         1,067        82       353
       Real estate mortgage                             630       129        56
       Installment                                      966       165         4
                                                   -----------------------------
                                                      2,663       376       413
                                                   -----------------------------
     Total Nonperforming Loans                        3,750       826       857
     Other real estate owned                            103        76        76
                                                   -----------------------------
     Total Nonperforming Assets                      $3,853    $  902    $  933
                                                   =============================

     Nonperforming loans to year-end loans             2.36%      .54%      .70%
     Nonperforming assets to year-end loans
       and other real estate owned                     2.43%      .59%      .76%
</TABLE>

Some increase in nonperforming loans was expected in 1997 due to the significant
loan growth that occurred in recent years. Customers are experiencing heavier
debt loads due to the ease of obtaining credit and this is resulting in an
increase in bankruptcy filings and delinquencies. These loans are subject to
continuous monitoring by management and are specifically reserved for in the
allowance for loan losses where appropriate.

At December 31, 1997, the Company had approximately $3,136,000 in commercial,
financial and agricultural loans for which payments are presently current but
the borrowers are experiencing certain financial and/or operational
difficulties. These loans are subject to frequent management review and their
classification is reviewed on a monthly basis.

In management's evaluation of the loan portfolio risks, any significant future
increases in nonperforming loans are dependent to a large extent on the economic
environment. In a deteriorating or uncertain economy, management applies more
conservative assumptions when assessing the future prospects of borrowers and
when estimating collateral values. This may result in a higher number of loans
being classified as nonperforming.

                                       9

1997 Annual Report to Shareholders


<PAGE>   10



MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

REGULATORY MATTERS

Representatives of the Financial Institutions Bureau, a division of the
Department of Commerce of the State of Michigan, completed an examination at the
Company's subsidiary bank using financial information as of December 31, 1996.
The purpose of the examination was to determine the safety and soundness of the
bank. The next safety and soundness examination of the Bank is scheduled for
March 1998 and will be performed by the Federal Deposit Insurance Corporation
(FDIC).

Examination procedures require individual judgments about a borrower's ability
to repay loans, sufficiency of collateral values and the effects of changing
economic circumstances. These procedures are similar to those employed by the
Company in determining the adequacy of the allowance for loan losses and in
classifying loans. Judgments made by regulatory examiners may differ from those
made by management. The Company's level and classification of identified
potential problem loans was not revised significantly as a result of this
regulatory examination process.

Management and the Board of Directors evaluate existing practices and procedures
on an ongoing basis. In addition, regulators often make recommendations during
the course of their examination that relate to the operations of the Company and
the Bank. As a matter of practice, management and the Board of Directors
consider such recommendations promptly.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company's primary market risk exposure is interest rate risk and to a lesser
extent liquidity risk. See the Liquidity and Interest Rate Sensitivity
discussions, above. Business is transacted in U.S. dollars with no foreign
exchange rate risk or any exposure to changes in commodity prices.

The following table provides information about the Company's financial
instruments that are sensitive to changes in interest rates as of December 31,
1997. The Company had no derivative financial instruments, or trading portfolio,
as of that date. The expected maturity date values for loans receivable were
calculated without adjusting the instrument's contractual maturity date for
expectations of prepayments. Investment securities are reported at the earlier
of maturity date or anticipated call date. Expected maturity date values for
interest-bearing core deposits were not based upon estimates of the period over
which the deposits would be outstanding, but rather the opportunity for
repricing. Similarly, with respect to its variable rate instruments, the Company
believes that repricing dates, as opposed to expected maturity dates, may be
more relevant in analyzing the value of such instruments and are reported as
such in the following table. Company borrowings are also reported based on
conversion or repricing dates.
<TABLE>
<CAPTION>
                                                        Principal Amount Maturing in:                      Fair Value
                                      --------------------------------------------------------------------------------
                                          1998      1999     2000      2001      2002    Thereafter  Total   12/31/97
                                      --------------------------------------------------------------------------------
                                                                   (Dollars in thousands)
Rate sensitive assets:
<S>                                   <C>       <C>      <C>       <C>       <C>       <C>        <C>        <C>     
  Fixed interest rate loans           $ 20,230  $ 12,383 $  9,288  $  7,163  $  4,843  $  4,414   $ 58,321   $ 57,958
    Average interest rate                 9.88%    10.03%   10.15%    10.18%    10.23%    10.04%     10.09%
  Variable interest rate loans          12,543       564      449     9,443    11,029    66,392    100,420    100,420
    Average interest rate                 9.17%     9.28%    9.59%     9.55%     9.63%     9.87%      9.52%
  Fixed interest rate securities        13,490    13,919    7,107     3,448     2,738     4,372     45,074     45,425
    Average interest rate                 5.85%     5.72%    5.98%     6.50%     4.98%     6.19%      5.75%
  Other interest bearing assets          4,500                                                       4,500      4,500
     Average interest rate                5.43%                                                       5.43%

Rate sensitive liabilities:
  Interest bearing demand deposits      67,032                                                      67,032     67,032
    Average interest rate                 3.39%                                                       3.39%
  Savings deposits                      34,416     5,332    2,174     1,330       140               43,392     43,396
    Average interest rate                 2.78%     5.89%    5.58%     5.31%     5.74%                3.41%
  Time deposits                         51,701     7,802    5,481       683        12        39     65,718     65,705
    Average interest rate                 5.43%     5.66%    5.72%     5.70%     5.70%     5.70%      5.46%
  Fixed interest rate borrowings                                                3,000                3,000      3,000
    Average interest rate                                                        5.71%                5.71%
                 
</TABLE>

                                       10

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   11



MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL INFORMATION


Management of Southern Michigan Bancorp, Inc. has prepared and is responsible
for the accompanying financial statements and for their integrity and
objectivity. In the opinion of management, the financial statements, which
necessarily include amounts based on management's estimates and judgments, have
been prepared in conformity with generally accepted accounting principles on a
consistent basis. Management also prepared the other information in the Annual
Report and is responsible for its accuracy and consistency with the financial
statements.

The Company maintains a system of internal accounting controls designed to
provide reasonable assurance that assets are safeguarded and that transactions
are executed in accordance with the Company's authorizations and policies.
Further, such a system provides reasonable assurances as to the integrity and
reliability of the financial statements which fairly present financial position
and results of operations in conformity with generally accepted accounting
principles. Internal accounting controls are augmented by written policies
covering standards of personal and business conduct and an organizational
structure providing for division of responsibility and authority.

Management monitors the effectiveness of and compliance with established control
systems through a continuous program of internal audit and credit examinations
and recommends possible improvements thereto. In addition, as part of their
audit of the Company's financial statements, Crowe, Chizek and Company LLP,
independent auditors, completed an evaluation of selected internal accounting
controls to establish a basis for reliance thereon in determining the nature,
timing, and extent of audit tests to be applied. Management has considered the
recommendations from the examination of controls concerning the Company's system
of internal controls and has taken actions that we believe are cost-effective in
the circumstances to respond appropriately to these recommendations. Management
believes that, as of December 31, 1997, the Company's system of internal
controls is adequate to accomplish the objectives discussed herein. Further,
management believes the system of controls has prevented or detected on a timely
basis any occurrences that could be material to the financial statements and
that timely corrective actions have been initiated when appropriate.

The Board of Directors exercises its responsibility for the financial statements
and related information through the Audit Committee, which is composed entirely
of outside directors. The Audit Committee meets regularly with management and
Crowe, Chizek and Company LLP, to assess the scope of the annual audit plan and
to review the status and results of audits, including major changes in
accounting policies and reporting practices. Crowe, Chizek and Company LLP has
direct and confidential access to the Audit Committee at all times to discuss
the results of their audits.




Jerry L. Towns                              James T. Grohalski
-------------------------------             -----------------------------------
Jerry L. Towns                              James T. Grohalski
President and                               Executive Vice-President
Chief Executive Officer                     and Chief Financial Officer



                                       11

1997 Annual Report to Shareholders

<PAGE>   12



CONSOLIDATED BALANCE SHEETS



<TABLE>
<CAPTION>
                                                                                   December 31
                                                                               1997            1996
                                                                           -------------------------
ASSETS                                                                            (In thousands)
<S>                                                                         <C>            <C>      
Cash                                                                        $   3,057      $   3,319
Due from banks                                                                 13,791         10,201
                                                                           -------------------------
   Cash and cash equivalents                                                   16,848         13,520
Federal funds sold                                                              4,500
Investment securities available-for-sale - Notes B and G                       12,853         24,099
Investment securities held to maturity
   (fair value of $32,572 in 1997 and $32,786  in 1996) - Notes B and G        32,221         32,500
Loans - Notes C and G                                                         158,741        152,678
Less allowance for loan losses - Note D                                        (1,863)        (1,814)
                                                                           -------------------------
                                                                              156,878        150,864
Premises and equipment - Note E                                                 5,588          5,227
Other assets - Notes H and I                                                    9,643          9,352
                                                                           -------------------------
TOTAL ASSETS                                                                $ 238,531      $ 235,562
                                                                           =========================
LIABILITIES AND SHAREHOLDERS' EQUITY                   
Deposits - Note F:
   Non-interest bearing                                                     $  30,923      $  35,014
   Interest bearing                                                           176,142        174,453
                                                                           -------------------------
Total deposits                                                                207,065        209,467
Accounts payable and other liabilities                                          2,977          2,924
Other borrowings - Note G                                                       3,000
                                                                           -------------------------
TOTAL LIABILITIES                                                             213,042        212,391
Common stock subject to repurchase obligation in ESOP - Note I                  4,899          3,555
Shareholders' equity:
Common stock, $2.50 par value:
   Authorized - 4,000,000 shares (2,000,000 shares in 1996)
   Outstanding - 1,772,839 shares (869,550 shares in 1996)                      4,432          2,174
Capital surplus                                                                 1,914          2,734
Retained earnings                                                              14,218         14,687
Net unrealized appreciation on available-for-sale
   securities, net of tax of $13 in 1997 and $10 in 1996                           26             21
                                                                           -------------------------
TOTAL SHAREHOLDERS' EQUITY                                                     20,590         19,616
                                                                           -------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                                  $ 238,531      $ 235,562
                                                                           =========================
</TABLE>

See accompanying notes to consolidated financial statements.




                                       13



1997 Annual Report to Shareholders                             


<PAGE>   13




CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

In thousands

<TABLE>
<CAPTION>
                                                                                                   Net Unrealized
                                                                                                    Appreciation
                                                                                                   (Depreciation)
                                                                                                   On Available-
                                                          Common      Capital         Retained       For-Sale
                                                           Stock      Surplus         Earnings      Securities       TOTAL
                                                       -------------------------------------------------------------------
<S>                                                    <C>         <C>             <C>            <C>           <C>
BALANCE AT JANUARY 1, 1995                             $   2,123   $    3,916      $   10,935      $     (119)  $   16,855

Net income for 1995                                                                     2,615                        2,615
Cash dividends declared - $.50 per share                                                 (920)                        (920)
Common stock issued under dividend
   reinvestment plan (12,493 shares)                          31          273                                          304
Change in common stock subject                                             
   to repurchase                                              (9)        (678)                                        (687)
Net change in unrealized appreciation
   (depreciation) on available-for-sale
   securities, net of tax                                                                                 330          330
                                                       -------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1995                               2,145        3,511          12,630             211       18,497

Net income for 1996                                                                     3,058                        3,058
Cash dividends declared - $.53 per share                                               (1,001)                      (1,001)
Common stock issued under
   dividend reinvestment plan (14,146 shares)                 35          440                                          475
Change in common stock subject to repurchase                  (6)      (1,217)                                      (1,223)
Net change in unrealized appreciation
   (depreciation) on available-for-sale
   securities, net of tax                                                                                (190)        (190)
                                                       -------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1996                               2,174        2,734          14,687              21       19,616

Net income for 1997                                                                     3,032                        3,032
Cash dividends declared - $ .58 per share                                              (1,109)                      (1,109)
Common stock issued under dividend
   reinvestment plan (9,879 shares)                           25          365                                          390
100% stock dividend issued (956,695 shares)                2,392                       (2,392)
Change in common stock subject to repurchase                (159)      (1,185)                                      (1,344)
Net change in unrealized appreciation
   (depreciation) on available-for-sale
   securities, net of tax                                                                                   5            5
                                                       -------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1997                           $   4,432   $    1,914      $   14,218      $       26   $   20,590
                                                       ===================================================================

</TABLE>



See accompanying notes to consolidated financial statements.









                                       14

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   14




CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>

                                                             Year ended December 31

                                                          1997        1996         1995
                                                        -------------------------------
Interest income:                                                  (In thousands)
<S>                                                     <C>         <C>         <C>    
   Loans, including fees                                $15,741     $13,717     $11,965
   Investment securities:
      Taxable                                             2,189       2,443       2,634
      Tax-exempt                                            861         775         742
                                                        -------------------------------
                                                          3,050       3,218       3,376
   Other                                                     74          69         135
                                                        -------------------------------
Total interest income                                    18,865      17,004      15,476
Interest expense:
   Deposits                                               7,260       6,427       6,116
   Capital notes                                                          9         110
   Other                                                    183         168         154
                                                        -------------------------------
Total interest expense                                    7,443       6,604       6,380
                                                        -------------------------------
NET INTEREST INCOME                                      11,422      10,400       9,096
Provision for loan losses - Note D                          460         267         222
                                                        -------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES      10,962      10,133       8,874
Non-interest income:
   Service charges on deposit accounts                      835         727         733
   Trust fees                                               528         545         479
   Securities gains - Note B                                  5          10          17
   Gain on sales of loans                                   451         236          41
   Earnings on life insurance policies                      181         203         142
   Other                                                    324         203         259
                                                        -------------------------------
                                                          2,324       1,924       1,671
                                                        -------------------------------
                                                         13,286      12,057      10,545
Non-interest expenses:
   Salaries and employee benefits - Note I                4,508       4,048       3,552
   Occupancy                                                697         605         512
   Equipment                                                762         712         485
   Deposit insurance premium                                 25           2         193
   Legal fees                                                43          91         186
   Other                                                  3,134       2,391       2,167
                                                        -------------------------------
                                                          9,169       7,849       7,095
                                                        -------------------------------
Income before income taxes                                4,117       4,208       3,450
Federal income taxes - Note H                             1,085       1,150         835
                                                        -------------------------------
NET INCOME                                              $ 3,032     $ 3,058     $ 2,615
                                                        ===============================
BASIC AND DILUTED EARNINGS PER SHARE                    $  1.59     $  1.62     $  1.41
                                                        ===============================
</TABLE>

See accompanying notes to consolidated financial statements.







                                       15

1997 Annual Report to Shareholders


<PAGE>   15



CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                                   Year ended December 31
                                                                              1997         1996         1995
                                                                          -------------------------------------
OPERATING ACTIVITIES                                                                 (In thousands)
<S>                                                                       <C>           <C>           <C>     
Net income                                                                $  3,032      $  3,058      $  2,615
Adjustments to reconcile net income to net cash 
provided by operating activities:
   Provision for loan losses                                                   460           267           222
   Provision for depreciation                                                  527           410           275
   Amortization of investment security premiums
      and accretion of discounts                                               138           166           220
   Amortization of deposit base intangible and goodwill                        167            50            39
   Deferred income taxes                                                        20           (31)         (118)
   Loans originated for sale                                               (17,175)      (11,073)       (4,808)
   Proceeds on loans sold                                                   17,390        11,162         4,848
   Realized gain on sale of loans originated for sale                         (451)         (236)          (41)
   Unrealized (gain) loss on loans held for sale                                (8)           61
   Realized investment security gains                                           (5)          (10)          (17)
   (Increase) decrease in interest receivable                                  (11)           18          (489)
   Increase (decrease) in interest payable                                     (21)           66            54
   Increase in other assets                                                   (470)       (1,781)         (675)
   Increase in accounts payable and other liabilities                           14           146           278
                                                                          -------------------------------------
Net cash provided by operating activities                                    3,607         2,273         2,403


INVESTING ACTIVITIES
Proceeds from maturities of investment securities available-for-sale        12,187        15,652        19,218
Proceeds from maturities of investment securities held to maturity           4,355         6,719        23,452
Proceeds from sales of investment securities                                   255           509           517
Purchases of investment securities available-for-sale                       (1,167)       (9,736)      (25,970)
Purchases of investment securities held to maturity                         (4,230)      (14,842)      (20,986)
Net (increase) decrease in federal funds sold                               (4,500)        4,500        (3,000)
Net increase in loans prior to charge-offs                                  (6,230)      (29,564)       (3,008)
Net purchases of premises and equipment                                       (888)       (1,675)         (950)
                                                                          -------------------------------------
Net cash used in investing activities                                         (218)      (28,437)      (10,727)


FINANCING ACTIVITIES
Acquisition of deposits                                                                   18,635
Net increase (decrease) in deposits                                         (2,402)        5,308        11,453
Proceeds from long-term borrowings                                           3,000
Payment of capital note                                                                   (1,000)
Common stock issued                                                            390           575           385
Cash dividends                                                              (1,049)       (1,014)         (763)
                                                                          -------------------------------------
Net cash provided by (used in) financing activities                            (61)       22,504        11,075
                                                                          -------------------------------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                             3,328        (3,660)        2,751
Cash and cash equivalents at beginning of year                              13,520        17,180        14,429
                                                                          -------------------------------------
CASH AND CASH EQUIVALENTS AT THE END OF YEAR                              $ 16,848      $ 13,520      $ 17,180
                                                                          =====================================
</TABLE>

See accompanying notes to consolidated financial statements.




                                       16

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   16




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


December 31, 1997

NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS: Southern Michigan Bancorp, Inc is a bank holding company.
The Company's business is concentrated in the commercial banking industry
segment. The business of commercial and retail banking accounts for more than
90% of its revenues, operating income and assets. The Bank offers individuals,
businesses, institutions and government agencies a full range of commercial
banking services primarily in the southern Michigan communities in which the
Bank is 1ocated and in areas immcdiately surrounding these communities. The Bank
grants commercial, real estate and consumer loans to customers. The majority of
loans are secured by specific assets and consumer assets. There are no foreign
loans.

PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the
accounts of Southern Michigan Bancorp, Inc. (the Company) and its wholly owned
subsidiary, Southern Michigan Bank & Trust (the Bank), after elimination of
significant intercompany balances and transactions.

USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS: The preparation of financial
statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that effect the reported amounts of
assets, liabilities and disclosure of contingent liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
Estimates that are more susceptible to change in the near term include the
allowance for loan losses, deferred income tax provisions, fair values of
certain securities and other financial instruments and the actuarial present
value of pension benefit obligations and net periodic pension expense and
prepaid pension costs.

INVESTMENT SECURITIES (including mortgage-backed securities): Management
determines the appropriate classification of securities at the time of purchase.
If management has the intent and the Company has the ability at the time of
purchase to hold securities until maturity, they are classified as held to
maturity and carried at amortized historical cost. Securities to be held for
indefinite periods of time and not intended to be held to maturity are
classified as available-for-sale and carried at fair value. Securities
classified as available-for-sale include securities that management intends to
use as part of its asset/liability management strategy and that may be sold in
response to changes in interest rates, resultant prepayment risk, and other
factors. The Company is not currently involved in trading activities.

Premiums and discounts on securities are recognized in interest income using the
level yield method over the estimated life of the security. Gains and losses on
the sale of available-for-sale securities are determined using the specific
identification method.

LOANS: Interest on loans is credited to income based upon principal amount
outstanding. The accrual of interest income generally is discontinued when a
loan becomes over 90 days past due as to principal or interest. When interest
accruals are discontinued, interest credited to income in the current year is
reversed, and accrued interest from the prior year is charged to the allowance
for loan losses. Management may elect to continue the accrual of interest when
the estimated net realized value of collateral is sufficient to cover the
principal balance and accrued interest. Under Financial Accounting Standards
Board (FASB) Statement 114, as amended by Statement 118, the carrying values of
impaired loans are periodically adjusted to reflect cash payments, revised
estimates of future cash flows and increases in the present value of expected
cash flows due to the passage of time. Cash payments representing interest
income are reported as such. Other cash payments are reported as reductions in
carrying value, while increases or decreases due to changes in estimates of
future payments and due to the passage of time are included in the provision for
loan losses.

ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is maintained at a
level believed adequate to absorb potential losses in the portfolio. Management
determines the adequacy of the allowance for loan losses based on a continuing
evaluation of the loan portfolio, past loan loss experience, current economic
conditions, composition of the loan portfolio and other relevant factors. The
allowance is increased by provisions charged against income.

Effective January 1, 1995, the Company adopted FASB Statement 114 as amended by
Statement 118. The Statement requires that impaired loans, as defined, be
reduced to the present value of expected cash flows discounted at the loan's
effective interest rate or to the fair value of collateral if the loan is
collateral dependent, by allocating a portion of the allowance for loan losses
to such loans. If these allocations cause the allowance for loan losses to
increase, such increase is included in the provision for loan losses. The effect
of adopting Statements 114 and 118 is included in the provision for loan losses
and is not material for 1995.

                                       17

1997 Annual Report to Shareholders



<PAGE>   17

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Real estate mortgage and installment loans are smaller balance homogeneous loans
and are collectively evaluated for impairment. Commercial loans are evaluated
individually for impairment. When credit analysis of borrower operating results
and financial condition indicates the underlying ability of the borrower's
business activity is not sufficient to generate cash flow to service the
business' cash needs, including the Bank's loans to the borrower, the loan is
evaluated for impairment. This may be a delay or shortfall in payments of 90
days or less. Loans to be evaluated for impairment are included on the Bank's
commercial loans watch list and assigned a liquidation probability. Loans with a
liquidation probability of greater than 50% are generally considered impaired.
The expected unrecoverable portion of impaired loans are charged-off when
foreclosure proceedings are underway and the actual loss can be determined.
Loans are generally moved to nonaccrual status when 90 days or more past due.
Management has also set minimum loan balance thresholds before consideration of
a loan for impaired status will occur.

PREMISES AND EQUIPMENT: Premises and equipment are stated at cost, less
accumulated depreciation. Depreciation is computed principally using accelerated
methods over their estimated useful lives.

LOAN SERVICING RIGHTS: The Company originates mortgage loans for sale to the
secondary market, and sells the loans with servicing retained. Effective January
1, 1996, the Company adopted FASB Statement 122 on accounting for mortgage
servicing rights. For servicing retained, this Statement requires capitalizing
the cost of mortgage servicing rights, regardless of whether those rights were
acquired through purchase or origination activities. Prior to adoption of
Statement 122, only purchased loan servicing rights were capitalized, and the
Company had no such activity.

Beginning in 1996, the total cost of mortgage loans originated with the intent
to sell is allocated between the loan servicing right and the mortgage loan
without servicing based on their relative fair values at the date of sale. The
capitalized cost of loan servicing rights is amortized in proportion to, and
over the period of, estimated net servicing revenue. For this purpose, estimated
servicing revenues include late charges and other ancillary income. Estimated
servicing costs include direct costs associated with performing the servicing
function and appropriate allocations of other costs. Mortgage servicing rights
are included in other assets.

Mortgage servicing rights are periodically evaluated for impairment by
stratifying them based on predominant risk characteristics of the underlying
serviced loans. These risk characteristics include loan type (fixed or
adjustable rate), term (15 year or 30 year), and note rate. Impairment
represents the excess of cost of an individual mortgage servicing rights stratum
over its fair value, and is recognized through a valuation allowance.

Fair values for individual stratum are based on the present value of estimated
future cash flows using a discount rate commensurate with the risks involved.
Estimates of fair value include assumptions about prepayment, default and
interest rates, and other factors which are subject to change over time. Changes
in these underlying assumptions could cause the fair value of loan servicing
rights, and the related valuation allowance, to change significantly in the
future.

GOODWILL AND CORE DEPOSIT INTANGIBLES: Goodwill is the excess of purchase price
over identified net assets in business acquisitions. Goodwill is amortized on
the straight-line method over 15 years. Core deposit intangibles represent the
value of depositor relationships purchased and are amortized on accelerated
methods over 10 years. Goodwill was $870,000 and $932,000 and core deposit
intangibles were $559,000 and $664,000 at December 31, 1997 and 1996
respectively, and these balances are included in other assets.

OTHER REAL ESTATE: Other real estate ($103,000 and $76,000 at December 31, 1997
and 1996 respectively), which is included in other assets, comprises properties
acquired through a foreclosure proceeding or acceptance of a deed in lieu of
foreclosure. These properties are initially recorded at fair value at the date
of foreclosure, establishing a new cost basis. After foreclosure, valuations are
periodically performed by management and real estate is carried at the lower of
fair value minus estimated cost of disposal or cost.

INCOME TAXES: Deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse.

EARNINGS PER SHARE: Basic earnings per share is based on weighted-average common
shares outstanding. Diluted earnings per share further assumes issue of any
dilutive potential common shares. The accounting standard for computing earnings
per share was revised for 1997, and all earnings per share previously reported
are restated to follow the new standard. The weighted average common shares
outstanding for the years ended December 31, 1997, 1996 and 1995 were 1,910,449,
1,886,324 and 1,853,982, respectively. All share and per share data have been
adjusted for a 1997 stock split effected in the form of a 100% stock dividend
and include the common stock subject to repurchase obligation in the ESOP.



                                       18

                                  Southern Michigan Bancorp, Inc. and Subsidiary
<PAGE>   18

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE A - NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

CASH FLOW INFORMATION: For purposes of the consolidated statements of cash
flows, the Company considers cash and due from banks as cash and cash
equivalents.

PENDING ACCOUNTING CHANGES: The FASB has issued Statement 125, "Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities". The Statement
is effective for some transactions in 1997 and others in 1998. It revises the
accounting for transfers of financial assets, such as loans and securities, and
for distinguishing between sales and secured borrowings. The Company adopted the
1997 provisions effective January 1, 1997. The remaining provisions for 1998
relate primarily to investment securities. The effect of the 1998 provisions on
the financial statements has not yet been determined.

The FASB has issued Statement 130, "Reporting Comprehensive Income", which is
effective for both interim and year-end financial statements for fiscal years
beginning after December 15, 1997. Statement 130 establishes standards for
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. Comprehensive income is defined as all changes in equity other than
those resulting from investments by owners or distributions by owners. Net
income is, therefore, a component of comprehensive income. The most common items
of other comprehensive income include unrealized gains or losses on securities
available for sale, gains and losses on certain foreign currency transactions,
and minimum pension liability adjustments. While full disclosure for each
reported period is required in year-end financial statements, in-terim financial
statements need only disclose total comprehensive income for each reported
period. No disclosure is required if the Company has no items of other
comprehensive income in any reported period included in the financial
statements. The effect of the provisions on the financial statements has not yet
been determined.

The Statement does not mandate a specific format for reporting comprehensive
income, but it does require that all items that are required to be recognized as
components of comprehensive income be reported in a financial statement that is
displayed with the same prominence as other financial statements. Companies will
generally choose between adding the items of other comprehensive income to the
Income Statement, adding them to the Statement of Changes in Shareholders'
Equity or displaying a new financial statement, which could be titled Statement
of Comprehensive Income.

The FASB has issued Statement 131, "Disclosures About Segments of an Enterprise
and Related Information" which is effective for reported periods included in
year-end financial statements for fiscal years beginning after December 15, 1997
and for all reported periods in interim financial statements for reporting
periods following the first required full fiscal year disclosure. Statement 131
establishes new guidance for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about reportable operating
segments in interim financial reports issued to shareholders. Statement 131
supersedes the industry approach to segment disclosures previously required by
Statement 14, "Financial Reporting for Segments of a Business Enterprise",
replacing it with a method of segment reporting which is based on the structure
of an enterprise's internal organization reporting. The Statement also
establishes standards for related disclosures about products and services,
geographic areas and major customers. The effect of the provisions on the
financial statements has not yet been determined.


NOTE B - INVESTMENT SECURITIES


Year end investment securities were as follows (in thousands):
<TABLE>
<CAPTION>
                                             GROSS       GROSS
                             AMORTIZED  UNREALIZED  UNREALIZED        FAIR
AVAILABLE-FOR-SALE, 1997          COST       GAINS      LOSSES       VALUE
                             ---------------------------------------------
<S>                          <C>         <C>         <C>         <C>    
U.S. Treasury and other U.S.
   Government agencies         $ 6,259     $    10     $     7     $ 6,262
States and political
   subdivisions thereof          3,464          36                   3,500
Corporate securities             1,096           4                   1,100
Mortgage-backed securities       1,646           1           5       1,642
                             ---------------------------------------------
Total debt securities           12,465          51          12      12,504
Equity securities                  349                                 349
                             ---------------------------------------------
TOTALS                          12,814          51          12      12,853
                             =============================================
</TABLE>






1997 Annual Report to Shareholders

                                       19
<PAGE>   19



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE B - INVESTMENT SECURITIES (CONTINUED)
<TABLE>
<CAPTION>
                                             GROSS        GROSS
                             AMORTIZED  UNREALIZED   UNREALIZED       FAIR
Available-for-sale, 1996          COST       GAINS       LOSSES      VALUE
                             ---------------------------------------------
<S>                            <C>         <C>         <C>         <C>    
U.S. Treasury and other U.S.
   Government agencies         $15,305     $    65     $    50   $  15,320
States and political
   subdivisions thereof          2,579          13           6       2,586
Corporate securities             4,144          22                   4,166
Mortgage-backed securities       1,959                      13       1,946
                             ---------------------------------------------
Total debt securities           23,987         100          69      24,018
Equity securities                   81                                  81
                             ---------------------------------------------
TOTALS                          24,068         100          69      24,099
                             =============================================
HELD TO MATURITY, 1997

States and political
   subdivisions thereof        $17,060     $   326     $     1   $  17,385
Corporate securities            14,464          41          15      14,490
                             ---------------------------------------------
Total debt securities           31,524         367          16      31,875
Equity securities                  697                                 697
                             ---------------------------------------------
TOTALS                          32,221         367          16      32,572
                             =============================================

Held to maturity, 1996

States and political
   subdivisions thereof        $16,449     $   316     $     9   $  16,756
Corporate securities            15,422          42          64      15,400
Mortgage-backed securities           7           1                       8
                             ---------------------------------------------
Total debt securities           31,878         359          73      32,164
Equity securities                  622                                 622
                             ---------------------------------------------
TOTALS                         $32,500     $   359     $    73   $  32,786
                             =============================================
</TABLE>

Sales of available-for-sale securities were (in thousands):

<TABLE>
<CAPTION>
                                            1997            1996            1995
                                            ------------------------------------
<S>                                         <C>            <C>             <C>
Proceeds                                    $255            $509            $517
Gross gains                                    5              10              17
Gross losses                                   0               0               0

</TABLE>

Contractual maturities of debt securities at year-end 1997 were as follows (in
thousands). Securities not due at a single maturity date, primarily
mortgage-backed securities, are shown separately. Expected maturities may differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.

<TABLE>
<CAPTION>
                                      HELD-TO-MATURITY SECURITIES                AVAILABLE-FOR-SALE SECURITIES  
                                   AMORTIZED                FAIR                AMORTIZED                FAIR 
                                        COST               VALUE                     COST               VALUE
                                   --------------------------------------------------------------------------
<S>                                  <C>                 <C>                      <C>                 <C>    
Due in one year or less              $ 5,488             $ 5,494                  $ 4,100             $ 4,102
Due from one to five years            20,721              20,886                    4,092               4,121
Due from five to ten years             4,714               4,854                    2,369               2,378
Due after ten years                      601                 641                      258                 261
Mortgage-backed securities                                                          1,646               1,642
                                   --------------------------------------------------------------------------
                                     $31,524             $31,875                  $12,465             $12,504
                                   ==========================================================================

</TABLE>

Investment securities with an amortized cost of $3,675,000 and $2,675,000 were
pledged as collateral for public deposits and for other purposes in 1997 and
1996.

                                       20

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   20
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE C - LOANS

A summary of the carrying amount of loans outstanding at December 31 follows (in
thousands):

<TABLE>
<CAPTION>
                                                             1997           1996
                                                         -----------------------
<S>                                                      <C>            <C>     
Commercial, financial and agricultural                   $ 74,819       $ 72,108
Real estate mortgage                                       49,144         47,561
Installments                                               34,778         33,009
                                                         -----------------------
TOTALS                                                   $158,741       $152,678
                                                         =======================
</TABLE>

Certain directors and executive officers of the Company and the Bank, including
their associates and companies in which they are principal owners, were loan
customers of the Bank. Loans to these customers are made in the ordinary course
of business at normal credit terms, including interest rates and collateral, and
generally do not involve more than normal risk of collectibility. The following
is a summary of loans (in thousands) exceeding $60,000 in the aggregate to these
individuals and their associates.

<TABLE>
<CAPTION>
                                                           1997             1996
                                                         -----------------------
<S>                                                      <C>              <C>   
Balance at January 1                                     $2,599           $1,874
New loans                                                 6,974            4,545
Repayments                                                5,851            3,820
                                                         -----------------------
Balance at December 31                                   $3,722           $2,599
                                                         =======================
</TABLE>

The unpaid principal balance of mortgage loans serviced for others, which are
not included on the consolidated balance sheet, was $31,085,000 and $16,836,000
at December 31, 1997 and 1996, respectively. The balance of loans serviced for
others related to servicing rights that have been capitalized was $ 26,214,000
in 1997 and $11,073,000 in 1996. The remaining balance of loans serviced for
others also have servicing rights associated with them; however, these servicing
rights arose prior to the adoption of FASB Statement 122, and accordingly, have
not been capitalized on the balance sheet.

Activity for capitalized mortgage servicing rights was as follows (in
thousands):
<TABLE>
<CAPTION>
                                                            1997            1996
                                                            --------------------
<S>                                                         <C>             <C> 
Balance at January 1                                        $142            $  0
Additions                                                    236             152
Amortized to expense                                          51              10
                                                            --------------------
Balance at December 31                                      $327            $142
                                                            ====================
</TABLE>

No valuation allowance was necessary at December 31, 1997 or 1996.

NOTE D - ALLOWANCES FOR LOAN LOSSES

Changes in the allowance for loan losses for the years ended December 31 were as
follows (in thousands):
<TABLE>
<CAPTION>
                                               1997          1996          1995
                                            -----------------------------------
<S>                                         <C>           <C>           <C>    
Balance at January 1                        $ 1,814       $ 1,609       $ 1,498
Provision for loan losses                       460           267           222
Loans charged off                              (508)         (170)         (211)
Recoveries                                       97           108           100
                                            -----------------------------------
Net charge-offs                                (411)          (62)         (111)
                                            -----------------------------------
Balance at December 31                      $ 1,863       $ 1,814       $ 1,609
                                            ===================================
</TABLE>



<TABLE>
<CAPTION>
                                                                                1997     1996
                                                                              ---------------
Information regarding impaired loans follows:
<S>                                                                           <C>      <C>   
         Average investment in impaired loans during the year                 $1,501   $  218
                                                                              ======   ======
         Interest income recognized on impaired loans on a cash basis    
         during the year                                                      $  118   $    9
                                                                              ======   ======

         Total impaired loans at year end                                     $1,328   $  209
         Less loans for which no allowance for loan losses is allocated           68       12
                                                                              ======   ======

         Impaired loans for which an allowance for loan losses is allocated   $1,260   $  197
                                                                              ======   ======

         Portion of allowance allocated to these loans                        $  358   $   33
                                                                              ======   ======

</TABLE>


1997 Annual Report to Shareholders  

                                       21

<PAGE>   21

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE E - PREMISES AND EQUIPMENT
Major classes of premises and equipment at December 31 follow (in thousands):

<TABLE>
<CAPTION>
                                                            1997            1996
                                                          ----------------------
<S>                                                       <C>             <C>   
Land                                                      $  540          $  540
Buildings and improvements                                 6,525           6,032
Equipment                                                  2,534           2,179
                                                          ----------------------
                                                           9,599           8,751
Less accumulated depreciation                              4,011           3,524
                                                          ----------------------
TOTALS                                                    $5,588          $5,227
                                                          ======================
</TABLE>


Depreciation and amortization expense charged to operations was approximately
$527,000, $410,000 and $275,000 in 1997, 1996 and 1995, respectively.

NOTE F - DEPOSITS
The carrying amount of domestic deposits at December 31 follows (in thousands):

<TABLE>
<CAPTION>
                                                               1997         1996
                                                           ---------------------
<S>                                                        <C>          <C>     
Non-interest bearing checking                              $ 30,923     $ 35,014
Interest bearing checking                                    32,085       28,615
Passbook savings                                             29,163       28,917
Money market accounts                                        34,271       34,128
Time deposits                                                64,301       66,551
Individual retirement accounts and other deposits            16,322       16,242
                                                           ---------------------
TOTALS                                                     $207,065     $209,467
                                                           =====================
</TABLE>

The carrying amount of time deposits over $100,000 was $16,437,000 and
$17,438,000 at December 31, 1997 and 1996, respectively. Interest expense on
time deposits over $100,000 was $1,025,000, $837,000, and $956,000 at December
31, 1997, 1996 and 1995, respectively.

At December 31, 1997, scheduled maturities of time deposits were as follows:

     1998                                    $50,284
     1999                                      7,802
     2000                                      5,481
     2001                                        683
     2002                                         12
     Thereafter                                   39
                                             -------
                                             $64,301
                                             =======

The amount of deposits accepted from certain officers and directors was
$1,762,000 and $1,527,000 at December 31, 1997 and 1996, respectively.

NOTE G - OTHER BORROWINGS
Other borrowings represents a putable advance obtained by the Bank from the
Federal Home Loan Bank (FHLB) of Indianapolis. The advance matures on December
16, 2002 and bears a fixed interest rate of 5.71% until December 16, 2000. On
that date, the FHLB will have the option to convert the advance to a periodic
adjustable rate and will continue to have this option quarterly thereafter. The
advance may not be prepaid by the Bank prior to the FHLB exercising its option
to convert the advance to an adjustable rate. The advance is secured by a
blanket collateral agreement with the FHLB which gives the FHLB an unperfected
security interest in the Bank's one-to-four family whole mortgage loans,
government and agency securities and highly rated private mortgage-backed
securities.

Interest paid on deposits and other borrowings was $7,464,000 in 1997,
$6,538,000 in 1996 and $6,327,000 in 1995.

NOTE H - INCOME TAXES
The components of federal income taxes for the years ended December 31 were as
follows (in thousands):
                                     1997         1996       1995
                                  ---------------------------------------
Currently payable                 $ 1,065      $ 1,181      $   953
Deferred expense (benefit)             20          (31)        (118)
                                  ---------------------------------------
                                  $ 1,085      $ 1,150      $   835
                                  =======================================

                                       22

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   22
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE H - INCOME TAXES (CONTINUED)

A reconciliation of federal income taxes with amounts computed by applying the
statutory federal income tax rate is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                   1997       1996            1995
                                                                ----------------------------------
<S>                                                             <C>        <C>             <C>  
Statutory tax on pretax income, including tax on security
   gains ($2,000 in 1997, $3,000 in 1996 and $6,000 in 1995)    $ 1,400    $ 1,431         $ 1,173
Effect of tax-exempt interest income                               (254)      (227)           (231)
Effect of life insurance policy cash surrender value increase       (65)       (75)            (60)
Other items-net                                                       4         21             (47)
                                                                ----------------------------------
                                                                $ 1,085    $ 1,150         $   835
                                                                ==================================
</TABLE>

The components of deferred tax assets and liabilities are comprised of the
following at December 31 (in thousands):

<TABLE>
<CAPTION>
                                                                 1997     1996
                                                               ----------------
<S>                                                            <C>      <C>   
Deferred tax assets:
Allowance for loan losses                                      $  405   $  389
Deferred compensation liability                                   430      392
Pension liability                                                  81       91
Other                                                             132      120
                                                               ----------------
                                                                1,048      992
Deferred tax liabilities:
Net unrealized appreciation on available-for-sale securities       13       10
Mortgage servicing rights                                         111       48
Other                                                              23       11
                                                               ----------------
                                                                  147       69
                                                               ----------------
Net deferred tax asset                                         $  901   $  923
                                                               ================
</TABLE>

The Company made income tax payments of $1,130,000 in 1997, $1,245,000 in 1996
and $910,000 in 1995. An allowance against the deferred tax asset was not
considered necessary at December 31, 1997, 1996, or 1995.

NOTE I - RETIREMENT PLANS

The Bank has a noncontributory defined benefit pension plan covering
substantially all full-time employees. The benefits are based on years of
service and the employee's average highest compensation during five consecutive
years of employment. The funding policy is to contribute annually an amount
sufficient to meet the minimum funding requirements set forth in the Employee
Retirement Income Security Act of 1974, plus additional amounts as the Bank may
determine to be appropriate from time to time. Assets of the plan are held in
trust by the Bank. Contributions are intended to provide not only for benefits
attributed to service to date but also for those expected to be earned in the
future.

The following table sets forth the plan's funded status and amounts recognized
in the Company's balance sheets at December 31 (in thousands):

<TABLE>
<CAPTION>
                                                                                       1997              1996
                                                                                     -------------------------
<S>                                                                                   <C>               <C>    
Actuarial present value of benefit obligation:
   Accumulated benefit obligation, including vested benefits
      of $1,155 in 1997 and $1,070 in 1996                                           $ 1,200           $ 1,101

Projected benefit obligation for service rendered to date                             (1,715)           (1,853)
Plan assets at fair value, primarily certificates of deposit and equity securities     1,856             1,574
                                                                                     -------------------------
Projected benefit obligation less than (in excess of) plan assets                        141              (279)
Unrecognized net gain                                                                   (447)              (71)
Unrecognized transition obligation                                                        21                25
Unrecognized prior service cost                                                           61                73
                                                                                     -------------------------
Accrued pension cost included in other liabilities                                   $  (224)          $  (252)
                                                                                     =========================
</TABLE>

Net pension cost included the following components:

<TABLE>
<CAPTION>
                                                     1997          1996     1995
                                                    ----------------------------
<S>                                                 <C>           <C>      <C>  
Service cost-benefits earned during the period      $ 130         $ 139    $ 125
Interest cost on projected benefit obligation         113           112       97
Actual return on plan assets                         (330)         (195)    (256)
Net amortization and deferral                         205            98      183
                                                    ----------------------------
Net periodic pension cost                           $ 118         $ 154    $ 149
                                                    ============================
</TABLE>

1997 Annual Report to Shareholders

                                       23
<PAGE>   23



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE I - RETIREMENT PLANS (CONTINUED)

The weighted-average discount rate and rate of increase in future compensation
levels used in determining the actuarial present value of the projected benefit
obligation were 7% for each of the periods and 3.5% in 1997 and 5% in 1996 and
1995.
The expected long term rate of return on plan assets was 8%.

The Company has an employee stock ownership plan (ESOP) for substantially all
full-time employees. The Board of Directors determines the Company's
contribution level annually. Assets of the plan are held in trust by the Bank
and administrative costs ofthe plan are borne by the plan sponsor. Costs charged
to operations for contributions to the plan totaled $66,000 in 1997, $71,000 in
1996 and $61,000 in 1995.

As of December 31, 1997 and 1996, the ESOP held 144,082 and 161,594 shares of
the Company's stock all of which is allocated to employees. The fair value of
the shares held by the ESOP approximated $4,899,000 and $3,555,000 at December
31, 1997 and 1996, respectively. Upon distribution of shares to a participant,
the participant has the right to require the Company to purchase shares at their
fair value in accordance with terms and conditions of the plan. As such these
shares are not classified in shareholders' equity as permanent equity.

As an incentive to retain key members of management and directors, the Bank has
a deferred compensation plan whereby participants defer a portion of current
compensation. Benefits are based on salary and length of service and are vested
as service is provided from the date of participation through age 65. A
liability is recorded on a present value basis and discounted at current
interest rates. This liability may change depending upon changes in long-term
interest rates. Deferred compensation expense was $187,000 in 1997, $176,000 in
1996 and $195,000 in 1995. The liability for vested benefits was $1,264,000 at
December 31, 1997 and $1,154,000 at December 31, 1996. The Bank holds life
insurance contracts on the plan's participants. The cash surrender value of
these policies was $3,725,000 at December 31, 1997 and $3,458,000 at December
31, 1996 and is included in other assets in the accompanying consolidated
financial statements.

NOTE J - COMMITMENTS

There are various commitments which arise in the normal course of business, such
as commitments under commercial letters of credit, standby letters of credit and
commitments to extend credit. Generally accepted accounting principles recognize
these transactions as contingent liabilities and accordingly, they are not
reflected in the accompanying financial statements. These arrangements have
credit risk essentially the same as that involved in extending loans to
customers and are subject to the Bank's normal credit policies. Collateral
generally consists of receivables, inventory and equipment and is obtained based
on management's credit assessment of the customer.

At December 31, 1997, the Bank had commitments under commercial letters of
credit, used to facilitate customers' trade transactions, of $136,000 (1996 -
$808,000).

Under standby letter of credit agreements, the Bank agrees to honor certain
commitments in the event that its customers are unable to do so. At December 31,
1997 commitments under outstanding standby letters of credit were $347,000 (1996
- $203,000).

Loan commitments outstanding to extend credit at December 31 are detailed below:

                                                1997                 1996
                                            -------------------------------
     Fixed rate                             $ 2,539,000         $ 1,892,000
     Variable rate                           20,510,000          24,537,000
                                            -------------------------------
                                            $23,049,000         $26,429,000
                                            ===============================

The fixed rate commitments have stated interest rates ranging from 6.9% to
18.0%. The terms of the above commitments range from 1 to 60 months.

Management does not anticipate any losses as a result of the above related
transactions; however, the above amount represents the maximum exposure to
credit loss for loan commitments and commercial and standby letters of credit.

NOTE K - RESTRICTIONS ON TRANSFERS FROM SUBSIDIARY

Banking laws and regulations restrict the amount the Bank may transfer to the
Company in the form of cash dividends, loans and advances. In 1998, the Bank is
permitted to pay the Company approximately $3,467,000 in addition to 1998 net
income as dividends without prior regulatory approval. Substantially all of the
remaining net assets of the Bank are restricted from transfer to the Company
under Federal Reserve regulations.

                                       24

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   24


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE L - SOUTHERN MICHIGAN BANCORP, INC. (PARENT COMPANY ONLY) FINANCIAL
INFORMATION

Condensed financial statements of Southern Michigan Bancorp, Inc. follow (in
thousands):

Balance Sheets
<TABLE>
<CAPTION>
                                                           December 31
                                                           1997      1996
                                                       ------------------
<S>                                                    <C>       <C>    
ASSETS
Cash                                                    $    19   $    21
Investment securities available-for-sale                  3,096     2,571
Investment in subsidiary                                 21,141    19,373
Premises and equipment                                    1,202     1,164
Other                                                       414       365
                                                        -----------------
TOTAL ASSETS                                            $25,872   $23,494
                                                        =================

LIABILITIES AND SHAREHOLDERS' EQUITY
Dividends payable                                       $   383   $   323
Common stock subject to repurchase obligation in ESOP     4,899     3,555
Shareholders' equity                                     20,590    19,616
                                                        -----------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY              $25,872   $23,494
                                                        =================
</TABLE>

Statements of Income
<TABLE>
<CAPTION>
                                                        Year ended December 31
                                                      1997       1996       1995
                                                   ------------------------------
<S>                                                <C>        <C>        <C>    
Dividends from Bank                                $ 1,109    $ 1,001    $   920
Interest income                                        137        113         94
Other income                                           206        205        104
Other expenses                                         (49)       (31)       (40)
                                                   -----------------------------
                                                     1,403      1,288      1,078
Federal income tax expense                             (68)       (98)       (54)
                                                   -----------------------------
                                                     1,335      1,190      1,024
Equity in undistributed net income of subsidiary     1,697      1,868      1,591
                                                   -----------------------------
NET INCOME                                         $ 3,032    $ 3,058    $ 2,615
                                                   =============================
</TABLE>


<TABLE>
<CAPTION>
Statements of Cash Flows                                          Year ended December 31
                                                                1997       1996       1995
                                                             -----------------------------
<S>                                                          <C>        <C>        <C>    
OPERATING ACTIVITIES
Net income                                                   $ 3,032    $ 3,058    $ 2,615
Adjustments to reconcile net income to net
     cash provided by operating activities:
         Equity in undistributed net income of subsidiary     (1,697)    (1,868)    (1,591)
         Amortization of investment security premiums and
           accretion of discounts                                 13         14          4
         Provision for depreciation                               31         29         26
         Other                                                  (146)        34       (125)
                                                             -----------------------------
Net cash provided by operating activities                      1,233      1,267        929

</TABLE>







1997 Annual Report to Shareholders

                                       25


<PAGE>   25



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE L - SOUTHERN MICHIGAN BANCORP, INC. (PARENT COMPANY ONLY)
           FINANCIAL INFORMATION (CONTINUED)


Statements of Cash Flows (continued)
<TABLE>
<CAPTION>
                                                                             Year ended December 31

                                                                          1997       1996       1995
                                                                       -----------------------------
<S>                                                                    <C>        <C>        <C>    
INVESTING ACTIVITIES
Proceeds from maturities of investment securities available-for-sale   $   734    $ 2,614    $ 2,443
Proceeds from maturities of investment securities held to maturity           0        780        514
Purchases of investment securities available-for-sale                   (1,248)    (4,110)    (2,224)
Purchases of investment securities held to maturity                         (0)               (1,298)
Purchases of premises and equipment                                        (62)      (116)       (22)
                                                                       -----------------------------
Net cash used in investing activities                                     (576)      (832)      (587)


FINANCING ACTIVITIES
Cash dividends                                                          (1,049)    (1,014)      (763)
Common stock issued                                                        390        575        385
                                                                       -----------------------------
Net cash used in financing activities                                     (659)      (439)      (378)
                                                                       -----------------------------
DECREASE IN CASH                                                            (2)        (4)       (36)
Cash at beginning of year                                                   21         25         61
                                                                       -----------------------------
CASH AT END OF YEAR                                                    $    19    $    21    $    25
                                                                       =============================
</TABLE>


NOTE M - FAIR VALUE INFORMATION

FASB Statement 107, "Disclosures about Fair Value of Financial Instruments,"
requires disclosure of fair value information aboutfinancial instruments,
whether or not recognized in the balance sheet, for which it is practicable to
estimate that value. In caseswhere quoted market prices are not available, fair
values are based on estimates using present value or other valuation techniques.
Those techniques are significantly affected by the assumptions used, including
the discount rate and estimates of future cash flows. Statement 107 excludes
certain financial instruments and all nonfinancial instruments from its
disclosure requirements.. Accordingly, the aggregate fair value amounts
presented do not represent the underlying value of the Company and represent
point-in-time estimates of value that might not be particularly relevant in
predicting the Company's future earnings or cash flows.

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

     CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance
     sheet for cash and due from banks approximate those assets' fair values.

     INVESTMENT SECURITIES (INCLUDING MORTGAGE-BACKED SECURITIES): Fair values
     for investment securities are based on quoted market prices, where
     available. If quoted market prices are not available, fair values are based
     on quoted market prices of comparable instruments. The fair value of
     restricted equity securities approximates amortized cost.

     LOANS: For variable-rate loans that reprice frequently and with no
     significant change in credit risk, fair values are based on carrying
     values. The fair values for other loans are estimated using discounted cash
     flows analyses, using interest rates currently being offered for loans with
     similar terms to borrowers of similar credit quality.

     OFF-BALANCE-SHEET INSTRUMENTS: Fair values for the Bank's letters of credit
     are based on fees currently charged to enter into similar agreements,
     taking into account the remaining terms of the agreements and the
     counterparties' credit standing. It is not practicable to estimate the fair
     value of lending commitments because of the wide variety of the
     instruments.





                                       26

                                  Southern Michigan Bancorp, Inc. and Subsidiary


<PAGE>   26



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE M - FAIR VALUE INFORMATION (CONTINUED)


     DEPOSIT LIABILITIES: The fair values disclosed for demand deposits (e.g.,
     interest and non-interest checking, passbook savings, and certain types of
     money market accounts) are, by definition, equal to the amount payable on
     demand at the reporting date (i.e., their carrying amounts). Fair values
     for fixed-rate certificates of deposit are estimated using a discounted
     cash flow calculation that applies interest rates currently being offered
     on certificates to a schedule of expected monthly maturities on time
     deposits.

     OTHER BORROWINGS: The fair value of the Bank's other borrowings is
     estimated using discounted cash flows analysis based on the Bank's current
     incremental borrowing rate for similar types of borrowing arrangements.


The estimated fair values of the Company's financial instruments at December 31
are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                      1997                                        1996
                                                        ------------------------------             -------------------------------
                                                          CARRYING                FAIR                Carrying                Fair
                                                            AMOUNT               VALUE                  Amount               Value
                                                        ------------------------------             -------------------------------
<S>                                                     <C>                 <C>                     <C>                 <C>       
Financial assets:
Cash and cash equivalents                               $   16,848          $   16,848              $   13,520          $   13,520
Federal funds sold                                           4,500               4,500
Investment securities available-for-sale                    12,853              12,853                  24,099              24,099
Investment securities held to maturity                      32,221              32,572                  32,500              32,786
Loans                                                      158,741             158,378                 152,678             152,632

                                                                      1997                                        1996
                                                        ------------------------------             -------------------------------
                                                          CARRYING                FAIR                Carrying                Fair
                                                            AMOUNT               VALUE                  Amount               Value
                                                        ------------------------------             -------------------------------
Financial liabilities:
Deposits                                               $ (207,065)         $ (207,057)             $ (209,467)         $ (209,817)
Other borrowings                                           (3,000)             (3,000)

Unrecognized financial instruments:
Commercial letters of credit                                               $       (3)                                 $      (16)
Standby letters of credit                                                          (7)                                         (4)
</TABLE>

1997 Annual Report to Shareholders  

                                       27


<PAGE>   27



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE N - REGULATORY MATTERS

The Company and 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 about components, risk weightings and other factors, and
the regulators can lower classifications in certain cases. Failure to meet
various capital requirements can initiate regulatory action that could have a
direct material effect on the financial statements.

The prompt corrective action regulations provide five classifications, including
well capitalized, adequately capitalized, under-capitalized, 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 are limited, as is asset growth and
expansion, and plans for capital restoration are required. The minimum
requirements are:
                                 Capital to risk-
                                  weighted assets                       
                                  ----------------        Tier 1 capital
                                  Total     Tier 1       to average assets
                                  ----------------       -----------------
Well capitalized                  10%           6%             5%
Adequately capitalized             8%           4%             4%
Undercapitalized                   6%           3%             3%

At year end, actual capital levels (in thousands) and minimum required levels
were:
<TABLE>
<CAPTION>
                                                                                                              Minimum Required
                                                                                                                   To Be
                                                                                Minimum Required              Well Capitalized
                                                                                  For Capital             Under Prompt Corrective
                                                          Actual                Adequacy Purposes            Action Regulations
                                                   ------------------          ------------------         ---------------------
                                                    Amount      Ratio           Amount      Ratio            Amount      Ratio
                                                   ------------------          ------------------         ---------------------
<S>                                                <C>          <C>            <C>           <C>            <C>          <C>  
1997
Total capital (to risk weighted assets)
   Consolidated                                    $25,295      14.3%          $14,143       8.0%           $17,679      10.0%
   Bank                                            $21,002      12.0%          $13,977       8.0%           $17,471      10.0%
Tier 1 capital (to risk weighted assets)
   Consolidated                                    $23,432      13.3%           $7,072       4.0%           $10,607       6.0%
   Bank                                            $19,139      11.0%           $6,988       4.0%           $10,483       6.0%
Tier 1 capital (to average assets)
   Consolidated                                    $23,432      10.1%           $9,250       4.0%           $11,563       5.0%
   Bank                                            $19,139       8.3%           $9,192       4.0%           $11,490       5.0%

1996
Total capital (to risk weighted assets)
   Consolidated                                    $22,731      12.9%          $14,067       8.0%           $17,584      10.0%
   Bank                                            $18,921      10.9%          $13,909       8.0%           $17,386      10.0%
Tier 1 capital (to risk weighted assets)
   Consolidated                                    $20,917      11.9%           $7,034       4.0%           $10,550       6.0%
   Bank                                            $17,107       9.8%           $6,954       4.0%           $10,431       6.0%
Tier 1 capital (to average assets)
   Consolidated                                    $20,917       9.9%           $8,423       4.0%           $10,529       5.0%
   Bank                                            $17,107       8.2%           $8,304       4.0%           $10,379       5.0%
</TABLE>



The Company and Bank at year-end 1997 and 1996 were categorized as well
capitalized.




                                       28

                                  Southern Michigan Bancorp, Inc. and Subsidiary



<PAGE>   28




REPORT OF INDEPENDENT AUDITORS


                              [Crowe Chizek Logo]


Shareholders and Board of Directors
Southern Michigan Bancorp, Inc.
Coldwater, Michigan



We have audited the accompanying consolidated balance sheets of Southern
Michigan Bancorp, Inc. as of December 31, 1997 and 1996 and the related
consolidated statements of income, shareholders' equity and cash flows for each
of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit 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 Southern Michigan
Bancorp, Inc. as of December 31, l997 and 1996 and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997 in conformity with generally accepted accounting principles.









                                                  Crowe, Chizek and Company LLP

                                                  Crowe, Chizek and Company LLP

Grand Rapids, Michigan
February 2, 1998


                                       29


1997 Annual Report to Shareholders