**U.S.SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM10-QSB**

** **

| **(MARK ONE)**                                         |
|--------------------------------------------------------|
|                                                   |   |   |
| **x**                                                  | ** ** | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                   |   |   |
| **For the  Quarterly Period ended September 30, 2007** |
|                                                   |   |   |
| **OR**                                                 |
|                                                   |   |   |
| **o**                                                  | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For theTransition Period from                to               **

 

**CommissionFile No. 000-51896**

 

**COMMUNITYSOUTHFINANCIAL CORPORATION**

(Exact name ofsmall business issuer as specified in its charter)

 

| **South  Carolina**           | ** ** | **20-0934786**       |
|-------------------------------|------------|----------------------|
| (State or other  jurisdiction |       | (I.R.S. Employer     |
| of  incorporation)            |       | Identification  No.) |

 

**6602Calhoun Memorial Highway**

**Easley,South Carolina 29640**

**(Addressof principal executive**

**offices,including zip code)**

** **

**(864) 306-2540**

(Issuer’stelephone number)

----

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days. Yes x  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act).

Large accelerated filer o                             Accelerated filer o                                    Non-accelerated filer x

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o  No x

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date:   4,698,697shares of common stock, par value $.01 per share, outstanding as of November13, 2007.

 

 

----

** **

**CommunitySouthFinancial Corporation**

** **

**Part I - Financial Information**

 

## **Item 1. Financial Statements**.

## ** **

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                          | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                          | ** ** | **(Unaudited)**                  | ** **  | **(Audited)**                   | ** ** |
| **Assets**                                                                                                                                                                          | ** ** | ** **                       | ** **  | ** **                      | ** ** |
| Cash and cash  equivalents                                                                                                                                                          |       |                             |        |                            |       |
| Cash and due  from bank                                                                                                                                                             |       | $                                | 5,438,487   |                            | $          | 3,116,070 |   |
| Federal funds  sold                                                                                                                                                                 |       | 17,183,000                       |        | 17,925,000                      |       |
| Total cash and  cash equivalents                                                                                                                                                    |       | 22,621,487                       |        | 21,041,070                      |       |
| Investment  securities available-for-sale                                                                                                                                           |       | 24,756,885                       |        | —                          |       |
| Other  investments, at cost                                                                                                                                                         |       | 546,800                          |        | 370,800                         |       |
| Loans, net                                                                                                                                                                          |       | 285,603,629                      |        | 214,573,046                     |       |
| Accrued interest  receivable                                                                                                                                                        |       | 1,859,177                        |        | 1,177,802                       |       |
| Property and  equipment, net                                                                                                                                                        |       | 4,973,749                        |        | 4,743,166                       |       |
| Bank owned life  insurance                                                                                                                                                          |       | 5,171,294                        |        | 5,004,758                       |       |
| Other assets                                                                                                                                                                        |       | 1,338,773                        |        | 1,362,641                       |       |
|                                                                                                                                                                                |       |                             |        |                            |       |
| Total assets                                                                                                                                                                        |       | $                                | 346,871,794 |                            | $          | 248,273,283 |   |
|                                                                                                                                                                                |       |                             |        |                            |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                       |       |                             |        |                            |       |
| **Liabilities**                                                                                                                                                                     |       |                             |        |                            |       |
| Deposits                                                                                                                                                                            |       |                             |        |                            |       |
| Non-interest  bearing                                                                                                                                                               |       | $                                | 21,950,186  |                            | $          | 14,784,450 |   |
| Interest bearing                                                                                                                                                                    |       | 290,755,549                      |        | 202,246,738                     |       |
| Total deposits                                                                                                                                                                      |       | 312,705,735                      |        | 217,031,188                     |       |
|                                                                                                                                                                                |       |                             |        |                            |       |
| Accrued expense                                                                                                                                                                     |       | 290,615                          |        | 100,330                         |       |
| Accrued interest  payable                                                                                                                                                           |       | 2,814,345                        |        | 1,425,106                       |       |
| Other  liabilities                                                                                                                                                                  |       | 53,418                           |        | 21,704                          |       |
|                                                                                                                                                                                |       |                             |        |                            |       |
| Total  liabilities                                                                                                                                                                  |       | 315,864,113                      |        | 218,578,328                     |       |
|                                                                                                                                                                                |       |                             |        |                            |       |
| **Shareholders’  Equity**                                                                                                                                                      |       |                             |        |                            |       |
| Preferred stock,  par value $.01 per share   10,000,000 shares authorized, no shares issued                                                                                         |       | —                           |        | —                          |       |
| Common stock,  par value $.01 per share   10,000,000 shares authorized, 4,698,697 and 4,697,697 issued   and outstanding at September 30, 2007 and  December 31, 2006, respectively |       | 46,987                           |        | 46,977                          |       |
| Additional  paid-in capital                                                                                                                                                         |       | 29,675,718                       |        | 29,635,458                      |       |
| Accumulated  other comprehensive income                                                                                                                                             |       | 142,224                          |        | —                          |       |
| Retained  earnings                                                                                                                                                                  |       | 1,142,752                        |        | 12,520                          |       |
| Total  shareholders’ equity                                                                                                                                                    |       | 31,007,681                       |        | 29,694,955                      |       |
|                                                                                                                                                                                |       |                             |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                                                                    |       | $                                | 346,871,794 |                            | $          | 248,273,283 |   |

 

**Seenotes to consolidated financial statements.**

 

2

----

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

 

**(UNAUDITED)**

** **
| ** **                                           | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| **Interest  income**                                 |       |                             |       |                             |       |
| Interest and  dividends on investments               |       | $                                | 476,312    |                             | $          | 308,060 |   |
| Interest and  fees on loans                          |       | 5,676,825                        |       | 3,839,653                        |       |
| Total interest  income                               |       | 6,153,137                        |       | 4,147,713                        |       |
|                                                 |       |                             |       |                             |       |
| **Interest  expense - deposits**                     |       | 3,413,663                        |       | 2,134,829                        |       |
| ** **                                           |       |                             |       |                             |       |
| Net interest  income                                 |       | 2,739,474                        |       | 2,012,884                        |       |
|                                                 |       |                             |       |                             |       |
| **Provision  for loan losses**                       |       | 362,000                          |       | 358,000                          |       |
| ** **                                           |       |                             |       |                             |       |
| Net interest  income after provision for loan losses |       | 2,377,474                        |       | 1,654,884                        |       |
|                                                 |       |                             |       |                             |       |
| **Non-interest  income**                             |       |                             |       |                             |       |
| Mortgage  origination fees                           |       | 285,600                          |       | 158,084                          |       |
| Other                                                |       | 120,145                          |       | 35,985                           |       |
| Total  non-interest income                           |       | 405,745                          |       | 194,069                          |       |
|                                                 |       |                             |       |                             |       |
| **Non-interest  expense**                            |       |                             |       |                             |       |
| Salaries and  benefits                               |       | 1,079,416                        |       | 779,293                          |       |
| Professional  fees                                   |       | 101,886                          |       | 28,904                           |       |
| Advertising                                          |       | 100,217                          |       | 52,409                           |       |
| Supplies                                             |       | 29,094                           |       | 50,300                           |       |
| Data processing                                      |       | 156,561                          |       | 98,453                           |       |
| Occupancy                                            |       | 110,853                          |       | 64,830                           |       |
| Depreciation                                         |       | 156,223                          |       | 108,392                          |       |
| Equipment  maintenance and rental                    |       | 25,637                           |       | 8,334                            |       |
| Telephone                                            |       | 33,815                           |       | 25,055                           |       |
| Other                                                |       | 365,030                          |       | 161,975                          |       |
| Total  non-interest expense                          |       | 2,158,732                        |       | 1,377,945                        |       |
|                                                 |       |                             |       |                             |       |
| **Income  before income taxes**                      |       | 624,487                          |       | 471,008                          |       |
|                                                 |       |                             |       |                             |       |
| **Income  tax expense**                              |       | 164,756                          |       | 80,301                           |       |
| ** **                                           |       |                             |       |                             |       |
| **Net  income**                                      |       | $                                | 459,731    |                             | $          | 390,707 |   |
| ** **                                           |       |                             |       |                             |       |   |   |
| **Earnings  per share (1)**                          |       |                             |       |                             |       |
| Basic                                                |       | $                                | 0.10       |                             | $          | 0.08 |   |
| Diluted                                              |       | $                                | 0.09       |                             | $          | 0.08 |   |
|                                                 |       |                             |       |                             |       |
| **Weighted  average shares outstanding (1)**         |       |                             |       |                             |       |
| Basic                                                |       | 4,698,697                        |       | 4,686,005                        |       |
| Diluted                                              |       | 5,089,566                        |       | 5,043,186                        |       |

 

----

(1)  Adjusted for 5-for-4 stock splits effectiveJanuary 16, 2006 and January 16, 2007.

 

**Seenotes to consolidated financial statements.**

 

3

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| ** **                                           | ** ** | **Nine months ended**  | ** ** | **Nine months ended**  | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
| **Interest  income**                                 |       |                             |       |                             |       |
| Interest and  dividends on investments               |       | $                                | 1,185,350  |                             | $          | 693,511 |   |
| Interest and  fees on loans                          |       | 15,474,063                       |       | 9,409,856                        |       |
| Total interest  income                               |       | 16,659,413                       |       | 10,103,367                       |       |
|                                                 |       |                             |       |                             |       |
| **Interest  expense – deposits**                |       | 9,294,250                        |       | 4,787,020                        |       |
| ** **                                           |       |                             |       |                             |       |
| Net interest  income                                 |       | 7,365,163                        |       | 5,316,347                        |       |
|                                                 |       |                             |       |                             |       |
| **Provision  for loan losses**                       |       | 994,000                          |       | 1,192,500                        |       |
| ** **                                           |       |                             |       |                             |       |
| Net interest  income after provision for loan losses |       | 6,371,163                        |       | 4,123,847                        |       |
|                                                 |       |                             |       |                             |       |
| **Non-interest  income**                             |       |                             |       |                             |       |
| Mortgage  origination fees                           |       | 807,612                          |       | 446,063                          |       |
| Other                                                |       | 340,907                          |       | 94,516                           |       |
| Total  non-interest income                           |       | 1,148,519                        |       | 540,579                          |       |
|                                                 |       |                             |       |                             |       |
| **Non-interest  expense**                            |       |                             |       |                             |       |
| Salaries and  benefits                               |       | 3,119,877                        |       | 2,037,355                        |       |
| Professional  fees                                   |       | 224,897                          |       | 101,375                          |       |
| Advertising                                          |       | 173,857                          |       | 141,358                          |       |
| Supplies                                             |       | 105,361                          |       | 135,353                          |       |
| Data processing                                      |       | 415,575                          |       | 235,500                          |       |
| Occupancy                                            |       | 354,978                          |       | 190,973                          |       |
| Depreciation                                         |       | 437,451                          |       | 244,845                          |       |
| Equipment  maintenance and rental                    |       | 79,001                           |       | 45,238                           |       |
| Telephone                                            |       | 105,565                          |       | 76,266                           |       |
| Other                                                |       | 810,063                          |       | 434,965                          |       |
| Total  non-interest expense                          |       | 5,826,625                        |       | 3,643,228                        |       |
|                                                 |       |                             |       |                             |       |
| **Income  before income taxes**                      |       | 1,693,057                        |       | 1,021,198                        |       |
|                                                 |       |                             |       |                             |       |
| **Income  tax expense**                              |       | 562,825                          |       | 177,950                          |       |
| ** **                                           |       |                             |       |                             |       |
| **Net  income**                                      |       | $                                | 1,130,232  |                             | $          | 843,248 |   |
| ** **                                           |       |                             |       |                             |       |   |   |
| **Earnings  per share (1)**                          |       |                             |       |                             |       |
| Basic                                                |       | $                                | 0.24       |                             | $          | 0.18 |   |
| Diluted                                              |       | $                                | 0.22       |                             | $          | 0.17 |   |
|                                                 |       |                             |       |                             |       |
| **Weighted  average shares outstanding (1)**         |       |                             |       |                             |       |
| Basic                                                |       | 4,698,613                        |       | 4,683,145                        |       |
| Diluted                                              |       | 5,159,546                        |       | 5,057,060                        |       |

 

----

(1)  Adjusted for 5-for-4 stock splits effectiveJanuary 16, 2006 and January 16, 2007.

 

**Seenotes to consolidated financial statements.**

 

4

----

 

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**ANDCOMPREHENSIVE INCOME**

**For thenine month periods ended September 30, 2007 and September 30, 2006**

**(UNAUDITED)**

** **
| ** **                       | ** ** | **Common Stock ** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|----------------------------------|------------|-----------------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                       | ** ** | **Shares (1)**         | ** ** | **Amount (1)**     | ** ** | **Capital (1)**                  | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance at  December 31, 2006    |       | 4,697,697                   |       | $                       | 46,977     |                                  | $          | 29,635,458   |       | $                             | —     |                     | $          | 12,520 |   | $ | 29,694,955 |   |   |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Net income                       |       | —                      |       | —                  |       | —                                |       | —       |       | 1,130,232                     |       | 1,130,232                |       | $ | 1,130,232 |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Other  comprehensive income:     |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  on securities  |       | —                      |       | —                  |       | —                                |       | 142,224      |       | —                        |       | 142,224                  |       | 142,224 |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total  comprehensive income      |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | 1,272,456 |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation       |       | —                      |       | —                  |       | 39,571                                |       | —       |       | —                        |       | 39,571                   |       |   |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Cash paid for  fractional shares |       | —                      |       | —                  |       | (5,701                                | )          | —       |       | —                        |       | (5,701                   | )          |   |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock options  exercised         |       | 1,000                       |       | 10                      |       | 6,390                                 |       | —       |       | —                        |       | 6,400                    |       |   |   |
|                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at  September 30, 2007   |       | 4,698,697                   |       | $                       | 46,987     |                                  | $          | 29,675,718   |       | $                             | 142,224    |                     | $          | 1,142,752 |   | $ | 31,007,681 |   |   |   |

 
| ** **                       | ** ** | **Common Stock ** | ** ** | **Additional  Paid-in ** | ** ** | **Accumulated  Other  Comprehensive ** | ** ** | **Retained ** | ** ** | **Total  Shareholders’ ** | ** ** | **Total  Comprehensive** | ** ** |
|----------------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------------------------|------------|--------------------|------------|-------------------------------------|------------|--------------------------|------------|
| ** **                       | ** ** | **Shares (1)**         | ** ** | **Amount (1)**           | ** ** | **Capital (1)**                        | ** ** | **Income**         | ** ** | **Deficit**                         | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance at  December 31, 2005    |       | 4,681,068                   |       | $                             | 46,810     |                                        | $          | 29,384,000         |       | $                                   | —     |                     | $          | (1,144,500 | ) | $ | 28,286,310 |   |   |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Net income                       |       | —                      |       | —                        |       | —                                      |       | —             |       | 843,248                             |       | 843,248                  |       | $ | 843,248 |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Other  comprehensive income:     |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Unrealized gains  on securities  |       | —                      |       | —                        |       | —                                      |       | —             |       | —                              |       | —                   |       | — |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Total  comprehensive income      |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       | $ | 843,248 |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Stock option  compensation       |       | —                      |       | —                        |       | 128,666                                     |       | —             |       | —                              |       | 128,666                  |       |   |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Cash paid for  fractional shares |       | —                      |       | —                        |       | (1,102                                      | )          | —             |       | —                              |       | (1,102                   | )          |   |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Stock options  exercised         |       | 16,530                      |       | 165                           |       | 108,147                                     |       | —             |       | —                              |       | 108,312                  |       |   |   |
|                             |       |                        |       |                          |       |                                        |       |               |       |                                |       |                     |       |   |   |
| Balance at  September 30, 2006   |       | 4,697,598                   |       | $                             | 46,975     |                                        | $          | 29,619,711         |       | $                                   | —     |                     | $          | (301,252 | ) | $ | 29,365,434 |   |   |   |

 

----

(1)  Adjusted for 5-for-4 stock splits effectiveJanuary 16, 2006 and January 16, 2007.

 

**Seenotes to consolidated financial statements.**

 

5

----

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

*** ***
| ** **                                                                         | ** ** | **Nine Months  ended** | ** ** | **Nine Months  ended** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**      | ** ** | **September 30,**      | ** ** |
| ** **                                                                         | ** ** | **2007**                    | ** ** | **2006**                    | ** ** |
| **Operating activities**                                                           |       |                        |       |                        |       |
| Net income                                                                         |       | $                           | 1,130,232  |                        | $          | 843,248 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                        |       |                        |       |
| Provision for  loan losses                                                         |       | 994,000                     |       | 1,192,500                   |       |
| Depreciation and  amortization                                                     |       | 437,451                     |       | 244,845                     |       |
| Loss on disposal  of property and equipment                                        |       | 709                         |       | —                      |       |
| Stock option  compensation                                                         |       | 39,571                      |       | 128,666                     |       |
| Increase in  accrued interest receivable                                           |       | (681,375                    | )          | (520,140                    | )          |
| Increase in  accrued interest payable                                              |       | 1,389,239                   |       | 301,207                     |       |
| Increase  (decrease) in accrued expenses                                           |       | 190,285                     |       | (99,625                     | )          |
| Decrease  (increase) in other assets                                               |       | (46,183                     | )          | (867,150                    | )          |
| Increase  (decrease) in other liabilities                                          |       | 31,714                      |       | (157,020                    | )          |
|                                                                               |       |                        |       |                        |       |
| Net cash  provided by operating activities                                         |       | 3,485,643                   |       | 1,066,531                   |       |
|                                                                               |       |                        |       |                        |       |
| **Investing activities**                                                           |       |                        |       |                        |       |
| Net increase in  loans outstanding                                                 |       | (72,024,583                 | )          | (78,051,937                 | )          |
| Increase in bank  owned life insurance                                             |       | (166,536                    | )          | —                      |       |
| Purchase of  investments                                                           |       | (24,544,610                 | )          | (288,500                    | )          |
| Purchase of FHLB  stock                                                            |       | (176,000                    | )          | —                      |       |
| Purchase of  property and equipment                                                |       | (668,743                    | )          | (2,353,222                  | )          |
|                                                                               |       |                        |       |                        |       |
| Net cash used in  investing activities                                             |       | (97,580,472                 | )          | (80,693,659                 | )          |
|                                                                               |       |                        |       |                        |       |
| **Financing activities**                                                           | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Net increase in  deposit accounts                                                  |       | 95,674,547                  |       | 98,419,693                  |       |
| Cash paid for  fractional shares                                                   |       | (5,701                      | )          | (1,102                      | )          |
| Stock options  exercised                                                           |       | 6,400                       |       | 108,312                     |       |
|                                                                               |       |                        |       |                        |       |
| Net cash  provided by financing activities                                         |       | 95,675,246                  |       | 98,526,903                  |       |
|                                                                               |       |                        |       |                        |       |
| Net increase in  cash and cash equivalents                                         |       | 1,580,417                   |       | 18,899,775                  |       |
|                                                                               |       |                        |       |                        |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                |       | 21,041,070                  |       | 19,159,333                  |       |
|                                                                               |       |                        |       |                        |       |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                      |       | $                           | 22,621,487 |                        | $          | 38,059,108 |   |
|                                                                               |       |                        |       |                        |       |
| **Schedule  of non-cash transactions**                                             |       |                        |       |                        |       |
| Unrealized gains  on securities available-for-sale, net of tax                     |       | $                           | 142,224    |                        | $          | — |   |

 

**Seenotes to consolidated financial statements.**

 

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**Notes toUnaudited Consolidated Financial Statements**

 

**NOTE 1 – NATURE OF BUSINESS ANDBASIS OF PRESENTATION**

 

**Business Activity andOrganization -**CommunitySouth Financial Corporation (the “Company”)is a South Carolina corporation organized for the purpose of owning andcontrolling all of the capital stock of CommunitySouth Bank and Trust (the “Bank”).The Bank is a state chartered bank organized under the laws of South Carolina. Frominception on March 20, 2004 through January 18, 2005, the Company engaged inorganizational and pre-opening activities necessary to obtain regulatoryapprovals and to prepare its subsidiary, the Bank, to commence business as afinancial institution. The Company received approval from the Federal DepositInsurance Corporation (“FDIC”), Federal Reserve (“FRB”) and the State Board ofFinancial Institutions in January 2005.

 

The Bank began operationson January 18, 2005. The Bank primarily is engaged in the business of acceptingdeposits insured by the FDIC, and providing commercial, consumer and mortgageloans to the general public.

 

The Company sold4,681,069 shares of common stock at $6.40 per share in an initial publicoffering that was completed on February 15, 2005 (as adjusted for all stocksplits). The offering raised $29,430,810, net of offering costs. The directorsand officers of the Company purchased 659,531 shares at $6.40 per share for atotal of $4,221,000.

 

**Basis of Presentation -**Theaccompanying financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-QSB. Accordingly,they do not include all the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals) considered necessary for a fair presentation havebeen included. Operating results for the three and nine month periods endedSeptember 30, 2007 is not necessarily indicative of the results that may beexpected for the year ending December 31, 2007. For further information, referto the audited consolidated financial statements and footnotes dated December31, 2006 included in the Company’s Form 10-KSB for the year ended December 31,2006 as filed with the Securities and Exchange Commission.

 

The accounting andreporting policies conform to accounting principles generally accepted in theUnited States of America and to general practices in the banking industry. TheCompany uses the accrual basis of accounting.

 

**NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

**Principles of Consolidation -**Theconsolidated financial statements include the accounts of CommunitySouthFinancial Corporation, the parent company, and CommunitySouth Bank and Trust,its wholly owned subsidiary. All significant intercompany items have beeneliminated in the consolidated statements.

 

**Management’sEstimates** - The preparation of consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of income and expenses during the reporting period. Actualresults could differ from those estimates.

 

**Disclosure Regarding Segments** -The Company reports as one operating segment, as management reviews the resultsof operations of the Company as a single enterprise.

 

**Cash and Cash Equivalents**- Forpurposes of reporting cash flows, cash and cash equivalents include cash onhand, amounts due from banks, short-term interest bearing deposits and federalfunds sold. Cash and cash equivalents have an original maturity of three monthsor less.

 

**Concentrationsof Credit Risk** - Financial instruments, which potentiallysubject the Company to concentrations of credit risk, consist principally ofloans receivable, investment securities, federal funds sold and amounts duefrom banks.

 

The Company makes loansto individuals and small businesses for various personal and commercialpurposes primarily in the upstate region of South Carolina. The Company’s loanportfolio is not concentrated in loans to any single borrower or to a 

 

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relatively small numberof borrowers. Additionally, management is not aware of any concentrations ofloans to classes of borrowers or industries that would be similarly affected byeconomic conditions.

 

In addition to monitoringpotential concentrations of loans to particular borrowers or groups ofborrowers, industries and geographic regions, management monitors exposure tocredit risk that could arise from potential concentrations of lending productsand practices such as loans that subject borrowers to substantial paymentincreases (e.g. principal deferral periods, loans with initial interest-onlyperiods, etc), and loans with high loan-to-value ratios. Additionally, thereare industry practices that could subject the Company to increased credit riskshould economic conditions change over the course of a loan’s life. Forexample, the Company makes variable rate loans and fixed rateprincipal-amortizing loans with maturities prior to the loan being fully paid(i.e. balloon payment loans). These loans are underwritten and monitored to managethe associated risks. Management has determined that there is no concentrationof credit risk associated with its lending policies or practices.

 

The Company’s investmentportfolio consists of government agency bonds, mortgage-backed securities andnon-marketable equity securities. Management believes credit risk associatedwith the non-marketable equity securities is not significant because theCompany does not invest a material amount in non-marketable equity securities.The Company places its deposits and correspondent accounts with and sells itsfederal funds to high quality institutions. Management believes credit riskassociated with correspondent accounts is not significant.

 

**Other Investments –**Other investments consist primarily of the Company’s investment in the stock ofthe Federal Home Loan Bank of Atlanta (“FHLB”). The stock has no quoted marketvalue and no ready market exists. Investment in the FHLB is a condition ofborrowing from the FHLB, and the stock is pledged to collateralize such borrowings.At September 30, 2007, the Company’s investment in FHLB stock was $446,800. Thedividend received on this stock is included in interest and dividends oninvestments.

 

**LoansReceivable** - Loans are stated at their unpaid principalbalance less an allowance for loan losses and net deferred loan originationfees. Interest income is computed using the simple interest method and isrecorded in the period earned. Loan origination fees collected and certain loanorigination costs are deferred and the net amount is accreted as income using amethod that approximates the level yield method over the life of the relatedloans.

 

When serious doubt existsas to the collectibility of a loan or when a loan becomes ninety days past dueas to principal or interest, interest income generally is discontinued unlessthe estimated net realizable value of collateral exceeds the principal balanceand accrued interest. When interest accruals are discontinued, income earnedbut not collected is reversed.

 

The Company identifiesimpaired loans through its normal internal loan review process. Loans on theCompany’s problem loan watch list are considered potentially impaired loans. Theseloans are evaluated in determining whether all outstanding principal andinterest are expected to be collected. Loans are not considered impaired if aminimal payment delay occurs and all amounts due, including accrued interest atthe contractual interest rate for the period of delay, are expected to becollected.

 

**Allowance for Loan Losses** – Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings. Loan lossesare charged against the allowance when management believes the uncollectibilityof a loan balance is confirmed. Subsequent recoveries, if any, are credited tothe allowance.

 

The allowance for loanlosses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectibility of the loans in light ofhistorical experiences, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions. This evaluationis inherently subjective as it requires estimates that are susceptible tosignificant revision as more information becomes available.

 

The allowance consists ofspecific, general and unallocated components. The specific component relates toloans that are classified as either doubtful, substandard or special mention.For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of theloan. The general component covers non-classified loans and is based onhistorical loss experience adjusted for qualitative factors. An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimating specific and general losses in theportfolio.

 

8

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A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loan agreement.Factors considered by management in determining impairment include paymentstatus, collateral value, and the probability of collecting scheduled principaland interest payments due. Loans that experience insignificant payment delaysand payment shortfalls generally are not classified as impaired. Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record and the amount ofthe shortfall in relation to the principal and interest owed. Impairment ismeasured on a loan by loan basis for commercial and construction loans byeither the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.

 

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.Accordingly, the Company does not separately identify individual consumer andresidential loans for impairment disclosures, unless such loans are the subjectof a restructuring agreement.

 

**Propertyand Equipment** - Premises, furniture and equipment are statedat cost, less accumulated depreciation. Depreciation expense is computed by thestraight-line method, based on the estimated useful lives for furniture andequipment of 5 to 10 years. Leasehold improvements are amortized over the lifeof the lease. Maintenance and repairs are charged to current expense. The costsof major renewals and improvements are capitalized.

 

**ResidentialLoan Origination Fees**- The Company offers residential loan origination service to its customers in itsimmediate market area. The loans are offered on terms and prices offered by theCompany’s correspondents and are closed in the name of the correspondents. TheCompany receives fees for services it provides in conjunction with theorigination services it provides. The fees are recognized at the time the loansare closed by the Company’s correspondents.

 

**Advertising -** Advertising,promotional, and other business development costs generally are expensed asincurred. External costs incurred in producing media advertising are expensedthe first time the advertising takes place. External costs relating to directmailing costs are expensed in the period in which the direct mailings are sent.

 

**Income Taxes** -Income taxes are the sum of amounts currently payable to taxing authorities andthe net changes in income taxes payable or refundable in future years. Incometaxes deferred to future years are determined utilizing an asset and liabilityapproach. This  method  gives consideration  to  the future  tax consequences  associated with differences  between financial  accounting and tax bases of certain assetsand liabilities  which are principallythe allowance for loan  losses,  depreciable premises  and  equipment, and  net  operating loss carryforwards.

 

**Earnings Per Share**- Basic earnings per share represents the net income allocated to shareholdersdivided by the weighted-average number of common shares outstanding during theperiod. Dilutive earnings per share reflects additional common shares thatwould have been outstanding if dilutive potential common shares had beenissued. Potential common shares that may be issued by the Company relate toboth outstanding warrants and stock options, and are determined using thetreasury stock method.

 

**Stock–based Compensation**– On January 1, 2006, the Company adopted the fair value recognition provisionsof Financial Accounting Standards Board (“FASB”) Statement of FinancialAccounting Standards (“SFAS”) No. 123(R), *Share-Based Payment*,which is a revision of SFAS No. 123, *Accounting for Stock-BasedCompensation*, to account for compensation costs under its stockoption plans.

 

In adopting SFAS No. 123(R), the Company elected to use the modifiedprospective method to account for the transition from the intrinsic value methodto the fair value recognition method. Under the modified prospective method,compensation cost is recognized from the adoption date forward for all newstock options granted and for any outstanding unvested awards as if the fairvalue method had been applied to those awards as of the date of grant.

 

**Off-Balance-SheetFinancial Instruments** - In the ordinary course of business,the Company enters into off-balance-sheet financial instruments consisting ofcommitments to extend credit and letters of credit. These financial instrumentsare recorded in the financial statements when they become payable by thecustomer.

 

**Recently Issued AccountingStandards –**The following is a summary of recentauthoritative pronouncements that could impact the accounting, reporting, and /or disclosure of financial information by the Company.

 

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In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities* — *Including anamendment of FASB Statement No. 115*. This statement permits, butdoes not require, entities to measure many financial instruments at fair value.The objective is to provide entities with an opportunity to mitigate volatilityin reported earnings caused by measuring related assets and liabilitiesdifferently without having to apply complex hedge accounting provisions.Entities electing this option will apply it when the entity first recognizes aneligible instrument and will report unrealized gains and losses on suchinstruments in current earnings. This statement 1) applies to all entities, 2)specifies certain election dates, 3) can be applied on aninstrument-by-instrument basis with some exceptions, 4) is irrevocable and 5)applies only to entire instruments. One exception is demand deposit liabilitieswhich are explicitly excluded as qualifying for fair value. With respect toSFAS No. 115, available-for-sale and held-to-maturity securities at theeffective date are eligible for the fair value option at that date. If the fairvalue option is elected for those securities at the effective date, cumulativeunrealized gains and losses at that date shall be included in thecumulative-effect adjustment and thereafter, such securities will be accountedfor as trading securities. SFAS No. 159 is effective for the Company on January1, 2008. Earlier adoption is permitted in 2007 if the Company also elects toapply the provisions of SFAS No. 157, *Fair Value Measurement*.The Company is currently analyzing the fair value option provided under SFASNo. 159.

 

Other accountingstandards that have been issued or proposed by the FASB or otherstandards-setting bodies are not expected to have a material impact on theCompany’s financial position, results of operations and cash flows.

 

**Risks and Uncertainties**- In the normal course of its business, the Company encounters two significanttypes of risks: economic and regulatory. There are three main components ofeconomic risk:  interest rate risk,credit risk and market risk. The Company is subject to interest rate risk tothe degree that its interest-bearing liabilities mature or reprice at differentspeeds, or on different basis, than its interest-earning assets. Credit risk isthe risk of default on the Company’s loan portfolio that results from aborrower’s inability or unwillingness to make contractually required payments. Marketrisk reflects changes in the value of collateral underlying loans receivableand the valuation of real estate held by the Company.

 

The Company is subject tothe regulations of various governmental agencies. These regulations can and dochange significantly from period to period. The Company also undergoes periodicexaminations by the regulatory agencies, which may subject it to furtherchanges with respect to asset valuations, amounts of required loss allowancesand operating restrictions from the regulators’ judgments based on informationavailable to them at the time of their examination.

 

**Reclassifications**- Certain captions and amounts in the 2006 financial statements werereclassified to conform to the 2007 presentation. Such reclassifications had noeffect on previously reported net income or shareholders’ equity.

 

**NOTE 3 - LEASES**

 

The Company leases branchlocations in Spartanburg, Mauldin, Anderson, Greer and Greenville as well as anoperations center in Easley. The initial lease terms range from three to tenyears with various renewal options. The total minimum future rental paymentsare $3,087,537. The operations center in Easley is leased from a director ofthe Company.

 

**NOTE 4 - RELATED PARTYTRANSACTIONS**

 

Certain parties(principally certain directors and executive officers of the Company, theirimmediate families and business interests) are loan and deposit customers inthe normal course of business with the Bank. The loans are made onsubstantially the same terms, including interest rates and collateral, as thoseprevailing at the time for comparable transactions with unrelated persons anddo not involve more than the normal risk of collectibility. The deposits areaccepted on the same terms, including interest rate as those offered forcomparable transactions with unrelated persons.

 

**NOTE 5 – STOCK BASED COMPENSATION**

 

Upon completion of theinitial public offering, the Company agreed to issue warrants to the organizingdirectors for the purchase of one share of common stock at $6.40 per share forevery two shares purchased in the stock offering, up to a maximum of 15,625warrants per director. The warrants were fully vested 120 days after January18, 2005 and will expire on January 18, 2015. Warrants held by the Company’sdirectors will expire 90 days after the director ceases to be a director orofficer of the Company (365 days if due to death or disability). The Companyissued a total of 171,406 warrants. In addition, the Company has adopted astock option plan. As of September 30, 2007 the Company has 762,080 optionsoutstanding to employees and directors. Under the plan, the Company may grantoptions for up to 21% of its issued shares of common stock. The exercise priceof each option is equal to the market price of the Company’s stock on the dateof grant. The maximum term is ten years, and the options vest in no greaterthan five years. When necessary, the Company may purchase

 

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shares on the open marketto satisfy share option exercises. During the ensuing year, the Company is notexpected to acquire shares for such purpose.

 

The table set forth belowsummarizes stock option activity for the Company’s stock compensation plans forthe period ended September 30, 2007 as adjusted for the 5-for-4 stock splitseffective January 16, 2006 and January 16, 2007.

 
| ** **                         | ** ** | **Stock Options** | ** ** | **Warrants**            | ** ** |
|------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | ** **             | ** ** | ** **              | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                         | ** ** | ** **             | ** ** | ** **              | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                         | ** ** | ** **             | ** ** | **Weighted-Average**    | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                         | ** ** | **Shares**             | ** ** | **Exercise Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
|                               |       |                   |       |                    |       |   |   |   |   |
| Outstanding at  December 31, 2006  |       | 738,013                |       | $                       | 6.87       |   | 171,406 |   | $ | 6.40 |   |
| Granted                            |       | 35,848                 |       | 15.41                   |       | — |   | — |   |
| Forfeited                          |       | 10,781                 |       | 13.43                   |       | — |   | — |   |
| Exercised                          |       | 1,000                  |       | 6.40                    |       | — |   | — |   |
| Outstanding at  September 30, 2007 |       | 762,080                |       | 7.18                    |       | 171,406 |   | 6.40 |   |
|                                    |            |                        |            |                         |            |  |  |  |  |  |  |

 

The table setforth below summarizes non-vested stock options as of September 30, 2007.

 
| ** **                         | ** ** | ** ** | ** ** | **Weighted- Average** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------|------------|
| ** **                         | ** ** | **Number** | ** ** | **Fair  Value**            | ** ** |
| Outstanding at  December 31, 2006  |       | 11,500     |       | $                          | 6.47       |   |
| Granted                            |       | 35,848     |       | 6.93                       |       |
| Vested during the  period          |       | 2,175      |       | 6.45                       |       |
| Forfeited during  the period       |       | 3,750      |       | 7.11                       |       |
| Outstanding at  September 30, 2007 |       | 41,423     |       | 6.81                       |       |
|                                    |            |            |            |                            |            |  |

 

As of September 30, 2007,there was $271,594 total unrecognized compensation cost related to non-vestedshare-based compensation arrangements, which is expected to be recognized overa weighted average period of 54 months.

 

The fair value of eachoption granted is estimated on the grant date using the Black-Scholesoption-pricing model with the following assumptions:  dividend yield of 0.0%, expected term of 10years, risk-free interest rate of 5.0%, expected life of 10 years, and expectedvolatility of 20%.

 

The following tablesummarizes information about stock options outstanding under the Company’splans at September 30, 2007 as adjusted for the 5-for-4 stock splits effectiveJanuary 16, 2006 and January 16, 2007.

 
| ** **                       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of  options               |       | 762,080         |       | 720,657         |       |
| Weighted average  remaining life |       | 7.60 years      |       | 7.50 years      |       |
| Weighted average  exercise price |       | $               | 7.18       |            | $          | 6.72 |   |
| High exercise  price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise  price              |       | $               | 6.40       |            | $          | 6.40 |   |

 

Cash received from theexercise of options during the year was $6,400. The intrinsic value of optionsexercised during 2007 was $2,280.

 

**Item 2. Management’s Discussionand Analysis or Plan of Operation.**

 

*The following discussion reviewsour results of operations and assesses our financial condition. You should readthe following discussion and analysis in conjunction with the accompanyingconsolidated financial statements. The commentary should be read in conjunctionwith the discussion of forward-looking statements, the financial statements,and the related notes and the other statistical information included in thisreport.*

 

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**DISCUSSION OF FORWARD-LOOKING STATEMENTS**

 

Thisreport contains “forward-looking statements” relating to, without limitation,future economic performance, plans and objectives of management for futureoperations, and projections of revenues and other financial items that arebased on the beliefs of management, as well as assumptions made by andinformation currently available to management. The words “may,” “will,” “anticipate,”“should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,”and “intend,” as well as other similar words and expressions of the future, areintended to identify forward-looking statements. Our actual results may differmaterially from the results discussed in the forward-looking statements, andour operating performance each quarter is subject to various risks anduncertainties that include, without limitation, those described under theheading “Risk Factors” in our Annual Report on Form 10-KSB for the year endedDecember 31, 2006 as filed with the Securities and Exchange Commission and thefollowing:

 

•      our rapid growth to date andshort operating history;

•      the opening of additionalfull-service branches and the resulting pressure this could cause on ourmanagement team;

•      significant increases in competitivepressure in the banking and financial services industries;

•      changes in the interest rateenvironment which could reduce anticipated or actual margins;

•      changes in politicalconditions or the legislative or regulatory environment;

•      general economic conditions,either nationally or regionally and especially in our primary service area,becoming less favorable than expected resulting in, among other things, adeterioration in credit quality;

•      changes occurring inbusiness conditions and inflation;

•      changes in technology;

•      changes in deposits flows;

•      changes in monetary and taxpolicies;

•      the lack of seasoning of ourloan portfolio, especially given our rapid loan growth;

•      the level of allowance forloan loss;

•      the rate of delinquenciesand amounts of charge-offs;

•      adverse changes in assetquality and resulting credit risk-related losses and expenses;

•      loss of consumer confidenceand economic disruptions resulting from terrorist activities;

•      changes in the securitiesmarkets; and

•      other risks anduncertainties detailed from time to time in our filings with the Securities andExchange Commission.

 

All forward-lookingstatements in this report are based on information available to us as of thedate of this report. We undertake no obligation to publicly update or otherwiserevise any forward-looking statements, whether as a result of new information,future events, or otherwise.

 

**Overview**

 

CommunitySouth FinancialCorporation is a bank holding company headquartered in Easley, South Carolina. Oursubsidiary, CommunitySouth Bank and Trust, opened for business on January 18,2005. In addition to the main office in Easley, the Bank has five branchlocations in the upstate region of South Carolina. We opened our Mauldin branchin the fourth quarter of 2005, our Spartanburg branch in the first quarter of2006, Anderson branch in the third quarter of 2006, and our Greer branch in thefourth quarter of 2006. We anticipate continued branch expansion in the upstateregion as opportunities arise. The bank provides banking services to domesticmarkets, principally in the upstate of South Carolina. The deposits of the Bankare insured by the Federal Deposit Insurance Corporation. All share and pershare information in this report has been adjusted for the 5-for-4 stock splitseffected in the form of a stock dividend paid on January 16, 2006 and January16, 2007 to shareholders of record as of December 15, 2005 and December 15,2006, respectively.

 

Like most community banks, we derive most of ourincome from interest we receive on our loans and investments. Our primarysource of funds for making these loans and investments is our deposits, onwhich we pay interest. Consequently, one of the key measures of our success isour amount of net interest income, or the difference between the income on ourinterest-earning assets, such as loans and investments, and the expense on ourinterest-bearing liabilities, such as deposits. Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

Of course, there are risks inherent in all loans, sowe maintain an allowance for loan losses to absorb probable losses on existingloans that may become uncollectible. We establish and maintain this allowanceby charging a provision for loan losses against our operating earnings. In thefollowing section we have included a detailed discussion of this process.

 

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In addition to earning interest on our loans andinvestments, we earn income through fees and other expenses we charge to ourcustomers. We describe the various components of this non-interest income, aswell as our non-interest expense, in the following discussion.

 

**Results of Operations**

 

*Three Months ended September 30,2007 and 2006*

 

*Overview*

 

Our net income was$459,731 for the three months ended September 30, 2007 as compared to $390,707for the three months ended September 30, 2006. Since we began operations in thefirst quarter of 2005, we have experienced significant growth, which has led toa substantial increase in revenues and expenses. Due to our growth, we have nowattained a level of earning assets that supports our costs and we are currentlyoperating profitably. For the three months ended September 30, 2007, werealized $6,153,137 in interest income, of which $476,312 was from investmentactivities and $5,676,825 was from loan activities. For the three months endedSeptember 30, 2006, we realized $4,147,713 in interest income, of which$308,060 was from investment activities and $3,839,653 was from loan activities.The substantial increase in our interest income is primarily a result of ourcontinued loan growth during our third year of operation. We anticipate thegrowth in loans will continue to drive the growth in assets and the growth ininterest income. The primary source of funding for our loan portfolio isdeposits that are acquired both locally and via the national brokeredcertificate market. We incurred interest expense of $3,413,663 and $2,134,829for the three months ended September 30, 2007 and September 30, 2006,respectively. This increase in our interest expense was a result of increasedlevels of interest bearing deposits and higher average interest rates on thosedeposits. We have experienced a decline in our net interest margin to 3.52%from 3.85% for the quarters ended September 30, 2007 and 2006, respectively.The decline was due to repricing of deposits and competitive pressure oncommercial loan pricing.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the three months ended September 30, 2007 was $362,000 compared to$358,000 for the comparable prior year period. The $4,000 increase was theresult of greater loan production in 2007 compared to the same period in 2006.The net increase in loans outstanding was $25.8 million for the third quarterof 2007 as compared to a net increase of $22.6 million for the third quarter of2006.

 

*Non-interest Income*

 

We had non-interestincome of $405,745 and $194,069 for the three months ended September 30, 2007and 2006, respectively. Mortgage origination fee income for the three monthsended September 30, 2007 was $285,600. We had $158,084 in mortgage originationfee income in the third quarter of 2006. The increase was the result ofadditions to our mortgage lending staff over the past year. If interest rateswere to rise, we would not anticipate this type of continued growth. Further,changes in state and federal laws regarding the oversight of mortgage brokers andlenders could increase our costs of operations and affect our mortgageorigination volume which could negatively impact our non-interest income in thefuture.

 

*Non-interest Expense*

 

We incurred non-interestexpense of $2,158,732 during the three months ended September 30, 2007. Includedin the expense was $1,079,416 of salaries and employee benefits, $101,886 ofprofessional expense, $156,561 of data processing expense, $100,217 ofadvertising expense and $29,094 of expense related to supplies. The non-interestexpense incurred in the three months ended September 30, 2006 was $1,377,945. Includedin the expense was $779,293 of salaries and employee benefits, $28,904 ofprofessional expense, $98,453 of data processing expense, $52,409 ofadvertising expense and $50,300 of expense related to supplies.

 

For the three monthsended September 30, 2007, we incurred $181,860 in other fixed asset expenses,which included $156,223 in depreciation and $25,637 in equipment maintenanceand rental. For the three months ended September 30, 2006, we incurred $116,726in other fixed asset expense, which included $108,392 in depreciation and$8,334 in equipment maintenance and rental. We incurred $110,853 and $64,830 inoccupancy expense related to all of our office locations for the three monthsended September 30, 2007 and 2006, respectively.

 

The increase innon-interest expense is the result of the addition of new branches andpersonnel over the past year.

 

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Income tax expense was$164,756 for the three months ended September 30, 2007 compared to $80,301during the same period in 2006.   The effective tax rate was 26.4%and 17.0%, respectively, for the three month periods ended September 30, 2007and 2006, respectively. The increase in the effective tax rate for the 2007period compared to 2006 results primarily from the increase net income for thethree months ended September 30, 2007 as compared to the net income for thethree months ended September 30, 2006 and from the use of net operating losscarry-forwards during 2006.

 

*Nine Months ended September 30,2007 and 2006*

 

*Overview*

 

Our net income was$1,130,232 for the nine months ended September 30, 2007 as compared to $843,248for the nine months ended September 30, 2006. Since we began operations in thefirst quarter of 2005, we have experienced significant growth, which has led toa substantial increase in revenues and expenses. Due to our growth, we have nowattained a level of earning assets that supports our costs and we are currentlyoperating profitably. For the nine months ended September 30, 2007, we realized$16,659,413 in interest income, of which $1,185,350 was from investmentactivities and $15,474,063 was from loan activities. For the nine months endedSeptember 30, 2006, we realized $10,103,367 in interest income, of which$693,511 was from investment activities and $9,409,856 was from loan activities.The substantial increase in our interest income is primarily a result of ourcontinued loan growth during our third year of operation. We anticipate thegrowth in loans will continue to drive the growth in assets and the growth ininterest income. The primary source of funding for our loan portfolio isdeposits that are acquired both locally and via the national brokeredcertificate market. We incurred interest expense of $9,294,250 and $4,787,020for the nine months ended September 30, 2007 and September 30, 2006,respectively. This increase in our interest expense was a result of increasedlevels of interest bearing deposits and higher average interest rates on thosedeposits. We have experienced a decline in our net interest margin to 3.48%from 4.08% for nine months ended September 30, 2007 and 2006, respectively. Thedecline was due to repricing of deposits and competitive pressure on commercialloan pricing.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the nine months ended September 30, 2007 was $994,000 compared to$1,192,500 for the comparable prior year period. The $198,500 decrease was theresult of greater loan production in 2006 compared to the same period in 2007.The net increase in loans outstanding was $72.0 million for the first ninemonths of 2007 as compared to a net increase of $78.1 million for the firstnine months of 2006.

 

*Non-interest Income*

 

We had non-interestincome of $1,148,519 and $540,579 for the nine months ended September 30, 2007and 2006, respectively. Mortgage origination fee income for the nine monthsended September 30, 2007 was $807,612. We had $446,063 in mortgage originationfee income in the first nine months of 2006. The increase was the result ofadditions to our mortgage lending staff over the past year. If interest rateswere to rise, we would not anticipate this type of continued growth. Further,changes in state and federal laws regarding the oversight of mortgage brokersand lenders could increase our costs of operations and affect our mortgageorigination volume which could negatively impact our non-interest income in thefuture.

 

*Non-interest Expense*

 

We incurred non-interestexpense of $5,826,625 during the nine months ended September 30, 2007. Includedin the expense was $3,119,877 of salaries and employee benefits, $224,897 ofprofessional expense, $415,575 of data processing expense, $173,857 of advertisingexpense and $105,361 of expense related to supplies. The non-interest expenseincurred in the nine months ended September 30, 2006 was $3,643,228. Includedin the expense was $2,037,355 of salaries and employee benefits, $101,375 ofprofessional expense, $235,500 of data processing expense, $141,358 ofadvertising expense and $135,353 of expense related to supplies.

 

For the nine months endedSeptember 30, 2007, we incurred $516,452 in other fixed asset expenses, whichincluded $437,451 in depreciation and $79,001 in equipment maintenance andrental. For the nine months ended September 30, 2006, we incurred $290,083 inother fixed asset expense, which included $244,845 in depreciation and $45,238in equipment maintenance and rental. We incurred $354,978 and $190,973 inoccupancy expense related to all of our office locations for the nine monthsended September 30, 2007 and 2006, respectively.

 

The increase innon-interest expense is the result of the addition of new branches andpersonnel over the past year.

 

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For the nine months endedSeptember 30, 2007, income tax expense was $562,825 compared to $177,950 forthe same period in 2006.  The effective tax rate was 33.2% and 17.4% forthe nine month periods ended September 30, 2007 and 2006, respectively. The increase in the effective tax rate for the 2007 period compared to 2006results primarily from the increase in the year-to-date net income and the useof net operating loss carry-forwards during 2006.

 

**Assets and Liabilities**

 

*General*

 

At September 30, 2007,total assets increased 39.7% to $346.9 million as compared to $248.3 million atDecember 31, 2006. Gross loans increased $72.0 million, or 33.1%, during thefirst nine months of 2007. Investments available for sale increased to $24.8million at September 30, 2007 compared to $0.0 million at December 31, 2006.Cash and cash equivalents increased $1.6 million, or 7.5%, since December 31,2006. Deposits increased $95.7 million, or 44.1%, during the first nine monthsof 2007. At September 30, 2007, shareholders’ equity was $31.0 million.

 

*Investment Securities*

 

Investments available forsale increased by $24.8 million since December 31, 2006 due to the purchase ofgovernment agency bonds and mortgaged-backed securities. Other investmentsincreased by $176,000 since December 31, 2006 due to the purchase of additionalFHLB stock.

 

*Loans*

 

Since loans typically provide higher interest yields than other typesof interest earning assets, we allocate the majority of our earning assets toour loan portfolio. Gross loans increased by $72.0 million, or 33.1%, duringthe first nine months of 2007.

 

Balances within major loan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Real estate –  construction  |       | $                                | 116,157    |                            | $          | 69,021 |   |
| Real estate –  mortgage      |       | 147,604                          |       | 128,709                         |       |
| Commercial and  industrial        |       | 22,434                           |       | 17,239                          |       |
| Consumer and  other               |       | 3,483                            |       | 2,695                           |       |
| Total loans,  gross               |       | 289,678                          |       | 217,664                         |       |
| Less allowance  for loan losses   |       | 4,074                            |       | 3,091                           |       |
| Total loans, net                  |       | $                                | 285,604    |                            | $          | 214,573 |   |

 

We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect interest from the borrower. We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts. Generally, we place a delinquent loan in nonaccrual status when the loan becomes 90 days or more past due. When we place a loan in nonaccrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income. We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain. At September 30, 2007, there was $70,282 in loans that were non-accruing and $1,362,940 in loans that were 30 days past due.

 

*Provision and Allowance for LoanLosses*

 

We have established anallowance for loan losses through a provision for loan losses charged toexpense on our statement of income. The allowance for loan losses represents anamount which we believe is adequate to absorb probable losses on existing loansthat may become uncollectible. Our judgment as to the adequacy of the allowancefor loan losses is based on a number of assumptions about future events, whichwe believe to be reasonable, but which may or may not prove to be accurate. Ourdetermination of the allowance for loan losses is based on evaluations of thecollectibility of loans, including consideration of factors such as the balanceof impaired loans, the quality, mix, and size of our overall loan portfolio,economic conditions that may affect the borrower’s ability to repay, the amountand quality of collateral securing the loans, our historical loan lossexperience, and a review of specific problem loans. We also consider subjectiveissues such as changes in the lending policies and procedures, changes in thelocal/national economy, changes in volume or type of credits, changes involume/severity of problem loans, quality of loan review and board of directoroversight, concentrations of credit, and peer group comparisons. Due to ourlimited operating history, to date the provision for loan losses has been made 

 

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primarily as a result ofour assessment of general loan loss risk compared to banks of similar size andmaturity. Due to our short operating history, the loans in our loan portfolioand our lending relationships are of very recent origin. In general, loans donot begin to show signs of credit deterioration or default until they have beenoutstanding for some period of time, a process known as seasoning. As a result,a portfolio of older loans will usually behave more predictably than a newerportfolio. Because our loan portfolio is new, the current level ofdelinquencies and defaults may not be representative of the level that willprevail when the portfolio becomes more seasoned, which may be higher thancurrent levels. If delinquencies and defaults increase, we may be required toincrease our provision for loan losses, which would adversely affect ourresults of operations and financial condition. Periodically, we adjust theamount of the allowance based on changing circumstances. We charge recognizedlosses to the allowance and add subsequent recoveries back to the allowance forloan losses. There can be no assurance that charge-offs of loans in futureperiods will not exceed the allowance for loan losses as estimated at any pointin time or that provisions for loan losses will not be significant to aparticular accounting period.

 

*Deposits*

 

Our primary source offunds for loans and investments is our deposits. We have chosen to obtain aportion of our certificates of deposits from areas outside of our market, whichare brokered deposits. The deposits obtained outside of our market areagenerally have rates comparable to those being offered for certificates ofdeposits in our local market. As of September 30, 2007, total deposits hadincreased by $95.7 million, or 44.1%, from December 31, 2006. The largestpercentage increase was in interest bearing demand deposits, which increased$11.0 million, or 200%, from December 31, 2006 to September 30, 2007.

 

Balances within the majordeposit categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Non-interest  bearing demand      |       | $                                | 21,950     |                            | $          | 14,784 |   |
| Interest bearing  demand          |       | 16,551                           |       | 5,508                           |       |
| Savings                           |       | 19,084                           |       | 13,868                          |       |
| Time deposits  less than $100     |       | 58,758                           |       | 64,457                          |       |
| Time deposits of  $100 or over    |       | 43,967                           |       | 46,606                          |       |
| Brokered  deposits                |       | 152,396                          |       | 71,808                          |       |
| Total deposits                    |       | $                                | 312,706    |                            | $          | 217,031 |   |

 

**Liquidity**

 

Liquidity  is the  ability  to  meet  current  and  future  obligations  through liquidation or maturity of existing  assets or the  acquisition of  liabilities. We manage both assets and liabilities to achieve appropriate levels of liquidity. Cash and short-term investments are our primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans. Individual and commercial deposits and borrowings are our primary source of funds for credit activities. At September 30, 2007, we had lines of credit with unrelated banks totaling $15 million. These lines, which are unsecured, are available on a one-to-seven day basis for general corporate purposes. We believe our liquidity sources are adequate to meet our operating needs. The level of liquidity is measured by the cash, cash equivalents and securities available for sale-to-total assets ratio, which was at 13.7% at September 30, 2007.

 

As members of the Federal Home Loan Bank of Atlanta, we have credit availability of up to 10% of the Bank’s total assets, which meant $32.0 million was available as of September 30, 2007. Advances under this credit facility are subject to qualifying collateral.

 

**Impactof Off-Balance Sheet Instruments**

 

Through the operations ofour Bank, we have made contractual commitments to extend credit in the ordinarycourse of our business activities. These commitments are legally bindingagreements to lend money to our customers at predetermined interest rates for aspecified period of time. At September 30, 2007, we had issued commitments toextend credit of $61.0 million through various types of lending arrangements. Weevaluate each customer’s credit worthiness on a case-by-case basis. The amountof collateral obtained, if deemed necessary by us upon extension of credit, isbased on our credit evaluation of the borrower. Collateral varies but mayinclude accounts receivable, inventory, property, plant and equipment,commercial and residential real estate. We manage the credit risk on thesecommitments by subjecting them to normal underwriting and risk managementprocesses. The following table summarizes our off-balance-sheet financialinstruments whose contract amounts represent credit risk:

 

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| ** **                    | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                    | ** ** | ** **                       | ** ** | ** **                      | ** ** |
| Commitments to  extend credit |       | $                                | 57,706,863 |                            | $          | 37,928,398 |   |
|                          |       |                             |       |                            |       |
| Standby letters  of credit    |       | $                                | 3,337,821  |                            | $          | 2,780,068 |   |

 

**Capital Resources**

 

Total shareholders’equity increased from $29.7 million at December 31, 2006 to $31.0 million atSeptember 30, 2007. The increase is principally due to the net income for theperiod of $1,130,232.

 

The Federal Reserve andbank regulatory agencies require bank holding companies and financialinstitutions to maintain capital at adequate levels based on a percentage ofassets and off-balance sheet exposures, adjusted for risk weights ranging from0% to 100%. The Federal Reserve guidelines contain an exemption from thecapital requirements for “small bank holding companies.”  On March 30, 2006, the Federal Reserveexpanded the definition of a “small bank holding company” to   include bank holding companies with lessthan $500 million in total assets. Bank holding companies that have less than$500 million in total assets do not qualify under the expanded definition ifthey (i) are engaged in significant non-banking activities either directly orindirectly through a subsidiary, (ii) conduct significant off-balance sheetactivities, including securitizations or managing or administering assets forthird parties, or (iii) have a material amount of debt or equity securities(including trust preferred securities) outstanding that are registered with theSEC. Although we have less than $500 million in total assets, it is unclear atthis point whether we otherwise meet the requirements for qualifying as a “smallbank holding company.”  According to theFederal Reserve, the revision of the criterion to exclude any bank holdingcompany that has outstanding a material amount of SEC-registered debt or equitysecurities reflects the fact that SEC registrants typically exhibit a degree ofcomplexity of operations and access to multiple funding sources that warrantsexcluding them from the new policy statement and subjecting them to the capitalguidelines.   In the adopting release for the new rule, the FederalReserve stated that what constitutes a “material” amount of SEC-registered debtor equity for a particular bank holding company depends on the size, activitiesand condition of the relevant bank holding company.  In lieu of usingfixed measurable parameters of materiality across all institutions, the ruleprovides the Federal Reserve with supervisory flexibility indetermining, on a case-by-case basis, the significance or materiality ofactivities or securities outstanding such that a bank holding company should beexcluded from the policy statement and subject to the capital guidelines. Priorto adoption of this new rule, our holding company was not subject to thesecapital guidelines, as it had less than $150 million in assets at the time. Untilthe Federal Reserve provides further guidance on the new rules, it will beunclear whether our holding company will be subject to the exemption from thecapital requirements for small bank holding companies. Regardless, our Bank is “wellcapitalized” under these minimum capital requirements as set per bankregulatory agencies.

 

Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a materialeffect on the Bank’s financial statements. Under capital adequacy guidelinesand the regulatory framework for prompt corrective action, the Bank must meetspecific capital guidelines that involve quantitative measures of the Bank’sassets, liabilities, and certain off-balance-sheet items as calculated underregulatory accounting practices. The Bank’s capital amounts and classificationsare also subject to qualitative judgments by the regulators about components,risk weightings, and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum ratios of  Tier 1 andtotal capital as a percentage of assets and off-balance-sheet exposures,adjusted for risk weights ranging from 0% to 100%. Tier 1 capital of the Bankconsists of common shareholders’ equity, excluding the unrealized gain or losson securities available-for-sale, minus certain intangible assets. The Bank’sTier 2 capital consists of the allowance for loan losses subject to certainlimitations. Total capital for purposes of computing the capital ratiosconsists of the sum of Tier 1 and Tier 2 capital. The regulatory minimumrequirements are 4% for Tier 1 capital and 8% for total risk-based capital.

 

The Bank is also requiredto maintain capital at a minimum level based on quarterly average assets, whichis known as the leverage ratio. Only the strongest banks are allowed tomaintain capital at the minimum requirement of 3%. All others are subject tomaintaining ratios 1% to 2% above the minimum.

 

The Bank exceeded theregulatory capital requirements at September 30, 2007 and December 31, 2006 asset forth in the following table.

 

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| ** **                              | ** ** | **September 30, 2007**                 | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **(dollar amounts in thousands)** | ** ** |
| ** **                              | ** ** | **Amount**                                       | ** ** | **Ratio**                       | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total capital to  risk weighted assets  |       | $                                                | 32,825     |                            | 10.20      | % | $ | 30,521 |   | 12.75 | % |
| Tier 1 capital  to risk weighted assets |       | 28,836                                           |       | 8.96                            | %          | 27,528 |   | 11.50 | % |
| Tier 1 capital  to average assets       |       | 28,836                                           |       | 8.98                            | %          | 27,528 |   | 11.49 | % |
|                                         |            |                                                  |            |                                 |            |  |  |  |  |  |  |

 

**Critical Accounting Policies**

 

We have adopted variousaccounting policies that govern the application of accounting principlesgenerally accepted in the United States of America and with general practiceswithin the banking industry in the preparation of our financial statements. Oursignificant accounting policies are described in Note 1 to the financialstatements in Item 1.

 

Certain accountingpolicies involve significant judgments and assumptions by us that have amaterial impact on the carrying value of certain assets and liabilities. Weconsider these accounting policies to be critical accounting policies. Thejudgment and assumptions we use are based on historical experience and otherfactors, which we believe to be reasonable under the circumstances. Because ofthe nature of the judgment and assumptions we make, actual results could differfrom these judgments and estimates that could have a material impact on thecarrying values of our assets and liabilities and our results of operations.

 

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flows, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses. Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 

**Item 3. Controls and Procedures.**

 

As ofthe end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our management, including ourChief Executive Officer and Chief Financial Officer, of the effectiveness ofour disclosure controls and procedures as defined in Exchange Act Rule13a-15(e). Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our current disclosure controls andprocedures are effective as of September 30, 2007. There have been nosignificant changes in our internal controls over financial reporting duringthe fiscal quarter ended September 30, 2007 that have materially affected, orare reasonably likely to materially affect, our internal controls overfinancial reporting.

 

The design of any system of controls and procedures isbased in part upon certain assumptions about the likelihood of future events. Therecan be no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions, regardless of how remote.

 

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**Part II - Other Information**

 

**Item 1. Legal Proceedings.**

 

Not Applicable.

 

**Item 2. Unregistered Sales ofEquity Securities and Use of Proceeds.**

 

Not applicable.

 

**Item 3. Defaults Upon SeniorSecurities.**

 

Not applicable.

 

**Item 4. Submission of Mattersto Vote of Security Holders.**

 

Not applicable.

 

**Items 5. Other Information.**

 

Not applicable.

 

**Item 6. Exhibits.**

 

31.1         Rule 13a-14(a) Certification of thePrincipal Executive Officer.

 

31.2                           Rule13a-14(a) Certification of the Principal Financial Officer.

 

32            Section 1350 Certifications.

 

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**SIGNATURES**

 

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   | Date: November 13, 2007                       | By:                            | /s/ C. Allan Ducker, III |   |
|--------|-----------------------------------------------|--------------------------------|--------------------------|--------|
|   |                                          | C. Allan Ducker, III           |
|   |                                          | Chief Executive Officer        |
|   |                                          | (Principal Executive  Officer) |
|   |                                          |                           |
|   | Date: November 13, 2007                       | By:                            | /s/ John W. Hobbs        |   |
|   | John W. Hobbs                                 |
|   | Chief Financial Officer                       |
|   | (Principal Financial  and Accounting Officer) |
|        |                                               |                                |                          |        |  |

 

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**EXHIBITINDEX**

 
| **Exhibit** | ** ** | ** **                                                        |
|-------------|------------|-------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                   |
|        |       |                                                              |
| 31.1        |       | Rule 13a-14(a)  Certification of the Principal Executive Officer. |
|        |       |                                                              |
| 31.2        |       | Rule 13a-14(a)  Certification of the Principal Financial Officer. |
|        |       |                                                              |
| 32          |       | Section 1350 Certifications.                                      |

 

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