##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-K
 (Mark One)
 þ
    
    ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2007
 or
 o
    
    TRANSITION REPORT UNDER SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-49912
 MOUNTAIN NATIONAL BANCSHARES, INC.
  Tennessee
    
    75-3036312(State or other jurisdiction 
of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 300 East Main, Sevierville, Tennessee
(Address of principal executive offices)
    
    37862
(Zip code)
 (865) 428-7990
    Yes o No þ
 Yes o No þ
 Yes þ No o
 o
  Large accelerated filer o
    
    Accelerated filer o
    
    Non-accelerated filer o
    
    Smaller reporting company þ(Do not check if a smaller reporting company)
 Yes o No þ
   DOCUMENTS INCORPORATED BY REFERENCE




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MOUNTAIN NATIONAL BANCSHARES, INC.
Annual Report on Form 10-K
For the Fiscal Year Ended December 31, 2007
 Table of Contents
 Item
    
    
    
    PageNumber
    
    
    
    NumberPart I1.
    
    Business
    
    11A.
    
    Risk Factors
    
    192.
    
    Properties
    
    233.
    
    Legal Proceedings
    
    244.
    
    Submission of Matters to a Vote of Security Holders
    
    24Part II5.
    
    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    247.
    
    Management's Discussion and Analysis of Financial Condition and Results of Operation
    
    268.
    
    Financial Statements and Supplementary Data
    
    549.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    549A(T).
    
    Controls and Procedures
    
    549B.
    
    Other Information
    
    55Part III10.
    
    Directors, Executive Officers and Corporate Governance
    
    5511.
    
    Executive Compensation
    
    55




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Item
    
    
    
    PageNumber
    
    
    
    Number12.
    
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    5513.
    
    Certain Relationships and Related Transactions, and Director Independence
    
    5614.
    
    Principal Accountant Fees and Services
    
    56Part IV15.
    
    Exhibits and Financial Statement Schedules
    
    56Signatures
    
    59EX-10.3 SUMMARY OF COMPENSATION AGREEMENTSEX-10.8 AMENDED AND RESTATED SALARY CONTINUATION AGREEMENTEX-10.9 AMENDMENT, DATED NOVEMBER 19, 2007, TO AMENDED AND RESTATED SALARY CONTINUATION AGREEMENTEX-10.10 AMENDED AND RESTATED SALARY CONTINUATION AGREEMENT, DATED JANUARY 19, 2007EX-10.11 AMENDMENT, DATED NOVEMBER 19,2007, TO AMENDED AND RESTATED SALARY CONTINUATION AGREEMENTEX-10.12 AMENDED AND RESTATED SALARY CONTINUATION AGREEMENT, DATED JANUARY 19, 2007EX-10.13 AMENDMENT, DATED NOVEMBER 19,2007, TO AMENDED AND RESTATED SALARY CONTINUATION AGREEMENTEX-21 SUBSIDIARIES OF THE REGISTRANTEx-23 Consent of Independent Registered Public Accounting FirmEX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION OF THE CEOEX-32.2 SECTION 906 CERTIFICATION OF THE CFO




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PART I
 
 ITEM 1.
    
    BUSINESS
 Forward-Looking Statements
    
    
    the effects of future economic or business conditions;
    
    governmental monetary and fiscal policies, as well as legislative and regulatory
changes, including changes in banking, securities and tax laws and regulations;
    
    the risks of changes in interest rates on the levels, composition and costs of
deposits, loan demand, and the values of loan collateral, securities and interest
sensitive assets and liabilities;
    
    credit risks of borrowers;
    
    the effects of competition from a wide variety of local, regional, national and
other providers of financial, investment and insurance services;
    
    the failure of assumptions underlying the establishment of reserves for possible
loan losses and other estimates;
    
    the risks of mergers, acquisitions and divestitures, including, without
limitation, the related time and costs of implementing such transactions,
integrating operations as part of these transactions and the possible failure to
achieve expected gains, revenue growth and/or expense savings from such
transactions;
 1




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
    
    changes in accounting policies, rules and practices;
    
    changes in technology or products that may be more difficult, or costly, or less
effective, than anticipated;
    
    the effects of war or other conflict, acts of terrorism or other catastrophic
events that may affect general economic conditions; and
    
    other factors and risks described in any of our subsequent reports that we make
with the Securities and Exchange Commission (the Commission) under the Exchange
Act.
  The Company
     2




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The Bank
  Our Banking Business
 General .
   3




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Market Areas .
 Lending Activities
 General
 Real Estate Lending
 Consumer Lending
 
    
    loans secured by junior liens on real estate, including home improvement and
home equity loans, which have an average maturity of about three years and
generally are limited to 80% of appraised value;
    
    loans secured by personal property, such as automobiles, recreational vehicles
or boats, which typically have 36 to 60 month maturities;
    
    loans to our depositors secured by their time deposit accounts or certificates
of deposit;
    
    unsecured personal loans and personal lines of credit; and
    
    credit card loans.
  Construction Lending
 4




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Commercial Lending
  5




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Creditworthiness and Collateral
 Loan Originations
 Secondary Market Activities
   Income from Lending Activities
 6




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Loan Delinquencies and Defaults
 Investment Activities
  Sources of Funds
 General
 Deposits
 Borrowings
 7




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Financing
   8




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Competition
     Employees
  Seasonality
  9




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Supervision and Regulation
 Supervision and Regulation
  Bank Holding Company Regulation
    10




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De novo
  11




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Bank Regulation
     12




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Community Reinvestment Act
    13




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Sarbanes-Oxley Act
  Payments of Dividends
   Capital
  14




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15




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Regulatory Minimum to beAdequately Capitalized
    
    BankTier 1 capital ratio
    
    
    4.0
    %
    
    
    13.10
    %Total capital ratio
    
    
    8.0
    %
    
    
    13.97
    %Leverage ratio
    
    
    3.0-5.0
    %
    
    
    11.24
    %
 FDICIA
    Enforcement Policies and Actions
  16




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Fiscal and Monetary Policy
  FDIC Insurance Assessments
    17




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Other Laws and Regulations
   
    
    to conduct enhanced scrutiny of account relationships to guard against money laundering
and report any suspicious transaction;
    
    to ascertain the identity of the nominal and beneficial owners of, and the source of
funds deposited into, each account as needed to guard against money laundering and report
any suspicious transactions;
    
    to ascertain for any foreign bank, the shares of which are not publicly traded, the
identity of the owners of the foreign bank, and the nature and extent of the ownership
interest of each such owner; and
    
    to ascertain whether any foreign bank provides correspondent accounts to other foreign
banks and, if so, the identity of those foreign banks and related due diligence
information.
  
    
    the development of internal policies, procedures, and controls;
    
    the designation of a compliance officer;
    
    an ongoing employee training program; and
    
    an independent audit function to test the programs.
 18




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Legislative and Regulatory Changes
 de novo .
 Statistical Information
  
 ITEM 1A.
    
    RISK FACTORS
 We have a concentration of credit exposure to borrowers dependent on the tourism industry.
  19




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We are geographically concentrated in Sevier County and Blount County, Tennessee, and changes in
local economic conditions impact our profitability.
   Our continued growth may require the need for additional capital and further regulatory approvals
which, if not obtained, could adversely impact our profitability and implementation of our current
business plan.
  If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings will
decrease.
  20




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Competition with other banking institutions could adversely affect our profitability.
   Fluctuations in interest rates could reduce our profitability.
    21




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Our common stock is currently traded on the over-the-counter, or OTC, bulletin board and has
substantially less liquidity than the average stock quoted on a national securities exchange.
   Loss of our senior executive officers or other key employees could impair our relationship with our
customers and adversely affect our business.
  Our business is dependent on technology, and an inability to invest in technological improvements
may adversely affect our results of operations and financial condition.
  We are subject to various statutes and regulations that may limit our ability to take certain
actions.
  22




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If a change in control or change in management is delayed or prevented, the market price of our
common stock could be negatively affected.
  
 ITEM 2.
    
    PROPERTIES
        23




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ITEM 3. LEGAL PROCEEDINGS
  
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
  
 PART
II
 
 ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES
  24




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Market Price RangePer ShareYear/Period
    
    High
    
    Low2007:
    
    $
    28.57
    
    
    $
    22.00First Quarter
    
    
    26.67
    
    
    
    25.71Second Quarter
    
    
    27.67
    
    
    
    25.71Third Quarter
    
    
    28.57
    
    
    
    27.43Fourth Quarter
    
    
    27.43
    
    
    
    22.002006:
    
    $
    27.21
    
    
    $
    23.54First Quarter
    
    
    24.62
    
    
    
    23.54Second Quarter
    
    
    27.21
    
    
    
    24.62Third Quarter
    
    
    26.85
    
    
    
    25.04Fourth Quarter
    
    
    26.08
    
    
    
    24.94
      25




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Issuer Purchases of Equity Securities
   Total Numberof Shares
    
    
    Approximate DollarPurchased as
    
    
    Value of SharesTotal Number
    
    
    
    
    
    
    Part of Publicly
    
    
    That May Yet Beof Shares
    
    
    Average Price
    
    
    Announced Plans
    
    
    Purchased UnderPurchased
    
    
    Paid per Share
    
    
    or Programs
    
    
    the Plans or ProgramsOctober 1-31, 2007
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    227,000November 1-30, 2007
    
    
    1,000
    
    
    
    27.00
    
    
    
    1,000
    
    
    
    200,000December 1-31, 2007
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    200,000Total
    
    
    1,000
    
    
    $
    27.00
    
    
    
    1,000
    
    
    
    200,000
 
 ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
  26




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Overview
  Critical Accounting Policies
   Impairment of Investment Securities
  27




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Allowance and Provision for Loan Losses
  Results of Operations for the Years Ended December 31, 2007, 2006 and 2005
 General Discussion of Our Results
  
    
    income received on interest-earning assets, such as loans and investment securities; and
    
    payments we make on our interest-bearing sources of funds, such as deposits and
borrowings.
  
    
    increases or decreases in the volumes of interest-earning assets and interest-bearing
liabilities;
    
    increases or decreases in the average rates earned and paid on those assets and
liabilities;
    
    our ability to manage our interest-earning asset portfolio, which includes loans;
    
    the availability and costs of particular sources of funds, such as non-interest bearing
deposits; and
    
    our ability to match liabilities to fund assets of similar maturities at a profitable
spread of rates earned on assets over rates paid on liabilities.
  28




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Net Income
  Years Ended December 31,
    
    
    Dollar Change
    
    
    Percent Change2007
    
    
    2006
    
    
    2005
    
    
    2007 to 2006
    
    
    2006 to 2005
    
    
    2007 to 2006
    
    
    2006 to 2005Interest income
    
    $
    36,714
    
    
    $
    29,001
    
    
    $
    19,224
    
    
    $
    7,713
    
    
    $
    9,777
    
    
    
    26.60
    %
    
    
    50.86
    %Interest expense
    
    
    19,028
    
    
    
    13,117
    
    
    
    6,749
    
    
    
    5,911
    
    
    
    6,368
    
    
    
    45.06
    %
    
    
    94.35
    %Net interest income
    
    
    17,686
    
    
    
    15,884
    
    
    
    12,475
    
    
    
    1,802
    
    
    
    3,409
    
    
    
    11.34
    %
    
    
    27.33
    %Provision for loan losses
    
    
    982
    
    
    
    915
    
    
    
    446
    
    
    
    67
    
    
    
    469
    
    
    
    7.32
    %
    
    
    105.16
    %Net interest income after
provision for loan losses
    
    
    16,704
    
    
    
    14,969
    
    
    
    12,029
    
    
    
    1,735
    
    
    
    2,940
    
    
    
    11.59
    %
    
    
    24.44
    %Noninterest income
    
    
    3,742
    
    
    
    3,246
    
    
    
    2,676
    
    
    
    496
    
    
    
    570
    
    
    
    15.28
    %
    
    
    21.30
    %Noninterest expense
    
    
    15,240
    
    
    
    13,023
    
    
    
    10,127
    
    
    
    2,217
    
    
    
    2,896
    
    
    
    17.02
    %
    
    
    28.60
    %Net income before
income taxes
    
    
    5,206
    
    
    
    5,192
    
    
    
    4,578
    
    
    
    14
    
    
    
    614
    
    
    
    0.27
    %
    
    
    13.41
    %Income tax expense
    
    
    1,294
    
    
    
    1,295
    
    
    
    1,454
    
    
    
    (1
    )
    
    
    (159
    )
    
    
    -0.08
    %
    
    
    -10.94
    %Net income
    
    $
    3,912
    
    
    $
    3,897
    
    
    $
    3,124
    
    
    $
    15
    
    
    $
    773
    
    
    
    0.38
    %
    
    
    24.74
    %Total revenues
    
    $
    40,456
    
    
    $
    32,247
    
    
    $
    21,900
    
    
    $
    8,209
    
    
    $
    10,347
    
    
    
    25.46
    %
    
    
    47.25
    %Total expenses
    
    
    36,544
    
    
    
    28,350
    
    
    
    18,776
    
    
    
    8,194
    
    
    
    9,574
    
    
    
    28.90
    %
    
    
    50.99
    %Basic earnings per share
    
    
    1.68
    
    
    
    1.93
    
    
    
    1.81Diluted earnings per share
    
    
    1.61
    
    
    
    1.79
    
    
    
    1.69
   29




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30




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2007
    
    
    2006
    
    
    2005First Quarter
    
    $
    901,478
    
    
    $
    935,453
    
    
    $
    640,171Second Quarter
    
    
    1,026,037
    
    
    
    1,046,081
    
    
    
    720,863Third Quarter
    
    
    1,006,677
    
    
    
    951,271
    
    
    
    862,185Fourth Quarter
    
    
    977,902
    
    
    
    964,568
    
    
    
    900,283Annual Total
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502
  Net Interest Income
 Average Balances, Interest Income, and Interest Expense
  31




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Average Balance Sheet and Analysis of Net Interest Income
for the Years Ended December 31,
(Dollars in thousands)
 2007
    
    
    2006
    
    
    2005Average
    
    
    
    
    
    
    Rates/
    
    
    Average
    
    
    
    
    
    
    Rates/
    
    
    Average
    
    
    
    
    
    
    Rates/Balances
    
    
    Interest
    
    
    Yields
    
    
    Balances
    
    
    Interest
    
    
    Yields
    
    
    Balances
    
    
    Interest
    
    
    YieldsInterest-earning assets:Loans (1)(2)
    
    $
    373,237
    
    
    $
    32,267
    
    
    
    8.65
    %
    
    $
    292,950
    
    
    $
    25,287
    
    
    
    8.63
    %
    
    $
    227,910
    
    
    $
    16,545
    
    
    
    7.26
    %Investment Securities: (3)Available for sale
    
    
    80,168
    
    
    
    3,915
    
    
    
    4.88
    %
    
    
    69,339
    
    
    
    3,281
    
    
    
    4.73
    %
    
    
    54,658
    
    
    
    2,378
    
    
    
    4.35
    %Held to maturity
    
    
    1,916
    
    
    
    92
    
    
    
    4.80
    %
    
    
    1,444
    
    
    
    68
    
    
    
    4.71
    %
    
    
    1,093
    
    
    
    54
    
    
    
    4.94
    %Equity securities
    
    
    3,187
    
    
    
    186
    
    
    
    5.84
    %
    
    
    2,053
    
    
    
    128
    
    
    
    6.23
    %
    
    
    1,509
    
    
    
    72
    
    
    
    4.77
    %Total securities
    
    
    85,271
    
    
    
    4,193
    
    
    
    4.92
    %
    
    
    72,836
    
    
    
    3,477
    
    
    
    4.77
    %
    
    
    57,260
    
    
    
    2,504
    
    
    
    4.37
    %Federal funds sold and other
    
    
    5,116
    
    
    
    254
    
    
    
    4.96
    %
    
    
    4,721
    
    
    
    237
    
    
    
    5.02
    %
    
    
    4,899
    
    
    
    175
    
    
    
    3.57
    %Total interest-earning
assets
    
    
    463,624
    
    
    
    36,714
    
    
    
    7.92
    %
    
    
    370,507
    
    
    
    29,001
    
    
    
    7.83
    %
    
    
    290,069
    
    
    
    19,224
    
    
    
    6.63
    %Nonearning assets
    
    
    45,361
    
    
    
    
    
    
    
    
    
    
    
    37,706
    
    
    
    
    
    
    
    
    
    
    
    29,806Total Assets
    
    $
    508,985
    
    
    
    
    
    
    
    
    
    
    $
    408,213
    
    
    
    
    
    
    
    
    
    
    $
    319,875Interest-bearing liabilities:Interest bearing deposits:Interest bearing
demand deposits
    
    $
    127,704
    
    
    $
    4,949
    
    
    
    3.88
    %
    
    $
    120,268
    
    
    $
    4,477
    
    
    
    3.72
    %
    
    $
    98,356
    
    
    $
    2,142
    
    
    
    2.18
    %Savings deposits
    
    
    8,673
    
    
    
    91
    
    
    
    1.05
    %
    
    
    7,860
    
    
    
    48
    
    
    
    0.61
    %
    
    
    6,764
    
    
    
    40
    
    
    
    0.59
    %Time deposits
    
    
    196,654
    
    
    
    10,032
    
    
    
    5.10
    %
    
    
    146,014
    
    
    
    6,249
    
    
    
    4.28
    %
    
    
    117,415
    
    
    
    3,503
    
    
    
    2.98
    %Total
interest bearing deposits
    
    
    333,031
    
    
    
    15,072
    
    
    
    4.53
    %
    
    
    274,142
    
    
    
    10,774
    
    
    
    3.93
    %
    
    
    222,535
    
    
    
    5,685
    
    
    
    2.55
    %Securities sold under
agreements
to repurchase
    
    
    5,815
    
    
    
    158
    
    
    
    2.72
    %
    
    
    4,779
    
    
    
    102
    
    
    
    2.13
    %
    
    
    4,287
    
    
    
    64
    
    
    
    1.49
    %Federal Home Loan Bank
advances
and other borrowings
    
    
    60,970
    
    
    
    2,812
    
    
    
    4.61
    %
    
    
    31,716
    
    
    
    1,493
    
    
    
    4.71
    %
    
    
    18,228
    
    
    
    650
    
    
    
    3.57
    %Subordinated debt
    
    
    13,403
    
    
    
    986
    
    
    
    7.36
    %
    
    
    10,181
    
    
    
    748
    
    
    
    7.35
    %
    
    
    5,671
    
    
    
    350
    
    
    
    6.17
    %Total interest-bearing
liabilities
    
    
    413,219
    
    
    
    19,028
    
    
    
    4.60
    %
    
    
    320,818
    
    
    
    13,117
    
    
    
    4.09
    %
    
    
    250,721
    
    
    
    6,749
    
    
    
    2.69
    %Noninterest-bearing deposits
    
    
    53,336
    
    
    
    
    
    
    
    
    
    
    
    54,163
    
    
    
    
    
    
    
    
    
    
    
    46,187
    
    
    
    Total deposits and interest-
bearings liabilities
    
    
    466,555
    
    
    
    19,028
    
    
    
    4.08
    %
    
    
    374,981
    
    
    
    13,117
    
    
    
    3.50
    %
    
    
    296,908
    
    
    
    6,749
    
    
    
    2.27
    %Other liabilities
    
    
    2,565
    
    
    
    
    
    
    
    
    
    
    
    2,066
    
    
    
    
    
    
    
    
    
    
    
    1,739Shareholders equity
    
    
    39,865
    
    
    
    
    
    
    
    
    
    
    
    31,166
    
    
    
    
    
    
    
    
    
    
    
    21,228$
    508,985
    
    
    
    
    
    
    
    
    
    
    $
    408,213
    
    
    
    
    
    
    
    
    
    
    $
    319,875Net interest income
    
    
    
    
    
    $
    17,686
    
    
    
    
    
    
    
    
    
    
    $
    15,884
    
    
    
    
    
    
    
    
    
    
    $
    12,475Net interest spread (4)
    
    
    
    
    
    
    
    
    
    
    3.32
    %
    
    
    
    
    
    
    
    
    
    
    3.74
    %
    
    
    
    
    
    
    
    
    
    
    3.94
    %Net interest margin (5)
    
    
    
    
    
    
    
    
    
    
    3.81
    %
    
    
    
    
    
    
    
    
    
    
    4.29
    %
    
    
    
    
    
    
    
    
    
    
    4.30
    %
 
 (1)
    
    Interest income from loans includes total fee income of approximately $2,138,000, $2,091,000
and $1,673,000 for the years ended December 31, 2007, 2006 and 2005, respectively.(2)
    
    For the purpose of these computations, non-accrual loans are included in average loans.(3)
    
    Tax-exempt income from investment securities is not presented on a tax-equivalent basis.(4)
    
    Yields realized on interest-earning assets less the rates paid on interest-bearing liabilities.(5)
    
    Net interest margin is the result of net interest income divided by average interest-earning assets for
the period.  32




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##### Table of Contents



Rate and Volume Analysis
  33




---



##### Table of Contents



ANALYSIS OF CHANGES IN NET INTEREST INCOME
FOR THE YEARS ENDED DECEMBER 31,
(Dollars in thousands)
 2007 Compared to 2006Increase (decrease)due to change inRate
    
    
    Volume
    
    
    TotalIncome from interest-earning assets:Interest and fees on loans
    
    $
    50
    
    
    $
    6,930
    
    
    $
    6,980Interest on securities
    
    
    122
    
    
    
    594
    
    
    
    716Interest on Federal funds sold and other
    
    
    (3
    )
    
    
    20
    
    
    
    17Total interest income
    
    
    169
    
    
    
    7,544
    
    
    
    7,713Expense from interest-bearing liabilities:Interest on interest-bearing deposits
    
    
    224
    
    
    
    291
    
    
    
    515Interest on time deposits
    
    
    1,616
    
    
    
    2,167
    
    
    
    3,783Interest on other borrowings
    
    
    (69
    )
    
    
    1,682
    
    
    
    1,613Total interest expense
    
    
    1,771
    
    
    
    4,140
    
    
    
    5,911Net interest income
    
    $
    (1,602
    )
    
    $
    3,404
    
    
    $
    1,802
 2006 Compared to 2005Increase (decrease)due to change inRate
    
    
    Volume
    
    
    TotalIncome from interest-earning assets:Interest and fees on loans
    
    $
    4,017
    
    
    $
    4,725
    
    
    $
    8,742Interest on securities
    
    
    251
    
    
    
    722
    
    
    
    973Interest on Federal funds sold and other
    
    
    70
    
    
    
    (8
    )
    
    
    62Total interest income
    
    
    4,338
    
    
    
    5,439
    
    
    
    9,777Expense from interest-bearing liabilities:Interest on interest-bearing deposits
    
    
    1,868
    
    
    
    476
    
    
    
    2,344Interest on time deposits
    
    
    1,892
    
    
    
    852
    
    
    
    2,744Interest on other borrowings
    
    
    583
    
    
    
    697
    
    
    
    1,280Total interest expense
    
    
    4,343
    
    
    
    2,025
    
    
    
    6,368Net interest income
    
    $
    (5
    )
    
    $
    3,414
    
    
    $
    3,409
 Provision for Loan Losses
  34




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##### Table of Contents



Noninterest Income
  Years Ended December 31,
    
    
    Dollar Change
    
    
    Percent Change2007
    
    
    2006
    
    
    2005
    
    
    2007 to 2006
    
    
    2006 to 2005
    
    
    2007 to 2006
    
    
    2006 to 2005Service charges on deposit accounts
    
    $
    1,414
    
    
    $
    1,293
    
    
    $
    1,142
    
    
    $
    121
    
    
    $
    151
    
    
    
    9.36
    %
    
    
    13.22
    %Other fees and commissions
    
    
    1,153
    
    
    
    1,020
    
    
    
    891
    
    
    
    133
    
    
    
    129
    
    
    
    13.04
    %
    
    
    14.48
    %Gain on sale of mortgage loans
    
    
    323
    
    
    
    424
    
    
    
    401
    
    
    
    (101
    )
    
    
    23
    
    
    
    -23.82
    %
    
    
    5.74
    %Other noninterest income
    
    
    852
    
    
    
    509
    
    
    
    187
    
    
    
    343
    
    
    
    322
    
    
    
    67.39
    %
    
    
    172.19
    %Total noninterest income
    
    
    3,742
    
    
    
    3,246
    
    
    
    2,621
    
    
    
    496
    
    
    
    625
    
    
    
    15.28
    %
    
    
    23.85
    %
  35




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##### Table of Contents



Interest Expense and Net Interest Margin
     36




---



##### Table of Contents



Noninterest Expenses
  Years Ended December 31,
    
    
    Dollar Change
    
    
    Percent Change2007
    
    
    2006
    
    
    2005
    
    
    2007 to 2006
    
    
    2006 to 2005
    
    
    2007 to 2006
    
    
    2006 to 2005Salaries and employee benefits
    
    $
    8,992
    
    
    $
    7,543
    
    
    $
    5,373
    
    
    $
    1,449
    
    
    $
    2,170
    
    
    
    19.21
    %
    
    
    40.39
    %Occupancy expenses
    
    
    1,080
    
    
    
    956
    
    
    
    852
    
    
    
    124
    
    
    
    104
    
    
    
    12.97
    %
    
    
    12.21
    %Other operating expenses
    
    
    5,167
    
    
    
    4,523
    
    
    
    3,903
    
    
    
    644
    
    
    
    620
    
    
    
    14.24
    %
    
    
    15.89
    %Total noninterest expense
    
    
    15,239
    
    
    
    13,022
    
    
    
    10,128
    
    
    
    2,217
    
    
    
    2,894
    
    
    
    17.03
    %
    
    
    28.57
    %
  37




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##### Table of Contents



Income Taxes
  Provision for Income Taxes and Effective Tax Rates
 (dollars in thousands)
    
    Provision
    
    Effective Tax Rates2007
    
    $
    1,294
    
    
    
    24.86
    %2006
    
    
    1,295
    
    
    
    24.95
    %2005
    
    
    1,454
    
    
    
    31.76
    %
  Discussion of Financial Condition
 General Discussion of Our Financial Condition
  38




---



##### Table of Contents



2007
    
    
    2006
    
    

$ change
    
    
    % changeCash and equivalents
    
    $
    16,329
    
    
    $
    13,396
    
    
    $
    2,933
    
    
    
    21.89
    %Loans
    
    
    397,674
    
    
    
    344,709
    
    
    
    52,965
    
    
    
    15.37
    %Allowance for loan losses
    
    
    3,974
    
    
    
    3,524
    
    
    
    450
    
    
    
    12.77
    %Investment securities
    
    
    82,987
    
    
    
    75,994
    
    
    
    6,993
    
    
    
    9.20
    %Premises and equipment
    
    
    25,427
    
    
    
    19,944
    
    
    
    5,483
    
    
    
    27.49
    %Total assets
    
    
    541,496
    
    
    
    469,982
    
    
    
    71,514
    
    
    
    15.22
    %Noninterest-bearing demand deposits
    
    
    56,307
    
    
    
    60,016
    
    
    
    (3,709
    )
    
    
    -6.18
    %Interest-bearing demand and savings deposits
    
    
    139,319
    
    
    
    130,011
    
    
    
    9,308
    
    
    
    7.16
    %Time deposits
    
    
    208,748
    
    
    
    171,702
    
    
    
    37,046
    
    
    
    21.58
    %Total deposits
    
    
    404,374
    
    
    
    361,729
    
    
    
    42,645
    
    
    
    11.79
    %Federal funds purchased
    
    
    1,300
    
    
    
    15,575
    
    
    
    (14,275
    )
    
    
    -91.65
    %Federal Home Loan Bank advances
    
    
    65,356
    
    
    
    36,710
    
    
    
    28,646
    
    
    
    78.03
    %Subordinated debentures
    
    
    13,403
    
    
    
    13,403
    
    
    
    
    
    
    
    0.00
    %Total liabilities
    
    
    492,548
    
    
    
    435,571
    
    
    
    56,977
    
    
    
    13.08
    %Accumulated other comprehensive income (loss)
    
    
    (279
    )
    
    
    (698
    )
    
    
    419
    
    
    
    -60.03
    %Total shareholders equity
    
    $
    48,948
    
    
    $
    34,411
    
    
    $
    14,537
    
    
    
    42.25
    %
 Loans
  Loan Portfolio
 At December 31,2007
    
    2006
    
    2005
    
    2004
    
    2003(In Thousands)Commercial, financial, agricultural
    
    $
    35,929
    
    
    $
    26,062
    
    
    $
    15,375
    
    
    $
    9,870
    
    
    $
    10,489Real estate  construction, development
    
    
    150,844
    
    
    
    137,989
    
    
    
    80,719
    
    
    
    55,618
    
    
    
    44,086Real estate  mortgage
    
    
    201,011
    
    
    
    173,085
    
    
    
    144,898
    
    
    
    134,272
    
    
    
    119,821Consumer and other
    
    
    9,890
    
    
    
    7,572
    
    
    
    7,872
    
    
    
    9,418
    
    
    
    5,449Less allowance for loan losses
    
    
    3,974
    
    
    
    3,524
    
    
    
    2,634
    
    
    
    2,281
    
    
    
    2,142Loans, net
    
    $
    393,700
    
    
    $
    341,184
    
    
    $
    246,230
    
    
    $
    206,897
    
    
    $
    177,703
  39




---



##### Table of Contents



Maturities and Sensitivities of Loan Portfolio to Changes in Interest Rates
 One year
    
    Over one year
    
    Over three years
    
    Over fiveor less
    
    through three years
    
    through five years
    
    years(Dollars in Thousands)Commercial, financial, agricultural
    
    $
    23,320
    
    
    $
    6,576
    
    
    $
    3,501
    
    
    $
    2,533Real estate  construction, development
    
    
    123,865
    
    
    
    23,751
    
    
    
    1,970
    
    
    
    1,252Real estate  mortgage
    
    
    104,970
    
    
    
    50,510
    
    
    
    30,037
    
    
    
    15,498Consumer and other
    
    
    6,604
    
    
    
    1,994
    
    
    
    1,040
    
    
    
    253Total
    
    $
    258,759
    
    
    $
    82,831
    
    
    $
    36,548
    
    
    $
    19,536
  Allowance for Loan Losses
    40




---



##### Table of Contents



41




---



##### Table of Contents



At December 31,2007
    
    2006
    
    2005
    
    2004
    
    2003(Dollars in Thousands)Loans accounted for on a nonaccrual basis
    
    $
    179
    
    
    $
    
    
    
    $
    92
    
    
    $
    161
    
    
    $
    289Loans contractually past due ninety days or more as
to interest or principal payments and still accruing
    
    
    19
    
    
    
    470
    
    
    
    342
    
    
    
    21
    
    
    
    1,460Loans, the terms of which have been renegotiated to
provide a reduction or deferral of interest or
principal because of deterioration in the financial
position of the borrower
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Loans now current about which there are serious
doubts as to the ability of the borrower to comply
with present loan repayment terms
    
    
    170
    
    
    
    30
    
    
    
    95
    
    
    
    15
    
    
    
    182
   2007
    
    2006Interest income that would have been recorded on
nonaccrual loans under original terms
    
    $
    7,006
    
    
    $
    458Interest income that was recorded on nonaccrual
loans
    
    
    41,397
    
    
    
    458
     42




---



##### Table of Contents



December 31,2007
    
    2006
    
    2005
    
    2004
    
    2003(Dollars in Thousands)Average balance of loans outstanding
    
    $
    373,237
    
    
    $
    292,950
    
    
    $
    227,910
    
    
    $
    188,481
    
    
    $
    162,133Balance of allowance for loan losses at beginning of year
    
    
    3,524
    
    
    
    2,634
    
    
    
    2,281
    
    
    
    2,142
    
    
    
    1,595Charge-offs:Commercial, financial, agricultural
    
    
    43
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Real estate  construction, development
    
    
    158
    
    
    
    1
    
    
    
    24
    
    
    
    
    
    
    
    3Real estate  mortgage
    
    
    250
    
    
    
    25
    
    
    
    40
    
    
    
    325
    
    
    
    7Consumer and other
    
    
    110
    
    
    
    23
    
    
    
    45
    
    
    
    42
    
    
    
    187Recoveries:Commercial, financial, agricultural
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Real estate  construction, development
    
    
    
    
    
    
    1
    
    
    
    
    
    
    
    17
    
    
    
    4Real estate  mortgage
    
    
    15
    
    
    
    18
    
    
    
    10
    
    
    
    21
    
    
    
    Consumer and other
    
    
    14
    
    
    
    5
    
    
    
    6
    
    
    
    
    
    
    
    5Net charge-offs
    
    
    532
    
    
    
    25
    
    
    
    93
    
    
    
    329
    
    
    
    188Additions to allowance charged to operations
    
    
    982
    
    
    
    915
    
    
    
    446
    
    
    
    468
    
    
    
    735Balance of allowance for loan losses at end of year
    
    
    3,974
    
    
    
    3,524
    
    
    
    2,634
    
    
    
    2,281
    
    
    
    2,142Ratio of net loan charge-offs during the year to
average loans outstanding during the year
    
    
    0.14
    %
    
    
    0.01
    %
    
    
    0.04
    %
    
    
    0.17
    %
    
    
    0.12
    %
  December 31,2007
    
    
    2006
    
    
    2005
    
    
    2004
    
    
    2003Loan
    
    
    
    
    
    
    Loan
    
    
    
    
    
    
    Loan
    
    
    
    
    
    
    Loan
    
    
    
    
    
    
    LoanCategory as
    
    
    
    
    
    
    Category as
    
    
    
    
    
    
    Category as
    
    
    
    
    
    
    Category as
    
    
    
    
    
    
    Category as% of Total
    
    
    
    
    
    
    % of Total
    
    
    
    
    
    
    % of Total
    
    
    
    
    
    
    % of Total
    
    
    
    
    
    
    % of TotalAmount
    
    
    Loans
    
    
    Amount
    
    
    Loans
    
    
    Amount
    
    
    Loans
    
    
    Amount
    
    
    Loans
    
    
    Amount
    
    
    Loans(Dollars in Thousands)Commercial
    
    $
    968
    
    
    
    9.03
    %
    
    $
    418
    
    
    
    7.56
    %
    
    $
    225
    
    
    
    3.16
    %
    
    $
    226
    
    
    
    4.72
    %
    
    $
    261
    
    
    
    5.83
    %Real estate  construction,
development
    
    $
    1,600
    
    
    
    37.93
    %
    
    $
    1,331
    
    
    
    40.03
    %
    
    $
    837
    
    
    
    32.43
    %
    
    $
    584
    
    
    
    26.59
    %
    
    $
    495
    
    
    
    24.51
    %Real estate  mortgage
    
    
    1,201
    
    
    
    50.55
    %
    
    
    1,669
    
    
    
    50.21
    %
    
    
    1,502
    
    
    
    58.23
    %
    
    
    1,411
    
    
    
    64.19
    %
    
    
    1,347
    
    
    
    66.63
    %Consumer, other
    
    
    205
    
    
    
    2.49
    %
    
    
    106
    
    
    
    2.20
    %
    
    
    70
    
    
    
    6.18
    %
    
    
    60
    
    
    
    4.50
    %
    
    
    39
    
    
    
    3.03
    %Total
    
    $
    3,974
    
    
    
    100.00
    %
    
    $
    3,524
    
    
    
    100.00
    %
    
    $
    2,634
    
    
    
    100.00
    %
    
    $
    2,281
    
    
    
    100.00
    %
    
    $
    2,142
    
    
    
    100.00
    %
 Securities
  43




---



##### Table of Contents



December 31,2007
    
    
    2006
    
    
    2005(Dollars in Thousands)Securities available for sale:U.S.
Treasury and government agencies and corporations
    
    $
    9,179
    
    
    $
    9,535
    
    
    $
    6,502Mortgage-backed securities
    
    
    57,975
    
    
    
    51,367
    
    
    
    40,851Obligations of states and political subdivisions
    
    
    13,812
    
    
    
    13,612
    
    
    
    9,663Total
    
    
    80,966
    
    
    
    74,514
    
    
    
    57,016Securities held to maturity:Obligations of states and political subdivisions
    
    
    2,021
    
    
    
    1,480
    
    
    
    1,411
  MaturityWeighted
    
    
    After 1
    
    
    Weighted
    
    
    After 5
    
    
    Weighted
    
    
    
    
    
    
    Weighted
    
    
    
    
    
    
    Weighted1 year
    
    
    Average
    
    
    Year - 5
    
    
    Average
    
    
    Years - 10
    
    
    Average
    
    
    Over 10
    
    
    Average
    
    
    
    
    
    
    Averageor less
    
    
    Yield
    
    
    5 Years
    
    
    Yield
    
    
    Years
    
    
    Yield
    
    
    Years
    
    
    Yield
    
    
    Total
    
    
    Yield(dollars in thousands)Available for Sale:U.S. Treasury and
Government Agencies
    
    $
    250
    
    
    
    4.32
    %
    
    
    2,503
    
    
    $
    5.37
    %
    
    $
    2,428
    
    
    
    4.69
    %
    
    $
    3,998
    
    
    
    5.06
    %
    
    $
    9,179
    
    
    
    5.03
    %Mortgage-Backed Securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,551
    
    
    
    5.37
    %
    
    
    46,424
    
    
    
    5.09
    %
    
    
    57,975
    
    
    
    5.14
    %Obligations of State and
Political Subdivisions
    
    
    311
    
    
    
    4.58
    %
    
    
    1,421
    
    
    
    4.81
    %
    
    
    3,700
    
    
    
    5.94
    %
    
    
    8,380
    
    
    
    5.69
    %
    
    
    13,812
    
    
    
    5.64
    %Total Available for Sale
    
    
    561
    
    
    
    4.46
    %
    
    
    3,924
    
    
    
    5.17
    %
    
    
    17,679
    
    
    
    5.40
    %
    
    
    58,802
    
    
    
    5.17
    %
    
    
    80,966
    
    
    
    5.22
    %Held to Maturity:U.S. Treasury and
Government Agencies
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Mortgage-Backed Securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Obligations of State and
Political Subdivisions
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,021
    
    
    
    8.95
    %
    
    
    2,021
    
    
    
    8.95
    %Total Held to Maturity
    
    
    
    
    
    
    0.00
    %
    
    
    
    
    
    
    0.00
    %
    
    
    
    
    
    
    0.00
    %
    
    
    2,021
    
    
    
    8.95
    %
    
    
    2,021
    
    
    
    8.95
    %Total Securities
    
    
    561
    
    
    
    4.46
    %
    
    
    3,924
    
    
    
    5.17
    %
    
    
    17,679
    
    
    
    5.40
    %
    
    
    60,823
    
    
    
    5.30
    %
    
    
    82,987
    
    
    
    5.31
    %
 44




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##### Table of Contents



Deposits
   2007
    
    
    2006
    
    
    $ change
    
    
    % changeNoninterest-bearing demand deposits
    
    $
    56,307
    
    
    $
    60,016
    
    
    $
    (3,709
    )
    
    
    -6.18
    %Total noninterest-bearing deposits
    
    
    56,307
    
    
    
    60,016
    
    
    
    (3,709
    )
    
    
    -6.18
    %NOW Accounts
    
    
    87,380
    
    
    
    76,070
    
    
    
    11,310
    
    
    
    14.87
    %Money market accounts
    
    
    42,959
    
    
    
    45,667
    
    
    
    (2,708
    )
    
    
    -5.93
    %Savings
    
    
    8,980
    
    
    
    8,275
    
    
    
    705
    
    
    
    8.52
    %Brokered Deposits
    
    
    48,210
    
    
    
    51,379
    
    
    
    (3,169
    )
    
    
    -6.17
    %Time deposits
    
    
    160,538
    
    
    
    120,322
    
    
    
    40,216
    
    
    
    33.42
    %Total interest-bearing deposits
    
    
    348,067
    
    
    
    301,713
    
    
    
    46,354
    
    
    
    15.36
    %Total deposits
    
    $
    404,374
    
    
    $
    361,729
    
    
    $
    42,645
    
    
    
    11.79
    %
   2007
    
    
    2006
    
    
    2005Amount
    
    
    Rate
    
    
    Amount
    
    
    Rate
    
    
    Amount
    
    
    Rate(Dollars in Thousands)Non-interest-bearing demand deposits
    
    $
    53,336
    
    
    
    0
    %
    
    $
    54,163
    
    
    
    0
    %
    
    $
    46,187
    
    
    
    0
    %Interest-bearing demand deposits
    
    
    127,704
    
    
    
    3.88
    %
    
    
    120,268
    
    
    
    3.72
    %
    
    
    98,356
    
    
    
    2.18
    %Savings deposits
    
    
    8,673
    
    
    
    1.05
    %
    
    
    7,860
    
    
    
    0.61
    %
    
    
    6,764
    
    
    
    0.59
    %Time deposits
    
    
    196,654
    
    
    
    5.10
    %
    
    
    146,014
    
    
    
    4.28
    %
    
    
    117,415
    
    
    
    2.98
    %Total
    
    $
    386,367
    
    
    
    
    
    
    $
    328,305
    
    
    
    
    
    
    $
    268,722
 45




---



##### Table of Contents



(Dollars inThousands)Three months or less
    
    $
    43,130Over three months through six months
    
    
    33,442Over six months through 12 months
    
    
    28,672Over 12 months
    
    
    31,894Total
    
    $
    137,138
   Shareholders Equity
  Interest Rate Sensitivity Management
    46




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##### Table of Contents



47




---



##### Table of Contents



Analysis of Interest Sensitivity
As of December 31, 2007
(Dollars in Thousands)
 0  3
    
    
    3  12
    
    
    1  3
    
    
    Over 3Months
    
    
    Months
    
    
    Years
    
    
    Years
    
    
    TotalFederal funds sold
    
    $
    3,317
    
    
    $
    0
    
    
    $
    0
    
    
    $
    0
    
    
    $
    3,317Securities
    
    
    2,876
    
    
    
    8,108
    
    
    
    20,821
    
    
    
    51,182
    
    
    
    82,987Loans (1)
    
    
    205,414
    
    
    
    70,177
    
    
    
    77,463
    
    
    
    44,620
    
    
    
    397,674Total interest-earning assets
    
    $
    211,607
    
    
    $
    78,285
    
    
    $
    98,284
    
    
    $
    95,802
    
    
    $
    483,978Interest-bearing liabilities:Interest-bearing demand deposits
    
    
    130,339
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    130,339Savings
    
    
    8,980
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    8,980Time deposits
    
    
    59,772
    
    
    
    107,446
    
    
    
    31,227
    
    
    
    10,303
    
    
    
    208,748Other borrowings
    
    
    6,742
    
    
    
    7,456
    
    
    
    7,700
    
    
    
    50,200
    
    
    
    72,098Total interest-bearing liabilities
    
    $
    200,391
    
    
    $
    114,902
    
    
    $
    38,927
    
    
    $
    60,503
    
    
    $
    414,723Interest rate sensitivity gap
    
    $
    11,216
    
    
    $
    (36,617
    )
    
    $
    59,357
    
    
    $
    35,299
    
    
    $
    69,255Cumulative interest rate sensitivity gap
    
    $
    11,216
    
    
    $
    (25,401
    )
    
    $
    33,956
    
    
    $
    69,255Interest rate sensitivity gap ratio
    
    
    5.30
    %
    
    
    (46.77
    %)
    
    
    60.39
    %
    
    
    36.85
    %Cumulative interest rate sensitivity gap ratio
    
    
    5.30
    %
    
    
    (8.76
    %)
    
    
    8.75
    %
    
    
    14.31
    %
 
 (1)
    
    Includes nonaccrual loans.   48




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##### Table of Contents



Return on Assets and Equity
  For the Years EndedDecember 31,2007
    
    2006
    
    2005Return on Average Assets
    
    
    0.77
    %
    
    
    0.95
    %
    
    
    0.98
    %Return on Average Equity
    
    
    9.81
    %
    
    
    11.26
    %
    
    
    16.87
    %Average Equity as a Percentage of Average Assets
    
    
    7.83
    %
    
    
    8.48
    %
    
    
    5.79
    %Dividend Payout Ratio
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 Capital Adequacy and Liquidity
   Regulatory Capital Requirements
   49




---



##### Table of Contents



December 31, 2007
    
    December 31, 2006Tier 1 Risk-Based Capital
    
    
    13.10
    %
    
    
    11.33
    %Regulatory Minimum
    
    
    4.00
    
    
    
    4.00Well-capitalized
    
    
    6.00
    
    
    
    6.00Total Risk-Based Capital
    
    
    13.97
    %
    
    
    12.22
    %Regulatory Minimum
    
    
    8.00
    
    
    
    8.00Well-capitalized
    
    
    10.00
    
    
    
    10.00Tier 1 Leverage
    
    
    11.24
    %
    
    
    9.99
    %Regulatory Minimum
    
    
    4.00
    
    
    
    4.00Well-capitalized
    
    
    5.00
    
    
    
    5.00
   50




---



##### Table of Contents



Off-Balance Sheet Arrangements
  Commitments and Lines of Credit
   2007
    
    
    2006(Dollars in thousands)Commitments to extend credit
    
    $
    125,475
    
    
    $
    110,963Standby letters of credit
    
    
    5,824
    
    
    
    12,250Totals
    
    $
    131,299
    
    
    $
    123,213
  51




---



##### Table of Contents



Effects of Inflation
   Significant Accounting Changes
  52




---



##### Table of Contents



Fair Value Measurements Effective Date of FASB
Statement No. 157
 The Fair Value Option for Financial
Assets and Financial Liabilities
 Accounting for Uncertainty in Income Taxes
 Accounting
for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life
Insurance Arrangements
 Accounting
for Purchases of Life Insurance  Determining the Amount That Could Be Realized in Accordance with
FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance)
 53




---



##### Table of Contents



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
  
 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
  
 ITEM 9A(T). CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
   Changes in Internal Control over Financial Reporting
  Managements Annual Report on Internal Control over Financial Reporting
  54




---



##### Table of Contents



ITEM 9B. OTHER INFORMATION
  
 PART
III
 
 ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
  
 ITEM 11. EXECUTIVE COMPENSATION
  
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS
  55




---



##### Table of Contents



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
  
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
  
 PART
IV
 
 ITEM 15. EXHIBITS
  Exhibit No.
    
    Description of Exhibit2.1
    
    Plan of Reorganization dated March 28, 2003, by and between
the Registrant and Mountain National Bank (included as Exhibit
2.1 to the Report on Form 8-K12G3 of the Registrant, dated
July 12, 2003 (File No. 000-49912), previously filed with the
Commission and incorporated herein by reference).2.2
    
    Amendment to Plan of Reorganization dated July 1, 2003
(included as Exhibit 2.2 to the Report on Form 8-K12G3 of the
Registrant, dated July 12, 2003 (File No. 000-49912),
previously filed with the Commission and incorporated herein
by reference).3.1
    
    Charter of Incorporation of the Registrant, as amended
(included as Exhibit 3.1 to the Report on Form 8-K of the
Registrant, dated May 19, 2006 (File No. 000-49912),
previously filed with the Commission and incorporated herein
by reference).3.2
    
    Bylaws of the Registrant, as amended (included as Exhibit 3.2
to the Report on Form 8-K of the Registrant, dated May 19,
2006 (File No. 000-49912), previously filed with the
Commission and incorporated herein by reference).10.1
    
    Stock Option Plan of the Registrant, as amended (included as
Exhibit 10.1 to the Report on Form 8-K of the Registrant,
dated May 19, 2006 (File No.
 56




---



##### Table of Contents



Exhibit No.
    
    Description of Exhibit000-49912), previously filed with
the Commission and incorporated herein by reference)*10.2
    
    Stock Option Agreement of Dwight B. Grizzell (assumed by
Registrant) (included as Exhibit 10.3 to the Registrants Form
10-KSB for the year ended December 31, 2002 and incorporated
herein by reference)*10.3
    
    Summary Description of Director and Named Executive Officer
Compensation Arrangements*10.4
    
    Form of Warrant Agreement (included as Exhibit 10.5 to the
Registrants Form SB-2/A filed with the Commission on August
23, 2005)10.5
    
    Employment Agreement dated as of May 18, 2006 by and between
Mountain National Bancshares, Inc. and Dwight Grizzell
(included as Exhibit 10.2 to the Report on Form 8-K of the
Registrant, dated May 19, 2006 (File No. 000-49912),
previously filed with the Commission and incorporated herein
by reference)*10.6
    
    Employment Agreement dated as of May 18, 2006 by and between
Mountain National Bancshares, Inc. and Grace McKinzie
(included as Exhibit 10.3 to the Report on Form 8-K of the
Registrant, dated May 19, 2006 (File No. 000-49912),
previously filed with the Commission and incorporated herein
by reference)*10.7
    
    Employment Agreement dated as of May 18, 2006 by and between
Mountain National Bancshares, Inc. and Michael Brown (included
as Exhibit 10.4 to the Report on Form 8-K of the Registrant,
dated May 19, 2006 (File No. 000-49912), previously filed with
the Commission and incorporated herein by reference)*10.8
    
    Amended and Restated Salary Continuation Agreement, dated
January 19, 2007, by and between Mountain National Bank and
Dwight Grizzell.*10.9
    
    Amendment, dated November 19, 2007, to Amended and Restated
Salary Continuation Agreement, by and between Mountain
National Bank and Dwight Grizzell.*10.10
    
    Amended and Restated Salary Continuation Agreement, dated
January 19, 2007, by and between Mountain National Bank and
Michael Brown.*10.11
    
    Amendment, dated November 19, 2007, to Amended and Restated
Salary Continuation Agreement, by and between Mountain
National Bank and Michael Brown.*10.12
    
    Amended and Restated Salary Continuation Agreement, dated
January 19, 2007, by and between Mountain National Bank and
Grace McKinzie.*
 57




---



##### Table of Contents



Exhibit No.
    
    Description of Exhibit10.13
    
    Amendment, dated November 19, 2007, to Amended and Restated
Salary Continuation Agreement, by and between Mountain
National Bank and Grace McKinzie.*21
    
    Subsidiaries of the Registrant23
    
    Consent of Independent Registered Public Accounting Firm31.1
    
    Certificate of CEO pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certificate of CFO pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certificate of CEO pursuant to Section 906 of the
Sarbanes-Oxley Act of 200232.2
    
    Certificate of CFO pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
 
 *
    
    Denotes management contract or compensatory plan or arrangement.  58




---



##### Table of Contents



SIGNATURES
  MOUNTAIN NATIONAL BANCSHARES, INC.
(Registrant)By:
    /s/ Dwight B. GrizzellDwight B. GrizzellPresident and Chief Executive OfficerDate: March 31, 2008  /s/ Dwight B. Grizzell

Dwight B. Grizzell, President,
Chief Executive Officer and Director
    
    
    
    Date: March 31, 2008/s/ Richard A. Hubbs

Richard A. Hubbs, Senior Vice President and
Chief Financial Officer
    
    
    
    Date: March 31, 2008/s/ James E. Bookstaff

James E. Bookstaff, Director
    
    
    
    Date: March 31, 2008/s/ Gary A. Helton

Gary A. Helton, Director
    
    
    
    Date: March 31, 2008/s/ Charlie R. Johnson

Charlie R. Johnson, Director
    
    
    
    Date: March 31, 2008/s/ Sam L. Large

Sam L. Large, Director
    
    
    
    Date: March 31, 2008
 59




---



##### Table of Contents



/s/ Jeffrey J. Monson

Jeffrey J. Monson, Director
    
    
    
    Date: March 31, 2008/s/ Linda N. Ogle

Linda N. Ogle, Director
    
    
    
    Date: March 31, 2008/s/ Michael C. Ownby

Michael C. Ownby, Director
    
    
    
    Date: March 31, 2008/s/ John R. Parker

John R. Parker, Director
    
    
    
    Date: March 31, 2008/s/ Ruth Reams

Ruth Reams, Director
    
    
    
    Date: March 31, 2008
 60




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##### Table of Contents



MOUNTAIN NATIONAL BANCSHARES, INC.
AND SUBSIDIARIES
 CONSOLIDATED FINANCIAL REPORT
 DECEMBER 31, 2007




---



##### 



PageREPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
    
    
    F-1CONSOLIDATED FINANCIAL STATEMENTSConsolidated balance sheets
    
    
    F-2Consolidated statements of income
    
    
    F-3Consolidated statements of changes in shareholders equity
    
    
    F-4Consolidated statements of cash flows
    
    
    F-5Notes to consolidated financial statements
    
    
    F-6 - F-38




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
    
 F-1




---



##### Table of Contents



2007
    
    
    2006ASSETSCash and due from banks
    
    $
    13,011,580
    
    
    $
    11,717,179Federal funds sold
    
    
    3,317,000
    
    
    
    1,679,000Total cash and cash equivalents
    
    
    16,328,580
    
    
    
    13,396,179Securities available for sale
    
    
    80,965,512
    
    
    
    74,514,075Securities held to maturity, fair value $2,040,376 in 2007 and $1,577,130 in 2006
    
    
    2,021,327
    
    
    
    1,479,620Restricted investments, at cost
    
    
    3,831,618
    
    
    
    2,621,167Loans, net of allowance for loan losses of $3,974,354 in 2007 and $3,524,374 in 2006
    
    
    393,699,847
    
    
    
    341,184,441Investment in partnership
    
    
    4,095,085
    
    
    
    4,093,228Premises and equipment
    
    
    25,427,243
    
    
    
    19,944,484Accrued interest receivable
    
    
    2,701,402
    
    
    
    2,638,219Cash surrender value of life insurance
    
    
    8,649,793
    
    
    
    8,314,168Other assets
    
    
    3,775,619
    
    
    
    1,796,435Total assets
    
    $
    541,496,026
    
    
    $
    469,982,016LIABILITIES AND SHAREHOLDERS EQUITYDeposits:Noninterest-bearing demand deposits
    
    $
    56,307,457
    
    
    $
    60,015,521NOW accounts
    
    
    87,380,047
    
    
    
    76,069,791Money market accounts
    
    
    42,958,868
    
    
    
    45,666,777Savings accounts
    
    
    8,980,122
    
    
    
    8,274,896Time deposits
    
    
    208,747,717
    
    
    
    171,702,308Total deposits
    
    
    404,374,211
    
    
    
    361,729,293Federal funds purchased
    
    
    1,300,000
    
    
    
    15,575,000Securities sold under agreements to repurchase
    
    
    5,441,515
    
    
    
    5,860,386Accrued interest payable
    
    
    1,240,117
    
    
    
    956,224Subordinated debentures
    
    
    13,403,000
    
    
    
    13,403,000Federal Home Loan Bank advances
    
    
    65,356,418
    
    
    
    36,710,212Other liabilities
    
    
    1,432,312
    
    
    
    1,337,038Total liabilities
    
    
    492,547,573
    
    
    
    435,571,153Commitments
and contingencies (Note 12)Shareholders equity:Common stock, $1.00 par value; 10,000,000 shares authorized; issued and
outstanding 2,499,629 shares at December 31, 2007 and 1,943,428 shares at
December 31, 2006
    
    
    2,499,629
    
    
    
    1,943,428Additional paid-in capital
    
    
    39,426,881
    
    
    
    27,096,848Retained earnings
    
    
    7,300,933
    
    
    
    6,068,324Accumulated other comprehensive loss
    
    
    (278,990
    )
    
    
    (697,737
    )Total shareholders equity
    
    
    48,948,453
    
    
    
    34,410,863Total liabilities and shareholders equity
    
    $
    541,496,026
    
    
    $
    469,982,016
  F-2




---



##### Table of Contents



2007
    
    
    2006
    
    
    2005INTEREST INCOMELoans
    
    $
    32,267,281
    
    
    $
    25,286,787
    
    
    $
    16,545,038Taxable securities
    
    
    3,575,785
    
    
    
    2,947,926
    
    
    
    2,108,720Tax-exempt securities
    
    
    616,277
    
    
    
    529,232
    
    
    
    395,695Federal funds sold and deposits in other banks
    
    
    254,274
    
    
    
    236,900
    
    
    
    174,636Total interest income
    
    
    36,713,617
    
    
    
    29,000,845
    
    
    
    19,224,089INTEREST EXPENSEDeposits
    
    
    15,071,725
    
    
    
    10,773,481
    
    
    
    5,685,712Federal funds purchased
    
    
    213,222
    
    
    
    149,443
    
    
    
    38,563Repurchase agreements
    
    
    157,734
    
    
    
    101,947
    
    
    
    64,165Federal Home Loan Bank advances
    
    
    2,599,215
    
    
    
    1,343,901
    
    
    
    610,943Subordinated debentures
    
    
    986,037
    
    
    
    748,370
    
    
    
    350,152Total interest expense
    
    
    19,027,933
    
    
    
    13,117,142
    
    
    
    6,749,535Net interest income
    
    
    17,685,684
    
    
    
    15,883,703
    
    
    
    12,474,554Provision for loan losses
    
    
    981,900
    
    
    
    915,000
    
    
    
    446,000Net interest income after provision for loan losses
    
    
    16,703,784
    
    
    
    14,968,703
    
    
    
    12,028,554NONINTEREST INCOMEService charges on deposit accounts
    
    
    1,414,005
    
    
    
    1,293,026
    
    
    
    1,141,994Other fees and commissions
    
    
    1,152,851
    
    
    
    1,019,664
    
    
    
    890,742Gain on sale of mortgage loans
    
    
    322,906
    
    
    
    424,536
    
    
    
    400,657Gain on sale of securities available for sale, net
    
    
    
    
    
    
    
    
    
    
    55,378Other noninterest income
    
    
    852,381
    
    
    
    509,173
    
    
    
    187,313Total noninterest income
    
    
    3,742,143
    
    
    
    3,246,399
    
    
    
    2,676,084NONINTEREST EXPENSESalaries and employee benefits
    
    
    8,992,172
    
    
    
    7,542,991
    
    
    
    5,372,600Occupancy expenses
    
    
    1,080,632
    
    
    
    956,688
    
    
    
    851,855Other operating expenses
    
    
    5,166,693
    
    
    
    4,522,713
    
    
    
    3,903,100Total noninterest expense
    
    
    15,239,497
    
    
    
    13,022,392
    
    
    
    10,127,555Income before income taxes
    
    
    5,206,430
    
    
    
    5,192,710
    
    
    
    4,577,083Income taxes
    
    
    1,294,336
    
    
    
    1,295,337
    
    
    
    1,453,581Net income
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502EARNINGS PER SHAREBasic
    
    $
    1.68
    
    
    $
    1.93
    
    
    $
    1.81Diluted
    
    $
    1.61
    
    
    $
    1.79
    
    
    $
    1.69
  F-3




---



##### Table of Contents



AccumulatedAdditional
    
    
    
    
    
    
    Other
    
    
    TotalComprehensive
    
    
    Common
    
    
    Paid-in
    
    
    Retained
    
    
    Comprehensive
    
    
    ShareholdersIncome
    
    
    Stock
    
    
    Capital
    
    
    Earnings
    
    
    Loss
    
    
    EquityBALANCE, January 1, 2005
    
    
    
    
    
    $
    1,268,614
    
    
    $
    12,059,704
    
    
    $
    3,400,852
    
    
    $
    (190,257
    )
    
    
    16,538,913Exercise of stock options, 53,152 shares
    
    
    
    
    
    
    53,152
    
    
    
    674,677
    
    
    
    
    
    
    
    
    
    
    
    727,8295% stock dividend
    
    
    
    
    
    
    63,482
    
    
    
    1,460,720
    
    
    
    (1,540,447
    )
    
    
    
    
    
    
    (16,245
    )Issuance of common stock
    
    
    
    
    
    
    416,500
    
    
    
    9,494,863
    
    
    
    
    
    
    
    
    
    
    
    9,911,363Comprehensive income:Net income
    
    $
    3,123,502
    
    
    
    
    
    
    
    
    
    
    
    3,123,502
    
    
    
    
    
    
    
    3,123,502Other comprehensive income, net of tax:Unrealized holding loss on
securities available for sale, net of
reclassification adjustment
    
    
    (652,354
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (652,354
    )
    
    
    (652,354
    )Total comprehensive income
    
    $
    2,471,148BALANCE, December 31, 2005
    
    
    
    
    
    
    1,801,748
    
    
    
    23,689,964
    
    
    
    4,983,907
    
    
    
    (842,611
    )
    
    
    29,633,008Exercise of stock options, 35,880 shares
    
    
    
    
    
    
    35,880
    
    
    
    296,896
    
    
    
    
    
    
    
    
    
    
    
    332,776Exercise of stock warrants, 14,922 shares
    
    
    
    
    
    
    14,922
    
    
    
    343,206
    
    
    
    
    
    
    
    
    
    
    
    358,1285% stock dividend
    
    
    
    
    
    
    90,878
    
    
    
    2,699,076
    
    
    
    (2,812,956
    )
    
    
    
    
    
    
    (23,002
    )Share-based compensation
    
    
    
    
    
    
    
    
    
    
    67,706
    
    
    
    
    
    
    
    
    
    
    
    67,706Comprehensive income:Net income
    
    $
    3,897,373
    
    
    
    
    
    
    
    
    
    
    
    3,897,373
    
    
    
    
    
    
    
    3,897,373Other comprehensive income, net of tax:Unrealized holding gain on
securities available for sale, net of
reclassification adjustment
    
    
    144,874
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    144,874
    
    
    
    144,874Total comprehensive income
    
    $
    4,042,247BALANCE, December 31, 2006
    
    
    
    
    
    $
    1,943,428
    
    
    $
    27,096,848
    
    
    $
    6,068,324
    
    
    $
    (697,737
    )
    
    $
    34,410,863Exercise of stock options, 32,216 shares
    
    
    
    
    
    
    32,216
    
    
    
    276,473
    
    
    
    
    
    
    
    
    
    
    
    308,689Exercise of stock warrants, 437,896 shares
    
    
    
    
    
    
    437,896
    
    
    
    9,578,237
    
    
    
    
    
    
    
    
    
    
    
    10,016,133Share repurchase program, 10,272 shares
    
    
    
    
    
    
    (10,272
    )
    
    
    (289,967
    )
    
    
    
    
    
    
    
    
    
    
    (300,239
    )5% stock dividend
    
    
    
    
    
    
    96,361
    
    
    
    2,553,567
    
    
    
    (2,679,485
    )
    
    
    
    
    
    
    (29,557
    )Share-based compensation
    
    
    
    
    
    
    
    
    
    
    138,596
    
    
    
    
    
    
    
    
    
    
    
    138,596Tax benefit from exercise of options
    
    
    
    
    
    
    
    
    
    
    73,127
    
    
    
    
    
    
    
    
    
    
    
    73,127Comprehensive income:Net income
    
    $
    3,912,094
    
    
    
    
    
    
    
    
    
    
    
    3,912,094
    
    
    
    
    
    
    
    3,912,094Other comprehensive income, net of tax:Unrealized holding gain on
securities available for sale, net of
reclassification adjustment
    
    
    418,747
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    418,747
    
    
    
    418,747Total comprehensive income
    
    $
    4,330,841BALANCE, December 31, 2007
    
    
    
    
    
    $
    2,499,629
    
    
    $
    39,426,881
    
    
    $
    7,300,933
    
    
    $
    (278,990
    )
    
    $
    48,948,453
  F-4




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##### Table of Contents



2007
    
    
    2006
    
    
    2005CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation
    
    
    1,058,203
    
    
    
    1,016,841
    
    
    
    913,490Net realized gains on securities available for sale
    
    
    
    
    
    
    
    
    
    
    (55,378
    )Net amortization on securities
    
    
    148,110
    
    
    
    219,270
    
    
    
    290,013Activity in held-to-maturity securities:Increase due to accretion
    
    
    (92,419
    )
    
    
    (68,230
    )
    
    
    (53,577
    )Provision for loan losses
    
    
    981,900
    
    
    
    915,000
    
    
    
    446,000Gain on sale of other real estate
    
    
    (271,614
    )
    
    
    (29,095
    )
    
    
    (9,201
    )Deferred income taxes
    
    
    (460,168
    )
    
    
    (302,492
    )
    
    
    (98,247
    )Gross mortgage loans originated for sale
    
    
    (33,096,725
    )
    
    
    (43,014,644
    )
    
    
    (40,599,140
    )Gross proceeds from sale of mortgage loans
    
    
    34,585,892
    
    
    
    42,354,341
    
    
    
    41,683,581Gain on sale of mortgage loans
    
    
    (322,906
    )
    
    
    (424,536
    )
    
    
    (400,657
    )Increase in cash surrender value of life insurance
    
    
    (335,625
    )
    
    
    (307,101
    )
    
    
    (122,672
    )Share-based compensation
    
    
    138,596
    
    
    
    67,706
    
    
    
    Tax benefit from exercise of options
    
    
    (73,127
    )
    
    
    
    
    
    
    Change in operating assets and liabilities:Accrued interest receivable
    
    
    (63,183
    )
    
    
    (1,113,554
    )
    
    
    (483,346
    )Accrued interest payable
    
    
    283,893
    
    
    
    521,883
    
    
    
    208,746Other assets and liabilities
    
    
    (2,283,894
    )
    
    
    (5,237,304
    )
    
    
    5,474,005Net cash provided/(used) in operating activities
    
    
    4,109,027
    
    
    
    (1,504,542
    )
    
    
    10,317,119CASH FLOWS FROM INVESTING ACTIVITIESActivity in available-for-sale securities:Proceeds from sales, maturities, and calls
    
    
    17,602,342
    
    
    
    9,009,587
    
    
    
    18,712,335Purchases
    
    
    (23,783,142
    )
    
    
    (26,581,864
    )
    
    
    (26,908,968
    )Activity in held-to-maturity securities:Purchases
    
    
    (449,288
    )
    
    
    
    
    
    
    (358,930
    )Purchases of other investments
    
    
    (1,210,451
    )
    
    
    (992,299
    )
    
    
    (361,563
    )Investment in partnership
    
    
    (1,857
    )
    
    
    (4,093,228
    )
    
    
    Loan originations and principal collections, net
    
    
    (54,663,567
    )
    
    
    (94,784,688
    )
    
    
    (40,462,915
    )Purchase of premises and equipment
    
    
    (6,540,962
    )
    
    
    (5,310,462
    )
    
    
    (1,683,355
    )Purchase of life insurance
    
    
    
    
    
    
    (192,788
    )
    
    
    (3,760,994
    )Proceeds from sale of other real estate
    
    
    1,204,893
    
    
    
    186,185
    
    
    
    596,194Net cash used in investing activities
    
    
    (67,842,032
    )
    
    
    (122,759,557
    )
    
    
    (54,228,196
    )CASH FLOWS FROM FINANCING ACTIVITIESNet increase in deposits
    
    
    42,644,918
    
    
    
    78,605,503
    
    
    
    38,051,771Proceeds from Federal Home Loan Bank advances
    
    
    60,000,000
    
    
    
    32,250,000
    
    
    
    24,100,000Matured Federal Home Loan Bank advances
    
    
    (31,353,794
    )
    
    
    (18,049,532
    )
    
    
    (11,140,256
    )Net (decrease)/increase in federal funds purchased
    
    
    (14,275,000
    )
    
    
    14,075,000
    
    
    
    (7,125,000
    )Net (decrease)/increase in securities sold under
agreements to repurchase
    
    
    (418,871
    )
    
    
    2,481,380
    
    
    
    529,439Proceeds from issuance of common stock, including warrants and options
    
    
    10,324,822
    
    
    
    690,904
    
    
    
    10,639,191Tax benefit from exercise of options
    
    
    73,127Purchase of common stock
    
    
    (300,239
    )
    
    
    
    
    
    
    Proceeds from issuance of subordinated debentures
    
    
    
    
    
    
    7,732,000
    
    
    
    Cash dividends
    
    
    (29,557
    )
    
    
    (23,002
    )
    
    
    (16,245
    )Net cash provided by financing activities
    
    
    66,665,406
    
    
    
    117,762,253
    
    
    
    55,038,900NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    2,932,401
    
    
    
    (6,501,846
    )
    
    
    11,127,823CASH AND CASH EQUIVALENTS, beginning of year
    
    
    13,396,179
    
    
    
    19,898,025
    
    
    
    8,770,202CASH AND CASH EQUIVALENTS, end of period
    
    $
    16,328,580
    
    
    $
    13,396,179
    
    
    $
    19,898,025SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATIONCash paid for:Interest
    
    $
    18,744,040
    
    
    $
    12,595,260
    
    
    $
    6,540,789Income taxes
    
    
    1,450,000
    
    
    
    1,590,000
    
    
    
    1,677,906Non-cash investing and financing activities:Transfers from loans to other real estate owned
    
    
    1,843,467
    
    
    
    436,185
    
    
    
    
  F-5




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting PoliciesThe accounting and reporting policies of Mountain National Bancshares, Inc. and its
subsidiaries (the Company) conform to generally accepted accounting principles in the
United States of America and practices within the banking industry. The policies that
materially affect financial position and results of operations are summarized as follows:Nature of operations and geographic concentration:The Company is a bank-holding company which owns all of the outstanding common stock of
Mountain National Bank (the Bank). The Bank provides a variety of financial services
through its branch offices located in Sevier and Blount County, Tennessee. The Banks
primary deposit products are demand deposits, savings accounts, and certificates of
deposit. Its primary lending products are commercial loans, real estate loans, and
installment loans.Principles of consolidation:The consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiary. The Companys principal subsidiary is Mountain National Bank. All material
intercompany accounts and transactions have been eliminated in consolidation.Use of estimates:The preparation of financial statements in conformity with generally accepted accounting
principles in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results could differ
from those estimates and such differences could be material to the financial statements.The determination of the adequacy of the allowance for loan losses is based on estimates
that are particularly susceptible to significant changes in the economic environment and
market conditions. In connection with the determination of the estimated losses on loans,
management obtains independent appraisals for significant collateral.The Banks loans are generally secured by specific items of collateral including real
property, consumer assets, and business assets. Although the Bank has a diversified loan
portfolio, a substantial portion of its debtors ability to honor their contracts is
dependent on local economic conditions.
 F-6




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Use of estimates: (continued)Due to the predominance of the tourism industry in Sevier County, a significant portion of
our commercial loan portfolio is concentrated within that industry. The predominance of
the tourism industry also makes our business more seasonal in nature than may be the case
with banks and financial institutions in other market areas.While management uses available information to recognize losses on loans, further
reductions in the carrying amounts of loans may be necessary based on changes in local
economic conditions. In addition, regulatory agencies, as an integral part of their
examination process, periodically review the estimated losses on loans. Such agencies may
advise the Bank to recognize additional losses based on their judgments about information
available to them at the time of their examination. Because of these factors, it is
reasonably possible that the estimated losses on loans may change materially in the near
term. However, the amount of the change that is reasonably possible cannot be estimated.Statements of cash flows:The Company considers all cash and amounts due from depository institutions with
maturities under 90 days and Federal Funds sold to be cash equivalents for purposes of the
statements of cash flows. Net cash flows are reported for customer loan and deposit
transactions, interest bearing deposits in other financial institutions, federal funds
purchased and repurchase agreements.Investment Securities:Debt securities are classified as held to maturity when the Bank has the positive intent
and ability to hold the securities to maturity. Securities held to maturity are carried
at amortized cost.Debt securities not classified as held to maturity are classified as available for sale.
Securities available for sale are carried at fair value with unrealized gains and losses,
net of taxes, reported in other comprehensive income. Realized gains (losses) on
securities available for sale are included in other income (expense) and, when applicable,
are reported as a reclassification adjustment, net of tax, in other comprehensive income.
Realized gains and losses on sales of securities are recorded in noninterest income on the
trade date and are determined on the specific-identification method.The amortization of premiums and accretion of discounts are recognized in interest income
using methods approximating the level- yield method over the period to maturity, without
anticipating prepayments, except for mortgage backed securities where prepayments are
anticipated.
 F-7




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Investment Securities: (continued)Restricted equity securities include common stock of the Federal Home Loan Bank of
Cincinnati, Silverton Bank stock (formerly The Bankers Bank) and Federal Reserve Bank
stock. These securities are carried at cost.Declines in the market value of held to maturity and available for sale securities below
their cost that are deemed to be other than temporary are reflected in earnings as
realized losses. In estimating other than temporary impairment losses, management
considers the length of time and the extent to which the market value has been less than
cost, the financial condition and near-term prospects of the issuer. Any decision by
management to sell a security classified as available for sale would be based on factors
such as, but not limited to, liquidity requirements, changes in pledging requirements or
changes in funding sources and terms.Securities sold under agreements to repurchase:The Bank enters into sales of securities under agreements to repurchase identical
securities the next day.Loans:Loans are stated at unpaid principal balances, less the allowance for loan losses.
Interest income is accrued on the unpaid principal balance.The accrual of interest on real estate and commercial loans is discontinued at the time
the loan is 90 days delinquent unless the credit is well-secured and in process of
collection. Installment loans and other personal loans are typically charged off no later
than 90 days past due. Past due status is based on the contractual terms of the loan. In
all cases, loans are placed on nonaccrual or charged off at an earlier date if collection
of principal or interest is considered doubtful.All interest accrued but not collected for loans that are placed on nonaccrual or charged
off is reversed against interest income. The interest on these loans is accounted for on
the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are
returned to accrual status when all the principal and interest amounts contractually due
are brought current and future payments are reasonably assured.Loans held for sale:Mortgage loans originated and intended for sale in the secondary market are carried at the
lower of aggregate cost or fair value, as determined by outstanding commitments from
investors. Net unrealized losses, if any, are recorded as a valuation allowance and
charged to earnings. Mortgage servicing rights are sold with the related loan. Loans held
 F-8




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Loans held for sale: (continued)for sale totaled $392,596 and $1,558,857 at December 31, 2007 and 2006, respectively, and
are included with loans on the balance sheet.Allowance for loan losses:The allowance for loan losses is maintained at a level which, in managements judgment, is
adequate to absorb credit losses inherent in the loan portfolio. The amount of the
allowance is based on managements evaluation of the collectability of the loan portfolio,
including the nature of the portfolio, credit concentrations, trends in historical loss
experience, specific impaired loans, economic conditions, and other risks inherent in the
portfolio. Allowances for impaired loans are generally determined based on collateral
values or the present value of estimated cash flows. Although management uses available
information to recognize losses on loans, because of uncertainties associated with local
economic conditions, collateral values, and future cash flows on impaired loans, it is
reasonably possible that a material change could occur in the allowance for loan losses in
the near term. However, the amount of the change that is reasonably possible cannot be
estimated. The allowance is increased by a provision for loan losses, which is charged to
expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating
to impaired loans are charged or credited to the provision for loan losses.Loans considered to be impaired are determined under Statement of Financial Accounting
Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan, paragraph
eight. This paragraph states, in part, A loan is impaired when, based on current
information and events, it is probable that a creditor will be unable to collect all
amounts due according to the contractual terms of the loan agreement. The Bank, through
its normal loan review process, determines impairment of loans and records any impaired
loans at the present value of estimated future cash flows using the loans existing rate
or at the fair value of the collateral if the loan is collateral dependent. This loan
review may result in a portion of the allowance for loan losses being allocated to the
loans.Reserve for unfunded commitments:The reserve for unfunded commitments represents the estimate for probable credit losses
inherent in these commitments to extend credit. Unfunded commitments to extend credit
include standby letters of credit and commitments to fund available lines of credit. The
process used to determine the reserve for unfunded commitments is consistent with the
process for determining the allowance for loan losses and the reserve, if any, is included
in other liabilities.
 F-9




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Investment in Partnership:The Bank is a partner in Appalachian Fund for Growth II, LLC with three other Tennessee
banking institutions. This partnership involves a new markets tax credit which is
generated from a tax credit allocation from the Community Development Financial
Institutions Fund (CDFI). The purposes of the partnership are (a) to have the primary
mission of providing investment capital, solely in the form of loans, to low-income
communities in accordance with the NMTC Program and (b) to make loans that are qualified
low-income community investment loans. This partnership is accounted for using the equity
method of accounting.Premises and equipment:Land is carried at cost. Other premises and equipment are carried at cost net of
accumulated depreciation. Depreciation is computed using the straight-line and the
declining balance methods based on the estimated useful lives of the assets. Useful lives
range from three to forty years for premises and improvements, and from three to ten years
for furniture and equipment. Maintenance and repairs are expensed as incurred while major
additions and improvements are capitalized. Gains and losses on dispositions are included
in current operations.Other real estate owned:Real estate properties acquired through or in lieu of loan foreclosure are initially
recorded at the fair value less estimated selling cost at the date of foreclosure. Any
write-downs based on the assets fair value at the date of acquisition are charged to the
allowance for loan losses. Valuations are periodically performed by management, and any
subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the
carrying value of a property to fair value less cost to sell. Other real estate owned also
includes excess Bank property not utilized when subdividing land acquired for the
construction of Bank branches. Costs of significant property improvements are
capitalized. Costs relating to holding property are expensed. Other real estate owned
totaled $1,328,798 and $500,000 at December 31, 2007 and 2006, respectively, and is
included in other assets on the balance sheet.Income taxes:The Company files consolidated federal and state income tax returns with the Bank and its
subsidiaries. Income taxes are provided for the tax effects of the transactions reported
in the financial statements and consist of taxes currently due plus deferred income taxes
related primarily to differences between the basis of the allowance for loan losses and
accumulated depreciation. The deferred tax assets and liabilities represent the future
tax return consequences of those differences, which will either be taxable or deductible
when the assets and liabilities are recovered or settled. Deferred tax assets and
liabilities are
 F-10




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Income taxes: (continued)reflected using enacted income tax rates. As changes in tax laws or rates are enacted,
deferred tax assets and liabilities are adjusted through the provision for income taxes.The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes
(FIN 48), as of January 1, 2007. A tax position is recognized as a benefit only if it is
more likely than not that the tax position would be sustained in a tax examination, with
a tax examination being presumed to occur. The amount recognized is the largest amount
of tax benefit that is greater than 50% likely of being realized on examination. For tax
positions not meeting the more likely than not test, no tax benefit is recorded. The
adoption had no effect on the Companys financial statements.Advertising costs:The Company expenses all advertising costs as incurred. Advertising expense was $455,453,
$342,619 and $229,600 for the years ended December 31, 2007, 2006 and 2005, respectively.
The increase in advertising expense was primarily due to the Banks expansion into the
Blount County market.Company owned life insurance:The Company has purchased life insurance policies on certain key executives. Company owned
life insurance is recorded at its cash surrender value, or the amount that can be
realized.In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4,
Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement
Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded
during the service period when a split-dollar life insurance agreement continues after
participants employment or retirement. The required accrued liability will be based on
either the post-employment benefit cost for the continuing life insurance or based on the
future death benefit depending on the contractual terms of the underlying agreement. This
issue is effective for fiscal years beginning after December 15, 2007. The impact of
adoption was not material.In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5,
Accounting for Purchases of Life Insurance  Determining the Amount That Could Be
Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of
Life Insurance)(EITF 06-5). This Issue requires that a policyholder consider
contractual terms of a life insurance policy in determining the amount that could be
realized under the insurance contract. It also requires that if the contract provides for
a
 F-11




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Company owned life insurance: (continued)greater surrender value if all individual policies in a group are surrendered at the same
time, that the surrender value be determined based on the assumption that policies will be
surrendered on an individual basis. Lastly, the Issue requires disclosure when there are
contractual restrictions on the Companys ability to surrender a policy. The adoption of
EITF 06-5 on January 1, 2007 had no impact on the Companys financial condition or results
of operation.Long-term assets:Premises and equipment and other long-term assets are reviewed for impairment when events
indicate their carrying amount may not be recoverable from future undiscounted cash flows.
If impaired, the assets are recorded at fair value.Loan commitments and related financial instruments:Financial instruments include off-balance sheet credit instruments, such as commitments to
make loans and commercial letters of credit, issued to meet customer financing needs. The
face amount for these items represents the exposure to loss, before considering customer
collateral or ability to repay. Such financial instruments are recorded when they are
funded.Retirement plans:Employee 401(k) and profit sharing plan expense is the amount of matching contributions
made by the Company pursuant to the Companys 401(k) benefit plan. Deferred compensation
and supplemental retirement plan expense allocates the benefits over years of service.Earnings per common share:Basic earnings per common share is net income divided by the weighted average number of
common shares outstanding during the period. Diluted earnings per common share includes
the dilutive effect of additional potential common shares issuable under stock options and
stock warrants. Earnings and dividends per share are restated for all stock splits and
dividends through the date of issue of the financial statements.Comprehensive income:Comprehensive income consists of net income and other comprehensive income. Other
comprehensive income includes unrealized gains and losses on securities available for
sale, which is also recognized as a separate component of equity.
 F-12




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Loss contingencies:Loss contingencies, including claims and legal actions arising in the ordinary course of
business, are recorded as liabilities when the likelihood of loss is probable and an
amount or range of loss can be reasonably estimated. Management does not believe there are
now such matters that will have a material effect on the financial statements.Restrictions on cash:Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory
reserve and clearing requirements. These balances do not earn interest.Equity:Stock dividends in excess of 20% are reported by transferring the par value of the stock
issued from retained earnings to common stock. Stock dividends for 20% or less are
reported by transferring the fair value, as of the ex-dividend date, of the stock issued
from retained earnings to common stock and additional paid-in capital. Fractional share
amounts are paid in cash with a reduction in retained earnings.Dividend restriction:Banking regulations require maintaining certain capital levels and may limit the dividends
paid by the bank to the holding company or by the holding company to shareholders. (See
Note 15  Regulatory Matters for more specific disclosure.)Reclassifications:Certain amounts reported in the 2005 and 2006 financial statements have been reclassified
to conform to the 2007 presentation.Stock-based compensation:At December 31, 2007, the Company has a stock-based compensation plan, which is described
more fully in Note 14  Stock Options and Warrants. The Company adopted the recognition
and measurement principles of SFAS No. 123 (R), Share-Based Payment (SFAS 123(R)) on
January 1, 2006, using the modified prospective transition method. Under this method,
stock-based awards that are granted, modified, or settled after December 31, 2005, are
measured and accounted for in accordance with SFAS 123 (R). Expense is recognized for
unvested awards that were granted prior to January 1, 2006 based upon the fair value
determined at the grant date under SFAS 123, Accounting for Stock-Based Compensation.
(SFAS 123) The effect of adopting this accounting pronouncement reduced 2006 pre-tax
income by $67,706 and $53,961, net of taxes. Basic and diluted earnings per share
decreased by $0.03 and $0.02 for 2006, respectively.
 F-13




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##### Table of Contents



Note 1.
    
    Summary of Significant Accounting Policies (continued)Stock-based compensation: (continued)Prior to the adoption of SFAS 123 (R), the Company applied the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations in accounting for the plan. No stock-based employee compensation was
reflected in net income as all options granted under this plan had an exercise price equal
to or above the market value of the underlying common stock on the date of the grant. The
following table illustrates the effect on net income and earnings per share as if the
Company had applied the fair value recognition provisions of SFAS 123 to stock-based
employee compensation for the year ended December 31, 2005.
 2005Net income, as reported
    
    $
    3,123,502Effect of stock-based employee compensation
expense determined under fair value method
for all awards, net of the related tax effects
    
    
    (79,518
    )Pro forma net income
    
    $
    3,043,984Earnings per share:Basic-as reported
    
    $
    1.81Basic-pro forma
    
    $
    1.76Diluted-as reported
    
    $
    1.69Diluted-pro forma
    
    $
    1.65
 Segment reporting:SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS
131) provides for the identification of reportable segments on the basis of discreet
business units and their financial information to the extent such units are reviewed by an
entitys chief decision maker (which can be an individual or group of management persons).
SFAS 131 permits aggregation or combination of segments that have similar characteristics.
In the Companys operations, each branch is viewed by management as being a separately
identifiable business or segment from the perspective of monitoring performance and
allocation of financial resources. Although the branches operate independently and are
managed and monitored separately, each is substantially similar in terms of business
focus, type of customers, products and services. Accordingly, the Companys consolidated
financial statements reflect the presentation of segment information on an aggregated
basis in one reportable segment.
 F-14




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##### Table of Contents



Note 2.
    
    SecuritiesSecurities have been classified in the balance sheet according to managements intent as
securities held to maturity or securities available for sale. The amortized cost and
approximate fair value of securities at December 31, 2007 and 2006 are as follows:
 2007Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueSecurities available for sale:U.S. Government
securities
    
    $
    247,708
    
    
    $
    1,902
    
    
    $
    
    
    
    $
    249,610U.S. Government
agencies
    
    
    8,880,411
    
    
    
    48,892
    
    
    
    (592
    )
    
    
    8,928,711Obligations of states and
political subdivisions
    
    
    13,833,607
    
    
    
    42,239
    
    
    
    (64,000
    )
    
    
    13,811,846Mortgage-backed
securities
    
    
    58,451,192
    
    
    
    183,853
    
    
    
    (659,700
    )
    
    
    57,975,345$
    81,412,918
    
    
    $
    276,886
    
    
    $
    (724,292
    )
    
    $
    80,965,512Securities held to maturity:Obligations of states and
political subdivisions
    
    $
    2,021,327
    
    
    $
    34,490
    
    
    $
    (15,441
    )
    
    $
    2,040,376
 2006Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    ValueSecurities available for sale:U.S. Government
securities
    
    $
    244,804
    
    
    $
    
    
    
    $
    (1,757
    )
    
    $
    243,047U.S. Government
agencies
    
    
    9,373,006
    
    
    
    15,888
    
    
    
    (97,387
    )
    
    
    9,291,507Obligations of states and
political subdivisions
    
    
    13,661,394
    
    
    
    19,863
    
    
    
    (69,533
    )
    
    
    13,611,724Mortgage-backed
securities
    
    
    52,192,757
    
    
    
    120,799
    
    
    
    (945,759
    )
    
    
    51,367,797$
    75,471,961
    
    
    $
    156,550
    
    
    $
    (1,114,436
    )
    
    $
    74,514,075Securities held to maturity:Obligations of states and
political subdivisions
    
    $
    1,479,620
    
    
    $
    97,510
    
    
    $
    
    
    
    $
    1,577,130
 F-15




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##### Table of Contents



Note 2.
    
    Securities (continued)Securities with unrealized losses at December 31, 2007 and 2006, aggregated by investment
category and length of time that individual securities have been in a continuous
unrealized loss position, are as follows:
 December 31, 2007:
 Less than 12 Months
    
    
    12 Months or More
    
    
    TotalFair
    
    
    Unrealized
    
    
    Fair
    
    
    Unrealized
    
    
    Fair
    
    
    UnrealizedDescription of Securties
    
    Value
    
    
    Loss
    
    
    Value
    
    
    Loss
    
    
    Value
    
    
    LossU. S. Government
agencies
    
    $
    
    
    
    $
    
    
    
    $
    998,440
    
    
    $
    (592
    )
    
    $
    998,440
    
    
    $
    (592
    )Obligations of states and
political subdivisions
    
    
    4,406,227
    
    
    
    (59,279
    )
    
    
    1,595,476
    
    
    
    (20,162
    )
    
    
    6,001,703
    
    
    
    (79,441
    )Mortgage-backed
securities
    
    
    3,009,017
    
    
    
    (30,117
    )
    
    
    30,736,827
    
    
    
    (629,583
    )
    
    
    33,745,844
    
    
    
    (659,700
    )Total temporarily impaired
    
    $
    7,415,244
    
    
    $
    (89,396
    )
    
    $
    33,330,743
    
    
    $
    (650,337
    )
    
    $
    40,745,987
    
    
    $
    (739,733
    )
 As a result, the Company does not believe that gross unrealized losses as of December 31,
2007 represent an other-than-temporary impairment.
 F-16




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##### Table of Contents



Note 2.
    
    Securities (continued)Unrealized losses on obligations of states and political subdivisions and mortgage-backed
securities have not been recognized into income because the issuer(s) bonds are of high
credit quality (rated AA or higher), management has the intent and ability to hold for the
foreseeable future, as discussed below, and the decline in fair value is largely due to
changes in interest rates. The fair value is expected to recover as the securities
approach maturity.
 December 31, 2006:
 Less than 12 Months
    
    
    12 Months or More
    
    
    TotalFair
    
    
    Unrealized
    
    
    Fair
    
    
    Unrealized
    
    
    Fair
    
    
    UnrealizedDescription of Securties
    
    Value
    
    
    Loss
    
    
    Value
    
    
    Loss
    
    
    Value
    
    
    LossU. S. Government
securities
    
    $
    243,047
    
    
    $
    (1,757
    )
    
    $
    
    
    
    $
    
    
    
    $
    243,047
    
    
    $
    (1,757
    )U. S. Government
agencies
    
    
    995,625
    
    
    
    (449
    )
    
    
    6,315,413
    
    
    
    (96,938
    )
    
    
    7,311,038
    
    
    
    (97,387
    )Obligations of states and
political subdivisions
    
    
    5,108,969
    
    
    
    (23,492
    )
    
    
    3,407,529
    
    
    
    (46,041
    )
    
    
    8,516,498
    
    
    
    (69,533
    )Mortgage-backed
securities
    
    
    9,274,782
    
    
    
    (38,301
    )
    
    
    33,134,818
    
    
    
    (907,458
    )
    
    
    42,409,600
    
    
    
    (945,759
    )Total temporarily impaired
    
    $
    15,622,423
    
    
    $
    (63,999
    )
    
    $
    42,857,760
    
    
    $
    (1,050,437
    )
    
    $
    58,480,183
    
    
    $
    (1,114,436
    )
 The gross unrealized losses reported for mortgage-backed securities relate primarily to
investment securities issued by the Federal National Mortgage Association, Federal Home
Loan Mortgage Corporation, and state and local municipalities. Total gross unrealized
losses, which represent 0.89% of the amortized cost basis of the Companys total
investment securities, were primarily attributable to changes in interest rates and not
due to the credit quality of the investment securities. The Banks dependence upon its investment portfolio to provide
liquidity during certain periods could, on occasion, create the need to sell an investment
security at a price below cost. However, the Company has both the
intent and ability to hold the investment securities for a period of time necessary to
recover the amortized cost.At December 31, 2007 and 2006, securities with a carrying value of approximately
$60,949,000 and $57,336,000, respectively, were pledged to secure public deposits and for
other purposes required or permitted by law. At December 31, 2007 and 2006, the carrying
amount of securities pledged to secure repurchase agreements was approximately $7,757,000
and $7,673,000, respectively.
 The amortized cost and estimated fair value of securities at December 31, 2007, by
contractual maturity, are shown below. Expected maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
 Securities Available for Sale
    
    
    Securities Held to MaturityAmortized
    
    
    Fair
    
    
    Amortized
    
    
    FairCost
    
    
    Value
    
    
    Cost
    
    
    ValueDue in one year or less
    
    $
    558,666
    
    
    $
    561,109
    
    
    $
    
    
    
    $
    Due more than one year
through five years
    
    
    3,902,333
    
    
    
    3,923,878
    
    
    
    
    
    
    
    Due more than five years
through ten years
    
    
    6,113,104
    
    
    
    6,128,356
    
    
    
    
    
    
    
    Due after ten years
    
    
    12,387,623
    
    
    
    12,376,824
    
    
    
    2,021,327
    
    
    
    2,040,376Mortgage-backed
securities
    
    
    58,451,192
    
    
    
    57,975,345
    
    
    
    
    
    
    
    $
    81,412,918
    
    
    $
    80,965,512
    
    
    $
    2,021,327
    
    
    $
    2,040,376
 F-17




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##### Table of Contents



Note 2.
    
    Securities (continued)Proceeds from the sale of securities available for sale were $0 for 2007 and 2006 and
$15,403,878 for 2005. Gross gains realized on those sales were $0 in 2007 and 2006 and
$61,255 in 2005. Gross losses on those sales were $0 in 2007 and 2006 and $5,877 in 2005.We did not hold any securities from a single issuer that exceeded 10% of total
shareholders equity as of December 31, 2007, except for securities of the U.S. Government
or U.S. Government agencies and except for mortgage-backed securities
issued by government sponsored entities that had a carrying value of
approximately $57,975,000 and $51,368,000 at December 31, 2007 and
2006, respectively.Note 3.
    
    Loans and Allowance for Loan Losses
  2007
    
    
    2006Mortgage loans on real estate:Residential 1-4 family
    
    $
    57,539,569
    
    
    $
    50,042,141Residential multifamily
    
    
    4,554,549
    
    
    
    4,505,251Commercial
    
    
    107,652,176
    
    
    
    92,814,521Construction
    
    
    150,843,738
    
    
    
    137,988,968Second mortgages
    
    
    4,712,743
    
    
    
    3,545,056Equity lines of credit
    
    
    26,551,874
    
    
    
    22,178,562351,854,649
    
    
    
    311,074,499Commercial loans
    
    
    35,929,294
    
    
    
    26,062,248Consumer installment loans:Personal
    
    
    7,863,684
    
    
    
    5,750,604Credit cards
    
    
    2,026,574
    
    
    
    1,821,4649,890,258
    
    
    
    7,572,068Total loans
    
    
    397,674,201
    
    
    
    344,708,815Less: Allowance for loan losses
    
    
    (3,974,354
    )
    
    
    (3,524,374
    )Loans, net
    
    $
    393,699,847
    
    
    $
    341,184,441
 F-18




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##### Table of Contents



Note 3.
    
    Loans and Allowance for Loan Losses (continued)A summary of transactions in the allowance for loan losses for the years ended December
31, 2007, 2006 and 2005 is as follows:
 2007
    
    
    2006
    
    
    2005Balance, beginning of year
    
    $
    3,524,374
    
    
    $
    2,634,175
    
    
    $
    2,280,554Provision for loan losses
    
    
    981,900
    
    
    
    915,000
    
    
    
    446,000Loans charged-off
    
    
    (561,315
    )
    
    
    (48,957
    )
    
    
    (108,904
    )Recoveries of loans previously charged-off
    
    
    29,395
    
    
    
    24,156
    
    
    
    16,525Balance, end of year
    
    $
    3,974,354
    
    
    $
    3,524,374
    
    
    $
    2,634,175
 The Banks only significant concentration of credit at December 31, 2007 occurred in real
estate loans, which totaled approximately $351,855,000. While real estate loans accounted
for 88% of total loans, these loans were primarily residential mortgage loans, commercial
loans secured by commercial properties and consumer loans. A large portion of these loans
are for construction, land acquisition and development. Substantially all real estate
loans are secured by properties located in Tennessee.
Loans to executive officers, principal shareholders, and directors and their affiliates
were approximately $16,108,000 and $12,176,000 at December 31, 2007 and 2006,
respectively. For the year ended December 31, 2007, the activity in these loans included
new borrowings approximately of $7,520,000 and repayments of approximately $3,588,000.Individually impaired loans were as follows:
 2007
    
    2006Year-end loans with allocated allowance for loan losses
    
    $
    368,164
    
    
    $
    1,677,832Allowance for loan losses on impaired loans
    
    
    222,691
    
    
    
    235,400Average of individually impaired loans during the year
    
    
    625,973
    
    
    
    1,543,670Nonperforming loans were as follows:
 2007
    
    2006Loans past due over 90 days still on accrual
    
    $
    18,806
    
    
    $
    470,162Nonaccrual loans
    
    
    178,579
    
    
    
    
 F-19




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##### Table of Contents



Note 3.
    
    Loans and Allowance for Loan Losses (continued)Nonperforming loans includes both smaller balance homogeneous loans that are collectively
evaluated for impairment and individually classified as impaired loans.Impaired loans without a valuation allowance were insignificant in relation to the Banks
loan portfolio at December 31, 2007 and 2006.Interest income recognized, on both an accrual and cash basis, on impaired loans was
insignificant to total interest income on loans for each of the years ended December 31,
2007, 2006 and 2005.Note 4.
    
    Bank Premises and EquipmentA summary of Bank premises and equipment at December 31, 2007 and 2006, is as follows:
 2007
    
    
    2006Land
    
    $
    9,424,151
    
    
    $
    7,952,709Buildings and improvements
    
    
    14,919,662
    
    
    
    10,772,349Furniture, fixtures and equipment
    
    
    6,136,612
    
    
    
    5,380,97530,480,425
    
    
    
    24,106,033Accumulated depreciation
    
    
    (5,053,182
    )
    
    
    (4,161,549
    )$
    25,427,243
    
    
    $
    19,944,484
 Depreciation expense for the years ended December 31, 2007, 2006 and 2005 amounted to
$1,058,203, $1,016,841 and $913,490, respectively.At December 31, 2007 and 2006, construction in process totaled $1,742,754 and $1,650,
respectively, and is included in the buildings and improvements line item above. At
December 31, 2007, the balance consisted primarily of costs associated with the
construction of our Collier Drive and Justice Center branches. The balance also included
costs associated with the construction of our Blount County Regional Headquarters and
Operations Center expansion.
 F-20




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##### Table of Contents



Note 5.
    
    DepositsThe aggregate amount of time deposits in denominations of $100,000 or more at December 31,
2007, was approximately $137,138,000.At December 31, 2007, the scheduled maturities of time deposits for each of the five years
subsequent to December 31, 2007 were as follows:
 2008
    
    $
    167,294,4512009
    
    
    23,269,6832010
    
    
    7,880,2852011
    
    
    6,805,0942012
    
    
    3,498,204Total
    
    $
    208,747,717
 Deposits of employees, officers and directors totaled approximately $9,063,000 at December
31, 2007 and $11,412,000 at December 31, 2006.Note 6.
    
    Income TaxesIncome tax expense in the statements of income for the years ended December 31, 2007, 2006 and 2005, consists of the following:
 2007
    
    
    2006
    
    
    2005Current tax expense
    
    $
    1,754,504
    
    
    $
    1,597,829
    
    
    $
    1,551,828Deferred tax expense (benefit)
    
    
    (460,168
    )
    
    
    (302,492
    )
    
    
    (98,247
    )Income Tax expense
    
    $
    1,294,336
    
    
    $
    1,295,337
    
    
    $
    1,453,581
 F-21




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##### Table of Contents



Note 6.
    
    Income Taxes (continued)Income tax expense differs from amounts computed by applying the Federal income tax
statutory rates of 34% in 2007, 2006 and 2005 to income before income taxes. A
reconciliation of the differences for the twelve months ended December 31, 2007, 2006 and
2005 is as follows:
 2007
    
    
    2006
    
    
    2005Expected tax at statutory rates
    
    $
    1,770,000
    
    
    $
    1,766,000
    
    
    $
    1,556,000Increase (decrease) resulting from tax effect of:State income taxes, net of federal tax
    
    
    (94,889
    )
    
    
    (97,308
    )
    
    
    28,973Increase in cash surrender value of life insurance
    
    
    (114,113
    )
    
    
    (104,414
    )
    
    
    (41,700
    )Tax exempt interest
    
    
    (200,153
    )
    
    
    (178,324
    )
    
    
    (134,000
    )General business credits, net of basis reduction
    
    
    (132,000
    )
    
    
    (132,000
    )
    
    
    Other
    
    
    65,491
    
    
    
    41,383
    
    
    
    44,308Income tax expense
    
    $
    1,294,336
    
    
    $
    1,295,337
    
    
    $
    1,453,581
 Significant components of the Companys deferred tax assets and liabilities at December
31, 2007 and 2006, were as follows:
 2007
    
    
    2006Deferred tax assets:Allowance for loan losses
    
    $
    1,254,945
    
    
    $
    1,055,168Deferred compensation
    
    
    203,238
    
    
    
    121,653Unrealized loss on securities available for sale
    
    
    168,417
    
    
    
    260,150Net operating loss
    
    
    138,250
    
    
    
    Other
    
    
    114,046
    
    
    
    86,817Total deferred tax assets
    
    
    1,878,896
    
    
    
    1,523,788Deferred tax liabilities:Accelerated depreciation
    
    
    (371,932
    )
    
    
    (458,602
    )Income from subsidiary
    
    
    (225,682
    )
    
    
    (226,433
    )Investment in partnership
    
    
    (136,227
    )
    
    
    Other
    
    
    (118,721
    )
    
    
    (180,854
    )Total deferred tax liabilities
    
    
    (852,562
    )
    
    
    (865,889
    )Total deferred tax assets
    
    $
    1,026,334
    
    
    $
    657,899
 F-22




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##### Table of Contents



Note 6.
    
    Income Taxes (continued)The Bank has a Tennessee net operating loss carryforward of approximately $1,590,000 which
will expire in 2021 and $1,630,000 which will expire in 2022 if not offset by future
taxable income.The Company currently has no unrecognized tax benefits that, if recognized, would
favorably affect the effective income tax rate in future periods. The Company does not
expect any unrecognized tax benefits to significantly increase or decrease in the next
twelve months. It is the Companys policy to recognize any interest accrued related to
unrecognized tax benefits in interest expense, with any penalties recognized as operating
expenses.The Company and its subsidiaries are subject to U.S. federal income tax as well as income
tax of the state of Tennessee. The Company is no longer subject to examination by taxing
authorities for tax years before 2004.Note 7.
    
    Federal Home Loan Bank AdvancesThe Bank has an agreement with the Federal Home Loan Bank of Cincinnati (FHLB) that
provides short-term and long-term funding to the Bank in an amount up to $100,000,000. The
Banks portfolio of one to four single-family mortgages, commercial real estate, home
equity lines of credit, multi-family mortgages and junior mortgages have been pledged as
collateral for any advances based upon an agreement requiring a collateral-to-loan ratio
of 125%, 300%, 300%, 125% and 350%, respectively. Maturities of the notes payable for each
of the years subsequent to December 31, 2007 are as follows: $7,456,418 in 2008, $0 in
2009, $200,000 in 2010, $7,500,000 in 2011, $5,200,000 in 2012, $5,000,000 in 2014, and
$40,000,000 in 2017. These advances are subject to prepayment penalties that vary
according to the type of advance.
 FHLB advances consisted of the following at December 31:
    
    2007
    
    
    2006Short-term advance requiring monthly interest payments
at 5.34% variable, principal due in January 2007
    
    
    
    
    
    
    4,250,000Short-term advance requiring monthly interest payments
at 5.34% variable, principal due in January 2007
    
    
    
    
    
    
    1,000,000Long-term advance requiring monthly interest payments
at 5.43% fixed, principal due in November 2007
    
    
    
    
    
    
    7,000,000Long-term advance requiring monthly interest payments
at 4.47% fixed, principal due in December 2012
    
    
    200,000
    
    
    
    200,000Long-term advance requiring monthly interest payments
at 4.32% fixed, principal due in June 2010
    
    
    200,000
    
    
    
    200,000Long-term advance requiring monthly interest payments
at 4.83% fixed, principal due in October 2008
    
    
    3,000,000
    
    
    
    3,000,000
 F-23




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##### Table of Contents



Note 7.
    
    Federal Home Loan Bank Advances (continued)
 FHLB advances consisted of the following at December 31:
    
    2007
    
    
    2006Long-term advance requiring monthly principal and interest
payments at 4.20% fixed, remaining principal due in July 2008
    
    
    1,756,418
    
    
    
    1,860,212Long-term advance requiring monthly interest payments
at 4.15% fixed, principal due in June 2008
    
    
    2,500,000
    
    
    
    2,500,000Long-term advance requiring monthly interest payments
at 4.12% fixed, principal due in June 2008
    
    
    200,000
    
    
    
    200,000Long-term advance requiring monthly interest payments
at 4.84% fixed, principal due in December 2007
    
    
    
    
    
    
    2,500,000Long-term advance requiring monthly interest payments
at 4.06% fixed, principal due in June 2007
    
    
    
    
    
    
    2,500,000Long-term advance requiring monthly interest payments
at 5.80% variable, principal due in March 2007
    
    
    
    
    
    
    4,000,000Long-term callable advance requiring monthly interest payments
at 4.39% fixed, principal due in November 2011
    
    
    7,500,000
    
    
    
    7,500,000Long-term callable advance requiring monthly interest payments
at 4.25% fixed, principal due in January 2017
    
    
    10,000,000
    
    
    
    Long-term callable advance requiring monthly interest payments
at 4.15% fixed, principal due in April 2017
    
    
    10,000,000
    
    
    
    Long-term callable advance requiring monthly interest payments
at 4.27% fixed, principal due in May 2017
    
    
    10,000,000
    
    
    
    Long-term callable advance requiring monthly interest payments
at 4.68% fixed, principal due in June 2017
    
    
    10,000,000
    
    
    
    Long-term callable advance requiring monthly interest payments
at 3.36% fixed, principal due in December 2012
    
    
    5,000,000
    
    
    
    Long-term callable advance requiring monthly interest payments
at 3.46% fixed, principal due in December 2014
    
    
    5,000,000
    
    
    
    $
    65,356,418
    
    
    $
    36,710,212
 Note 8.
    
    Subordinated DebenturesOn November 7, 2003, we established MNB Capital Trust I and on June 9, 2006, we established MNB
Capital Trust II (Trust I and Trust II or collectively, the Trusts). Both are wholly-owned
statutory business trusts. The Company is the sole sponsor of the Trusts and acquired each Trusts
common securities for $171,000 and $232,000, respectively. The Trusts were created for the
exclusive purpose of issuing 30-year capital trust preferred securities (Trust Preferred
Securities) in the aggregate amount of $5,500,000 for Trust I and $7,500,000 for Trust II and
using the proceeds to acquire junior subordinated debentures (Subordinated Debentures) issued by
the Company. The sole assets of the Trusts are the Subordinated Debentures. The Companys aggregate
$403,000
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##### Table of Contents



Note 8.
    
    Subordinated Debentures (continued)investment in the Trusts is included in other assets in the accompanying consolidated balance
sheets and the $13,403,000 obligation of the Company is reflected as subordinated debt.The Trust I Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR
and was 8.279% at December 31, 2007 which is set each quarter and mature on December 31, 2033. The
Trust II Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR
and was 6.843% at December 31, 2007 which is set each quarter and mature on July 7, 2036.
Distributions are payable quarterly. The Trust Preferred Securities are subject to mandatory
redemption upon repayment of the Subordinated Debentures at their stated maturity date or their
earlier redemption in an amount equal to their liquidation amount plus accumulated and unpaid
distributions to the date of redemption. The Company guarantees the payment of distributions and
payments for redemption or liquidation of the Trust Preferred Securities to the extent of funds
held by the Trusts. The Companys obligations under the Subordinated Debentures together with the
guarantee and other back-up obligations, in the aggregate, constitute a full and unconditional
guarantee by the Company of the obligations of the Trusts under the Trust Preferred Securities.The Subordinated Debentures are unsecured, bear interest at a rate equal to the rates paid by the
Trusts on the Trust Preferred Securities and mature on the same dates as those noted above for the
Trust Preferred Securities. Interest is payable quarterly. The Company may defer the payment of
interest at any time for a period not exceeding 20 consecutive quarters provided that deferral
period does not extend past the stated maturity. During any such deferral period, distributions on
the Trust Preferred Securities will also be deferred and the Companys ability to pay dividends on
its common shares will be restricted.Subject to approval by the Federal Reserve Bank of Atlanta, if then required, the Trust Preferred
Securities may be redeemed prior to maturity at the Companys option on or after December 31, 2008,
for Trust I and on or after July 7, 2011, for Trust II. The Trust Preferred Securities may also be
redeemed at any time in whole (but not in part) in the event of unfavorable changes in laws or
regulations that result in (1) the Trusts becoming subject to federal income tax on income received
on the Subordinated Debentures, (2) interest payable by the Company on the Subordinated Debentures
becoming non-deductible for federal tax purposes, (3) the requirement
for the Trusts to register under the Investment Company Act of 1940, as amended, or (4) loss of the
ability to treat the Trust Preferred Securities as Tier 1 capital under the Federal Reserve
capital adequacy guidelines.The Companys investments in Trust I and Trust II are included in other assets. These investments
are accounted for under the equity method and consist of 100% of the common stock of Trust I and
Trust II.Note 9.
    
    Securities Sold under Agreements to RepurchaseSecurities sold under agreements to repurchase are variable rate
financing arrangements with no fixed maturity. Upon cancellation
of the agreement, the securities underlying the agreements are
returned to the Company. Information concerning securities sold
under agreements to repurchase is summarized as follows:
 2007
    
    2006Weighted average borrowing rate at year-end
    
    
    2.72
    %
    
    
    2.67
    %Weighted average borrowing rate during the year
    
    
    2.71
    %
    
    
    2.13
    %Average daily balance during the year
    
    
    5,815,161
    
    
    
    4,778,705Maximum month-end balance during the year
    
    
    8,602,461
    
    
    
    6,889,703Balance at year-end
    
    $
    5,441,515
    
    
    $
    5,860,386
 Note 10.
    
    Employee Benefit PlansThe Bank sponsors a 401(k) employee benefit plan covering substantially all employees who
have completed at least six months of service and met minimum age requirements. The
Banks contribution to the plan is discretionary and was $127,580 for 2007, $93,932 for
2006 and $72,876 for 2005.The Company also has salary continuation agreements in place with certain key officers.
Such agreements are structured with differing benefits based on the participants overall
position and responsibility. These agreements provide the participants with a supplemental
income upon retirement at age 65, additional incentive to remain with the Company in order
to receive these deferred retirement benefits and a compensation package that is
competitive in the market. These agreements vest over a ten year period, require a minimum
number of years service and contain change of control provisions. All benefits would cease
in the event of termination for cause, and if the participants employment were to end due
to disability, voluntary termination or termination without cause, the participant would
be entitled to receive certain reduced benefits based on vesting and other conditions.The estimated cost of this obligation is being accrued over the service period for each
officer. The Company recognized expense of $213,071, $159,969 and $48,444 during 2007,
2006 and 2005, respectively, related to these agreements. The total amount accrued at
December 31, 2007, 2006 and 2005 was $530,786, $317,715 and $157,746, respectively.
 F-25




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##### Table of Contents



Note 11.
    
    LeasesThe Bank is leasing the land on which its Gatlinburg branch is located under a
noncancelable lease agreement that expires in 2013. This lease agreement contains renewal
options for twelve additional five-year terms.During 2007, the Bank entered into a long-term lease agreement for land in Blount County,
Tennessee. The lease agreement expires in 2013 and contains renewal options for six
additional five-year terms. The Bank is constructing its Justice Center branch on this
property with an anticipated completion date during the third quarter of 2008.In addition, the Bank is leasing the building in which its Gatlinburg walk-up facility is
located and the property on which it has placed certain automated teller machines. These
leases expire at various dates through 2010 and contain various renewal options. Total
rental expense under all operating leases was $152,240 in 2007, $109,549 in 2006 and
$103,717 in 2005.The following is a schedule by years of future minimum rental payments required under
operating leases that have initial or remaining noncancelable lease terms in excess of one
year as of December 31, 2007:
 2008
    
    $
    167,9322009
    
    
    148,3182010
    
    
    129,1492011
    
    
    101,7452012
    
    
    103,369Thereafter
    
    
    78,270Total
    
    $
    728,783
 Note 12.
    
    Financial Instruments with Off-Balance-Sheet RiskIn the normal course of business, the Bank has outstanding commitments and contingent
liabilities, such as commitments to extend credit and standby letters of credit, which are
not included in the accompanying financial statements. The Banks exposure to credit loss
in the event of nonperformance by the other party to the financial instruments for
commitments to extend credit and standby letters of credit is represented by the
contractual or notional amount of those instruments. The Bank uses the same credit
policies in making such commitments as it does for instruments that are included in the
balance sheet. At December 31, 2007, commitments under standby letters of credit and
undisbursed loan commitments aggregated approximately $131,299,000
substantially all of which are carried at variable rates.Commitments to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee. Since many
of the commitments are expected to expire without being drawn upon, the total commitment
amounts do not necessarily represent future cash requirements. The Bank
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##### Table of Contents



Note 12.
    
    Financial Instruments with Off-Balance-Sheet Risk (continued)evaluates each customers creditworthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on
managements credit evaluation. Collateral held varies but may include accounts
receivable, inventory, property and equipment, and income-producing commercial properties.Standby letters of credit are conditional commitments issued by the Bank to guarantee the
performance of a customer to a third party. Standby letters of credit generally have fixed
expiration dates or other termination clauses and may require payment of a fee. The credit
risk involved in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers. The Banks policy for obtaining collateral, and
the nature of such collateral, is essentially the same as that involved in making
commitments to extend credit.The Bank was not required to perform on any financial guarantees and did not incur any
losses on its commitments during 2007, 2006 or 2005.Note 13.
    
    Fair Value of Financial InstrumentsFair value estimates are made at a specific point in time, based on relevant market
information about the financial instrument. These estimates do not reflect any premium or
discount that could result from offering for sale at one time the Companys entire
holdings of a particular financial instrument. Because no market exists for a significant
portion of the Companys financial instruments, fair value estimates are based on
judgments regarding future expected loss experience, current economic conditions, risk
characteristics of various financial instruments, and other factors. These estimates are
subjective in nature; involve uncertainties and matters of judgment; and, therefore,
cannot be determined with precision. Changes in assumptions could significantly affect
the estimates. Accordingly, the aggregate fair value amounts presented are not intended to
represent the underlying value of the Company.Fair value estimates are based on existing financial instruments without attempting to
estimate the value of anticipated future business and the value of assets and liabilities
that are not considered financial instruments. The following methods and assumptions were
used to estimate the fair value of each class of financial instruments:Cash and cash equivalents:For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.Investment Securities:The fair value of securities is estimated based on bid prices published in financial
newspapers or bid quotations received from securities dealers.
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##### Table of Contents



Note 13.
    
    Fair Value of Financial Instruments (continued)Restricted investments:Restricted investments consist of Federal Home Loan Bank, Federal Reserve Bank, and The
Bankers Bank stock and the carrying amount approximates fair value based on the stock
redemption provisions of each of the entities.Loans:The fair value of loans is calculated by discounting scheduled cash flows through the
estimated maturity using estimated market discount rates, adjusted for credit risk and
servicing costs. The estimate of maturity is based on historical experience with
repayments for each loan classification, modified, as required, by an estimate of the
effect of current economic and lending conditions. The allowance for loan losses is
considered a reasonable discount for credit risk.Cash surrender value of life insurance:The estimated value of cash surrender value of life insurance approximates its carrying
value.Deposits:The fair value of deposits with no stated maturity, such as demand deposits, money market
accounts, and savings deposits, is equal to the amount payable on demand. The fair value
of time deposits is based on the discounted value of contractual cash flows. The discount
rate is estimated using the rates currently offered for deposits of similar remaining
maturities.Federal funds purchased and securities sold under agreements to repurchase:The estimated value of these liabilities, which are extremely short term, approximates
their carrying value.Subordinated debentures:For the subordinated debentures with a floating interest rate tied to LIBOR, the fair
value is based on the discounted value of contractual cash flows. The discount rate is
estimated using the rates currently offered for subordinated debentures of similar amounts
and remaining maturities.Federal Home Loan Bank advances:For FHLB advances the fair value is based on the discounted value of contractual cash
flows. The discount rate is estimated using the rates currently offered for FHLB advances
of similar amounts and remaining maturities.
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##### Table of Contents



Note 13.
    
    Fair Value of Financial Instruments (continued)Accrued interest receivable and payable:The carrying amounts of accrued interest receivable and payable approximate their fair
value.Commitments to extend credit, letters of credit and lines of credit:The fair value of commitments is estimated using the fees currently charged to enter into
similar agreements, taking into account the remaining terms of the agreements and the
present creditworthiness of the counterparties. For fixed-rate loan commitments, fair
value
also considers the difference between current levels of interest rates and the committed
rates. The fair values of these commitments are insignificant and are
not included in the table below.The carrying amount and estimated fair value of the Companys financial instruments at
December 31, 2007 and 2006, are as follows (in thousands):
 2007
    
    2006Carrying
    
    Estimated
    
    Carrying
    
    EstimatedAmount
    
    Fair Value
    
    Amount
    
    Fair ValueAssets:Cash and cash equivalents
    
    $
    16,329
    
    
    $
    16,329
    
    
    $
    13,396
    
    
    $
    13,396Investment securities
    
    
    82,987
    
    
    
    83,006
    
    
    
    75,994
    
    
    
    76,091Restricted investments
    
    
    3,832
    
    
    
    3,832
    
    
    
    2,621
    
    
    
    2,621Loans
    
    
    393,700
    
    
    
    393,117
    
    
    
    341,184
    
    
    
    340,853Cash surrender value of life
insurance
    
    
    8,650
    
    
    
    8,650
    
    
    
    8,314
    
    
    
    8,314Accrued interest receivable
    
    
    2,701
    
    
    
    2,701
    
    
    
    2,638
    
    
    
    2,638Liabilities:Noninterest-bearing demand deposits
    
    $
    56,307
    
    
    $
    56,307
    
    
    $
    60,016
    
    
    $
    60,016NOW accounts
    
    
    87,380
    
    
    
    87,380
    
    
    
    76,070
    
    
    
    76,070Savings and money market accounts
    
    
    51,939
    
    
    
    51,939
    
    
    
    53,942
    
    
    
    53,942Time deposits
    
    
    208,748
    
    
    
    210,089
    
    
    
    171,702
    
    
    
    171,596Subordinated debentures
    
    
    13,403
    
    
    
    14,356
    
    
    
    13,403
    
    
    
    14,171Federal funds purchased and securities
sold under agreements to repurchase
    
    
    6,742
    
    
    
    6,742
    
    
    
    21,435
    
    
    
    21,435Federal Home Loan Bank advances
    
    
    65,356
    
    
    
    67,435
    
    
    
    36,710
    
    
    
    36,710Accrued interest payable
    
    
    1,240
    
    
    
    1,240
    
    
    
    956
    
    
    
    956
 Note 14.
    
    Stock Options and WarrantsThe Company has a stock option plan that is administered by the Board of Directors and
provides for both incentive stock options and nonqualified stock options. The exercise
price of each option shall not be less than 100 percent of the fair market value of the
common stock on the date of grant. The maximum number of shares that can be issued under
the plan is 689,751. At December 31, 2007, there were 349,992 shares remaining
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Note 14.
    
    Stock Options and Warrants (continued)available for future issuance under equity compensation plans. All options have been granted at the fair market value of the shares at the date of grant. The maximum term for each option is ten years.The Company has granted incentive stock options to certain key officers and employees. The Company has also granted nonqualified stock options to non-employee organizers of the Bank. The stock option agreements state that upon termination of employment, employees have 90 days to exercise any stock options vested as of the termination date.The Company issues new shares to satisfy option exercises from the authorized shares allocated to the employee stock option plan.A summary of activity in the Companys stock option plan for the year ended December 31,
2007, is as follows:
 Weighted AverageNumber
    
    
    Weighted Average
    
    
    Remaining
    
    
    Aggregateof Options
    
    
    Exercise Price
    
    
    Contractual Term
    
    
    Intrinsic ValueOptions outstanding, December 31, 2006
    
    
    182,591
    
    
    $
    12.76Options granted
    
    
    49,381
    
    
    
    28.54Options exercised
    
    
    (33,401
    )
    
    
    9.24Options forfeited
    
    
    (6,740
    )
    
    
    28.13Options outstanding, December 31, 2007
    
    
    191,831
    
    
    
    16.89
    
    
    
    5.45
    
    
    $
    1,128,004Exercisable at December 31, 2007
    
    
    113,915
    
    
    
    10.36
    
    
    
    3.50
    
    
    $
    1,370,747
 All outstanding options are either fully vested or expected
to vest. The weighted-average grant-date fair value of options granted during 2007, 2006 and 2005
was $7.95 per share, $10.38 per share and $5.52 per share, respectively. The total
intrinsic value of options exercised during 2007, 2006 and 2005 was $577,539, $653,298
and $798,401, respectively. Cash received from the exercise of options was $308,689,
$332,775 and $727,829 in 2007, 2006 and 2005, respectively. Tax benefits realized in 2007
were $73,127 and were insignificant in 2006 and 2005.As of December 31, 2007, there was $478,373 of total unrecognized compensation cost
related to nonvested share-based compensation arrangements granted under the stock option
plan. The cost is expected to be recognized over a weighted-average period of 3.10 years.
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##### Table of Contents



Note 14.
    
    Stock Options and Warrants (continued)The fair value of each stock option is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average assumptions:
 2007
    
    2006Dividend yield
    
    
    0.00
    %
    
    
    0.00
    %Expected life
    
    7.2 years
    
    
    6.5 yearsExpected volatility
    
    
    19
    %
    
    
    17
    %Risk-free interest rate
    
    
    4.61
    %
    
    
    4.67
    %
 The fair value of each option grant is estimated on the date of grant using the Black-Scholes
option-pricing model using the assumptions noted in the following table. Expected volatilities are
based on historical exercise patterns, employee terminations and historical stock prices. The
expected life of options granted represents the period of time that options granted are expected to
be outstanding. The U.S. Treasury 10 year constant maturity rate in effect at the date of the grant
is used to derive the risk-free interest rate for the contractual period of the options.During the third quarter of 2005, the Company sold 416,500 shares of common stock.
This sale resulted in an increase in common stock and surplus of approximately $9,896,500.
In connection with the offering, there were 416,500 warrants issued, one warrant for each share of stock sold, that had an exercise price of $25.20 per warrant.
The warrants could be exercised beginning after one year from the date of the sale of the
common stock, and had to be exercised no later than two years from the date of the sale.
The final day to exercise the common stock warrants was September 7, 2007. During the
period in which they could be exercised, 476,194 out of 482,151 (adjusted for 5% stock
dividends) warrants were exercised at a weighted average exercise price of $21.77
(adjusted for 5% stock dividends). The total corresponding increase to shareholders
equity from the conversion of the stock warrants to common stock from September 7, 2006 to
September 7, 2007, the period the warrants could be exercised, was approximately
$10,367,000.At December 31, 2006 and 2005, there were 465,699 and 482,151 warrants outstanding,
adjusted for the effect of the June 2006, February 2007 and February 2008 stock dividends.Note 15.
    
    Regulatory MattersThe Bank is subject to various regulatory capital requirements administered by the federal
banking agencies. Failure to meet minimum capital requirements can initiate certain
mandatory and possibly additional discretionary actions by regulators that, if undertaken,
could have a direct material effect on the Banks financial statements. Under capital
adequacy guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the Banks
assets, liabilities, and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Banks capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings, and other
factors.
 F-31




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##### Table of Contents



Note 15.
    
    Regulatory Matters (continued)Quantitative measures established by regulation to ensure
capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and
Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and
of Tier I capital (as defined) to average assets (as defined). Management believes, as of
December 31, 2007, that the Bank met all capital adequacy requirements to which it is
subject.As of December 31, 2007, the most recent notification from the Office of the Comptroller
of the Currency categorized the Bank as well capitalized under the regulatory framework
for prompt corrective action. There are no conditions or events since that notification
that management believes have changed the Banks prompt corrective action category for
bank capital.The Banks actual capital amounts and ratios are presented in the table. Dollar amounts
are presented in thousands.
 For CapitalActual
    
    Adequacy Purposes
    
    Well-CapitalizedAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioAs of December 31, 2007:Total capital to risk-weighted assets:Mountain National Bank
    
    $
    63,777
    
    
    
    13.97
    %
    
    $
    36,531
    
    
    
    8.00
    %
    
    $
    45,663
    
    
    
    10.00
    %Tier I capital to risk-weighted assets:Mountain National Bank
    
    
    59,803
    
    
    
    13.10
    %
    
    
    18,265
    
    
    
    4.00
    %
    
    
    27,398
    
    
    
    6.00
    %Tier I capital to average assets:Mountain National Bank
    
    
    59,803
    
    
    
    11.24
    %
    
    
    21,288
    
    
    
    4.00
    %
    
    
    26,610
    
    
    
    5.00
    %
 For CapitalActual
    
    Adequacy Purposes
    
    Well-CapitalizedAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioAs of December 31, 2006:Total capital to risk-weighted assets:Mountain National Bank
    
    $
    48,520
    
    
    
    12.22
    %
    
    $
    31,764
    
    
    
    8.00
    %
    
    $
    39,705
    
    
    
    10.00
    %Tier I capital to risk-weighted assets:Mountain National Bank
    
    
    44,996
    
    
    
    11.33
    %
    
    
    15,882
    
    
    
    4.00
    %
    
    
    23,823
    
    
    
    6.00
    %Tier I capital to average assets:Mountain National Bank
    
    
    44,996
    
    
    
    9.99
    %
    
    
    18,023
    
    
    
    4.00
    %
    
    
    22,528
    
    
    
    5.00
    %
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Note 15.
    
    Regulatory Matters (continued)Dividend restrictions:The Companys principal source of funds for dividend payments is dividends received from
the Bank. Under applicable federal laws, the Comptroller of the Currency restricts the
amount of dividends that may be paid without prior approval. Under these regulations, the
amount of dividends that may be paid in any calendar year is limited to the current years
net profits, combined with the retained net profits of the preceding two years, subject to
the capital requirements described above. As of December 31, 2007, the Bank could, without
prior approval, declare dividends of approximately $3,900,000.Note 16.
    
    Other Comprehensive IncomeOther comprehensive income (loss) consists of unrealized holding gains and losses on
securities available for sale. A summary of other comprehensive income (loss) and the
related tax effects for the years ended December 31, 2007, 2006 and 2005 is as follows:
 TaxBefore-Tax
    
    
    (Expense)
    
    
    Net-of-TaxAmount
    
    
    Benefit
    
    
    AmountYear ended December 31, 2007:Unrealized holding gains and losses
arising during the period
    
    $
    510,480
    
    
    $
    (91,733
    )
    
    $
    418,747Less reclassification adjustment for
gains realized in net income
    
    
    
    
    
    
    
    
    
    
    $
    510,480
    
    
    $
    (91,733
    )
    
    $
    418,747Year ended December 31, 2006:Unrealized holding gains and losses
arising during the period
    
    $
    318,796
    
    
    $
    (173,922
    )
    
    $
    144,874Less reclassification adjustment for
gains realized in net income
    
    
    
    
    
    
    
    
    
    
    $
    318,796
    
    
    $
    (173,922
    )
    
    $
    144,874Year ended December 31, 2005:Unrealized holding gains and losses
arising during the period
    
    $
    (990,929
    )
    
    $
    376,553
    
    
    $
    (614,376
    )Less reclassification adjustment for
gains realized in net income
    
    
    61,255
    
    
    
    (23,277
    )
    
    
    37,978$
    (1,052,184
    )
    
    $
    399,830
    
    
    $
    (652,354
    )
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Note 17.
    
    Earnings Per Common ShareBasic earnings per share represents income available to common stockholders divided by the
weighted-average number of common shares outstanding during the period. Diluted earnings
per share reflects additional common shares that would have been outstanding if
dilutive potential common shares had been issued, as well as any adjustment to income that
would result from the assumed issuance.Potential common shares that may be issued by the Company relate to outstanding stock
options and warrants, determined using the treasury stock method.Earnings per common share have been computed based on the following:
 2007
    
    
    2006
    
    
    2005Net income applicable to common stock
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502Average number of common shares
outstanding
    
    
    2,331,396
    
    
    
    2,019,783
    
    
    
    1,725,539Dilutive effect of stock options
    
    
    64,696
    
    
    
    88,694
    
    
    
    107,413Dilutive effect of warrants
    
    
    39,868
    
    
    
    72,591
    
    
    
    9,977Average number of common shares
outstanding used to calculate diluted
earnings per common share
    
    
    2,435,960
    
    
    
    2,181,068
    
    
    
    1,842,929
 At December 31, 2007, 2006 and 2005, there were options for the purchase of 44,535, 4,815
and 0 shares, respectively, outstanding that were antidilutive.Note 18.
    
    Recent Accounting PronouncementsIn February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments, an amendment of FASB Statements No. 133 and 140. (SFAS 155) SFAS 155
permits, but does not require, fair value accounting for hybrid financial instruments that
contain an embedded derivative that would otherwise require bifurcation in accordance with
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. (SFAS 133)
SFAS 155 also eliminated the temporary exemption for interests in securitized financial
assets provided for by SFAS 133, Derivatives Implementation Group (DIG) Issue D1,
Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.
The FASB issued interpretive guidance in SFAS 133 during January 2007, DIG Issue B40,
Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets,
in which the FASB concluded that a securitized interest in prepayable financial assets was
not subject to the bifurcation requirements of SFAS 155 when the interest met both of the
following criteria: (1) the right to accelerate the settlement of the securitized interest
cannot be controlled by the
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Note 18.
    
    Recent Accounting Pronouncements (continued)investor; and (2) the securitized interest itself does not contain an embedded derivative
for which bifurcation would be required other than embedded derivative that results solely
from the embedded call options in the underlying financial assets. SFAS 155 is effective
for all financial instruments acquired or issued after December 31, 2006 as well as to
those hybrid financial instruments that had been previously bifurcated under SFAS 133.
The guidance in DIG Issue B40 is effective upon the adoption of SFAS 155. As of December
31, 2007, the Company did not have any hybrid financial instruments that were previously
bifurcated under SFAS 133 and the guidance provided for in DIG Issue B40 allowed the
Company to continue to purchase mortgage-backed securities without applying the
bifurcation requirements of SFAS 155. The adoption of SFAS 155 and DIG Issue B40 did not
have a material impact on the Companys financial statements.In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This
Statement defines fair value, establishes a framework for measuring fair value and expands
disclosures about fair value measurements. This Statement establishes a fair value
hierarchy about the assumptions used to measure fair value and clarifies assumptions about
risk and the effect of a restriction on the sale or use of an asset. The standard is
effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB
issued Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157. This FSP
delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial
liabilities, except those that are recognized or disclosed at fair value on a recurring
basis (at least annually) to fiscal years beginning after November 15, 2008, and interim
periods within those fiscal years. The impact of adoption was not material.In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities. The standard provides companies with an option to report
selected financial assets and liabilities at fair value and establishes presentation and
disclosure requirements designed to facilitate comparisons between companies that choose
different measurement attributes for similar types of assets and liabilities. The new
standard is effective for the Company on January 1, 2008. The Company did not elect the
fair value option for any financial assets or financial liabilities as of January 1, 2008.Note 19.
    
    Stock DividendsDuring January 2005, the Board of Directors approved a 5% stock dividend for stockholders
of record as of January 7, 2005. In lieu of fractional shares, certain stockholders
received cash payments totaling $16,245. This stock dividend resulted in the issuance of
63,482 additional shares of common stock. All per share data included in the accompanying
financial statements reflects this stock dividend.During May 2006, the Board of Directors approved a 5% stock dividend for stockholders of
record as of June 1, 2006. In lieu of fractional shares, certain stockholders received
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Note 19.
    
    Stock Dividends (continued)cash payments totaling $23,002. This stock dividend resulted in the issuance of 90,878
additional shares of common stock. All per share data included in the accompanying
financial statements reflects this stock dividend.During January 2007, the Board of Directors approved a 5% stock dividend for stockholders
of record as of February 15, 2007. In lieu of fractional shares, certain stockholders
received cash payments totaling $29,557. This stock dividend resulted in the issuance of
96,361 additional shares of common stock. All per share data included in the accompanying
financial statements reflects this stock dividend.During January 2008, the Board of Directors approved a 5% stock dividend for stockholders
of record as of February 15, 2008. In lieu of fractional shares, certain stockholders
received cash payments totaling $17,802. This stock dividend resulted in the issuance of
124,718 additional shares of common stock. All per share data included in the accompanying
financial statements reflects this stock dividend.
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Note 20.
    
    Condensed Parent Information
 BALANCE SHEETS
    
    2007
    
    
    2006ASSETSCash
    
    $
    2,183,860
    
    
    $
    2,999,826Investment in subsidiary
    
    
    59,524,171
    
    
    
    44,298,037Other assets
    
    
    737,854
    
    
    
    612,969Total assets
    
    $
    62,445,885
    
    
    $
    47,910,832LIABILITIES AND SHAREHOLDERS EQUITYNotes payable
    
    $
    13,403,000
    
    
    $
    13,403,000Accrued interest payable
    
    
    132,265
    
    
    
    134,802Other liabilities
    
    
    (37,833
    )
    
    
    (37,833
    )Total liabilities
    
    
    13,497,432
    
    
    
    13,499,969Shareholders equity
    
    
    48,948,453
    
    
    
    34,410,863Total liabilities and shareholders equity
    
    $
    62,445,885
    
    
    $
    47,910,832
 STATEMENTS OF INCOME
    
    2007
    
    
    2006
    
    
    2005INCOME
    
    $
    
    
    
    $
    
    
    
    $
    EXPENSES
    
    
    1,117,990
    
    
    
    881,884
    
    
    
    514,948Loss before equity in undistributed earnings of subsidiary
    
    
    (1,117,990
    )
    
    
    (881,884
    )
    
    
    (514,948
    )Equity in undistributed earnings of subsidiary
    
    
    4,595,663
    
    
    
    4,441,584
    
    
    
    3,434,104Income tax benefit
    
    
    434,421
    
    
    
    337,673
    
    
    
    204,346Net income
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502
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Note 20.
    
    Condensed Parent Information (continued)
 STATEMENTS OF CASH FLOWS
    
    2007
    
    
    2006
    
    
    2005CASH FLOWS FROM OPERATING ACTIVITIESNet income
    
    $
    3,912,094
    
    
    $
    3,897,373
    
    
    $
    3,123,502Adjustments to reconcile net income to net cash
provided by operating activities:Equity in undistributed income of subsidiary
    
    
    (4,595,663
    )
    
    
    (4,441,584
    )
    
    
    (3,434,104
    )Other
    
    
    (127,423
    )
    
    
    184,838
    
    
    
    (276,720
    )Net cash used in operating activities
    
    
    (810,992
    )
    
    
    (359,373
    )
    
    
    (587,322
    )CASH FLOWS FROM INVESTING ACTIVITIESPayments for investments in and advances to subsidiaries
    
    
    (10,000,000
    )
    
    
    (7,500,000
    )
    
    
    (8,000,000
    )Net cash used in investing activities
    
    
    (10,000,000
    )
    
    
    (7,500,000
    )
    
    
    (8,000,000
    )CASH FLOWS FROM FINANCING ACTIVITIESDividends
    
    
    (29,557
    )
    
    
    (23,002
    )
    
    
    (16,245
    )Proceeds from issuance of common stock
    
    
    10,324,822
    
    
    
    690,903
    
    
    
    10,639,191Proceeds from issuance of subordinated debentures
    
    
    
    
    
    
    7,732,000
    
    
    
    Purchase of common stock
    
    
    (300,239
    )
    
    
    
    
    
    
    Net cash provided by financing activities
    
    
    9,995,026
    
    
    
    8,399,901
    
    
    
    10,622,946NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    (815,966
    )
    
    
    540,528
    
    
    
    2,035,624CASH AND CASH EQUIVALENTS, beginning of year
    
    
    2,999,826
    
    
    
    2,459,298
    
    
    
    423,674CASH AND CASH EQUIVALENTS, end of year
    
    $
    2,183,860
    
    
    $
    2,999,826
    
    
    $
    2,459,298SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATIONCash paid (received) during the year for:Interest
    
    $
    988,574
    
    
    $
    607,008
    
    
    $
    350,152Income taxes
    
    
    (272,133
    )
    
    
    (411,883
    )
    
    
    (131,675
    )
 F-38