**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C.  20549**

 

**FORM 10-KSB**

 
| **(MARK ONE)**                                       |       |                                                                                            |
|------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|
| ** **                                           |       |                                                                                            |   |   |
| **ý**                                           | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                 |       |                                                                                            |
| **For the Fiscal Year Ended December 31, 2004** |
|                                                 |       |                                                                                            |
| **o**                                                | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT OF 1934**               |
| ** **                                           | ** ** | **For the Transition Period from _____________  to _____________**                              |
|                                                      |            |                                                                                                 |  |  |

 

**CommissionFile No. 00050921**

 
| **SOUTHERN  HERITAGE BANCSHARES, INC**                             |
|--------------------------------------------------------------------|
| (Exact Name  of Small Business Issuer as Specified in its Charter) |

 
| **Tennessee**                                                    | ** **                                              | **42-1627829**                     |
|------------------------------------------------------------------|---------------------------------------------------------|------------------------------------|
| (State or  Other Jurisdiction of  Incorporation or Organization) |                                                    | (IRS  Employer Identification No.) |
|                                                             |                                                    |                               |
|                                                             | **3020 Keith Street, N.W., Cleveland, Tennessee 37321** |                               |
| (Address of  Principal Executive Offices and Zip Code)           |
|                                                             |                                                    |                               |
|                                                             | **(423) 473-7980**                                      |                               |
| (Issuer’s  Telephone Number)                                |
|                                                                  |                                                         |                                    |  |  |  |  |

 

Securities registered pursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g) of the Act: **Common Stock, $1.00 par value per share.**

 

Check whether the issuer (1) filed all reports required to be filed by section 13or 15(d) of the Exchange Act during the past 12 months (or for such shorterperiod that the registrant was required to file such Reports) and (2) has beensubject to such filing requirements for the past 90 days.   Yes  ý     No  o

 

Check if there is no disclosure of delinquent filers in response toItem 405 of the Regulation S-B is not contained in this form, and no disclosurewill be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of theForm 10-KSB or any amendment to this Form 10-KSB.   ý

 

The issuer’s revenues for the year ended December 31, 2004 were$9,439,000.

 

The aggregate market value of the issuer’s voting common stock held bynon-affiliates of the registrant at February 28, 2005 was $20,424,700,based upon 816,988 shares at an estimated $25.00 per share.

 

The number of shares of the issuer’s common stock issued andoutstanding on March 31, 2005 was 1,024,720.

 

DOCUMENTS INCORPORATED BY REFERENCE: Certain Portions of the Issuer’sProxy Statement relating to its annual meeting of shareholders to be held May19, 2005 are incorporated herein by reference in response to Part III.

 

Transitional Small Business Disclosure Format (checkone):   Yes  o   No  ý

 

 

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TABLE OFCONTENTS

 
| PART I                                                                                                                   | 1      |
|--------------------------------------------------------------------------------------------------------------------------|--------|
| ITEM 1. DESCRIPTION OF  BUSINESS                                                                                         | 1      |
| ITEM 2. DESCRIPTION OF  PROPERTY                                                                                         | 10     |
| ITEM 3. LEGAL PROCEEDINGS                                                                                                | 10     |
| ITEM  4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                             | 10     |
|                                                                                                                     |   |
| PART II                                                                                                                  | 11     |
| ITEM  5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS  ISSUER PURCHASES OF EQUITY SECURITIES | 11     |
| ITEM  6. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS                     | 12     |
| ITEM 7. FINANCIAL  STATEMENTS                                                                                            | 24     |
| ITEM  8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL  DISCLOSURE                           | 24     |
| ITEM 8A. CONTROLS AND  PROCEDURES                                                                                        | 24     |
| ITEM 8B. OTHER INFORMATION                                                                                               | 25     |
|                                                                                                                     |   |
| PART III                                                                                                                 | 25     |
| ITEM  9. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT                                                                  | 25     |
| ITEM 10. EXECUTIVE  COMPENSATION                                                                                         | 25     |
| ITEM  11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND  RELATED STOCKHOLDER MATTERS                | 25     |
| ITEM  12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                 | 25     |
| ITEM 13. EXHIBITS                                                                                                        | 26     |
| ITEM  14. PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                         | 26     |

 

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# **PART I**

# ** **

## **ITEM1.  DESCRIPTION OF BUSINESS**

 

General

 

Southern Heritage Bancshares, Inc. (the “Company”) wasformed in 2004 under the laws of the State of Tennessee as a bank holdingcompany for the purpose of acquiring 100% of Southern Heritage Bank (the “Bank”)by means of a share exchange.  On August 31,2004, shareholders of the Bank received one share of the Company for everyshare of the Bank they owned.  Since thetransaction involved entities under common control, financial information forthe prior periods of the Bank is shown as if the transactions occurred as ofthe beginning of the earliest period presented. Substantially all of the consolidated operations are that of the Bank.

 

The Bank commenced operations as a state charteredbank on April 12, 1999.  The Bankhas total assets of approximately $156 million at December 31, 2004.  The Bank’s deposit accounts are insured underthe Federal Deposit Insurance Corporation (the “FDIC”), up to the maximumapplicable limits thereof.  The Bank isnot a member of the Federal Reserve System.

 

The Bank’s customer base consists primarily of smallto medium-sized business retailers, manufacturers, distributors, contractors,professionals, service businesses and local residents.  The Bank offers a full range of competitiveretail and commercial banking services. The deposit services offered include various types of checking accounts,savings accounts, money market investment accounts, certificates of deposits,automated teller machines, and retirement accounts.  Lending services include consumer installmentloans, various types of mortgage loans, personal lines of credit, home equityloans, credit cards, real estate construction loans, commercial loans to smalland medium size businesses and professionals, and letters of credit.  The Bank also offers safe deposit boxes ofvarious sizes.  The Bank issues VISA andMasterCard credit cards and is a merchant depository for cardholder draftsunder both types of credit cards.  TheBank offers its customers drive-through banking services at all of itslocations**.** The Bank has trust powers and is currently inthe early stages of implementing a trust department.

 

The Bank is subject to the regulatory authority of theBoard of Governors of the Federal Reserve System, the Department of FinancialInstitutions of the State of Tennessee (“TDFI”) and the FDIC.

 

The Company’s principal executive offices are locatedat the Bank, at 3020 Keith Street, N.W., Cleveland, Tennessee 37321, and itstelephone number is (423) 473-7980.

 

MarketArea and Competition

 

The Bank’s primary service area is BradleyCounty.  The Bank competes with othercommercial banks, savings and loan associations, credit unions and financecompanies operating in Bradley County and elsewhere. Nine other financialinstitutions are doing business in Bradley County.  The Bank is subject to substantialcompetition in all aspects of its business. Intense competition for loans and deposits comes from other financialinstitutions in the Bank’s market area. In certain aspects of its business, the Bank also competes with creditunions, small loan companies, insurance companies, mortgage companies, financecompanies, brokerage houses and other financial institutions, some of which arenot subject to the same degree of regulation and restriction as the Bank andsome of which have financial resources greater than those of the Bank.  The future success of the Bank will dependprimarily upon the difference between the cost of its borrowing (primarilyinterest paid on deposits) and income from operations (primarily interest orfees earned on loans, sales of loans and investments). The Bank competes forfunds with other institutions, which, in most cases, are significantly largerand are able to provide a greater variety of services than the Bank and thusmay obtain deposits at lower rates of interest.

 

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Employees

 

At December 31, 2004, the Bank employed 40persons on a full-time basis and 15 persons on a part-time basis.  The Bank’s employees are not represented byany union or other collective bargaining agreement and the Bank believes itsemployee relations are satisfactory.

 

Supervisionand Regulation

 

*Bank Holding Company Regulation.*The Company is a bank holding companywithin the meaning of the Bank Holding Company Act of 1956, as amended (the “HoldingCompany Act”), and is registered with the Federal Reserve Board. Its bankingsubsidiary, the Bank, is subject to restrictions under federal law which limitthe transfer of funds by it to the Company and nonbanking subsidiaries, whetherin the form of loans, extensions of credit, investments, or assetpurchases.  Such transfers by anysubsidiary bank to its holding company or any non-banking subsidiary arelimited in amount to 10% of the subsidiary bank’s capital and surplus and, withrespect to the Company and all such nonbanking subsidiaries, to an aggregate of20% of such bank’s capital and surplus. Furthermore, such loans and extensions of credit are required to besecured in specified amounts.  TheHolding Company Act also prohibits, subject to certain exceptions, a bankholding company from engaging in or acquiring direct or indirect control ofmore than 5% of the voting stock of any company engaged in non bankingactivities.  An exception to thisprohibition is for activities expressly found by the Federal Reserve Board tobe so closely related to banking or managing or controlling banks as to be aproper incident thereto or financial in nature.

 

As a bank holding company, the Company is required tofile with the Federal Reserve Board semi-annual reports and such additionalinformation as the Federal Reserve Board may require.  The Federal Reserve Board also makesexaminations of the Company.

 

According to Federal Reserve Board policy, bankholding companies are expected to act as a source of financial strength to eachsubsidiary bank and to commit resources to support each such subsidiary.  This support may be required at times when abank holding company may not be able to provide such support.

 

A bank holding company and its subsidiaries are alsoprohibited from acquiring any voting shares of, or interest in, any bankslocated outside of the state in which the operations of the bank holdingcompany’s subsidiaries are located, unless the acquisition is specificallyauthorized by the statutes of the state in which the target is located.  Further, a bank holding company and itssubsidiaries are prohibited from engaging in certain tie-in arrangements inconnection with the extension of credit or provision of any property orservice.  Thus, an affiliate of a bankholding company may not extend credit, lease or sell property, or furnish anyservices or fix or vary the consideration for these on the condition that (i)the customer must obtain or provide some additional credit, property orservices from or to its bank holding company or subsidiaries thereof or (ii)the customer may not obtain some other credit, property, or services from acompetitor, except to the extent reasonable conditions are imposed to assurethe soundness of the credit extended.

 

In approving acquisitions by bank holding companies ofbanks and companies engaged in the banking-related activities described above,the Federal Reserve Board considers a number of factors, including the expectedbenefits to the public such as greater convenience, increased competition, orgains in efficiency, as weighed against the risks of possible adverse effectssuch as undue concentration of resources, decreased or unfair competition,conflicts of interest, or unsound banking practices.  The Federal Reserve Board is also empoweredto differentiate between new activities and activities commenced through theacquisition of a going concern.

 

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The Attorney General of the United States may, within30 days after approval by the Federal Reserve Board of an acquisition, bring anaction challenging such acquisition under the federal antitrust laws, in whichcase the effectiveness of such approval is stayed pending a final ruling by thecourts.  Failure of the Attorney Generalto challenge an acquisition does not, however, exempt the holding company fromcomplying with both state and federal antitrust laws after the acquisition isconsummated or immunize the acquisition from future challenge under theanti-monopolization provisions of the Sherman Act.

 

*Sarbanes-Oxley Act of 2002*. On July 30, 2002, President Bushsigned into law the Sarbanes-Oxley Act of 2002. This legislation represents a comprehensive revision of laws affectingcorporate governance, accounting obligations and corporate reporting. TheSarbanes-Oxley Act is applicable to all companies with equity securitiesregistered, or that file reports under, the Securities Exchange Act of1934.  In particular, the Sarbanes-OxleyAct establishes (i) new requirements for audit committees, includingindependence, expertise and responsibilities; (ii) additional responsibilitiesregarding financial statements for the chief executive officer and chieffinancial officer of the reporting company and new requirements for them tocertify the accuracy of periodic reports; (iii) new standards for auditors andregulation of audits; (iv) increased disclosure and reporting obligations forthe reporting company and its directors and executive officers, including anaccelerated time frame for reporting of insider transactions; and (v) new andincreased civil and criminal penalties for violations of the federal securitieslaws. The legislation also established a new accounting oversight board toenforce auditing standards and restrict the scope of services that accountingfirms may provide to their public company audit clients.  Because the Company’s common stock isregistered with the SEC, it is subject to the requirements of this legislation.

 

*Tennessee Banking Act; FederalDeposit Insurance Act*. The Bank is a Tennessee state-chartered bank and is subject to theregulations of and supervision by the FDIC as well as the TDFI, Tennessee’sstate banking authority.  The Bank isalso subject to various requirements and restrictions under federal and statelaw, including requirements to maintain reserves against deposits, restrictionson the types and amounts of loans that may be granted and the interest that maybe charged thereon and limitations on the types of investments that may be madeand the types of services that may be offered. Various consumer laws and regulations also affect the operations of theBank.  In addition to the impact ofregulation, commercial banks are affected significantly by the actions of theFederal Reserve Board as it attempts to control the money supply and creditavailability in order to influence the economy.

 

From time to time, legislation is enacted which hasthe effect of increasing the cost of doing business, limiting or expandingpermissible activities or affecting the competitive balance between banks andother financial institutions.  Proposalsto change the laws and regulations governing the operations and taxation ofbanks, bank holding companies and other financial institutions are frequentlymade in Congress, in the Tennessee legislature and before various bankregulatory and other professional agencies. The likelihood of any major legislative changes and the impact suchchanges might have on the Bank are impossible to predict.

 

The Bank, as a Tennesseestate chartered bank, is subject to primary supervision, periodic examinationand regulation by the Commissioner of the TDFI (“Commissioner”) and theFDIC.  If, as a result of an examinationof a bank, the FDIC should determine that the financial condition, capitalresources, asset quality, earnings prospects, management, liquidity or otheraspects of the Bank’s operations are unsatisfactory or that the Bank or itsmanagement is violating or has violated any law or regulation, various remediesare available to the FDIC.  Such remediesinclude the power to enjoin “unsafe or unsound” practices, to requireaffirmative action to correct any conditions resulting from any violation orpractice, to issue an administrative order that can be judicially enforced, todirect an increase in capital, to restrict the growth of the Bank, to assesscivil monetary penalties, to remove officers and directors and ultimately toterminate the Bank’s deposit insurance. The Commissioner has many of the same remedial powers, including thepower to take possession of a bank  whosecapital becomes impaired.  As of April 1,2005, the Bank is not the subject of any such action by the FDIC or theCommissioner.

 

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The deposits of the Bank are insured by the FDIC inthe manner and to the extent provided by law. For this protection, the Bank pays a semiannual statutoryassessment.  Although the Bank is not amember of the Federal Reserve System, it is nevertheless subject to certainregulations of the Federal Reserve Board.

 

Various requirements and restrictions under the lawsof the State of Tennessee and the United States affect the operations of theBank.  State and federal statutes andregulations relate to many aspects of the Bank’s operations, including reservesagainst deposits, interest rates payable on deposits, loans, investments,mergers and acquisitions, borrowings, dividends, locations of branch officesand capital requirements.  Further, theBank is required to maintain certain levels of capital.

 

Tennessee law contains limitations on the interestrates that may be charged on various types of loans and restrictions on thenature and amount of loans that may be granted and on the types of investmentswhich may be made.  The operations ofbanks are also affected by various consumer laws and regulations, includingthose relating to equal credit opportunity and regulation of consumer lendingpractices.  All Tennessee banks mustbecome and remain insured banks under the FDIA. (See 12 U.S.C. §1811, et seq.).

 

*FIRREA.*Congress enacted the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) on August 9,1989.  FIRREA provides that a depositoryinstitution insured by the FDIC can be held liable for any loss incurred by, orreasonable expected to be incurred by, the FDIC in connection with (i) thedefault of a commonly controlled FDIC insured depository institution or (ii)any assistance provided by the FDIC to a commonly controlled FDIC insureddepository institution in danger of default.  FIRREA provides that certain types of personsaffiliated with financial institutions can be fined by the federal regulatoryagency having jurisdiction over a depository institution with federal depositinsurance (such as the Bank) up to $1 million per day for each violation ofcertain regulations related (primarily) to lending to and transactions withexecutive officers, directors, principal shareholders and the interests ofthese individuals.  Other violations mayresult in civil money penalties of $5,000 to $30,000 per day or in criminalfines and penalties.  In addition, theFDIC has been granted enhanced authority to withdraw or to suspend depositinsurance in certain cases.

 

*FDICIA.*The Federal Deposit Insurance CorporationImprovement Act of 1991 (“FDICIA”) which was enacted on December 19, 1991,substantially revised the depository institution regulatory and fundingprovisions of the FDIA and made revisions to several other federal bankingstatutes.  Among other things, FDICIArequires the federal banking regulators to take “prompt corrective action” inrespect of FDIC-insured depository institutions that do not meet minimumcapital requirements. FDICIA establishes five capital tiers: “well capitalized,”“adequately capitalized,” “undercapitalized,” “significantly undercapitalized”and “critically undercapitalized.”  Underapplicable regulations, a FDIC-insured depository institution is defined to bewell capitalized if it maintains a Leverage Ratio of at least 5%, a riskadjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of atleast 10% and is not subject to a directive, order or written agreement to meetand maintain specific capital levels.  Aninsured depository institution is defined to be adequately capitalized if itmeets all of its minimum capital requirements as described above.  In addition, an insured depositoryinstitution will be considered undercapitalized if it fails to meet any minimumrequired measure, significantly undercapitalized if it is significantly belowsuch measure and critically undercapitalized if it fails to maintain a level oftangible equity equal to not less than 2% of total assets.  An insured depository institution may bedeemed to be in a capitalization category that is lower than is indicated byits actual capital position if it receives an unsatisfactory examinationrating.

 

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The capital-based prompt corrective action provisionof FDICIA and their implementing regulations apply to FDIC-insured depositoryinstitutions and are not directly applicable to holding companies which controlsuch institutions.  However, the FederalReserve Board has indicated that, in regulating bank holding companies, it willtake appropriate action at the holding company level based on an assessment ofthe effectiveness of supervisory actions imposed upon subsidiary depositoryinstitutions pursuant to such provisions and regulations.

 

FDICIA generally prohibits an FDIC-insured depositoryinstitution from making any capital distribution (including payment ofdividends) or paying any management fee to its holding company if thedepository institution would thereafter be undercapitalized.  Undercapitalized depository institutions aresubject to restrictions on borrowing from the Federal Reserve System.  In addition, undercapitalized depositoryinstitutions are subject to growth limitations and are required to submitcapital restoration plans.  A depositoryinstitution’s holding company must guarantee the capital plan, up to an amountequal to the lesser of 5% of the depository institution’s assets at the time itbecomes undercapitalized or the amount of the capital deficiency when theinstitution fails to comply with the plan. The federal banking agencies may not accept a capital plan withoutdetermining, among other things, that the plan is based on realisticassumptions and is likely to succeed in restoring the depository institution’scapital.  If a depository institutionfails to submit an acceptable plan, it is treated as if it is significantlyundercapitalized.

 

Significantly undercapitalized depository institutionsmay be subject to a number of requirements and restrictions, including ordersto sell sufficient voting stock to become adequately capitalized, requirementsto reduce total assets and cessation of receipt of deposits from correspondentbanks.  Critically undercapitalizeddepository institutions are subject to appointment of a receiver or conservatorgenerally within 90 days of the date on which they became critically undercapitalized.

 

The Bank believes that at March 1, 2005, the Bankwas well capitalized under the criteria discussed above.

 

FDICIA contains numerous other provisions, includingaccounting, audit and reporting requirements, termination of the “too big tofail” doctrine except in special cases, limitations on the FDIC’s payment ofdeposits at foreign branches, new regulatory standards in such areas as assetquality, earnings and compensation and revised regulatory standards for, amongother things, powers of state banks, real estate lending and capitaladequacy.  FDICIA also requires that adepository institution provide 90 days prior notice of the closing of anybranches.

 

Various other legislation, including proposals torevise the bank regulatory system and to limit the investments that adepository institution may make with insured funds, is from time to timeintroduced in Congress.  The TDFI andFDIC will examine the Bank periodically for compliance with various regulatoryrequirements.  Such examinations,however, are for the protection of the Bank Insurance Fund (“BIF”) and fordepositors, and not for the protection of investors and shareholders.

 

*Interstate Act*. The Riegle-Neal Interstate Banking andBranching Efficiency Act of 1994 (“Interstate Act”), which was enacted on September 29,1994, among other things and subject to certain conditions and exceptions,permits on an interstate basis (i) bank holding company acquisitions commencingone year after enactment of banks of a minimum age of up to five years asestablished by state law in any state, (ii) mergers of national and state banksafter May 31, 1997 unless the home state of either bank has opted out of theinterstate bank merger provision, (iii) branching de novo by national and statebanks if the host state has opted-in to this provision of the Interstate Act,and (iv) certain bank agency activities after one year after enactment.  The Interstate Act contains a 30% intrastatedeposit cap, except for the initial acquisition in the state, restriction thatapplies to certain interstate acquisitions unless a different intrastate caphas been adopted by the applicable state pursuant to the provisions of the InterstateAct 

 

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and a 10% nationaldeposit cap restriction.  Tennessee hasopted-in to the Interstate Act. Management cannot predict the extent to which the business of the Bankmay be affected.  Tennessee has alsoadopted legislation allowing banks to acquire branches across state linessubject to certain conditions, including the availability of similarlegislation in the other state.

 

*Brokered Deposits and Pass-ThroughInsurance*. TheFDIC has adopted regulations under FDICIA governing the receipt of brokereddeposits and pass-through insurance. Under the regulations, a bank cannot accept or rollover or renewbrokered deposits unless (i) it is well capitalized or (ii) it is adequatelycapitalized and receives a waiver from the FDIC.  A bank that cannot receive brokered depositsalso cannot offer “pass-through” insurance on certain employee benefitaccounts.  Whether or not it has obtainedsuch a waiver, an adequately capitalized bank may not pay an interest rate onany deposits in excess of 75 basis points over certain index prevailing marketrates specified by regulation.  There areno such restrictions on a bank that is well capitalized.  Because it believes that the Bank was wellcapitalized as of March 1, 2005, the Bank believes the brokered depositsregulation will have no material effect on the funding or liquidity of theBank.

 

*FDIC Insurance Premiums*. The Bank is required to pay semiannualFDIC deposit insurance assessments.  Asrequired by FDICIA, the FDIC adopted a risk-based premium schedule whichincreased the assessment rates for most FDIC-insured depositoryinstitutions.  Under the schedule, thepremiums initially range from $.00 to $.27 for every $100 of deposits.  Each financial institution is assigned to oneof three capital groups - well capitalized, adequately capitalized or undercapitalized- and further assigned to one of three subgroups within a capital group, on thebasis of supervisory evaluations by the institution’s primary federal and, ifapplicable, state supervisors and other information relevant to the institution’sfinancial condition and the risk posed to the applicable FDIC deposit insurancefund.  The actual assessment rateapplicable to a particular institution will, therefore, depend in part upon therisk assessment classification so assigned to the institution by the FDIC.  Recently the FDIC has passed a resolution tolower premiums.

 

Under the FDIA, insurance of deposits may beterminated by the FDIC upon a finding that the institution has engaged inunsafe and unsound practices, is in an unsafe or unsound condition to continueoperations or has violated any applicable law, regulation, rule, order orcondition imposed by a federal bank regulatory agency.

 

*Gramm-Leach-Bliley Act*. The Gramm-Leach-Bliley Act adopted in November 1999has been referred to as the most important banking bill in over 60 years.  The most significant provisions ratify newpowers for banks and bank holding companies, especially in the areas ofsecurities and insurance.  The Act alsoincludes requirements regarding the privacy and protection of customerinformation held by financial institutions, as well as many other providers offinancial services.  There are provisionsproviding for functional regulation of the various services provided byinstitutions among different regulators. There are other provisions which limit the future expansion of unitarythrift holding companies which now prevent companies like Wal-Mart from owninga thrift institution.  Finally, amongmany other sections of the Act, there is some relief for small banks from theregulatory burden of the Community Reinvestment Act.  The regulatory agencies have been adoptingmany new regulations to implement the Act.

 

*USA Patriot Act*. On October 26, 2001, PresidentBush signed the USA PATRIOT Act of 2001 into law.  This act contains the International MoneyLaundering Abatement and Financial Anti-Terrorism Act of 2001 (the “IMLAFA”).  The IMLAFA substantially broadens existinganti-money laundering legislation and the extraterritorial jurisdiction of theUnited States, imposes new compliance and due diligence obligations, createsnew crimes and penalties, compels the production of documents located bothinside and outside the United States, including those of foreign institutionsthat have a correspondent relationship in the United States, and

 

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clarifies the safe harborfrom civil liability to customers.  TheU.S. Treasury Department has issued a number of regulations implementing theUSA PATRIOT Act that apply certain of its requirements to financialinstitutions such as our banking and broker-dealer subsidiaries.  The regulations impose new obligations onfinancial institutions to maintain appropriate policies, procedures andcontrols to detect, prevent and report money laundering and terroristfinancing.  The Treasury Department isexpected to issue a number of additional regulations which will further clarifythe USA PATRIOT Act’s requirements.

 

The IMLAFA requires all “financial institutions,” asdefined, to establish anti-money laundering compliance and due diligenceprograms no later than April 2003. Such programs must include, among other things, adequate policies, thedesignation of a compliance officer, employee training programs, and anindependent audit function to review and test the program.  The Bank has established anti-moneylaundering compliance and due diligence programs to comply with IMLAFA.

 

Payment of Dividends. The payment of dividends by the Company depends to a great extent on theability of the Bank to pay dividends to the Company.  The Bank is subject to the Tennessee BankingAct, which provides that the Bank may not declare dividends in any calendaryear that exceeds the total of its net income of that year combined with itsretained net income of the preceding two years without the approval of theTDFI.  Thereafter, 10% of net profitsmust be transferred to capital surplus prior to payment of dividends untilcapital surplus equals capital stock. The Bank is also subject to the minimum capital requirements of the FDICwhich impact the Bank’s ability to pay dividends.  If the Bank fails to meet these standards, itmay not be able to pay dividends or to accept additional deposits because ofregulatory requirements.

 

InvestmentPolicy

 

The objective of the Bank’s investment policy is toinvest funds not otherwise needed to meet the loan demand of its market area toearn the maximum return for the Bank, yet still maintain sufficient liquidityto meet fluctuations in the Bank’s loan demand and deposit structure.  In doing so, the Bank balances the market andcredit risks against the potential investment return, makes investmentscompatible with the pledge requirements of the Bank’s deposits of public funds,maintains compliance with regulatory investment requirements, and assists thevarious public entities with their financing needs.  The funds management committee of the Bankhas full authority over the investment portfolio and makes decisions onpurchases and sales of securities.  Theentire portfolio, along with all investment transactions occurring since theprevious board of director’s meeting, is reviewed by the board at its nextmonthly meeting.  The investment policyallows portfolio holdings to include short-term securities purchased to providethe Bank’s needed liquidity and longer term securities purchased to generatelevel income for the Bank over periods of interest rate fluctuations.  The Bank’s investment securities portfolio atDecember 31, 2004, consisted of securities available for sale.

 

LoanPolicy

 

All lending activities ofthe Bank are under the direct supervision and control of the loan committee,which consists of seven directors, Len Graham, C.A. Kyle, Steve Ledbetter,Larry McDaniel, Lester Simerville, Lee Stewart and James Williams.  The loan committee enforces loanauthorizations for each officer, decides on loans exceeding such limits,services all requests for officer credits to the extent allowable under currentlaws and regulations, administers all problem credits, and determines theallocation of funds for each lending division. The Bank’s established maximum loan ratio of deposits is 90%.  The loan portfolio consists primarily of realestate, commercial, farming and installment loans.  Commercial loans consist of either realestate loans or term loans.  Maturity ofterm loans is normally limited to a maximum of seven years.  Conventional real estate loans may be made upto 85% of the appraised value or purchase cost of the real estate for no morethan a thirty-year term.  Installmentloans are based on the earning capacity and vocational stability of theborrower.

 

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The loan committee makes after-the-fact reviews of allloans in excess of $150,000 secured and $50,000 unsecured.  The loan committee makes a monthly review ofloans which are 30 days or more past due and the full board of directors makesa monthly review of loans which are 45 days or more past due.

 

Management of the Bank periodically reviews the loanportfolio, particularly nonaccrual and renegotiated loans.  The review may result in a determination thata loan should be placed on a nonaccrual status for income recognition.  In addition, to the extent that managementidentifies potential losses in the loan portfolio, it reduces the book value ofsuch loans, through charge-offs, to their estimated collectible value.  The Bank’s policy is that accrual of interestis discontinued on a loan when management of the Bank determines uponconsideration of economic and business factors affecting collection effortsthat collection of interest is doubtful. The Bank currently has no loans where known information about possiblecredit problems of borrowers causes management to have serious doubts as to theability of such borrowers to comply with the present loan repayment terms.

 

When a loan is classified as nonaccrual, any unpaidinterest is reversed against current income. Interest is included in income thereafter only to the extent received incash.  The loan remains in a nonaccrualclassification until such time as the loan is brought current, when it may bereturned to accrual classification.  Whenprincipal or interest on a nonaccrual loan is brought current, if in management’sopinion future payments are questionable, the loan would remain classified asnonaccrual.  After a nonaccrual orrenegotiated loan is charged off, any subsequent payments of either interest orprincipal are applied first to any remaining balance outstanding, then torecoveries and lastly to income.

 

The Bank had no loans outstanding to foreign borrowersat December 31, 2004.

 

The Bank’s underwriting guidelines are applied to fourmajor categories of loans:  commercialand industrial, consumer, agricultural and real estate, which includesresidential, construction and development and certain other real estateloans.  The Bank requires its loanofficers and loan committee to consider the borrower’s character, the borrower’sfinancial condition as reflected in current financial statements, the borrower’smanagement capability, the borrower’s industry and the economic environment inwhich the loan will be repaid.  Beforeapproving a loan, the loan officer or committee must determine that theborrower is basically honest and creditworthy, determine that the borrower is acapable manager, understand the specific purpose of the loan, understand thesource and plan of repayment, determine that the purpose, plan and source ofrepayment as well as collateral are acceptable, reasonable and practical giventhe normal framework within which the borrower operates.

 

CreditRisk Management and Reserve for Loan Losses

 

Credit risk and exposure to loss are inherent parts ofthe banking business.  Management seeksto manage and minimize these risks through its loan and investment policies andloan review procedures.  Managementestablishes and continually reviews lending and investment criteria andapproval procedures that it believes reflect the risk sensitive nature of theBank.  The loan review procedures are setto monitor adherence to the established criteria and to ensure that on acontinuing basis such standards are enforced and maintained.  Management’s objective in establishinglending and investment standards is to manage the risk of loss and provide forincome generation through pricing policies.

 

The loan portfolio is regularly reviewed andmanagement determines the amount of loans to be charged-off.  In addition, such factors as the Bank’sprevious loan loss experience, prevailing and anticipated economic conditions,industry concentrations and the overall quality of the loan portfolio areconsidered.  While management usesavailable information to recognize losses on loans 

 

8

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and real estate owned,future additions to the allowance may be necessary based on changes in economicconditions.  In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the allowances for losses on loans and real estateowned.  Such agencies may require theBank to recognize additions to the allowances based on their judgments aboutinformation available at the time of their examinations.  In addition, any loan or portion thereofwhich is classified as a “loss” by regulatory examiners is charged-off.

 

CapitalResources/Liquidity

 

*Liquidity.* Of primary importance to depositors, creditors and regulators is theability to have readily available funds sufficient to repay fully maturingliabilities.  The Bank’s liquidity,represented by cash and cash due from banks, is a result of its operating,investing and financing activities.  Inorder to insure funds are available at all times, the Bank devotes resources toprojecting on a monthly basis the amount of funds which will be required andmaintains relationships with a diversified customer base so funds areaccessible.  Liquidity requirements canalso be met through short-term borrowings or the disposition of short-termassets which are generally matched to correspond to the maturity ofliabilities.

 

The Bank is subject to general FDIC guidelines whichdo not require a minimum level of liquidity. Management believes its liquidity ratios meet or exceed theseguidelines.  Management does not know ofany trends or demands which are reasonably likely to result in liquidityincreasing or decreasing in any material manner.

 

*Impact of Inflation and ChangingPrices. *The consolidated financial statements and relatedconsolidated financial data presented herein have been prepared in accordancewith generally accepted accounting principles which require the measurement offinancial position and operating results in terms of historical dollars withoutconsidering the changes in the relative purchasing power of money over time anddue to inflation.  The impact ofinflation on operations of the Bank is reflected in increased operatingcosts.  Unlike most industrial companies,virtually all of the assets and liabilities of the Bank are monetary innature.  As a result, interest rates havea more significant impact on the Bank’s performance than the effects of generallevels of inflation.  Interest rates donot necessarily move in the same direction or in the same magnitude as theprice of goods and services.

 

CapitalAdequacy

 

Capital adequacy refers to the level of capital requiredto sustain asset growth over time and to absorb losses.  The objective of the Bank’s management is tomaintain a level of capitalization that is sufficient to take advantage ofprofitable growth opportunities while meeting regulatory requirements.  This is achieved by improving profitabilitythrough effectively allocating resources to more profitable businesses,improving asset quality, strengthening service quality, and streamliningcosts.  The primary measures used bymanagement to monitor the results of these efforts are the ratios of averageequity to average assets, average tangible equity to average tangible assets,and average equity to net loans.

 

The Federal Reserve Board has adopted capitalguidelines governing the activities of bank holding companies.  These guidelines require the maintenance ofan amount of capital based on risk-adjusted assets so that categories of assetswith potentially higher credit risk will require more capital backing thanassets with lower risk.  In addition,banks and bank holding companies are required to maintain capital to support,on a risk-adjusted basis, certain off-balance sheet activities such as loancommitments.

 

The capital guidelines classify capital into twotiers, referred to as Tier I and Tier II. Under risk-based capital requirements, total capital consists of Tier Icapital which is generally common stockholders’ equity less goodwill and TierII capital which is primarily a portion of the allowance for loan losses andcertain qualifying debt instruments.  Indetermining risk-based capital 

 

9

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requirements, assets areassigned risk-weights of 0% to 100%, depending primarily on the regulatoryassigned levels of credit risk associated with such assets.  Off-balance sheet items are considered in thecalculation of risk-adjusted assets through conversion factors established bythe regulators.  The framework forcalculating risk-based capital requires banks and bank holding companies tomeet the regulatory minimums of 4% Tier I and 8% total risk-basedcapital.  In 1990 regulators added aleveraged computation to the capital requirements, comparing Tier Icapital to total average assets less goodwill.

 

The Federal Deposit Insurance Corporation ImprovementAct of 1991 (“FDICIA”) established five capital categories for banks and bankholding companies.  The bank regulatorsadopted regulations defining these five capital categories in September 1992.  Under these new regulations each bank isclassified into one of the five categories based on its level of risk-basedcapital as measured by Tier I capital, total risk-based capital, andTier I leverage ratios and its supervisory ratings.

 

The following table lists the five categories ofcapital and each of the minimum requirements for the three risk-based capitalratios.

 
| ** **                     | ** ** | **Total Risk-Based  Capital Ratio** | ** ** | **Tier I Risk-Based  Capital Ratio** | ** ** | **Leverage Ratio** | ** ** |
|--------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|--------------------|------------|
|                           |       |                                |       |                                 |       |               |       |
| Well-capitalized               |       | 10% or above                        |       | 6% or above                          |       | 5% or above        |       |
|                           |       |                                |       |                                 |       |               |       |
| Adequately capitalized         |       | 8% or above                         |       | 4% or above                          |       | 4% or above        |       |
|                           |       |                                |       |                                 |       |               |       |
| Undercapitalized               |       | Less than 8%                        |       | Less than 4%                         |       | Less than 4%       |       |
|                           |       |                                |       |                                 |       |               |       |
| Significantly undercapitalized |       | Less than 6%                        |       | Less than 3%                         |       | Less than 3%       |       |
|                           |       |                                |       |                                 |       |               |       |
| Critically undercapitalized    |       | —                              |       | —                               |       | 2% or less         |       |

 

## **ITEM2.  DESCRIPTION OF PROPERTY**

 

All of the Bank’s properties are newly constructed andare located in Cleveland, Tennessee. The Bank’s main office is located at 3020Keith Street, NW.  This facility isapproximately 17,000 square feet, two stories and was opened in December 2002.  The Bank has two branch offices,approximately 2,400 square feet each. The branch located at 2530 Dalton Pike opened in May 2000 and the branchlocated at 3795 Georgetown Road opened in March 2001.

 

## **ITEM 3. LEGAL PROCEEDINGS**

## ** **

To the best of the Company’s knowledge, there are nopending legal proceedings, other than routine litigation incidental to thebusiness, to which the Company or the Bank is a party or of which any of theCompany’s or the Bank’s property is the subject.

 

## **ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

No matters were submitted to a vote of securityholders during the Company’s last quarter of 2004.

 

10

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# **PART II**

 

## **ITEM 5.  MARKET FOR COMMON EQUITY, RELATED STOCKHOLDERMATTERS AND SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES**

 

**Marketfor Common Stock**

 

As of December 31, 2004, the number of holders ofcommon stock, the only class of equity security of the Company issued andoutstanding, was 774.  The common stockof the Company is not traded through an organized exchange nor is there a knownactive public trading market.  All of thepurchases and sales of the common stock, of which management is aware withinthe last two fiscal years, for the Company’s common stock and the Bank’s commonstock, as applicable, have occurred in a price range of $20-$25 per share.  This sale price represents transactions whichmanagement is aware of, but does not necessarily represent all tradingtransactions for the period. There are outstanding options to purchase 150,535shares of common stock, 42,414 of which are currently exercisable.

 

**Dividends**

 

The payment of dividends is subject to the discretionof the Company’s board of directors. The Company’s ability to pay dividends isdependent on cash dividends paid to it by the Bank.  The ability of the Bank to pay dividends tothe Company is restricted by applicable regulatory requirements. For moreinformation on these restrictions, please see PART I, ITEM 1 “DESCRIPTION OFBUSINESS – Payment of Dividends.” The Company’s board of directors has notdeclared a dividend on the outstanding shares of its common stock during theprior two fiscal years.

 

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

** **

On August 8, 2000, the board of directors of theBank approved the Southern Heritage Bank 2000 Stock Option Plan for Employees(the “Plan for Employees”).  On August 8,2000, the board of directors of the Bank approved the 2000 Non-EmployeeDirectors’ Stock Option Plan (the “Non-Employee Director Plan”).  The Company’s stockholders have also approvedthe Plan for Employees and the Non-Employee Director Plan.  The Company exchanged its options with theholders of the Bank stock options under the Plan for Employees and the Non-EmployeeDirector Plan on an option-for-option basis. Thus, options that wereoutstanding under these Plans have been exchanged for options under the Company’sStock Option Plans.

 

The following table reflects the number of shares tobe issued upon the exercise of options granted under the Non-Employee DirectorPlan and the Plan for Employees, the weighted-average exercise price of allsuch options, and the total number of shares of common stock reserved forissuance upon the exercise of authorized, not-yet-granted options as of December 31,2004:

 

11

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| **Plan Category**                                               | ** ** | **# of Securities to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-average  Exercise Price of  Outstanding Options,  Warrants, and Rights** | ** ** | **# of Equity Securities  Remaining Available for  Future Issuance Under  Equity Compensation  Plans** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| **Equity  Compensation Plans Approved by Security Holders**     |       |                                                                                          |       |                                                                                |       |                                                                                                   |       |
| ** **                                                      |       |                                                                                          |       |                                                                                |       |                                                                                                   |       |
| **2000  Non-Employee Director Plan**                            |       | 11,000                                                                                        |       | $ 10.00                                                                        |       | -0-                                                                                                    |       |
| ** **                                                      |       |                                                                                          |       |                                                                                |       |                                                                                                   |       |
| **2000  Plan for Employees**                                    |       | 139,535                                                                                       |       | $ 12.80                                                                        |       | 1,908                                                                                                  |       |
| ** **                                                      |       |                                                                                          |       |                                                                                |       |                                                                                                   |       |
| **Equity  Compensation Plans Not Approved by Security Holders** | ** ** | **—**                                                                                    | ** ** | **—**                                                                          | ** ** | **—**                                                                                             | ** ** |
| ** **                                                      | ** ** | ** **                                                                                    | ** ** | ** **                                                                          | ** ** | ** **                                                                                             | ** ** |
| **TOTAL**                                                       |       | 150,535                                                                                       |       | $ 12.60                                                                        |       | 1,908                                                                                                  |       |

 

**Recent Sales of Unregistered Securities**

 

Since 2004, when holdersof stock of the Bank exchanged their shares for common stock of the Company,through December 31, 2004, the Company has not sold any securities withoutregistration under the Securities Act of 1933.

 

**Purchases of Equity Securities by the Company**

 

The Company did not makeany purchases of its common stock during the fourth quarter of 2004.

 

## **ITEM 6. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

## ** **

**Forward-Looking Statements**

** **

Management’s discussion of the Company and management’sanalysis of the Company’s operations and prospects, and other matters, mayinclude forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995 and other provisions of federal and statesecurities laws.  Although the Companybelieves that the assumptions underlying such forward-looking statementscontained in this Annual Report on Form 10-KSB are reasonable, any of theassumptions could be inaccurate and, accordingly, there can be no assurancethat the forward-looking statements included herein will prove to beaccurate.  The use of such words as “expect,”“anticipate,” “forecast,” and comparable terms should be understood by thereader to indicate that the statement is “forward-looking” and thus subject tochange in a manner that can be unpredictable. Factors that could cause actual results to differ from the resultsanticipated, but not guaranteed, in this Annual Report, include (withoutlimitation) economic and social conditions, competition for loans, mortgages,and other financial services and products, changes in interest rates,unforeseen changes in liquidity, results of operations, and financialconditions affecting the Company’s customers, and other risks that cannot beaccurately quantified 

 

12

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or completelyidentified.  Many factors affecting theCompany’s financial condition and profitability, including changes in economicconditions, the volatility of interest rates, political events and competitionfrom other providers of financial services simply cannot be predicted.  Because these factors are unpredictable andbeyond the Company’s control, earnings may fluctuate from period toperiod.  The purpose of this type ofinformation is to provide readers with information relevant to understandingand assessing the financial condition and results of operations of the Company,and not to predict the future or to guarantee results.  The Company is unable to predict the types ofcircumstances, conditions and factors that can cause anticipated results tochange.  The Company undertakes noobligation to publish revised forward-looking statements to reflect theoccurrence of changes or unanticipated events, circumstances, or results.

 

**Overview**

 

The following discussion and financial information arepresented to provide shareholders with a more comprehensive review of thefinancial condition and results of operations of the Bank than could beobtained from an examination of the financial statements alone.  The review should be read in conjunction withthe financial statements and accompanying notes set forth on pages F-1 throughF-18 of this Annual Report.

 

**Resultsof Operations**

 

Net income, after tax for 2004 was $1,376,000 comparedto $1,033,000 in 2003, an increase of 33.2%. Basic and diluted income per common share were $1.34 and $1.25respectively, in 2004, compared to $1.01 and $.97 in 2003.  No dividends were paid in 2004 or 2003.

 

NetInterest Income

 

Net interest income for 2004 was $5,252,000 comparedwith $4,325,000 in 2003.  This was dueprimarily to continued growth in the Bank’s loan portfolio in 2003, which wasfunded primarily by deposit growth.  Netinterest margin during 2004 was 3.85%, compared to 3.90% in 2003.  In 2004, the average yield on interestearning assets was 5.59%, compared with 5.71% in 2003.  During 2004, loans yielded 5.98%, comparedwith 6.16% in 2003.  The average ratepaid on interest-bearing deposits was 2.13% during 2004, compared to 2.17%during 2003.  Management expects that thecost of funds will increase in 2005 due to the Federal Reserve increasing thediscount rate.  During the last half of2004 the discount rate was increased five times by a total of 125 basis points,from 1.00% to 2.25%.  Due to thecompetition among all financial services firms for customers’ deposits the Bankexpects continued pressure on the net interest margin.

 

NoninterestIncome

 

Total noninterest income was $1,824,000 in 2004,compared with $1,486,000 in 2003.  Thelargest single source of noninterest income is service charges on depositaccounts.  Service charges on depositstotaled $1,184,000 in 2004 and $666,000 in 2003.  In May of 2004 we implemented a “bounceprotection” program for our customers. Bounce protection is an overdraftproduct that pays our customers’ non-sufficient fund checks (to a predeterminedlimit) for a fee.  This program and ourgrowing deposit base cause our NSF fee income to increase.  Mortgage banking income was $404,000 in 2004,versus $656,000 in 2003, the decline due to a decrease in refinancingactivity.  In 2004, we originated forsubsequent sale, 148 loans for $21,412,000 compared to 251 loans for$31,175,000 in 2003.  Net securitiesgains or losses reflected a gain of $16,000 in 2004 compared to a loss of$26,000 in 2003.  Other income includessafe deposit box rent, ATM interchange and surcharges, credit card interchangeincome, and the sales of checks to depositors. The most significant increase, $34,000 was in the ATM area which was dueto volume increase.  Management expects thatother fee income will continue to increase as the Bank increases in size.

 

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Noninterest Expense

 

Total noninterest expense was $4,442,000 in 2004, anincrease of $454,000, or 11.4% over the $3,988,000 in 2003.  Major components of this increase includesalaries and employee benefits (which increased $213,000 in 2004 when comparedto 2002), the cost of premises and equipment (an increase of $10,000 over theprior year), data processing ($11,000 increase), advertising and publicrelations ($44,000) and other expense ($176,000) which includes such items aspostage, outside fees and assessments, human resources, dues and subscriptions,loan expense, telephone, and loss on disposition of foreclosed property.

 

As of December 31, 2004, the Bank had 47full-time equivalent employees as compared to 44 at December 31,2003.  In September 2004, a 401Kprofit sharing retirement plan for all employees was implemented.  The Company’s match for the balance of 2004was $22,000.

 

The most significant area of increase in other expenseis in the outside fee area ( $113,000 or 47%). This area includes FDIC and State fees which increased $27,000 due tothe growth of the Bank.  Accounting,audit and consulting fees increased $81,000 due to outsourcing parts ofinternal audit, compliance and information technology testing, as well as thecost for external audit and tax services, along with legal advice on variousmatters.

 

Management expects that the cost of compliance withthe internal control requirements of Section 404 of the Sarbanes-Oxley Actof 2002 will have an adverse effect on noninterest expense in futureyears.  Overhead costs as a percentage ofboth interest income and total assets should continue to decrease as the Bankcontinues to grow.

 

ProvisionFor Loan Losses

 

The allowance for loan losses is maintained bymanagement at a level considered adequate to cover probable future losses inthe Bank’s loan portfolio.  Management’sdetermination of the appropriate provision for loan losses and the adequacy ofthe allowance for loan losses is based, in part, on the consideration of losshistories of other similar community financial institutions which managementbelieves are representative of the probable expected loss experience of theBank.  Other factors considered bymanagement include the composition of the loan portfolio, current economicconditions, the creditworthiness of the Bank’s borrowers and other relatedfactors.  The provision for loan losseswas $452,000 in 2004, compared with $283,000 in 2003.  At December 31, 2004, the allowance forloan losses was 1.37% of total loans, compared to 1.33% at year-end 2003.  Management allocated approximately 59% of thetotal allowance to commercial loans, 18% to residential mortgage and homeequity loans and 23% to consumer and credit card loans to individuals.  At December 31, 2004, $0 of theallowance for loan losses was allocated to impaired loan balances.  At December 31, 2004, five loanstotaling $85,000 was in nonaccrual status. Management believes the allowance for loan losses at December 31,2004, is adequate to absorb probable losses in the loan portfolio.

 

IncomeTaxes

 

The Company booked incometax expense of $806,000 in 2004 compared to $507,000 in 2003.  The effective tax rates for 2004 and 2003 are37% and 33% respectively.  Subject tolegislative tax changes, it is anticipated the effective tax rate to remainstable in 2005.  As of December 31,2004, the Company’s net deferred tax benefit was $256,000 compared to $136,000as of December 31, 2003.

 

14

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**Financial Condition**

 

Total assets at December 31, 2004, were$156,861,000 an increase of $27,945,000 or 21.7% over 2003 year-end assets of$128,916,000.  Deposits increased to$137,359,000 at December 31, 2004, an increase of $21,659,000 or 18.7%from $115,700,000 at December 31, 2003. The increased deposits were used primarily to fund loan growth.  Loans increased by $23,094,000, or 22.5%, to$125,925,000 at year-end 2004, from $102,831,000 at year-end 2003.  Securities were $19,667,000 at December 31,2004 compared to $15,654,000 at December 31, 2003.

 

Loans

 

Gross loans grew from $102,831,000 in 2003, to$125,925,000 in 2004, an increase of $23,094,000, or 22.5%.  Mortgage loans held for sale in 2004 were$683,000 compared to $278,000 in 2003, an increase of $405,000.  Most of the net loan growth in 2004 was incommercial and construction loans secured by real estate. Commercial loanssecured by real estate increased $11,200,000 and construction loans secured byreal estate increased $5,509,000.  In2004, $85,790,000, or 68.1% of total loans consist of construction, 1-4 familyresidential, and commercial loans secured by real estate.  Commercial loans totaling $33,503,000represent 26.6% of total loans.

 

Of the total loans of $125,925,000 in the portfolio asof year-end 2004, approximately $56,913,000 or 45.2% are variable rate loansand $69,012,000 are fixed rate loans.  Ofthe total loans, $82,863,000, or 65.8% mature or reprice within 12 months.  Only $2,673,000 or 2.1%  mature or reprice over five years.

 

Loan quality continues to be good as delinquent andnonaccrual loans were very low at the end of 2004.  On December 31, 2004 the Bank’s loan todeposit ratio (including mortgage loans held for sale) was 92.2%, compared to89.1% in 2003.  The loan to asset ratio(including mortgage loans held for sale) was 80.7% for 2004, compared to 79.9%in 2003.

 

Management expects loan demand to remain strong,especially in commercial loans. Management anticipates the loan-to-deposit ratio to remain in the rangeof approximately 85%-90% during the coming year.  Funding of future loan growth may berestricted by our ability to raise core deposits, although we will usealternative funding sources if necessary and cost effective.  Loan growth may also be restricted by thenecessity for us to maintain appropriate capital levels, as well as adequateliquidity.  We anticipate theloan-to-deposit ratio to remain in the range of 85%-90% during 2005.

 

Securities

 

 The compositionof our securities portfolio reflects our investment strategy of maintaining anappropriate level of liquidity while providing a relatively stable source ofincome.  Our securities portfolio alsoprovides a balance to interest rate and credit risk while providing a vehiclefor investing available funds, furnishing liquidity, and supplying securitiesto pledge as required for certain deposits and borrowed funds.  All securities are classified as “availablefor sale”.  We have no plans to liquidatea significant amount of the securities portfolio.

 

At December 31, 2004, the Bank owned $19,667,000in securities, compared to $15,654,000 in 2003. The net unrealized gain on securities at year-end 2004 was $5,000.  Total securities increased in 2004 by$4,013,000.  The Bank’s investmentportfolio is used to provide yield, liquidity and provide pledging to securepublic fund deposits.

 

15

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Premises and Equipment

 

The Bank’s fixed asset purchases were $123,000 in2003.  The most significant purchaseduring the year was the land acquisition in Polk county for a future branch,total cost $77,000.

 

Deposits

 

Total deposits were $137,359,000 at December 31,2004, compared to $115,700,000 at December 31, 2003.  At year-end 2004, $22,724,000, or 16.5% ofthe Bank’s total deposits are in noninterest-bearing demand accounts.  Interest-bearing demand accounts were$38,745,000 or 28.2% of total deposits.  Savingsaccounts total $5,948,000, or 4.3% of total deposits.  The majority of the deposits continue to bein time deposits.  Time deposits(certificate of deposits) total $69,943,000, or 50.9% of total deposits.  Time deposits greater than $100,000 were$37,008,000 and time deposits less than $100,000 were $32,935,000 in 2004.  The Bank has $52,998,000 in time depositsmaturing within three years.  Timedeposits maturing within one year were $31,151,000 or 44.5% of total timedeposits.  The weighted average cost ofall interest bearing deposit accounts was 2.13% in 2004. The weighted averageyield on certificates of deposits was 2.75%. There were $11,470,000 in brokered CDs at December 31,2004 comparedto $8,893,000 at December 31, 2003.

 

Liquidity

 

Liquidity refers to the Bank’s ability to fund loandemand, meet deposit customers’ withdrawal needs and provide for operatingexpenses.  As summarized in the Statementof Cash Flows, the Bank’s main sources of cash flow are from receiving depositsfrom its customers, and to a lesser extent, repayment of loan principal andinterest income on loans and securities.

 

The primary uses of cash are lending to the Bank’sborrowers, and investing in securities and short-term interest-earningassets.  In 2004, loan demand exceededdeposit growth by $1,435,000.  Theshortage was offset with the issuance of $5,155,000 of subordinatedebentures.  Other potential sources ofliquidity include the sale of securities available for sale from the Bank’ssecurities portfolio, the sale of loans held for sale, Federal Home Loan Bankadvances, the purchase of federal funds, repurchase agreements or brokereddeposits.

 

CapitalResources

 

The Bank’s total shareholders’ equity at December 31,2004 was $12,527,000, compared to $11,073,000 in December 31, 2003.  The increase of $1,454,000 was the result of2004 net income of $1,376,000, and the net increase of $78,000 in unrealizedgains on securities available for sale.

 

As of December 31, 2004 and 2003, the most recentregulatory notifications categorized the Bank as well capitalized under theregulatory framework for prompt corrective action.  The total capital to risk-weighted assetsratio for the Bank was 13.79%.  Tier-1 torisk weighted assets ratio was 11.96%. Tier 1 to average asset ratio was 10.73%.

 

InterestRate Sensitivity

 

Financial institutions are subject to interest raterisk to the degree that their interest-bearing liabilities (consistingprincipally of customer deposits) mature or reprice more or less frequentlythan their interest-earning assets (generally consisting of loans andinvestment securities.  The match betweenthe scheduled repricing and maturities of earning assets and liabilities withindefined time periods is referred to as “gap” analysis.  At December 31, 2004 the cumulativeone-year gap was a positive (or asset sensitive) $7,679,000, or 5.2% of totalearnings assets.

 

16

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One of management’s objectives in managing the Bank’sbalance sheet for interest rate sensitivity is to reduce volatility in the netinterest margin by matching, as closely as possible, the timing of therepricing of its interest rate sensitive assets with interest rate sensitiveliabilities.  During 2004 the Bankexperienced five increases compared to one decrease in 2003.  The result was a decrease in the net interestmargin to 3.85% in 2004 compared to 3.90% in 2003.  Management believes that, as of year-end2004, interest rates will continue to increase over the next two years.

 

**Interest Rate Gap Analysis**

 
| ** **                                             | ** ** | **Reprice’s or Maturing Within  (Dollars in Thousands)** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **0-3  Months**                                               | ** ** | **3-12  Months** | ** ** | **Total  1 Year** | ** ** | **1-5  Years** | ** ** | **Over  5 Years** | ** ** | **Total** | ** ** |
| ASSETS                                                 |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Securities                                             |       | $                                                             | 565        |   | $ | 52 |   | $ | 617 |   | $ | 3,636 |   | $ | 15,414 |   | $ | 19,667 |   |
| Fed Funds  Sold                                        |       | 440                                                           |       | — |   | 440 |   | — |   | — |   | 440 |   |
| Loans                                                  |       | 66,889                                                        |       | 16,657 |   | 83,546 |   | 40,389 |   | 2,673 |   | 126,608 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Total  Earning Assets                                  |       | $                                                             | 67,894     |   | $ | 16,709 |   | $ | 84,603 |   | $ | 44,025 |   | $ | 18,087 |   | 146,715 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                            |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits                             |       | $                                                             | 55,447     |   | $ | 20,425 |   | $ | 75,872 |   | $ | 38,763 |   | $ | — |   | 114,635 |   |
| Other  borrowings                                      |       | 1,052                                                         |       | — |   | 1,052 |   | — |   | — |   | 1,052 |   |
| Total  interest-bearing liabilities                    |       | $                                                             | 56,499     |   | $ | 20,425 |   | $ | 76,924 |   | $ | 38,763 |   | $ | — |   | 115,687 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Asset  (liability) GAP                                 |       | 11,395                                                        |       | (3,716 | ) | 7,679 |   | 5,262 |   | 18,087 |   | 31,028 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative  asset (liability) GAP                      |       | 11,395                                                        |       | 7,679 |   | 7,679 |   | 12,941 |   | 31,028 |   | 31,028 |   |
|                                                   |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Cumulative  as a percentage of interest-earning assets |       | 7.8%                                                          |       | 5.2% |   | 5.2% |   | 8.8% |   | 21.1% |   | 21.1% |   |
|                                                        |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

17

----

 

**Item1.  BUSINESS - STATISTICAL DISCLOSURE**

 

**I.  Distribution of Assets, Liabilities andShareholders’ Equity; Interest Rates and Interest Differential**

 

**SOUTHERN HERITAGE BANK**

**Average Balance Sheets, Net Interest Revenue and**

**Changes in Interest Income and Interest Expense**

 

                The following table shows the average daily balancesof each principal category of assets, liabilities and stockholders’ equity ofthe Bank, and an analysis of net interest revenue, and the change in interestincome and interest expense segregated into amounts attributable to changes involume and changes in rates.

 
| ** **                                      | ** ** | **In Thousands of dollars** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **December 31, 2004**       | ** ** | **December 31, 2003** | ** ** | **Change** | ** ** |
| ** **                                      | ** ** | **Average  Balance**        | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Average  Balance** | ** ** | **Interest  Rate** | ** ** | **Revenue/  Expense** | ** ** | **Due to  Volume** | ** ** | **Due to  Rate (1)** | ** ** | **Total** | ** ** |
| ** **                                      | ** ** | ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Gross loans (2 and 3)                           | ** ** | $                           | 116,267    |   | 5.98 | % | $ | 6,957 |   | $ | 94,428 |   | 6.16 | % | $ | 5,821 |   | $ | 1,346 |   | (210 | ) | 1,136 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities available for sale                   | ** ** | 15,781                      |       | 3.82 | % | 603 |   | 11,384 |   | 4.01 | % | 456 |   | 176 |   | (29 | ) | 147 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                              | ** ** | 4,244                       |       | 1.30 | % | 55 |   | 5,049 |   | 1.09 | % | 55 |   | (9 | ) | 9 |   | 0 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                   | ** ** | 136,292                     |       | 5.59 | % | $ | 7,615 |   | 110,861 |   | 5.71 | % | $ | 6,332 |   | $ | 1,513 |   | (230 | ) | 1,283 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                         | ** ** | 4,260                       |       |   |   |   |   | 3,791 |   |   |   |   |   |   |   |   |   |   |   |
| Other nonearning assets                         | ** ** | 6,719                       |       |   |   |   |   | 6,783 |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for loan losses                       | ** ** | (1,549                      | )          |   |   |   |   | (1,287 | ) |   |   |   |   |   |   |   |   |   |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                    | ** ** | $                           | 145,722    |   |   |   |   |   | $ | 120,148 |   |   |   |   |   |   |   |   |   |   |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                       | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money market investments                | ** ** | $                           | 38,196     |   | 1.23 | % | $ | 468 |   | $ | 32,773 |   | 1.31 | % | $ | 429 |   | $ | 71 |   | (32 | ) | 39 |   |
| Savings                                         | ** ** | 5,391                       |       | 0.96 | % | 52 |   | 3,817 |   | 1.10 | % | 42 |   | 17 |   | (7 | ) | 10 |   |
| Time depositis $100,000 and over                | ** ** | 35,520                      |       | 2.67 | % | 947 |   | 27,334 |   | 2.61 | % | 714 |   | 214 |   | 19 |   | 233 |   |
| Other time deposits                             | ** ** | 31,628                      |       | 2.83 | % | 896 |   | 28,482 |   | 2.89 | % | 822 |   | 91 |   | (17 | ) | 74 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing deposits                 | ** ** | 110,735                     |       | 2.13 | % | 2,363 |   | 92,406 |   | 2.17 | % | 2,007 |   | 393 |   | (37 | ) | 356 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities                 | ** ** | 22,976                      |       | — |   | — |   | 17,071 |   | — |   | — |   | — |   | — |   | — |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                               | ** ** | 133,711                     |       |   |   |   |   | 109,477 |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                       | ** ** | 12,011                      |       |   |   |   |   | 10,671 |   |   |   |   |   |   |   |   |   |   |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities and shareholders’ equity | ** ** | $                           | 145,722    |   |   |   |   |   | $ | 120,148 |   |   |   |   |   |   |   |   |   |   |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                             | ** ** |                        |       |   |   | $ | 5,252 |   |   |   |   |   | $ | 4,325 |   | $ | 1,120 |   | (193 | ) | 927 |   |
|                                            | ** ** |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4)                         | ** ** |                        |       | 3.85 | % |   |   |   |   | 3.90 | % |   |   |   |   |   |   |   |   |

 

----

(1)   Changes in interest income and expense notdue solely to balance or rate changes are included in the rate category.

(2)   Interest income includes fees on loans of$730,000 in 2004 and $456,000 in 2003.

(3)   Nonaccrual loans are included in average loanbalances and the associated income (recognized on a cash basis) is included ininterest.

(4)   Net interest income to averageinterest-earning assets

 

18

----

                The following table showsthe average daily balances of each principal category of assets, liabilitiesand stockholders’ equity of the Bank, and an analysis of net interest revenue,and the change in interest income and interest expense segregated into amountsattributable to changes in volume and changes in rates.

 
| ** **                                       | ** ** | **In  Thousands of dollars** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | ** **                   | ** ** |
| ** **                                       | ** ** | **December  31, 2003**       | ** ** | **December  31, 2002** | ** ** | **Change** | ** ** |
| ** **                                       | ** ** | **Average**                  | ** ** | **Interest** | ** ** | **Revenue/** | ** ** | **Average** | ** ** | **Interest** | ** ** | **Revenue/** | ** ** | **Due to** | ** ** | **Due to** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Balance**                  | ** ** | **Rate** | ** ** | **Expense** | ** ** | **Balance** | ** ** | **Rate** | ** ** | **Expense** | ** ** | **Volume** | ** ** | **Rate (1)** | ** ** | **Total** | ** ** |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross loans (2  and 3)                           |       | $                            | 94,428     |   | 6.16 | % | $ | 5,821 |   | $ | 69,462 |   | 6.81 | % | $ | 4,733 |   | $ | 1,701 |   | (613 | ) | 1,088 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities  available for sale                   |       | 11,384                       |       | 4.01 | % | 456 |   | 11,051 |   | 5.71 | % | 631 |   | 19 |   | (194 | ) | (175 | ) |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold                              |       | 5,049                        |       | 1.09 | % | 55 |   | 4,231 |   | 1.65 | % | 70 |   | 14 |   | (29 | ) | (15 | ) |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 110,861                      |       | 5.71 | % | $ | 6,332 |   | 84,744 |   | 6.41 | % | $ | 5,434 |   | $ | 1,734 |   | (836 | ) | 898 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from  banks                         |       | 3,791                        |       |   |   |   |   | 3,151 |   |   |   |   |   |   |   |   |   |   |   |
| Other nonearning  assets                         |       | 6,783                        |       |   |   |   |   | 4,919 |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for  loan losses                       |       | (1,287                       | )          |   |   |   |   | (909 | ) |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                            | 120,148    |   |   |   |   |   | $ | 91,905 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                        |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW and money  market investments                |       | $                            | 32,773     |   | 1.31 | % | $ | 429 |   | $ | 26,188 |   | 1.67 | % | $ | 437 |   | $ | 110 |   | (118 | ) | (8 | ) |
| Savings                                          |       | 3,817                        |       | 1.10 | % | 42 |   | 2,087 |   | 1.39 | % | 29 |   | 24 |   | (11 | ) | 13 |   |
| Time depositis  $100,000 and over                |       | 27,334                       |       | 2.61 | % | 714 |   | 18,991 |   | 3.11 | % | 590 |   | 259 |   | (135 | ) | 124 |   |
| Other time  deposits                             |       | 28,482                       |       | 2.89 | % | 822 |   | 22,091 |   | 3.05 | % | 673 |   | 195 |   | (46 | ) | 149 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing deposits                 |       | 92,406                       |       | 2.17 | % | 2,007 |   | 69,357 |   | 2.49 | % | 1,729 |   | 588 |   | (310 | ) | 278 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities                 |       | 17,071                       |       | — |   | — |   | 12,891 |   | — |   | — |   | — |   | — |   | — |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                |       | 109,477                      |       |   |   |   |   | 82,248 |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’  equity                       |       | 10,671                       |       |   |   |   |   | 9,657 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities  and shareholders’ equity |       | $                            | 120,148    |   |   |   |   |   | $ | 91,905 |   |   |   |   |   |   |   |   |   |   |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income                             |       |                         |       |   |   | $ | 4,325 |   |   |   |   |   | $ | 3,705 |   | $ | 1,146 |   | (526 | ) | 620 |   |
|                                             |       |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin (4)                         |       |                         |       | 3.90 | % |   |   |   |   | 4.37 | % |   |   |   |   |   |   |   |   |

----

(1)    Changes in interest income and expense notdue solely to balance or rate changes are included in the rate category.

(2)    Interest income includes fees on loans of$456,000 in 2003 and $215,000 in 2002.

(3)    Nonaccrual loans areincluded in average loan balances and the associated income (recognized on acash basis) is included in interest.

(4)    Net interest income to averageinterest-earning assets

 

19

----

 

 

II.            INVESTMENT PORTFOLIO

 

The carrying value ofsecurities at December 31 is summarized as follows:

 
| ** **                  | ** ** | **December 31**      | ** ** |
|-----------------------------|------------|---------------------------|------------|
| **Category**                | ** ** | **2004**                  | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **($ in thousands)** | ** ** |
| Available  for sale:        |       |                      |       |   |   |
|                        |       |                      |       |   |   |
| U.S.  Government securities |       | $                         | 1,486      |   | $ | 1,477 |   |
| State and  municipal        |       | 12,070                    |       | 6,132 |   |
| Mortgage-backed             |       | 5,611                     |       | 7,538 |   |
| Corporate  notes            |       | 500                       |       | 507 |   |
|                        |       |                      |       |   |   |
| Total                       |       | $                         | 19,667     |   | $ | 15,654 |   |

 

The following table presents the carrying value bymaturity distribution of the investment portfolio along with weighted averageyields thereon as of December 31, 2004:

 
| **($ in thousands)**                | ** ** | **Within  1 Year** | ** ** | **1-5  Years** | ** ** | **Beyond  5 Years** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|--------------------|------------|----------------|------------|---------------------|------------|-----------|------------|
| U.S.  Government securities              |       | $                  |       |           |       |                | $          | 1,486     |       | $ | 1,486 |   |
| State and  municipal                     |       |               |       |           |       | 12,070              |       | 12,070    |       |
| Corporate  notes                         |       |               |       |           |       | 500                 |       | 500       |       |
| Weighted  average yield (tax equivalent) |       |               |       |           |       | 4.44                | %          | 4.44      | %          |
|                                     |       |               |       |           |       |                |       |      |       |
| Mortgage-backed                          |       |               |       |           |       |                |       | $         | 5,611      |   |
|                                     |       |               |       |           |       |                |       |      |       |
| Weighted  average yield                  |       |               |       |           |       |                |       | 4.18      | %          |
|                                          |            |                    |            |                |            |                     |            |           |            |  |  |  |

 

III.           LOAN PORTFOLIO

 

The following table presents various categories ofloans contained in the Bank’s loan portfolio for the periods indicated and thetotal amount of all loans for such period:

 
| ** **                               | ** ** | **2004**                  | ** ** | **2003** | ** ** |
|------------------------------------------|------------|---------------------------|------------|----------|------------|
| ** **                               | ** ** | **($ in thousands)** | ** ** |
| Domestic:                                |       |                      |       |     |       |
|                                     |       |                      |       |     |       |
| Commercial,  financial and agricultural  |       | $                         | 33,503     |     | $          | 29,773 |   |
| Real estate  - construction              |       | 22,014                    |       | 16,505   |       |
| Real estate  - 1 to 4 family residential |       | 23,144                    |       | 21,357   |       |
| Real estate  - commercial                |       | 40,632                    |       | 29,432   |       |
| Consumer                                 |       | 6,632                     |       | 5,768    |       |
| Total loans                              |       | 125,925                   |       | 102,830  |       |
| Allowance  for possible loan losses      |       | (1,723                    | )          | (1,372   | )          |
|                                     |       |                      |       |     |       |
| Total (net  of allowance)                |       | $                         | 124,202    |     | $          | 101,458 |   |

 

20

----

 

The following is apresentation of an analysis of maturities of loans as of December 31,2004:

 
| **Type of Loan**                        | ** ** | **Due in 1  Year or  Less** | ** ** | **Due in 1  to 5 Years** | ** **               | **Due After  5 Years** | ** ** | **Total**                    | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|--------------------------|--------------------------|------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **($ in thousands)**   | ** ** |
| Commercial,  financial and agricultural |       | $ 27,528               |       |                     | $   5,437 |                   |       | $    538 |       |   | $ 33,503 |   |   |
| Real estate  - construction             |       | 14,108                      |       |                     | 6,377                    |                   |       | 1,529                        |       |   | 22,014 |   |   |
|                                    |       |                        |       |                     |                     |                   |       |                         |       |   |   |   |   |
| Total                                   |       | $ 41,636               |       |                     | $ 11,814            |                   |       | $ 2,067                 |       |   | $ 55,517 |   |   |

 

The following is apresentation of an analysis of sensitivities of such loans to changes ininterest rates as of December 31, 2002 (in thousands):

 
| Loans due  after 1 year with fixed interest rates    |   | $      | 10,952 |   |
|------------------------------------------------------|--------|--------|--------|--------|
|                                                 |   |   |   |
| Loans due  after 1 year with variable interest rates |   | $      | 2,929  |   |

 

The following tablepresents information regarding nonaccrual, past due and restructured loans atthe dates indicated:

 
| ** **                                                                                                                          | ** ** | **December 31,**       | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                          | ** ** | **2004**                    | ** ** | **2003** | ** ** |
| ** **                                                                                                                          | ** ** | **($ in thousands)**   | ** ** |
| Loans  accounted for on a non-accrual basis:                                                                                        |       |                        |       |   |   |
| Number                                                                                                                              |       | 5                           |       | 1 |   |
| Amount                                                                                                                              |       | $    85 |       | $   5 |   |
|                                                                                                                                |       |                        |       |   |   |
| Accruing  loans (including consumer loans) which are contractually past due 90 days or  more as to principal and interest payments: |       |                        |       |   |   |
| Number                                                                                                                              |       | 2                           |       | 2 |   |
| Amount                                                                                                                              |       | $  1,518          |       | $  80 |   |
|                                                                                                                                |       |                        |       |   |   |
| Loans  defined as “troubled debt restructurings”                                                                          |       |                        |       |   |   |
| Number                                                                                                                              |       | —                      |       | — |   |
| Amount                                                                                                                              |       | $  —         |       | $  — |   |

 

As of December 31, 2004, there are no loansclassified for regulatory purposes as doubtful or substandard that have notbeen disclosed in the above table, which (i) represent or result from trends oruncertainties which management reasonably expects will materially impact futureoperating results, liquidity, or capital resources, or (ii) represent materialcredits about which management is aware of any information which causesmanagement to have serious doubts as to the ability of such borrowers to complywith the loan repayment terms.

 

21

----

 

Accrual of interest isdiscontinued on a loan when management of the Bank determines uponconsideration of economic and business factors affecting collection effortsthat collection of interest is doubtful.

 

There are no other loanswhich are not disclosed above, but where known information about possiblecredit problems of borrowers causes management to have serious doubts as to theability of such borrowers to comply with the present loan repayment terms.

 

IV.           SUMMARY OF LOAN LOSSEXPERIENCE

 

An analysis of the Bank’sloss experience is furnished in the following table for the periods indicated,as well as a breakdown of the allowance for possible loan losses (in thousands):

 
| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                         | ** ** | **2003** | ** ** |
|                                                                                       |       |                             |       |   |   |
| Balance at  beginning of period                                                            |       | $                                | 1,372      |   | $ | 1,196 |   |
|                                                                                       |       |                             |       |   |   |
| Charge-offs:                                                                               | Commercial |                             | (67        | ) | (82 | ) |
|                                                                                       | Consumer   |                             | (47        | ) | (44 | ) |
|                                                                                       |       | (114                             | )          | (126 | ) |
| Recoveries                                                                                 |       | 14                               |       | 19 |   |
| Net  Charge-offs                                                                           |       | (100                             | )          | (107 | ) |
|                                                                                       |       |                             |       |   |   |
| Additions  charged to operations                                                           |       | 452                              |       | 283 |   |
|                                                                                       |       |                             |       |   |   |
| Balance at  end of period                                                                  |       | $                                | 1,724      |   | $ | 1,372 |   |
|                                                                                       |       |                             |       |   |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |       | .09                              | %          | .11 | % |

 

At December 31, 2004and 2003 the allowance was allocated as follows ($ in thousands):

 
| ** **                              | ** ** | **2004**                           | ** ** | **2003**                                                   | ** ** |
|-----------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                              | ** ** | **Amount**                         | ** ** | **Percentage of  loans in each  category to  total loans** | ** ** | **Amount** | ** ** | **Percentage of  loans in each  category to  total loans** | ** ** |
|                                    |       |                               |       |                                                       |       |   |   |   |   |
| Commercial,  financial and agricultural |       | $  690    |       | 29%                                                        |       | $  549    |   | 29% |   |
| Real  estate-construction               |       | 172                                |       | 13%                                                        |       | 137 |   | 16% |   |
| Real  estate-1 to 4 family residential  |       | 172                                |       | 20%                                                        |       | 137 |   | 21% |   |
| Real  estate-commercial                 |       | 259                                |       | 35%                                                        |       | 206 |   | 28% |   |
| Consumer  loans                         |       | 431                                |       | 6%                                                         |       | 343 |   | 6% |   |
|                                    |       |                               |       |                                                       |       |   |   |   |   |
| Total                                   |       | $  1,724                 |       | 100%                                                       |       | $  1,372 |   | 100% |   |

 

22

----

 

Allowance For Loan Losses

 

In considering the adequacy of the Company’s allowancefor loan losses, management has focused on the fact that as of December 31,2004, 67% of outstanding loans are secured by real estate.

 

The Bank’s consumer loan portfolio is also wellsecured, and as such, does not, in management’s opinion involve more thannormal credit risk.  The same is true forthe Bank’s real estate mortgage portfolio, approximately 18% of which issecured by first mortgage on 1-4 family residential properties.

 

Although the Bank’s loan portfolio is concentrated inEast Tennessee, management does not believe this geographic concentrationpresents an abnormally high risk.

 

V.            DEPOSITS

 

The following tables present, for the periodsindicated, the average amount of and average rate paid on each of the followingdeposit categories ($ in thousands):

 
| ** **                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| **Deposit Category**        | ** ** | **Average  Amount**               | ** ** | **Average Rate  Paid** | ** ** | **Average  Amount** | ** ** | **Average Rate  Paid** | ** ** |
|                        |       |                              |       |   |   |   |   |   |   |
| Noninterest-bearing  demand |       | $  22,443               |       |   | Not  applicable |   | $  15,928 |   |   | Not  applicable |   |
| NOW deposits                |       | 38,196                            |       |   | 1.23 | % |   | 32,773 |   |   | 1.31 | % |   |
| Savings  deposits           |       | 5,391                             |       |   | .96 | % |   | 3,817 |   |   | 1.10 | % |   |
| Time  deposits              |       | 66,891                            |       |   | 2.75 | % |   | 55,816 |   |   | 2.75 | % |   |

 

The following table indicates amount outstanding oftime certificates of deposit of $100,000 or more and respective maturities forthe year ended December 31, 2004 (in thousands):

 

| ** **              | ** ** | **Certificates of Deposit**                            | ** ** |
|-------------------------|------------|--------------------------------------------------------|------------|
|                    |       |                                                   |       |
| 3 months or  less       |       | $        5,772 |       |   |
| 3-12 months             |       | 10,583                                                 |       |   |
| 12 months  thru 3 years |       | 11,195                                                 |       |   |
| over 3 years            |       | 9,458                                                  |       |   |
|                    |       |                                                   |       |   |
| Total                   |       | $      37,008            |       |   |

 

23

----

 

VI.           RETURN ON EQUITY AND ASSETS

 

Returns on averageconsolidated assets and average consolidated equity for the periods indicatedare as follows:

 
| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **2004**                         | ** ** | **2003** | ** ** |
|                                    |       |                             |       |   |   |
| Return  (loss) on average assets        |       | .97                              | %          |   | .86 | % |   |
| Return  (loss) on average equity        |       | 11.68                            | %          |   | 9.72 | % |   |
| Average  equity to average assets ratio |       | 8.32                             | %          |   | 8.91 | % |   |
| Dividend  payout ratio                  |       | —                           | %          |   | — | % |   |

 

VII.          SHORT-TERM BORROWINGS

 

Information concerningsecurities sold under agreements to repurchase is summarized as follows ($ inthousands):

 
| ** **                                  | ** ** | **2004**         | ** ** | **2003** | ** **       |
|---------------------------------------------|------------|------------------|------------|----------|------------------|
|                                        |       |             |       |     |             |
| Average  daily balance during the year      |       | $  206 |       |     | $  613 |   |   |
| Average  interest rate during the year      |       | .32              | %          |     | .52              | % |   |
| Maximum  month-end balance during the year  |       | $  316 |       |     | $  694 |   |   |
| Weighted  average interest rate at year-end |       | .93              | %          |     | .15              | % |   |

 

VIII.        OTHER BORROWINGS

 

A trust formed by the Company issued $5,000 offloating rate( 3 month LIBOR plus 2.05%) trust preferred securities in December 2004 as part of a pooledoffering of such securities.  The Companyissued subordinated debentures in amount of $5,155 to the trust in exchange forthe proceeds of the offering; the debentures represent the sole asset of thetrust.  The Company may redeem thesubordinated debentures, in whole or in part, after December 2009.  The subordinated debentures must be redeemedno later than December 2034.

 

## **ITEM 7. FINANCIAL STATEMENTS**

 

The report of Independent Accountants, ConsolidatedFinancial Statements and supplementary data required by Item 7 are set forth onpages F-1 through F-19 of this Annual Report and are incorporated herein byreference.

 

## **ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 8A.  CONTROLS ANDPROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

The Company maintains disclosure controls andprocedures, as defined in Rule 13a-15(a) promulgated under the SecuritiesExchange Act of 1934 (the “Exchange Act”), that are designed to ensure thatinformation required to be disclosed by it in the reports 

 

24

----

 

that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported withinthe time period specified in the SEC’s rules and forms and that suchinformation is accumulated and communicated to the Company’s management, includingits Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosure. The Company carried outan evaluation, under the supervision and with the participation of itsmanagement, including its Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of its disclosure controls andprocedures as of the end of the period covered by this report. Based on theevaluation of these disclosure controls and procedures, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures were effective.

 

**Changesin Internal Controls and Procedures**

 

There were no changes in the Company’s internalcontrol over financial reporting during the Company’s fiscal quarter ended December 31,2004 that have materially affected, or are reasonably likely to materiallyaffect, its internal control over financial reporting.

 

**ITEM8B.  OTHER INFORMATION**

 

None.

 

# **PART III**

 

## **ITEM 9. **DIRECTORSAND EXECUTIVE OFFICERS OF REGISTRANT

 

Information relating to our directors and executiveofficers will be contained in a definitive Proxy Statement involving theelection of directors at the annual meeting of shareholders to be held May 19,2005, and such information is incorporated herein by reference.

 

## **ITEM 10.  EXECUTIVE COMPENSATION.**

 

Information relating to executive compensation will becontained in the Proxy Statement referred to above in Item 9, and suchinformation is incorporated herein by reference.

 

## **ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.**

 

Information relating to security ownership of certainbeneficial owners and management will be contained in the Proxy Statement referredto above in Item 9, and such information is incorporated herein by reference.

 

## **ITEM 12. **CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

 

Information relating to certain relationships andrelated transactions will be contained in the Proxy Statement referred to abovein Item 9, and such information is incorporated herein by reference.

 

25

----

 

## **ITEM 13.  EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                            |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                       |
| 3.1*            |       | Charter of Southern Heritage Bank                                                                                                          |
| 3.2*            |       | Bylaws of Southern Heritage Bank                                                                                                           |
| 4*              |       | Specimen Stock Certificate for Southern Heritage  Bancshares, Inc.                                                                         |
| 10.1            |       | 2000 Stock Option Plan for Employees for Southern  Heritage Bancshares, Inc., as successor-in-interest to Southern Heritage Bank           |
| 10.2            |       | 2000 Non-Employee Directors Stock Option Plan for  Southern Heritage Bancshares, Inc., as successor-in-interest to Southern  Heritage Bank |
| 21              |       | Subsidiaries of Registrant                                                                                                                 |
| 31.1            |       | Certification pursuant to Rule 13a-14a/15d-14(a)                                                                                           |
| 31.2            |       | Certification pursuant to Rule 13a-14a/15d-14(a)                                                                                           |
| 32.1            |       | Certification pursuant to Rule 18 USC Section 1350-Sarbanes-Oxley  Act of 2002                                                        |
| 33.2            |       | Certification pursuant to Rule 18 USC Section 1350-Sarbanes-Oxley  Act of 2002                                                        |

 

----

*Previously filed as anexhibit to the Company’s Registration Statement on Form 8-KSB, as filed withthe Securities and Exchange Commission on August 31, 2004.

 

## **ITEM 14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Information relating tocertain relationships and related transactions will be contained in the ProxyStatement referred to above in Item 9, and such information is incorporatedherein by reference.

 

26

----

 

In accordance with Section 13or 15(d) of the Securities Exchange Act of 1934, the registrant caused thisregistration statement to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|   |   | **SOUTHERN HERITAGE BANCSHARES, INC.** |
|--------|--------|----------------------------------------|
|   |   | ** **                             |
|   |   |                                   |   |
|   |   | By:                                    | /s/ Steven W. Ledbetter |
|   |   |                                   | Steven W. Ledbetter, Executive Vice  President and Chief Financial Officer |

 

In accordance withthe Exchange Act, this report has been signed below by the following persons onbehalf of the registrant in their capacities as directors.

 
| By:                         |  /s/ R. Danny Hays, M.D.          |                            |   | By:         |  /s/ Larry S. McDaniel     |   |
|-----------------------------|----------------------------------------|---------------------------------|--------|-------------|---------------------------------|--------|
|  R. Danny Hays, M.D.   |                                   |  Larry S. McDaniel         |
| Date:                       |   April 13, 2005        |                            |   | Date:  |   April 13, 2005 |   |
|                        |                                   |                            |
|                        |                                   |                            |
| By:                         |  /s/ Steven W. Ledbetter          |                            |   | By:    | /s/ J. Lee Stewart              |   |
|  Steven W. Ledbetter   |                                   |  J. Lee Stewart            |
| Date:                       |    April 13,  2005 |                            |   | Date:  |   April 13, 2005 |   |
|                        |                                   |                            |
|                        |                                   |                            |
| By:                         |  /s/ Henry F. Smith               |                            |   | By:    | /s/ Len D. Graham               |   |
|  Henry F. Smith        |                                   |  Len D. Graham             |
| Date:                  |   April 13, 2005        |                            |   | Date:  |   April 13, 2005 |   |
|                        |                                   |                            |
|                        |                                   |                            |
| By:                    | /s/ Jim A. Workman                     |                            |   | By:    | /s/ Clyde A. Kyle, Jr., M.D.    |   |
|  Jim A. Workman        |                                   |  Clyde A. Kyle, Jr., M.D.  |
| Date:                  |   April 13, 2005        |                            |   | Date:  |   April 13, 2005 |   |
|                        |                                   |                            |
|                        |                                   |                            |
| By:                    | /s/ Eddie N. Duncan, M.D.              |                            |   | By:    | /s/ Lester T. Simerville, Sr.   |   |
|  Eddie N. Duncan, M.D. |                                   |  Lester T. Simerville, Sr. |
| Date:                  |   April 13, 2005        |                            |   | Date:  |   April 13, 2005 |   |
|                        |                                   |                            |
|                        |                                   |                            |
| By:                    | /s/ Roger E. Jenne, Esq.               |                            |   | By:    | /s/ James F. Williams, Jr.      |   |
|  Roger E. Jenne, Esq.  |                                   |  James F. Williams, Jr.    |
| Date:                  |   April 13, 2005        |                            |   | Date:  |   April 13, 2005 |   |
|                             |                                        |                                 |        |             |                                 |        |  |  |  |

 

27

----

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

 

# **CONSOLIDATEDFINANCIAL STATEMENTS**

**December31, 2004 and 2003**

 

----

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

# **Cleveland, Tennessee**

 

**CONSOLIDATED FINANCIAL STATEMENTS**

# **D**ecember31, 2004 and 2003

 

# **CONTENTS**

 

 
| REPORT  OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 1 |                                                             |
|------------------------------------------------------------|------------------------------------------------------------------|
|                                                       |                                                             |   |
| CONSOLIDATED  FINANCIAL STATEMENTS                         |                                                             |
|                                                       |                                                             |   |
|                                                       | CONSOLIDATED BALANCE SHEETS                                      |   |
|                                                       |                                                             |   |
|                                                       | CONSOLIDATED  STATEMENTS OF OPERATIONS                           |   |
|                                                       |                                                             |   |
|                                                       | CONSOLIDATED  STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY |   |
|                                                       |                                                             |   |
|                                                       | CONSOLIDATED  STATEMENTS OF CASH FLOWS                           |   |
|                                                       |                                                             |   |
|                                                       | NOTES  TO CONSOLIDATED FINANCIAL STATEMENTS                      |   |
|                                                            |                                                                  |  |  |

 

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

 

The Board of Directors

Southern Heritage Bancshares, Inc.

Cleveland, Tennessee

 

We have audited the consolidated balance sheets of Southern HeritageBancshares, Inc. as of December 31, 2004 and 2003, and the related consolidatedstatements of operations, changes in shareholders’ equity and cash flows forthe years then ended.  These financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards of thePublic Company Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of SouthernHeritage Bancshares, Inc. as of December 31, 2004 and 2003, and the results ofits operations and its cash flows for the years then ended in conformity withaccounting principles generally accepted in the United States of America.

 

 
|                 |   | Crowe Chizek and Company LLC |
|----------------------|--------|------------------------------|
| Brentwood, Tennessee |   |                         |
| March 29, 2005       |   |                         |

 

F-1

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**December 31, 2004 and 2003**

 

(Dollar amounts in thousands except per sharedata)

 
| ** **                                                                        | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **ASSETS**                                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and due from financial institutions                                          |       | $          | 4,653      |       | $          | 4,455 |   |
| Federal funds sold                                                                |       | 440        |       | 90         |       |
| Cash and cash equivalents                                                         |       | 5,093      |       | 4,545      |       |
|                                                                              |       |       |       |       |       |
| Securities available for sale                                                     |       | 19,667     |       | 15,654     |       |
| Loans held for sale                                                               |       | 683        |       | 278        |       |
| Loans                                                                             |       | 125,925    |       | 102,831    |       |
| Allowance for loan losses                                                         |       | (1,723     | )          | (1,372     | )          |
| Net loans                                                                         |       | 124,202    |       | 101,459    |       |
|                                                                              |       |       |       |       |       |
| Premises and equipment                                                            |       | 5,580      |       | 5,824      |       |
| Federal Home Loan Bank and Bankers Bank  stock                                    |       | 455        |       | 266        |       |
| Accrued interest receivable                                                       |       | 529        |       | 373        |       |
| Other assets                                                                      |       | 652        |       | 517        |       |
|                                                                              |       |       |       |       |       |
| Total assets                                                                      |       | $          | 156,861    |       | $          | 128,916 |   |
|                                                                              |       |       |       |       |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                     |       |       |       |       |       |
| Liabilities                                                                       |       |       |       |       |       |
| Deposits                                                                          |       |       |       |       |       |
| Non-interest bearing                                                              |       | $          | 22,724     |       | $          | 15,341 |   |
| Interest bearing                                                                  |       | 114,635    |       | 100,359    |       |
| Total deposits                                                                    |       | 137,359    |       | 115,700    |       |
|                                                                              |       |       |       |       |       |
| Repurchase agreements and federal funds  purchased                                |       | 1,052      |       | 1,783      |       |
| Accrued interest payable                                                          |       | 429        |       | 311        |       |
| Subordinated debentures                                                           |       | 5,155      |       | —     |       |
| Other liabilities                                                                 |       | 339        |       | 49         |       |
| Total liabilities                                                                 |       | 144,334    |       | 117,843    |       |
|                                                                              |       |       |       |       |       |
| Shareholders’ equity                                                         |       |       |       |       |       |
| Preferred stock, no par value; 1,000,000  shares authorized; none issued          |       | —     |       | —     |       |
| Common stock, $1 par value; 2,000,000  shares authorized; 1,024,720 shares issued |       | 1,025      |       | 1,025      |       |
| Additional paid-in capital                                                        |       | 9,222      |       | 9,222      |       |
| Retained earnings                                                                 |       | 2,277      |       | 901        |       |
| Accumulated other comprehensive income  (loss)                                    |       | 3          |       | (75        | )          |
|                                                                              |       |       |       |       |       |
| Total shareholders’ equity                                                   |       | 12,527     |       | 11,073     |       |
|                                                                              |       |       |       |       |       |
| Total liabilities and shareholders’ equity                                   |       | $          | 156,861    |       | $          | 128,916 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-2

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**Years Ended December 31, 2004 and 2003**

 

(Dollar amounts in thousands except per sharedata)

 
| ** **                                               | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|----------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Interest income                                          |       |      |       |      |       |
| Loans, including fees                                    |       | $         | 6,957      |      | $          | 5,821 |   |
| Securities                                               |       | 603       |       | 456       |       |
| Federal funds sold                                       |       | 55        |       | 55        |       |
|                                                     |       | 7,615     |       | 6,332     |       |
| Interest expense                                         |       |      |       |      |       |
| Deposits                                                 |       | 2,362     |       | 2,005     |       |
| Other                                                    |       | 1         |       | 2         |       |
|                                                     |       | 2,363     |       | 2,007     |       |
|                                                     |       |      |       |      |       |
| **Net interest income**                                  |       | 5,252     |       | 4,325     |       |
|                                                     |       |      |       |      |       |
| Provision for loan losses                                |       | 452       |       | 283       |       |
|                                                     |       |      |       |      |       |
| **Net interest income after provision for  loan losses** |       | 4,800     |       | 4,042     |       |
|                                                     |       |      |       |      |       |
| Noninterest income                                       |       |      |       |      |       |
| Service charges on deposit accounts                      |       | 1,184     |       | 666       |       |
| Mortgage banking activities                              |       | 404       |       | 656       |       |
| Net securities gains (losses)                            |       | 16        |       | (26       | )          |
| Other                                                    |       | 220       |       | 190       |       |
|                                                     |       | 1,824     |       | 1,486     |       |
| Noninterest expense                                      |       |      |       |      |       |
| Salaries and employee benefits                           |       | 2,172     |       | 1,959     |       |
| Occupancy                                                |       | 346       |       | 328       |       |
| Furniture and equipment                                  |       | 137       |       | 145       |       |
| Data processing                                          |       | 483       |       | 472       |       |
| Advertising and public relations                         |       | 264       |       | 220       |       |
| Operating supplies                                       |       | 88        |       | 88        |       |
| Other                                                    |       | 952       |       | 776       |       |
|                                                     |       | 4,442     |       | 3,988     |       |
|                                                     |       |      |       |      |       |
| **Income before income taxes**                           |       | 2,182     |       | 1,540     |       |
|                                                     |       |      |       |      |       |
| Income taxes                                             |       | 806       |       | 507       |       |
|                                                     |       |      |       |      |       |
| **Net income**                                           |       | $         | 1,376      |      | $          | 1,033 |   |
|                                                     |       |      |       |      |       |
| Earnings per share:                                      |       |      |       |      |       |
| Basic                                                    |       | $         | 1.34       |      | $          | 1.01 |   |
| Diluted                                                  |       | $         | 1.25       |      | $          | .97 |   |
|                                                     |       |      |       |      |       |
| Shares used in computation of earnings per  share:       |       |      |       |      |       |
| Basic                                                    |       | 1,024,720 |       | 1,024,720 |       |
| Diluted                                                  |       | 1,097,701 |       | 1,067,507 |       |

 

See accompanying notes toconsolidated financial statements.

 

F-3

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CHANGES INSHAREHOLDERS’ EQUITY**

**Years Ended December 31, 2004 and 2003**

 

(Amounts in thousands)

 
| ** **                                                                                 | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------|------------|
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Balance at January 1, 2003                                                                 |       | 1,025              |       | $                 | 1,025      |                             | $          | 9,222                                          |       | $                                             | (132       | )                                     | $          | 28 |   | $ | 10,143 |   |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Comprehensive income:                                                                      |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Net income                                                                                 |       | —             |       | —            |       | —                           |       | 1,033                                          |       | —                                        |       | 1,033                                 |       |
| Change in unrealized gain on securities available  for sale                                |       | —             |       | —            |       | —                           |       | —                                         |       | (119                                          | )          | (119                                  | )          |
| Reclassification adjustment for losses included  in net income, net of tax benefits of $10 |       | —             |       | —            |       | —                           |       | —                                         |       | 16                                            |       | 16                                    |       |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Total comprehensive income                                                                 |       |               |       |              |       |                             |       |                                           |       |                                          |       | 930                                   |       |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Balance at December 31, 2003                                                          |       | 1,025              |       | 1,025             |       | 9,222                            |       | 901                                            |       | (75                                           | )          | 11,073                                |       |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Comprehensive income:                                                                      |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Net income                                                                                 |       | —             |       | —            |       | —                           |       | 1,376                                          |       | —                                        |       | 1,376                                 |       |
| Change in unrealized gain on securities available  for sale                                |       | —             |       | —            |       | —                           |       | —                                         |       | 89                                            |       | 89                                    |       |
| Reclassification adjustment for gains included  in net income, net of tax benefits of $5   |       | —             |       | —            |       | —                           |       | —                                         |       | (11                                           | )          | (11                                   | )          |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Total comprehensive income                                                                 |       |               |       |              |       |                             |       |                                           |       |                                          |       | 1,454                                 |       |
|                                                                                       |       |               |       |              |       |                             |       |                                           |       |                                          |       |                                  |       |
| Balance at December 31, 2004                                                          |       | 1,025              |       | $                 | 1,025      |                             | $          | 9,222                                          |       | $                                             | 2,277      |                                  | $          | 3 |   | $ | 12,527 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-4

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Years Ended December 31, 2004 and 2003**

 

(Dollar amounts in thousands)

 
| ** **                                                                 | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Cash flows from operating activities**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                 |       | $          | 1,376      |       | $          | 1,033 |   |
| Adjustments to reconcile net income to net  cash from operating activities |       |       |       |       |       |
| Depreciation and amortization                                              |       | 421        |       | 421        |       |
| Provision for loan losses                                                  |       | 452        |       | 283        |       |
| FHLB stock dividends                                                       |       | (10        | )          | (5         | )          |
| Securities (gains) losses                                                  |       | (16        | )          | 26         |       |
| Gains on sales of mortgage loans                                           |       | (404       | )          | (656       | )          |
| Mortgage loans originated for sale                                         |       | (21,413    | )          | (31,175    | )          |
| Proceeds from sale of mortgage loans                                       |       | 21,512     |       | 32,596     |       |
| Increase in accrued interest receivable                                    |       | (156       | )          | (2         | )          |
| Increase in accrued interest payable                                       |       | 118        |       | 26         |       |
| Increase (decrease) in other liabilities                                   |       | 290        |       | (125       | )          |
| Other, net                                                                 |       | (290       | )          | (186       | )          |
| Net cash from operating activities                                         |       | 1,780      |       | 2,236      |       |
|                                                                       |       |       |       |       |       |
| **Cash flows from investing activities**                                   |       |       |       |       |       |
| Purchases of securities available for sale                                 |       | (11,740    | )          | (16,300    | )          |
| Maturities and redemptions of securities  available for sale               |       | 2,749      |       | 7,995      |       |
| Proceeds from sales of securities available  for sale                      |       | 5,082      |       | 972        |       |
| Purchases of FHLB and Bankers Bank stock                                   |       | (189       | )          | (15        | )          |
| Net increase in loans                                                      |       | (23,094    | )          | (18,651    | )          |
| Purchases of premises and equipment                                        |       | (123       | )          | (207       | )          |
| Net cash from investing activities                                         |       | (27,315    | )          | (26,207    | )          |
|                                                                       |       |       |       |       |       |
| **Cash flows from financing activities**                                   |       |       |       |       |       |
| Proceeds from issuance of subordinate  debentures                          |       | 5,155      |       | —     |       |
| Net increase in deposits                                                   |       | 21,659     |       | 18,563     |       |
| Increase (decrease) in repurchase  agreements and federal funds purchased  |       | (731       | )          | 1,063      |       |
| Net cash from financing activities                                         |       | 26,083     |       | 19,626     |       |
|                                                                       |       |       |       |       |       |
| Net change in cash and cash equivalents                                    |       | 548        |       | (4,345     | )          |
|                                                                       |       |       |       |       |       |
| Cash and cash equivalents at beginning of  year                            |       | 4,545      |       | 8,890      |       |
|                                                                       |       |       |       |       |       |
| Cash and cash equivalents at end of year                                   |       | $          | 5,093      |       | $          | 4,545 |   |
|                                                                       |       |       |       |       |       |
| Cash paid during year for interest                                         |       | $          | 2,245      |       | $          | 1,981 |   |
| Cash paid during year for income taxes                                     |       | 783        |       | 566        |       |

 

See accompanying notes toconsolidated financial statements.

 

F-5

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Years Ended December 31, 2004 and 2003**

 

(Dollar amounts in thousands)

 

**NOTE1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The accounting principles followed and the methods of applying thoseprinciples conform with accounting principles generally accepted in the UnitedStates of America and to general practices in the banking industry.  The significant policies are summarized asfollows:

 

Principles of Consolidation:The consolidated financial statements include Southern Heritage Bancshares,Inc. and its wholly owned subsidiary, Southern Heritage Bank, together referredto as “the Company”.  Intercompanytransactions and balances are eliminated in consolidation.

 

Nature of Operations:  Southern Heritage Bancshares, Inc. was formedin 2004 as a one bank holding company that owns 100% of Southern Heritage Bank(the Bank).  Shareholders of the Bankreceived one share of the Company for every share of the Bank they owned.  Since the transaction involved entities undercommon control, financial information for prior periods of the Bank is shown asif the transaction occurred as of the beginning of the earliest periodpresented.  Substantially all of theconsolidated operations are that of the Bank.

 

Southern Heritage Bank received its charter as a state bank and beganoperations on April 12, 1999.  The Bankprovides a variety of banking services to individuals and businesses in BradleyCounty, Tennessee. Its primary deposit products are demand and savings depositsand certificates of deposit, and its primary lending products are commercial,real estate mortgage and installment loans.

 

Use of Estimates:  To prepare financial statements in conformitywith accounting principles generally accepted in the United States of America,management makes estimates and assumptions based on available information.  These estimates and assumptions affect theamounts reported in the financial statements and the disclosures provided, andfuture results could differ.  Theallowance for loan losses and fair values of financial instruments areparticularly subject to change.

 

Cash Flows:  Cash and cash equivalents includes cash,deposits with other financial institutions under 90 days, and federal fundssold.  Net cash flows are reported forcustomer loan and deposit transactions, federal funds purchased and repurchaseagreements.  The Bank is required tomaintain noninterest-bearing average reserve balances with the Federal ReserveBank.

 

Securities:  Securities are classified as held to maturityand carried at amortized cost when management has the positive intent andability to hold them to maturity. Securities are classified as available for sale when they might be soldbefore maturity.  Securities availablefor sale are carried at fair value, with unrealized holding gains and lossesreported in other comprehensive income. Other securities such as Federal Home Loan Bank stock are carried atcost.

 

F-6

----

 

Interest income includes amortization of purchase premium ordiscount.  Premiums and discounts onsecurities are amortized on the level-yield method without anticipatingprepayments.  Gains and losses on salesare recorded on the trade date and determined using the specific identificationmethod.

 

Declines in the fair value of securities below their cost that areother than temporary are reflected as realized losses.  In estimating other-than-temporary losses,management considers: (1) the length of time and extent that fair value hasbeen less than cost, (2) the financial condition and near term prospects of theissuer, and (3) the Company’s ability and intent to hold the security for aperiod sufficient to allow for any anticipated recovery in fair value.

 

Loans:  Loans that management has the intent andability to hold for the foreseeable future or until maturity or payoff arereported at the principal balance outstanding, net of unearned interest,deferred loan fees and costs, and an allowance for loan losses.

 

Interest income is reported on the interest method and includesamortization of net deferred loan fees and costs over the loan term using thelevel-yield method without anticipating prepayments.  Interest income on mortgage and commercialloans is discontinued at the time the loan is 90 days delinquent unless thecredit is well-secured and in process of collection.  In all cases, loans are placed on nonaccrualor charged-off at an earlier date if collection of principal or interest isconsidered doubtful.

 

All interest accrued but not received for loans placed on nonaccrual isreversed against interest income. Interest received on such loans is accounted for on the cash-basis orcost-recovery method, until qualifying for return to accrual.  Loans are returned to accrual status when allthe principal and interest amounts contractually due are brought current andfuture payments are reasonably assured.

 

#### Mortgage LoansHeld for Sale: Certain mortgage loans held for sale, servicing released, to permanentinvestors are stated at lower of cost or market in the aggregate with respectto the entire portfolio.  At December 31,2004 and 2003, cost approximates the market value of such loans.

 

#### ForeclosedAssets:  Assetsacquired through or instead of loan foreclosure are initially recorded at fairvalue when acquired, establishing a new cost basis.  If fair value declines, a valuation allowanceis recorded through expense.  Costs afteracquisition are expensed.

 

F-7

----

 

Allowance for Loan Losses:  The allowance for loan losses is a valuationallowance for probable incurred credit losses, increased by the provision forloan losses and decreased by charge-offs less recoveries.  Management estimates the allowance balancerequired using past loan loss experience, the nature and volume of theportfolio, information about specific borrower situations and estimatedcollateral values, economic conditions, and other factors.  Allocations of the allowance may be made forspecific loans, but the entire allowance is available for any loan that, inmanagement’s judgment, should be charged-off. Loan losses are charged against the allowance when management believesthe uncollectibility of a loan balance is confirmed.

 

The allowance consists of specific and general components.  The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful.  The generalcomponent covers non-classified loans and is based on historical loss experienceadjusted for current factors.

 

A loan is impaired when full payment under the loan terms is notexpected.  Commercial and commercial realestate loans meeting certain size and performance characteristics areindividually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so thatthe loan is reported, net, at the present value of estimated future cash flowsusing the loan’s existing rate or at the fair value of collateral if repaymentis expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer andresidential real estate loans, are collectively evaluated for impairment, andaccordingly, they are not separately identified for impairment disclosures.

 

Premises and Equipment:  Land is carried at cost.  Premises and equipment are stated at costless accumulated depreciation.  Buildingsand related components are depreciated using the straight-line method withuseful lives ranging from 5 to 33 years.**** Furniture, fixtures and equipment aredepreciated using the straight-line method with useful lives ranging from 3 to5 years.

** **

Long-term Assets:** **Premises andequipment and other long-term assets are reviewed for impairment when eventsindicate their carrying amount may not be recoverable from future undiscountedcash flows.  If impaired, the assets arerecorded at fair value

 

Income Taxes:  Income tax expense is the total of thecurrent year income tax due or refundable and the change in deferred tax assetsand liabilities.  Deferred tax assets andliabilities are the expected future tax amounts for the temporary differencesbetween carrying amounts and tax bases of assets and liabilities, computedusing enacted tax rates.  A valuationallowance, if needed, reduces deferred tax assets to the amount expected to berealized.

 

F-8

----

 

Repurchase Agreements:  Substantially all repurchase agreementliabilities represent amounts advanced by various customers.  Securities are pledged to cover theseliabilities, which are not covered by federal deposit insurance.

 

Earnings Per Share Amounts:  Basic earnings per share is computed usingthe weighted average number of common shares outstanding during the period andexcludes any dilutive effects of options. Diluted earnings per share is computed using the weighted average numberof common and common stock equivalent shares outstanding during the period;common stock equivalent shares are excluded from the computation if theireffect is antidilutive.  The effect ofthese options on earnings per common share was to increase average sharesoutstanding by 72,981 and 42,787 in 2004 and 2003 and decrease earnings pershare by $.09 and $.04.  No shares wereantidilutive at December 31, 2004 and 2003.

 

Comprehensive Income:  Comprehensive income consists of net incomeand other comprehensive income.  Othercomprehensive income includes unrealized gains and losses on securitiesavailable for sale which are also recognized as separate components of equity.

 

### *Fair Value of FinancialInstruments*:  Fair values of financial instruments areestimated using relevant market information and other assumptions, as morefully disclosed in a separate note.  Fairvalue estimates involve uncertainties and matters of significant judgmentregarding interest rates, credit risk, prepayments, and other factors,especially in the absence of broad markets for particular items. Changes inassumptions or in market conditions could significantly affect the estimates.

 

Off Balance Sheet Financial Instruments:  Financial instruments include off-balancesheet credit instruments, such as commitments to make loans and standby lettersof credit, issued to meet customer financing needs.  The face amount for these items representsthe exposure to loss, before considering customer collateral or ability torepay.  Such financial instruments arerecorded when they are funded.

 

Operating Segments:  While the chief decision-makers monitor therevenue streams of the various products and services, the identifiable segmentsare not material and operations are managed and financial performance isevaluated on a Company-wide basis. Accordingly, all of the financial service operations are considered bymanagement to be aggregated in one reportable operating segment.

 

Reclassifications:  Some items in the prior year financialstatements were reclassified to conform to the current presentation.

 

F-9

----

 

Stock Compensation:  Employee compensation expense under stockoptions is reported using the intrinsic value method.  No stock-based compensation cost is reflectedin net income, as all options granted had an exercise price equal to or greaterthan the market price of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*.

 
| ** **                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                               |       |     |       |     |       |
| Net income as reported                                                             |       | $        | 1,376      |     | $          | 1,033 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |       | 48       |       | 27       |       |
|                                                                               |       |     |       |     |       |
| Pro forma net income                                                               |       | $        | 1,328      |     | $          | 1,006 |   |
|                                                                               |       |     |       |     |       |
| Basic earnings per share as reported                                               |       | $        | 1.34       |     | $          | 1.01 |   |
| Pro forma basic earnings per share                                                 |       | 1.30     |       | .98      |       |
|                                                                               |       |     |       |     |       |
| Diluted earnings per share as reported                                             |       | 1.25     |       | .97      |       |
| Pro forma diluted earnings per share                                               |       | 1.21     |       | .94      |       |

 

In calculating the pro forma disclosures, thefair value of the options granted is estimated as of the date granted using theBlack-Scholes option pricing model with the following weighted averageassumptions used for grants in 2003: dividend yield of 0 percent, risk freeinterest rate of 3.76%, and expected lives of 8 years.  The estimated stock price volatility of theoptions granted in 2003 was 10.51%.  Theweighted-average fair value of options granted during 2003 was $4.57 pershare.   There were no options granted in2004.

 

F-10

----

 

**NOTE 2 - SECURITIES**

** **

**The fairvalue of available for sale securities and the related gross unrealized gainsand losses recognized in accumulated other comprehensive income were asfollows:**

** **
| ** **          | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** |
|---------------------|------------|-----------------|------------|------------------------------|------------|-------------------------------|------------|
| 2004                |       |            |       |                         |       |                          |       |
| Agencies            |       | $               | 1,487      |                         | $          | —                        |       | $ | (13 | ) |
| State and municipal |       | 12,069          |       | 93                           |       | (36                           | )          |
| Mortgage-backed     |       | 5,611           |       | 13                           |       | (52                           | )          |
| Corporate           |       | 500             |       | —                       |       | —                        |       |
|                |       |            |       |                         |       |                          |       |
| Total               |       | $               | 19,667     |                         | $          | 106                           |       | $ | (101 | ) |
|                |       |            |       |                         |       |                          |       |
| 2003                |       |            |       |                         |       |                          |       |
| Agencies            |       | $               | 1,477      |                         | $          | 3                             |       | $ | (23 | ) |
| State and municipal |       | 6,131           |       | 39                           |       | (70                           | )          |
| Mortgage-backed     |       | 7,538           |       | 24                           |       | (95                           | )          |
| Corporate           |       | 508             |       | 8                            |       | —                        |       |
|                |       |            |       |                         |       |                          |       |
| Total               |       | $               | 15,654     |                         | $          | 74                            |       | $ | (188 | ) |

 

Proceeds from sales, gross gains and gross losses of available for salesecurities were as follows:

 
| ** **          | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
|                |       |     |       |     |       |
| Proceeds from sales |       | $        | 5,082      |     | $          | 972 |   |
| Gross gains         |       | 41       |       | 23       |       |
| Gross losses        |       | 25       |       | 49       |       |
|                     |            |          |            |          |            |  |  |

 

Thefair value of debt securities at year end 2004 by contractual maturity were asfollows.  Securities not due at a singlematurity date, primarily mortgage-backed securities, are shown separately.

 
| ** **                 | ** ** | **Fair Value** | ** ** |
|----------------------------|------------|----------------|------------|
|                       |       |           |       |
| Due from one to five years |       | $              | —     |   |
| Due from five to ten years |       | 5,802          |       |
| Due after ten years        |       | 8,254          |       |
| Mortgage-backed            |       | 5,611          |       |
|                       |       |           |       |
|                       |       | $              | 19,667     |   |

 

F-11

----

 

Securities pledged at year end 2004 and 2003 had a carrying amount of$1,694 and $2,175 and were pledged to secure public deposits and repurchaseagreements.

** **

**At yearend 2004 and 2003, there were no holdings of securities of any one issuer,other than the U.S. Government and its agencies, in an amount greater than 10%of shareholders’ equity.**

** **

The following table shows securities with unrealized losses and theirfair value, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position:

 
| **2004**                      | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------|------------|
| **Description of Securities** | ** ** | **Fair  Value**         | ** ** | **Unrealized  Loss**  | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                          |       |                    |       |                  |       |            |       |   |   |   |   |   |   |
| Agencies                      |       | $                       | 493        |                  | $          | 6               |       | $ | 492 |   | $ | 7 |   | $ | 985 |   | $ | 13 |   |
| State and municipal           |       | 4,153                   |       | 36                    |       | —          |       | — |   | 4,153 |   | 36 |   |
| Mortgage-backed               |       | 2,597                   |       | 24                    |       | 1,646           |       | 28 |   | 4,243 |   | 52 |   |
|                          |       |                    |       |                  |       |            |       |   |   |   |   |   |   |
| Total temporarily impaired    |       | $                       | 7,243      |                  | $          | 66              |       | $ | 2,138 |   | $ | 35 |   | $ | 9,381 |   | $ | 101 |   |

 
| **2003**                      | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**       | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------|------------|
| **Description of Securities** | ** ** | **Fair  Value**         | ** ** | **Unrealized  Loss**  | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                          |       |                    |       |                  |       |            |       |   |   |   |   |   |   |
| Agencies                      |       | $                       | 975        |                  | $          | 23              |       | — |   | — |   | $ | 975 |   | $ | 23 |   |
| State and municipal           |       | 3,279                   |       | 70                    |       | —          |       | — |   | 3,279 |   | 70 |   |
| Mortgage-backed               |       | 6,047                   |       | 95                    |       | —          |       | — |   | 6,047 |   | 95 |   |
|                          |       |                    |       |                  |       |            |       |   |   |   |   |   |   |
| Total temporarily impaired    |       | $                       | 10,301     |                  | $          | 188             |       | — |   | — |   | $ | 10,301 |   | $ | 188 |   |
|                               |            |                         |            |                       |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Unrealized losseson securities have not been recognized into income because the issuer(s) are ofhigh credit quality, management has the intent and ability to hold for theforeseeable future, and the decline in fair value is largely due to increasesin market interest rates.  The fair valueis expected to recover as the securities approach their maturity date and/ormarket rates decline.

 

F-12

----

 

**NOTE 3 - LOANS**

 

Loans at year-end were as follows:

 
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |
| Commercial                      |       | $        | 33,503     |     | $          | 29,773 |   |
| Real estate:                    |       |     |       |     |       |
| Residential                     |       | 23,144   |       | 21,358   |       |
| Commercial                      |       | 40,632   |       | 29,432   |       |
| Construction                    |       | 22,014   |       | 16,505   |       |
| Consumer                        |       | 6,632    |       | 5,763    |       |
| Subtotal                        |       | 125,925  |       | 102,831  |       |
| Less: Allowance for loan losses |       | 1,723    |       | 1,372    |       |
| Loans, net                      |       | $        | 124,202    |     | $          | 101,459 |   |
|                                 |            |          |            |          |            |  |  |  |

 

**NOTE 4 - ALLOWANCE FOR LOAN LOSSES**

** **

Activity in the allowance for loan losses was as follows:
| ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
|                                       |       |     |       |     |       |
| Balance at beginning of year               |       | $        | 1,372      |     | $          | 1,196 |   |
| Provision charged to operating expenses    |       | 452      |       | 283      |       |
| Loans charged off                          |       | (114     | )          | (126     | )          |
| Recoveries on previously charged-off loans |       | 13       |       | 19       |       |
|                                       |       |     |       |     |       |
| Ending balance                             |       | $        | 1,723      |     | $          | 1,372 |   |

** **

The Bank hadno impaired loans at year-end 2004 or 2003 or during the years then ended.

 

**Nonperformingloans were as follows:**

** **
| ** **                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |
| Loans past due over 90 days still on  accrual |       | $        | 1,518      |     | $          | 80 |   |
| Nonaccrual loans                              |       | 85       |       | 5        |       |
|                                               |            |          |            |          |            |  |  |

 

Nonperforming loans and impaired loans aredefined differently.  Some loans may beincluded in both categories, whereas other loans may only be included in onecategory.

 

F-13

----

 

**NOTE 5 - PREMISES AND EQUIPMENT**

** **

Year-endpremises and equipment were as follows:

 
| ** **                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |
| Land                              |       | $        | 1,456      |     | $          | 1,379 |   |
| Buildings                         |       | 2,939    |       | 2,939    |       |
| Leasehold improvements            |       | 706      |       | 697      |       |
| Furniture, fixtures and equipment |       | 1,719    |       | 1,728    |       |
|                              |       | 6,820    |       | 6,743    |       |
| Less: Accumulated depreciation    |       | 1,240    |       | 919      |       |
|                              |       |     |       |     |       |
|                              |       | $        | 5,580      |     | $          | 5,824 |   |

** **

**Depreciationexpense was $367 and $363 for 2004 and 2003.  Rent expense was $0 and $4 for 2004 and 2003.**

** **

**NOTE 6 - DEPOSITS**

** **

Time deposits of $100 or more were $37,008and $30,778 at year end 2004 and 2003.

 

Scheduled maturities of time deposits for thenext five years and thereafter were as follows at year-end 2004:

 
| 2005       |   | $      | 31,151 |   |
|------------|--------|--------|--------|--------|
| 2006       |   | 10,688 |   |
| 2007       |   | 11,159 |   |
| 2008       |   | 9,719  |   |
| 2009       |   | 6,900  |   |
| Thereafter |   | 326    |   |
|       |   | $      | 69,943 |   |

 

**NOTE 7 – REPURCHASE AGREEMENTS**

 

Repurchase agreements are secured bysecurities with a carrying amount of $780 and $204 at year-end 2004 and2003.  Information concerning repurchaseagreements is summarized as follows:

 
| ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
|                                       |       |     |       |     |       |
| Average daily balance during the year      |       | $        | 206        |     | $          | 613 |   |
| Average interest rate during the year      |       | .74      | %          | .52      | %          |
| Maximum month-end balance during the year  |       | 316      |       | 694      |       |
| Weighted average interest rate at year-end |       | .93      | %          | .15      | %          |
| Balance at year end                        |       | 100      |       | 204      |       |
|                                            |            |          |            |          |            |  |  |

 

F-14

----

 

**NOTE 8- SUBORDINATED DEBENTURES**

 

A trust formed by the Company issued $5,000of floating rate trust preferred securities in 2004 as part of a pooledoffering of such securities.  The Companyissued subordinated debentures in the amount of $5,155 to the trust in exchangefor the proceeds of the offering; the debentures represent the sole assets ofthe trust.  The rate varies quarterly at3-month LIBOR, plus 2.05% and was 4.50% at December 31, 2004.  The Company may redeem the subordinateddebentures, in whole or in part, after December 2009 at face value.  The subordinated debentures must be redeemedno later than December 2034.

 

**NOTE 9 - INCOME TAXES**

 

The components of income tax expense(benefit) are summarized as follows:

 
| ** **                                                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                              |       |     |       |     |       |
| Current federal                                                                   |       | $        | 725        |     | $          | 484 |   |
| Current state                                                                     |       | 198      |       | 98       |       |
| Deferred federal                                                                  |       | (97      | )          | (22      | )          |
| Deferred state                                                                    |       | (20      | )          | (3       | )          |
|                                                                              |       | 806      |       | 557      |       |
| Less change in valuation allowance related to  realization of deferred tax assets |       | —   |       | (50      | )          |
|                                                                              |       |     |       |     |       |
| Actual tax expense                                                                |       | $        | 806        |     | $          | 507 |   |

** **

Temporary differences between tax andfinancial reporting that result in net deferred tax assets (liabilities) are asfollows at December 31, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:           |       |     |       |     |       |
| Allowance for loan losses      |       | $        | 602        |     | $          | 475 |   |
| Unrealized loss on securities  |       | —   |       | 39       |       |
| Total deferred tax assets      |       | 602      |       | 514      |       |
| Less valuation allowance       |       | —   |       | —   |       |
| Total deferred tax assets      |       | 602      |       | 514      |       |
|                           |       |     |       |     |       |
| Deferred tax liabilities:      |       |     |       |     |       |
| Depreciation                   |       | (335     | )          | (310     | )          |
| Unrealized gains on securities |       | (2       | )          | —   |       |
| Other                          |       | (11      | )          | (26      | )          |
| Total deferred tax liabilities |       | (348     | )          | (336     | )          |
|                           |       |     |       |     |       |
| Net deferred tax asset         |       | $        | 254        |     | $          | 178 |   |

 

F-15

----

 

A reconciliation of actual income tax expensein the financial statements to the “expected” tax expense (computed by applyingthe statutory Federal income tax rate of 34% to income or loss before incometaxes) is as follows:

 
| ** **                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                       |       |     |       |     |       |
| Computed “expected” tax expense                  |       | $        | 742        |     | $          | 524 |   |
| Tax exempt interest                                        |       | (90      | )          | (42      | )          |
| State income taxes, net of effect of Federal  income taxes |       | 117      |       | 67       |       |
| Change in valuation allowance                              |       | —   |       | (50      | )          |
| Expenses not allowed as tax deductions                     |       | 41       |       | 5        |       |
| Other, net                                                 |       | (4       | )          | 3        |       |
|                                                       |       |     |       |     |       |
| Income tax expense                                         |       | $        | 806        |     | $          | 507 |   |

 

**NOTE10 – RELATED PARTY TRANSACTIONS**

** **

**Loans toprincipal officers, directors, and their affiliates in 2004 were as follows:**

 
| Beginning balance |   | $      | 5,571  |   |
|-------------------|--------|--------|--------|--------|
| New loans         |   | 2,591  |   |
| Repayments        |   | (201   | )      |
|              |   |   |   |
| Ending balance    |   | $      | 7,961  |   |

 

Deposits from principal officers, directors, and their affiliates atyear-end 2004 and 2003 were $4,573 and $3,087.

 

**NOTE 11 — CAPITAL REQUIREMENTS AND RESTRICTIONS ONRETAINED EARNINGS**

** **

**Banks andholding companies are subject to regulatory capital requirements administeredby federal banking agencies.  Capitaladequacy guidelines and prompt corrective action regulations involvequantitative measures of assets, liabilities, and certain off-balance-sheetitems calculated under regulatory accounting practices.  Capital amounts and classifications are alsosubject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.  At year-end 2004, only the Bank was subjectto these regulatory capital requirements.**

 

F-16

----

 

**Promptcorrective action regulations provide five classifications:  well capitalized, adequately capitalized,undercapitalized, significantly undercapitalized, and criticallyundercapitalized, although these terms are not used to represent overallfinancial condition.  If adequatelycapitalized, regulatory approval is required to accept brokered deposits.  If undercapitalized, capital distributionsare limited, as is asset growth and expansion, and capital restoration plansare required.  As of December 31, 2004and 2003, the most recent regulatory notifications categorized the Bank as wellcapitalized under the regulatory framework for prompt corrective action.  There are no conditions or events since thatnotification that management believes have changed the Bank’s category.**

** **

Actual and required capital amounts andratios for the Bank are presented below at year-end.

 
| ** **                                     | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|------------------------------------------------|------------|------------|------------|------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| December 31, 2004                              |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total Capital to risk weighted assets          |       | $          | 19,248     |                               | 13.79      | %                                                                       | $          | 11,167 |   | 8 | % | $ | 13,959 |   | 10 | % |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 (Core) Capital to risk weighted  assets |       | 16,701     |       | 11.96                              | %          | 5,584                                                                   |       | 4 | % | 8,375 |   | 6 | % |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 (Core) Capital to average assets        |       | 16,701     |       | 10.73                              | %          | 6,228                                                                   |       | 4 | % | 7,784 |   | 5 | % |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| December 31, 2003                              |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Total Capital to risk weighted assets          |       | $          | 12,521     |                               | 11.01      | %                                                                       | $          | 9,101 |   | 8.00 | % | $ | 11,376 |   | 10.00 | % |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 (Core) Capital to risk weighted  assets |       | 11,149     |       | 9.80                               | %          | 4,550                                                                   |       | 4.00 | % | 6,826 |   | 6.00 | % |
|                                           |       |       |       |                               |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 (Core) Capital to average assets        |       | 11,149     |       | 8.54                               | %          | 5,224                                                                   |       | 4.00 | % | 6,531 |   | 5.00 | % |

 

**The Bankis also subject to state regulations restricting the amount of dividends thatcan be paid.  At year end 2004, the Bankcould pay approximately $2,200 in dividends under these regulations.**

 

F-17

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**NOTE 12 — OFF-BALANCE-SHEET ACTIVITIES**

 

Some financial instruments, such as loan commitments, credit lines,letters of credit, and overdraft protection, are issued to meet customerfinancing needs.  These are agreements toprovide credit or to support the credit of others, as long as conditionsestablished in the contract are met, and usually have expiration dates.  Commitments may expire without beingused.  Off-balance-sheet risk to creditloss exists up to the face amount of these instruments, although materiallosses are not anticipated.  The samecredit policies are used to make such commitments as are used for loans,including obtaining collateral at exercise of the commitment.  The majority of the Bank’s commitments toextend credit has maturities less than one year and reflects the prevailingmarket interest rates at the time of the commitment.

 

The contractual amount of financialinstruments with off-balance-sheet risk was as follows at year end.

 
| ** **                   | ** ** | **2004**       | ** ** | **2003**          | ** ** |
|------------------------------|------------|----------------|------------|-------------------|------------|
| ** **                   | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** |
| Commitments to extend credit |       | $              | 8,979,000  |              | $          | 20,787,000 |   | $ | 6,716,000 |   | $ | 15,943,000 |   |
| Letters of credit            |       | 78,000         |       | 1,923,000         |       | 1,329,000 |   | — |   |
|                              |            |                |            |                   |            |  |  |  |  |  |  |  |  |

 

The fixed rate commitments have interestrates ranging from 4.20% to 8.50% at year end 2004.

 

**NOTE 13 - STOCK COMPENSATION PLANS**

 

The Bank established an Incentive StockOption Plan for certain officers and employees and a Non-Employee Directors’Non-Qualified Stock Option Plan effective August 8, 2000.  The plans grant options to key employees anddirectors at fair value at date of grant. The director options vest 100% after six months from the grant date, andthe employee options vest 20% every two years. At December 31, 2004, there were options to purchase 11,000 sharespursuant to the Non-Employee Directors’ Plan and options to purchase 139,535shares pursuant to the Employees Plan. All options expire within ten years from the date of grant.

 

A summary of the status of the Company’sstock option plans is presented below:

 
| ** **                               | ** ** | ** **      | ** ** | ** **      | ** ** | **Average**  | ** ** |
|------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                               | ** ** | **Options**     | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** |
| ** **                               | ** ** | **Outstanding** | ** ** | **Options**     | ** ** | **Price**    | ** ** |
| Outstanding at December 31, 2002         |       | 101,535         |       | 24,307          |       | $            | 10.00      |   |
| Options granted                          |       | 49,000          |       | —          |       | 18.00        |       |
| Options which became exercisable         |       | —          |       | 4,800           |       | 10.00        |       |
| Options exercised                        |       | —          |       | —          |       | —       |       |
|                                     |       |            |       |            |       |         |       |
| Options outstanding at December 31, 2003 |       | 150,535         |       | 29,107          |       | 12.60        |       |
| Options granted                          |       | —          |       | —          |       | —       |       |
| Options which became exercisable         |       | —          |       | 13,307          |       | 12.81        |       |
| Options exercised                        |       | —          |       | —          |       | —       |       |
|                                     |       |            |       |            |       |         |       |
| Options outstanding at December 31, 2004 |       | 150,535         |       | 42,414          |       | $            | 12.60      |   |

 

F-18

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The number or outstandingand exercisable options and the weighted average lives at year-end 2004 were asfollows:

 
| ** **         | ** ** | **Options Outstanding** | ** ** | **Exercisable Options** | ** ** |
|--------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **         | ** ** | ** **              | ** ** | **Weighted**            | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| **Exercise Price** | ** ** | **Number**              | ** ** | **Average Life**        | ** ** | **Number** | ** ** | **Average Life** | ** ** |
| $ 10          |       | 101,435                 |       | 6.3 years               |       | 42,414 |   | 6.3 years |   |
| $ 18          |       | 49,000                  |       | 9.0 years               |       | — |   | — |   |

 

**NOTE 14 — RETIREMENT PLAN**

 

The Company, effective September 1, 2004, hasa 401(k) profit sharing plan covering employees meeting certain age and servicerequirements.  Employees may contributeup to a certain dollar amount which is set by law.  The Company makes matching contributionsequal to 75% of the employee’s contribution up to 6% of the employee’scompensation.  Participants are vestedimmediately in their contributions plus the actual earnings thereon.  Company contributions are vested 20% per yearover 5 years.  Expense for 2004 was $22.

 

**NOTE 15 - FAIR VALUES OF FINANCIALINSTRUMENTS**

** **

The methodsand assumptions used to estimate fair value are described as follows:

 

Carrying amount is the estimated fair valuefor cash and cash equivalents, Federal Home Loan Bank and Bankers Bank stock,accrued interest receivable and payable, demand deposits, repurchaseagreements, and variable rate loans or deposits that reprice frequently andfully.  Security fair values are based onmarket prices or dealer quotes, and if no such information is available, on therate and term of the security and information about the issued.  For fixed rate loans or deposits and forvariable rate loans or deposits with infrequent repricing or repricing limits,fair value is based on discounted cash flows using current market rates appliedto the estimated life and credit risk. Fair value of loans held for sale is based on market quotes.  The fair value of off-balance-sheet loancommitments is considered nominal.

 

The estimatedfair value of the Company’s financial instruments at December 31, 2004 and 2003are as follows:

 
| ** **                    | ** ** | **2004**     | ** ** | **2003**  | ** ** |
|-------------------------------|------------|--------------|------------|-----------|------------|
| ** **                    | ** ** | **Carrying** | ** ** | **Fair**  | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                    | ** ** | **Amount**   | ** ** | **Value** | ** ** | **Amount** | ** ** | **Value** | ** ** |
| Financial assets              |       |         |       |      |       |   |   |   |   |
| Cash and cash equivalents     |       | $            | 5,093      |      | $          | 5,093 |   | $ | 4,545 |   | $ | 4,545 |   |
| Securities available for sale |       | 19,667       |       | 19,667    |       | 15,654 |   | 15,654 |   |
| Loans held for sale           |       | 683          |       | 683       |       | 278 |   | 278 |   |
| Loans, net of allowance       |       | 124,202      |       | 121,432   |       | 101,459 |   | 102,840 |   |
| FHLB and Bankers Bank stock   |       | 455          |       | 455       |       | 266 |   | 266 |   |
| Accrued interest receivable   |       | 529          |       | 529       |       | 373 |   | 373 |   |
|                          |       |         |       |      |       |   |   |   |   |
| Financial liabilities         |       |         |       |      |       |   |   |   |   |
| Deposits                      |       | $            | 137,359    |      | $          | 137,214 |   | $ | 115,700 |   | $ | 115,700 |   |
| Repurchase agreements         |       | 1,052        |       | 1,052     |       | 1,783 |   | 1,783 |   |
| Accrued interest payable      |       | 429          |       | 429       |       | 311 |   | 311 |   |
| Subordinated Debentures       |       | 5,155        |       | 5,155     |       | — |   | — |   |
|                               |            |              |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-19

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