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U.S. Securities and Exchange Commission  Form 10-K [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the fiscal year ended December 31, 2003 [  ] Transition Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the transition period from ____________ to ____________ Commission file number 000-33227 Southern Community Financial Corporation 
  North Carolina
    
    56-2270620(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 4605 Country Club RoadWinston-Salem, North Carolina
    
    27104(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code (336) 768-8500 Securities Registered Pursuant to Section 12(b) of the Exchange Act:
None
Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, No Par Value 7.25% Cumulative Convertible Trust Preferred Securities
7.25% Convertible Junior Subordinated Debentures
Guarantee with respect to 7.25% Cumulative Convertible Trust Preferred Securities 7.95% Cumulative Trust Preferred Securities
7.95% Junior Subordinated Debentures
Guarantee with respect to 7.95% Cumulative Trust Preferred Securities Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [ X ] No [  ] Indicate by check mark if disclosure of delinquent filers in response to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [  ] No [ X ] State the aggregate market value of the voting and non-voting common equity
held by non-affiliates computed by reference to the price at which the common
equity was last sold, or the average bid and asked price of such common equity,
as of the last business day of the registrants most recently completed second
fiscal quarter. $73.4 million. As of March 12, 2004, (the most recent practicable date), the registrant had
outstanding 17,610,132 shares of Common Stock, no par value. Page 1




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Documents Incorporated By Reference Document
    
    Where Incorporated1.
    
    
    Proxy
Statement for the Annual Meeting of Shareholders to be held May 13, 2004 to be mailed to shareholders
within 120 days of December 31, 2003.
    
    Part III
 Form 10-K Table of Contents Index
    
    PAGEPART IItem 1.
    
    Business
    
    
    3Item 2.
    
    Properties
    
    
    13Item 3.
    
    Legal
    
    
    13Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    14PART IIItem 5.
    
    Market for Common Stock and Related Stockholder Matters
    
    
    14Item 6.
    
    Selected Financial Data
    
    
    16Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    45Item 8.
    
    Financial Statements
    
    
    45Item 8A.
    
    Controls and Procedures
    
    
    45Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    77PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    77Item 11.
    
    Executive Compensation
    
    
    77Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    77Item 13.
    
    Certain Relationships and Related Transactions
    
    
    77Item 14.
    
    Principal Accountant Fees and Services
    
    
    77PART IVItem 15.
    
    Exhibits, Financial Statement Schedules, and Reports on Form 8-K
    
    
    78
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PART I 
 Item 1. Business Who We Are Southern Community Financial Corporation (company) is the holding
company for Southern Community Bank and Trust (bank). The bank commenced
operations on November 18, 1996 and effective October 1, 2001 became a
wholly-owned subsidiary of the newly formed holding company. We are based in
Winston-Salem, North Carolina which is located in the north central region of
the state, an area also known as the Piedmont Triad. The Piedmont Triad area
includes the cities of Winston-Salem, Greensboro and High Point. At December 31, 2003, we had total assets of $798.5 million, net loans of
$512.5 million, deposits of $575.2 million, and shareholders equity of $50.9
million. We had net income of $3.7 million and $3.2 million and diluted
earnings per share of $.40 and $.35 for the years ended December 31, 2003 and
2002, respectively. We had net income of $2.1 million and diluted earnings per
share of $.23 for the year ended December 31, 2001. We have been, and intend to remain, a community-focused financial
institution offering a full range of financial services to individuals,
businesses and nonprofit organizations in the communities we serve. Our
banking services include checking and savings accounts; commercial,
installment, mortgage, and personal loans; trust and investment services; safe
deposit boxes; and other associated services to satisfy the needs of our
customers. In our seven years of existence we have accomplished the following:  
    
    Assembled a management team with knowledge of our local
markets and over 100 years of banking experience;  
    
    Registered 22 consecutive quarters of profitability after
becoming profitable in our seventh quarter of operation;  
    
    Established eight banking offices including four in
Winston-Salem and one each in Clemmons, Kernersville, High Point,
and Yadkinville;  
    
    Focused on growing internally reaching total assets of $798.5
million as of December 31, 2003 without any acquisitions;  
    
    Have one subsidiary of the bank, managed by professionals
with substantial previous experience:  
    
    VCS Management, LLC, the managing general partner
of Salem Capital Partners, L.P., a small business investment
company in which the bank is an investor, with offices in
Winston-Salem, North Carolina and Atlanta, Georgia;  
    
    Began offering trust services in 2002 including investment
management, administration and advisory services primarily for
individuals, partnerships and corporations;  
    
    Increased our equity to $50.9 million as a result of our
initial public offering which raised $12 million, two secondary
stock offerings in February 1998 and January 2001, raising $18.7
million and $4.9 million, respectively, and the retention of
earnings;  
    
    Listed our common stock on the Nasdaq National Market System
on January 2, 2002;  
    
    Created a capital trust, Southern Community Capital Trust I,
that issued 1,725,000 cumulative convertible trust preferred
securities in February 2002 generating gross proceeds of $17.3
million;  
    
    Announced on July 30, 2003, the agreement to acquire The
Community Bank, which was completed on January 12, 2004;  
    
    Created Southern Community Capital Trust II, that issued
3,450,000 trust preferred securities in November 2003 generating
gross proceeds of $34.5 million; and  
    
    Maintained a strong credit culture. As of December 31, 2003,
our non-performing assets totaled $1.0 million or 0.13% of total
assets and our allowance for loan losses was $7.3 million or 1.40%
of total loans and 946% of non-performing loans. The website for the bank is www.smallenoughtocare.com. Our periodic
reports on Forms 10-Q and 10-K are available on our website under Investor
Relations. The company is registered as a financial holding company with the
Federal Reserve System. The bank is a member of the Federal Reserve System and
the Federal Deposit Insurance Corporation insures its deposits up to applicable
limits. The address of our principal executive office is 4605 Country Club
Road, Winston-Salem, North Carolina 27104 and our telephone number is (336)
768-8500. Our common stock as well as each of our trust preferred securities
are traded on the Nasdaq National Market System Page 3




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under the symbols SCMF, SCMFP and SCMFO, respectively. Trading on
SCMFP ceased on March 8th, 2004. Our Market Area We consider our primary market area to be the Piedmont Triad area of North
Carolina, including Winston-Salem, Clemmons, Kernersville (all in Forsyth
County), Yadkinville (Yadkin County) and High Point (Guilford County), North
Carolina, and to a lesser extent, adjoining counties. The Piedmont Triad is a 12 county region located in the north central
Piedmont of North Carolina and is named for the three largest cities in the
region, Winston-Salem, Greensboro and High Point. The region has one fifth of
the states population and one fifth of its labor force. The regions
population grew an estimated 12.3% between 1990 and 2000. Its estimated
population in 2002 was 1.2 million. The Piedmont Triad is the largest Metropolitan Statistical Area located
entirely in North Carolina. The MSA is also one of the top 50 in the country
in both total population and number of households. Winston-Salem is the
largest city in Forsyth County and the fourth largest city in North Carolina.
Forsyth County had an estimated population of 314,375 in 2003, Yadkin County
was estimated at 39,892, and Guilford County had an estimated population of
463,087. The Piedmont Triad is the economic hub of northwest North Carolina.
In 2002, the median family income in both Forsyth and Guilford Counties was
over $42,000. In Yadkin County, it was over $36,600. The Piedmont Triad has a
very balanced and diversified economy. Approximately 99% of the work force is
employed in nonagricultural wage and salary positions. The major employment
sectors in 2002 were services (29%), manufacturing (23%), trade (22%), finance,
communications and utilities (11%), government (11%) and construction (5%).
Unemployment has increased in the Piedmont Triad over the last two years and
averaged 6.3% in Guilford County, 5.5% in Yadkin County and 5.4% in Forsyth
County in 2002. The bank serves our market area through eight full service banking
offices, including four offices located in Winston-Salem. Our television and
radio advertising has extended into this market area for several years,
providing the bank name recognition in the Piedmont Triad area. The banks
customers may access various banking services through twelve ATMs owned by the
bank and ATMs owned by others, through debit cards, and through the banks
automated telephone and Internet electronic banking products. These products
allow the banks customers to apply for loans, access account information and
conduct various transactions from their telephones and computers. Business Strategy We established our bank with the objective of becoming a vital, long-term
player in our markets with a reputation for quality customer service provided
by a financially sound organization. Our business strategy is to operate as an
institution that is well capitalized, strong in asset quality, profitable,
independent, customer-oriented and connected to our community. A commitment to customer service is at the foundation of our approach.
Our commitment is to put our customers first and we believe it differentiates
us from our competitors. Making good quality, profitable loans, which result
in a long-standing relationship with our borrowers, will continue to be a
cornerstone of our strategy. We intend to leverage the core relationships we
build by providing a variety of services to our customers. With that focus, we
target:  
    
    Small and medium sized businesses, and the owners and managers of these entities;  
    
    Professional and middle managers of locally based companies;  
    
    Residential real estate developers; and  
    
    Individual consumers. We intend to grow our franchise through new and existing relationships
developed by our associates, and by expanding to contiguous areas through de
novo entry and acquisitions which make strategic and economic sense. Page 4




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We also intend to continue to diversify our revenue in order to generate
non-interest income. These efforts have included offering investment brokerage
services, our mortgage loan department, our small business investment company
manager (which generates management fees) and the creation of our trust
department. For the year ended December 31, 2003 our non-interest income
represented 19.0% of our total revenue. We believe that the profitability of
these added businesses and services, not just the revenue generated, is
critical to our success. Key aspects of our strategy and mission include:  
    
    To provide community-oriented banking services by
delivering a broad range of financial services to our
customers through responsive service and communication;  
    
    To form a partnership with our customers whereby
our decision making and product offerings are geared toward
their best long-term interests;  
    
    To be recognized in our community as a long- term
player with employees, stockholders and board members
committed to that effort; and  
    
    To be progressive in our adoption of new
technology so that we can provide our customers access to
products and services that meet their needs for convenience
and efficiency. Our belief is that our way of doing business will build a profitable
corporation and shareholder value. We want to consistently reward our
shareholders for their investment and trust in us. Subsidiaries The bank operates one subsidiary that provides financial services in
addition to those offered directly by the bank. The company formed two
additional subsidiaries to issue trust preferred securities. Each subsidiary
is described below. VCS Management, LLC was formed in March 2000 as the managing general
partner of Salem Capital Partners, L.P., a small business investment company
licensed by the Small Business Administration. Southern Community Bank and
Trust has committed $1.7 million for investment in the partnership, which has a
total of $9.2 million of committed capital from various private investors
including the bank. The partnership can also borrow funds on a non-recourse
basis from the Small Business Administration to increase its capital available
for investment. The partnership makes investments in the form of subordinated
debt and earns revenue through interest received on its investments and
potentially through gains realized from warrants that it receives in
conjunction with its debt investments. The bank shares in any earnings of the
partnership through its investment in the partnership. VCS Management earns
management fees for managing the investment activities of the partnership. For
the year ended December 31, 2003 VCS Management earned $562,000 of fee income,
representing 2.2% of total consolidated revenue. In February of 2002, Southern Community Capital Trust I (Trust I), a
newly formed subsidiary of the company, issued 1,725,000 Cumulative Convertible
Trust Preferred Securities (Trust I Securities), generating total proceeds of
$17.3 million. At December 31, 2003, holders of the Trust I Securities had
voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of
our common stock at the Conversion Price of $8.26 per share of our common
stock. On January 14, 2004, we announced the redemption of all of the Trust I
Securities. We redeemed the Trust I Securities under a provision that
permitted us to redeem the Trust I Securities in whole at any time prior to
March 31, 2007 once the trading price of our common stock had been at least
125% of the Conversion Price for a period of twenty consecutive trading days
ending within five days of the date that we gave notice of redemption. The
Trust I Securities were redeemed on March 12, 2004 which resulted in the
issuance of 2,060,000 shares of our common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. The
Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I
Securities began paying quarterly distributions on March 31, 2002. The company
had fully and unconditionally guaranteed the obligations of Trust I. The
proceeds from the Trust I Securities were utilized to purchase convertible
junior subordinated debentures from us under the same terms and conditions as
the Trust I Securities. Subject to certain limitations, the Trust I Securities
qualified as Tier 1 capital of the company for regulatory capital purposes.
The principal use of the net proceeds from the sale of the convertible
debentures was to infuse capital into our bank subsidiary, Southern Community
Bank and Trust, to fund its operations and continued expansion, and to maintain
the companys and the banks status as well capitalized under regulatory
guidelines. Page 5




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In November of 2003, Southern Community Capital Trust II (Trust II), a
newly formed subsidiary of the company, issued 3,450,000 Trust Preferred
Securities (Trust II Securities), generating total proceeds of $34.5 million.
The Trust II Securities pay distributions at an annual rate of 7.95% and
mature on December 31, 2033. The Trust II Securities began paying quarterly
distributions on December 31, 2003. The company has fully and unconditionally
guaranteed the obligations of Trust II. The Trust II Securities are redeemable
in whole or in part at any time after December 31, 2008. The proceeds from the
Trust II Securities were utilized to purchase convertible junior subordinated
debentures from us under the same terms and conditions as the Trust II
Securities. We have the right to defer payment of interest on the debentures
at any time and from time to time for a period not exceeding five years,
provided that no deferral period extend beyond the stated maturities of the
debentures. Such deferral of interest payments by the company will result in a
deferral of distribution payments on the related Trust II Securities. Should
we defer the payment of interest on the debentures, the company will be
precluded from the payment of cash dividends to shareholders. The principal
use of the net proceeds from the sale of the debentures was to provide cash for
the acquisition of The Community Bank, to increase our regulatory capital, and
to support the growth and operations of our subsidiary banks. The amount of
proceeds we count as Tier 1capital cannot comprise more than 25% of our core
capital elements. Amounts in excess of that 25% limitation count as Tier 2
supplementary capital on our books. Prior to the closing of the acquisition of
The Community Bank on January 12, 2004, substantially all of the proceeds from
the Trust II Securities qualified as Tier 2 supplementary capital. Prior to
the redemption of the Trust I Securities, approximately $20 million of the
proceeds of the Trust II Securities counted as Tier 1 capital on our books.
After the redemption of the Trust I Securities on March 12, 2004, subject to
certain limitations, substantially all of the proceeds from the Trust II
Securities qualify as Tier 1 capital of the company for regulatory capital
purposes. Competition The activities in which the bank, as our operating subsidiary, engages are
highly competitive. Commercial banking in North Carolina is extremely
competitive due to state laws, which permit state-wide branching.
Consequently, many commercial banks have branches located in several
communities. One of the largest regional commercial banks in North Carolina,
and one savings institution have their headquarters in Winston-Salem. As of
June 2003, there were 97 branches in Forsyth County operated by twelve
commercial banks and one savings institution. Approximately $9.5 billion in
deposits are located in Forsyth County. Yadkin County had eight banks with ten
branches and approximately $378.5 million in deposits. Twenty banks and two
savings institutions were operating in Guilford County with 134 branches and
approximately $6.7 billion in deposits. Deposits of the bank in June 2003 were
$426.4 million in Forsyth County, $69.2 million in Yadkin County, and $10.1
million in Guilford County. Therefore, in its market area, the bank has
significant competition for deposits and loans from other depository
institutions. Other financial institutions such as savings and loan associations, credit
unions, consumer finance companies, insurance companies, brokerage companies
and other financial institutions with varying degrees of regulatory
restrictions compete vigorously for a share of the financial services market.
Brokerage companies continue to become more competitive in the financial
services arena and pose an ever increasing challenge to banks. Legislative
changes also greatly affect the level of competition we face. During 1998
federal legislation allowed credit unions to expand their membership criteria
and compete more intensely for traditional bank business. Additionally, the
Gramm-Leach-Bliley Financial Services Modernization Act of 1999 expanded the
types of activities in which a bank holding company can engage. Currently, we
must compete against some institutions located in the Piedmont Triad area that
have capital resources and legal loan limits substantially in excess of those
available to us and the bank. We expect competition to continue to be
significant. Employees Southern Community Financial Corporation has no employees of its own and
all employees during 2003 were compensated by the bank. At December 31, 2003,
the bank employed 157 full-time equivalent persons (including our executive
officers). None of the employees are represented by any unions or similar
groups, and we have not experienced any type of strike or labor dispute. We
consider our relationship with our employees to be extremely important to our
long-term success. The Board and management continually seek ways to enhance
their benefits and well being. Page 6




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SUPERVISION AND REGULATION Southern Community Financial Corporation is registered as a financial
holding company with the Federal Reserve. The bank is a North Carolina
chartered banking corporation and a member bank of the Federal Reserve System.
Banking is a complex, highly regulated industry. The primary goals of bank
regulations are to maintain a safe and sound banking system and to facilitate
the conduct of sound monetary policy. In furtherance of these goals, Congress
has created several largely autonomous regulatory agencies and enacted numerous
laws that govern banks, bank holding companies and the banking industry. The
descriptions of and references to the statutes and regulations below are brief
summaries and do not purport to be complete. The descriptions are qualified in
their entirety by reference to the specific statutes and regulations discussed. Southern Community Financial Corporation Southern Community Financial Corporation is a bank holding company that
has elected to be treated as a financial holding company. As a bank holding
company under the Bank Holding Company Act of 1956, as amended, we are
registered with and subject to regulation by the Federal Reserve. We are
required to file annual and other reports with, and furnish information to, the
Federal Reserve. The Federal Reserve conducts periodic examinations of us and
may examine any of our subsidiaries, including the bank. The Bank Holding Company Act provides that a bank holding company must
obtain the prior approval of the Federal Reserve for the acquisition of more
than five percent of the voting stock or substantially all the assets of any
bank or bank holding company. In addition, the Bank Holding Company Act
restricts the extension of credit to any bank holding company by its subsidiary
bank. The Bank Holding Company Act also provides that, with certain
exceptions, a bank holding company may not engage in any activities other than
those of banking or managing or controlling banks and other authorized
subsidiaries or own or control more than five percent of the voting shares of
any company that is not a bank. The Federal Reserve has deemed limited
activities to be closely related to banking and therefore permissible for a
bank holding company. However, with the passage of the Gramm-Leach-Bliley Financial Services
Modernization Act of 1999, which became effective on March 11, 2000, the types
of activities in which a bank holding company may engage were significantly
expanded. Subject to various limitations, the Modernization Act generally
permits a bank holding company to elect to become a financial holding
company. A financial holding company may affiliate with securities firms and
insurance companies and engage in other activities that are financial in
nature. Among the activities that are deemed financial in nature are, in
addition to traditional lending activities, securities underwriting, dealing in
or making a market in securities, sponsoring mutual funds and investment
companies, insurance underwriting and agency activities, certain merchant
banking activities as well as activities that the Federal Reserve considers to
be closely related to banking. A bank holding company may become a financial holding company under the
Modernization Act if each of its subsidiary banks is well capitalized under
the Federal Deposit Insurance Corporation Improvement Act prompt corrective
action provisions, is well managed and has at least a satisfactory rating under
the Community Reinvestment Act. In addition, the bank holding company must
file a declaration with the Federal Reserve that the bank holding company
wishes to become a financial holding company. A bank holding company that falls
out of compliance with these requirements may be required to cease engaging in
some of its activities. Southern Community Financial Corporation elected, and
was authorized by the Federal Reserve, to be a financial holding company. Under the Modernization Act, the Federal Reserve serves as the primary
umbrella regulator of financial holding companies, with supervisory authority
over each parent company and limited authority over its subsidiaries. Expanded
financial activities of financial holding companies generally will be regulated
according to the type of such financial activity: banking activities by banking
regulators, securities activities by securities regulators and insurance
activities by insurance regulators. The Modernization Act also imposes
additional restrictions and heightened disclosure requirements regarding
private information collected by financial institutions. Enforcement Authority. We will be required to obtain the approval of the
Federal Reserve prior to engaging in or, with certain exceptions, acquiring
control of more than 5% of the voting shares of a company engaged in, any new
activity. Prior to granting such approval, the Federal Reserve must weigh the
expected benefits of any such new activity to the public (such as greater
convenience, increased competition, or gains in efficiency) against the risk of
possible adverse effects of such activity (such as undue concentration of
resources, decreased or Page 7




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unfair competition, conflicts of interest, or unsound banking practices).
The Federal Reserve has cease-and-desist powers over bank holding companies and
their nonbanking subsidiaries where their actions would constitute a serious
threat to the safety, soundness or stability of a subsidiary bank. The Federal
Reserve also has authority to regulate debt obligations (other than commercial
paper) issued by bank holding companies. This authority includes the power to
impose interest ceilings and reserve requirements on such debt obligations. A
bank holding company and its subsidiaries are also prohibited from engaging in
certain tie-in arrangements in connection with any extension of credit, lease
or sale of property or furnishing of services. Interstate Acquisitions. Federal banking law generally provides that a
bank holding company may acquire or establish banks in any state of the United
States, subject to certain aging and deposit concentration limits. In
addition, North Carolina banking laws permit a bank holding company which owns
stock of a bank located outside North Carolina to acquire a bank or bank
holding company located in North Carolina. In any event, federal banking law
will not permit a bank holding company to own or control banks in North
Carolina if the acquisition would exceed 20% of the total deposits of all
federally-insured deposits in North Carolina. Capital Adequacy. The Federal Reserve has promulgated capital adequacy
regulations for all bank holding companies with assets in excess of $150
million. The Federal Reserves capital adequacy regulations are based upon a
risk based capital determination, whereby a bank holding companys capital
adequacy is determined in light of the risk, both on- and off-balance sheet,
contained in the companys assets. Different categories of assets are assigned
risk weightings and are counted at a percentage of their book value. The regulations divide capital between Tier 1 capital (core capital) and
Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily
of common stock, related surplus, noncumulative perpetual preferred stock,
minority interests in consolidated subsidiaries and a limited amount of
qualifying cumulative preferred securities. Goodwill and certain other
intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an
amount equal to the allowance for loan and lease losses up to a maximum of
1.25% of risk weighted assets, limited other types of preferred stock not
included in Tier 1 capital, hybrid capital instruments and term subordinated
debt. Investments in and loans to unconsolidated banking and finance
subsidiaries that constitute capital of those subsidiaries are excluded from
capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total
capital. The Tier 1 component must comprise at least 50% of qualifying total
capital. Every bank holding company has to achieve and maintain a minimum Tier 1
capital ratio of at least 4.0% and a minimum total capital ratio of at least
8.0%. In addition, banks and bank holding companies are required to maintain a
minimum leverage ratio of Tier 1 capital to average total consolidated assets
(leverage capital ratio) of at least 3.0% for the most highly-rated,
financially sound banks and bank holding companies and a minimum leverage ratio
of at least 4.0% for all other banks. The Federal Deposit Insurance
Corporation and the Federal Reserve define Tier 1 capital for banks in the same
manner for both the leverage ratio and the risk-based capital ratio. However,
the Federal Reserve defines Tier 1 capital for bank holding companies in a
slightly different manner. As of
December 31, 2003, our Tier 1 leverage capital ratio and total capital
were 8.63% and 17.74%, respectively. The guidelines also provide that banking organizations experiencing
internal growth or making acquisitions will be expected to maintain strong
capital positions substantially above the minimum supervisory level, without
significant reliance on intangible assets. The guidelines also indicate that
the Federal Reserve will continue to consider a Tangible Tier 1 Leverage
Ratio in evaluating proposals for expansion or new activities. The Tangible
Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not
deducted from Tier 1 capital, to quarterly average total assets. As of
December 31, 2003, the Federal Reserve had not advised us of any specific
minimum Tangible Tier 1 Leverage Ratio applicable to us. In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities. This interpretation addresses the
consolidation by business enterprises of variable interest entities as defined
in the interpretation. In December 2003, the FASB issued a revision to FIN 46
(FIN 46R) to clarify some of the provisions of FIN 46 and to exempt certain
entities from its requirements. The company must apply FIN 46R no later than
the end of the first reporting period ending after March 15, 2004. Adoption of
FIN 46R will require deconsolidation of the companys remaining trust preferred
subsidiary, Southern Community Capital Trust II (the Trust I Securities were
redeemed as of March 12, 2004). Upon deconsolidation, the junior subordinated
debentures issued by the company to Trust II will be included in long-term debt
(instead of the trust preferred securities) and the companys equity interest
in Trust II will be included in other assets. If Trust I and Trust II were
deconsolidated as of December 31, 2003, the effect on the companys balance
sheet would be an increase in other assets of $1.6 Page 8




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million with a corresponding increase in long-term debt. The
deconsolidation of Trust I and Trust II will not materially impact net income. The Trust Preferred Securities presently qualify as Tier 1 regulatory
capital and are reported in Federal Reserve regulatory reports as a minority
interest in our consolidated subsidiaries. The junior subordinated debentures
do not qualify as Tier 1 regulatory capital. On July 2, 2003, the Board of
Governors of the Federal Reserve issued a letter, SR 03-13, stating that
notwithstanding FIN 46, trust preferred securities will continue to be included
in Tier 1 capital until notice is given to the contrary. There can be no
assurance that the Federal Reserve will continue to allow institutions to
include trust preferred securities in Tier I capital for regulatory capital
purposes. In the event of a disallowance, there would be a reduction in the
companys consolidated capital ratios. However, the company believes that the
bank would remain well capitalized under Federal Reserve Board guidelines. Source of Strength for Subsidiaries.Bank holding companies are required
to serve as a source of financial strength for their depository institution
subsidiaries, and, if their depository institution subsidiaries become
undercapitalized, bank holding companies may be required to guarantee the
subsidiaries compliance with capital restoration plans filed with their bank
regulators, subject to certain limits. Dividends. On January 14, 2004, the company announced the declaration of
its first annual cash dividend of $0.11 per share of its common stock which was
paid on March 15, 2004, to shareholders of record on February 20, 2004. As a
bank holding company that does not, as an entity, currently engage in separate
business activities of a material nature, our ability to pay cash dividends
depends upon the cash dividends we receive from our subsidiary banks (Southern
Community Bank and Trust and after January 12, 2004, The Community Bank). Our
only source of income is dividends paid by these banks. We must pay all of our
operating expenses from funds we receive from these banks. North Carolina
banking requires that dividends be paid out of retained earnings and prohibits
the payment of cash dividends if payment of the dividend would cause the banks
surplus to be less than 50% of its paid-in capital. Also, under federal
banking law, no cash dividend may be paid if the bank is undercapitalized or
insolvent or if payment of the cash dividend would render the bank
undercapitalized or insolvent, and no cash dividend may be paid by the bank if
it is in default of any deposit insurance assessment due to the FDIC.
Therefore, shareholders may receive dividends from us only to the extent that
funds are available from our subsidiary banks. In addition, the Federal
Reserve generally prohibits bank holding companies from paying dividends except
out of operating earnings, and the prospective rate of earnings retention
appears consistent with the bank holding companys capital needs, asset quality
and overall financial condition. Change of Control.State and federal banking law restrict the amount of
voting stock of the company that a person may acquire without the prior
approval of banking regulators. The Bank Holding Company Act requires that a
bank holding company obtain the approval of the Federal Reserve before it may
merge with a bank holding company, acquire a subsidiary bank, acquire
substantially all of the assets of any bank, or before it may acquire ownership
or control of any voting shares of any bank or bank holding company if, after
such acquisition, it would own or control, directly or indirectly, more than 5%
of the voting shares of that bank or bank holding company. The overall effect
of such laws is to make it more difficult to acquire us by tender offer or
similar means than it might be to acquire control of another type of
corporation. Consequently, our shareholders may be less likely to benefit from
rapid increases in stock prices that often result from tender offers or similar
efforts to acquire control of other types of companies. The Bank The bank is subject to various requirements and restrictions under the
laws of the United States and the State of North Carolina. As a North Carolina
bank, our subsidiary bank is subject to regulation, supervision and regular
examination by the North Carolina Banking Commission. As a member of the
Federal Reserve, the bank is subject to regulation, supervision and regular
examination by the Federal Reserve. The North Carolina Banking Commission and
the Federal Reserve have the power to enforce compliance with applicable
banking statutes and regulations. These requirements and restrictions include
requirements to maintain reserves against deposits, restrictions on the nature
and amount of loans that may be made and the interest that may be charged
thereon and restrictions relating to investments and other activities of the
bank. Transactions with Affiliates. The bank may not engage in specified
transactions (including, for example, loans) with its affiliates unless the
terms and conditions of those transactions are substantially the same or at
least as favorable to the bank as those prevailing at the time for comparable
transactions with or involving other Page 9




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nonaffiliated entities. In the absence of comparable transactions, any
transaction between the bank and its affiliates must be on terms and under
circumstances, including credit standards, that in good faith would be offered
or would apply to nonaffiliated companies. In addition, transactions referred
to as covered transactions between the bank and its affiliates may not exceed
10% of the banks capital and surplus per affiliate and an aggregate of 20% of
its capital and surplus for covered transactions with all affiliates. Certain
transactions with affiliates, such as loans, also must be secured by collateral
of specific types and amounts. The bank also is prohibited from purchasing low
quality assets from an affiliate. Every company under common control with the
bank, including us and Southern Community Capital Trust I and II, is deemed to
be an affiliate of the bank. Loans to Insiders. Federal law also constrains the types and amounts of
loans that the bank may make to its executive officers, directors and principal
shareholders. Among other things, these loans are limited in amount, must be
approved by the banks board of directors in advance, and must be on terms and
conditions as favorable to the bank as those available to an unrelated person. Regulation of Lending Activities. Loans made by the bank are also subject
to numerous federal and state laws and regulations, including the
Truth-In-Lending Act, Federal Consumer Credit Protection Act, the Equal Credit
Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate
mortgage disclosure requirements. Remedies to the borrower or consumer and
penalties to the bank are provided if the bank fails to comply with these laws
and regulations. The scope and requirements of these laws and regulations have
expanded significantly in recent years. Branch Banking. All banks located in North Carolina are authorized to
branch statewide. Accordingly, a bank located anywhere in North Carolina has
the ability, subject to regulatory approval, to establish branch facilities
near any of our facilities and within our market area. If other banks were to
establish branch facilities near our facilities, it is uncertain whether these
branch facilities would have a material adverse effect on our business. Federal law provides for nationwide interstate banking and branching,
subject to certain aging and deposit concentration limits that may be imposed
under applicable state laws. Applicable North Carolina statutes permit
regulatory authorities to approve de novo branching in North Carolina by
institutions located in states that would permit North Carolina institutions to
branch on a de novo basis into those states. Federal regulations prohibit an
out-of-state bank from using interstate branching authority primarily for the
purpose of deposit production. These regulations include guidelines to insure
that interstate branches operated by an out-of-state bank in a host state are
reasonably helping to meet the credit needs of the host state communities
served by the out-of-state bank. Reserve Requirements.Pursuant to regulations of the Federal Reserve,
the bank must maintain average daily reserves against its transaction accounts.
No reserves are required to be maintained on the first $6.6 million of
transaction accounts, but reserves equal to 3.0% must be maintained on the
aggregate balances of those accounts between $6.6 million and $45.4 million,
and reserves equal to 10.0% plus $1.2 million must be maintained on aggregate
balances in excess of $45.4 million. These percentages are subject to
adjustment by the Federal Reserve. Because required reserves must be
maintained in the form of vault cash or in a non-interest-bearing account at a
Federal Reserve Bank, the effect of the reserve requirement is to reduce the
amount of the institutions interest-earning assets. As of December 31, 2003,
the bank met its reserve requirements. Community Reinvestment.Under the Community Reinvestment Act (CRA), as
implemented by regulations of the federal bank regulatory agencies, an insured
bank has a continuing and affirmative obligation, consistent with its safe and
sound operation, to help meet the credit needs of its entire community,
including low and moderate income neighborhoods. The CRA does not establish
specific lending requirements or programs for banks, nor does it limit a banks
discretion to develop the types of products and services that it believes are
best suited to its particular community, consistent with the CRA. The CRA
requires the federal bank regulatory agencies, in connection with their
examination of insured banks, to assess the banks records of meeting the
credit needs of their communities, using the ratings of outstanding,
satisfactory, needs to improve, or substantial noncompliance, and to take
that record into account in its evaluation of certain applications by those
banks. All banks are required to make public disclosure of their CRA
performance ratings. The bank received a satisfactory rating in its most
recent CRA examination. Governmental Monetary Policies. The commercial banking business is
affected not only by general economic conditions but also by the monetary
policies of the Federal Reserve. Changes in the discount rate on member bank
borrowings, control of borrowings, open market transactions in United States
government securities, the imposition of and changes in reserve requirements
against member banks and deposits and assets of foreign bank Page 10




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branches, and the imposition of and changes in reserve requirements
against certain borrowings by banks and their affiliates are some of the
monetary policies available to the Federal Reserve. Those monetary policies
influence to a significant extent the overall growth of all bank loans,
investments and deposits and the interest rates charged on loans or paid on
time and savings deposits in order to mitigate recessionary and inflationary
pressures. These techniques are used in varying combinations to influence
overall growth and distribution of bank loans, investments, and deposits, and
their use may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant
effect on the operating results of commercial banks in the past and are
expected to continue to do so in the future. In view of changing conditions in
the national economy and money markets, as well as the effect of actions by
monetary and fiscal authorities, no prediction can be made as to possible
future changes in interest rates, deposit levels, loan demand or the business
and earnings of the bank. Dividends. All dividends paid by the bank are paid to us, the sole
shareholder of the bank. The general dividend policy of the bank is to pay
dividends at levels consistent with maintaining liquidity and preserving our
applicable capital ratios and servicing obligations. The dividend policy of the
bank is subject to the discretion of the board of directors of the bank and
will depend upon such factors as future earnings, growth, financial condition,
cash needs, capital adequacy, compliance with applicable statutory and
regulatory requirements and general business conditions. The ability of the bank to pay dividends is restricted under applicable
law and regulations. Under North Carolina banking law, dividends must be paid
out of retained earnings and no cash dividends may be paid if the banks
surplus is less than 50% of its paid-in capital. Also, under federal banking
law, no cash dividend may be paid if the bank is undercapitalized or insolvent
or if payment of the cash dividend would render the bank undercapitalized or
insolvent, and no cash dividend may be paid by the bank if it is in default of
any deposit insurance assessment due to the Federal Deposit Insurance
Corporation. The exact amount of future dividends on the stock of the bank will be a
function of the profitability of the bank in general and applicable tax rates
in effect from year to year. The banks ability to pay dividends in the future
will directly depend on future profitability, which cannot be accurately
estimated or assured. We expect that, for the foreseeable future, dividends
will be paid by the bank to us as needed to pay any separate expenses of
Southern Community Financial Corporation and/or to make required payments on
our debt obligations, including the debentures which fund the interest payments
on the preferred securities issued by our trust subsidiary, and to pay cash
dividends to our shareholders. Capital Adequacy. The capital adequacy regulations which apply to state
banks, such as the bank, are similar to the Federal Reserve requirements
promulgated with respect to bank holding companies discussed above. Changes in Management. Any depository institution that has been chartered
less than two years, is not in compliance with the minimum capital requirements
of its primary federal banking regulator, or is otherwise in a troubled
condition must notify its primary federal banking regulator of the proposed
addition of any person to the board of directors or the employment of any
person as a senior executive officer of the institution at least 30 days before
such addition or employment becomes effective. During this 30-day period, the
applicable federal banking regulatory agency may disapprove of the addition of
such director or employment of such officer. The bank is not subject to any
such requirements. Enforcement Authority. The federal banking laws also contain civil and
criminal penalties available for use by the appropriate regulatory agency
against certain institution-affiliated parties primarily including
management, employees and agents of a financial institution, as well as
independent contractors such as attorneys and accountants and others who
participate in the conduct of the financial institutions affairs and who
caused or are likely to cause more than minimum financial loss to or a
significant adverse affect on the institution, who knowingly or recklessly
violate a law or regulation, breach a fiduciary duty or engage in unsafe or
unsound practices. These practices can include the failure of an institution
to timely file required reports or the submission of inaccurate reports. These
laws authorize the appropriate banking agency to issue cease and desist orders
that may, among other things, require affirmative action to correct any harm
resulting from a violation or practice, including restitution, reimbursement,
indemnification or guarantees against loss. A financial institution may also
be ordered to restrict its growth, dispose of certain assets or take other
action as determined by the primary federal banking agency to be appropriate. Page 11




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Prompt Corrective Action. Banks are subject to restrictions on their
activities depending on their level of capital. Federal prompt corrective
action regulations divide banks into five different categories, depending on
their level of capital. Under these regulations, a bank is deemed to be well
capitalized if it has a total risk-based capital ratio of 10% or more, a core
capital ratio of six percent or more and a leverage ratio of five percent or
more, and if the bank is not subject to an order or capital directive to meet
and maintain a certain capital level. Under these regulations, a bank is
deemed to be adequately capitalized if it has a total risk-based capital
ratio of eight percent or more, a core capital ratio of four percent or more
and a leverage ratio of four percent or more (unless it receives the highest
composite rating at its most recent examination and is not experiencing or
anticipating significant growth, in which instance it must maintain a leverage
ratio of three percent or more). Under these regulations, a bank is deemed to
be undercapitalized if it has a total risk-based capital ratio of less than
eight percent, a core capital ratio of less than four percent or a leverage
ratio of less than three percent. Under these regulations, a bank is deemed to
be significantly undercapitalized if it has a risk-based capital ratio of
less than six percent, a core capital ratio of less than three percent and a
leverage ratio of less than three percent. Under such regulations, a bank is
deemed to be critically undercapitalized if it has a leverage ratio of less
than or equal to two percent. In addition, the applicable federal banking
agency has the ability to downgrade a banks classification (but not to
critically undercapitalized) based on other considerations even if the bank
meets the capital guidelines. If a state member bank, such as the bank, is classified as
undercapitalized, the bank is required to submit a capital restoration plan to
the Federal Reserve. An undercapitalized bank is prohibited from increasing
its assets, engaging in a new line of business, acquiring any interest in any
company or insured depository institution, or opening or acquiring a new branch
office, except under certain circumstances, including the acceptance by the
Federal Reserve of a capital restoration plan for the bank. If a state member bank were classified as undercapitalized, the Federal
Reserve may take certain actions to correct the capital position of the bank.
If a state member bank is classified as significantly undercapitalized, the
Federal Reserve would be required to take one or more prompt corrective
actions. These actions would include, among other things, requiring sales of
new securities to bolster capital, changes in management, limits on interest
rates paid, prohibitions on transactions with affiliates, termination of
certain risky activities and restrictions on compensation paid to executive
officers. If a bank is classified as critically undercapitalized, the bank
must be placed into conservatorship or receivership within 90 days, unless the
Federal Deposit Insurance Corporation determines otherwise. The capital classification of a bank affects the frequency of examinations
of the bank and impacts the ability of the bank to engage in certain activities
and affects the deposit insurance premiums paid by the bank. The Federal
Reserve is required to conduct a full-scope, on-site examination of every
member bank on a periodic basis. Banks also may be restricted in their ability to accept brokered deposits,
depending on their capital classification. Well capitalized banks are
permitted to accept brokered deposits, but all banks that are not well
capitalized are not permitted to accept such deposits. The Federal Reserve
may, on a case-by-case basis, permit member banks that are adequately
capitalized to accept brokered deposits if the Federal Reserve determines that
acceptance of such deposits would not constitute an unsafe or unsound banking
practice with respect to the bank. Deposit Insurance.The banks deposits are insured up to $100,000 per
insured account by the Bank Insurance Fund of the Federal Deposit Insurance
Corporation. The banks deposit insurance assessments may increase depending
upon the risk category and subcategory to which the bank is assigned. The
Federal Deposit Insurance Corporation assesses insurance premiums on a banks
deposits at a variable rate depending on the probability that the deposit
insurance fund will incur a loss with respect to the bank. The Federal Deposit
Insurance Corporation determines the deposit insurance assessment rates on the
basis of the banks capital classification and supervisory evaluations. Each
of these categories has three subcategories, resulting in nine assessment risk
classifications. The three subcategories with respect to capital are well
capitalized, adequately capitalized and less than adequately capitalized
(that would include undercapitalized, significantly undercapitalized and
critically undercapitalized banks). The three subcategories with respect to
supervisory concerns are healthy, supervisory concern and substantial
supervisory concern. A bank is deemed healthy if it is financially sound
with only a few minor weaknesses. A bank is deemed subject to supervisory
concern if it has weaknesses that, if not corrected, could result in
significant deterioration of the bank and increased risk to the Bank Insurance
Fund of the Federal Deposit Insurance Corporation. A bank is deemed subject to
substantial supervisory concern if it poses a substantial probability of loss
to the Bank Insurance Fund. Any increase in insurance assessments could have
an adverse effect on the banks earnings. Page 12




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Our management cannot predict what other legislation might be enacted or
what other regulations might be adopted or the effects thereof. 
 Item 2. Properties As of December 31, 2003 we operated out of eight banking offices and four
operations/administrative offices. All banking offices have ATMs. A summary
of our offices is as follows: Approximate
    
    YearSquare
    
    Established
    
    Owned orFootage
    
    or Acquired
    
    LeasedBanking Offices:Winston Salem, North Carolina4701 Country Club Rd.
    
    
    5,500
    
    
    
    1996
    
    
    Leased3151 Peters Creek Parkway
    
    
    2,400
    
    
    
    1998
    
    
    Leased225 Hanes Mill Rd.
    
    
    2,800
    
    
    
    2001
    
    
    Owned536 South Stratford Rd.
    
    
    1,600
    
    
    
    1998
    
    
    LeasedYadkinville, North Carolina532 East Main Street
    
    
    7,100
    
    
    
    1998
    
    
    OwnedClemmons, North Carolina2755 Lewisville Clemmons Rd.
    
    
    2,000
    
    
    
    2000
    
    
    LeasedKernersville, North Carolina1207 South Main Street
    
    
    7,700
    
    
    
    2002
    
    
    OwnedHigh Point, North Carolina2541 Eastchester Drive
    
    
    3,000
    
    
    
    2003
    
    
    OwnedOperations and Administrative Offices:Winston Salem, North Carolina4625 Country Club Rd.
    
    
    3,200
    
    
    
    1998
    
    
    Owned1600 Hanes Mall Blvd.
    
    
    10,500
    
    
    
    2000
    
    
    Owned112 Cambridge Plaza
    
    
    3,750
    
    
    
    2002
    
    
    Leased4605 Country Club Rd. - Corporate
    
    
    27,000
    
    
    
    2003
    
    
    Owned
 In addition to the above locations, we have four off site ATMs located at
3484 Robinhood Road, and Ernie Shore Field 401 Deacon Boulevard in
Winston-Salem, 1466 River Ridge Road in Clemmons and at 4575 Yadkinville Road,
Pfafftown, North Carolina. In February 2004, we opened a loan production
office at 249 Williamson Road in Mooresville, North Carolina. All of our properties, including land, buildings and improvements,
furniture, equipment and vehicles, had a net book value at December 31, 2003 of
$17.3 million. Additional banking offices may be opened at later dates if deemed
appropriate by the Board of Directors and if regulatory approval can then be
obtained. The Board of Directors may acquire property in which a director,
directly or indirectly, has an interest. In such event, the acquisition of
such facilities shall be approved by a majority of the Board of Directors,
excluding any individual who may have such an interest in the property. 
 Item 3. Legal We are party to legal proceedings arising in the normal conduct of
business. Our management believes that this litigation is not material to our
financial position or results of our operations or the operations of the bank. Page 13




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Item 4. Submission of Matters To a Vote of Security Holders At a special meeting of the shareholders conducted on December 11, 2003,
shareholders of Southern Community Financial Corporation voted to approve the
transaction allowing the company to acquire The Community Bank of Pilot
Mountain, North Carolina. At the special meeting, 4,723,670 voted for approval
of the transaction, 26,465 voted against, and 119,749 abstained. There were no additional matters submitted to a vote of our security
holders during the fourth quarter of our fiscal year ended. 
 PART II 
 Item 5. Market for Common Stock and Related Stockholder Matters Price Range of Common Stock and Dividends Our common stock is listed on the Nasdaq National Market System under the
symbol SCMF. The following table sets forth the high and low sales prices
per share of our common stock and our convertible preferred securities
(SCMFP), based on published financial sources, for the last two years. The
convertible preferred securities did not begin trading until the first quarter
of 2002. All information has been adjusted for stock splits and stock
dividends effected during the periods presented. PriceSCMF
    
    SCMFPYear
    
    Quarterly Period
    
    High
    
    Low
    
    High
    
    Low2002
    
    
    First Quarter
    
    $
    9.76
    
    
    $
    5.82
    
    
    $
    11.01
    
    
    $
    9.90Second Quarter
    
    
    7.62
    
    
    
    6.24
    
    
    
    11.20
    
    
    
    10.22Third Quarter
    
    
    7.10
    
    
    
    5.48
    
    
    
    10.65
    
    
    
    9.76Fourth Quarter
    
    
    7.36
    
    
    
    6.10
    
    
    
    11.15
    
    
    
    9.902003
    
    
    First Quarter
    
    
    8.08
    
    
    
    6.30
    
    
    
    11.98
    
    
    
    10.60Second Quarter
    
    
    9.95
    
    
    
    7.57
    
    
    
    14.00
    
    
    
    10.85Third Quarter
    
    
    10.46
    
    
    
    8.88
    
    
    
    14.50
    
    
    
    12.50Fourth Quarter
    
    
    11.17
    
    
    
    9.91
    
    
    
    13.99
    
    
    
    12.90
 At December 31, 2003, there were approximately 5,200 holders of record of
our common stock, and as of March 12, 2004 there were 7,400 holders of record
of our common stock. On January 12, 2004, we issued 6,391,452 shares of our
common stock to the former shareholders of The Community Bank. On January 14,
2004, the company announced that Southern Community Capital Trust I would
redeem all of its 7.25% Cumulative Convertible Trust Preferred Securities and
its 7.25% Common Securities at the stated liquidation amount of $10.00 per
security on March 12, 2004. The record date for the redemption was February
25, 2004 and the redemption resulted in the issuance of 2,060,000 shares of
common stock through the conversions and the retirement of $61,000 of the Trust
I Securities. On January 14, 2004, the company announced the payment of an annual cash
dividend of $0.11 per share to all common stock shareholders of record on
February 20, 2004. Holders of our common stock will be entitled to receive any
cash dividends the Board of Directors may declare. The declaration and payment
of future dividends to holders of our common stock will be at the discretion of
our Board of Directors and will depend upon our earnings and financial
condition, regulatory conditions and considerations and such other factors as
our Board of Directors may deem relevant. As a holding company, Southern
Community Financial Corporation is ultimately dependent upon its bank
subsidiaries (Southern Community Bank and Trust and, after January 12, 2004,
The Community Bank) to provide funding for its operating expenses, debt service
(including the interest payments on the preferred securities issued by our
remaining trust subsidiary), and dividends. Our only source of income is
dividends paid by these banks. We must pay all of our operating expenses from
funds we receive from these banks. Various banking laws applicable to our bank
subsidiaries limit the payment of dividends, management fees and other
distributions by the banks to us and may therefore limit our ability to make
dividend payments. Under North Carolina banking law, dividends must be paid
out of retained earnings and no cash dividends may be paid if payment of the
dividend Page 14




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would cause the banks surplus to be less than 50% of its paid-in capital.
Under federal banking law, no cash dividend may be paid if the bank is
undercapitalized or insolvent or if payment of the cash dividend would render
the bank undercapitalized or insolvent, or if it is in default of any deposit
insurance assessment due to the Federal Deposit Insurance Corporation. In the future, any declaration and payment of cash dividends will be
subject to the Board of Directors evaluation of the companys operating
results, financial condition, future growth plans, general business and
economic conditions, and tax and other relevant considerations. There is no
assurance that, in the future, the company will have funds available to pay
cash dividends, or, even if funds are available, that it will pay dividends in
any particular amount or at any particular times, or that it will pay dividends
at all. Page 15




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Item 6. Selected Financial Data SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA Effective October 1, 2001, the Southern Community Bank and Trust became a
wholly owned subsidiary of Southern Community Financial Corporation. Southern
Community Financial Corporation has no material assets other than those of the
bank. Therefore, the financial statements of the bank prior to October 1, 2001
are the historical consolidated financial statements of Southern Community
Financial Corporation. The information set forth below does not purport to be
complete and should be read in conjunction with the companys consolidated
financial statements appearing elsewhere in this annual report. For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands, except per share data)Operating Data:Interest income
    
    $
    36,019
    
    
    $
    33,281
    
    
    $
    31,366
    
    
    $
    26,831
    
    
    $
    16,562Interest expense
    
    
    14,751
    
    
    
    15,803
    
    
    
    18,034
    
    
    
    14,944
    
    
    
    8,481Net interest income
    
    
    21,268
    
    
    
    17,478
    
    
    
    13,332
    
    
    
    11,887
    
    
    
    8,081Provision for loan losses
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320
    
    
    
    1,480
    
    
    
    1,135Net interest income after
provision for loan losses
    
    
    18,983
    
    
    
    15,823
    
    
    
    11,012
    
    
    
    10,407
    
    
    
    6,946Non-interest income
    
    
    4,985
    
    
    
    3,927
    
    
    
    3,402
    
    
    
    2,198
    
    
    
    775Non-interest expense
    
    
    18,333
    
    
    
    14,781
    
    
    
    11,162
    
    
    
    8,723
    
    
    
    5,892Income before
income taxes
    
    
    5,635
    
    
    
    4,969
    
    
    
    3,252
    
    
    
    3,882
    
    
    
    1,829Provision for income taxes
    
    
    1,972
    
    
    
    1,755
    
    
    
    1,147
    
    
    
    1,466
    
    
    
    293Net income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105
    
    
    $
    2,416
    
    
    $
    1,536Per Share Data:(7)Net incomeBasic
    
    $
    .41
    
    
    $
    .37
    
    
    $
    .24
    
    
    $
    .30
    
    
    $
    .19Diluted
    
    
    .40
    
    
    
    .35
    
    
    
    .23
    
    
    
    .29
    
    
    
    .18Cash dividends
    
    
    .00
    
    
    
    .00
    
    
    
    .00
    
    
    
    .00
    
    
    
    .00Book value
    
    
    5.66
    
    
    
    5.41
    
    
    
    4.84
    
    
    
    4.41
    
    
    
    3.93Weighted average sharesBasic
    
    
    8,826,780
    
    
    
    8,788,295
    
    
    
    8,707,678
    
    
    
    8,097,552
    
    
    
    8,037,904Diluted
    
    
    11,369,429
    
    
    
    9,085,853
    
    
    
    9,043,611
    
    
    
    8,450,245
    
    
    
    8,540,293Balance Sheet Data:Total assets
    
    $
    798,502
    
    
    $
    612,239
    
    
    $
    481,220
    
    
    $
    384,027
    
    
    $
    254,172Loans
    
    
    519,746
    
    
    
    421,938
    
    
    
    360,288
    
    
    
    282,161
    
    
    
    200,312Allowance for loan losses
    
    
    7,275
    
    
    
    6,342
    
    
    
    5,400
    
    
    
    4,283
    
    
    
    3,013Deposits
    
    
    575,218
    
    
    
    449,216
    
    
    
    392,851
    
    
    
    338,753
    
    
    
    218,953Short-term borrowings
    
    
    51,900
    
    
    
    40,706
    
    
    
    19,980
    
    
    
    6,000
    
    
    
    2,500Long-term debt
    
    
    117,627
    
    
    
    72,250
    
    
    
    25,000
    
    
    
    
    
    
    
    Stockholders equity
    
    
    50,891
    
    
    
    47,539
    
    
    
    42,451
    
    
    
    36,950
    
    
    
    31,766Capital Ratios:(5)Total risk-based capital
    
    
    10.66
    %
    
    
    12.23
    %
    
    
    11.53
    %
    
    
    13.03
    %
    
    
    16.40
    %Tier 1 risk-based capital
    
    
    9.46
    %
    
    
    10.98
    %
    
    
    10.28
    %
    
    
    11.78
    %
    
    
    15.15
    %Leverage ratio
    
    
    7.50
    %
    
    
    8.95
    %
    
    
    9.21
    %
    
    
    11.16
    %
    
    
    14.26
    %Equity to assets ratio
    
    
    6.37
    %
    
    
    7.76
    %
    
    
    8.82
    %
    
    
    9.62
    %
    
    
    12.50
    %
 Page 16




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##### 



For the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands, except per share data)Selected Performance Ratios:Return on average assets
    
    
    .53
    %
    
    
    .58
    %
    
    
    .50
    %
    
    
    .77
    %
    
    
    .71
    %Return on average equity
    
    
    7.48
    %
    
    
    7.24
    %
    
    
    5.13
    %
    
    
    7.27
    %
    
    
    5.00
    %Net interest spread (2)
    
    
    3.03
    %
    
    
    3.02
    %
    
    
    2.82
    %
    
    
    3.22
    %
    
    
    3.02
    %Net interest margin (1)
    
    
    3.25
    %
    
    
    3.34
    %
    
    
    3.36
    %
    
    
    4.01
    %
    
    
    3.90
    %Non-interest income as a
percentage of total
revenue (6)
    
    
    18.99
    %
    
    
    18.35
    %
    
    
    20.33
    %
    
    
    15.61
    %
    
    
    8.75
    %Non-interest income as a
percentage of average
assets
    
    
    .72
    %
    
    
    .71
    %
    
    
    .80
    %
    
    
    .70
    %
    
    
    .36
    %Non-interest expense to
average assets
    
    
    2.63
    %
    
    
    2.66
    %
    
    
    2.63
    %
    
    
    2.79
    %
    
    
    2.71
    %Efficiency ratio (3)
    
    
    69.83
    %
    
    
    69.05
    %
    
    
    66.70
    %
    
    
    61.93
    %
    
    
    66.53
    %Dividend payout ratio
    
    
    .00
    %
    
    
    .00
    %
    
    
    .00
    %
    
    
    .00
    %
    
    
    .00
    %Asset Quality Ratios:Nonperforming loans to
period-end loans
    
    
    .15
    %
    
    
    .43
    %
    
    
    .25
    %
    
    
    .10
    %
    
    
    .00
    %Allowance for loan losses
to period-end loans
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %
    
    
    1.50
    %Allowance for loan losses
to nonperforming loans
    
    
    946
    %
    
    
    348
    %
    
    
    604
    %
    
    
    1,552
    %
    
    NMNonperforming assets
to total assets (4)
    
    
    .13
    %
    
    
    .36
    %
    
    
    .26
    %
    
    
    .07
    %
    
    
    .00
    %Net loan charge-offs
to average loans outstanding
    
    
    .29
    %
    
    
    .18
    %
    
    
    .38
    %
    
    
    .09
    %
    
    
    .02
    %Other Data:Number of banking offices
    
    
    8
    
    
    
    8
    
    
    
    7
    
    
    
    7
    
    
    
    5Number of full-time
equivalent employees
    
    
    157
    
    
    
    141
    
    
    
    121
    
    
    
    104
    
    
    
    70
  (1)
    
    Net interest margin is net interest income divided by average
interest-earning assets.  (2)
    
    Net interest spread is the difference between the average yield on
interest-earning assets and the average cost of interest-bearing
liabilities.  (3)
    
    Efficiency ratio is non-interest expense divided by the sum of net
interest income and non-interest income.  (4)
    
    Nonperforming assets consist of non-accrual loans, restructured loans,
and real estate owned, where applicable.  (5)
    
    Capital ratios are for the bank.  (6)
    
    Total revenue consists of net interest income and non-interest income.  (7)
    
    All per share data has been restated to reflect the dilutive effect of a
stock split effected in the form of a two-for-one stock split in 1999, a
stock split effected in the form of a 10% stock dividend in 2000, and 5%
stock dividends in 2001 and 2002. 
 Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations The following presents managements discussion and analysis of our
financial condition and results of operations and should be read in conjunction
with the financial statements and related notes included elsewhere in this
annual report. This discussion contains forward-looking statements that
involve risks and uncertainties. Our actual results could differ significantly
from those anticipated in these forward-looking statements as a result of
various factors. All share data have been adjusted to give retroactive effect
to stock splits and stock dividends. The following discussion is intended to
assist in understanding the financial condition and results of operations of
the company. Page 17




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##### 



CRITICAL ACCOUNTING POLICY The companys most significant critical accounting policy is the
determination of its allowance for loan losses. A critical accounting policy is
one that is both very important to the portrayal of the companys financial
condition and results of operations, and requires managements most difficult,
subjective or complex judgments. What makes these judgments difficult,
subjective and/or complex is the need to make estimates about the effects of
matters that are inherently uncertain. For further discussion, see
Nonperforming Assets and Analysis of Allowance for Loan Losses under ASSET
QUALITY. OVERVIEW Our founders recognized an opportunity to fulfill the financial service
needs of individuals and organizations left underserved by consolidation within
the financial services industry. To fill a part of this void, we began in 1995
the process by which Southern Community Financial Corporation was created,
finally beginning operations on November 18, 1996. From inception, we have
strived to serve the financial needs of small to medium-sized businesses,
individuals, residential homebuilders and others in and around Winston-Salem
and the Piedmont Triad area of North Carolina. We offer a broad array of
banking and other financial products  products similar to those offered by our
larger competitors, but with an emphasis on superior customer service. We
believe that our emphasis on quality customer service is the single most
important factor among many that have fueled our growth to $799 million in
total assets in just over seven years of operations. We began operations in November 1996 with $11 million in capital, a single
branch facility and thirteen employees. Through December 31, 2003, Southern
Community Financial Corporation has grown to a total of eight full-service
banking offices with $575 million in customer deposit accounts. In support of
this growth, we have generated $24 million of additional capital through sales
of common stock in 1998, 2000 and 2001. Through our banking subsidiary we
offer traditional banking products as well as a full array of financial
services. More recently we have created a Trust Department that began
operating in the first quarter of 2002. In October of 2001, we formed Southern
Community Financial Corporation, a financial holding company, to become the
parent company of Southern Community Bank and Trust. In April of 2003 we
completed the construction of a new corporate office on property adjacent to
our main banking office in Winston-Salem. Real estate secured loans, including construction loans and loans secured
by existing commercial and residential properties, comprise the majority of our
loan portfolio, with the balance of our loans consisting of commercial and
industrial loans and loans to individuals. Through associations with various
mortgage lending companies, we originate residential mortgages, at both fixed
and variable rates, earning fees for loans originated and additional income for
loans sold to others. It has been our strategy to recruit skilled banking
professionals who are well trained and highly knowledgeable about our market
area, enabling us to develop and maintain a loan portfolio of sound credit
quality. We recognize that our growth may expose us to increased operational and
market risk, primarily with respect to managing overhead, funding costs and
credit quality. We have developed critical functions such as Training, Audit,
and Credit Administration to assist in managing and monitoring these and other
risks. We are committed to creating a solid and diversified financial services
organization with a focus on customer service. It is our firm belief that this
foundation will continue building our loyal customer base while attracting new
clients and providing opportunities for future growth. As bank consolidations
continue to take place in our marketplace, Southern Community Financial
Corporation is positioned to continue to benefit from their effects. Financial Condition at December 31, 2003 and 2002 During the year ended December 31, 2003, our total assets increased by
$186.3 million, or 30.4%, to $798.5 million. Of this increase in total assets,
$176.1 represented growth in interest-earning assets. Continued strong loan
demand resulted in an increase of $96.9 million, or 23.3%, in net loans
receivable, while investment securities available for sale and held to maturity
increased by $71.6 million and $17.5 million, respectively. Much of the growth
in the investment portfolio during the first half of the year was primarily due
to planned growth combined with pre-investment of projected maturities for the
remainder of the year. During the fourth quarter of 2003 we purchased bonds
for the investment portfolio to employ funds received from the issuance of
Southern Community Capital Trust II in excess of those needed for The Community
Bank acquisition, and to leverage that additional capital. The only category
of interest-earning assets that decreased was federal funds sold, which ended
2003 at $271,000 as compared with $11.1 million at the end of 2002. Federal
funds sold, with an average annual return of 1.21%, is the lowest yielding
among interest-earning assets. Premises and equipment increased by $1.4
million, principally as a result of the investment of $610,000 in a new branch
facility located in High Point, NC, and the completion of a new corporate
office in the first half of 2003. Other assets increased by $3.5 million,
which included the capitalization of costs associated with the issuance of
Southern Community Capital Trust II and costs associated with the acquisition
of The Community Bank. Page 18




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##### 



Loan growth in 2003 was concentrated in commercial and real estate
lending. Our total loan growth of $97.8 million in 2003 was spread among
portfolios secured by residential and commercial mortgages, which increased by
$31.7 million and $48.9 million, respectively. Commercial and industrial
lending and construction loan outstandings increased by $15.2 and $7.4 million,
respectively during the year. Consumer lending declined $5.5 million from 2002
levels as the bank exited the consumer finance business and liquidated
Southeastern Acceptance Corporation. During 2003 we continued our active
program of originations of residential mortgage loans for sale in the secondary
market. At the end of the year loans held for sale totaled $1.1 million. Our total liquid assets, defined as cash and due from banks, federal funds
sold and investment securities, increased by $84.6 million during the year, to
$254.0 million at December 31, 2003 versus $169.4 million at the beginning of
the year. Liquid assets represented 31.8% of total assets at December 31, 2003
as compared to 27.7% at the beginning of the year. We have been able to
further leverage our capital and generate significant funds for investment both
through deposit growth and through borrowings. These available funds have
exceeded our lending needs, so we have invested at a positive interest rate
spread in securities. In order to optimize our ability to manage interest rate
risk, the majority of our increase in liquid assets in 2003 has been in
available for sale securities. Customer deposits continue to be our primary funding source. While our
deposits are primarily generated through our growing branch network, we do
utilize some out-of-market and brokered deposits as a funding source. Brokered
and out-of-market deposits totaled $159.2 million and $115.7 million at
year-end 2003 and 2002, respectively. At December 31, 2003, deposits totaled
$575.2 million, an increase of $126.0 million or 28.1% from year-end 2002. As
explained above, we have also utilized borrowings to fund growth in 2003.
Total borrowings, including $51.7 million in trust preferred securities issued
during 2002 and 2003, aggregated $169.5 million at December 31, 2003.
Borrowings also included $96.5 million of advances from the Federal Home Loan
Bank of Atlanta (FHLB), Federal funds purchased of $11.4 million and securities
sold under agreements to repurchase of $10.0 million. We will use FHLB
advances and other funding sources as necessary to support balance sheet
management and growth. However, we believe that as our branch network grows
and matures, the volume of core deposits will become a relatively larger
portion of our funding mix, which should contribute to a reduction in our
overall funding cost. Our capital position remains strong, with all of our regulatory capital
ratios at levels that make us well capitalized under federal bank regulatory
capital guidelines. At December 31, 2003, our stockholders equity totaled
$50.9 million, an increase of $3.4 million from the December 31, 2002 balance.
This increase includes net income of $3.7 million earned during the year and a
decrease in other comprehensive income of $1.6 million. On July 30, 2003, the company and The Community Bank jointly announced the
execution of a definitive agreement in which Southern Community Financial
Corporation would acquire The Community Bank of Pilot Mountain, North Carolina
in a fixed exchange of cash and stock. The Community Bank, founded in 1987
operates 10 community banking offices throughout Surry, Rockingham, Stokes,
Iredell and Yadkin counties of North Carolina. On December 11, 2003,
shareholders approved the transaction allowing Southern Community Financial
Corporation to acquire The Community Bank. On January 12, 2004, the
acquisition was completed. For each share of stock owned, The Community Bank
shareholders receive $53.05 in cash, 4.8714 shares of newly issued Southern
Community common stock or a combination of both, subject to an overall
allocation of approximately 6.4 million shares of common stock and $15.2
million in cash. As a result of the acquisition, consolidated assets for the
company reached $1.1 billion, with $120 million of shareholders equity, and
approximately $48 million of goodwill was created. On January 14, 2004, the company announced the redemption of all of its
7.25% Cumulative Convertible Trust Preferred Securities issued through Southern
Community Capital Trust I under the provision that the trading price of our
common stock had been at least 125% of the Conversion Price for a period of
twenty consecutive trading days ending within five days of the notice of
redemption. The Securities were redeemed on March 12, 2004 which resulted in
the issuance of 2,060,000 shares of common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. On
January 14, 2004, the company announced the declaration of its first annual
cash dividend of $0.11 per share of its common stock which was paid on March
15, 2004, to shareholders of record on February 20, 2004. Financial Condition at December 31, 2002 and 2001 During the year ended December 31, 2002, our total assets increased by
$131.0 million, or 27.2%, to $612.2 million. Of this increase in total assets,
$125.3 represented growth in interest-earning assets. Continued strong loan
demand drove an increase of $60.7, or 17.1%, in net loans receivable, while
investment securities available for sale and held to maturity increased by
$66.3 million and $10.2 million, respectively. The only category of
interest-earning assets that decreased was federal funds sold, which Page 19




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##### 



ended 2002 at $11.1 million as compared with $22.9 million at the end of
2001. Federal funds sold provided the lowest yield among all interest-earning
assets, declining from 1.70% at the beginning to 1.16% at year-end. Premises
and equipment increased by $3.9 million, principally as a result of the
investment of $422,000 in a new branch facility located in Kernersville, NC,
and the investment of $3.2 million in a new corporate headquarters that is
scheduled for occupancy in the first half of 2003. Other assets increased by
$4.1 million, including additional investments in bank-owned life insurance of
$557,000. Our total investment in bank-owned life insurance at December 31,
2002 was $2.8 million. This investment is included in other assets in our
balance sheet and yielded a tax exempt return of 5.20% during the year 2002. Loan growth in 2002 was concentrated in commercial and real estate
lending. Our loan growth of $60.7 million in 2002 was spread among our
residential and commercial mortgage loans, which increased by $13.2 million and
$48.5 million, respectively. Construction loans and loans to individuals
increased by $2.9 million and $2.9 million, respectively, while commercial and
industrial loans decreased by $5.9 million. During 2002 we continued our active
program of originations of residential mortgage loans for sale in the secondary
market. At the end of the year loans held for sale totaled $4.9 million. Our total liquid assets, defined as cash and due from banks, federal funds
sold and investment securities, increased by $62.4 million during the year, to
$169.4 million at December 31, 2002 versus $107 million at the beginning of the
year. Liquid assets represented 27.7% of total assets at December 31, 2002 as
compared to 22.2% at the beginning of the year. We have been able to generate
significant funds for investment both through deposit growth and through
borrowings. These available funds have exceeded our lending needs, so we have
invested at a positive interest rate spread in securities. In order to
optimize our ability to manage interest rate risk, substantially all of our
increased investment in liquid assets in 2002 has been in investments available
for sale. Customer deposits continue to be our primary funding source. While our
deposits are primarily generated through our growing branch network, we do
utilize some out-of-market and brokered deposits to support our funding base.
Brokered and out-of-market deposits totaled $115.7 million and $61.0 million at
year-end 2002 and 2001, respectively. At December 31, 2002, deposits totaled
$449.2 million, an increase of $56.4 million or 14.4% from year-end 2001. As
explained above, we have also utilized borrowings to fund growth in 2002.
Total borrowings, including $17.3 million in convertible preferred securities
issued during 2002, aggregated $113 million at December 31, 2002. Borrowings
also included $75.5 million from the Federal Home Loan Bank of Atlanta (FHLB)
and securities sold under agreements to repurchase of $20.2 million. We will
use FHLB advances and other funding sources as necessary to support balance
sheet management and growth. However, we believe that as our branch network
grows and matures, the volume of core deposits will become a relatively larger
portion of our funding mix, which should contribute to a reduction in our
overall funding cost. Our capital position remains strong, with all of our regulatory capital
ratios at levels that make us well capitalized under federal bank regulatory
capital guidelines. At December 31, 2002, our stockholders equity totaled
$47.5 million, an increase of $5.0 million from the December 31, 2001 balance.
This increase includes net income of $3.2 million earned during the year and
other comprehensive income of $1.8 million. Page 20




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##### 



NET INTEREST INCOME Like most financial institutions, the primary component of our earnings is
net interest income. Net interest income is the difference between interest
income, principally from loans and investments, and interest expense,
principally on customer deposits and borrowings. Changes in net interest
income result from changes in volume and changes in interest rates earned and
paid. By volume, we mean the average dollar level of interest-earning assets
and interest-bearing liabilities. Spread refers to the difference between the
average yield on interest-earning assets and the average cost of
interest-bearing liabilities, and margin refers to net interest income divided
by average interest-earning assets. Spread and margin are influenced by the
levels and relative mix of interest-earning assets and interest-bearing
liabilities, as well as by levels of noninterest-bearing liabilities. During
the years ended December 31, 2003, 2002 and 2001, our average interest-earning
assets were $655.3 million, $523.3 million, and $397.0 million, respectively.
During these same years, our net interest margins were 3.25%, 3.34% and 3.36%,
respectively. Average Balances and Average Rates Earned and Paid.The following table
sets forth, for the years 2001 through 2003, information with regard to average
balances of assets and liabilities, as well as the total dollar amounts of
interest income from interest-earning assets and interest expense on
interest-bearing liabilities, resultant yields or costs, net interest income,
net interest spread, net interest margin and ratio of average interest-earning
assets to average interest-bearing liabilities. Average loans include
nonaccruing loans, the effect of which is to lower the average yield. For the Years Ended December 31,2003
    
    2002
    
    2001Interest
    
    
    
    
    
    
    
    
    
    Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    earned/
    
    Average
    
    Average
    
    earned/
    
    Average
    
    Average
    
    earned/
    
    Averagebalance
    
    paid
    
    yield/cost
    
    balance
    
    paid
    
    yield/cost
    
    balance
    
    paid
    
    yield/cost(Dollars in thousands)Interest-earning assets:Loans
    
    $
    471,808
    
    
    $
    27,478
    
    
    
    5.82
    %
    
    $
    395,745
    
    
    $
    25,689
    
    
    
    6.49
    %
    
    $
    318,696
    
    
    $
    26,292
    
    
    
    8.25
    %Investment securities
available for sale
    
    
    118,194
    
    
    
    6,022
    
    
    
    5.10
    %
    
    
    82,296
    
    
    
    4,901
    
    
    
    5.96
    %
    
    
    36,439
    
    
    
    2,320
    
    
    
    6.37
    %Investment securities
held to maturity
    
    
    61,215
    
    
    
    2,469
    
    
    
    4.03
    %
    
    
    38,831
    
    
    
    2,576
    
    
    
    6.63
    %
    
    
    32,261
    
    
    
    2,201
    
    
    
    6.82
    %Federal fund sold
    
    
    4,122
    
    
    
    50
    
    
    
    1.21
    %
    
    
    6,414
    
    
    
    115
    
    
    
    1.79
    %
    
    
    9,620
    
    
    
    553
    
    
    
    5.75
    %Total interest-earning assets
    
    
    655,339
    
    
    
    36,019
    
    
    
    5.50
    %
    
    
    523,286
    
    
    
    33,281
    
    
    
    6.36
    %
    
    
    397,016
    
    
    
    31,366
    
    
    
    7.90
    %Other assets
    
    
    41,182
    
    
    
    
    
    
    
    
    
    
    
    32,113
    
    
    
    
    
    
    
    
    
    
    
    27,158Total assets
    
    $
    696,521
    
    
    
    
    
    
    
    
    
    
    $
    555,399
    
    
    
    
    
    
    
    
    
    
    $
    424,174Interest-bearing liabilities:Deposits:NOW and money market
    
    $
    138,926
    
    
    
    1,346
    
    
    
    0.97
    %
    
    $
    102,427
    
    
    
    1,342
    
    
    
    1.31
    %
    
    $
    80,695
    
    
    
    2,135
    
    
    
    2.65
    %Time deposits greater
than $100,000
    
    
    154,026
    
    
    
    4,300
    
    
    
    2.79
    %
    
    
    114,971
    
    
    
    4,549
    
    
    
    3.96
    %
    
    
    96,542
    
    
    
    5,795
    
    
    
    6.00
    %Other time deposits
    
    
    163,960
    
    
    
    4,244
    
    
    
    2.59
    %
    
    
    172,456
    
    
    
    6,251
    
    
    
    3.62
    %
    
    
    155,979
    
    
    
    9,063
    
    
    
    5.81
    %Borrowings
    
    
    141,019
    
    
    
    4,861
    
    
    
    3.23
    %
    
    
    83,933
    
    
    
    3,661
    
    
    
    4.36
    %
    
    
    21,810
    
    
    
    1,041
    
    
    
    4.77
    %Total interest-bearing
liabilities
    
    
    597,931
    
    
    
    14,751
    
    
    
    2.47
    %
    
    
    473,787
    
    
    
    15,803
    
    
    
    3.34
    %
    
    
    355,026
    
    
    
    18,034
    
    
    
    5.08
    %Demand deposits
    
    
    45,101
    
    
    
    
    
    
    
    
    
    
    
    34,766
    
    
    
    
    
    
    
    
    
    
    
    25,749Other liabilities
    
    
    4,512
    
    
    
    
    
    
    
    
    
    
    
    2,425
    
    
    
    
    
    
    
    
    
    
    
    2,351Stockholders equity
    
    
    48,977
    
    
    
    
    
    
    
    
    
    
    
    44,421
    
    
    
    
    
    
    
    
    
    
    
    41,048Total liabilities and
stockholders equity
    
    $
    696,521
    
    
    
    
    
    
    
    
    
    
    $
    555,399
    
    
    
    
    
    
    
    
    
    
    $
    424,174Net interest income and
net interest spread
    
    
    
    
    
    $
    21,268
    
    
    
    3.03
    %
    
    
    
    
    
    $
    17,478
    
    
    
    3.02
    %
    
    
    
    
    
    $
    13,332
    
    
    
    2.82
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    3.25
    %
    
    
    
    
    
    
    
    
    
    
    3.34
    %
    
    
    
    
    
    
    
    
    
    
    3.36
    %Ratio of average interest-earning
assets to average interest-bearing
liabilities
    
    
    109.60
    %
    
    
    
    
    
    
    
    
    
    
    110.45
    %
    
    
    
    
    
    
    
    
    
    
    111.83
    %
 Page 21




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##### 



RATE/VOLUME ANALYSIS The following table analyzes the dollar amount of changes in interest
income and interest expense for major components of interest-earning assets and
interest-bearing liabilities. The table distinguishes between (i) changes
attributable to volume (changes in volume multiplied by the prior periods
rate), (ii) changes attributable to rate (changes in rate multiplied by the
prior periods volume), and (iii) net change (the sum of the previous columns).
The change attributable to both rate and volume (changes in rate multiplied by
changes in volume) has been allocated equally to both the changes attributable
to volume and the changes attributable to rate. Year Ended
    
    Year EndedDecember 31, 2003 vs. 2002
    
    December 31, 2002 vs. 2001Increase (Decrease) Due to
    
    Increase (Decrease) Due toVolume
    
    Rate
    
    Total
    
    Volume
    
    Rate
    
    Total(Dollars in thousands)Interest income:Loans
    
    $
    4,684
    
    
    $
    (2,895
    )
    
    $
    1,789
    
    
    $
    5,679
    
    
    $
    (6,282
    )
    
    $
    (603
    )Investment securities available
for sale
    
    
    1,983
    
    
    
    (862
    )
    
    
    1,121
    
    
    
    2,825
    
    
    
    (244
    )
    
    
    2,581Investment securities held
to maturity
    
    
    1,194
    
    
    
    (1,301
    )
    
    
    (107
    )
    
    
    442
    
    
    
    (67
    )
    
    
    375Federal funds sold
    
    
    (34
    )
    
    
    (30
    )
    
    
    (64
    )
    
    
    (121
    )
    
    
    (317
    )
    
    
    (438
    )Total interest income
    
    
    7,827
    
    
    
    (5,088
    )
    
    
    2,739
    
    
    
    8,825
    
    
    
    (6,910
    )
    
    
    1,915Interest expense:Deposits:NOW and money market
    
    
    416
    
    
    
    (412
    )
    
    
    4
    
    
    
    430
    
    
    
    (1,223
    )
    
    
    (793
    )Time deposits greater
than $100,000
    
    
    1,318
    
    
    
    (1,567
    )
    
    
    (249
    )
    
    
    918
    
    
    
    (2,164
    )
    
    
    (1,246
    )Other time deposits
    
    
    (264
    )
    
    
    (1,743
    )
    
    
    (2,007
    )
    
    
    777
    
    
    
    (3,589
    )
    
    
    (2,812
    )Borrowings
    
    
    2,229
    
    
    
    (1,029
    )
    
    
    1,200
    
    
    
    2,837
    
    
    
    (217
    )
    
    
    2,620Total interest expense
    
    
    3,699
    
    
    
    (4,751
    )
    
    
    (1,052
    )
    
    
    4,962
    
    
    
    (7,193
    )
    
    
    (2,231
    )Net interest income increase
(decrease)
    
    $
    4,128
    
    
    $
    (337
    )
    
    $
    3,791
    
    
    $
    3,863
    
    
    $
    283
    
    
    $
    4,146
 RESULTS OF OPERATIONS
Years Ended December 31, 2003 and 2002 Net Income.Our net income for 2003 was $3.7 million, an increase of
$449,000 from net income of $3.2 million earned in 2002. Net income per share
was $.41 basic and $.40 diluted for the year ended December 31, 2003, up from
$.37 basic and $.35 diluted for 2002. We have continued to experience strong
growth, with total assets averaging $696.5 million during the current year as
compared to $555.4 million in 2002, an increase of 25.4%. In absolute terms,
our net interest income after provision for loan losses increased by $3.2
million and our non-interest income grew by $1.1 million to $5.0 million,
exceeding the increase of $3.6 million in non-interest expenses. Primarily as
a result of strong loan growth during 2003, the provision for loan losses
increased $630,000 from 2002 levels to $2.3 million. While the interest rate
environment was less volatile in 2003 than in recent prior years, we did
experience an additional interest rate cut by the Federal Reserve in June of
2003. While this historically low interest rate environment has hampered our
asset yields, our growth in interest-earning assets combined with lower funding
costs resulted in an increase of $3.8 million in net interest income. Our
expense growth included the completion of a new banking office and corporate
headquarters building, entering into a servicing agreement for our consumer
finance loan portfolio, as well as personnel and other infrastructure costs
associated with expansion of our business. While these expenses represent
investments in building and refining our franchise for the future, their
initial effect hampers earnings. Net Interest Income.During 2003, our net interest income increased by
$3.8 million or 21.7% to $21.3 million. Our growth in interest income was the
result of growth in our overall level of average earning assets. Average total
interest-earning assets increased $132.1 million, or 25.2%, during 2003 as
compared to 2002, while our average yield dropped by 86 basis points Page 22




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##### 



from 6.36% to 5.50%. The rates earned on a significant portion of our
loans adjust immediately when index rates such as our prime rate changes.
Conversely, most of our interest-bearing liabilities, including certificates of
deposit and borrowings, have rates fixed until maturity. As a result, interest
rate reductions such as the one imposed in June of 2003 generally result in an
immediate drop in our interest income on loans, with a more delayed impact on
interest expense because reductions in interest costs will only occur upon
renewals of certificates of deposit or borrowings. Our average total
interest-bearing liabilities increased by $124.1 million, or 26.2%, consistent
with our increase in interest-earning assets. With rates sustained at lower
levels, our average cost of interest-bearing liabilities decreased by 87 basis
points from 3.34% to 2.47%, allowing our interest rate spread to remain
relatively unchanged. For the year ended December 31, 2003, our net interest
spread was 3.03% and our net interest margin was 3.25%. For the year ended
December 31, 2002, our net interest spread was 3.02% and our net interest
margin was 3.34%. In November of 2003 the company, through its non-bank
subsidiary Southern Community Capital Trust II, issued 3,450,000 Trust
Preferred Securities generating total proceeds of $34.5 million. The
Securities pay distributions at an annual rate of 7.95% and mature on December
31, 2033. The principal use of the net proceeds from the sale of the
debentures was to provide cash for the acquisition of The Community Bank, to
increase our regulatory capital, and to support the growth and operations of
our subsidiary bank. While this transaction has strengthened the companys
overall financial condition, its fixed rate coupon will initially hamper our
margins given the current interest rate environment. The company has entered
into a $20.0 million notional amount receive fixed, pay floating interest rate
swap to manage the impact of this transaction on the companys margin and
consolidated asset/ liability position. Provision for Loan Losses.We recorded a $2.3 million provision for loan
losses for the year ended
December 31, 2003, representing an increase of $630,000 from the $1.7
million provision we made for the year ended December 31, 2002. Provisions for
loan losses are charged to income to bring our allowance for loan losses to a
level deemed appropriate by management based on the factors discussed under
Analysis of Allowance for Loan Losses. We have continued to increase the
level of our allowance for loan losses as a result of the continued growth in
our loan portfolio. Total loans receivable increased by $97.8 million during
2003, and by $61.7 million during 2002. In addition to loan growth affecting
our provision for loan losses, net loan charge-offs, which totaled $1.4 million
during 2003, an increase from $713,000 in 2002, also impacted the provision
expense. On an annualized basis, our percentage of net loan charge-offs to
average loans outstanding was .29% for the year ended December 31, 2003 as
compared with .18% for the year ended December 31, 2002. Our consumer finance
lending accounted for $774,000 or 57.2% of net charge-offs during 2003, an
increase of $368,000 from the prior year. Management decided the consumer
finance business was no longer part of the companys strategic direction, and
during the fourth quarter of 2003 we ceased originating new consumer finance
loans. It is expected that the residual consumer finance loan portfolio will
payoff over a thirty-six month time frame and the companys level of
charge-offs as a percentage of loan outstandings will decline. Nonperforming
loans totaled $769,000 or .15% of total loans at December 31, 2003, as compared
with $1.8 million or .43% of total loans at December 31, 2002. The allowance
for loan losses at
December 31, 2003 of $7.3 million represents 1.40% of total loans and 946%
of nonperforming loans. The allowance for loan losses at December 31, 2002 of
$6.3 million equaled 1.50% of total loans outstanding at that date. Non-Interest Income.For the year ended December 31, 2003, non-interest
income increased $1.1 million or 26.9% to $5.0 million from $3.9 million for
the prior year. This favorable increase resulted from factors that include an
increase of $321,000, or 28.6% to $1.4 million, in service charges and fees on
deposit accounts due to deposit growth and implementation of a new overdraft
protection program during 2003. Income from investment brokerage fees
increased by $614,000, or 184.4%, to $947,000. This increase was a result of
a new investment product that was offered for a limited time. Fees on the
origination of residential mortgage loans sold into the secondary market
remained strong and increased slightly to $1.4 million. Fees generated from
mortgage originations during 2002 and 2003 were strong as a result of the
increased level of home mortgage refinancings due to the low interest rate
environment. However, baring another decline in interest rates we anticipate a
reduction in fee income from this line of business in the near term. Non-Interest Expense. We strive to maintain non-interest expenses at
levels that we believe are appropriate given the nature of our operations and
the investments in personnel and facilities that have been necessary to support
our growth. From 1998 forward, we have consistently maintained our ratio of
non-interest expenses to average total assets below 3%. For 2003 our ratio was
2.63%, down slightly from a ratio of 2.66% in 2002. Because of our continued
strong growth we have seen increases in every major component of our
non-interest expenses. For the year ended December 31, 2003, our non-interest
expense increased $3.6 million, or 24.0%. Salary and employee benefits expense
increased $1.8 million, or 23.8%, and reflects the addition of personnel
associated with branch expansion, additions of personnel to expand and support
our lines of business, and normal increases in salaries and employee benefits.
Occupancy and equipment expense increased $537,000, or 21.4%, reflecting the
expenses associated with our continued branch expansion, new corporate office
and investments in technology to support our banking operations. Other
non-interest expenses increased $1.2 million, or 25.9%, reflecting the
increased volume of business activity, principally increases in lending and
growth in deposit accounts. In addition, during the fourth quarter of 2003 the
bank ceased operation of its consumer finance subsidiary. Simultaneously, the
bank entered into an agreement with the former Page 23




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##### 



president of that subsidiary to service these loans on the behalf of the
bank. The fees paid to service these loans, combined with severance payments
to the former employees and costs associated with the transaction, contributed
to the increase in non-interest expense. Provision for Income Taxes.Our provision for income taxes, as a
percentage of income before income taxes, was 35.0 % for the year ending
December 31, 2003 and 35.3% for the year ended December 31, 2002. RESULTS OF OPERATIONS
Years Ended December 31, 2002 and 2001 Net Income.Our net income for 2002 was $3.2 million, an increase of $1.1
million from net income of $2.1 million earned in 2001. Net income per share
was $.37 basic and $.35 diluted for the year ended December 31, 2002, up from
$.24 basic and $.23 diluted for 2001. We have continued to experience strong
growth, with total assets averaging $555.4 million during the current year as
compared to $424.2 million in 2001, an increase of 30.9%. Our percentage
growth in net interest income after provision for loan losses of 43.7% exceeded
our rate of asset growth, outpacing our 32.4% increase in non-interest
expenses, which approximated our rate of asset growth. In absolute terms, our
net interest income after provision for loan losses increased by $4.8 million
and our non-interest income grew by $525,000, well exceeding the increase of
$3.6 million in non-interest expenses. Largely as a result of a lower level of
net loan charge-offs in 2002, our provision for loan losses for the year of
$1.7 million was $665,000 lower than the provision of $2.3 million made for
2001. Interest rates, which declined dramatically during 2001, were more
stable at lower levels during 2002. This interest rate environment, combined
with our growth in interest-earning assets, yielded an increase of $4.2 million
in net interest income. Our expense growth included a full year of costs for
the two new branches opened in 2001 and a partial years costs for the new
branch opened in 2002, as well as personnel costs associated with expansion of
our business. These expenses represent investments in building our franchise,
but their initial effect is to dampen earnings. Net Interest Income.During 2002, our net interest income increased by
$4.2 million or 31.1% to $17.5 million. Our growth in interest income was the
result of growth in our overall level of average earning assets. The rates
earned on a significant portion of our loans adjust immediately when index
rates such as our prime rate change. Conversely, most of our interest-bearing
liabilities, including certificates of deposit and borrowings, have rates fixed
until maturity. As a result, interest rate reductions will generally result in
an immediate drop in our interest income on loans, with a more delayed impact
on interest expense because reductions in interest costs will only occur upon
renewals of certificates of deposit or borrowings. This affected our net
interest income dramatically in 2001. In 2002, however, interest rates were
relatively stable at lower levels throughout the year. As a result, the
sustained lower rates affected our funding costs more than it did our asset
yields, resulting in a 20 basis point increase in our interest rate spread with
a decline of only 2 basis points in our net interest margin. Average total
interest-earning assets increased $126.3 million, or 31.8%, during 2002 as
compared to 2001, while our average yield dropped by 154 basis points from
7.90% to 6.36%. Our average total interest-bearing liabilities increased by
$118.8 million, or 33.5%, consistent with our increase in interest-earning
assets. With rates sustained at lower levels, our average cost of
interest-bearing liabilities decreased by 174 basis points from 5.08% to 3.34%,
resulting in the 20 basis point increase in our interest rate spread described
above. For the year ended December 31, 2002, our net interest spread was 3.02%
and our net interest margin was 3.34%. For the year ended December 31, 2001,
our net interest spread was 2.82% and our net interest margin was 3.36%. Provision for Loan Losses.We recorded a $1.7 million provision for loan
losses for the year ended
December 31, 2002, representing a decrease of $665,000 from the $2.3
million provision we made for the year ended
December 31, 2001. Provisions for loan losses are charged to income to
bring our allowance for loan losses to a level deemed appropriate by management
based on the factors discussed under Analysis of Allowance for Loan Losses.
We have continued to increase the level of our allowance for loan losses
principally as a result of the continued growth in our loan portfolio. Total
loans receivable increased by $61.7 million during 2002, and by $78.1 million
during 2001. Our reduced provision for loan losses for the current year was
made largely in response the lower total of loan growth and to a decrease in
net loan charge-offs, which totaled $713,000 during 2002, down from $1.2
million 2001. On an annualized basis, our percentage of net loan charge-offs
to average loans outstanding was .18% for the year ended December 31, 2002 as
compared with .38% for the year ended December 31, 2001. Southeastern
Acceptance Corporation, as a stand-alone entity, experienced loan charge-offs
of $406,000 in 2002, an increase of $116,000 from $290,000 in 2001 and
represented 3.7% and 4.1% of average loans, respectively. Nonperforming loans
totaled $1.8 million or .43% of total loans at December 31, 2002, as compared
with $894,000 or .25% of total loans at December 31, 2001. The allowance for
loan losses at December 31, 2002 of $6.3 million represents 1.50% of total
loans and 348% of nonperforming loans. The allowance for loan losses at
December 31, 2001 of $5.4 million equaled 1.50% of total loans outstanding at
that date. Page 24




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##### 



Non-Interest Income.For the year ended December 31, 2002, non-interest
income increased $525,000 or 15.4% to $3.9 million from $3.4 million for the
prior year. This favorable increase resulted from factors that include an
increase of $242,000, or 27.5% to $1.1 million, in service charges and fees on
deposit accounts as a result of deposit growth and an increase of $301,000, or
29.8% to $1.3 million, in income from the origination of residential mortgage
loans sold into the secondary market. We also generated an increase of
$140,000 in investment brokerage fees and gains of $70,000 from sales of
investment securities available for sale. In aggregate, the increased level of
core non-interest income more than offset the effects of nonrecurring income of
$383,000 realized in 2001 from an interest rate floor contract. Non-Interest Expense. We strive to maintain non-interest expenses at
levels that we believe are appropriate given the nature of our operations and
the investments in personnel and facilities that have been necessary to support
our growth. From 1998 forward, we have consistently maintained our ratio of
non-interest expenses to average total assets below 3%. For 2002 our ratio was
2.66%, up slightly from a ratio of 2.63% in 2001. Because of our continued
strong growth we have continued to see increases in every major component of
our non-interest expenses. For the year ended December 31, 2002, our
non-interest expense increased $3.6 million, or 32.4%. Salary and employee
benefit expense increased $2.2 million, or 40.8%, and reflects the addition of
personnel associated with branch expansion, additions of personnel to expand
our lines of business, and normal increases in salaries and employee benefits.
Occupancy and equipment expense increased $441,000, or 21.3%, reflecting the
expenses associated with our continued branch expansion and investments in
technology to support our banking operations. Other non-interest expenses
increased $930,000, or 25.9%, reflecting the increased volume of business
activity, principally increases in lending and growth in deposit accounts. Provision for Income Taxes.Our provision for income taxes, as a
percentage of income before income taxes, was 35.3% for each of the years ended
December 31, 2002 and 2001. LIQUIDITY Market and public confidence in our financial strength and in the strength
of financial institutions in general will largely determine our access to
appropriate levels of liquidity. This confidence is significantly dependent on
our ability to maintain sound asset quality and appropriate levels of capital
resources. The term liquidity refers to our ability to generate adequate amounts of
cash to meet our needs for funding loan originations, deposit withdrawals,
maturities of borrowings and operating expenses. Management measures our
liquidity position by giving consideration to both on- and off-balance sheet
sources of, and demands for, funds on a daily and weekly basis. Sources of liquidity include cash and cash equivalents, net of federal
requirements to maintain reserves against deposit liabilities, investment
securities eligible for pledging to secure borrowings from correspondent banks
pursuant to securities sold under repurchase agreements, investments available
for sale, loan repayments, loan sales, deposits, and borrowings from the
Federal Home Loan Bank secured with pledged loans and securities, and from
correspondent banks under overnight federal funds credit lines. In addition to
interest rate-sensitive deposits, the companys primary demand for liquidity is
anticipated fundings under credit commitments to customers. Because of our continued growth and the availability of relatively low
cost funding sources, we have maintained a high level of liquidity in the form
of federal funds sold and investment securities. These aggregated $231.0
million at December 31, 2003, compared to $152.8 million and $88.1 million at
December 31, 2002 and 2001, respectively. Supplementing customer deposits as a
source of funding, we have available lines of credit from various correspondent
banks to purchase federal funds on a short-term basis of approximately $27.0
million. We also have the ability to borrow up to $198.5 million, as of
December 31, 2003, from the Federal Home Loan Bank of Atlanta, with $96.5
million outstanding as of that date. At December 31, 2002 we had FHLB
borrowings outstanding of $75.5 million. Funding costs have been low during
2003, and we have taken advantage of favorable interest rates offered by the
FHLB to provide funding for increased investments. In the second quarter of
2003 the investment portfolio was increased due to planned growth in
combination with the pre-investment of projected maturities for the remainder
of the year. During the fourth quarter of 2003 we again purchased bonds for
the investment portfolio to employ funds received from the issuance of Southern
Community Capital Trust II in excess of those needed for The Community Bank
acquisition, and to leverage that additional capital. We also had repurchase
agreements with a total outstanding balance of $10.0 million at December 31,
2003. Securities sold under agreements to repurchase generally mature within
ninety days from the transaction date and are collateralized by U.S. Government
Agency obligations. We have repurchase lines of credit aggregating $100
million from various institutions. The repurchases must be adequately
collateralized. At December 31, 2003, our outstanding commitments to extend
credit consisted of loan commitments of $55.8 million and amounts available
under home equity credit lines, other credit lines and standby letters of Page 25




---



##### 



credit of $48.6 million, $42.0 million and $4.7 million, respectively. We
believe that our combined aggregate liquidity position from all sources is
sufficient to meet the funding requirements of loan demand and deposit
maturities and withdrawals in the near term. Throughout our seven-year history, our loan demand has exceeded our growth
in core deposits. We have therefore relied heavily on certificates of deposits
as a source of funds. While the majority of these funds are from our local
market area, the bank has utilized brokered and out-of-market certificates of
deposits to diversify and supplement our deposit base. Certificates of
deposits represented 59.9% of our total deposits at December 31, 2003, reduced
from 64.9% at December 31, 2002. Brokered and out-of-market deposits totaled
$159.2 million at year-end 2003 and $115.7 million at year-end 2002, which
comprised 27.7% and 25.8% of total deposits, respectively. Certificates of
deposit of $100,000 or more, inclusive of brokered and out-of-market
certificates, represented 31.7% of our total deposits at December 31, 2003 and
29.3% at December 31, 2002. A portion of these deposits are controlled by
members of our Board of Directors and Advisory Board members, or otherwise come
from customers considered to have long-standing relationships with our
management. Based upon the nature of these relationships, management does not
believe we are subject to significant liquidity risk related to these deposits.
Large certificates of deposits are generally considered rate sensitive. While
we will need to pay competitive rates to retain these deposits at their
maturities, there are other subjective factors that will determine their
continued retention. Page 26




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##### 



CONTRACTUAL OBLIGATIONS AND COMMITMENTS In the normal course of business there are various outstanding contractual
obligations of the company that will require future cash outflows. In
addition, there are commitments and contingent liabilities, such as commitments
to extend credit, that may or may not require future cash outflows. The
following table reflects contractual obligations of the company outstanding as
of December 31, 2003. Payments Due by PeriodOn DemandOr Within
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    1 Year
    
    2-3 Years
    
    4-5 Years
    
    5 Years(In thousands)Short-term borrowings
    
    $
    51,900
    
    
    $
    51,900
    
    
    $
    
    
    
    $
    
    
    
    $
    Long-term debt
    
    
    65,975
    
    
    
    
    
    
    
    5,000
    
    
    
    15,250
    
    
    
    45,725Trust preferred securities
    
    
    51,652
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    51,652Operating leases
    
    
    1,951
    
    
    
    352
    
    
    
    594
    
    
    
    439
    
    
    
    566Funding obligations
    
    
    464
    
    
    
    464
    
    
    
    
    
    
    
    
    
    
    
    Total contractual cash obligations
excluding deposits
    
    
    171,942
    
    
    
    52,716
    
    
    
    5,594
    
    
    
    15,689
    
    
    
    97,943Deposits
    
    
    575,218
    
    
    
    495,329
    
    
    
    41,794
    
    
    
    32,795
    
    
    
    5,300Total contractual cash obligations
    
    $
    747,160
    
    
    $
    548,045
    
    
    $
    47,388
    
    
    $
    48,484
    
    
    $
    103,243
 During 2004, the Company anticipates terminating its current relationship
with our third party service provider for item processing. The anticipated
cost to exit this contract is expected to be no more than $400,000. The following table reflects other commitments of the company outstanding
as of December 31, 2003. Amount of Commitment Expiration Per PeriodTotalAmounts
    
    Within
    
    
    
    
    
    
    
    
    
    AfterOther Commitments
    
    Committed
    
    1 Year
    
    2-3 Years
    
    4-5 Years
    
    5 Years(In thousands)Undisbursed portion of home equity
credit lines collateralized primarily
by junior liens on 1-4 family properties
    
    $
    48,563
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    48,563Other commitments and credit lines
    
    
    68,550
    
    
    
    58,549
    
    
    
    1,539
    
    
    
    4,703
    
    
    
    3,759Undisbursed portion of construction loans
    
    
    33,508
    
    
    
    16,021
    
    
    
    11,470
    
    
    
    3,213
    
    
    
    2,804Fixed rate mortgage loan commitments
    
    
    184
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    180Adjustable rate mortgage loan
commitments
    
    
    358
    
    
    
    299
    
    
    
    
    
    
    
    12
    
    
    
    47Total other commitments
    
    $
    151,163
    
    
    $
    74,873
    
    
    $
    13,009
    
    
    $
    7,928
    
    
    $
    55,353
 Page 27




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OFF-BALANCE SHEET ARRANGEMENTS Information about the companys off-balance sheet risk exposure is
presented in Note 16 to the accompanying consolidated financial statements.
As part of its ongoing business, the company does not participate in
transactions that generate relationships with unconsolidated entities or
financial partnerships, such as entities often referred to as special purpose
entities (SPEs), which generally are established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. As of December 31, 2003, the company is not involved in any
unconsolidated SPE transactions. CAPITAL RESOURCES Stockholders equity at December 31, 2003 was $50.9 million. At that
date, our capital to asset ratio was 6.4%, and all of our capital ratios
exceeded the minimums established for a well-capitalized bank holding company
by regulatory measures. Our Tier 1 risk-based capital ratio at December 31,
2003 was 10.85%. The bank and the company are subject to minimum capital requirements. See
SUPERVISION AND REGULATION. As the following table indicates, at December
31, 2003, the company exceeded its regulatory capital requirements. At December 31, 2003Actual
    
    Minimum
    
    Well-CapitalizedRatio
    
    Requirement
    
    RequirementTotal risk-based capital ratio
    
    
    17.74
    %
    
    
    8.00
    %
    
    
    10.00
    %Tier 1 risk-based capital ratio
    
    
    10.85
    %
    
    
    4.00
    %
    
    
    6.00
    %Leverage ratio
    
    
    8.63
    %
    
    
    4.00
    %
    
    
    5.00
    %
 The trust preferred securities presently qualify as Tier 1 regulatory
capital and are reported in Federal Reserve regulatory reports as a minority
interest in our consolidated subsidiaries. The junior subordinated debentures
do not qualify as Tier 1 regulatory capital. On July 2, 2003, the Board of
Governors of the Federal Reserve issued a letter, SR 03-13, stating that
notwithstanding FIN 46, trust preferred securities will continue to be included
in Tier 1 capital until notice is given to the contrary. There can be no
assurance that the Federal Reserve will continue to allow institutions to
include trust preferred securities in Tier I capital for regulatory capital
purposes. In the event of a disallowance, there would be a reduction in the
companys consolidated capital ratios. However, the company believes that the
bank would remain well capitalized under Federal Reserve Board guidelines. As of December 31, 2003 the company had formed two subsidiaries for the
purpose of issuing trust preferred securities. In November of 2003, Southern Community Capital Trust II (Trust II), a
newly formed subsidiary of the company, issued 3,450,000 Trust Preferred
Securities (Trust II Securities), generating total proceeds of $34.5 million.
The Trust II Securities pay distributions at an annual rate of 7.95% and
mature on December 31, 2033. The Trust II Securities began paying quarterly
distributions on December 31, 2003. The company has fully and unconditionally
guaranteed the obligations of Trust II. The Trust II Securities are redeemable
in whole or in part at any time after December 31, 2008. The proceeds from the
Trust II Securities were utilized to purchase convertible junior subordinated
debentures from us under the same terms and conditions as the Trust II
Securities. We have the right to defer payment of interest on the debentures
at any time and from time to time for a period not exceeding five years,
provided that no deferral period extend beyond the stated maturities of the
debentures. Such deferral of interest payments by the company will result in a
deferral of distribution payments on the related Trust II Securities. Should
we defer the payment of interest on the debentures, the company will be
precluded from the payment of cash dividends to shareholders. The principal
use of the net proceeds from the sale of the debentures was to provide cash for
the acquisition of The Community Bank, to increase our regulatory capital, and
to support the growth and operations of our subsidiary banks. The amount of
proceeds we count as Tier 1capital cannot comprise more than 25% of our core
capital elements. Amounts in excess of that 25% limitation count as Tier 2
supplementary capital on our books. Prior to the closing of the acquisition of
The Community Bank on January 12, 2004, substantially all of the proceeds from
the Trust II Securities qualified as Tier 2 supplementary capital. Prior to
the redemption of the Trust I Securities, approximately $20 million of the
proceeds of the Trust II Securities counted as Tier 1 capital on our books.
After the redemption of the Trust I Securities on March 12, 2004, subject to
certain limitations, substantially all of the proceeds from the Trust II
Securities qualify as Tier 1 capital of the company for regulatory capital
purposes. Page 28




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##### 



In February of 2002, Southern Community Capital Trust I (Trust I), a
newly formed subsidiary of the company, issued 1,725,000 Cumulative Convertible
Trust Preferred Securities (Trust I Securities), generating total proceeds of
$17.3 million. At December 31, 2003, holders of the Trust I Securities had
voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of
our common stock at the Conversion Price of $8.26 per share of our common
stock. On January 14, 2004, we announced the redemption of all of the Trust I
Securities. We redeemed the Trust I Securities under a provision that
permitted us to redeem the Trust I Securities in whole at any time prior to
March 31, 2007 once the trading price of our common stock had been at least
125% of the Conversion Price for a period of twenty consecutive trading days
ending within five days of the date that we gave notice of redemption. The
Trust I Securities were redeemed on March 12, 2004 which resulted in the
issuance of 2,060,000 shares of our common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. The
Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I
Securities began paying quarterly distributions on March 31, 2002. The company
had fully and unconditionally guaranteed the obligations of Trust I. The
proceeds from the Trust I Securities were utilized to purchase convertible
junior subordinated debentures from us under the same terms and conditions as
the Trust I Securities. Subject to certain limitations, the Trust I Securities
qualified as Tier 1 capital of the company for regulatory capital purposes.
The principal use of the net proceeds from the sale of the convertible
debentures was to infuse capital into our bank subsidiary, Southern Community
Bank and Trust, to fund its operations and continued expansion, and to maintain
the companys and the banks status as well capitalized under regulatory
guidelines. On July 30, 2003, the company and The Community Bank jointly announced the
execution of a definitive agreement in which Southern Community Financial
Corporation would acquire The Community Bank in a fixed exchange of cash and
stock. The Community Bank, founded in 1987 and headquartered in Pilot
Mountain, North Carolina operates 10 community banking offices throughout
Surry, Rockingham, Stokes, Iredell and Yadkin counties, North Carolina. On
December 11, 2003, shareholders approved the transaction allowing Southern
Community Financial Corporation to acquire The Community Bank. On January 12,
2004, the acquisition was completed. For each share of stock owned, The
Community Bank shareholders received $53.05 in cash, 4.8714 shares of newly
issued Southern Community common stock or a combination of both, subject to an
overall allocation of approximately 6.4 million shares of common stock and
$15.2 million in cash. ASSET/LIABILITY MANAGEMENT Our results of operations depend substantially on net interest income.
Like most financial institutions, our interest income and cost of funds are
affected by general economic conditions and by competition in the market place.
The purpose of asset/liability management is to provide stable net interest
income growth by protecting earnings from undue interest rate risk, which
arises from volatile interest rates and changes in the balance sheet mix, and
by managing the risk/return relationships between liquidity, interest rate
risk, market risk and capital adequacy. We adhere to a Board-approved
asset/liability management policy that provides guidelines for controlling,
monitoring, and reporting exposure to interest rate risk. Our policy is to
manage the companys net interest income exposure by measuring the impact of
changing interest rate environments and adjusting the mix of assets and
liabilities to provide an acceptable return within established risk limits.
Net interest income simulation and gap reports in conjunction with other tools
are utilized to measure and monitor interest rate risk. When suitable lending opportunities are not sufficient to utilize
available funds, we have generally invested such funds in securities, primarily
securities issued by governmental agencies and mortgage-backed securities. The
securities portfolio contributes to profitability and plays an important part
in our overall interest rate risk management. However, management of the
securities portfolio alone cannot balance overall interest rate risk. The
securities portfolio must be used in combination with other asset/liability
techniques to actively manage the balance sheet. The primary objectives in the
overall management of the securities portfolio are safety, liquidity, yield,
asset/liability management (interest rate risk), and investing in securities
that can be pledged for public deposits or for borrowings. In reviewing the needs of our bank with regard to proper management of its
asset/liability program, we estimate future needs, taking into consideration
investment portfolio purchases, calls and maturities in addition to estimated
loan and deposit increases (due to increased demand through marketing) and
forecasted interest rate changes. We use a number of measures to monitor and
manage interest rate risk, including income simulations and gap analyses. An
income simulation model is the primary tool used to assess the direction and
magnitude of changes in net interest income resulting from changes in interest
rates. Key assumptions in the model include prepayment speeds on
mortgage-related assets, cash flows and maturities of other investment
securities, loan and deposit volumes and pricing. These assumptions are
inherently uncertain and, as a result, the model cannot precisely estimate net
interest income or precisely predict the impact of higher or lower interest
rates on net interest income. Actual results will differ from simulated
results due to timing, magnitude and frequency of interest rate changes and
changes in market conditions and management strategies, among other factors.
Based on the results of the income simulation model as of October 31, 2003, we
would expect an increase in net interest income of $391,000 if interest rates
increase from Page 29




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##### 



current rates by 200 basis points over the next twelve months, and a
decrease in net interest income of $872,000 if interest rates decrease from
current rates by 100 basis points over the next twelve months. The analysis of interest rate gap (the difference between the amount of
interest-earning assets and interest-bearing liabilities re-pricing or maturing
during a given period of time) is another standard tool we use to measure
exposure to interest rate risk. We believe that because interest rate gap
analysis does not address all factors that can affect earnings performance, it
should be used in conjunction with other methods of evaluating interest rate
risk. Our balance sheet was asset-sensitive at December 31, 2003 in the
three-month horizon and liability-sensitive in the one-year period. An
asset-sensitive position means that there are more assets than liabilities
subject to repricing in that period as market rates change, and conversely with
a liability-sensitive position. As a result, in a falling rate environment,
our earnings position could deteriorate initially followed by improvement, with
the opposite expectation in a rising rate environment, depending on the
correlation of rate changes in these categories. The following table presents information about the periods in which the
interest-sensitive assets and liabilities at December 31, 2003 will either
mature or be subject to repricing in accordance with market rates, and the
resulting interest-sensitivity gaps. This table shows the sensitivity of the
balance sheet at one point in time and is not necessarily indicative of what
the sensitivity will be on other dates. Included in interest-bearing
liabilities subject to rate changes within 90 days is 100% of the money market
and NOW deposits. These types of deposits historically have not repriced
coincidentally with or in the same proportion as general market indicators. As
simplifying assumptions concerning repricing behavior, all money market and NOW
deposits are assumed to reprice immediately and fixed rate loans and
mortgage-backed securities are assumed to reprice at their contractual
maturity. At December 31, 2003Over 3
    
    Total3 Months
    
    Months to
    
    Within
    
    Over 12or Less
    
    12 Months
    
    12 Months
    
    Months
    
    Total(Dollars in thousands)Interest-earning
assetsLoans and loans held for sale
    
    $
    230,908
    
    
    $
    34,749
    
    
    $
    265,657
    
    
    $
    254,089
    
    
    $
    519,746Investment securities available for sale
    
    
    1,000
    
    
    
    1,000
    
    
    
    2,000
    
    
    
    166,500
    
    
    
    168,500Investment securities held to maturity
    
    
    15
    
    
    
    
    
    
    
    15
    
    
    
    62,242
    
    
    
    62,257Federal funds sold
    
    
    271
    
    
    
    
    
    
    
    271
    
    
    
    
    
    
    
    271Total interest-earning assets
    
    $
    232,194
    
    
    $
    35,749
    
    
    $
    267,943
    
    
    $
    482,831
    
    
    $
    750,774Interest-bearing liabilitiesDeposits:Money market and NOW deposits
    
    $
    179,076
    
    
    $
    
    
    
    $
    179,076
    
    
    $
    
    
    
    $
    179,076Time deposits greater than $100,000
    
    
    36,414
    
    
    
    84,388
    
    
    
    120,802
    
    
    
    61,367
    
    
    
    182,169Other time deposits
    
    
    52,367
    
    
    
    91,509
    
    
    
    143,876
    
    
    
    18,229
    
    
    
    162,105Borrowings
    
    
    69,052
    
    
    
    
    
    
    
    69,052
    
    
    
    100,475
    
    
    
    169,527Total interest-bearing liabilities
    
    $
    336,909
    
    
    $
    175,897
    
    
    $
    512,806
    
    
    $
    180,071
    
    
    $
    692,877Interest sensitivity gap per period
    
    $
    (104,715
    )
    
    $
    (140,148
    )
    
    $
    (244,863
    )
    
    $
    302,760
    
    
    $
    57,897Cumulative gap
    
    $
    (104,715
    )
    
    $
    (244,863
    )
    
    $
    (244,863
    )
    
    $
    57,897
    
    
    $
    57,897Cumulative ratio of interest-sensitive
assets to interest-sensitive liabilities
    
    
    68.92
    %
    
    
    52.25
    %
    
    
    52.25
    %
    
    
    108.36
    %
    
    
    108.36
    %
 Page 30




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##### 



MARKET RISK Market risk reflects the risk of economic loss resulting from adverse
changes in market price and interest rates. This risk of loss can be reflected
in diminished current market values and/or reduced potential net interest
income in future periods. Our market risk arises primarily from interest rate
risk inherent in our lending and deposit-taking activities. The structure of
our loan and deposit portfolios is such that a significant decline in interest
rates may adversely impact net market values and net interest income. We do
not maintain a trading account nor are we subject to currency exchange risk or
commodity price risk. Interest rate risk is monitored as part of the banks
asset/liability management function, which is discussed in Asset/Liability
Management above. The following table presents information about the
contractual maturities, average interest rates and estimated fair values of our
financial instruments that are considered market risk sensitive at December 31,
2003. Expected Maturities of Market Sensitive Instruments Heldat December 31, 2003 Occurring in the Indicated YearAverageBeyond
    
    
    
    
    
    Interest
    
    Estimated2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    Five Years
    
    Total
    
    Rate
    
    Fair Value(Dollars in thousands)FINANCIAL ASSETSFederal funds sold
    
    $
    271
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    271
    
    
    
    0.89
    %
    
    $
    271Investment securities(1)(2)
    
    
    2,015
    
    
    
    4,034
    
    
    
    
    
    
    
    5,970
    
    
    
    9,000
    
    
    
    208,887
    
    
    
    229,906
    
    
    
    4.13
    %
    
    
    229,544Loans(3):Fixed rate
    
    
    56,581
    
    
    
    29,545
    
    
    
    20,522
    
    
    
    69,585
    
    
    
    48,045
    
    
    
    86,392
    
    
    
    310,670
    
    
    
    6.61
    %
    
    
    311,491Variable rate
    
    
    209,076
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    209,076
    
    
    
    4.42
    %
    
    
    209,350Total
    
    $
    267,943
    
    
    $
    33,579
    
    
    $
    20,522
    
    
    $
    75,555
    
    
    $
    57,045
    
    
    $
    295,279
    
    
    $
    749,923
    
    
    
    5.24
    %
    
    $
    750,656FINANCIAL LIABILITIESMoney market and NOW
deposits
    
    $
    179,076
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    179,076
    
    
    
    1.12
    %
    
    $
    179,076Time deposits
    
    
    264,678
    
    
    
    24,141
    
    
    
    17,653
    
    
    
    18,541
    
    
    
    14,254
    
    
    
    5,007
    
    
    
    344,274
    
    
    
    2.44
    %
    
    
    344,941Preferred securities
    
    
    17,152
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    34,500
    
    
    
    51,652
    
    
    
    7.72
    %
    
    
    60,311Borrowings
    
    
    51,900
    
    
    
    5,000
    
    
    
    
    
    
    
    10,000
    
    
    
    5,250
    
    
    
    45,725
    
    
    
    117,875
    
    
    
    2.31
    %
    
    
    116,641Total
    
    $
    512,806
    
    
    $
    29,141
    
    
    $
    17,653
    
    
    $
    28,541
    
    
    $
    19,504
    
    
    $
    85,232
    
    
    $
    692,877
    
    
    
    2.47
    %
    
    $
    700,969
  (1)
    
    Tax-exempt securities are reflected at a tax-equivalent basis using a 34%
tax rate.  (2)
    
    Callable securities and borrowings with favorable market rates at
December 31, 2003
are assumed to mature at their call dates for purposes of this table.  (3)
    
    Includes nonaccrual loans but not the allowance the loan losses. Page 31




---



##### 



QUARTERLY FINANCIAL INFORMATION The following table sets forth, for the periods indicated, certain of our
consolidated quarterly financial information. This information is derived from
our unaudited financial statements, which include, in the opinion of
management, all normal recurring adjustments which management considers
necessary for a fair presentation of the results for such periods. This
information should be read in conjunction with our consolidated financial
statements included elsewhere in this report. The results for any quarter are
not necessarily indicative of results for any future period. Year Ended December 31, 2003
    
    Year Ended December 31, 2002Fourth
    
    Third
    
    Second
    
    First
    
    Fourth
    
    Third
    
    Second
    
    FirstQuarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Quarter(In thousands, except per share data)Interest income
    
    $
    9,150
    
    
    $
    9,338
    
    
    $
    8,801
    
    
    $
    8,917
    
    
    $
    8,917
    
    
    $
    8,656
    
    
    $
    8,165
    
    
    $
    7,543Interest expense
    
    
    3,945
    
    
    
    3,657
    
    
    
    3,625
    
    
    
    3,524
    
    
    
    3,880
    
    
    
    3,954
    
    
    
    4,028
    
    
    
    3,941Net interest income
    
    
    5,565
    
    
    
    5,681
    
    
    
    5,176
    
    
    
    4,846
    
    
    
    5,037
    
    
    
    4,702
    
    
    
    4,137
    
    
    
    3,602Provision for loan losses
    
    
    595
    
    
    
    465
    
    
    
    685
    
    
    
    540
    
    
    
    475
    
    
    
    400
    
    
    
    420
    
    
    
    360Net interest income
after provision for
loan losses
    
    
    4,970
    
    
    
    5,216
    
    
    
    4,491
    
    
    
    4,306
    
    
    
    4,562
    
    
    
    4,302
    
    
    
    3,717
    
    
    
    3,242Non-interest income
    
    
    1,134
    
    
    
    1,257
    
    
    
    1,424
    
    
    
    1,170
    
    
    
    1,274
    
    
    
    1,008
    
    
    
    883
    
    
    
    762Non-interest expense
    
    
    4,818
    
    
    
    4,892
    
    
    
    4,604
    
    
    
    4,019
    
    
    
    4,192
    
    
    
    3,871
    
    
    
    3,572
    
    
    
    3,146Income before income
taxes
    
    
    1,286
    
    
    
    1,581
    
    
    
    1,311
    
    
    
    1,457
    
    
    
    1,644
    
    
    
    1,439
    
    
    
    1,028
    
    
    
    858Income taxes
    
    
    450
    
    
    
    533
    
    
    
    459
    
    
    
    510
    
    
    
    594
    
    
    
    503
    
    
    
    354
    
    
    
    304Net income
    
    $
    836
    
    
    $
    1,028
    
    
    $
    852
    
    
    $
    947
    
    
    $
    1,050
    
    
    $
    936
    
    
    $
    674
    
    
    $
    554Per share data(1):Net income:Basic
    
    $
    .09
    
    
    $
    .12
    
    
    $
    .10
    
    
    $
    .11
    
    
    $
    .12
    
    
    $
    .11
    
    
    $
    .08
    
    
    $
    .06Diluted
    
    
    .09
    
    
    
    .11
    
    
    
    .09
    
    
    
    .10
    
    
    
    .12
    
    
    
    .10
    
    
    
    .07
    
    
    
    .06Common stock price:High
    
    $
    11.17
    
    
    $
    10.46
    
    
    $
    9.95
    
    
    $
    8.08
    
    
    $
    7.36
    
    
    $
    7.10
    
    
    $
    7.62
    
    
    $
    9.76Low
    
    
    9.91
    
    
    
    8.88
    
    
    
    7.57
    
    
    
    6.30
    
    
    
    6.10
    
    
    
    5.48
    
    
    
    6.24
    
    
    
    5.82
  (1)
    
    Per share data has been adjusted to reflect the dilutive effect of a 5%
stock dividend in 2002. Page 32




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##### 



Lending Activities General. We provide to our customers residential, commercial and
construction loans secured by real estate, as well as a full range of short- to
medium-term commercial and industrial, Small Business Administration guaranteed
and personal loans, both secured and unsecured. We have implemented loan
policies and procedures that establish the basic guidelines governing our
lending operations. Generally, those guidelines address the types of loans
that we seek, our target markets, underwriting and collateral requirements,
terms, interest rate and yield considerations and compliance with laws and
regulations. All loans or credit lines are subject to approval procedures and
amount limitations. These limitations apply to the borrowers total
outstanding indebtedness to us, including the indebtedness of any guarantor.
The policies are reviewed and approved at least annually by our Board of
Directors. We supplement our supervision of the loan underwriting and approval
process with periodic loan audits by internal loan examiners and outside
professionals experienced in loan review work. We have focused our lending
activities on the types of loans that we believe will be most in demand by our
target customers, as presented in the loan portfolio composition tables below: At December 31,2003
    
    2002
    
    2001Percent
    
    
    
    
    
    Percent
    
    
    
    
    
    PercentAmount
    
    of Total
    
    Amount
    
    of Total
    
    Amount
    
    of Total(Dollars in thousands)Residential mortgage loans
    
    $
    150,312
    
    
    
    28.9
    %
    
    $
    118,572
    
    
    
    28.1
    %
    
    $
    105,357
    
    
    
    29.2
    %Commercial mortgage loans
    
    
    186,758
    
    
    
    35.9
    %
    
    
    137,812
    
    
    
    32.7
    %
    
    
    89,354
    
    
    
    24.8
    %Construction loans
    
    
    71,908
    
    
    
    13.8
    %
    
    
    64,500
    
    
    
    15.3
    %
    
    
    61,558
    
    
    
    17.1
    %Commercial and industrial loans
    
    
    87,127
    
    
    
    16.8
    %
    
    
    71,948
    
    
    
    17.0
    %
    
    
    77,820
    
    
    
    21.6
    %Loans to individuals
    
    
    23,641
    
    
    
    4.6
    %
    
    
    29,106
    
    
    
    6.9
    %
    
    
    26,199
    
    
    
    7.3
    %Subtotal
    
    
    519,746
    
    
    
    100.0
    %
    
    
    421,938
    
    
    
    100.0
    %
    
    
    360,288
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (7,275
    )
    
    
    
    
    
    
    (6,342
    )
    
    
    
    
    
    
    (5,400
    )Net loans
    
    $
    512,471
    
    
    
    
    
    
    $
    415,596
    
    
    
    
    
    
    $
    354,888
 At December 31,2000
    
    1999Percent
    
    
    
    
    
    PercentAmount
    
    of Total
    
    Amount
    
    of Total(Dollars in thousands)Residential mortgage loans
    
    $
    84,280
    
    
    
    29.9
    %
    
    $
    65,399
    
    
    
    32.6
    %Commercial mortgage loans
    
    
    59,410
    
    
    
    21.0
    %
    
    
    38,293
    
    
    
    19.1
    %Construction loans
    
    
    52,800
    
    
    
    18.7
    %
    
    
    32,427
    
    
    
    16.2
    %Commercial and industrial loans
    
    
    60,280
    
    
    
    21.4
    %
    
    
    44,563
    
    
    
    22.3
    %Loans to individuals
    
    
    25,391
    
    
    
    9.0
    %
    
    
    19,630
    
    
    
    9.8
    %Subtotal
    
    
    282,161
    
    
    
    100.0
    %
    
    
    200,312
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (4,283
    )
    
    
    
    
    
    
    (3,013
    )Net loans
    
    $
    277,878
    
    
    
    
    
    
    $
    197,299
 Page 33




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The following table presents at December 31, 2003 (i) the aggregate
maturities of loans in the named categories of our loan portfolio and (ii) the
aggregate amounts of such loans, by variable and fixed rates, that mature after
one year: At December 31, 2003Due within
    
    Due after one year
    
    Due afterone year
    
    but within five years
    
    five years
    
    TotalAmount
    
    Yield
    
    Amount
    
    Yield
    
    Amount
    
    Yield
    
    Amount
    
    Yield(Dollars in thousands)Loans:Residential mortgage
    
    $
    88,419
    
    
    
    4.45
    %
    
    $
    35,554
    
    
    
    6.43
    %
    
    $
    26,221
    
    
    
    5.72
    %
    
    $
    150,194
    
    
    
    5.14
    %Commercial mortgage
    
    
    55,081
    
    
    
    4.62
    %
    
    
    79,553
    
    
    
    5.84
    %
    
    
    52,105
    
    
    
    5.70
    %
    
    
    186,739
    
    
    
    5.44
    %Construction
    
    
    56,157
    
    
    
    4.78
    %
    
    
    14,945
    
    
    
    4.26
    %
    
    
    806
    
    
    
    5.78
    %
    
    
    71,908
    
    
    
    4.68
    %Commercial and
industrial
    
    
    57,822
    
    
    
    4.51
    %
    
    
    21,978
    
    
    
    5.01
    %
    
    
    6,990
    
    
    
    4.54
    %
    
    
    86,790
    
    
    
    4.64
    %Individuals
    
    
    8,012
    
    
    
    6.80
    %
    
    
    15,087
    
    
    
    14.30
    %
    
    
    247
    
    
    
    6.19
    %
    
    
    23,346
    
    
    
    11.61
    %Total
    
    
    265,349
    
    
    
    4.63
    %
    
    
    167,259
    
    
    
    6.49
    %
    
    
    86,369
    
    
    
    5.61
    %
    
    
    518,977
    
    
    
    5.39
    %Nonaccrual loans
    
    
    308
    
    
    
    
    
    
    
    438
    
    
    
    
    
    
    
    23
    
    
    
    
    
    
    
    769Loans, gross
    
    $
    265,657
    
    
    
    
    
    
    $
    167,697
    
    
    
    
    
    
    $
    86,392
    
    
    
    
    
    
    $
    519,746
 The above table is based on contractual scheduled maturities. Early
repayment of loans or renewals at maturity are not considered in this table. Real Estate Loans.Real estate loans represent our greatest concentration
of loans, and are divided into three categories: residential mortgage,
commercial mortgage, and construction loans. We make real estate loans for
purchasing, constructing and refinancing one to four family residential, five
or more family residential and commercial properties. We also make loans
secured by real estate to commercial and individual borrowers who use the loan
proceeds for other purposes. Our real estate loans totaled $409.0 million at
December 31, 2003, representing 78.6% of our total loans outstanding. Our loan
policy requires appraisal prior to funding a real estate loan and also outlines
the requirements for appraisals on renewals. We pursue an aggressive policy of evaluation and monitoring on any real
estate loan that becomes troubled, including reappraisal when appropriate. We
recognize and reserve for potential exposures as soon as we identify them.
However, the pace of absorption of real properties is affected both by each
propertys individual nature and characteristics, the status of the real estate
market at the time, general economic conditions and other factors that could
adversely affect our volume of non-performing real estate loans and our ability
to dispose of foreclosed properties without loss. Residential Mortgage Loans.We provide our customers access to long-term
conventional real estate loans through the origination of Federal National
Mortgage Associationconforming loans. Many of the fixed-rate one to four
family owner occupied residential mortgage loans that we originated are for
sale in the secondary market and have been pre-sold for the account of third
parties. Residential mortgage loans held for sale totaled $1.1 million at
December 31, 2003. We receive income from residential mortgage loans
originated for sale in the secondary market, with such fees aggregating $1.4
million for the year ended December 31, 2003 and $1.3 million for the year
ended December 31, 2002. We anticipate that we will continue to be an active
originator of residential loans for sale to third parties. Residential loans are generated through our in-house staff as well as the
banks existing customer base, referrals from real estate agents and builders,
and local marketing efforts. Our lending efforts include the origination of
loans secured by first mortgages on one to four family residences and on home
equity credit lines. Our residential mortgage loans totaled $150.3 million at
December 31, 2003, and included $67.1 million in one-to-four family permanent
mortgage loans, $66.1 million in outstanding advances under home equity credit
lines, and $17.1 million of other loans secured by residential real estate. Of
our residential mortgage loans, 54% have variable rates of interest while 46%
have fixed interest rates. Substantially all of our residential mortgage loans
are secured by properties located within our market area, although we will make
loans secured by properties outside our market area to qualifying existing
customers. We believe that the amount of risk associated with this group of
loans is mitigated in part due to the type of loans involved. Historically,
the amount of losses suffered on this type of loan has been significantly less
than those loans collateralized by other types of properties. Page 34




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Our one to four family residential loans generally have maturities ranging
from 1 to 30 years. These loans are either fully amortizing with monthly
payments sufficient to repay the total amount of the loan or amortizing with a
balloon feature, typically due in fifteen years or less. We review information
concerning the income, financial condition, employment history and credit
history when evaluating the creditworthiness of an applicant for a residential
mortgage loan. Commercial Mortgage Loans.Our commercial mortgage loans totaled $186.8
million at December 31, 2003. These loans are secured principally by
commercial buildings for office, retail, manufacturing, storage and warehouse
properties. Generally in underwriting commercial mortgage loans, we require
the personal guaranty of borrowers and a demonstrated cash flow capability
sufficient to service the debt. Loans secured by commercial real estate may be
in greater amount and involve a greater degree of risk than one to four family
residential mortgage loans, and payments on such loans are often dependent on
successful operation or management of the properties and the underlying
businesses. We make commercial mortgage loans at both fixed and variable rates
for terms generally up to 15 years. Of our commercial mortgage loans, 23% have
variable rates of interest while 77% have fixed interest rates, including those
loans, which contractually have floating rate terms but have hit a rate floor
temporally fixing the interest rate. Construction Loans.We originate one to four family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower), and we provide construction financing to builders. We have a
staff of lending professionals and assistants who service only our construction
loan portfolio. We generally receive a pre-arranged permanent financing
commitment from an outside banking entity prior to financing the construction
of pre-sold homes. We lend to builders who have demonstrated a favorable
record of performance and profitable operations and who are building in our
market area. We also make commercial real estate construction loans, as noted
in the preceding paragraph. We endeavor to limit our construction lending risk
through adherence to established underwriting procedures. Also, we generally
require documentation of all draw requests and utilize loan officers to inspect
the project prior to paying any draw requests from the builder. With few
exceptions, the bank requires personal guarantees and secondary sources of
repayment on construction loans. Construction loans aggregated $71.9 million
at December 31, 2003. Commercial Loans.Commercial business lending is a primary focus of our
lending activities. At December 31, 2003, our commercial loan portfolio
equaled $87.1 million or 16.8% of total loans. Commercial loans include both
secured and unsecured loans for working capital, expansion, and other business
purposes. Short-term working capital loans generally are secured by accounts
receivable, inventory and/or equipment. The bank also makes term commercial
loans secured by equipment and real estate. Lending decisions are based on an
evaluation of the financial strength, management and credit history of the
borrower, and the quality of the collateral securing the loan. With few
exceptions, the bank requires personal guarantees and secondary sources of
repayment. Commercial loans generally provide greater yields and re-price more
frequently than other types of loans, such as real estate loans. More frequent
re-pricing means that yields on our commercial loans adjust with changes in
interest rates. Loans to Individuals.Loans to individuals include automobile loans, boat
and recreational vehicle financing, and miscellaneous secured and unsecured
personal loans. Consumer loans generally can carry significantly greater risks
than other loans, even if secured, if the collateral consists of rapidly
depreciating assets such as automobiles and equipment. Repossessed collateral
securing a defaulted consumer loan may not provide an adequate source of
repayment of the loan. We attempt to manage the risks inherent in consumer
lending by following established credit guidelines and underwriting practices
designed to minimize risk of loss. Loan Approvals.Our loan policies and procedures establish the basic
guidelines governing our lending operations. Generally, the guidelines address
the type of loans that we seek, our target markets, underwriting and collateral
requirements, terms, interest rate and yield considerations and compliance with
laws and regulations. All loans or credit lines are subject to approval
procedures and amount limitations. These limitations apply to the borrowers
total outstanding indebtedness to us, including the indebtedness of any
guarantor. The policies are reviewed and approved at least annually. We
supplement our supervision of the loan underwriting and approval process with
periodic loan audits by independent, outside professionals experienced in loan
review work. Individual lending authorities are established by the Board of Directors
as periodically requested by Management. All individual lending authorities
are reviewed and approved at least annually by the Board of Directors. The Board Loan Committee consists of the CEO, President, Managing EVP of
Commercial Lending, SVP in charge of Credit Administration, and four outside
Directors as appointed by the Board of Directors. This Committee meets on a
monthly Page 35




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##### 



basis to review for approval all loan requests in excess of $3.5 million.
As of December 31, 2003, the legal lending limit for the bank was approximately
$9.7 million. ASSET QUALITY We consider asset quality to be of primary importance. We employ a formal
internal loan review process to ensure adherence to the Lending Policy as
approved by the Board of Directors. It is the responsibility of each lending
officer to assign an appropriate risk grade to every loan originated. Credit
Administration, through the loan review process, validates the accuracy of the
initial risk grade assessment. In addition, as a given loans credit quality
improves or deteriorates, it is Credit Administrations responsibility to
change the borrowers risk grade accordingly. The function of determining the
allowance for loan losses is fundamentally driven by the risk grade system. As
part of the loan review function, we use a third party professional to review
the underwriting documentation and risk grading analysis. In determining the
allowance for loan losses and any resulting provision to be charged against
earnings, particular emphasis is placed on the results of the loan review
process. We also give consideration to historical loan loss experience, the
value and adequacy of collateral, economic conditions in our market area and
other factors. For loans determined to be impaired, the allowance is based on
discounted cash flows using the loans initial effective interest rate or the
fair value of the collateral for certain collateral dependent loans. This
evaluation is inherently subjective as it requires material estimates,
including the amounts and timing of future cash flows expected to be received
on impaired loans that may be susceptible to significant change. The allowance
for loan losses represents managements estimate of the appropriate level of
reserve to provide for probable losses inherent in the loan portfolio. Our policy in regard to past due loans normally requires a prompt
charge-off to the allowance for loan losses following timely collection efforts
and a thorough review. Further efforts are then pursued through various means
available. Loans carried in a non-accrual status are generally collateralized
and probable losses are considered in the determination of the allowance for
loan losses. Nonperforming Assets The table sets forth, for the period indicated, information about our
nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual
loans plus restructured loans), and total nonperforming assets. At December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands)Nonaccrual loans
    
    $
    769
    
    
    $
    1,823
    
    
    $
    894
    
    
    $
    276
    
    
    $
    Restructured loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total nonperforming loans
    
    
    769
    
    
    
    1,823
    
    
    
    894
    
    
    
    276
    
    
    
    Foreclosed assets
    
    
    272
    
    
    
    383
    
    
    
    347
    
    
    
    4
    
    
    
    Total nonperforming assets
    
    $
    1,041
    
    
    $
    2,206
    
    
    $
    1,241
    
    
    $
    280
    
    
    $
    Accruing loans past due
90 days or more
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    15
    
    
    $
    7Allowance for loan losses
    
    
    7,275
    
    
    
    6,342
    
    
    
    5,400
    
    
    
    4,283
    
    
    
    3,013Nonperforming loans to period end loans
    
    
    0.15
    %
    
    
    .43
    %
    
    
    .25
    %
    
    
    .10
    %
    
    
    .00
    %Allowance for loan losses to period end loans
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %
    
    
    1.50
    %Allowance for loan losses to
nonperforming loans
    
    
    946
    %
    
    
    348
    %
    
    
    604
    %
    
    
    1,552
    %
    
    NMNonperforming assets to total assets
    
    
    0.13
    %
    
    
    .36
    %
    
    
    .26
    %
    
    
    .07
    %
    
    
    .00
    %
 Page 36




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Our financial statements are prepared on the accrual basis of accounting,
including the recognition of interest income on loans, unless we place a loan
on nonaccrual basis. We account for loans on a nonaccrual basis when we have
serious doubts about the collectibility of principal or interest. Generally,
our policy is to place a loan on nonaccrual status when the loan becomes past
due 90 days. We also place loans on nonaccrual status in cases where we are
uncertain whether the borrower can satisfy the contractual terms of the loan
agreement. Amounts received on nonaccrual loans generally are applied first to
principal and then to interest only after all principal has been collected.
Restructured loans are those for which concessions, including the reduction of
interest rates below a rate otherwise available to that borrower or the
deferral of interest or principal, have been granted due to the borrowers
weakened financial condition. We record interest on restructured loans at the
restructured rates, as collected, when we anticipate that no loss of original
principal will occur. Potential problem loans are loans which are currently
performing and are not included in nonaccrual or restructured loans above, but
about which we have serious doubts as to the borrowers ability to comply with
present repayment terms. These loans are likely to be included later in
nonaccrual, past due or restructured loans, therefore they are considered by
our management in assessing the adequacy of our allowance for loan losses. At
December 31, 2003, we had identified $4.7 million of potential problem loans. At December 31, 2003, we had $769,000 of nonaccrual loans. At that time,
the largest nonaccrual balance to any one borrower was $290,000, with the
average balance for the 62 nonaccrual loans being $12,400. Interest on
nonaccrual loans foregone was approximately $130,000 for the year ended
December 31, 2003, $110,000 for the year ended December 31, 2002 and $60,000
for the year ended December 31, 2001. Real estate owned consists of foreclosed assets, repossessed and idled
properties. At December 31, 2003 real estate owned totaled $267,000 or .03% of
total assets, and consisted of one commercial and one residential property. We
have reviewed recent appraisals of these properties and believe that the fair
value, less estimated costs to sell, exceed their carrying value. Analysis of Allowance for Loan Losses Our allowance for loan losses is established through charges to earnings
in the form of a provision for loan losses. We increase our allowance for loan
losses by provisions charged to operations and by recoveries of amounts
previously charged off, and we reduce our allowance by loans charged off. We
evaluate the adequacy of the allowance at least quarterly. In addition, on a
quarterly basis our Board of Directors reviews our loan portfolio, conducts an
evaluation of our credit quality and reviews our computation of the loan loss
provision, recommending changes as may be required. In evaluating the adequacy
of the allowance, we consider the growth, composition and industry
diversification of the portfolio, historical loan loss experience, current
delinquency levels, adverse situations that may affect a borrowers ability to
repay, estimated value of any underlying collateral, prevailing economic
conditions and other relevant factors deriving from our limited history of
operations. Because we have a limited history of our own, we also consider the
loss experience and allowance levels of other similar banks and the historical
experience encountered by our management and senior lending officers prior to
joining us. In addition, regulatory agencies, as an integral part of their
examination process, periodically review our allowance for loan losses and may
require us to make adjustments for estimated losses based upon judgments
different from those of our management. We use our risk grading program, as described under ASSET QUALITY, to
facilitate our evaluation of probable inherent loan losses and the adequacy of
the allowance for loan losses. In this program, risk grades are initially
assigned by loan officers, reviewed by Credit Administration, and tested by our
internal auditor and by an independent professional. The testing program
includes an evaluation of a sample of new loans, large loans, loans that are
identified as having potential credit weaknesses, loans past due 90 days or
more, and nonaccrual loans. We strive to maintain our loan portfolio in
accordance with conservative loan underwriting policies that result in loans
specifically tailored to the needs of our market area. Every effort is made to
identify and minimize the credit risks associated with such lending strategies.
We have no foreign loans and we do not engage in lease financing or highly
leveraged transactions. We follow a loan review program designed to evaluate the credit risk in
our loan portfolio. Through this loan review process, we maintain an internally
classified watch list that helps management assess the overall quality of the
loan portfolio and the adequacy of the allowance for loan losses. In
establishing the appropriate classification for specific assets, management
considers, among other factors, the estimated value of the underlying
collateral, the borrowers ability to repay, the borrowers payment history and
the current status. As a result of this process, certain loans are categorized
as substandard, doubtful or loss and reserves are allocated based on
managements judgment and historical experience. Loans classified as substandard are those loans with clear and defined
weaknesses such as unfavorable financial ratios, uncertain repayment sources or
poor financial condition that may jeopardize the liquidation of the debt. They
are characterized by the distinct possibility that we will sustain some losses
if the deficiencies are not corrected. A reserve of up to Page 37




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##### 



20% is generally allocated to each of these loans. Loans classified as
doubtful are those loans that have characteristics similar to substandard
loans but with an increased risk that collection or liquidation in full is
highly questionable and improbable. A reserve of 50% is generally allocated to
loans classified as doubtful. Loans classified as loss are considered
uncollectible and of such little value that their continuance as bankable
assets is not warranted. This classification does not mean that the loan has
absolutely no recovery or salvage value but rather it is not practical or
desirable to defer writing off this asset even though partial recovery may be
achieved in the future. As a practical matter, when loans are identified as
loss they are charged off against the allowance for loan losses. In addition
to the above classification categories, we also categorize loans based upon
risk grade and loan type, assigning an allowance allocation based upon each
category. Growth in loans outstanding has, throughout our history, been the primary
reason for increases in our allowance for loan losses and the resultant
provisions for loan losses necessary to provide for those increases. This
growth has been spread among our major loan categories, with the concentrations
of major loan categories being relatively consistent in recent years. For all
full fiscal years through 2000, our loan loss experience was similar to that of
other new banks, with net loan charge-offs in each year of less than .10% of
average loans outstanding. Our percentage of net loan charge-offs to average
loans outstanding was .18% for the year ended December 31, 2002, which
increased to .29% for 2003. Continued loan demand coupled with higher net
charge-offs resulted in a $630,000 increase in our provision for loan losses
which totaled $2.3 million for the year-ended December 31, 2003. Our consumer
finance lending accounted for $774,000 or 57.2% of net charge-offs during 2003,
an increase of $368,000 from the prior year. During the fourth quarter of 2003
the bank ceased the consumer finance operations. It is expected that the
residual consumer finance loan portfolio will payoff over a thirty-six month
time frame and the companys level of charge-off as a percentage of loan
outstandings will decline. Our allowance for loan losses at December 31, 2003
of $7.3 million represents 1.40% of total loans and 946% of nonperforming
loans. The allowance for loan losses represents managements estimate of an
amount adequate to provide for known and inherent losses in the loan portfolio
in the normal course of business. We make specific allowances that are
allocated to certain individual loans and pools of loans based on risk
characteristics, as discussed below. In addition to the allocated portion of
the allowance for loan losses, we maintain an unallocated portion that is not
assigned to any specific category of loans. This unallocated portion is
intended to reserve for the inherent risk in the portfolio and the intrinsic
inaccuracies associated with the estimation of the allowance for loan losses
and its allocation to specific loan categories. While management believes that
it uses the best information available to establish the allowance for loan
losses, future adjustments to the allowance may be necessary and results of
operations could be adversely affected if circumstances differ substantially
from the assumptions used in making the determinations. Furthermore, while we
believe we have established the allowance for loan losses in conformity with
generally accepted accounting principles, there can be no assurance that
regulators, in reviewing our portfolio, will not require adjustments to our
allowance for loan losses. In addition, because future events affecting
borrowers and collateral cannot be predicted with certainty, there can be no
assurance that the existing allowance for loan losses is adequate or that
increases will not be necessary should the quality of any loans deteriorate as
a result of the factors discussed herein. Any material increase in the
allowance for loan losses may adversely affect our financial condition and
results of operations. The following table describes the allocation of the allowance for loan
losses among various categories of loans and certain other information for the
dates indicated. The allocation is made for analytical purposes only and is not
necessarily indicative of the categories in which future losses may occur. At December 31,2003
    
    2002
    
    2001% of Total
    
    
    
    
    
    % of Total
    
    
    
    
    
    % of TotalAmount
    
    Loans(1)
    
    Amount
    
    Loans(1)
    
    Amount
    
    Loans (1)(Dollars in thousands)Residential mortgage loans
    
    $
    475
    
    
    
    28.9
    %
    
    $
    350
    
    
    
    28.1
    %
    
    $
    550
    
    
    
    29.2
    %Commercial mortgage loans
    
    
    2,200
    
    
    
    35.9
    %
    
    
    1,500
    
    
    
    32.7
    %
    
    
    825
    
    
    
    24.8
    %Construction loans
    
    
    1,100
    
    
    
    13.8
    %
    
    
    1,100
    
    
    
    15.3
    %
    
    
    1,000
    
    
    
    17.1
    %Commercial and industrial loans
    
    
    1,200
    
    
    
    16.8
    %
    
    
    1,000
    
    
    
    17.0
    %
    
    
    1,100
    
    
    
    21.6
    %Loans to individuals
    
    
    1,050
    
    
    
    4.6
    %
    
    
    1,225
    
    
    
    6.9
    %
    
    
    925
    
    
    
    7.3
    %Unallocated
    
    
    1,250
    
    
    
    
    %
    
    
    1,167
    
    
    
    
    %
    
    
    1,000
    
    
    
    
    %Total
    
    $
    7,275
    
    
    
    100.0
    %
    
    $
    6,342
    
    
    
    100.0
    %
    
    $
    5,400
    
    
    
    100.0
    %
 Page 38




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##### 



At December 31,2000
    
    1999% of Total
    
    
    
    
    
    % of TotalAmount
    
    Loans (1)
    
    Amount
    
    Loans (1)(Dollars in thousands)Residential mortgage loans
    
    $
    350
    
    
    
    29.9
    %
    
    $
    125
    
    
    
    32.6
    %Commercial mortgage loans
    
    
    525
    
    
    
    21.0
    %
    
    
    425
    
    
    
    19.1
    %Construction loans
    
    
    900
    
    
    
    18.7
    %
    
    
    750
    
    
    
    16.2
    %Commercial and
industrial loans
    
    
    900
    
    
    
    21.4
    %
    
    
    725
    
    
    
    22.3
    %Loans to individuals
    
    
    650
    
    
    
    9.0
    %
    
    
    225
    
    
    
    9.8
    %Unallocated
    
    
    958
    
    
    
    
    %
    
    
    763
    
    
    
    
    %Total
    
    $
    4,283
    
    
    
    100.0
    %
    
    $
    3,013
    
    
    
    100.0
    %
 (1) Represents total of all outstanding loans in each category as a percentage
of total loans outstanding. The following table presents for the periods indicated information
regarding changes in our allowance for loan losses: At or for the Years Ended December 31,2003
    
    2002
    
    2001
    
    2000
    
    1999(Dollars in thousands)Balance at beginning of period
    
    $
    6,342
    
    
    $
    5,400
    
    
    $
    4,283
    
    
    $
    3,013
    
    
    $
    1,905Charge-offs:Residential mortgage loans
    
    
    
    
    
    
    82
    
    
    
    115
    
    
    
    
    
    
    
    28Commercial mortgage loans
    
    
    
    
    
    
    
    
    
    
    53
    
    
    
    
    
    
    
    Construction loans
    
    
    
    
    
    
    113
    
    
    
    
    
    
    
    
    
    
    
    Commercial and industrial loans
    
    
    398
    
    
    
    90
    
    
    
    416
    
    
    
    122
    
    
    
    5Loans to individuals
    
    
    1,022
    
    
    
    473
    
    
    
    663
    
    
    
    90
    
    
    
    14Total charge-offs
    
    
    1,420
    
    
    
    758
    
    
    
    1,247
    
    
    
    212
    
    
    
    47Recoveries:Construction loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    20Commercial and industrial loans
    
    
    31
    
    
    
    15
    
    
    
    29
    
    
    
    1
    
    
    
    Loans to individuals
    
    
    37
    
    
    
    30
    
    
    
    15
    
    
    
    1
    
    
    
    Total recoveries
    
    
    68
    
    
    
    45
    
    
    
    44
    
    
    
    2
    
    
    
    20Net charge-offs
    
    
    (1,352
    )
    
    
    (713
    )
    
    
    (1,203
    )
    
    
    (210
    )
    
    
    (27
    )Provision for loan losses
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320
    
    
    
    1,480
    
    
    
    1,135Balance at end of period
    
    $
    7,275
    
    
    $
    6,342
    
    
    $
    5,400
    
    
    $
    4,283
    
    
    $
    3,013Total loans outstanding
    
    $
    519,746
    
    
    $
    421,938
    
    
    $
    360,288
    
    
    $
    282,161
    
    
    $
    200,312Average loans outstanding
    
    $
    471,808
    
    
    $
    395,745
    
    
    $
    318,696
    
    
    $
    240,888
    
    
    $
    160,718Allowance for loan losses to
loans outstanding
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %
    
    
    1.50
    %Ratio of net loan charge-offs to
average loans outstanding
    
    
    .29
    %
    
    
    .18
    %
    
    
    .38
    %
    
    
    .09
    %
    
    
    .02
    %
 Page 39




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##### 



Investment Activities Our investment portfolio plays a primary role in management of liquidity
and interest rate sensitivity and, therefore, is managed in the context of the
overall balance sheet. The securities portfolio generates a substantial
percentage of our interest income and serves as a necessary source of
liquidity. Management attempts to deploy investable funds into instruments that are
expected to increase the overall return of the portfolio given the current
assessment of economic and financial conditions, while maintaining acceptable
levels of capital, and interest rate and liquidity risk. The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting market value of securities at the dates indicated: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    MarketCost
    
    Gains
    
    Losses
    
    Value(Dollars in thousands)December 31, 2003Securities available for sale:U.S. Government agencies
    
    $
    33,567
    
    
    $
    685
    
    
    $
    7
    
    
    $
    34,245Mortgage-backed
    
    
    127,678
    
    
    
    1,058
    
    
    
    884
    
    
    
    127,852Other
    
    
    6,403
    
    
    
    
    
    
    
    
    
    
    
    6,403$
    167,648
    
    
    $
    1,743
    
    
    $
    891
    
    
    $
    168,500Securities held to maturity:U.S. Government agencies
    
    $
    61,291
    
    
    $
    56
    
    
    $
    1,276
    
    
    $
    60,071Mortgage-backed
    
    
    640
    
    
    
    11
    
    
    
    13
    
    
    
    638Municipals
    
    
    326
    
    
    
    9
    
    
    
    
    
    
    
    335$
    62,257
    
    
    $
    76
    
    
    $
    1,289
    
    
    $
    61,044December 31, 2002Securities available for sale:U.S. Government agencies
    
    $
    21,254
    
    
    $
    901
    
    
    $
    
    
    
    $
    22,155Mortgage-backed
    
    
    67,618
    
    
    
    1,802
    
    
    
    
    
    
    
    69,420Other
    
    
    5,355
    
    
    
    
    
    
    
    
    
    
    
    5,355$
    94,227
    
    
    $
    2,703
    
    
    $
    
    
    
    $
    96,930Securities held to maturity:U.S. Government agencies
    
    $
    44,000
    
    
    $
    540
    
    
    $
    
    
    
    $
    44,540Mortgage-backed
    
    
    421
    
    
    
    22
    
    
    
    
    
    
    
    443Municipals
    
    
    328
    
    
    
    8
    
    
    
    
    
    
    
    336$
    44,749
    
    
    $
    570
    
    
    $
    
    
    
    $
    45,319December 31, 2001Securities available for sale:U.S. Government agencies
    
    $
    22,172
    
    
    $
    1,162
    
    
    $
    
    
    
    $
    23,334Mortgage-backed
    
    
    4,271
    
    
    
    147
    
    
    
    
    
    
    
    4,418Other
    
    
    2,926
    
    
    
    
    
    
    
    
    
    
    
    2,926$
    29,369
    
    
    $
    1,309
    
    
    $
    
    
    
    $
    30,678Securities held to maturity:U.S. Government agencies
    
    $
    33,500
    
    
    $
    664
    
    
    $
    2
    
    
    $
    34,162Mortgage-backed
    
    
    1,029
    
    
    
    34
    
    
    
    
    
    
    
    1,063$
    34,529
    
    
    $
    698
    
    
    $
    2
    
    
    $
    35,225
 Page 40




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##### 



The following table presents the carrying values, fair values, intervals
of maturities or repricings, and weighted average yields of our investment
portfolio at December 31, 2003: WeightedAmortized
    
    Fair
    
    Average/Cost
    
    Value
    
    Yield(Amounts in thousands)Securities available for sale:U.S. Government agenciesDue after one but within five years
    
    $
    8,970
    
    
    $
    9,079
    
    
    
    4.54
    %Due after five but within ten years
    
    
    24,597
    
    
    
    25,166
    
    
    
    5.19
    %33,567
    
    
    
    34,245
    
    
    
    5.02
    %Mortgage-backedDue after one but within five years
    
    
    8
    
    
    
    8
    
    
    
    5.57
    %Due after five but within ten years
    
    
    56,324
    
    
    
    55,999
    
    
    
    4.95
    %Due after ten years
    
    
    71,346
    
    
    
    71,845
    
    
    
    4.90
    %127,678
    
    
    
    127,852
    
    
    
    4.92
    %OtherDue after ten years
    
    
    6,403
    
    
    
    6,403
    
    
    
    4.21
    %Total securities available for saleDue after one but within five years
    
    
    8,978
    
    
    
    9,087
    
    
    
    4.54
    %Due after five but within ten years
    
    
    80,921
    
    
    
    81,165
    
    
    
    5.02
    %Due after ten years
    
    
    77,749
    
    
    
    78,248
    
    
    
    4.84
    %$
    167,648
    
    
    $
    168,500
    
    
    
    4.91
    %Securities held to maturity:U. S. Government agenciesDue after one but within five years
    
    $
    8,000
    
    
    $
    7,945
    
    
    
    3.45
    %Due after five but within ten years
    
    
    33,291
    
    
    
    32,572
    
    
    
    4.04
    %Due after ten years
    
    
    20,000
    
    
    
    19,554
    
    
    
    4.93
    %61,291
    
    
    
    60,071
    
    
    
    4.25
    %Mortgage-backedDue within one year
    
    
    15
    
    
    
    16
    
    
    
    5.57
    %Due after five but within ten years
    
    
    102
    
    
    
    113
    
    
    
    6.83
    %Due after ten years
    
    
    523
    
    
    
    509
    
    
    
    4.07
    %640
    
    
    
    638
    
    
    
    4.59
    %State and local governments(1)Due after one but within five years
    
    
    326
    
    
    
    335
    
    
    
    3.59
    %Total securities held to maturityDue within one year
    
    
    15
    
    
    
    16
    
    
    
    5.57
    %Due after one but within five years
    
    
    8,326
    
    
    
    8,280
    
    
    
    3.46
    %Due after five but within ten years
    
    
    33,393
    
    
    
    32,685
    
    
    
    4.05
    %Due after ten years
    
    
    20,523
    
    
    
    20,063
    
    
    
    4.91
    %$
    62,257
    
    
    $
    61,044
    
    
    
    4.25
    %
 (1) Yields on tax-exempt investments have been adjusted to a taxable equivalent
basis using a 34% tax rate. At December 31, 2003, there were no securities of any issuer (other than
governmental agencies) that exceeded 10% of the companys stockholders equity. Page 41




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##### 



Derivative Financial Instruments A derivative is a financial instrument that derives its cash flows, and
therefore its value, by reference to an underlying instrument, index or
reference rate. These instruments primarily consist of interest rate swaps,
caps, floors, financial forward and futures contracts and options written or
purchased. Derivative contracts are written in amounts referred to as notional
amounts. Notional amounts only provide the basis for calculating payments
between counterparties and do not represent amounts to be exchanged between
parties and are not a measure of financial risks. Credit risk arises when
amounts receivable from a counterparty exceed amounts payable. We control our
risk of loss on derivative contracts by subjecting counterparties to credit
reviews and approvals similar to those used in making loans and other
extensions of credit. Late in 2000, in anticipation of declining interest rates, we bought an
interest rate floor contract with a notional amount of $20 million, which we
subsequently sold in 2001. We recognized income aggregating $383,000 on this
floor contract in 2001, including the gain realized upon its disposal, in
non-interest income. We have also used interest rate swaps in the management of interest rate
risk. Interest rate swaps are contractual agreements between two parties to
exchange a series of cash flows representing interest payments. A swap allows
both parties to alter the repricing characteristics of assets or liabilities
without affecting the underlying principal positions. Through the use of a
swap, assets and liabilities may be transformed from fixed to floating rates,
from floating rates to fixed rates, or from one type of floating rate to
another. At December 31, 2003, swap derivatives with a total notional value of
$51.0 million, with terms ranging up to thirty years, were outstanding. Although off-balance sheet derivative financial instruments do not expose
the company to credit risk equal to the notional amount, such agreements
generate credit risk to the extent of the fair value gain in an off-balance
sheet derivative financial instrument if the counterparty fails to perform.
Such risk is minimized through the creditworthiness of the counterparties and
the consistent monitoring of these agreements. The counterparties to these
arrangements were primarily large commercial banks and investment banks. Where
appropriate, master netting agreements are arranged or collateral is obtained
in the form of rights to securities. At December 31, 2003, our interest rate
swaps reflected a net unrealized loss of $32,700. In addition, the bank has
liquidated two interest rate swap contracts in order to effectively lock-in its
hedged position. The bank realized gains of $1.1 million on the liquidation of
these contracts, which are being amortized into income over the remaining lives
of the original contract terms. Other risks associated with interest-sensitive derivatives include the
effect on fixed rate positions during periods of changing interest rates.
Indexed amortizing swaps notional amounts and maturities change based on
certain interest rate indices. Generally, as rates fall the notional amounts
decline more rapidly, and as rates increase notional amounts decline more
slowly. At December 31, 2003, we had no indexed amortizing swaps outstanding.
Under unusual circumstances, financial derivatives also increase liquidity
risk, which could result from an environment of rising interest rates in which
derivatives produce negative cash flows while being offset by increased cash
flows from variable rate loans. Such risk is considered insignificant due to
the relatively small derivative positions we hold. A discussion of derivatives is presented in Note 15 to our consolidated
financial statements, which are presented under Item 8 in this Form 10-K. Sources of Funds Deposit Activities We provide a range of deposit services, including non-interest-bearing
checking accounts, interest-bearing checking and savings accounts, money market
accounts and certificates of deposit. These accounts generally earn interest
at rates established by management based on competitive market factors and our
desire to increase or decrease certain types or maturities of deposits. We
have used brokered deposits and out of market deposits as funding sources. As
of December 31, 2003, we have $97.1 million of brokered deposits and $62.1
million of out of market deposits. However, we strive to establish customer
relations to attract core deposits in non-interest-bearing transactional
accounts and thus to reduce our costs of funds. Page 42




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##### 



The following table sets forth for the periods indicated the average
balances outstanding and average interest rates for each of our major
categories of deposits. For the Years Ended December 31,2003
    
    2002
    
    2001Average
    
    Average
    
    Average
    
    Average
    
    Average
    
    AverageBalance
    
    Rate
    
    Balance
    
    Rate
    
    Balance
    
    Rate(Dollars in thousands)Interest-bearing NOW and money market accounts
    
    $
    138,926
    
    
    
    0.97
    %
    
    $
    102,427
    
    
    
    1.31
    %
    
    $
    80,695
    
    
    
    2.65
    %Time deposits $100,000 or more
    
    
    154,026
    
    
    
    2.79
    %
    
    
    114,971
    
    
    
    3.96
    %
    
    
    96,542
    
    
    
    6.00
    %Other time deposits
    
    
    163,960
    
    
    
    2.59
    %
    
    
    172,456
    
    
    
    3.62
    %
    
    
    155,979
    
    
    
    5.81
    %Total interest-bearing deposits
    
    
    456,912
    
    
    
    2.17
    %
    
    
    389,854
    
    
    
    3.11
    %
    
    
    333,216
    
    
    
    5.10
    %Demand and other non-interest-bearing deposits
    
    
    45,101
    
    
    
    
    
    
    
    34,766
    
    
    
    
    
    
    
    25,749Total average deposits
    
    $
    502,013
    
    
    
    1.97
    %
    
    $
    424,620
    
    
    
    2.86
    %
    
    $
    358,965
    
    
    
    4.73
    %
 The following table presents the amounts and maturities of our
certificates of deposit with balances of $100,000 or more at December 31, 2003: At December 31, 2003(In thousands)Remaining maturity:Less than three months
    
    $
    36,414Three to six months
    
    
    54,564Six to twelve months
    
    
    29,824Over twelve months
    
    
    61,367Total
    
    $
    182,169
 Borrowings As an additional source of funding, we use advances from the Federal Home
Loan Bank of Atlanta. As set forth in the following table, outstanding
advances at December 31, 2003 totaled $96.5 million, and are secured by loans
with a carrying amount of $96.1 million, which approximates market value, and
investment securities with a market value of $110.5 million. Available
additional borrowings, based on the collateral value of these assets, was
$110.2 million at December 31, 2003. InterestYear of Maturity
    
    Rate
    
    Amount(In thousands)2004
    
    
    2.73
    %
    
    $
    30,5002005
    
    
    3.74
    %
    
    
    5,0002006
    
    
    
    %
    
    
    2007
    
    
    3.12
    %
    
    
    10,0002008
    
    
    1.93
    %
    
    
    5,250Thereafter
    
    
    3.31
    %
    
    
    45,725$
    96,475
 In addition to the Federal Home Loan Bank advances, we also had a
repurchase agreement with an outstanding balance of $10.0 million at December
31, 2003. Securities sold under agreements to repurchase generally mature
within ninety days from the transaction date and are collateralized by U.S.
Government Agency obligations. The company has repurchase lines of credit
aggregating $100.0 million from various institutions. The repurchases must be
adequately collateralized. Page 43




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##### 



In addition, we may purchase federal funds through unsecured federal funds
lines of credit with various banks aggregating $27.0 million. These lines are
intended for short-term borrowings and are subject to restrictions limiting the
frequency and term of advances. These lines of credit are payable on demand
and bear interest based upon the daily federal funds rate. We had $11.4
million of federal funds borrowings outstanding under these lines as of
December 31, 2003. Borrowings that are scheduled to be repaid within one year are classified
as short-term borrowings. For 2003 and 2002, average outstanding short-term
borrowings were $37.5 million and $35.1 million, respectively. In November of 2003, Southern Community Capital Trust II (Trust II), a
newly formed subsidiary of the company, issued 3,450,000 Trust Preferred
Securities (Trust II Securities), generating total proceeds of $34.5 million.
The Trust II Securities pay distributions at an annual rate of 7.95% and
mature on December 31, 2033. The Trust II Securities began paying quarterly
distributions on December 31, 2003. The company has fully and unconditionally
guaranteed the obligations of Trust II. The Trust II Securities are redeemable
in whole or in part at any time after December 31, 2008. The proceeds from the
Trust II Securities were utilized to purchase convertible junior subordinated
debentures from us under the same terms and conditions as the Trust II
Securities. We have the right to defer payment of interest on the debentures
at any time and from time to time for a period not exceeding five years,
provided that no deferral period extend beyond the stated maturities of the
debentures. Such deferral of interest payments by the company will result in a
deferral of distribution payments on the related Trust II Securities. Should
we defer the payment of interest on the debentures, the company will be
precluded from the payment of cash dividends to shareholders. The principal
use of the net proceeds from the sale of the debentures was to provide cash for
the acquisition of The Community Bank, to increase our regulatory capital, and
to support the growth and operations of our subsidiary banks. The amount of
proceeds we count as Tier 1capital cannot comprise more than 25% of our core
capital elements. Amounts in excess of that 25% limitation count as Tier 2
supplementary capital on our books. Prior to the closing of the acquisition of
The Community Bank on January 12, 2004, substantially all of the proceeds from
the Trust II Securities qualified as Tier 2 supplementary capital. Prior to
the redemption of the Trust I Securities, approximately $20 million of the
proceeds of the Trust II Securities counted as Tier 1 capital on our books.
After the redemption of the Trust I Securities on March 12, 2004, subject to
certain limitations, substantially all of the proceeds from the Trust II
Securities qualify as Tier 1 capital of the company for regulatory capital
purposes. In February of 2002, Southern Community Capital Trust I (Trust I), a
newly formed subsidiary of the company, issued 1,725,000 Cumulative Convertible
Trust Preferred Securities (Trust I Securities), generating total proceeds of
$17.3 million. At December 31, 2003, holders of the Trust I Securities had
voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of
our common stock at the Conversion Price of $8.26 per share of our common
stock. On January 14, 2004, we announced the redemption of all of the Trust I
Securities. We redeemed the Trust I Securities under a provision that
permitted us to redeem the Trust I Securities in whole at any time prior to
March 31, 2007 once the trading price of our common stock had been at least
125% of the Conversion Price for a period of twenty consecutive trading days
ending within five days of the date that we gave notice of redemption. The
Trust I Securities were redeemed on March 12, 2004, which resulted in the
issuance of 2,060,000 shares of our common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. The
Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I
Securities began paying quarterly distributions on March 31, 2002. The company
had fully and unconditionally guaranteed the obligations of Trust I. The
proceeds from the Trust I Securities were utilized to purchase convertible
junior subordinated debentures from us under the same terms and conditions as
the Trust I Securities. Subject to certain limitations, the Trust I Securities
qualified as Tier 1 capital of the company for regulatory capital purposes.
The principal use of the net proceeds from the sale of the convertible
debentures was to infuse capital into our bank subsidiary, Southern Community
Bank and Trust, to fund its operations and continued expansion, and to maintain
the companys and the banks status as well capitalized under regulatory
guidelines. Other Recent Developments On July 30, 2003, the company and The Community Bank jointly announced the
execution of a definitive agreement in which Southern Community Financial
Corporation would acquire The Community Bank in a fixed exchange of cash and
stock. The Community Bank, founded in 1987 and headquartered in Pilot
Mountain, North Carolina operates 10 community banking offices throughout
Surry, Rockingham, Stokes, Iredell and Yadkin counties, North Carolina. On
December 11, 2003, shareholders approved the transaction allowing Southern
Community Financial Corporation to acquire The Community Bank. On January 12,
2004, the acquisition was completed. For each share of stock owned, The
Community Bank shareholders received $53.05 in cash, 4.8714 shares of newly
issued Southern Community common stock or a combination of both, subject to an
overall allocation of approximately 6.4 million shares of common stock and
$15.2 million in cash. Page 44




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##### 



RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities. This interpretation addresses the
consolidation by business enterprises of variable interest entities as defined
in the interpretation. In December 2003, the FASB issued a revision to FIN 46
(FIN 46R) to clarify some of the provisions of FIN 46 and to exempt certain
entities from its requirements. The company must apply FIN 46R no later than
the end of the first reporting period ending after March 15, 2004. Adoption of
FIN 46R will require deconsolidation of the companys remaining trust preferred
subsidiary, Southern Community Capital Trust II (the Trust I Securities were
redeemed as of March 12, 2004). Upon deconsolidation, the junior subordinated
debentures issued by the company to Trust II will be included in long-term debt
(instead of the trust preferred securities) and the companys equity interest
in Trust II will be included in other assets. If Trust I and Trust II were
deconsolidated as of December 31, 2003, the effect on the companys balance
sheet would be an increase in other assets of $1.6 million with a corresponding
decrease in long-term debt. The deconsolidation of Trust I and Trust II will
not materially impact net income. A discussion of other recent accounting pronouncements is presented in
Note 2 to our consolidated financial statements, which are presented under Item
8 in this Form 10-K. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Statements contained in this annual report, which are not historical
facts, are forward-looking statements, as that term is defined in the Private
Securities Litigation Reform Act of 1995. Amounts herein could vary as a result
of market and other factors. Such forward-looking statements are subject to
risks and uncertainties which could cause actual results to differ materially
from those currently anticipated due to a number of factors, which include, but
are not limited to, factors discussed in documents filed by the company with
the Securities and Exchange Commission and the bank with the Federal Reserve
Bank from time to time. Such forward-looking statements may be identified by
the use of such words as believe, expect, anticipate, should,
planned, estimated, and potential. Examples of forward-looking statements
include, but are not limited to, estimates with respect to the financial
condition, expected or anticipated revenue, results of operations and business
of the company that are subject to various factors which could cause actual
results to differ materially from these estimates. These factors include, but
are not limited to, general economic conditions, changes in interest rates,
deposit flows, loan demand, real estate values, and competition; changes in
accounting principles, policies, or guidelines; changes in legislation or
regulation; and other economic, competitive, governmental, regulatory, and
technological factors affecting the companys operations, pricing, products and
services. 
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk See MARKET RISK under Item 6. 
 Item 8. Financial Statements The information required by this item is filed herewith. 
 Item 8A. Controls and Procedures Southern Community Financial Corporations management, with the
participation of the its Chief Executive Officer and Chief Financial Officer,
has evaluated the effectiveness of the companys disclosure controls and
procedures as of December 31, 2003. Based on that evaluation, the companys Chief Executive
Officer and Chief Financial Officer concluded that the companys disclosure
controls and procedures were effective as of December 31, 2003. There were no
material changes in the companys internal controls over financial reporting
during the fourth quarter of 2003. Page 45




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##### 



(DIXON HUGHES LOGO) INDEPENDENT AUDITORS REPORT To the Stockholders and the Board of Directors
Southern Community Financial Corporation and Subsidiaries
Winston-Salem, North Carolina We have audited the accompanying consolidated balance sheets of Southern
Community Financial Corporation and Subsidiaries as of December 31, 2003 and
2002, and the related consolidated statements of operations, comprehensive
income, changes in stockholders equity and cash flows for each of the years in
the three-year period ended December 31, 2003. These consolidated financial
statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Southern Community
Financial Corporation and Subsidiaries at December 31, 2003 and 2002 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. /s/ Dixon Hughes PLLC Sanford, North Carolina
March 12, 2004 Page 46




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSDecember 31, 2003 and 2002 2003
    
    2002(Amounts in thousands,except share data)AssetsCash and due from banks
    
    $
    22,929
    
    
    $
    16,632Federal funds sold
    
    
    271
    
    
    
    11,084Investment securities (Note 3)Available for sale, at fair value
    
    
    168,500
    
    
    
    96,930Held to maturity (fair value of $61,044 and $45,319
at December 31, 2003 and 2002, respectively)
    
    
    62,257
    
    
    
    44,749Loans (Note 4)
    
    
    519,746
    
    
    
    421,938Allowance for loan losses (Note 5)
    
    
    (7,275
    )
    
    
    (6,342
    )Net Loans
    
    
    512,471
    
    
    
    415,596Premises and equipment (Note 6)
    
    
    17,337
    
    
    
    15,962Other assets (Note 12)
    
    
    14,737
    
    
    
    11,286Total Assets
    
    $
    798,502
    
    
    $
    612,239Liabilities and Stockholders EquityDepositsDemand
    
    $
    51,868
    
    
    $
    41,869Money market and NOW
    
    
    179,076
    
    
    
    115,981Time (Note 7)
    
    
    344,274
    
    
    
    291,366Total Deposits
    
    
    575,218
    
    
    
    449,216Short-term borrowings (Note 8)
    
    
    51,900
    
    
    
    40,706Long-term debt (Note 8)
    
    
    65,975
    
    
    
    55,000Preferred securities (Note 9)
    
    
    51,652
    
    
    
    17,250Other liabilities (Note 10)
    
    
    2,866
    
    
    
    2,528Total Liabilities
    
    
    747,611
    
    
    
    564,700Stockholders Equity (Notes 9 and 14)Preferred stock, no par value, 1,000,000 shares authorized;
none issued or outstanding at December 31, 2003 and 2002,
respectively
    
    
    
    
    
    
    Common stock, no par value, 30,000,000 shares authorized;
8,986,796 and 8,791,683 shares issued and outstanding
at December 31, 2003 and 2002, respectively
    
    
    44,377
    
    
    
    43,123Retained earnings
    
    
    5,493
    
    
    
    1,830Accumulated other comprehensive income
    
    
    1,021
    
    
    
    2,586Total Stockholders Equity
    
    
    50,891
    
    
    
    47,539Commitments (Notes 11 and 16)Total Liabilities and
Stockholders Equity
    
    $
    798,502
    
    
    $
    612,239
 See
accompanying notes. Page 47




---



##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands, exceptshare and per share data)Interest IncomeLoans
    
    $
    27,478
    
    
    $
    25,689
    
    
    $
    26,292Investment securities available for sale
    
    
    6,022
    
    
    
    4,901
    
    
    
    2,320Investment securities held to maturity
    
    
    2,469
    
    
    
    2,576
    
    
    
    2,201Federal funds sold
    
    
    50
    
    
    
    115
    
    
    
    553Total Interest Income
    
    
    36,019
    
    
    
    33,281
    
    
    
    31,366Interest ExpenseMoney market and NOW deposits
    
    
    1,346
    
    
    
    1,342
    
    
    
    2,135Time deposits
    
    
    8,544
    
    
    
    10,800
    
    
    
    14,858Borrowings
    
    
    4,861
    
    
    
    3,661
    
    
    
    1,041Total Interest Expense
    
    
    14,751
    
    
    
    15,803
    
    
    
    18,034Net Interest Income
    
    
    21,268
    
    
    
    17,478
    
    
    
    13,332Provision for Loan Losses (Note 5)
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320Net Interest Income After
Provision for Loan Losses
    
    
    18,983
    
    
    
    15,823
    
    
    
    11,012Non-Interest Income (Note 13)
    
    
    4,985
    
    
    
    3,927
    
    
    
    3,402Non-Interest ExpenseSalaries and employee benefits
    
    
    9,603
    
    
    
    7,758
    
    
    
    5,510Occupancy and equipment
    
    
    3,045
    
    
    
    2,508
    
    
    
    2,067Other (Note 13)
    
    
    5,685
    
    
    
    4,515
    
    
    
    3,585Total Non-Interest Expense
    
    
    18,333
    
    
    
    14,781
    
    
    
    11,162Income Before Income Taxes
    
    
    5,635
    
    
    
    4,969
    
    
    
    3,252Income Tax Expense (Note 12)
    
    
    1,972
    
    
    
    1,755
    
    
    
    1,147Net Income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105Net Income Per ShareBasic
    
    $
    .41
    
    
    $
    .37
    
    
    $
    .24Diluted
    
    
    .40
    
    
    
    .35
    
    
    
    .23Weighted Average Shares OutstandingBasic
    
    
    8,826,780
    
    
    
    8,788,295
    
    
    
    8,707,678Diluted
    
    
    11,369,429
    
    
    
    9,085,853
    
    
    
    9,043,611
 See
accompanying notes. Page 48




---



##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands)Net income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105Other comprehensive income:Securities available for sale:Unrealized holding gains
(losses) on available for
sale securities
    
    
    (1,851
    )
    
    
    1,465
    
    
    
    802Tax effect
    
    
    713
    
    
    
    (565
    )
    
    
    (309
    )Reclassification of gains
recognized in net income
    
    
    
    
    
    
    (70
    )
    
    
    Tax effect
    
    
    
    
    
    
    27
    
    
    
    Net of tax amount
    
    
    (1,138
    )
    
    
    857
    
    
    
    493Cash flow hedging activities:Unrealized holding gains
(losses) on cash flow
hedging activities
    
    
    (250
    )
    
    
    1,461
    
    
    
    Tax effect
    
    
    73
    
    
    
    (502
    )
    
    
    Reclassification of gains
recognized in net income
    
    
    (406
    )
    
    
    (52
    )
    
    
    Tax effect
    
    
    156
    
    
    
    18
    
    
    
    Net of tax amount
    
    
    (427
    )
    
    
    925
    
    
    
    Total other comprehensive
income
(loss)
    
    
    (1,565
    )
    
    
    1,782
    
    
    
    493Comprehensive income
    
    $
    2,098
    
    
    $
    4,996
    
    
    $
    2,598
 See accompanying notes. Page 49




---



##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITYYears Ended December 31, 2003, 2002 and 2001 Common Stock
    
    Additional
    
    
    
    
    
    Accumulated
Other
    
    TotalPaid-in
    
    Retained
    
    Comprehensive
    
    StockholdersShares
    
    Amount
    
    Capital
    
    Earnings
    
    Income
    
    Equity(Amounts in thousands, except share data)Balance at December 31, 2000
    
    
    7,595,979
    
    
    $
    18,990
    
    
    $
    15,766
    
    
    $
    1,883
    
    
    $
    311
    
    
    $
    36,950Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,105
    
    
    
    
    
    
    
    2,105Other comprehensive income, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    493
    
    
    
    493Formation of holding company
    
    
    
    
    
    
    17,771
    
    
    
    (17,771
    )
    
    
    
    
    
    
    
    
    
    
    Common stock issued pursuant to:Sale of common stock
    
    
    344,118
    
    
    
    860
    
    
    
    1,951
    
    
    
    
    
    
    
    
    
    
    
    2,8115% stock dividend
    
    
    396,702
    
    
    
    2,618
    
    
    
    
    
    
    
    (2,626
    )
    
    
    
    
    
    
    (8
    )Stock options exercised
    
    
    18,191
    
    
    
    46
    
    
    
    35
    
    
    
    
    
    
    
    
    
    
    
    81Current income tax benefit
    
    
    
    
    
    
    
    
    
    
    19
    
    
    
    
    
    
    
    
    
    
    
    19Balance at December 31, 2001
    
    
    8,354,990
    
    
    
    40,285
    
    
    
    
    
    
    
    1,362
    
    
    
    804
    
    
    
    42,451Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,214
    
    
    
    
    
    
    
    3,214Other comprehensive income, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,782
    
    
    
    1,782Common stock issued pursuant to:5% stock dividend
    
    
    416,601
    
    
    
    2,733
    
    
    
    
    
    
    
    (2,733
    )
    
    
    
    
    
    
    Cash paid in lieu of fractional shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (13
    )
    
    
    
    
    
    
    (13
    )Stock options exercised
    
    
    20,092
    
    
    
    77
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    77Current income tax benefit
    
    
    
    
    
    
    28
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    28Balance at December 31, 2002
    
    
    8,791,683
    
    
    
    43,123
    
    
    
    
    
    
    
    1,830
    
    
    
    2,586
    
    
    
    47,539Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,663
    
    
    
    
    
    
    
    3,663Other comprehensive loss, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,565
    )
    
    
    (1,565
    )Common stock issued pursuant to:Conversion of trust preferred securities
    
    
    21,187
    
    
    
    175
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    175Issuance costs
    
    
    
    
    
    
    (13
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (13
    )Stock options exercised
    
    
    173,926
    
    
    
    770
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    770Current income tax benefit
    
    
    
    
    
    
    322
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    322Balance at December 31, 2003
    
    
    8,986,796
    
    
    $
    44,377
    
    
    $
    
    
    
    $
    5,493
    
    
    $
    1,021
    
    
    $
    50,891
 See accompanying notes. Page 50




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSYears Ended December 31, 2003, 2002 and 2001 2003
    
    2002
    
    2001(Amounts in thousands)Cash Flows from Operating ActivitiesNet income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation and amortization
    
    
    2,041
    
    
    
    1,337
    
    
    
    1,003Provision for loan losses
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320Realized gain on sales of available for sale securities, net
    
    
    
    
    
    
    (70
    )
    
    
    Realized gain on sale of equipment
    
    
    (98
    )
    
    
    (3
    )
    
    
    Deferred income taxes
    
    
    (357
    )
    
    
    (452
    )
    
    
    (91
    )Realized (gain) loss on sale of foreclosed assets
    
    
    76
    
    
    
    (21
    )
    
    
    Change in assets and liabilities:Increase in other assets
    
    
    (2,153
    )
    
    
    (1,505
    )
    
    
    (165
    )Increase (decrease) in other liabilities
    
    
    338
    
    
    
    1,590
    
    
    
    (1,695
    )Total Adjustments
    
    
    2,132
    
    
    
    2,531
    
    
    
    1,372Net Cash Provided by Operating Activities
    
    
    5,795
    
    
    
    5,745
    
    
    
    3,477Cash Flows from Investing Activities
(Increase) decrease in federal funds sold
    
    
    10,813
    
    
    
    11,842
    
    
    
    (1,881
    )Purchases of:Available for sale investment securities
    
    
    (127,391
    )
    
    
    (112,297
    )
    
    
    (2,061
    )Held to maturity investment securities
    
    
    (66,463
    )
    
    
    (43,328
    )
    
    
    (35,000
    )Proceeds from maturities and calls of:Available for sale investment securities
    
    
    53,326
    
    
    
    26,152
    
    
    
    11,190Held to maturity investment securities
    
    
    48,962
    
    
    
    33,104
    
    
    
    20,712Proceeds from sales of available for sale investment securities
    
    
    
    
    
    
    21,220
    
    
    
    Net increase in loans
    
    
    (100,229
    )
    
    
    (62,667
    )
    
    
    (79,330
    )Proceeds from termination of interest rate swaps
    
    
    951
    
    
    
    208
    
    
    
    Purchases of premises and equipment
    
    
    (3,543
    )
    
    
    (5,066
    )
    
    
    (3,407
    )Proceeds from disposal of premises and equipment
    
    
    657
    
    
    
    3
    
    
    
    Proceeds from sale of foreclosed assets
    
    
    1,109
    
    
    
    289
    
    
    
    Purchase of bank-owned life insurance
    
    
    (144
    )
    
    
    (557
    )
    
    
    (2,000
    )Net Cash Used by Investing Activities
    
    
    (181,952
    )
    
    
    (131,097
    )
    
    
    (91,777
    )Cash Flows from Financing ActivitiesNet increase in deposits
    
    
    126,223
    
    
    
    56,365
    
    
    
    54,098Net increase in borrowings
    
    
    22,169
    
    
    
    50,726
    
    
    
    38,980Proceeds from issuance of trust preferred securities, net
of debt issuance costs
    
    
    33,292
    
    
    
    15,923
    
    
    
    Net proceeds from issuance of common stock
    
    
    770
    
    
    
    105
    
    
    
    2,911Cash paid in lieu of fractional shares
    
    
    
    
    
    
    (13
    )
    
    
    (8
    )Net Cash Provided by Financing Activities
    
    
    182,454
    
    
    
    123,106
    
    
    
    95,981Net Increase (Decrease) in Cash and Cash Equivalents
    
    
    6,297
    
    
    
    (2,246
    )
    
    
    7,681Cash and Cash Equivalents, Beginning of Year
    
    
    16,632
    
    
    
    18,878
    
    
    
    11,197Cash and Cash Equivalents, End of Year
    
    $
    22,929
    
    
    $
    16,632
    
    
    $
    18,878Supplemental Disclosures of Cash Flow InformationInterest paid on deposits and borrowed funds
    
    $
    14,446
    
    
    $
    15,385
    
    
    $
    18,269Income taxes paid
    
    
    2,879
    
    
    
    1,721
    
    
    
    1,530Supplemental Schedule of Noncash Investing and Financing ActivitiesTransfer of loans to foreclosed assets
    
    $
    1,069
    
    
    $
    304
    
    
    $
    79Increase (decrease) in fair value of securities available for
sale, net of tax
    
    
    (1,138
    )
    
    
    857
    
    
    
    493Increase (decrease) in fair value of cash flow hedges, net of tax
    
    
    (334
    )
    
    
    925
    
    
    
    Unrealized loss of fair value hedges
    
    
    (140
    )
    
    
    
    
    
    
    Convertible trust preferred securities converted to common stock
    
    
    175
    
    
    
    
    
    
    
    
 See accompanying notes. Page 51




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (1) ORGANIZATION AND OPERATIONS In October 2001, Southern Community Financial Corporation (the company) was
formed as a financial holding company for Southern Community Bank and Trust.
Upon formation, one share of Southern Community Financial Corporations no par
value common stock was exchanged for each of the outstanding shares of Southern
Community Bank and Trusts $2.50 par value common stock. Southern Community Bank and Trust (the bank) was incorporated November 14,
1996 and began banking operations on November 18, 1996. The bank is engaged in
general commercial and retail banking in the Piedmont area of North Carolina,
principally Forsyth, Guilford and Yadkin Counties, operating under the banking
laws of North Carolina and the rules and regulations of the Federal Deposit
Insurance Corporation, and on February 2, 2001 the bank became a member of the
Federal Reserve System. The bank undergoes periodic examinations by those
regulatory authorities. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements include the accounts of Southern
Community Financial Corporation and its wholly-owned subsidiaries, Southern
Community Capital Trust I and Trust II, trusts for the trust preferred
securities, and Southern Community Bank and Trust and its wholly-owned
subsidiaries, Southeastern Acceptance Corporation, a consumer finance company
(dissolved during 2003), and VCS Management, L.L.C., the managing general
partner for Salem Capital Partners L.P., a Small Business Investment Company. All intercompany transactions and
balances have been eliminated in consolidation. Southern Community Financial
Corporation and its subsidiaries are collectively referred to herein as the
company. Use of Estimates The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the consolidated financial statements, and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates. Material estimates that are
particularly susceptible to significant change relate to the determination of
the allowance for losses on loans. Cash and Cash Equivalents For the purpose of presentation in the consolidated statements of cash flows,
cash and cash equivalents are defined as those amounts included in the balance
sheet caption Cash and due from banks. Federal regulations require institutions to set aside specified amounts of cash
as reserves against transaction and time deposits. As of December 31, 2003,
the daily average gross reserve requirement was $12.2 million. Investment Securities Available for sale securities are carried at fair value and consist of bonds
and mortgage-backed securities not classified as trading securities or as held
to maturity securities. Unrealized holding gains and losses on available for
sale securities are reported as a net amount in accumulated other comprehensive
income, net of income taxes. Gains and losses on the sale of available for
sale securities are determined using the specific-identification method. Bonds
and mortgage-backed securities for which the bank has the positive intent and
ability to hold to maturity are reported at cost, adjusted for premiums and
discounts that are recognized in interest income using a method that
approximates the interest method over the period to maturity. Declines in the
fair value of individual held to maturity and available for sale securities
below their cost that are other than temporary would result in write-downs of
the individual securities to their fair value. Such write-downs would be
included in earnings as realized losses. Page 52




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Loans Held for Sale The company originates single family, residential first mortgage loans on a
presold basis. Loans held for sale are carried at the lower of cost or fair
value in the aggregate as determined by outstanding commitments from investors.
Upon closing, these loans, together with their servicing rights, are sold to
other financial institutions under prearranged terms. The company recognizes
certain origination and service release fees upon the sale which are included
in non-interest income in the consolidated statement of operations. Loans Loans that management has the intent and ability to hold for the foreseeable
future or until maturity are reported at their outstanding principal adjusted
for any charge-offs, the allowance for loan losses, and any deferred fees or
costs on originated loans and unamortized premiums or discounts on purchased
loans. Loan origination fees and certain direct origination costs are
capitalized and recognized as an adjustment of the yield of the related loan.
Interest on loans is recorded based on the principal amount outstanding. The
accrual of interest on impaired loans is discontinued when, in managements
opinion, the borrower may be unable to meet payments as they become due. When
interest accrual is discontinued, all unpaid accrued interest is reversed
against interest income. Interest income is subsequently recognized only to
the extent cash payments are received. Allowance for Loan Losses The provision for loan losses is based upon managements estimate of the amount
needed to maintain the allowance for loan losses at an adequate level. In
making the evaluation of the adequacy of the allowance for loan losses,
management gives consideration to current economic conditions, statutory
examinations of the loan portfolio by regulatory agencies, delinquency
information and managements internal review of the loan portfolio. Loans are
considered impaired when it is probable that all amounts due under the
contractual terms of the loan will not be collected. The measurement of
impaired loans is generally based on the present value of expected future cash
flows discounted at the historical effective interest rate, or upon the fair
value of the collateral if readily determinable. If the recorded investment in
the loan exceeds the measure of fair value, a valuation allowance is
established as a component of the allowance for loan losses. While management
uses the best information available to make evaluations, future adjustments to
the allowance may be necessary if conditions differ substantially from the
assumptions used in making the evaluations. In addition, regulatory examiners
may require the bank to recognize changes to the allowance for loan losses
based on their judgments about information available to them at the time of
their examination. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation.
Depreciation is calculated on the straight-line method over the estimated
useful lives of the assets which are 30 years for buildings and
3 - 10 years
for furniture and equipment. Leasehold improvements are amortized over the
expected terms of the respective leases or the estimated useful lives of the
improvements, whichever is shorter. Repairs and maintenance costs are charged
to operations as incurred and additions and improvements to premises and
equipment are capitalized. Upon sale or retirement, the cost and related
accumulated depreciation are removed from the accounts and any gains or losses
are reflected in current operations. Foreclosed Assets Assets acquired through, or in lieu of, foreclosure are held for sale and are
initially recorded at fair value at the date of foreclosure, establishing a new
cost basis. Subsequent to foreclosure, valuations are periodically performed
by management and the assets are carried at the lower of carrying amount or
fair value less expected cost to sell. Revenue and expenses from operations
and changes in the valuation allowance are included in other expenses. Page 53




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax
consequences attributable to differences between the tax bases of assets and
liabilities and their carrying amounts for financial reporting purposes.
Deferred tax assets and liabilities are measured using enacted tax rates in
effect for the year in which the temporary differences are expected to be
recovered or settled. Deferred tax assets are reduced by a valuation allowance
if it is more likely than not that the tax benefits will not be realized. Derivatives The company utilizes interest rate swaps in the management of interest rate
risk. Interest rate swaps are contractual agreements between two parties to
exchange a series of cash flows representing interest payments. A swap allows
both parties to alter the repricing characteristics of assets or liabilities
without affecting the underlying principal positions. Through the use of a
swap, assets and liabilities may be transformed from fixed to floating rates,
from floating rates to fixed rates, or from one type of floating rate to
another. Swap terms generally range from one year to ten years depending on
the need. The company utilizes interest rate swap agreements to convert a portion of its
variable-rate loans to a fixed rate (cash flow hedge), and to convert a portion
of its fixed-rate debt to a variable rate (fair value hedge). Interest rate
swaps are contracts in which a series of interest rate flows are exchanged over
a prescribed period. The notional amount on which the interest payments are
based is not exchanged. Under SFAS No. 133, the gain or loss on a derivative designated and qualifying
as a fair value hedging instrument, as well as the offsetting gain or loss on
the hedged item attributable to the risk being hedged, is recognized currently
in earnings in the same accounting period. The effective portion of the gain
or loss on a derivative designated and qualifying as a cash flow hedging
instrument is initially reported as a component of other comprehensive income
and subsequently reclassified into earnings in the same period or periods
during which the hedged transaction affects earnings. The ineffective portion
of the gain or loss on the derivative instrument, if any, is recognized
currently in earnings. The net interest payable or receivable on interest rate swaps that are
designated as hedges is accrued and recognized as an adjustment to the interest
income or expense of the related asset or liability. Gains and losses from
early terminations of derivatives are deferred and amortized as yield
adjustments over the shorter of the remaining term of the hedged asset or
liability or the remaining term of the derivative instrument. Upon disposition
or settlement of the asset or liability being hedged, deferral accounting is
discontinued and any gains or losses are recognized in income. Unrealized
holding gains and losses on derivatives designated as cash flow hedges are
reported, net of applicable income tax effect, in accumulated other
comprehensive income. Derivative financial instruments that fail to qualify as a hedge are carried at
fair value with gains and losses recognized in current earnings. Per Share Data Basic and diluted net income per share are computed based on the weighted
average number of shares outstanding during each period after retroactively
adjusting for a 5% stock dividend distributed October 15, 2002 and 2001.
Diluted net income per share reflects the potential dilution that could occur
if stock options were exercised or convertible trust preferred securities were
converted, resulting in the issuance of common stock that then shared in the
net income of the company. Page 54




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Per Share Data (Continued) Basic and diluted net income per share have been computed based upon net income
as presented in the accompanying consolidated statements of operations divided
by the weighted average number of common shares outstanding or assumed to be
outstanding as summarized below: 2003
    
    2002
    
    2001Weighted average number of common shares used in computing
basic net income per share
    
    
    8,826,780
    
    
    
    8,788,295
    
    
    
    8,707,678Effect of dilutive convertible preferred securities
    
    
    2,088,975
    
    
    
    
    
    
    
    Effect of dilutive stock options
    
    
    453,674
    
    
    
    297,558
    
    
    
    335,933Weighted average number of common shares and dilutive potential
common shares used in computing diluted net income per share
    
    
    11,369,429
    
    
    
    9,085,853
    
    
    
    9,043,611
 For the year ended December 31, 2003, net income for determining diluted
earnings per share was $4,504 thousand, after adjusting for the $842 thousand
after tax effect of the expense associated with the 2,088,975 dilutive
convertible preferred securities. For the years ended December 31, 2003, 2002
and 2001, there were 14,700, 227,925, and 182,952 options, respectively, that
were antidilutive since the exercise price exceeded the average market price
for the year. For the year ended December 31, 2002 there were 2,088,975 of
antidilutive shares related to the convertible trust preferred securities (see
Note 9) since the conversion price exceeded the average market price for the
year. These common stock equivalents have been omitted from the calculation of
diluted earnings per share for their respective years. Stock Compensation Plans Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for
Stock-Based Compensation, encourages all entities to adopt a fair value based
method of accounting for employee stock compensation plans, whereby
compensation cost is measured at the grant date based on the value of the award
and is recognized over the service period, which is usually the vesting period.
However, it also allows an entity to continue to measure compensation cost for
those plans using the intrinsic value based method of accounting prescribed by
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees,whereby compensation cost is the excess, if any, of the quoted
market price of the stock at the grant date (or other measurement date) over
the amount an employee must pay to acquire the stock. Stock options issued
under the companys stock option plans have no intrinsic value at the grant
date and, under Opinion No. 25, no compensation cost is recognized for them.
The company has elected to continue with the accounting methodology in Opinion
No. 25. Presented below are the pro forma disclosures of net income and
earnings per share and other disclosures as if the fair value based method of
accounting had been applied. Page 55




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Stock Compensation Plans (Continued) 2003
    
    2002
    
    2001(Amounts in thousands,except per share data)Net income:As reported
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105Deduct: Total stock-based employee compensation
expense determined under fair value method
for all awards, net of related tax effects
    
    
    (257
    )
    
    
    (447
    )
    
    
    (552
    )Pro forma
    
    $
    3,406
    
    
    $
    2,767
    
    
    $
    1,553Basic earnings per share:As reported
    
    $
    .41
    
    
    $
    .37
    
    
    $
    .27Pro forma
    
    
    .39
    
    
    
    .31
    
    
    
    .18Diluted earnings per share:As reported
    
    $
    .40
    
    
    $
    .35
    
    
    $
    .23Pro forma
    
    
    .37
    
    
    
    .31
    
    
    
    .18
 Comprehensive Income Comprehensive income is defined as the change in equity during a period for
non-owner transactions and comprises net income and other comprehensive income.
Other comprehensive income includes revenues, expenses, gains, and losses that
are excluded from earnings under current accounting standards. Components of
other comprehensive income for the company consist of the unrealized gains and
losses, net of taxes, in the companys available for sale securities portfolio
and unrealized gains and losses, net of taxes, in the companys cash flow hedge
instruments. Accumulated other comprehensive income at December 31, 2003 and 2002 consists
of the following: 2003
    
    2002(Amounts in thousands)Unrealized holding gains - investment securities available for sale
    
    $
    852
    
    
    $
    2,704Deferred income taxes
    
    
    (329
    )
    
    
    (1,043
    )Net unrealized holding gains - investment securities available for sale
    
    
    523
    
    
    
    1,661Unrealized holding gains - cash flow hedge instruments
    
    
    812
    
    
    
    1,409Deferred income taxes
    
    
    (314
    )
    
    
    (484
    )Net unrealized holding gains - cash flow hedge instruments
    
    
    498
    
    
    
    925Total accumulated other comprehensive income
    
    $
    1,021
    
    
    $
    2,586
 Segment Reporting SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information,requires management to report selected financial and descriptive
information about reportable operating segments. It also establishes standards
for related disclosures about products and services, geographic areas, and
major customers. Generally, disclosures are required for segments internally
identified to evaluate performance and resource allocation. In all material
respects, the companys operations are entirely within the commercial banking
segment, and the consolidated financial statements presented herein reflect the
results of that segment. Also, the company has no foreign operations or
customers. Page 56




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements In April 2003, the FASB issued SFAS No. 149, Amendment of Statement No. 133 on
Derivative Instruments and Hedging Activities.SFAS No. 149 improves financial
reporting by requiring that contracts with comparable characteristics be
accounted for similarly. In particular, SFAS No. 149 clarifies under what
circumstances a contract with an initial net investment meets the
characteristic of a derivative, clarifies when a derivative contains a
financing component, amends the definition of an underlying to conform it to
language used in FIN 45 and amends certain other existing pronouncements. SFAS
No. 149 is effective for contracts entered into or modified after June 30,
2003, and for hedging relationships designated after June 30, 2003. In
addition, with some exceptions, all provisions of SFAS No. 149 should be
applied prospectively. The adoption of SFAS No. 149 did not have a material
impact on the companys consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. This Statement
establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its
scope as a liability (or an asset in some circumstances). This Statement is
effective for financial instruments entered into or modified by the company
after May 31, 2003, and is effective at the beginning of the first interim
period beginning after June 15, 2003. However, the FASB has deferred
indefinitely the classification and measurement provisions as they related to
certain mandatorily redeemable noncontrolling interests. The adoption of SFAS
No. 150 did not have a material impact on the companys consolidated financial
statements. In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities. This interpretation addresses the
consolidation by business enterprises of variable interest entities as defined
in the interpretation. In December 2003, the FASB issued a revision to FIN 46
(FIN 46R) to clarify some of the provisions of FIN 46 and to exempt certain
entities from its requirements. FIN 46R is effective for public entities that
have interests in structures that are commonly referred to as special-purpose
entities for periods ending after December 15, 2003. Application by public
entities, other than small business issuers, for all other types of variable
interest entities is required in financial statements for periods ending after
March 15, 2004. The adoption of FIN 46 and FIN 46R is not expected to have a
material impact on the companys consolidated financial statements. In November 2003, the Emerging Issues Task Force (EITF) reached a partial
consensus on Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments. Issue 03-1 requires certain quantitative
and qualitative disclosures for investments subject to SFAS No. 115, Accounting
for Certain Investments in Debt and Equity Securities,that are impaired at the
balance sheet date but for which an other-than-temporary impairment has not
been recognized. The company adopted the partial consensus on Issue 03-1
during 2003 and has provided the new disclosures in Note 3. The EITF is
expected to continue deliberating other aspects of Issue 03-1, including when
to recognize other-than-temporary impairment. Page 57




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (3) INVESTMENT SECURITIES The following is a summary of the securities portfolio by major classification
at December 31, 2003 and 2002: 2003Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(Amounts in thousands)Securities available for sale:U. S. Government agencies
    
    $
    33,567
    
    
    $
    685
    
    
    $
    7
    
    
    $
    34,245Mortgage-backed
    
    
    127,678
    
    
    
    1,058
    
    
    
    884
    
    
    
    127,852Other
    
    
    6,403
    
    
    
    
    
    
    
    
    
    
    
    6,403$
    167,648
    
    
    $
    1,743
    
    
    $
    891
    
    
    $
    168,500Securities held to maturity:U. S. Government agencies
    
    $
    61,291
    
    
    $
    56
    
    
    $
    1,276
    
    
    $
    60,071Mortgage-backed
    
    
    640
    
    
    
    11
    
    
    
    13
    
    
    
    638Municipals
    
    
    326
    
    
    
    9
    
    
    
    
    
    
    
    335$
    62,257
    
    
    $
    76
    
    
    $
    1,289
    
    
    $
    61,044
 2002Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(Amounts in thousands)Securities available for sale:U. S. Government agencies
    
    $
    21,254
    
    
    $
    901
    
    
    $
    
    
    
    $
    22,155Mortgage-backed
    
    
    67,618
    
    
    
    1,802
    
    
    
    
    
    
    
    69,420Other
    
    
    5,355
    
    
    
    
    
    
    
    
    
    
    
    5,355$
    94,227
    
    
    $
    2,703
    
    
    $
    
    
    
    $
    96,930Securities held to maturity:U. S. Government agencies
    
    $
    44,000
    
    
    $
    540
    
    
    $
    
    
    
    $
    44,540Mortgage-backed
    
    
    421
    
    
    
    22
    
    
    
    
    
    
    
    443Municipals
    
    
    328
    
    
    
    8
    
    
    
    
    
    
    
    336$
    44,749
    
    
    $
    570
    
    
    $
    
    
    
    $
    45,319
 The following tables show our investments gross unrealized losses and fair
value, aggregated by investment category and length of time that the individual
securities have been in a continuous unrealized loss position, at December 31,
2003. All unrealized losses on investment securities are a result of
volatility in the market during 2003. For available for sale securities, the
unrealized losses relate to one U.S. Government Agency bond and nine
mortgage-backed securities. For held to maturity securities, the unrealized
losses relate to eight U.S. Government Agency bonds and one mortgage-backed
security. All unrealized losses on investment securities are considered by
management to be temporarily impaired given the credit ratings on these
investment securities and the short duration of the unrealized loss. Page 58




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (3) INVESTMENT SECURITIES (Continued) Less Than 12 Months
    
    12 Months or More
    
    TotalFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    Unrealizedvalue
    
    losses
    
    value
    
    losses
    
    value
    
    losses(Amounts in thousands)Securities available for sale:U.S. government securities
    
    $
    1,926
    
    
    $
    7
    
    
    $
    
    
    
    $
    
    
    
    $
    1,926
    
    
    $
    7Mortgage-backed securities
    
    
    82,990
    
    
    
    884
    
    
    
    
    
    
    
    
    
    
    
    82,990
    
    
    
    884Total temporarily impaired
securities
    
    $
    84,916
    
    
    $
    891
    
    
    $
    
    
    
    $
    
    
    
    $
    84,916
    
    
    $
    891Securities held to maturity:U.S. government securities
    
    $
    50,016
    
    
    $
    1,276
    
    
    $
    
    
    
    $
    
    
    
    $
    50,016
    
    
    $
    1,276Mortgage-backed securities
    
    
    509
    
    
    
    13
    
    
    
    
    
    
    
    
    
    
    
    509
    
    
    
    13Total temporarily impaired
securities
    
    $
    50,525
    
    
    $
    1,289
    
    
    $
    
    
    
    $
    
    
    
    $
    50,525
    
    
    $
    1,289
 Proceeds from sales of securities available for sale during 2002 were $21.2
million. Gross gains of $101,000 and gross losses of $31,000 were realized on
those sales. There were no sales of investment securities in 2003 and 2001. The amortized cost and fair values of securities available for sale and held to
maturity at December 31, 2003 by contractual maturity are shown below. Actual
expected maturities may differ from contractual maturities because issuers may
have the right to call or prepay obligation. Securities Available for Sale
    
    Securities Held to MaturityAmortized
    
    Fair
    
    Amortized
    
    FairCost
    
    Value
    
    Cost
    
    Value(Amounts in thousands)Due within one year
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Due after one year through five years
    
    
    8,970
    
    
    
    9,079
    
    
    
    8,326
    
    
    
    8,280Due after five years through ten years
    
    
    24,597
    
    
    
    25,166
    
    
    
    33,291
    
    
    
    32,572Due after ten years
    
    
    6,403
    
    
    
    6,403
    
    
    
    20,000
    
    
    
    19,554Mortgage-backed securities
    
    
    127,678
    
    
    
    127,852
    
    
    
    640
    
    
    
    638$
    167,648
    
    
    $
    168,500
    
    
    $
    62,257
    
    
    $
    61,044
 Securities with carrying values of $15.8 million and $7.7 million and fair
values of $16.3 million and $10.9 million at December 31, 2003 and 2002,
respectively, were pledged to secure public deposits as required by law.
Additionally, at December 31, 2003, securities with carrying values of $118.2
million and fair values of $120.0 million were pledged to secure both the
companys borrowings from the FHLB and a repurchase agreement. Page 59




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (4) LOANS Following is a summary of loans at December 31, 2003 and 2002: 2003
    
    2002(Amounts in thousands)Residential mortgage loans
    
    $
    150,312
    
    
    $
    118,572Commercial mortgage loans
    
    
    186,758
    
    
    
    137,812Construction loans
    
    
    71,908
    
    
    
    64,500Commercial and industrial loans
    
    
    87,127
    
    
    
    71,948Loans to individuals
    
    
    23,641
    
    
    
    29,106Total
    
    $
    519,746
    
    
    $
    421,938
 Loans are primarily made in the Piedmont area of North Carolina, principally
Forsyth, Guilford and Yadkin Counties. Real estate loans can be affected by
the condition of the local real estate market. Commercial and installment
loans can be affected by the local economic conditions. Included in
residential mortgage loans at December 31, 2003 and 2002 are loans held for
sale totaling approximately $1.1 million and $4.9 million, respectively. The following is a summary of nonperforming assets at December 31, 2003 and
2002: 2003
    
    2002(Amounts in thousands)Nonaccrual loans
    
    $
    769
    
    
    $
    1,823Foreclosed assets
    
    
    272
    
    
    
    383Total
    
    $
    1,041
    
    
    $
    2,206
 At December 31, 2003, the recorded investment in loans considered impaired in
accordance with SFAS No. 114 totaled $5.5 million, of which $769,000 consisted
of nonaccrual loans. The corresponding valuation allowance for the impaired
loans amounted to $1.45 million. For the year ended December 31, 2003, the
average recorded investment in impaired loans was approximately $1.6 million.
The amount of interest recognized on impaired loans during the portion of the
year that they were impaired was not material. At December 31, 2002, the recorded investment in loans considered impaired in
accordance with SFAS No. 114 totaled $1.8 million, all of which were nonaccrual
loans, with no corresponding valuation allowances. For the year ended December
31, 2002, the average recorded investment in impaired loans was approximately
$1.3. The amount of interest recognized on impaired loans during the portion
of the year that they were impaired was not material. The company has granted loans to certain directors and executive officers of
the company and their related interests. Such loans are made on substantially
the same terms, including interest rates and collateral, as those prevailing at
the time for comparable transactions with other borrowers and, in managements
opinion, do not involve more than the normal risk of collectibility. All loans
to directors and executive officers or their interests are submitted to the
Board of Directors for approval. A summary of loans to directors and their
interests follows (amounts in thousands): Loans to directors and officers as a group (12) at December 31, 2002
    
    $
    8,011Disbursements during year ended December 31, 2003
    
    
    16,067Amounts collected during year ended December 31, 2003
    
    
    (5,782
    )Loans to directors and officers as a group (12) at December 31, 2003
    
    $
    18,296
 At December 31, 2003, the company had pre-approved but unused lines of credit
totaling $2.7 million to executive officers, directors and their affiliates. Page 60




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (5) ALLOWANCE FOR LOAN LOSSES An analysis of the allowance for loan losses follows: 2003
    
    2002
    
    2001(Amounts in thousands)Balance at beginning of year
    
    $
    6,342
    
    
    $
    5,400
    
    
    $
    4,283Provision charged to operations
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320Charge-offs
    
    
    (1,420
    )
    
    
    (758
    )
    
    
    (1,247
    )Recoveries
    
    
    68
    
    
    
    45
    
    
    
    44Net charge-offs
    
    
    (1,352
    )
    
    
    (713
    )
    
    
    (1,203
    )Balance at end of year
    
    $
    7,275
    
    
    $
    6,342
    
    
    $
    5,400
 (6) PREMISES AND EQUIPMENT Following is a summary of premises and equipment at December 31, 2003 and 2002: 2003
    
    2002(Amounts in thousands)Land
    
    $
    3,214
    
    
    $
    2,874Buildings and leasehold improvements
    
    
    12,039
    
    
    
    11,052Furniture and equipment
    
    
    6,472
    
    
    
    5,19621,725
    
    
    
    19,122Less accumulated depreciation
    
    
    (4,388
    )
    
    
    (3,160
    )Total
    
    $
    17,337
    
    
    $
    15,962
 Depreciation and amortization amounting to $1.6 million in 2003, $1.2 million
in 2002, and $1.0 million in 2001 is included in occupancy and equipment
expense. (7) DEPOSITS Time deposits in denominations of $100,000 or more were approximately $182.2
million and $131.5 million at
December 31, 2003 and 2002, respectively. At December 31, 2003, the scheduled
maturities of certificates of deposit are as follows: $100,000
    
    Underand Over
    
    $100,000
    
    Total(Amounts in thousands)2004
    
    $
    120,802
    
    
    $
    143,876
    
    
    $
    264,6782005
    
    
    13,173
    
    
    
    10,968
    
    
    
    24,1412006
    
    
    14,872
    
    
    
    2,781
    
    
    
    17,6532007
    
    
    15,794
    
    
    
    2,747
    
    
    
    18,5412008
    
    
    12,521
    
    
    
    1,733
    
    
    
    14,254Thereafter
    
    
    5,007
    
    
    
    
    
    
    
    5,007Total
    
    $
    182,169
    
    
    $
    162,105
    
    
    $
    344,274
 Page 61




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (8) BORROWINGS The company has an $102.0 million credit line available with the Federal Home
Loan Bank for advances. These advances are secured by both loans with a
carrying value of $96.1 million and pledged investment securities with a market
value of $110.5 million. At December 31, 2003, the companys fixed rate Federal Home Loan Bank advances
of $96.5 million mature through 2013. At December 31, 2003 and 2002, the
interest rate on these advances ranged from 1.21% to 5.35% and from 1.51% to
5.35%, respectively. At December 31, 2003 and 2002, the weighted average
interest rates on the advances were 3.03% and 3.72%, respectively. The contractual maturities of the Federal Home Loan Bank advances at December
31, 2003 are as follows: 2003(Amounts in thousands)Due in 2004
    
    $
    30,500Due in 2005
    
    
    5,000Due in 2006
    
    
    Due in 2007
    
    
    10,000Due in 2008
    
    
    5,250Thereafter
    
    
    45,725$
    96,475
 In addition to the above advances, the company also has a repurchase agreement
with an outstanding balance of $10.0 million at December 31, 2003. Securities
sold under agreements to repurchase generally mature within ninety days from
the transaction date and are collateralized by U.S. Government Agency
obligations. The company has repurchase lines of credit of $100.0 million from
various institutions, which must be adequately collateralized. In addition to the above advances, the company has lines of credit of $27.0
million from various correspondent banks to purchase federal funds on a
short-term basis. The company has $11.4 million outstanding as of December 31,
2003. Aggregate borrowings at December 31, 2003 amounted to $117.9 million, including
$51.9 million that is due within one year and classified as short-term
borrowings and $66.0 million due after one year that is classified as long-term
debt in the accompanying consolidated balance sheet. Page 62




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (9) PREFERRED SECURITIES In November of 2003, Southern Community Capital Trust II (Trust II), a newly
formed subsidiary of the company, issued 3,450,000 Trust Preferred Securities
(Trust II Securities), generating total proceeds of $34.5 million. The Trust
II Securities pay distributions at an annual rate of 7.95% and mature on
December 31, 2033. The Trust II Securities began paying quarterly
distributions on December 31, 2003. The company has fully and unconditionally
guaranteed the obligations of Trust II. The Trust II Securities are redeemable
in whole or in part at any time after December 31, 2008. The proceeds from the
Trust II Securities were utilized to purchase convertible junior subordinated
debentures from us under the same terms and conditions as the Trust II
Securities. We have the right to defer payment of interest on the debentures
at any time and from time to time for a period not exceeding five years,
provided that no deferral period extend beyond the stated maturities of the
debentures. Such deferral of interest payments by the company will result in a
deferral of distribution payments on the related Trust II Securities. Should
we defer the payment of interest on the debentures, the company will be
precluded from the payment of cash dividends to shareholders. The principal
use of the net proceeds from the sale of the debentures was to provide cash for
the acquisition of The Community Bank, to increase our regulatory capital, and
to support the growth and operations of our subsidiary banks. The amount of
proceeds we count as Tier 1 capital cannot comprise more than 25% of our core
capital elements. Amounts in excess of that 25% limitation count as Tier 2
supplementary capital on our books. Prior to the closing of the acquisition of
The Community Bank on January 12, 2004, substantially all of the proceeds from
the Trust II Securities qualified as Tier 2 supplementary capital. Prior to
the redemption of the Trust I Securities, approximately $20 million of the
proceeds of the Trust II Securities counted as Tier 1 capital on our books.
After the redemption of the Trust I Securities on March 12, 2004, subject to
certain limitations, substantially all of the proceeds from the Trust II
Securities qualify as Tier 1 capital of the company for regulatory capital
purposes. In February of 2002, Southern Community Capital Trust I (Trust I), a newly
formed subsidiary of the company, issued 1,725,000 Cumulative Convertible Trust
Preferred Securities (Trust I Securities), generating total proceeds of $17.3
million. At December 31, 2003, holders of the Trust I Securities had
voluntarily converted $175,000 of the Trust I Securities into 21,187 shares of
our common stock at the Conversion Price of $8.26 per share of our common
stock. On January 14, 2004, we announced the redemption of all of the Trust I
Securities. We redeemed the Trust I Securities under a provision that
permitted us to redeem the Trust I Securities in whole at any time prior to
March 31, 2007 once the trading price of our common stock had been at least
125% of the Conversion Price for a period of twenty consecutive trading days
ending within five days of the date that we gave notice of redemption. The
Trust I Securities were redeemed on March 12, 2004, which resulted in the
issuance of 2,060,000 shares of our common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. The
Trust I Securities paid distributions at an annual rate of 7.25%. The Trust I
Securities began paying quarterly distributions on March 31, 2002. The company
had fully and unconditionally guaranteed the obligations of Trust I. The
proceeds from the Trust I Securities were utilized to purchase convertible
junior subordinated debentures from us under the same terms and conditions as
the Trust I Securities. Subject to certain limitations, the Trust I Securities
qualified as Tier 1 capital of the company for regulatory capital purposes.
The principal use of the net proceeds from the sale of the convertible
debentures was to infuse capital into our bank subsidiary, Southern Community
Bank and Trust, to fund its operations and continued expansion, and to maintain
the companys and the banks status as well capitalized under regulatory
guidelines. A description of the trust preferred outstanding at December 31, 2003 and 2003
is as follows (in thousands): Carrying value atShares
    
    Interest
    
    Maturity
    
    December 31,Issuing Entity
    
    outstanding
    
    Rate
    
    date
    
    2003
    
    2002Southern Community Capital Trust I
    
    
    1,707,500
    
    
    
    7.25
    %
    
    
    12/31/33
    
    
    $
    17,075
    
    
    $
    17,250Southern Community Capital Trust II
    
    
    3,450,000
    
    
    
    7.95
    %
    
    
    3/31/32
    
    
    
    34,577
    
    
    
    51,652
    
    
    
    17,250
 Page 63




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (10) EMPLOYEE AND DIRECTOR BENEFIT PLANS 401(k) Retirement Plan The company maintains a 401(k) retirement plan that covers all eligible
employees. The company matches 100% of employee contributions, with the
companys contribution limited to 6% of each employees salary. Matching
contributions are funded when accrued. Matching expenses totaled approximately
$355,000 in 2003, $315,000 in 2002, and $240,000 in 2001. Employment Agreements The company has entered into employment agreements with its chief executive
officer and two other executive officers to ensure a stable and competent
management base. The agreements provide for a three-year term, but the
agreements may annually be extended for an additional year. The agreements
provide for benefits as spelled out in the contracts and cannot be terminated
by the Board of Directors, except for cause, without prejudicing the officers
rights to receive certain vested benefits, including compensation. In the
event of a change in control of the company, as outlined in the agreements, the
acquirer will be bound to the terms of the contracts. Termination Agreements The company has entered into special termination agreements with substantially
all other employees, who have completed one year of service, which provide for
severance pay benefits in the event of a change in control of the company which
results in the termination of such employee or diminished compensation, duties
or benefits. Supplemental Retirement The company during 2001 implemented a non-qualifying deferred compensation plan
for certain key executive and senior officers. The company has purchased life
insurance policies on the participating officers in order to provide future
funding of benefit payments. Benefits will accrue during employment based upon
the performance of the underlying life insurance policies both during
employment and after retirement. Such benefits will continue to accrue and be
paid throughout each participants life assuming satisfactory performance of
the funding life insurance policies. The plan also provides for payment of
death or disability benefits in the event a participating officer becomes
permanently disabled or dies prior to attainment of retirement age. Provisions
of $217,000 in 2003, $142,000 in 2002 and $58,000 in 2001 were expensed for
future benefits to be provided under this plan. The corresponding liability
related to this plan was $384,000 and $200,000 as of December 31, 2003 and
2002, respectively. Employee Stock Purchase Plan On December 19, 2002, the Board approved the creation of, and on February 20,
2003 the Board adopted, subject to shareholder approval, the 2002 Employee
Stock Purchase Plan (the 2002 ESPP). An aggregate of 1,000,000 shares of
common stock of the company has been reserved for issuance by the company upon
exercise of options to be granted from time to time under the 2002 ESPP. The
purpose of the 2002 ESPP is to provide employees of the company with an
opportunity to purchase shares of the common stock of the company in order to
encourage employee participation in the ownership and economic success of the
company. The 2002 ESPP provides employees of the company the right to purchase,
annually, shares of the companys common stock at 85% of fair market value.
The number of shares that can be purchased in any calendar year by any
individual is limited to the lesser of: (1) shares with a fair market value of
$25,000; or (2) shares with a fair market value of 20% of the individuals
annual compensation. Shares purchased through the 2002 ESPP must be held by
the employee for one year, after which time the employee is free to dispose of
the stock. Page 64




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (10) EMPLOYEE AND DIRECTOR BENEFIT PLAN (Continued) Stock Option Plans During 1997 the company adopted, with stockholder approval, the 1997 Incentive
Stock Option Plan and the 1997 Nonstatutory Stock Option Plan. Both plans were
amended in 2000 and in 2001, with stockholder approval, to increase the number
of shares available for grant. Each of these plans makes available options to
purchase 875,253 shares of the companys common stock. During 2002 the company
adopted, with stockholder approval in 2003, the 2002 Incentive Stock Option
Plan with 350,000 options available and the 2002 Nonstatutory Stock Option Plan
with 150,000 options available. The aggregate number of shares available for
issuance pursuant to options is 2,250,506. The exercise price of all options
granted to date is the fair value of the companys common shares on the date of
grant. All options vest over a five-year period. All unexercised options
expire ten years after the date of grant. A summary of the companys option
plans and stock purchase plan as of and for the years ended December 31, 2003,
2002 and 2001, reflecting the effects of stock splits and dividends declared,
including the 5% stock dividend declared and distributed in 2002, is as
follows: Outstanding Options
    
    Exercisable OptionsShares
    
    
    
    
    
    Weighted
    
    
    
    
    
    WeightedAvailable
    
    
    
    
    
    Average
    
    
    
    
    
    Averagefor Future
    
    Number
    
    Exercise
    
    Number
    
    ExerciseGrants
    
    Outstanding
    
    Price
    
    Outstanding
    
    PriceAt December 31, 2000
    
    
    94,285
    
    
    
    1,372,394
    
    
    $
    4.80
    
    
    
    843,116
    
    
    $
    4.38Options authorized
    
    
    132,917
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted/vested
    
    
    (91,061
    )
    
    
    91,061
    
    
    
    5.18
    
    
    
    311,624
    
    
    
    4.44Options exercised
    
    
    
    
    
    
    (20,055
    )
    
    
    4.00
    
    
    
    (20,055
    )
    
    
    4.00Options forfeited
    
    
    63,184
    
    
    
    (63,184
    )
    
    
    6.18
    
    
    
    (23,381
    )
    
    
    5.08At December 31, 2001
    
    
    199,325
    
    
    
    1,380,216
    
    
    
    4.77
    
    
    
    1,111,304
    
    
    
    4.39Options authorized
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted/vested
    
    
    (124,950
    )
    
    
    124,950
    
    
    
    6.66
    
    
    
    182,830
    
    
    
    5.77Options exercised
    
    
    
    
    
    
    (21,097
    )
    
    
    3.64
    
    
    
    (21,097
    )
    
    
    3.64Options forfeited
    
    
    48,940
    
    
    
    (48,940
    )
    
    
    6.49
    
    
    
    (13,808
    )
    
    
    5.33At December 31, 2002
    
    
    123,315
    
    
    
    1,435,129
    
    
    
    4.88
    
    
    
    1,259,229
    
    
    
    4.59Options authorized
    
    
    500,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted/vested
    
    
    (150,000
    )
    
    
    150,000
    
    
    
    8.45
    
    
    
    104,187
    
    
    
    7.85Options exercised
    
    
    
    
    
    
    (173,926
    )
    
    
    5.32
    
    
    
    (173,926
    )
    
    
    5.32Options forfeited
    
    
    39,192
    
    
    
    (39,192
    )
    
    
    8.55
    
    
    
    (39,192
    )
    
    
    8.55At December 31, 2003
    
    
    512,507
    
    
    
    1,372,011
    
    
    $
    5.35
    
    
    
    1,150,298
    
    
    $
    4.79
 Page 65




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (10) EMPLOYEE AND DIRECTOR BENEFIT PLAN (Continued) Stock Option Plans (Continued) The weighted average remaining life of options outstanding at December 31, 2003
is 5 years. The range of exercise prices for options outstanding at December
31, 2003 is $3.44 to $12.16. Information pertaining to options outstanding at
December 31, 2003 is as follows: Number of
    
    Number ofRange of Exercise Prices
    
    Options Outstanding
    
    Options Exercisable$3.44 - $6.66
    
    
    1,071,660
    
    
    
    1,003,459$6.85 - $8.90
    
    
    152,561
    
    
    
    93,332$9.25 - $12.16
    
    
    147,790
    
    
    
    53,507Outstanding at end of year
    
    
    1,372,011
    
    
    
    1,150,298
 The estimated per share fair value of options granted, together with the
assumptions used in estimating those fair values, are displayed below: 2003
    
    2002
    
    2001Estimated fair value of options granted
    
    $
    4.54
    
    
    $
    2.30
    
    
    $
    2.35Assumptions in estimating option values:Risk-free interest rate
    
    
    3.00
    %
    
    
    3.50
    %
    
    
    4.00
    %Dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Volatility
    
    
    39.00
    %
    
    
    22.00
    %
    
    
    18.00
    %Expected life
    
    7 years
    
    7 years
    
    7 years
 (11) LEASES The company leases office space under non-cancelable operating leases. Future
minimum lease payments under these leases for the years ending December 31 are
as follows (amounts in thousands): 2004
    
    $
    3522005
    
    
    3212006
    
    
    2732007
    
    
    2272008
    
    
    212Thereafter
    
    
    566Total
    
    $
    1,951
 Total rental expense under operating leases was $414,000 in 2003, $461,000 in
2002, and $427,000 in 2001. Page 66




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (12) INCOME TAXES The significant components of the provision for income taxes for the years
ended December 31, 2003, 2002 and 2001 are as follows: 2003
    
    2002
    
    2001(Amounts in thousands)Current tax provision:Federal
    
    $
    1,952
    
    
    $
    2,074
    
    
    $
    1,151State
    
    
    377
    
    
    
    133
    
    
    
    872,329
    
    
    
    2,207
    
    
    
    1,238Deferred tax provision:Federal
    
    
    (231
    )
    
    
    (380
    )
    
    
    (80
    )State
    
    
    (126
    )
    
    
    (72
    )
    
    
    (11
    )(357
    )
    
    
    (452
    )
    
    
    (91
    )Net provision for income taxes
    
    $
    1,972
    
    
    $
    1,755
    
    
    $
    1,147
 The difference between the provision for income taxes and the amounts computed
by applying the statutory federal income tax rate of 34% to income before
income taxes is summarized below: 2003
    
    2002
    
    2001(Amounts in thousands)Tax computed at the statutory federal rate
    
    $
    1,915
    
    
    $
    1,689
    
    
    $
    1,106Increase (decrease) resulting from:State income taxes, net of federal benefit
    
    
    166
    
    
    
    40
    
    
    
    50Tax exempt income
    
    
    (77
    )
    
    
    (75
    )
    
    
    (49
    )Other permanent differences
    
    
    (32
    )
    
    
    101
    
    
    
    4057
    
    
    
    66
    
    
    
    41Provision for income taxes included in operations
    
    $
    1,972
    
    
    $
    1,755
    
    
    $
    1,147
 Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of deferred taxes at December 31, 2003 and 2002 are as follows: 2003
    
    2002(Amounts in thousands)Deferred tax assets relating to:Allowance for loan losses
    
    $
    2,682
    
    
    $
    2,287Deferred compensation
    
    
    148
    
    
    
    77Other
    
    
    120
    
    
    
    60Total deferred tax assets
    
    
    2,950
    
    
    
    2,424Deferred tax liabilities relating to:Property and equipment
    
    
    (436
    )
    
    
    (304
    )Loan fees and costs
    
    
    (356
    )
    
    
    (299
    )Other comprehensive income
    
    
    (643
    )
    
    
    (1,526
    )Other
    
    
    (5
    )
    
    
    (25
    )Total deferred tax liabilities
    
    
    (1,440
    )
    
    
    (2,154
    )Net recorded deferred tax asset
    
    $
    1,510
    
    
    $
    270
 The company has no valuation allowance at December 31, 2003 or 2002 because
management has determined that it is more likely than not that the results of
future operations will generate sufficient taxable income to realize the
deferred tax assets. Page 67




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (13) NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE The major components of non-interest income for the years ended December 31,
2003, 2002 and 2001 are as follows: 2003
    
    2002
    
    2001(Amounts in thousands)Service charges and fees on deposit accounts
    
    $
    1,442
    
    
    $
    1,121
    
    
    $
    879Presold mortgage loan fees
    
    
    1,350
    
    
    
    1,310
    
    
    
    1,009Investment brokerage fees
    
    
    947
    
    
    
    333
    
    
    
    193SBIC management fees
    
    
    562
    
    
    
    542
    
    
    
    564Income from derivative
    
    
    
    
    
    
    
    
    
    
    383Gain on sale of investment securities
    
    
    
    
    
    
    70
    
    
    
    Other
    
    
    684
    
    
    
    551
    
    
    
    374Total
    
    $
    4,985
    
    
    $
    3,927
    
    
    $
    3,402
 The major components of other non-interest expense for the years ended December
31, 2003, 2002 and 2001 are as follows: 2003
    
    2002
    
    2001(Amounts in thousands)Postage, printing and office supplies
    
    $
    383
    
    
    $
    313
    
    
    $
    339Advertising and promotion
    
    
    862
    
    
    
    566
    
    
    
    519Data processing and other outsourced services
    
    
    1,317
    
    
    
    1,177
    
    
    
    1,033Professional services
    
    
    706
    
    
    
    260
    
    
    
    341Other
    
    
    2,417
    
    
    
    2,199
    
    
    
    1,353Total
    
    $
    5,685
    
    
    $
    4,515
    
    
    $
    3,585
 (14) REGULATORY MATTERS The bank, as a North Carolina banking corporation, may pay cash dividends to
the company only out of undivided profits as determined pursuant to North
Carolina banking laws. However, regulatory authorities may limit payment of
dividends by any bank when it is determined that such limitation is in the
public interest and is necessary to ensure financial soundness of the bank. The bank is subject to various regulatory capital requirements administered by
federal and state banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory - and possibly additional
discretionary - actions by regulators that, if undertaken, could have a direct
material effect on the companys consolidated financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the bank must meet specific capital guidelines that involve
quantitative measures of the banks assets, liabilities, and certain
off-balance-sheet items as calculated under regulatory accounting practices.
The banks capital amounts and classifications are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors. Page 68




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SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (14) REGULATORY MATTERS (Continued) Quantitative measures established by regulation to ensure capital adequacy
require the bank to maintain minimum amounts and ratios, as prescribed by
regulations, of total and Tier I capital to risk-weighted assets and of Tier I
capital to average assets. As of December 31, 2003 and 2002, the most recent
notification from the FDIC categorized the bank as well capitalized under the
regulatory framework for prompt correction action. To be categorized as well
capitalized, the bank must maintain minimum amounts and ratios, as set forth in
the table below. There are no conditions or events since that notification
that management believes have changed the banks category. Information
regarding the banks capital and capital ratios is set forth below: Minimum To Be WellMinimum For Capital
    
    Capitalized Under PromptActual
    
    Adequacy Purposes
    
    Corrective Action ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(Dollars in thousands)As of December 31, 2003:Total Capital (to Risk-Weighted Assets)
    
    $
    64,828
    
    
    
    10.66
    %
    
    $
    48,670
    
    
    
    8.00
    %
    
    $
    60,838
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    57,553
    
    
    
    9.46
    %
    
    
    24,335
    
    
    
    4.00
    %
    
    
    36,503
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    57,553
    
    
    
    7.50
    %
    
    
    30,710
    
    
    
    4.00
    %
    
    
    38,387
    
    
    
    5.00
    %As of December 31, 2002:Total Capital (to Risk-Weighted Assets)
    
    $
    60,563
    
    
    
    12.23
    %
    
    $
    39,601
    
    
    
    8.00
    %
    
    $
    49,501
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    54,373
    
    
    
    10.98
    %
    
    
    19,800
    
    
    
    4.00
    %
    
    
    29,701
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    54,373
    
    
    
    8.95
    %
    
    
    24,314
    
    
    
    4.00
    %
    
    
    30,392
    
    
    
    5.00
    %
 The company is also subject to these capital requirements. At December 31,
2003, the companys total capital to risk-weighted assets, Tier I capital to
risk-weighted assets and Tier I capital to average assets were 17.74%, 10.85%
and 8.63%, respectively. (15) DERIVATIVES Derivative Financial Instruments The company has stand-alone derivative financial instruments in the form of
interest rate swap agreements, which derive their value from underlying
interest rates. These transactions involve both credit and market risk. The
notional amounts are amounts on which calculations, payments, and the value of
the derivative are based. Notional amounts do not represent direct credit
exposures. Direct credit exposure is limited to the net difference between the
calculated amounts to be received and paid, if any. Such difference, which
represents the fair value of the derivative instruments, is reflected on the
companys consolidated balance sheets as derivative assets and derivative
liabilities. The company is exposed to credit-related losses in the event of nonperformance
by the counterparties to these agreements. The company controls the credit
risk of its financial contracts through credit approvals, limits and monitoring
procedures, and does not expect any counterparties to fail their obligations.
The company deals only with primary dealers. Derivative instruments are generally either negotiated OTC contracts or
standardized contracts executed on a recognized exchange. Negotiated OTC
derivative contracts are generally entered into between two counterparties that
negotiate specific agreements terms, including the underlying instruments,
amount, exercise prices and maturity. Page 69




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2003, 2002 and 2001 (15) DERIVATIVES (Continued) Risk Management Policies - Hedging Instruments The primary focus of the companys asset/liability management program is to
monitor the sensitivity of the companys net portfolio value and net income
under varying interest rate scenarios to take steps to control its risks. On a
quarterly basis, the company simulates the net portfolio value and net income
expected to be earned over a twelve-month period following the date of
simulation. The simulation is based on a projection of market interest rates
at varying levels and estimates the impact of such market rates on the levels
of interest-earning assets and interest-bearing liabilities during the
measurement period. Based upon the outcome of the simulation analysis, the
company considers the use of derivatives as a means of reducing the volatility
of net portfolio value and projected net income within certain ranges of
projected changes in interest rates. The company evaluates the effectiveness
of entering into any derivative instrument agreement by measuring the cost of
such an agreement in relation to the reduction in net portfolio value and net
income volatility within an assumed range of interest rates. Interest
Rate Risk Management - Cash Flow Hedging Instruments The company originates variable rate loans for its loan portfolio. These loans
expose the company to variability in interest receipts due to changes to
interest rates. If interest rates increase, interest income increases.
Conversely, if interest rates decrease, interest income decreases. Management
believes it is prudent to limit the variability of a portion of its interest
receipts and therefore, generally hedges a portion of its variable-rate
interest receipts. To meet this objective, management enters into interest
rate swap agreements whereby the company receives fixed rate payments and makes
variable interest rate payments during the contract period. At December 31, 2003, the information pertaining to outstanding interest rate
swap agreements used to hedge variable rate loans is as follows (amounts in
thousands): 2003
    
    2002Notional amount
    
    $
    10,000
    
    
    $
    35,000Weighted average pay rate
    
    
    4.00
    %
    
    
    4.25
    %Weighted average receive rate
    
    
    6.21
    %
    
    
    6.46
    %Weighted average maturity in years
    
    
    .3
    
    
    
    2.2Unrealized gain relating to interest rate swaps
    
    $
    111
    
    
    $
    1,253Deferred gain from early termination
    
    $
    701
    
    
    $
    156
 These agreements require the company to make payments at a variable rate
determined by a specified index (prime) in exchange for receiving payments at a
fixed rate. At December 31, 2003 and 2002, the companys interest rate swaps used to hedge
variable rate loans reflected an unrealized gain of $812,000 and $1.4 million,
respectively, which included deferred gains from the early termination of
interest rate swaps in the amount of $701,000 and $156,000, respectively. The
unrealized gain is included in other comprehensive income, net of tax, in the
accompanying consolidated balance sheets. The recognized portion of the gains
from early termination, which was $406,000 for 2003 and $52,000 for 2002, is
included in interest income in the accompanying consolidated statements of
operations. The unrecognized gain at December 31, 2003 will be included in
income over an eighteen-month period, with $482,000 expected to be recognized
in income in 2004. Risk management results for the years ended December 31, 2003 and 2002 related
to the balance sheet hedging of variable rate loans indicate that the hedges
were 100% effective and that there was no component of the derivative
instruments gain or loss which was excluded from the assessment of hedge
effectiveness. At December 31, 2003, the unrealized gain relating to use of interest rate
swaps was recorded in other assets. Page 70




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (15) DERIVATIVES (Continued) Interest Rate Risk Management - Cash Flow Hedging Instruments (Continued) Late in 2000, the company purchased an off-balance sheet financial contract, an
interest rate floor, to assist in managing interest rate risk. During 2001,
the company sold the interest rate floor. The company recognized income
aggregating $383,000 on this floor contract in 2001, including the gain
realized upon its disposal, in non-interest income. Interest Rate Risk Management - Fair Value Hedging Instruments During 2003, the company utilized fixed rate time deposits and trust preferred
securities for use in the companys lending and investment activities and other
general purposes. These debt obligations expose the company to variability in
their fair value due to changes in the level of interest rates. Management
believes that it is prudent to limit the variability in the fair value of a
portion of its fixed-rate funding. It is the companys objective to hedge the
change in fair value of fixed-rate funding coverage levels that are
appropriate, given anticipated or existing interest rate levels and other
market considerations, as well as the relationship of change in this liability
to other liabilities of the company. To meet this objective, the company
utilizes interest rate swaps as an asset/liability management strategy to hedge
the change in value of the funding due to changes in expected interest rate
assumptions. These interest rate swap agreements are contracts to make a
series of floating rate payments determined by a specified index (LIBOR) in
exchange for receiving a series of fixed rate payments. Although the company
hedges the change in value of its fixed-rate funding, its hedge coverage ratio
does not equate to 100%. The company believes it is economically prudent to
keep hedge coverage ratios at acceptable risk levels, which may vary depending
on current and expected interest rate movement. At December 31, 2003, the
ineffective portion of the fair value hedge amounted to $4,000 and is included
in non-interest income. At December 31, 2003, the information pertaining to outstanding interest rate
swap agreements used to hedge fixed-rate funding is as follows (amounts in
thousands): Notional amount
    
    $
    41,000Weighted average pay rate
    
    
    2.15
    %Weighted average receive rate
    
    
    5.22
    %Weighted average maturity in years
    
    
    16.9Unrealized loss relating to interest rate swaps
    
    $
    140
 No interest rate swap agreements used to hedge fixed-rate funding were terminated during 2003. At December 31, 2003, the unrealized loss relating to
use of interest rate swaps was recorded in other assets. (16) OFF-BALANCE SHEET RISK The company is a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amount recognized in the balance
sheets. The contract or notional amounts of those instruments reflect the
extent of involvement the company has in particular classes of financial
instruments. The company uses the same credit policies in making commitments
and conditional obligations as it does for on-balance-sheet instruments. Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of conditions established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Since some of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The company evaluates each customers
creditworthiness on a case-by-case basis. The amount of collateral obtained,
if deemed necessary by the company, upon extension of credit is based on
managements credit evaluation of the borrower. Collateral obtained varies but
may include real estate, stocks, bonds, and certificates of deposit. Page 71




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (16) OFF-BALANCE SHEET RISK (Continued) A summary of the contract amount of the companys exposure to off-balance sheet
risk as of December 31, 2003 and 2002 is as follows (amounts in thousands): 2003
    
    2002Financial instruments whose contract amounts represent credit risk:Loan commitments and undisbursed lines of credit
    
    $
    146,414
    
    
    $
    99,706Undisbursed standby letters of credit
    
    
    4,749
    
    
    
    11,090Construction contracts outstanding
    
    
    
    
    
    
    445
 (17) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS Financial instruments include cash and due from banks, federal funds sold,
investment securities, loans, bank-owed life insurance, deposit accounts and
other borrowings, accrued interest and derivatives. Fair value estimates are
made at a specific moment in time, based on relevant market information and
information about the financial instrument. These estimates do not reflect any
premium or discount that could result from offering for sale at one time the
companys entire holdings of a particular financial instrument. Because no
active market readily exists for a portion of the companys financial

instruments, fair value estimates are based on judgments regarding future
expected loss experience, current economic conditions, risk characteristics of
various financial instruments, and other factors. These estimates are
subjective in nature and involve uncertainties and matters of significant
judgment and, therefore, cannot be determined with precision. Changes in
assumptions could significantly affect the estimates. The following methods and assumptions were used to estimate the fair value of
each class of financial instruments for which it is practicable to estimate
that value: Cash and Due from Banks, and Federal Funds Sold The carrying amounts for cash and due from banks, and federal funds sold
approximate fair value because of the short maturities of those
instruments. Investment Securities Fair value for investment securities equals quoted market price if such
information is available. If a quoted market price is not available,
fair value is estimated using quoted market prices for similar
securities. Loans For certain homogenous categories of loans, such as residential
mortgages, fair value is estimated using the quoted market prices for
securities backed by similar loans, adjusted for differences in loan
characteristics. The fair value of other types of loans is estimated by
discounting the future cash flows using the current rates at which
similar loans would be made to borrowers with similar credit ratings and
for the same remaining maturities. Investment in Bank-Owned Life Insurance The carrying value of bank-owned life insurance approximates fair value
because this investment is carried at cash surrender value, as
determined by the insurer. Page 72




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (17) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued) Deposits The fair value of demand deposits is the amount payable on demand at the
reporting date. The fair value of time deposits is estimated based on
discounting expected cash flows using the rates currently offered for
deposits of similar remaining maturities. Borrowings The fair values are based on discounting expected cash flows at the
interest rate for debt with the same or similar remaining maturities and
collected requirements. Accrued Interest The carrying amounts of accrued interest approximate fair value. Derivative financial instruments Fair values for interest rate swap agreements are based upon the amounts
required to settle the contracts. Fair values for on-balance-sheet
commitments to originate loans held for sale are based on fees currently
charged to enter into similar agreements, and for fixed-rate commitments
also consider the difference between current levels of interest rates
and the committed rates. Financial Instruments with Off-Balance Sheet Risk With regard to financial instruments with off-balance sheet risk
discussed in Note 16, it is not practicable to estimate the fair value
of future financing commitments. The carrying amounts and estimated fair values of the companys financial
instruments, none of which are held for trading purposes, are as follows at
December 31, 2003 and 2002: 2003
    
    2002Carrying
    
    Estimated
    
    Carrying
    
    Estimatedamount
    
    fair value
    
    amount
    
    fair value(In thousands)Financial assets:Cash and due from banks
    
    $
    22,929
    
    
    $
    22,929
    
    
    $
    16,632
    
    
    $
    16,632Federal funds sold
    
    
    271
    
    
    
    271
    
    
    
    11,084
    
    
    
    11,084Investment securities available for sale
    
    
    168,500
    
    
    
    168,500
    
    
    
    96,930
    
    
    
    96,930Investment securities held to maturity
    
    
    62,257
    
    
    
    61,044
    
    
    
    44,749
    
    
    
    45,319Loans, net
    
    
    512,471
    
    
    
    513,566
    
    
    
    415,596
    
    
    
    416,631Investment in life insurance
    
    
    2,895
    
    
    
    2,895
    
    
    
    2,751
    
    
    
    2,751Accrued interest receivable
    
    
    3,430
    
    
    
    3,430
    
    
    
    3,269
    
    
    
    3,269Financial liabilities:Deposits
    
    
    575,218
    
    
    
    575,885
    
    
    
    449,216
    
    
    
    449,481Short-term borrowings
    
    
    51,900
    
    
    
    51,900
    
    
    
    40,706
    
    
    
    40,706Long-term debt
    
    
    65,975
    
    
    
    64,741
    
    
    
    55,000
    
    
    
    53,393Trust preferred securities
    
    
    51,652
    
    
    
    60,311
    
    
    
    17,250
    
    
    
    18,458Accrued interest payable
    
    
    1,324
    
    
    
    1,324
    
    
    
    1,019
    
    
    
    1,019On-balance sheet derivative financial instruments:Interest rate swap agreements:Assets, net
    
    
    (29
    )
    
    
    (29
    )
    
    
    1,253
    
    
    
    1,253
 Page 73




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (18) PARENT COMPANY FINANCIAL DATA Southern Community Financial Corporations condensed balance sheets as of
December 31, 2003 and 2002, and its related condensed statements of operations
and cash flows for each of the years in the three-year period ended December
31, 2003 are as follows: Condensed Balance Sheets
December 31, 2003 and 2002
(Amounts in thousands) 2003
    
    2002Asset:Cash and due from banks
    
    $
    384
    
    
    $
    67Investment in subsidiaries
    
    
    58,574
    
    
    
    56,835Receivable from subsidiaries
    
    
    39,000
    
    
    
    6,320Investment securities available for sale
    
    
    70
    
    
    
    70Other assets
    
    
    6,116
    
    
    
    2,031Total assets
    
    $
    104,144
    
    
    $
    65,323Liabilities:Junior subordinated debentures
    
    $
    53,253
    
    
    $
    17,784Stockholders equity:Common stock
    
    
    44,378
    
    
    
    43,123Retained earnings
    
    
    5,492
    
    
    
    1,830Accumulated other comprehensive income
    
    
    1,021
    
    
    
    2,586Total stockholders equity
    
    
    50,891
    
    
    
    47,539Total liabilities and stockholders equity
    
    $
    104,144
    
    
    $
    65,323
 Condensed Statements of Operations
Years Ended December 31, 2003, 2002 and 2001
(Amounts in thousands) 2003
    
    2002
    
    2001Equity in income of subsidiaries
    
    $
    4,634
    
    
    $
    3,890
    
    
    $
    2,105Interest income
    
    
    232
    
    
    
    171
    
    
    
    Other income
    
    
    4
    
    
    
    90
    
    
    
    Interest expense
    
    
    (1,543
    )
    
    
    (1,131
    )
    
    
    Other expense
    
    
    (312
    )
    
    
    (154
    )
    
    
    Income tax benefit
    
    
    648
    
    
    
    348
    
    
    
    Net income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105
 Page 74




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (18) PARENT COMPANY FINANCIAL DATA (Continued) Condensed Statements of Cash Flows
Years Ended December 31, 2003 and 2002
(Amounts in thousands) 2003
    
    2002
    
    2001Operating activities:Net income
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105Equity in income of subsidiaries
    
    
    (4,634
    )
    
    
    (3,890
    )
    
    
    (2,105
    )Amortization of debt issuance costs
    
    
    44
    
    
    
    33
    
    
    
    Increase in receivable from subsidiaries
    
    
    (31,350
    )
    
    
    (316
    )
    
    
    Increase in other assets
    
    
    (1,468
    )
    
    
    (203
    )
    
    
    (33,745
    )
    
    
    (1,162
    )
    
    
    Investing activities:Investment in subsidiaries
    
    
    
    
    
    
    (14,716
    )
    
    
    Purchase of investments
    
    
    
    
    
    
    (70
    )
    
    
    
    
    
    
    (14,786
    )
    
    
    Financing activities:Proceeds from junior subordinated debentures,
net of debt issuance costs
    
    
    33,292
    
    
    
    15,923
    
    
    
    Proceeds from exercise of stock options
    
    
    770
    
    
    
    105
    
    
    
    Cash paid in lieu of fractional shares on
5% stock dividend
    
    
    
    
    
    
    (13
    )
    
    
    34,062
    
    
    
    16,015
    
    
    
    Net increase in cash
    
    
    317
    
    
    
    67
    
    
    
    Cash, beginning of year
    
    
    67
    
    
    
    
    
    
    
    Cash, end of year
    
    $
    384
    
    
    $
    67
    
    
    $
    
 (19) SUBSEQUENT EVENTS (unaudited) On July 30, 2003, the company and The Community Bank jointly announced the
execution of a definitive agreement in which Southern Community Financial
Corporation would acquire The Community Bank of Pilot Mountain, North Carolina
in a fixed exchange of cash and stock. The Community Bank, founded in 1987
operates 10 community-banking offices throughout Surry, Rockingham, Stokes,
Iredell and Yadkin counties of North Carolina. On December 11, 2003,
shareholders approved the transaction allowing Southern Community Financial
Corporation to acquire The Community Bank. On January 12, 2004, the
acquisition was completed. For each share of stock owned, The Community Bank
shareholders receive $53.05 in cash, 4.8714 shares of newly issued Southern
Community common stock or a combination of both, subject to an overall
allocation of approximately 6.4 million shares of common stock and $15.2
million in cash. As a result of the acquisition, consolidated assets for the
company reached $1.1 billion, with $120 million of shareholders equity, and
approximately $48 million of goodwill was created. Page 75




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003, 2002 and 2001 (19) SUBSEQUENT EVENTS (unaudited) (Continued) On January 14, 2004, the company announced the redemption of all of its 7.25%
Cumulative Convertible Trust Preferred Securities issued through Southern
Community Capital Trust I under the provision that the trading price of our
common stock had been at least 125% of the conversion price for a period of
twenty consecutive trading days ending within five days of the notice of
redemption. The Securities were redeemed on March 12, 2004 which resulted in
the issuance of 2,060,000 shares of common stock through the conversions and
the retirement of $61,000 of the convertible trust preferred securities. On
January 14, 2004, the company announced the declaration of its first annual
cash dividend of $0.11 per share of its common stock which was paid on March
15, 2004, to shareholders of record on February 20, 2004. Page 76




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##### 



Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure None. 
 PART III 
 Item 10. Directors and Executive Officers of the Registrant Incorporated by reference from the companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 13, 2004. 
 Item 11. Executive Compensation Incorporated by reference from the companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 13, 2004. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated by reference from the companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 13, 2004. The following table sets forth equity compensation plan information at December
31, 2003. Equity Compensation Plan Information Number of securitiesNumber of securities
    
    
    
    
    
    remaining available forto be issued
    
    Weighted-average
    
    future issuance underupon exercise of
    
    exercise price of
    
    equity compensation plansoutstanding options,
    
    outstanding options,
    
    (excluding securitiesPlan Category
    
    warrants and rights
    
    warrants and rights
    
    reflected in column(a))(a)
    
    (b)
    
    (c)Equity compensation
plans approved by
security holdersStock Option Plans
    
    
    1,372,011
    
    
    $
    5.35
    
    
    
    512,524Employee Stock
Purchase Plan
    
    
    20,000
    
    
    $
    7.65
    
    
    
    980,000Equity compensation
plans not approved
by security holders
    
    NA
    
    NA
    
    NATotal
    
    
    1,392,011
    
    
    $
    5.39
    
    
    
    1,492,524
 
 Item 13. Certain Relationships and Related Transactions Incorporated by reference from the companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 13, 2004. 
 Item 14. Principal Accountant Fees and Services Incorporated by reference from the companys definitive proxy statement, to be
filed with the Securities and Exchange Commission with respect to the Annual
Meeting of Shareholders to be held on May 13, 2004. Page 77




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##### 



PART IV 
 Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K  (a)(1)
    
    Financial Statements. The following financial statements and
supplementary data are included in Item 8 of this report. Financial Statements
    
    Form 10-K PageIndependent Auditors Report
    
    
    46Consolidated Balance Sheets as of December 31, 2003 and 2002
    
    
    47Consolidated Statements of Operations for the years ended
December 31, 2003, 2002 and 2001
    
    
    48Consolidated Statements of Comprehensive Income for the years ended
December 31, 2003, 2002 and 2001
    
    
    49Consolidated Statements of Changes in Stockholders Equity for the years ended
December 31, 2003, 2002 and 2001
    
    
    50Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001
    
    
    51Notes to Consolidated Financial Statements
    
    
    52-76
  (a)(2)
    
    Financial Statement Schedules. All applicable financial statement
schedules required under Regulation S-X
have been included in the Notes to the Consolidated Financial
Statements.  (a)(3)
    
    Exhibits. The exhibits required by Item 601 of Regulation S-K are listed below. Exhibit No.
    
    DescriptionExhibit 3.1:
    
    Articles of Incorporation (incorporated by reference to Exhibit
3(i) to the Current Report on Form
8K dated October 1, 2001)Exhibit 3.2:
    
    Bylaws (incorporated by reference to Exhibit 3(ii) to the Current Report on Form 8K dated October 1, 2001)Exhibit 3.3:
    
    Amendment to Articles of Incorporation (incorporated by reference to Exhibit 3.3 to the Annual Report on Form
10K for the year ended December 31, 2001 (2001 Annual Report))Exhibit 4.1:
    
    Specimen certificate for Common Stock of Southern Community Financial Corporation (incorporated by reference to
Exhibit 4 to the Current Report on Form 8K dated October 1, 2001)Exhibit 4.2:
    
    Form of 7.25% Convertible Junior Subordinated Debenture (incorporated by reference to Exhibit 4.2 to the
Registration Statement on Form S-2 dated November 28, 2001, Registration No. 333-74084 (the S-2 Registration
Statement))Exhibit 4.3:
    
    Form of Certificate for 7.25% Trust Preferred Security of Southern Community Capital Trust I (incorporated by
reference to Exhibit 4.6 to Amendment Number One to the S-2 Registration Statement dated January 10, 2002)Exhibit 4.4:
    
    Form of 7.95% Convertible Junior Subordinated Debenture (incorporated by reference to Exhibit 4.2 to the
Registration Statement on Form S-3 dated September 26, 2003, Registration No. 333-109167 (the S-3 Registration
Statement))Exhibit 4.5:
    
    Form of Certificate for 7.95% Trust Preferred Security of Southern Community Capital Trust I (incorporated by
reference to Exhibit 4.6 to the S-3 Registration Statement)
 Page 78




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##### 



Exhibit No.
    
    DescriptionExhibit 10.1:
    
    1997 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 10.1 to Amendment Number One to the Registration Statement dated
January 10, 2002)Exhibit 10.2:
    
    1997 Non-Statutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 10.2 to Amendment Number One to the Registration Statement dated
January 10, 2002)Exhibit 10.3:
    
    Indenture with respect to the Companys 7.25% Convertible Junior Subordinated Debentures (incorporated by
reference to Exhibit 10.3 to the 2001 Annual Report)Exhibit 10.4:
    
    Amended and Restated Trust Agreement of Southern Community Capital Trust I (incorporated by reference to Exhibit
10.4 to the 2001 Annual Report)Exhibit 10.5:
    
    Guarantee Agreement for Southern Community Capital Trust I (incorporated by reference to Exhibit 10.5 to the
2001 Annual Report)Exhibit 10.6:
    
    Agreement as to Expenses and Liabilities with respect to Southern Community Capital Trust I (incorporated by
reference to Exhibit 10.6 to the 2001 Annual Report)Exhibit 10.7:
    
    2002 Incentive Stock Option Plan of Southern Community Financial CorporationExhibit 10.8:
    
    2002 Non-Statutory Stock Option Plan of Southern Community Financial CorporationExhibit 10.9:
    
    Indenture with respect to the Companys 7.95% Convertible Junior Subordinated DebenturesExhibit 10.10:
    
    Amended and Restated Trust Agreement of Southern Community Capital Trust IIExhibit 10.11:
    
    Guarantee Agreement for Southern Community Capital Trust IIExhibit 10.12:
    
    Agreement as to Expenses and Liabilities with respect to Southern Community Capital Trust IIExhibit 10.13:
    
    2002 Employee Stock Purchase PlanExhibit 21:
    
    Subsidiaries of the RegistrantExhibit 23:
    
    Consent of Dixon Hughes PLLCExhibit 31.1:
    
    Rule 13a-14(a)/15d-14(a) Certification by Chief Executive OfficerExhibit 31.2:
    
    Rule 13a-14(a)/15d-14(a) Certification by Chief Financial OfficerExhibit 32:
    
    Section 1350 Certifications
 (b)    Current Reports on Form 8-K filed during the fourth quarter of 2003. Type
    
    Date Filed
    
    Reporting PurposeItem 5
    
    October 6, 2003
    
    Registration statement filed with regard to
3 million shares of Capital Trust II.Item 5.
    
    October 16, 2003
    
    To announce ceasing consumer finance
Operations.Item 9.
    
    October 21, 2003
    
    To report results for the period ending 9/30/03.Item 5.
    
    October 27, 2003
    
    To report resignation of a director.Item 5.
    
    November 5, 2003
    
    To announce sale of $30 million of Capital
Trust II trust preferred securities.Item 9.
    
    November 13, 2003
    
    To announce presenting at 11/19/03 Ryan Beck
Financial Institutions Investors Conference.Item 5.
    
    December 17, 2003
    
    To announce shareholder approval of the
acquisition of The Community Bank.
 Page 79




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##### 



SIGNATURES Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on behalf of the undersigned, thereunto duly authorized. SOUTHERN COMMUNITYFINANCIAL CORPORATIONDate: March 24, 2004
    
    By:
    /s/ F. Scott BauerF. Scott BauerChairman, President and Chief Executive OfficerDate: March 24, 2004
    
    By:
    /s/ Richard M. CobbRichard M. CobbExecutive Vice President, Chief Operating
Officer and Chief Financial Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. SIGNATURE
    
    TITLE
    
    DATE/s/ F. Scott Bauer
F. Scott Bauer
    
    Chairman of the Board
    
    March 24, 2004/s/ James O. Frye
James O. Frye
    
    Vice Chairman of the Board
    
    March 24, 2004/s/ Don Gray Angell
Don Gray Angell
    
    Director
    
    March 24, 2004/s/ Zack W. Blackmon, Sr.
Zack W. Blackmon, Sr.
    
    Director
    
    March 24, 2004/s/ Edward T. Brown
Edward T. Brown
    
    Director
    
    March 24, 2004/s/ Charles R. Bokesch
Charles R. Bokesch
    
    Director
    
    March 24, 2004/s/ James G. Chrysson
James G. Chrysson
    
    Director
    
    March 24, 2004
 Page 80




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##### 



SIGNATURE
    
    TITLE
    
    DATE/s/ Matthew G. Gallins

Matthew G. Gallins
    
    Director
    
    March 24, 2004/s/ H. Lee Merritt, Jr.
H. Lee Merritt, Jr.
    
    Director
    
    March 24, 2004Dianne M. Neal
    
    Director
    
    March , 2004/s/ Billy D. Prim
Billy D. Prim
    
    Director
    
    March 24, 2004/s/ Durward A. Smith, Jr.
Durward A. Smith, Jr.
    
    Director
    
    March 24, 2004/s/ William G. Ward, Sr., M.D.
William G. Ward, Sr., M.D.
    
    Director
    
    March 24, 2004
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