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U.S. Securities and Exchange Commission Washington, D.C. 20549
 Form 10-K þ
Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the fiscal year ended December 31, 2004 o Transition Report Under Section 13 or 15(d) of the 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 Road
Winston-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 7.95% 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
þ No o 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. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes þ No
o 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. $163.9 million. As of March 29, 2005, (the most recent practicable date), the registrant had outstanding 17,941,028
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 24, 2005 to be mailed to shareholders
within 120 days of December 31, 2004.
    
    Part III
 Form 10-K Table of Contents Index
    
    
    
    PAGEPART IItem 1.
    
    Business
    
    
    3Item 2.
    
    Properties
    
    
    12Item 3.
    
    Legal
    
    
    14Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    14PART IIItem 5.
    
    Market for Common Stock and Related Stockholder Matters and Issuer Purchases ofEquity Securities
    
    
    14Item 6.
    
    Selected Financial Data
    
    
    15Item 7.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 7A.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    45Item 8.
    
    Financial Statements
    
    
    45Item 9.
    
    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    87Item9A.
    
    Controls and Procedures
    
    
    87Item9B.
    
    Other Information
    
    
    87PART IIIItem 10.
    
    Directors and Executive Officers of the Registrant
    
    
    87Item 11.
    
    Executive Compensation
    
    
    87Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management
    
    
    87Item 13.
    
    Certain Relationships and Related Transactions
    
    
    88Item 14.
    
    Principal Accountant Fees and Services
    
    
    88PART IVItem 15.
    
    Exhibits, Financial Statement Schedules
    
    
    89
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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) a Community bank with eighteen banking offices throughout the Piedmont
Triad region of North Carolina. The bank commenced operations on November 18, 1996 and effective
October 1, 2001 became a wholly-owned subsidiary of the newly formed holding company. The Piedmont
Triad area is located in the north central region of North Carolina and includes the cities of
Winston-Salem (our headquarters), Greensboro and High Point. At December 31, 2004, we had total assets of $1.2 billion, net loans of $783.6 million, deposits of
$845.2 million, and shareholders equity of $136.9 million. We had net income of $8.1 million and
$3.7 million and diluted earnings per share of $.45 and $.40 for the years ended December 31, 2004
and 2003, respectively. We had net income of $3.2 million and diluted earnings per share of $.35
for the year ended December 31, 2002. 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 eight years of existence we have accomplished the following:  
    Registered 22 consecutive quarters of profitability after becoming profitable in our
seventh quarter of operation;
    Completed the acquisition of The Community Bank, Pilot Mountain, North Carolina,
raising our assets to over $1.0 billion and increasing the number of banking offices to
eighteen;
    Began payment of an annual cash dividend in 2004;
    Were added to the Russell 3000 Index on June 25, 2004;
    Began in-house item processing for the bank in October 2004;
    Began offering trust services in 2002 including investment management,
administration and advisory services primarily for individuals, partnerships and
corporations;
    Listed our common stock on the Nasdaq National Market System on January 2, 2002; and
    Maintained a strong credit culture. As of December 31, 2004, our non-performing
assets totaled $3.3 million or 0.27% of total assets and our allowance for loan losses
was $12.5 million or 1.57% of total loans and 577% 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 and our trust
preferred securities are traded on the Nasdaq National Market System under the symbols SCMF and
SCMFO, respectively. Our Market Area We consider our primary market area to be the Piedmont Triad area of 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 (where our headquarters is located), Greensboro and High Point. The region has one
fifth of the states population and one fifth of its labor force. Its estimated population in 2003
was in excess of 1.52 million. The regions population is expected to grow an estimated 15.5%
between 2000 and 2010. 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 Page 3




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314,375 in 2003. The Piedmont Triad is the economic hub of northwest North Carolina. In 2003, the
median family income in the Piedmont Triad was over $55,000. The Piedmont Triad has a very
balanced and diversified economy and a work force in excess of 779,800 in May 2004. Approximately
99% of the work force is employed in nonagricultural wage and salary positions. The major
employment sectors in 2002 were services (36%), manufacturing (19%), trade (14%), government (14%),
finance, communications and utilities (10%), and construction (4%). From January 2002 to May 2004,
the unemployment rate in the Piedmont Triad had decreased from 6.5% to 5.2%. The bank serves our market area through eighteen full service banking offices. 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 twenty two 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. We have also diversified our revenue in order to generate non-interest income. These efforts
include our mortgage loan department, our small business investment company manager (which
generates management fees) and our wealth management department, Southern Community Advisors, which
offers investment advisory, brokerage, trust and insurance services. For the year ended December
31, 2004 our non-interest income represented 17.5% 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. Page 4




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Subsidiaries The bank operates one subsidiary that provides financial services in addition to those offered
directly by the bank. The company has a subsidiary 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., and 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 generally 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, 2004, VCS Management
earned $552,000 of fee income, representing 1.3% of total consolidated revenue. 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 gross
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 bank. 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.
Subject to certain limitations, a significant amount 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 2004, we operated branches in
Forsyth, Guilford, Iredell, Rockingham, Stokes, Surry and Yadkin Counties, North Carolina. On that
date, there were 351 branches operated by twenty-eight commercial banks, one trust company and five
savings institutions in these seven counties with approximately $20.9 billion in deposits.
Deposits of the banks in June 2004 were $795.8 million. Many of these competing banks have capital
resources and legal lending limits substantially in excess of those available to us and the bank.
Therefore, in our market area, the bank has significant competition for deposits and loans from
other depository institutions. Other financial institutions such as credit unions, consumer finance companies, insurance
companies, brokerage companies, small loan companies and other financial institutions with varying
degrees of regulatory restrictions compete vigorously for a share of the financial services market.
Credit unions have been permitted to expand their membership criteria and expand their loan
services to include such traditional bank services as commercial lending. These entities pose an
ever-increasing challenge to our efforts to serve the markets traditionally served by banks. We
expect competition to continue to be significant. Page 5




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Employees Southern Community Financial Corporation has no employees of its own and all employees during 2004
were compensated by the bank. At December 31, 2004, the bank employed 271 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 good and extremely important to our long-term success. The
Board and management continually seek ways to enhance their benefits and well being. 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. Subject to various limitations, federal banking law 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 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. 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 are generally regulated according to
the type of such financial activity: banking activities by banking regulators, securities
activities by securities regulators, and insurance activities by insurance Page 6




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regulators. Federal law imposes certain restrictions and 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 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 that
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, 2004, our Tier 1 leverage capital ratio and total
capital were 9.68% and 13.82%, 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, 2004, the Federal Reserve had not advised us of any specific minimum Tangible
Tier 1 Leverage Ratio applicable to us. Effective in March 2004, the company was required to apply 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. Adoption of
FIN 46 required us to deconsolidate the companys remaining Page 7




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trust preferred subsidiary, Southern Community Capital Trust II. Upon deconsolidation, the junior
subordinated debentures issued by the company to Trust II were included in long-term debt (instead
of the trust preferred securities) and the companys equity interest in Trust II was included in
other investments. The deconsolidation of Trust II has not materially impacted net income. The companys 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. The
Board of Governors of the Federal Reserve, on March 1, 2005, adopted a final rule allowing the
continued limited inclusion of trust preferred securities in the Tier 1 capital. The Boards final
rule limits restricted core capital elements to twenty-five percent of all core capital elements. 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. On January 20, 2005, the company announced the declaration of its
second annual cash dividend of $0.12 per share of its common stock, which was paid on March 15,
2005, to shareholders of record on February 22, 2005. 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 bank. Our only
source of income is dividends paid by the bank. We must pay all of our operating expenses from
funds we receive from the bank. North Carolina banking law 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 bank. 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. Until October 2004 when it was merged with and into the bank,
we operated The Community Bank as a separate subsidiary and affiliate of the bank. 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 Page 8




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transactions with or involving other 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, which 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 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 which has announced that,
effective January 2005, no reserves will be required to be maintained on the first $7.0 million of
transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of
those accounts between $7.0 million and $47.6 million, and additional reserves must be maintained
on aggregate balances in excess of $47.6 million in an amount equal to equal to 10.0% of the
excess. 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, 2004, 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. Page 9




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##### 



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 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 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 Federal Deposit Insurance Corporation. The exact amount of future dividends paid to us by 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, Page 10




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##### 



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. 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 Page 11




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##### 



substantial probability of loss to the Bank Insurance Fund. Any increase in insurance assessments
could have an adverse effect on the banks earnings. 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, 2004 we operated out of eighteen banking offices, four operations/administrative
offices, five lending offices and an investment advisory office. All banking offices have ATMs. A
summary of our offices is as follows: Approximate
    
    
    YearSquare
    
    
    Established
    
    
    Owned orFootage
    
    
    or Acquired
    
    
    LeasedBanking Offices:Clemmons, North Carolina6290 Towncenter Drive
    
    
    3,800
    
    
    
    2004
    
    
    OwnedDobson, North Carolina201 West Kapp Street
    
    
    2,800
    
    
    
    1995
    
    
    OwnedHigh Point, North Carolina2541 Eastchester Drive
    
    
    3,000
    
    
    
    2003
    
    
    OwnedJonesville, North Carolina503 Winston Road
    
    
    2,500
    
    
    
    1995
    
    
    OwnedKernersville, North Carolina1207 South Main Street
    
    
    8,300
    
    
    
    2002
    
    
    OwnedKing, North Carolina105 Post Office Street
    
    
    4,000
    
    
    
    2004
    
    
    OwnedMadison, North Carolina619 Ayersville Road
    
    
    2,000
    
    
    
    1990
    
    
    OwnedMount Airy Downtown, North Carolina255 East Independence Blvd.
    
    
    10,345
    
    
    
    1999
    
    
    OwnedMount Airy, North Carolina2010 Community Drive
    
    
    3,500
    
    
    
    1988
    
    
    OwnedPilot Mountain, North Carolina616 South Key Street
    
    
    8,300
    
    
    
    1987
    
    
    OwnedSandy Ridge, North Carolina4928 Highway 704 West
    
    
    1,250
    
    
    
    1989
    
    
    OwnedUnion Grove, North Carolina1439 W. Memorial Highway
    
    
    2,300
    
    
    
    1990
    
    
    Owned
 Page 12




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##### 



Approximate
    
    
    YearSquare
    
    
    Established
    
    
    Owned orFootage
    
    
    or Acquired
    
    
    LeasedBanking Offices:Walnut Cove, North Carolina1072 North Main Street
    
    
    1,700
    
    
    
    1999
    
    
    LeasedWinston Salem, North Carolina4701 Country Club Rd.
    
    
    4,300
    
    
    
    1996
    
    
    Leased225 Hanes Mill Rd.
    
    
    2,800
    
    
    
    2001
    
    
    Owned3151 Peters Creek Parkway
    
    
    2,500
    
    
    
    1998
    
    
    Leased536 South Stratford Rd.
    
    
    1,600
    
    
    
    1998
    
    
    LeasedYadkinville, North Carolina532 East Main Street
    
    
    7,800
    
    
    
    1998
    
    
    OwnedOperations and Administrative Offices:Winston Salem, North Carolina1600 Hanes Mall Blvd.
    
    
    10,500
    
    
    
    2000
    
    
    Owned112 Cambridge Plaza
    
    
    3,750
    
    
    
    2002
    
    
    Leased4605 Country Club Rd.  Corporate
    
    
    27,000
    
    
    
    2003
    
    
    OwnedPilot Mountain, North Carolina315 West Main Street
    
    
    5,600
    
    
    
    1995
    
    
    OwnedLending Offices:Winston Salem, North Carolina4625 Country Club Rd.
    
    
    3,200
    
    
    
    1998
    
    
    Owned3400 Healy Drive
    
    
    3,600
    
    
    
    2004
    
    
    LeasedCornelius, North Carolina19520 West Catawba Avenue
    
    
    1,950
    
    
    
    2004
    
    
    LeasedLexington, South Carolina150 Whiteford Court
    
    
    960
    
    
    
    2004
    
    
    LeasedMooresville, North Carolina249 Williamson Road, Ste. 100
    
    
    1,700
    
    
    
    2004
    
    
    LeasedInvestment Advisory Office:4505 Country Club Rd.
    
    
    4,200
    
    
    
    2004
    
    
    Leased
 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. All of our properties, including land, buildings and improvements, furniture, equipment and
vehicles, had a net book value at December 31, 2004 of $28.3 million. [See further information
presented in Note 7 to our consolidated financial statements, which are presented under Item 8 in
this Form 10-K.] 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. Page 13




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##### 



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. Item 4. Submission of Matters to a Vote of Security Holders There were no 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 and Issuer Purchases of Equity
Securities 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
preferred securities (SCMFO), based on published financial sources, for the last two years. The
preferred securities did not begin trading until the fourth quarter of 2003. PriceSCMF
    
    
    
    
    
    
    SCMFOYear
    
    Quarterly Period
    
    High
    
    
    
    
    
    
    Low
    
    
    
    
    
    
    High
    
    
    Low2003
    
    First Quarter
    
    $
    8.08
    
    
    
    
    
    
    $
    6.30
    
    
    
    
    
    
    $
    
    
    
    $
    Second Quarter
    
    
    9.95
    
    
    
    
    
    
    
    7.57
    
    
    
    
    
    
    
    
    
    
    
    Third Quarter
    
    
    10.46
    
    
    
    
    
    
    
    8.88
    
    
    
    
    
    
    
    
    
    
    
    Fourth Quarter
    
    
    11.17
    
    
    
    
    
    
    
    9.91
    
    
    
    
    
    
    
    10.85
    
    
    
    10.582004
    
    First Quarter
    
    $
    13.43
    
    
    
    
    
    
    $
    11.00
    
    
    
    
    
    
    $
    11.10
    
    
    $
    10.62Second Quarter
    
    
    12.15
    
    
    
    
    
    
    
    9.27
    
    
    
    
    
    
    
    11.07
    
    
    
    9.82Third Quarter
    
    
    11.73
    
    
    
    
    
    
    
    8.71
    
    
    
    
    
    
    
    11.15
    
    
    
    10.20Fourth Quarter
    
    
    11.67
    
    
    
    
    
    
    
    9.82
    
    
    
    
    
    
    
    12.10
    
    
    
    10.65
 At March 15, 2005, there were approximately 7,400 holders of record of our common stock. 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. On January 20, 2005, the
company announced the declaration of its second annual cash dividend of $0.12 per share of its
common stock, which was paid on March 15, 2005, to shareholders of record on February 22, 2005.
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 subsidiary 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 primary sources of income are dividends paid by the bank and
interest income on loans and deposits with the bank subsidiary. We must pay all of our operating
expenses from funds we receive from the bank. Various banking laws applicable to our bank
subsidiary limit the payment of dividends, management fees and other distributions by the bank 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 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. Page 14




---



##### 



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. 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 and its investment in Southern Community Capital Trust
II. Therefore, the financial statements of the bank prior to October 1, 2001 are the historical
consolidated financial statements of Southern Community Financial Corporation. The results for
2004 included The Community Bank from January 12, 2004. 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 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands, except per share data)Operating Data:Interest income
    
    $
    54,656
    
    
    $
    36,019
    
    
    $
    33,281
    
    
    $
    31,366
    
    
    $
    26,831Interest expense
    
    
    19,657
    
    
    
    14,751
    
    
    
    15,803
    
    
    
    18,034
    
    
    
    14,944Net interest income
    
    
    34,999
    
    
    
    21,268
    
    
    
    17,478
    
    
    
    13,332
    
    
    
    11,887Provision for loan losses
    
    
    2,239
    
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320
    
    
    
    1,480Net interest income after
provision for loan losses
    
    
    32,760
    
    
    
    18,983
    
    
    
    15,823
    
    
    
    11,012
    
    
    
    10,407Non-interest income
    
    
    7,406
    
    
    
    4,985
    
    
    
    3,927
    
    
    
    3,402
    
    
    
    2,198Non-interest expense
    
    
    27,520
    
    
    
    18,333
    
    
    
    14,781
    
    
    
    11,162
    
    
    
    8,723Income before
income taxes
    
    
    12,646
    
    
    
    5,635
    
    
    
    4,969
    
    
    
    3,252
    
    
    
    3,882Provision for income taxes
    
    
    4,544
    
    
    
    1,972
    
    
    
    1,755
    
    
    
    1,147
    
    
    
    1,466Net income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214
    
    
    $
    2,105
    
    
    $
    2,416Per Share Data:(7)Net incomeBasic
    
    $
    .47
    
    
    $
    .41
    
    
    $
    .37
    
    
    $
    .24
    
    
    $
    .30Diluted
    
    
    .45
    
    
    
    .40
    
    
    
    .35
    
    
    
    .23
    
    
    
    .29Cash dividends
    
    
    .11
    
    
    
    .00
    
    
    
    .00
    
    
    
    .00
    
    
    
    .00Book value
    
    
    7.68
    
    
    
    5.66
    
    
    
    5.41
    
    
    
    4.84
    
    
    
    4.41Weighted average sharesBasic
    
    
    17,298,285
    
    
    
    8,826,780
    
    
    
    8,788,295
    
    
    
    8,707,678
    
    
    
    8,097,552Diluted
    
    
    18,033,333
    
    
    
    11,369,429
    
    
    
    9,085,853
    
    
    
    9,043,611
    
    
    
    8,450,245Balance Sheet Data:Total assets
    
    $
    1,222,361
    
    
    $
    798,502
    
    
    $
    612,239
    
    
    $
    481,220
    
    
    $
    384,027Loans
    
    
    796,103
    
    
    
    519,746
    
    
    
    421,938
    
    
    
    360,288
    
    
    
    282,161Allowance for loan losses
    
    
    12,537
    
    
    
    7,275
    
    
    
    6,342
    
    
    
    5,400
    
    
    
    4,283Deposits
    
    
    845,228
    
    
    
    575,218
    
    
    
    449,216
    
    
    
    392,851
    
    
    
    338,753Short-term borrowings
    
    
    69,647
    
    
    
    51,900
    
    
    
    40,706
    
    
    
    19,980
    
    
    
    6,000Long-term debt
    
    
    163,493
    
    
    
    117,627
    
    
    
    72,250
    
    
    
    25,000
    
    
    
    Stockholders equity
    
    
    136,906
    
    
    
    50,891
    
    
    
    47,539
    
    
    
    42,451
    
    
    
    36,950Capital Ratios: (5)Total risk-based capital
    
    
    11.70
    %
    
    
    10.66
    %
    
    
    12.23
    %
    
    
    11.53
    %
    
    
    13.03
    %Tier 1 risk-based capital
    
    
    10.45
    %
    
    
    9.46
    %
    
    
    10.98
    %
    
    
    10.28
    %
    
    
    11.78
    %Leverage ratio
    
    
    8.55
    %
    
    
    7.50
    %
    
    
    8.95
    %
    
    
    9.21
    %
    
    
    11.16
    %Equity to assets ratio
    
    
    12.40
    %
    
    
    6.37
    %
    
    
    7.76
    %
    
    
    8.82
    %
    
    
    9.62
    %
 Page 15




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##### 



For the Years Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands, except per share data)Selected Performance Ratios:Return on average assets
    
    
    .69
    %
    
    
    .53
    %
    
    
    .58
    %
    
    
    .50
    %
    
    
    .77
    %Return on average equity
    
    
    6.20
    %
    
    
    7.48
    %
    
    
    7.24
    %
    
    
    5.13
    %
    
    
    7.27
    %Net interest spread (2)
    
    
    3.08
    %
    
    
    3.03
    %
    
    
    3.02
    %
    
    
    2.82
    %
    
    
    3.22
    %Net interest margin (1)
    
    
    3.31
    %
    
    
    3.25
    %
    
    
    3.34
    %
    
    
    3.36
    %
    
    
    4.01
    %Non-interest income as a
percentage of total
revenue (6)
    
    
    17.46
    %
    
    
    18.99
    %
    
    
    18.35
    %
    
    
    20.33
    %
    
    
    15.61
    %Non-interest income as a
percentage of average
assets
    
    
    .63
    %
    
    
    .72
    %
    
    
    .71
    %
    
    
    .80
    %
    
    
    .70
    %Non-interest expense to
average assets
    
    
    2.36
    %
    
    
    2.63
    %
    
    
    2.66
    %
    
    
    2.63
    %
    
    
    2.79
    %Efficiency ratio (3)
    
    
    64.90
    %
    
    
    69.83
    %
    
    
    69.05
    %
    
    
    66.70
    %
    
    
    61.93
    %Dividend payout ratio
    
    
    23.49
    %
    
    
    .00
    %
    
    
    .00
    %
    
    
    .00
    %
    
    
    .00
    %Asset Quality Ratios:Nonperforming loans to
period-end loans
    
    
    .27
    %
    
    
    .15
    %
    
    
    .43
    %
    
    
    .25
    %
    
    
    .10
    %Allowance for loan losses
to period-end loans
    
    
    1.57
    %
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %Allowance for loan losses
to nonperforming loans
    
    
    577
    %
    
    
    946
    %
    
    
    348
    %
    
    
    604
    %
    
    
    1,552
    %Nonperforming assets
to total assets (4)
    
    
    .27
    %
    
    
    .13
    %
    
    
    .36
    %
    
    
    .26
    %
    
    
    .07
    %Net loan charge-offs
to average loans outstanding
    
    
    .19
    %
    
    
    .29
    %
    
    
    .18
    %
    
    
    .38
    %
    
    
    .09
    %Other Data:Number of banking offices
    
    
    18
    
    
    
    8
    
    
    
    8
    
    
    
    7
    
    
    
    7Number of full-time
equivalent employees
    
    
    271
    
    
    
    157
    
    
    
    141
    
    
    
    121
    
    
    
    104
   (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 affected
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 16




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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 $1.2 billion in total assets in just over eight years of operations. We began operations in November 1996 with $11 million in capital, a single branch facility and
thirteen employees. Through December 31, 2004, Southern Community Financial Corporation has grown
to a total of eighteen full-service banking offices with $845 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. On January 12, 2004 the company acquired The Community Bank.
In the later part of June 2004, The Community Bank subsidiary converted its primary operating
system. In October 2004, Southern Community Bank and Trust also converted to this same operating
system and the two bank subsidiaries were merged into one charter retaining the Southern Community
Bank and Trust name and began in-house core processing for the consolidated bank. In addition, at
the end of August 2004, the bank acquired two residential mortgage offices from Davidson Mortgage
(Davidson), one office in Cornelius, North Carolina and the other in Lexington, South Carolina. 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, Compliance 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. Please note that the company completed the acquisition of The Community Bank in the first quarter
of 2004. This transaction provided much of the companys year-over-year growth. At December 31,
2003 Communitys balance sheet had total assets of $258.9 million. Significant balance sheet
categories included $69.0 million of investment securities, $176.6 million of loans, $202.9 million
of deposits and $27.5 million of capital. Additionally, in the first quarter of 2004 the company
announced the redemption of all of its 7.25% Cumulative Convertible Trust Preferred Securities
issued through Southern Community Capital Trust I. The Securities were redeemed on March 12, 2004
which resulted in the issuance of 2,060,000 shares of common stock through conversions and the
retirement of $61,000 of the convertible trust preferred securities. On January 14, 2004, the
company announced the declaration Page 17




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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. On January 20, 2005, the company
announced the declaration of its second annual cash dividend of $0.12 per share of its common stock
which was paid on March 15, 2005, to shareholders of record on February 22, 2005. Financial Condition at December 31, 2004 and 2003 During the year ended December 31, 2004, our total assets increased by $423.9 million, or 53.1%, to
$1.2 billion. Of this increase in total assets, $353.2 million represented growth in
interest-earning assets. Continued strong loan demand resulted in an increase of $271.1 million,
or 52.9%, in net loans receivable. Investment securities, available for sale and held to maturity,
increased by $69.3 million and $12.9 million, respectively. Growth in the investment portfolio is
primarily due to the addition of The Community Bank in the first quarter of 2004. While
Communitys loan portfolio accounted for the $179.6 million increase in net loan growth during the
first quarter of 2004, strong loan demand during the balance of the year resulted in $91.5 million
of additional loan growth for the company. Federal funds sold, with an average annual return of
1.39%, is the lowest yielding among interest-earning assets. Premises and equipment increased by
$11.0 million net of depreciation, principally as a result of the Community acquisition. Other
assets increased by $14.9 million during the year, and in addition $50.1 million of goodwill was
created as a result of purchase accounting associated with the Community and Davidson transactions. Loan growth in 2004 was concentrated in commercial and real estate lending. Our total loan growth
of $271.1 million in 2004 was spread among portfolios secured by residential and commercial
mortgages, which increased by $128.4 million and $68.1 million, respectively. Commercial and
industrial lending and construction loan outstandings increased by $40.3 million and $30.4 million,
respectively during the year. Consumer lending increased $9.2 million from 2003 levels as
Communitys addition more than offset the attrition in the residual Southeastern Acceptance loan
portfolio. During 2004 we continued our active program of originations of residential mortgage
loans for sale in the secondary market. At the end of the year mortgage loans held for sale
totaled $3.6 million. Our total liquid assets, defined as cash and due from banks, federal funds sold and investment
securities, increased by $76.8 million during the year, to $330.7 million at December 31, 2004
versus $253.9 million at the beginning of the year. Liquid assets represented 27.1% of total
assets at December 31, 2004 as compared to 31.8% 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. However, our funding growth has been used primarily to fund strong
loan demand. 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 $195.3 million and
$159.2 million at year-end 2004 and 2003, respectively. At December 31, 2004, deposits totaled
$845.2 million, an increase of $270.0 million or 46.9% from year-end 2003. We have also utilized
borrowings to fund growth in 2004. Total borrowings, including $34.5 million in trust preferred
securities issued during 2003, aggregated $233.1 million at December 31, 2004. Borrowings also
included $147.8 million of advances from the Federal Home Loan Bank of Atlanta (FHLB), Federal
funds purchased of $19.0 million and securities sold under agreements to repurchase of $30.6
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 an increasingly 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, 2004, our
stockholders equity totaled $136.9 million, an increase of $86.0 million from the December 31,
2003 balance. This net increase includes $62.7 million of shares issued in association with the
Community transaction, $17.0 million associated with the conversion of trust preferred securities,
$8.1 million of net income earned during the year, $1.6 million of stock options exercised during
the year, and a decrease in accumulated other comprehensive income of $1.0 million. Page 18




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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, 2004, 2003 and 2002, our
average interest-earning assets were $1.1 billion, $655.3 million, and $523.3 million,
respectively. During these same years, our net interest margins were 3.31%, 3.25% and 3.34%,
respectively. Average Balances and Average Rates Earned and Paid.The following table sets forth, for the years
2002 through 2004, 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 31,2004
    
    
    2003
    
    
    2002Interest
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    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:(1)Loans
    
    $
    742,433
    
    
    $
    42,843
    
    
    
    5.77
    %
    
    $
    471,808
    
    
    $
    27,478
    
    
    
    5.82
    %
    
    $
    395,745
    
    
    $
    25,689
    
    
    
    6.49
    %Investment securities
available for sale
    
    
    239,306
    
    
    
    9,306
    
    
    
    3.89
    %
    
    
    118,194
    
    
    
    6,022
    
    
    
    5.10
    %
    
    
    82,296
    
    
    
    4,901
    
    
    
    5.96
    %Investment securities
held to maturity
    
    
    71,336
    
    
    
    2,454
    
    
    
    3.44
    %
    
    
    61,215
    
    
    
    2,469
    
    
    
    4.03
    %
    
    
    38,831
    
    
    
    2,576
    
    
    
    6.63
    %Federal fund sold
    
    
    3,816
    
    
    
    53
    
    
    
    1.39
    %
    
    
    4,122
    
    
    
    50
    
    
    
    1.21
    %
    
    
    6,414
    
    
    
    115
    
    
    
    1.79
    %Total interest-earning
assets
    
    
    1,056,891
    
    
    
    54,656
    
    
    
    5.17
    %
    
    
    655,339
    
    
    
    36,019
    
    
    
    5.50
    %
    
    
    523,286
    
    
    
    33,281
    
    
    
    6.36
    %Other assets
    
    
    110,970
    
    
    
    
    
    
    
    
    
    
    
    41,182
    
    
    
    
    
    
    
    
    
    
    
    32,113Total assets
    
    $
    1,167,861
    
    
    
    
    
    
    
    
    
    
    $
    696,521
    
    
    
    
    
    
    
    
    
    
    $
    555,399Interest-bearing liabilities:Deposits:NOW and money market
    
    $
    241,363
    
    
    
    2,027
    
    
    
    .84
    %
    
    $
    138,926
    
    
    
    1,346
    
    
    
    0.97
    %
    
    $
    102,427
    
    
    
    1,342
    
    
    
    1.31
    %Time deposits greater
than $100,000
    
    
    257,034
    
    
    
    6,609
    
    
    
    2.63
    %
    
    
    154,026
    
    
    
    4,300
    
    
    
    2.79
    %
    
    
    114,971
    
    
    
    4,549
    
    
    
    3.96
    %Other time deposits
    
    
    229,584
    
    
    
    4,590
    
    
    
    1.95
    %
    
    
    163,960
    
    
    
    4,244
    
    
    
    2.59
    %
    
    
    172,456
    
    
    
    6,251
    
    
    
    3.62
    %Borrowings
    
    
    213,822
    
    
    
    6,431
    
    
    
    3.01
    %
    
    
    141,019
    
    
    
    4,861
    
    
    
    3.23
    %
    
    
    83,933
    
    
    
    3,661
    
    
    
    4.36
    %Total interest-bearing
liabilities
    
    
    941,803
    
    
    
    19,657
    
    
    
    2.09
    %
    
    
    597,931
    
    
    
    14,751
    
    
    
    2.47
    %
    
    
    473,787
    
    
    
    15,803
    
    
    
    3.34
    %Demand deposits
    
    
    85,583
    
    
    
    
    
    
    
    
    
    
    
    45,101
    
    
    
    
    
    
    
    
    
    
    
    34,766Other liabilities
    
    
    9,819
    
    
    
    
    
    
    
    
    
    
    
    4,512
    
    
    
    
    
    
    
    
    
    
    
    2,425Stockholders equity
    
    
    130,656
    
    
    
    
    
    
    
    
    
    
    
    48,977
    
    
    
    
    
    
    
    
    
    
    
    44,421Total liabilities and
stockholders equity
    
    $
    1,167,861
    
    
    
    
    
    
    
    
    
    
    $
    696,521
    
    
    
    
    
    
    
    
    
    
    $
    555,399Net interest income and
net interest spread
    
    
    
    
    
    $
    34,999
    
    
    
    3.08
    %
    
    
    
    
    
    $
    21,268
    
    
    
    3.03
    %
    
    
    
    
    
    $
    17,478
    
    
    
    3.02
    %Net interest margin
    
    
    
    
    
    
    
    
    
    
    3.31
    %
    
    
    
    
    
    
    
    
    
    
    3.25
    %
    
    
    
    
    
    
    
    
    
    
    3.34
    %Ratio of average
interest-earning
assets to average
interest-bearing
liabilities
    
    
    
    
    
    
    112.22
    %
    
    
    
    
    
    
    
    
    
    
    109.60
    %
    
    
    
    
    
    
    
    
    
    
    110.45
    %
   (1)
    
    Nonaccrual notes are included in the loan amounts. Page 19




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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. December 31, 2004 vs. 2003
    
    
    December 31, 2003 vs. 2002Increase (Decrease) Due to
    
    
    Increase (Decrease) Due toVolume
    
    
    Rate
    
    
    Total
    
    
    Volume
    
    
    Rate
    
    
    Total(Dollars in thousands)Interest income:Loans
    
    $
    15,689
    
    
    $
    (324
    )
    
    $
    15,365
    
    
    $
    4,684
    
    
    $
    (2,895
    )
    
    $
    1,789Investment securities available
for sale
    
    
    5,440
    
    
    
    (2,156
    )
    
    
    3,284
    
    
    
    1,983
    
    
    
    (862
    )
    
    
    1,121Investment securities held
to maturity
    
    
    378
    
    
    
    (393
    )
    
    
    (15
    )
    
    
    1,194
    
    
    
    (1,301
    )
    
    
    (107
    )Federal funds sold
    
    
    (4
    )
    
    
    7
    
    
    
    3
    
    
    
    (34
    )
    
    
    (30
    )
    
    
    (64
    )Total interest income
    
    
    21,503
    
    
    
    (2,866
    )
    
    
    18,637
    
    
    
    7,827
    
    
    
    (5,088
    )
    
    
    2,739Interest expense:Deposits:NOW and money market
    
    
    926
    
    
    
    (245
    )
    
    
    681
    
    
    
    416
    
    
    
    (412
    )
    
    
    4Time deposits greater
than $100,000
    
    
    2,762
    
    
    

    (453
    )
    
    
    2,309
    
    
    
    1,318
    
    
    
    (1,567
    )
    
    
    (249
    )Other time deposits
    
    
    1,505
    
    
    
    (1,159
    )
    
    
    346
    
    
    
    (264
    )
    
    
    (1,743
    )
    
    
    (2,007
    )Borrowings
    
    
    2,350
    
    
    
    (780
    )
    
    
    1,570
    
    
    
    2,229
    
    
    
    (1,029
    )
    
    
    1,200Total interest expense
    
    
    7,543
    
    
    
    (2,637
    )
    
    
    4,906
    
    
    
    3,699
    
    
    
    (4,751
    )
    
    
    (1,052
    )Net interest income increase
(decrease)
    
    $
    13,960
    
    
    $
    (229
    )
    
    $
    13,731
    
    
    $
    4,128
    
    
    $
    (337
    )
    
    $
    3,791
 RESULTS OF OPERATIONS
Years Ended December 31, 2004 and 2003 Net Income. Our net income for 2004 was $8.1 million, an increase of $4.4 million from net
income of $3.7 million earned in 2003. Net income per share was $.47 basic and $.45 diluted for
the year ended December 31, 2004, up from $.41 basic and $.40 diluted for 2003. We have continued
to experience strong growth, in most part due to the acquisition of Community, with total assets
averaging $1.2 billion during the current year as compared to $696.5 million in 2003, an increase
of 67.7%. In absolute terms, our net interest income after provision for loan losses increased by
$13.7 million and our non-interest income grew by $2.4 million to $7.4 million. However this
growth did not keep pace with the $9.2 million increase in non-interest expenses. Provision
expense for loans remained relatively unchanged from the prior year. During the first half of 2004
the bank endured a historically low interest rate environment which hampered our asset yields. As
the Federal Reserve increased the targeted federal funds rate in July of 2004, the Prime rate
increased for the first time since June of 2000. In the last half of 2004; the Prime rate
increased 125 basis points to 5.25%. While it is managements goal to remain relatively interest
rate neutral, the institution is slightly asset sensitive and does benefit from rising rate
environment. As a result of our growth in interest-earning assets (Community transaction coupled
with strong loan demand) combined with lower funding costs and rising interest rates during the
later portion of the year, our net interest income increased $13.7 million. Our expense growth
included some non-recurring merger related costs as well as personnel and other infrastructure
costs associated with bringing in core in house processing as well as item capture and other
expansion of our business. While these expenses represent investments in building and refining our
franchise for the future, their initial effect hampers earnings. Page 20




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Net Interest Income. During 2004, our net interest income increased by $13.7 million or
64.6% to $35.0 million. Our growth in interest income was the result of growth in our overall
level of average earning assets due to the Community transaction as well as strong loan demand.
Average total interest-earning assets increased $401.6 million or 61.3%, during 2004 as compared to
2003, while our average yield dropped by 33 basis points from 5.50% to 5.17%. 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 increases generally
result in an immediate increase in our interest income on loans. There is a more delayed impact on
interest expense because most reductions in interest costs only occur upon renewals of certificates
of deposit or borrowings. Our average total interest-bearing liabilities increased by $343.9
million, or 57.5%. With rates sustained at lower levels for the first half of 2004, our average
cost of interest-bearing liabilities decreased by 38 basis points from 2.47% to 2.09%, allowing our
interest rate spread to increase 5 basis points. For the year ended December 31, 2004, our net
interest spread was 3.08% and our net interest margin was 3.31%. For the year ended December 31,
2003, our net interest spread was 3.03% and our net interest margin was 3.25%. 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. On a net basis this swap reduced interest expense by
$869,000 in 2004. We believe that our balance sheet is well positioned to produce consistent
growing results in the future as the company continues to expand our marketplace. Provision for Loan Losses. We recorded a $2.2 million provision for loan loss for the year
ended December 31, 2004, representing a slight decrease of $46,000 from the $2.3 million provision
we made for the year ended December 31, 2003. The level of provisions for 2004 is consistent with
that of the loan growth, excluding the Community transaction, and net charge-offs that the bank
experienced in the previous year. Gross loans increased $97.8 million in 2003 and $98.8 in 2004
excluding the $177.6 million of loans contributed through the Community acquisition. 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. While the dollar amount of provisions remained relatively flat on a year-over-year basis,
the level of the allowance to period-ending loans increased 17 basis points from the prior year-end
to 1.57%. In addition to loan growth affecting our provision for loan losses, net loan
charge-offs, which remained relatively stable, totaling $1.4 million for both 2004 and 2003, also
impacted the provision expense. On an annualized basis, our percentage of net loan charge-offs to
average loans outstanding was .19% for the year ended December 31, 2004 as compared with .29% for
the year ended December 31, 2003. Our consumer finance lending portfolio accounted for $687,000 or
49.3% of net charge-offs during 2004, a decrease of $87,000 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 ceased originating new consumer finance loans. It is expected
that the residual consumer finance loan portfolio will payoff over a twenty-four month time frame
and the companys level of charge-offs as a percentage of loan outstandings will decline.
Nonperforming loans totaled $2.2 million or .27% of total loans at December 31, 2004, as compared
with $769,000 or .15% of total loans at December 31, 2003. The allowance for loan losses at
December 31, 2004 of $12.5 million represents 1.57% of total loans and 577% of nonperforming loans.
The allowance for loan losses at December 31, 2003 of $7.3 million equaled 1.40% of total loans
outstanding at that date. Non-Interest Income. For the year ended December 31, 2004, non-interest income increased
$2.4 million, or 48.6%, to $7.4 million from $5.0 million for the prior year despite declines in
investment brokerage and mortgage origination fees. This favorable increase resulted primarily
from an increase of $2.1 million, or 142.8% to $3.5 million, in service charges and fees on deposit
accounts due to the addition of Community coupled with deposit growth and the benefit of a full
year of the overdraft protection service implemented during 2003. Non-interest income also
benefited from a one-time gain received on The Community Banks investment in Sidus Financial, LLC
(Sidus). Sidus was a mortgage banking company that served Community bank and mortgage broker
customers. On October 4, 2004, Sidus was sold for a combination of cash, stock and future
consideration if certain performance targets are met. As a result of this transaction, the Company
realized a pre-tax gain of $293,000. In addition, during the fourth quarter the company posted a
pre-tax gain of $107,000 on our investment in Salem Capital Partners, L.P. Income from investment
brokerage fees decreased from the prior year by $235,000, or 24.8%, to $712,000. The strong 2003
results Page 21




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were due to a new investment product that was offered for a limited time. Fees on the origination
of residential mortgage loans sold into the secondary market declined $600,000 to $750,000 as the
level of home mortgage refinancings dramatically slowed from the levels experienced in 2002 and
2003 due to the low interest rate environment in those periods. While market conditions may not
provide the opportunities to generate fee income similar to those levels we experienced in 2003,
management is committed to growing our non-interest income base through continued support of those
areas that generate our fee income. 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 2004 our ratio
was 2.36%, down from a ratio of 2.63% in 2003. 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,
2004, our non-interest expense increased $9.2 million, or 50.1%. Salary and employee benefits
expense increased $4.1 million, or 43.2%, and reflects the addition of personnel associated with
Community and Davidson transactions, staff additions to bring item processing in-house for the
consolidated company, additions of personnel to expand and support our lines of business, and
normal increases in salaries and employee benefits. Occupancy and equipment expense increased $1.3
million, or 42.9%, reflecting the expenses associated with our continued expansion and investments
in technology to support our banking operations, including in-house processing. Other non-interest
expenses increased $3.7 million, or 65.7%, reflecting the increased volume of business activity,
principally increases in lending and growth in deposit accounts. Also, the company has incurred a
significant increase in fees paid to outside service providers to assist us in the documentation
and testing required for compliance with Section 404 of the 2002 Sarbanes-Oxley Act (SOX). In
addition, we incurred a full year of fees paid to service our consumer finance loan portfolio.
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 president of that subsidiary to
service these loans on the behalf of the bank. On October 18, 2004, the bank and Community were
merged into a single bank under the banks name. In conjunction with this merger, the newly
consolidated bank has successfully brought core processing in-house. This function was previously
an outsourced service for the bank. As a consequence of converting the banks primary operating
system, it was necessary to terminate our contract with our previous item processing provider at a
cost of $550,000. The company believes that the synergies we will achieve by taking these steps
will have an immediate and lasting positive impact on our customers as well as our non-interest
expense Provision for Income Taxes. Our provision for income taxes, as a percentage of income
before income taxes, was 35.9% for the year ending December 31, 2004 and 35.0% for the year ended
December 31, 2003. 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 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 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 Page 22




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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 president of that subsidiary to
service these loans on the behalf of the bank. The fees paid to service these loans, combined with Page 23




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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. 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 funding under credit commitments to
customers. Because of our continued growth and the availability of relatively low cost funding sources, we
have maintained a relatively high level of liquidity in the form of federal funds sold and
investment securities. These aggregated $313.0 million at December 31, 2004, compared to $231.0
million and $152.8 million at December 31, 2003 and 2002, 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 $73.0 million. We also have the
credit capacity to borrow up to $304.2 million, as of December 31, 2004, from the Federal Home Loan
Bank of Atlanta, with $147.8 million outstanding as of that date. At December 31, 2003 we had FHLB
borrowings outstanding of $96.5 million. Funding costs have been low during 2004 with lower
deposit costs due to the core deposit base acquired from Community coupled with higher rate
certificates of deposit maturing into the lower rate environment and increased use of floating rate
funding on both deposits and borrowings. We also had repurchase agreements with a total
outstanding balance of $30.6 million at December 31, 2004. Of this balance, $10.6 million were
done as accommodations for our deposit customers and $20.0 million were outstanding with our
correspondent banks. 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 $130 million from various institutions. The
repurchases must be adequately collateralized. At December 31, 2004, our outstanding commitments
to extend credit consisted of loan commitments of $139.4 million and amounts available under home
equity credit lines, other credit lines and letters of credit of $66.4 million, $8.5 million and
$10.1 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 eight-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 60.4% of our total deposits at December 31, 2004, a slight increase from 59.9% at
December 31, 2003. Brokered and out-of-market deposits totaled $195.3 million at year-end 2004 and
$159.2 million at year-end 2003, which comprised 23.7% and 27.7% of total deposits, respectively.
Certificates of deposit of $100,000 or more, inclusive of brokered and out-of-market certificates,
represented 33.3% of our total deposits at December 31, 2004 and 31.7% at December 31, 2003. 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 24




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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, which may or may not require future cash
outflows. The following table reflects contractual obligations of the company outstanding as of
December 31, 2004. Payments Due by PeriodOn DemandOr Within
    
    
    
    
    
    
    
    
    
    
    AfterContractual Obligations
    
    Total
    
    
    1 Year
    
    
    2-3 Years
    
    
    4-5 Years
    
    
    5 Years(In thousands)Short-term borrowings
    
    $
    69,647
    
    
    $
    69,647
    
    
    $
    
    
    
    $
    
    
    
    $
    Long-term debt
    
    
    163,493
    
    
    
    
    
    
    
    50,250
    
    
    
    10,000
    
    
    
    103,243Operating leases
    
    
    2,178
    
    
    
    564
    
    
    
    664
    
    
    
    505
    
    
    
    445Total contractual cash obligations
excluding deposits
    
    
    235,318
    
    
    
    70,211
    
    
    
    50,914
    
    
    
    10,505
    
    
    
    103,688Deposits
    
    
    845,228
    
    
    
    643,698
    
    
    
    133,166
    
    
    
    52,864
    
    
    
    15,500Total contractual cash obligations
    
    $
    1,080,546
    
    
    $
    713,909
    
    
    $
    184,080
    
    
    $
    63,369
    
    
    $
    119,188
 The following table reflects other commitments of the company outstanding as of December 31, 2004. 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
    
    $
    66,443
    
    
    $
    542
    
    
    $
    69
    
    
    $
    96
    
    
    $
    65,736Other commitments and credit lines
    
    
    108,941
    
    
    
    88,506
    
    
    
    15,651
    
    
    
    2,070
    
    
    
    2,714Undisbursed portion of construction loans
    
    
    48,938
    
    
    
    31,965
    
    
    
    12,739
    
    
    
    1,915
    
    
    
    2,319Fixed rate mortgage loan commitments
    
    
    86
    
    
    
    86
    
    
    
    
    
    
    
    
    
    
    
    Other purchase commitments
    
    
    325,000
    
    
    
    325,000
    
    
    
    
    
    
    
    
    
    
    
    Total other commitments
    
    $
    549,408
    
    
    $
    446,099
    
    
    $
    28,459
    
    
    $
    4,081
    
    
    $
    70,769
 Page 25




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OFF-BALANCE SHEET ARRANGEMENTS Information about the companys off-balance sheet risk exposure is presented in Note 18 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, 2004, the companys sole SPE
activity is with Southern Community Capital Trust II, the subsidiary that issued 3,450,000 Trust
Preferred Securities in November 2003. CAPITAL RESOURCES Stockholders equity at December 31, 2004 was $136.9 million. At that date, our capital to asset
ratio was 11.2%, 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, 2004 was 11.79%. The bank and the company are subject to minimum capital requirements. See SUPERVISION AND
REGULATION. As the following table indicates, at December 31, 2004, the company exceeded its
regulatory capital requirements. At December 31, 2004Actual
    
    
    Minimum
    
    
    Well-CapitalizedRatio
    
    
    Requirement
    
    
    RequirementTotal risk-based capital ratio
    
    
    13.82
    %
    
    
    8.00
    %
    
    
    10.00
    %Tier 1 risk-based capital ratio
    
    
    11.79
    %
    
    
    4.00
    %
    
    
    6.00
    %Leverage ratio
    
    
    9.68
    %
    
    
    4.00
    %
    
    
    5.00
    %
 The companys 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. The
Board of Governors of the Federal Reserve, on March 1, 2005, adopted a final rule allowing the
continued limited inclusion of trust preferred securities in the Tier 1 capital. The Boards final
rule limits restricted core capital elements to twenty-five percent of all core capital elements. As of December 31, 2004 the company had a single subsidiary 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 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. Page 26




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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. 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 increased 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, 2004, if interest rates increase by two percentage points, our net interest
income over a one-year time frame could increase by approximately 3.7% or $1.3 million. As of
October 31, 2004, if interest rates decrease by one percentage point (given the present level of
the targeted Federal funds rate), our net interest income over a one-year time frame could decrease
by approximately 3.1% or $1.1 million. 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 Page 27




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##### 



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, based on gap measurements, was asset-sensitive at December 31, 2004 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, 2004 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, 2004Over 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
    
    $
    491,094
    
    
    $
    31,955
    
    
    $
    523,049
    
    
    $
    273,054
    
    
    $
    796,103Investment securities available for sale
    
    
    
    
    
    
    2,750
    
    
    
    2,750
    
    
    
    235,014
    
    
    
    237,764Investment securities held to maturity
    
    
    
    
    
    
    2,053
    
    
    
    2,053
    
    
    
    73,092
    
    
    
    75,145Federal funds sold
    
    
    80
    
    
    
    
    
    
    
    80
    
    
    
    
    
    
    
    80Total interest-earning assets
    
    $
    491,174
    
    
    $
    36,758
    
    
    $
    527,932
    
    
    $
    581,160
    
    
    $
    1,109,092Interest-bearing liabilitiesDeposits:Money market and NOW deposits
    
    $
    236,121
    
    
    $
    
    
    
    $
    236,121
    
    
    $
    
    
    
    $
    236,121Time deposits greater than $100,000
    
    
    72,085
    
    
    
    60,240
    
    
    
    132,325
    
    
    
    149,052
    
    
    
    281,377Other time deposits
    
    
    80,538
    
    
    
    101,194
    
    
    
    181,732
    
    
    
    47,478
    
    
    
    229,210Borrowings
    
    
    69,647
    
    
    
    
    
    
    
    69,647
    
    
    
    163,493
    
    
    
    233,140Total interest-bearing liabilities
    
    $
    458,391
    
    
    $
    161,434
    
    
    $
    619,825
    
    
    $
    360,023
    
    
    $
    979,848Interest sensitivity gap per period
    
    $
    32,783
    
    
    $
    (124,676
    )
    
    $
    (91,893
    )
    
    $
    221,137
    
    
    $
    129,244Cumulative gap
    
    $
    32,783
    
    
    $
    (91,893
    )
    
    $
    (91,893
    )
    
    $
    129,244
    
    
    $
    129,244Cumulative ratio of interest-sensitive
assets to interest-sensitive liabilities
    
    
    107.15
    %
    
    
    22.77
    %
    
    
    85.17
    %
    
    
    161.42
    %
    
    
    113.19
    %
 Page 28




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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, 2004. Expected Maturities of Market Sensitive Instruments Heldat December 31, 2004 Occurring in the Indicated YearAverageBeyond
    
    
    
    
    
    
    Interest
    
    
    Estimated2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    Five Years
    
    
    Total
    
    
    Rate
    
    
    Fair Value(Dollars in thousands)FINANCIAL ASSETSFederal funds sold
    
    $
    80
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    80
    
    
    
    2.41
    %
    
    $
    80Investment securities (1) (2)
    
    
    4,803
    
    
    
    10,614
    
    
    
    32,981
    
    
    
    22,033
    
    
    
    8,995
    
    
    
    233,483
    
    
    
    312,909
    
    
    
    3.94
    %
    
    
    312,469Loans (3):Fixed rate
    
    
    46,677
    
    
    
    43,119
    
    
    
    29,950
    
    
    
    47,696
    
    
    
    32,931
    
    
    
    119,358
    
    
    
    319,731
    
    
    
    6.20
    %
    
    
    300,981Variable rate
    
    
    476,372
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    476,372
    
    
    
    5.68
    %
    
    
    500,094Total
    
    $
    527,932
    
    
    $
    53,733
    
    
    $
    62,931
    
    
    $
    69,729
    
    
    $
    41,926
    
    
    $
    352,841
    
    
    $
    1,109,092
    
    
    
    4.84
    %
    
    $
    1,113,624FINANCIAL LIABILITIESMoney market and NOW
deposits
    
    $
    236,121
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    236,121
    
    
    
    0.87
    %
    
    
    236,121Time deposits
    
    
    314,057
    
    
    
    79,802
    
    
    
    53,364
    
    
    
    14,837
    
    
    
    33,027
    
    
    
    15,500
    
    
    
    510,587
    
    
    
    2.81
    %
    
    
    496,559Short-term borrowings
    
    
    69,647
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    69,647
    
    
    
    2.48
    %
    
    
    69,607Long-term borrowings
    
    
    35,653
    
    
    
    5,250
    
    
    
    45,000
    
    
    
    
    
    
    
    10,000
    
    
    
    67,590
    
    
    
    163,493
    
    
    
    4.12
    %
    
    
    167,328Total
    
    $
    655,478
    
    
    $
    85,052
    
    
    $
    98,364
    
    
    $
    14,837
    
    
    $
    43,027
    
    
    $
    83,090
    
    
    $
    979,848
    
    
    
    2.10
    %
    
    $
    969,615
   (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, 2004
are assumed to mature at their call dates for purposes of this table.(3)
    
    Includes nonaccrual loans but not the allowance for loan losses. Page 29




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##### 



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, 2004
    
    
    Year Ended December 31, 2003Fourth
    
    
    Third
    
    
    Second
    
    
    First
    
    
    Fourth
    
    
    Third
    
    
    Second
    
    
    FirstQuarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter
    
    
    Quarter(In thousands, except per share data and common stock price)Interest income
    
    $
    14,744
    
    
    $
    13,909
    
    
    $
    13,154
    
    
    $
    12,849
    
    
    $
    9,510
    
    
    $
    9,338
    
    
    $
    8,801
    
    
    $
    8,370Interest expense
    
    
    5,674
    
    
    
    5,061
    
    
    
    4,513
    
    
    
    4,409
    
    
    
    3,945
    
    
    
    3,657
    
    
    
    3,625
    
    
    
    3,524Net interest income
    
    
    9,070
    
    
    
    8,848
    
    
    
    8,641
    
    
    
    8,440
    
    
    
    5,565
    
    
    
    5,681
    
    
    
    5,176
    
    
    
    4,846Provision for loan losses
    
    
    350
    
    
    
    575
    
    
    
    717
    
    
    
    597
    
    
    
    595
    
    
    
    465
    
    
    
    685
    
    
    
    540Net interest income
after provision for
loan losses
    
    
    8,720
    
    
    
    8,273
    
    
    
    7,924
    
    
    
    7,843
    
    
    
    4,970
    
    
    
    5,216
    
    
    
    4,491
    
    
    
    4,306Non-interest income
    
    
    2,249
    
    
    
    1,848
    
    
    
    1,780
    
    
    
    1,529
    
    
    
    1,134
    
    
    
    1,257
    
    
    
    1,424
    
    
    
    1,170Non-interest expense
    
    
    7,147
    
    
    
    6,896
    
    
    
    6,726
    
    
    
    6,751
    
    
    
    4,818
    
    
    
    4,892
    
    
    
    4,604
    
    
    
    4,019Income before income
taxes
    
    
    3,822
    
    
    
    3,225
    
    
    
    2,978
    
    
    
    2,621
    
    
    
    1,286
    
    
    
    1,581
    
    
    
    1,311
    
    
    
    1,457Income taxes
    
    
    1,469
    
    
    
    1,119
    
    
    
    1,021
    
    
    
    935
    
    
    
    450
    
    
    
    553
    
    
    
    459
    
    
    
    510Net income
    
    $
    2,353
    
    
    $
    2,106
    
    
    $
    1,957
    
    
    $
    1,686
    
    
    $
    836
    
    
    $
    1,028
    
    
    $
    852
    
    
    $
    947Per share data:Net income:Basic
    
    $
    0.13
    
    
    $
    0.12
    
    
    $
    0.11
    
    
    $
    0.11
    
    
    $
    0.09
    
    
    $
    0.12
    
    
    $
    0.10
    
    
    $
    0.11Diluted
    
    
    0.13
    
    
    
    0.12
    
    
    
    0.11
    
    
    
    0.10
    
    
    
    0.09
    
    
    
    0.11
    
    
    
    0.09
    
    
    
    0.10Common stock price:High
    
    $
    11.67
    
    
    $
    11.73
    
    
    $
    12.15
    
    
    $
    13.43
    
    
    $
    11.17
    
    
    $
    10.46
    
    
    $
    9.95
    
    
    $
    8.08Low
    
    
    9.82
    
    
    
    8.71
    
    
    
    9.27
    
    
    
    11.00
    
    
    
    9.91
    
    
    
    8.88
    
    
    
    7.57
    
    
    
    6.30
 Page 30




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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 31,2004
    
    
    2003
    
    
    2002Percent
    
    
    
    
    
    
    Percent
    
    
    
    
    
    
    PercentAmount
    
    
    of Total
    
    
    Amount
    
    
    of Total
    
    
    Amount
    
    
    of Total(Dollars in thousands)Residential mortgage loans
    
    $
    238,454
    
    
    
    30.0
    %
    
    $
    150,312
    
    
    
    28.9
    %
    
    $
    118,572
    
    
    
    28.1
    %Commercial mortgage loans
    
    
    295,130
    
    
    
    37.1
    %
    
    
    186,758
    
    
    
    35.9
    %
    
    
    137,812
    
    
    
    32.7
    %Construction loans
    
    
    102,282
    
    
    
    12.8
    %
    
    
    71,908
    
    
    
    13.8
    %
    
    
    64,500
    
    
    
    15.3
    %Commercial and industrial loans
    
    
    127,432
    
    
    
    16.0
    %
    
    
    87,127
    
    
    
    16.8
    %
    
    
    71,948
    
    
    
    17.0
    %Loans to individuals
    
    
    32,805
    
    
    
    4.1
    %
    
    
    23,641
    
    
    

    4.6
    %
    
    
    29,106
    
    
    
    6.9
    %Subtotal
    
    
    796,103
    
    
    
    100.0
    %
    
    
    519,746
    
    
    
    100.0
    %
    
    
    421,938
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (12,537
    )
    
    
    
    
    
    
    (7,275
    )
    
    
    
    
    
    
    (6,342
    )Net loans
    
    $
    783,566
    
    
    
    
    
    
    $
    512,471
    
    
    
    
    
    
    $
    415,596
 At December 31,2001
    
    
    2000Percent
    
    
    
    
    
    
    PercentAmount
    
    
    of Total
    
    
    Amount
    
    
    of Total(Dollars in thousands)Residential mortgage loans
    
    $
    105,357
    
    
    
    29.2
    %
    
    $
    84,280
    
    
    
    29.9
    %Commercial mortgage loans
    
    
    89,354
    
    
    
    24.8
    %
    
    
    59,410
    
    
    
    21.0
    %Construction loans
    
    
    61,558
    
    
    
    17.1
    %
    
    
    52,800
    
    
    
    18.7
    %Commercial and industrial loans
    
    
    77,820
    
    
    
    21.6
    %
    
    
    60,280
    
    
    
    21.4
    %Loans to individuals
    
    
    26,199
    
    
    
    7.3
    %
    
    
    25,391
    
    
    
    9.0
    %Subtotal
    
    
    360,288
    
    
    
    100.0
    %
    
    
    282,161
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (5,400
    )
    
    
    
    
    
    
    (4,283
    )Net loans
    
    $
    354,888
    
    
    
    
    
    
    $
    277,878
 Page 31




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##### 



The following table represents The Community Bank as of: At December 31,2003PercentAmount
    
    
    of Total(Dollars in thousands)Residential mortgage loans
    
    $
    60,061
    
    
    
    34.0
    %Commercial mortgage loans
    
    
    75,557
    
    
    
    42.9
    %Construction loans
    
    
    3,459
    
    
    
    2.0
    %Commercial and industrial loans
    
    
    26,801
    
    
    
    15.2
    %Loans to individuals
    
    
    10,424
    
    
    
    5.9
    %Subtotal
    
    
    176,302
    
    
    
    100.0
    %Less: Allowance for loan losses
    
    
    (4,860
    )Net loans
    
    $
    171,442
 The following table presents at December 31, 2004 (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, which mature after one year: At December 31, 2004Due 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
    
    $
    136,800
    
    
    
    5.97
    %
    
    $
    46,147
    
    
    
    6.93
    %
    
    $
    54,175
    
    
    
    6.42

    %
    
    $
    237,122
    
    
    
    6.26
    %Commercial mortgage
    
    
    164,326
    
    
    
    5.81
    %
    
    
    77,005
    
    
    
    6.44
    %
    
    
    53,742
    
    
    
    5.72
    %
    
    
    295,073
    
    
    
    5.97
    %Construction
    
    
    97,165
    
    
    
    5.55
    %
    
    
    858
    
    
    
    6.31
    %
    
    
    4,259
    
    
    
    6.00
    %
    
    
    102,282
    
    
    
    5.58
    %Commercial and
industrial
    
    
    106,718
    
    
    
    5.70
    %
    
    
    15,753
    
    
    
    6.10
    %
    
    
    4,386
    
    
    
    5.50
    %
    
    
    126,857
    
    
    
    5.74
    %Individuals
    
    
    17,281
    
    
    
    6.96
    %
    
    
    12,828
    
    
    
    8.01
    %
    
    
    2,486
    
    
    
    4.08
    %
    
    
    32,595
    
    
    
    7.15
    %Total
    
    
    522,290
    
    
    
    5.82
    %
    
    
    152,591
    
    
    
    6.68
    %
    
    
    119,048
    
    
    
    6.01
    %
    
    
    793,929
    
    
    
    6.01
    %Nonaccrual loans
    
    
    759
    
    
    
    
    
    
    
    1,105
    
    
    
    
    
    
    
    310
    
    
    
    
    
    
    
    2,174Loans, gross
    
    $
    523,049
    
    
    
    
    
    
    $
    153,696
    
    
    
    
    
    
    $
    119,358
    
    
    
    
    
    
    $
    796,103
 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 $635.9 million at December 31, 2004, representing 79.9% 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. Page 32




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##### 



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 originate 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 $3.6 million at December 31, 2004. We receive
income from residential mortgage loans originated for sale in the secondary market, with such fees
aggregating $750,000 for the year ended December 31, 2004 and $1.4 million for the year ended
December 31, 2003. 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 $238.4 million
at December 31, 2004, and included $128.5 million in one-to-four family permanent mortgage loans,
$89.8 million in outstanding advances under home equity credit lines, and $20.0 million of other
loans secured by residential real estate. 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. 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 $295.1 million at December 31,
2004. 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. 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 including acquisition development and spec home financing. 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 $102.3 million at December 31, 2004. Commercial Loans.Commercial business lending is a primary focus of our lending activities. At
December 31, 2004, our commercial loan portfolio equaled $127.4 million or 16.0% 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 Page 33




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##### 



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 five outside Directors as appointed by the Board of Directors.
This Committee meets on a monthly basis to review for approval all loan requests in excess of $3.5
million. As of December 31, 2004, the legal lending limit for the bank was approximately $16.7
million. Subsequent to year-end 2004, an internal bank committee was formed. This committee is
comprised of seven members whom review all loan requests between $6.1 million and $9.0 million.
The Board Loan Committee will review all loan requests in excess of $9.0 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 used an independent third party 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 potential
losses inherent in the loan portfolio. Our policy in regard to past due loans normally requires a charge-off to the allowance for loan
losses within a reasonable period after timely collection efforts and a thorough review has been
completed. Further collection efforts are then pursued through various means including legal
remedies. Loans carried in a non-accrual status are generally collateralized and probable losses
are considered in the determination of the allowance for loan losses. Page 34




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##### 



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 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands)Nonaccrual loans
    
    $
    2,174
    
    
    $
    769
    
    
    $
    1,823
    
    
    $
    894
    
    
    $
    276Restructured loans
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total nonperforming loans
    
    
    2,174
    
    
    
    769
    
    
    
    1,823
    
    
    
    894
    
    
    
    276Foreclosed assets
    
    
    1,085
    
    
    
    272
    
    
    
    383
    
    
    
    347
    
    
    
    4Total nonperforming assets
    
    $
    3,259
    
    
    $
    1,041
    
    
    $
    2,206
    
    
    $
    1,241
    
    
    $
    280Accruing loans past due
90 days or more
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    15Allowance for loan losses
    
    
    12,537
    
    
    
    7,275
    
    
    
    6,342
    
    
    
    5,400
    
    
    
    4,283Nonperforming loans to period end loans
    
    
    .27
    %
    
    
    .15
    %
    
    
    .43
    %
    
    
    .25
    %
    
    
    .10
    %Allowance for loan losses to period end loans
    
    
    1.57
    %
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %Allowance for loan losses to
nonperforming loans
    
    
    577
    %
    
    
    946
    %
    
    
    348
    %
    
    
    604
    %
    
    
    1,552
    %Nonperforming assets to total assets
    
    
    .27
    %
    
    
    .13
    %
    
    
    .36
    %
    
    
    .26
    %
    
    
    .07
    %
 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,
2004, we had identified $7.8 million of potential problem loans. Had these potential problem loans
been placed on non-accrual status our ratio of nonperforming loans to total loans a would have been
1.3% at December 31, 2004. At December 31, 2004, we had $2.2 million of nonaccrual loans. At that time, the largest
nonaccrual balance to any one borrower was $510,000, with the average balance for the 72 nonaccrual
loans being $30,200. Real estate owned consists of foreclosed assets, repossessed and idled properties. At December 31,
2004 real estate owned totaled $1.1 million or .09% of total assets, and consisted of twelve
properties. The largest dollar value of a property is $445,000. We have reviewed recent
appraisals of these properties and believe that the fair value, less estimated costs to sell,
exceed their carrying value. Page 35




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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 monthly basis our
Board Loan Committee reviews our loan portfolio and conducts an evaluation of our credit quality.
The Board Loan Committee reports directly to Board of Directors. Quarterly the Board of Directors
reviews the loan loss provision. 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, trends in past dues and classified assets, 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. 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 auditors, internal loan review and by an independent third party. 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, objective criteria 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 or the borrower may default if the deficiencies are not corrected. A
reserve of up to 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 default is likely.
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. Net charge-offs
increased $72,000 in 2004 to $1.4 million. However, due to our expanded loan base as a result of
the Community transaction, the percentage of net loan charge-offs to average loans outstanding
decreased to .19% for the year ended December 31, 2004, from .29% for the year-ended 2003. Our
consumer finance lending accounted for $687,000 or 48.2% of net charge-offs
during 2004, a decrease of $87,000 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 twenty-four month time frame and the companys level of charge-off as
a percentage of loan outstandings will decline as a result. Our provision for loan losses totaled
$2.2 million for the year-ended December 31, 2004. Our allowance for loan losses at December 31,
2004 of $12.5 million represents 1.57% of total loans and 577% of nonperforming loans. Our
allowance for loan losses at December 31, 2003 was $7.3 million and represented 1.40% of total
loans. Page 36




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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. While net loan charge-offs to average loans experienced improvement in 2004, nonperforming loans as
a percentage of total loans and nonperforming assets to total assets have increased 12 basis points
and 14 basis points, respectively, from year-end 2003. In addition, potential problem loans, as
described under ASSET QUALITY, have increased $3.1 million from December 2003 levels to $7.8
million. The unfavorable trends in nonperforming loans and assets coupled with deterioration in
previously disclosed impaired loans and continued evaluation of Communitys loan portfolio has
cautioned management to maintain the allowance for loan losses to total loans at a level above that
of 2003. Specific reserves have been established for certain problem loans and management
continuously monitors our asset quality. As potential problem credit issues are resolved, as our
nonperforming trends improve and as management further evaluates the asset quality of the Community
loan portfolio, the allowance will be adjusted to reflect those changes. Page 37




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##### 



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. It is managements practice to maintain the unallocated portion of the allowance
to 10% to 20% of the total allowance. As of December 31, 2004 the unallocated allowance
represented 20% of the total allowance. As of December 31, 2003 the unallocated allowance
represented 17% of the total allowance. At December 31,2004
    
    
    2003
    
    
    2002% of Total
    
    
    
    
    
    
    % of Total
    
    
    
    
    
    
    % of TotalAmount
    
    
    Loans (1)
    
    
    Amount
    
    
    Loans (1)
    
    
    Amount
    
    
    Loans (1)(Dollars in thousands)Residential mortgage loans
    
    $
    1,419
    
    
    
    30.0
    %
    
    $
    475
    
    
    
    28.9
    %
    
    $
    350
    
    
    
    28.1
    %Commercial mortgage loans
    
    
    3,500
    
    
    
    37.1
    %
    
    
    2,200
    
    
    
    35.9
    %
    
    
    1,500
    
    
    
    32.7
    %Construction loans
    
    
    1,924
    
    
    
    12.8
    %
    
    
    1,100
    
    
    
    13.8
    %
    
    
    1,100
    
    
    
    15.3
    %Commercial and
industrial loans
    
    
    1,815
    
    
    
    16.0
    %
    
    
    1,200
    
    
    
    16.8
    %
    
    
    1,000
    
    
    
    17.0
    %Loans to individuals
    
    
    1,304
    
    
    
    4.1
    %
    
    
    1,050
    
    
    
    4.6
    %
    
    
    1,225
    
    
    
    6.9
    %Unallocated
    
    
    2,575
    
    
    
    
    %
    
    
    1,250
    
    
    
    
    %
    
    
    1,167
    
    
    
    
    %Total
    
    $
    12,537
    
    
    
    100.0
    %
    
    $
    7,275
    
    
    
    100.0
    %
    
    $
    6,342
    
    
    
    100.0
    %
 At December 31,2001
    
    
    2000% of Total
    
    
    
    
    
    
    % of TotalAmount
    
    
    Loans (1)
    
    
    Amount
    
    
    Loans (1)(Dollars in thousands)Residential mortgage loans
    
    $
    550
    
    
    
    29.2
    %
    
    $
    350
    
    
    
    29.9
    %Commercial mortgage loans
    
    
    825
    
    
    
    24.8
    %
    
    
    525
    
    
    
    21.0
    %Construction loans
    
    
    1,000
    
    
    
    17.1
    %
    
    
    900
    
    
    
    18.7
    %Commercial and
industrial loans
    
    
    1,100
    

    
    
    21.6
    %
    
    
    900
    
    
    
    21.4
    %Loans to individuals
    
    
    925
    
    
    
    7.3
    %
    
    
    650
    
    
    
    9.0
    %Unallocated
    
    
    1,000
    
    
    
    
    %
    
    
    958
    
    
    
    
    %Total
    
    $
    5,400
    
    
    
    100.0
    %
    
    $
    4,283
    
    
    
    100.0
    %
   (1)
    
    Represents total of all outstanding loans in each category as a percentage of total loans
outstanding. Page 38




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##### 



The following table presents for the periods indicated information regarding changes in our
allowance for loan losses: At or for the Years Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars in thousands)Balance at beginning of period
    
    $
    7,275
    
    
    $
    6,342
    
    
    $
    5,400
    
    
    $
    4,283
    
    
    $
    3,013Charge-offs:Residential mortgage loans
    
    
    
    
    
    
    
    
    
    
    82
    
    
    
    115
    
    
    
    Commercial mortgage loans
    
    
    43
    
    
    
    
    
    
    
    
    
    
    
    53
    
    
    
    Construction loans
    
    
    312
    
    
    
    
    
    
    
    113
    
    
    
    
    
    
    
    Commercial and industrial loans
    
    
    120
    
    
    
    398
    
    
    
    90
    
    
    
    416
    
    
    
    122Loans to individuals
    
    
    1,099
    
    
    
    1,022
    
    
    
    473
    
    
    
    663
    
    
    
    90Total charge-offs
    
    
    1,574
    
    
    
    1,420
    
    
    
    758
    
    
    
    1,247
    
    
    
    212Recoveries:Construction loans
    
    
    
    
    

    
    
    
    
    
    
    
    
    
    
    
    
    
    Commercial and industrial loans
    
    
    7
    
    
    
    31
    
    
    
    15
    
    
    
    29
    
    
    
    1Loans to individuals
    
    
    143
    
    
    
    37
    
    
    
    30
    
    
    
    15
    
    
    
    1Total recoveries
    
    
    150
    
    
    
    68
    
    
    
    45
    
    
    
    44
    
    
    
    2Net charge-offs
    
    
    (1,424
    )
    
    
    (1,352
    )
    
    
    (713
    )
    
    
    (1,203
    )
    
    
    (210
    )Provision for loan losses
    
    
    2,239
    
    
    
    2,285
    
    
    
    1,655
    
    
    
    2,320
    
    
    
    1,480Allowance for loans acquired in

purchase transactions, net
    
    
    4,447
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at end of period
    
    $
    12,537
    
    
    $
    7,275
    
    
    $
    6,342
    
    
    $
    5,400
    
    
    $
    4,283Total loans outstanding
    
    $
    796,103
    
    
    $
    519,746
    
    
    $
    421,938
    
    
    $
    360,288
    
    
    $
    282,161Average loans outstanding
    
    $
    742,333
    
    
    $
    471,808
    
    
    $
    395,745
    
    
    $
    318,696
    
    
    $
    240,888Allowance for loan losses to
loans outstanding
    
    
    1.57
    %
    
    
    1.40
    %
    
    
    1.50
    %
    
    
    1.50
    %
    
    
    1.52
    %Ratio of net loan charge-offs to
average loans outstanding
    
    
    .19
    %
    
    
    .29
    %
    
    
    .18
    %
    
    
    .38
    %
    
    
    .09
    %
 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, 2004Securities available for sale:U.S. Government agencies
    
    $
    69,038
    
    
    $
    106
    
    
    $
    274
    
    
    $
    68,870Mortgage-backed
    
    
    150,282
    
    
    
    833
    
    
    
    947
    
    
    
    150,168Municipals
    
    
    1,000
    
    
    
    1
    
    
    
    2
    
    
    
    999Other
    
    
    17,635
    
    
    
    92
    
    
    
    
    
    
    
    17,727$
    237,955
    
    
    $
    1,032
    
    
    $
    1,223
    
    
    $
    237,764Securities held to maturity:U.S. Government agencies
    
    $
    59,692
    
    
    $
    22
    
    
    $
    851
    
    
    $
    58,863Mortgage-backed
    
    
    3,971
    
    
    
    46
    
    
    
    4
    
    
    
    4,013Municipals
    
    
    10,481
    
    
    
    341
    
    
    
    9
    
    
    
    10,813Other
    
    
    1,001
    
    
    
    15
    
    
    
    
    
    
    
    1,016$
    75,145
    
    
    $
    424
    
    
    $
    864
    
    
    $
    74,705December 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
    
    
    $
    
    
    
    $
    45,319
 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, 2004: WeightedAmortized
    
    
    Fair
    
    
    Average/Cost
    
    
    Value
    
    
    Yield(Amounts in thousands)Securities available for sale:U.S. Government agenciesDue within one year
    
    $
    2,402
    
    
    $
    2,425
    
    
    
    5.52
    %Due after one but within five years
    
    
    50,195
    
    
    
    49,948
    
    
    
    3.17
    %Due after five but within ten years
    
    
    16,441
    
    
    
    16,497
    
    
    
    4.43
    %69,038
    
    
    
    68,870
    
    
    
    3.55
    %Mortgage-backedDue after one but within five years
    
    
    2,829
    
    
    
    2,825
    
    
    
    3.33
    %Due after five but within ten years
    
    
    97,612
    
    
    
    96,995
    
    
    
    3.75
    %Due after ten years
    
    
    49,841
    
    
    
    50,348
    
    
    
    4.27
    %150,282
    
    
    
    150,168
    
    
    
    3.92
    %State and local governmentsDue after ten years
    
    
    1,000
    
    
    
    999
    
    
    
    4.24
    %OtherDue within one year
    
    
    325
    
    
    
    325
    
    
    
    2.00
    %Due after five but within ten years
    
    
    617
    
    
    
    617
    
    
    
    3.75
    %Due after ten years
    
    
    16,693
    
    
    
    16,785
    
    
    
    5.37
    %17,635
    
    
    
    17,727
    
    
    
    4.36
    %Total securities available for saleDue within one year
    
    $
    2,727
    
    
    $
    2,750
    
    
    
    4.86
    %Due after one but within five years
    
    
    53,024
    
    
    
    52,773
    
    
    
    3.18
    %Due after five but within ten years
    
    
    114,670
    
    
    
    114,109
    
    
    
    3.83
    %Due after ten years
    
    
    67,534
    
    
    
    68,132
    
    
    
    4.35
    %$
    237,955
    
    
    $
    237,764
    
    
    
    3.82
    %Securities held to maturity:U. S. Government agenciesDue after one but within five years
    
    $
    16,104
    
    
    $
    16,041
    
    
    
    3.51
    %Due after five but within ten years
    
    
    23,451
    
    
    
    23,008
    
    
    
    3.74
    %Due after ten years
    
    
    20,137
    
    
    
    19,814
    
    
    
    5.14
    %59,692
    
    
    
    58,863
    
    
    
    4.15
    %Mortgage-backedDue after five but within ten years
    
    
    754
    
    
    
    782
    
    
    
    5.74
    %Due after ten years
    
    
    3,217
    
    
    
    3,231
    
    
    
    4.81
    %3,971
    
    
    
    4,013
    
    
    
    4.99
    %State and local governments (1)Due within one year
    
    
    1,052
    
    
    
    1,059
    
    
    
    3.55
    %Due after one but within five years
    
    
    5,747
    
    
    
    5,863
    
    
    
    3.07
    %Due after five but within ten years
    
    
    2,533
    
    
    
    2,689
    
    
    
    4.17
    %Due after ten years
    
    
    1,149
    
    
    
    1,202
    
    
    
    4.26
    %10,481
    
    
    
    10,813
    
    
    
    3.51
    %OtherDue within one year
    
    
    1,001
    
    
    
    1,016
    
    
    
    7.26
    %Total securities held to maturityDue within one year
    
    
    2,053
    
    
    
    2,075
    
    
    
    5.35
    %Due after one but within five years
    
    
    21,851
    
    
    
    21,904
    
    
    
    3.40
    %Due after five but within ten years
    
    
    26,738
    
    
    
    26,479
    
    
    
    3.83
    %Due after ten years
    
    
    24,503
    
    
    
    24,247
    
    
    
    5.05
    %$
    75,145
    
    
    $
    74,705
    
    
    
    4.15
    %
   (1)
    
    Yields on tax-exempt investments have been adjusted to a taxable equivalent basis using a 34%
tax rate. At December 31, 2004, 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. 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, 2004, swap derivatives
with a total notional value of $53.5 million, with terms ranging up to twenty-nine 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, 2004, our
interest rate swaps reflected a net unrealized loss of $188,300. In addition, the bank 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, 2004, 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 17 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,
2004, we have $137.9 million of brokered deposits and $57.4 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 31,2004
    
    
    2003
    
    
    2002Average
    
    
    Average
    
    
    Average
    
    
    Average
    
    
    Average
    
    
    AverageBalance
    
    
    Rate
    
    
    Balance
    
    
    Rate
    
    
    Balance
    
    
    Rate(Dollars in thousands)Interest-bearing NOW and money market accounts
    
    $
    241,363
    
    
    
    0.84
    %
    
    $
    138,926
    
    
    
    0.97
    %
    
    $
    102,427
    
    
    
    1.31
    %Time deposits $100,000 or more
    
    
    257,034
    
    
    
    2.63
    %
    
    
    154,026
    
    
    
    2.79
    %
    
    
    114,971
    
    
    
    3.96
    %Other time deposits
    
    
    229,584
    
    
    
    1.95
    %
    
    
    163,960
    
    
    
    2.59
    %
    
    
    172,456
    
    
    
    3.62
    %Total interest-bearing deposits
    
    
    727,981
    
    
    
    1.82
    %
    
    
    456,912
    
    
    
    2.17
    %
    
    
    389,854
    
    
    
    3.11
    %Demand and other non-interest-bearing deposits
    
    
    85,583
    
    
    
    
    
    
    
    45,101
    
    
    
    
    
    
    
    34,766Total average deposits
    
    $
    813,564
    
    
    
    1.63
    %
    
    $
    502,013
    
    
    
    1.97
    %
    
    $
    424,620
    
    
    
    2.86
    %
 The following table presents the amounts and maturities of our certificates of deposit with
balances of $100,000 or more at December 31, 2004: At December 31, 2004(In thousands)Remaining maturity:Less than three months
    
    $
    72,085Three to six months
    
    
    32,725Six to twelve months
    
    
    27,515Over twelve months
    
    
    149,052Total
    
    $
    281,377
 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, 2004 totaled $147.8 million,
and are secured by loans with a carrying amount of $188.2 million, which approximates market value,
and investment securities with a market value of $128.1 million. InterestYear of Maturity
    
    Rate
    
    
    Amount(In thousands)2005
    
    
    2.59
    %
    
    $
    20,0002006
    
    
    
    %
    
    
    2007
    
    
    3.00
    %
    
    
    45,0002008
    
    
    1.93
    %
    
    
    5,2502009
    
    
    2.15
    %
    
    
    10,000Thereafter
    
    
    3.45
    %
    
    
    67,590$
    147,840
 In addition to the Federal Home Loan Bank advances, we also had a repurchase agreement with an
outstanding balance of $30.6 million at December 31, 2004. 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 $130.0
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 $73.0 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 $19.0 million
of federal funds borrowings outstanding under these lines as of December 31, 2004. Borrowings that are scheduled to be repaid within one year are classified as short-term borrowings.
For 2004 and 2003, average outstanding short-term borrowings were $68.9 million and $37.5 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
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. Other Recent Developments On January 20, 2005, the company announced the declaration of its second annual cash dividend of
$0.12 per share of its common stock which was paid on March 15, 2005, to shareholders of record on
February 22, 2005. On February 5, 2005, Richard M. Cobb, Executive Vice President, Chief Operating Officer and Chief
Financial Officer of Southern Community Financial Corporation, announced his resignation from the
Company effective February 7, 2005. Mr. Cobb notified the Companys Chairman that he was resigning
to pursue other interests. He had served as Chief Financial Officer of Southern Community Bank and
Trust, the Companys subsidiary and its predecessor, since its incorporation. As a result of Mr.
Cobbs departure, the company will take a onetime charge of approximately $300,000 in the first
quarter relating to supplemental retirement benefits. Page 44




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##### 



On February 18, 2005, a borrower included in our discussion of potential problem loans, as noted in
Nonperforming Assets above, filed Chapter 11 Bankruptcy. The loan has been placed on nonaccrual
status and we are working through the bankruptcy process to collect our loan. The bank has total
exposure of $4.4 million to this customer with $4.0 million outstanding as of the March 7, 2005.
The loan is secured by real estate, accounts receivable, inventory and equipment. Management had
previously established a specific reserve that is estimated to be sufficient to absorb losses in
excess of the liquidation value of our collateral position. In addition, subsequent to year-end another borrower, also included in our discussion of potential
problem loans as noted in Nonperforming Assets above, defaulted on their agreement. The banks
current exposure to this counterparty is approximately $2.2 million. The loan is secured by real
estate. Upon default by the borrower management placed the loan on nonaccrual status, initiated
demand letters and has begun foreclosure proceedings. Based on our collateral position, management
believes that any losses on this credit will be minimal. Due to the pending adoption of SFAS No. 123 (revised), on March 8, 2005, the Compensation Committee
of the Board voted to immediately vest all outstanding unvested options. As a result of this
change, the Company will take an estimated one-time charge of less than $200,000 during the first
quarter of 2005. RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the Financial Accounting Standards Board issued SFAS No. 123 (revised), Share
Based Payment. SFAS No. 123 (revised) establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The primary focus of this statement is on accounting for transactions in
which an entity obtains employee services in exchange for share-based payment transactions. This
Statement is effective for the beginning of the first interim or annual reporting period that
begins after June 15, 2005. Management has calculated the companys net income impact to be in
excess of $3.0 million, on a pre-tax basis, over the ensuing five-year period after the July 1,
2005 adoption of SFAS No. 123 (revised). 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 7. Item 8. Financial Statements The information required by this item is filed herewith. Page 45




---



##### 



(DIXON HUGHES LOGO) Report of Independent Registered Public Accounting Firm 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, 2004 and 2003, 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, 2004. 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 the standards of the Public Company Accounting Oversight
Board (United States) 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, 2004 and 2003 and the results of their operations and their cash flows
for each of the years in the three-year period ended December 31, 2004 in conformity with
accounting principles generally accepted in the United States of America. /s/ Dixon Hughes PLLCSanford, North Carolina
March 18, 2005 Page 46




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003   2004
    
    
    2003(Amounts in thousands,except share data)AssetsCash and due from banks
    
    $
    17,758
    
    
    $
    22,929Federal funds sold
    
    
    80
    
    
    
    271Investment securities (Note 4)Available for sale, at fair value
    
    
    237,764
    
    
    
    168,500Held to maturity (fair value of $74,705 and $61,044
at December 31, 2004 and 2003, respectively)
    
    
    75,145
    
    
    
    62,257Loans (Note 5)
    
    
    796,103
    
    
    
    519,746Allowance for loan losses (Note 6)
    
    
    (12,537
    )
    
    
    (7,275
    )Net Loans
    
    
    783,566
    
    
    
    512,471Premises and equipment (Note 7)
    
    
    28,325
    
    
    
    17,337Goodwill
    
    
    50,135
    
    
    
    Other assets (Note 8 and 12)
    
    
    29,588
    
    
    
    14,737Total Assets
    
    $
    1,222,361
    
    
    $
    798,502Liabilities and Stockholders EquityDepositsDemand
    
    $
    98,520
    
    
    $
    51,868Money market and NOW
    
    
    221,025
    
    
    
    179,076Savings
    
    
    15,096
    
    
    
    Time (Note 9)
    
    
    510,587
    
    
    
    344,274Total Deposits
    
    
    845,228
    
    
    
    575,218Short-term borrowings (Note 10)
    
    
    69,647
    
    
    
    51,900Long-term debt (Note 10 and 11)
    
    
    163,493
    
    
    
    117,627Other liabilities (Note 12)
    
    
    7,087
    
    
    
    2,866Total Liabilities
    
    
    1,085,455
    
    
    
    747,611Stockholders Equity (Notes 11 and 16)Preferred stock, no par value, 1,000,000 shares authorized;
none issued or outstanding at December 31, 2004 and 2003,
respectively
    
    
    
    
    
    
    Common stock, no par value, 30,000,000 shares authorized;
17,819,234 and 8,986,796 shares issued and outstanding
at December 31, 2004 and 2003, respectively
    
    
    125,200
    
    
    
    44,377Retained earnings
    
    
    11,693
    
    
    
    5,493Accumulated other comprehensive income
    
    
    13
    
    
    
    1,021Total Stockholders Equity
    
    
    136,906
    
    
    
    50,891Commitments (Notes 13 and 18)Total Liabilities and
Stockholders Equity
    
    $
    1,222,361
    
    
    $
    798,502
 See accompanying notes Page 47




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2004, 2003 and 2002 
 2004
    
    
    2003
    
    
    2002(Amounts in thousands, exceptshare and per share data)Interest IncomeLoans
    
    $
    42,843
    
    
    $
    27,478
    
    
    $
    25,689Investment securities available for sale
    
    
    9,306
    
    
    
    6,022
    
    
    
    4,901Investment securities held to maturity
    
    
    2,454
    
    
    
    2,469
    
    
    
    2,576Federal funds sold
    
    
    53
    
    
    
    50
    
    
    
    115Total Interest Income
    
    
    54,656
    
    
    
    36,019
    
    
    
    33,281Interest ExpenseMoney market, savings and NOW deposits
    
    
    2,027
    
    
    
    1,346
    
    
    
    1,342Time deposits
    
    
    11,199
    
    
    
    8,544
    
    
    
    10,800Borrowings
    
    
    6,431
    
    
    
    4,861
    
    
    
    3,661Total Interest Expense
    
    
    19,657
    
    
    
    14,751
    
    
    
    15,803Net Interest Income
    
    
    34,999
    
    
    
    21,268
    
    
    
    17,478Provision for Loan Losses (Note 6)
    
    
    2,239
    
    
    
    2,285
    
    
    
    1,655Net Interest Income After
Provision for Loan Losses
    
    
    32,760
    
    
    
    18,983
    
    
    
    15,823Non-Interest Income (Note 15)
    
    
    7,406
    
    
    
    4,985
    
    
    
    3,927Non-Interest ExpenseSalaries and employee benefits
    
    
    13,749
    
    
    
    9,603
    
    
    
    7,758Occupancy and equipment
    
    
    4,352
    
    
    
    3,045
    
    
    
    2,508Other (Note 15)
    
    
    9,419
    
    
    
    5,685
    
    
    
    4,515Total Non-Interest Expense
    
    
    27,520
    
    
    
    18,333
    
    
    
    14,781Income Before Income Taxes
    
    
    12,646
    
    
    
    5,635
    
    
    
    4,969Income Tax Expense (Note 14)
    
    
    4,544
    
    
    
    1,972
    
    
    
    1,755Net Income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214Net Income Per ShareBasic
    
    $
    .47
    
    
    $
    .41
    
    
    $
    .37Diluted
    
    
    .45
    
    
    
    .40
    
    
    
    .35Weighted Average Shares OutstandingBasic
    
    
    17,298,285
    
    
    
    8,826,780
    
    
    
    8,788,295Diluted
    
    
    18,033,333
    
    
    
    11,369,429
    
    
    
    9,085,853
 See accompanying notes. Page 48




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 2004, 2003 and 2002 
 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Net income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214Other comprehensive income (loss):Securities available for sale:Unrealized holding gains (losses) on available for sale securities
    
    
    (1,043
    )
    
    
    (1,851
    )
    
    
    1,465Tax effect
    
    
    403
    
    
    
    713
    
    
    
    (565
    )Reclassification of gains recognized in net income
    
    
    
    
    
    
    
    
    
    
    (70
    )Tax effect
    
    
    
    
    
    
    
    
    
    
    27Net of tax amount
    
    
    (640
    )
    
    
    (1,138
    )
    
    
    857Cash flow hedging activities:Unrealized holding gains (losses) on cash flow hedging activities
    
    
    (111
    )
    
    
    (250
    )
    
    
    1,461Tax effect
    
    
    43
    
    
    
    73
    
    
    
    (502
    )Reclassification of gains recognized in net income
    
    
    (480
    )
    
    
    (406
    )
    
    
    (52
    )Tax effect
    
    
    180
    
    
    
    156
    
    
    
    18Net of tax amount
    
    
    (368
    )
    
    
    (427
    )
    
    
    925Total other comprehensive income (loss)
    
    
    (1,008
    )
    
    
    (1,565
    )
    
    
    1,782Comprehensive income
    
    $
    7,094
    
    
    $
    2,098
    
    
    $
    4,996
 See accompanying notes Page 49




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY
Years Ended December 31, 2004, 2003 and 2002  AccumulatedCommon Stock
    
    
    
    
    
    
    Other
    
    
    TotalRetained
    
    
    Comprehensive
    
    
    StockholdersShares
    
    
    Amount
    
    
    Earnings
    
    
    Income
    
    
    Equity(Amounts in thousands, except share data)Balance 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
    
    
    
    50,891Net income
    
    
    
    
    
    
    
    
    
    
    8,102
    
    
    
    
    
    
    
    8,102Other comprehensive loss, net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,008
    )
    
    
    (1,008
    )Common stock issued pursuant to:Conversion of trust preferred securities
    
    
    2,059,846
    
    
    
    15,788
    
    
    
    
    
    
    
    
    
    
    
    15,788Business combination
    
    
    6,426,532
    
    
    
    62,659
    
    
    
    
    
    
    
    
    
    
    
    62,659Fair value of stock options issued
in connection with a business combination
    
    
    
    
    
    
    349
    
    
    
    
    
    
    
    
    
    
    
    349Stock options exercised
    
    
    323,710
    
    
    
    1,445
    
    
    
    
    
    
    
    
    
    
    
    1,445Employee stock purchase plan
    
    
    22,350
    
    
    
    171
    
    
    
    
    
    
    
    
    
    
    
    171Current income tax benefit
    
    
    
    
    
    
    411
    
    
    
    
    
    
    
    
    
    
    
    411Cash dividends of $.11 per share
    
    
    
    
    
    
    
    
    
    
    (1,902
    )
    
    
    
    
    
    
    (1,902
    )Balance at December 31, 2004
    
    
    17,819,234
    
    
    $
    125,200
    
    
    $
    11,693
    
    
    $
    13
    
    
    $
    136,906
 See accompanying notes Page 50




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2004, 2003 and 2002   2004
    
    
    2003
    
    
    2002(Amounts in thousands)Cash Flows from Operating ActivitiesNet income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214Adjustments to reconcile net income to net cash provided
by operating activities:Depreciation and amortization
    
    
    4,087
    
    
    
    2,041
    
    
    
    1,337Provision for loan losses
    
    
    2,239
    
    
    
    2,285
    
    
    
    1,655Realized (gain) on sales of available for sale securities, net
    
    
    
    
    
    
    
    
    
    
    (70
    )Realized (gain) on sale of premises and equipment
    
    
    (20
    )
    
    
    (98
    )
    
    
    (3
    )Deferred income taxes
    
    
    820
    
    
    
    (357
    )
    
    
    (452
    )Realized (gain) loss on sale of foreclosed assets
    
    
    (75
    )
    
    
    76
    
    
    
    (21
    )Change in assets and liabilities:Increase in other assets
    
    
    (4,349
    )
    
    
    (2,153
    )
    
    
    (1,505
    )Increase (decrease) in other liabilities
    
    
    1,606
    
    
    
    338
    
    
    
    1,590Total Adjustments
    
    
    4,308
    
    
    
    2,132
    
    
    
    2,531Net Cash Provided by Operating Activities
    
    
    12,410
    
    
    
    5,795
    
    
    
    5,745Cash Flows from Investing Activities(Increase) decrease in federal funds sold
    
    
    191
    
    
    
    10,813
    
    
    
    11,842Purchases of:Available for sale investment securities
    
    
    (141,996
    )
    
    
    (127,391
    )
    
    
    (112,297
    )Held to maturity investment securities
    
    
    (15,915
    )
    
    
    (66,463
    )
    
    
    (43,328
    )Proceeds from maturities and calls of:Available for sale investment securities
    
    
    122,073
    
    
    
    53,326
    
    
    
    26,152Held to maturity investment securities
    
    
    20,572
    
    
    
    
    
    
    
    21,220Net increase in loans
    
    
    (102,762
    )
    
    
    (100,229
    )
    
    
    (62,667
    )Proceeds from termination of interest rate swaps
    
    
    
    
    
    
    951
    
    
    
    208Purchases of premises and equipment
    
    
    (7,626
    )
    
    
    (3,543
    )
    
    
    (5,066
    )Proceeds from disposal of premises and equipment
    
    
    169
    
    
    
    657
    
    
    
    3Proceeds from sale of foreclosed assets
    
    
    1,444
    
    
    
    1,109
    
    
    
    289Purchase of bank-owned life insurance
    
    
    (7,000
    )
    
    
    (144
    )
    
    
    (577
    )Net cash used in business combination
    
    
    (9,393
    )
    
    
    
    
    
    
    Net Cash Used by Investing Activities
    
    
    (140,243
    )
    
    
    (181,952
    )
    
    
    (131,097
    )Cash Flows from Financing ActivitiesNet increase in deposits
    
    
    67,578
    
    
    
    126,223
    
    
    
    56,365Net increase in borrowings
    
    
    55,370
    
    
    
    22,169
    
    
    
    50,726Proceeds from issuance of trust preferred securities, net
of debt issuance costs
    
    
    
    
    
    
    33,292
    
    
    
    15,923Net proceeds from issuance of common stock
    
    
    1,616
    
    
    
    770
    
    
    
    105Cash dividends paid
    
    
    (1,902
    )
    
    
    
    
    
    
    Cash paid in lieu of fractional shares
    
    
    
    
    
    
    
    
    
    
    (13
    )Net Cash Provided by Financing Activities
    
    
    122,662
    
    
    
    182,454
    
    
    
    123,106Net Increase (Decrease) in Cash and Cash Equivalents
    
    
    (5,171
    )
    
    
    6,297
    
    
    
    (2,246
    )Cash and Cash Equivalents, Beginning of Year
    
    
    22,929
    
    
    
    16,632
    
    
    
    18,878Cash and Cash Equivalents, End of Year
    
    $
    17,758
    
    
    $
    22,929
    
    
    $
    16,632Supplemental Disclosures of Cash Flow InformationInterest paid on deposits and borrowed funds
    
    $
    19,090
    
    
    $
    14,446
    
    
    $
    15,385Income taxes paid
    
    
    2,135
    
    
    
    2,879
    
    
    
    1,721Supplemental Schedule of Noncash Investing and Financing ActivitiesTransfer of loans to foreclosed assets
    
    $
    1,923
    
    
    $
    1,069
    
    
    $
    304Increase (decrease) in fair value of securities available for sale,
net of tax
    
    
    (640
    )
    
    
    (1,138
    )
    
    
    857Increase (decrease) in fair value of cash flow hedges, net of tax
    
    
    368
    
    
    
    (427
    )
    
    
    925Unrealized loss of fair value hedges
    
    
    188
    
    
    
    (140
    )
    
    
    Convertible trust preferred securities converted to common stock
    
    
    15,788
    
    
    
    175
    
    
    
    
 See accompanying notes Page 51




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002   (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 subsidiary, Southern Community Bank and Trust and its wholly-owned
subsidiary, 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, which include cash on hand, amounts due from banks with an original maturity of less than
90 days, and repurchase agreements. Federal regulations require institutions to set aside specified amounts of cash as reserves against
transaction and time deposits. As of December 31, 2004, the daily average gross reserve requirement was $6.9 million. Investment Securities Available for sale securities are carried at fair value and consist of bonds, mortgage-backed
securities, and municipal securities not classified as trading securities or as held to maturity
securities. The cost of debt securities available for sale is adjusted for amortization of
premiums and accretion of discounts to maturity. Amortization of premiums, accretion of discounts,
interest and dividend income are included in investment income. 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. The
classification of securities is generally determined at the date of purchase. Page 52




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002   (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
the loan is collateral dependent. 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 adjust the allowance
for loan losses based on their judgments about information available to them at the time of their
examination. Premises and Equipment Land is carried at cost. 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 11-30 years for premises and 3-7 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 estimated 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 STATEMENTS
December 31, 2004, 2003 and 2002   (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Goodwill and Other Intangibles In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 required companies
to cease amortizing goodwill and established a new method for testing goodwill for impairment on an
annual basis. All goodwill resulting from acquisitions during the year ended December 31, 2004
will not be amortized. However, the other intangible assets, which consists of two not to compete
agreements, which will be amortized over 36 and 48 months, respectively, and premiums on purchased
core deposits which will be amortized over ten years using the straight-line method. SFAS No. 142
also requires that an identifiable intangible asset which is determined to have an indefinite
useful economic life not be amortized, but be separately tested for impairment using a
fair-value-approach. The company has not identified any impairment of goodwill. The carrying
amount of goodwill resulting from acquisitions during the year ended December 31, 2004 is $50.1
million while the carrying amount of other intangible assets resulting from those acquisitions is
$2.4 million. 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. These temporary differences consist primarily of
provision for loan losses, differences in the financial statement and income tax basis in premises
and equipment and differences in financial statement and income tax basis in accrued liabilities.
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 had utilized 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. Page 54




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Derivatives (Continued) 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 Statement of Financial Accounting Standards (SFAS) No. 128, Accounting for Earnings Per Share,
requires dual presentation of basic and diluted earnings per share (EPS) on the face of the
statements of income and a reconciliation of the numerators and denominators of the basic and
diluted EPS calculations. 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. 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. 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: 2004
    
    
    2003
    
    
    2002Weighted average number of common shares used in
computing basic net income per share
    
    
    17,298,285
    
    
    
    8,826,780
    
    
    
    8,788,295Effect of dilutive convertible preferred securities
    
    
    219,624
    
    
    
    2,088,975
    
    
    
    Effect of dilutive stock options
    
    
    515,424
    
    
    
    453,674
    
    
    
    297,558Weighted average number of common shares and dilutive
potential common shares used in computing diluted net
income per share
    
    
    18,033,333
    
    
    
    11,369,429
    
    
    
    9,085,853
 For the year ended December 31, 2004, net income for determining diluted earnings per share was
$8.1 million. For the year ended December 31, 2003, net income for determining diluted earnings
per share was $4.5 million after adjusting for the $842,000 after tax effect of the expense
associated with the 2,088,975 dilutive convertible preferred securities. For the years ended
December 31, 2004, 2003 and 2002, there were 227,630, 14,700, and 227,925 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 11) since the conversion price exceeded the
average market price for the year. These antidilutive common stock equivalents have been omitted
from the calculation of diluted earnings per share for their respective years. Page 55




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 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. As shown in
the Recent Accounting Pronouncements of the Summary of Significant Accounting Policies, effective
for the interim period beginning July 1, 2005, SFAS No. 123 and APB No. 25 will be superseded by
SFAS No. 123 (revised). 2004
    
    
    2003
    
    
    2002(Amounts in thousands,except per share data)Net income:As reported
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214Deduct: Total stock-based employee compensation
expense determined under fair value method
for all awards, net of related tax effects
    
    
    (861
    )
    
    
    (257
    )
    
    
    (447
    )Pro forma
    
    $
    7,241
    
    
    $
    3,406
    
    
    $
    2,767Basic earnings per share:As reported
    
    $
    .47
    
    
    $
    .41
    
    
    $
    .37Pro forma
    
    
    .42
    
    
    
    .39
    
    
    
    .31Diluted earnings per share:As reported
    
    $
    .45
    
    
    $
    .40
    
    
    $
    .35Pro forma
    
    
    .40
    
    
    
    .37
    
    
    
    .31
 Page 56




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 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, 2004 and 2003 consists of the following: 2004
    
    
    2003(Amounts in thousands)Unrealized holding gains - investment securities available for sale
    
    $
    (191
    )
    
    $
    852Deferred income taxes
    
    
    74
    
    
    
    (329
    )Net unrealized holding gains / (loss) - investment securities
available for sale
    
    
    (117
    )
    
    
    523Unrealized holding gains - cash flow hedge instruments
    
    
    219
    
    
    
    812Deferred income taxes
    
    
    (89
    )
    
    
    (314
    )Net unrealized holding gains - cash flow hedge instruments
    
    
    130
    
    
    
    498Total accumulated other comprehensive income
    
    $
    13
    
    
    $
    1,021
 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. Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board issued SFAS No. 123 (revised), Share
Based Payment. SFAS No. 123 (revised) establishes standards for the accounting for transactions in
which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The primary focus of this statement is on accounting for transactions in
which an entity obtains employee services in exchange for share-based payment transactions. This
Statement is effective for the beginning of the first interim or annual reporting period that
begins after June 15, 2005. Management has calculated the companys net income impact to be in
excess of $3.0 million, on a pre-tax basis, over the ensuing five-year period after the July 1,
2005 adoption of SFAS No. 123 (revised). In December 2003, the Financial Accounting Standards Board issued FAS No. 132 (revised), Employers
Disclosure about pensions and Other Postretirement Benefits. The revised statement requires
additional disclosures to those in the original FAS No. 132 about the assets, obligations, cash
flows, and net periodic benefit costs of defined benefit pension plans and other defined benefit
postretirement plans. Except for certain disclosures for foreign pension plans, future benefit
payments and obligations, FAS No. 132 (revised) was effective for financial statements with fiscal
years ending after December 15, 2003 and has been adopted by the company. Those exceptions
mentioned above are effective for financial statements with fiscal years ending after June 15, 2005
and have been adopted by the company. The adoption of FAS No. 132 (revised) did not have a
material impact on the companys consolidated financial statements. Page 57




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Recent Accounting Pronouncements (Continued) In December 2004, the Financial Accounting Standards Board issued FAS No. 153, Exchanges of
Nonmonetary Assets.This statement amends APB Opinion No. 29, Accounting for Nonmonetary
Transactions,and is based on the principle that exchanges of nonmonetary assets should be measured
based on the fair value of the assets exchanged. This statement is a result of the Financial
Accounting Standards Board working with the International Accounting Standards Board in eliminating
certain narrow differences between their existing accounting standards. The provisions of this
statement are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after
June 15, 2005. The adoption of FAS No. 153 is not expected to have a material effect on the
companys consolidated financial statements. In March 2004, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 105,
Application of Accounting Principles to Loan Commitments.This Staff Accounting Bulletin
summarizes the views of the staff regarding the application of accounting principles generally
accepted in the United States of America to loan commitments accounted for as derivative
instruments. The provisions of this Staff Accounting Bulletin were effective after March 31, 2004.
The adoption of this Staff Accounting Bulletin did not have a material impact on the consolidated
financial statements of the company. In March 2004, the Emerging Issue Task Force (EITF) issued No. 03-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. This issue provides
guidance for evaluating whether an investment is other-than-temporarily impaired and is effective
for other-than-temporary impairment evaluations made in reporting periods beginning after June 15,
2004. Certain effects of this issue, however, have been delayed and will be superseded
concurrently with the final issuance of proposed EITF issue No. 03-1-a, Implication Guidance for
the Application of Paragraph 16 of EITF issue No. 03-1. The adoption of EITF 03-1 is not expected
to have a material effect on the companys consolidated financial statements. Accounting Changes In January 2004, the company adopted FASB Interpretation No. (FIN) 46, Consolidation of Variable
Interest Entities. The primary objectives of FIN 46 were to provide guidance on the identification
of entities for which control is achieved through means other than through voting rights and how to
determine when and which business enterprise should consolidate the variable interest entity.
However for the Company, adoption of FIN 46 required the deconsolidation of a grantor trust that
issued the trust preferred securities reported in the consolidated financial statements as of
December 31, 2003. The Company discontinued the consolidation of the trust and began reporting the
junior subordinated debentures that the Company had issued in exchange for the proceeds that
resulted from the issuance of the trust preferred securities. The trust preferred securities that
were previously reported and the junior subordinated debentures that are currently being reported
are classified as long-term obligations. The impact of this change did not have a material effect
on the consolidated financial statements. Except for the accounting treatment, the relationship
between the Company and Southern Community Capital Trust II has not changed. Southern Community
Capital Trust II continues to be a wholly-owned subsidiary of the Company, and the full and
unconditional guarantee of the Company for the repayment of the trust preferred securities remains
in effect. Preferred securities have been reclassified and are included in long-term debt for
consistent presentation. This change had no effect on either stockholders equity or net income. Page 58




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 3)BUSINESS COMBINATIONS On January 12, 2004, the company acquired all the stock of The Community Bank of Pilot Mountain,
North Carolina through a definitive agreement 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. 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. The acquisition provided the company with over $177
million in new loans, over $200 million in new deposits and just under $260 million in total new
assets. The results of The Community Banks operations are reflected in the companys consolidated
financial statements from the date of acquisition. The pro forma impact of The Community Bank is not material to 2004 as the acquisition occurred near
the beginning of the year. The following table reflects the pro forma combined results of
operations for the twelve months ended
December 31, 2003, assuming the acquisition had occurred at the beginning of fiscal year 2003. Twelve Months EndedDecember 31, 2003(Amounts in thousands)Net interest income
    
    $
    32,404Net income
    
    
    7,985Net income per share:Basic
    
    $
    0.52Diluted
    
    
    0.46
 In August 2004, the company acquired certain assets of two residential mortgage offices from J.R.
Davidson Inc., dba Davidson Mortgage in Cornelius, North Carolina in exchange for cash. Davidson
Mortgage, formed in 1997, is a mortgage banking company with two offices located in Cornelius,
North Carolina and Lexington, South Carolina. Davidsons primary focus is on conventional
conforming and jumbo loan products and it closed over $90 million in loans during the year ended
December 31, 2003, its last full year of operations under previous management. The results of
Davidson Mortgages operations are reflected in the companys consolidated financial statements
from the date of acquisition. The proforma impact of the Davidson Mortgage acquisition is not
material. Purchase Price Allocations The costs to acquire The Community Bank and Davidson Mortgage have been allocated to the assets
acquired and liabilities assumed according to estimated fair values. The following tables
summarize the estimated fair values of the assets acquired and liabilities assumed at the date of
their acquisition as well as a summary of the total purchase price. A summary of the total purchase price of The Community Bank is as follows: (In thousands)Fair value of common stock issued
    
    $
    62,659Cash paid for shares
    
    
    15,257Fair value of stock options exchanged
    
    
    349Transaction costs
    
    
    878Total purchase price
    
    $
    79,143
 Page 59




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 3)BUSINESS COMBINATIONS (Continued) Purchase Price Allocations (Continued) A summary of the estimated value of The Community Bank assets acquired and liabilities assumed is
as follows: (In thousands)Cash and cash equivalents
    
    $
    6,942Investment securities available for sale
    
    
    51,875Investment securities held to maturity
    
    
    17,796Loans receivable, net
    
    
    172,495Premises and equipment
    
    
    5,706Deferred tax asset
    
    
    692Goodwill
    
    
    49,844Core deposit intangible
    
    
    2,177Other assets
    
    
    1,418Deposits
    
    
    (202,595
    )Borrowings
    
    
    (25,286
    )Other liabilities
    
    
    (2,799
    )Net assets acquired
    
    
    78,265Transaction costs
    
    
    878Total purchase price
    
    $
    79,143
 A summary of the total purchase price of Davidson Mortgage is as follows: (In thousands)Cash paid
    
    $
    388Transaction costs
    
    
    77Total purchase price
    
    $
    465
 A summary of the estimated value of the Davidson Mortgage assets acquired and liabilities assumed is as follows:
 (In thousands)Premises and equipment
    
    $
    24Goodwill
    
    
    291Other identifiable intangible asset
    
    
    150Net assets acquired
    
    $
    465
 Page 60




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (4) INVESTMENT SECURITIES The following is a summary of the securities portfolio by major classification at December 31, 2004
and 2003: 2004Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    Value(Amounts in thousands)Securities available for sale:U. S. Government agencies
    
    $
    69,038
    
    
    $
    106
    
    
    $
    274
    
    
    $
    68,870Mortgage-backed
    
    
    150,282
    
    
    
    833
    
    
    
    947
    
    
    
    150,168Municipals
    
    
    1,000
    
    
    
    1
    
    
    
    2
    
    
    
    999Other
    
    
    17,635
    
    
    
    92
    
    
    
    
    
    
    
    17,727$
    237,955
    
    
    $
    1,032
    
    
    $
    1,223
    
    
    $
    237,764Securities held to maturity:U. S. Government agencies
    
    $
    59,692
    
    
    $
    22
    
    
    $
    851
    
    
    $
    58,863Mortgage-backed
    
    
    3,971
    
    
    
    46
    
    
    
    4
    
    
    
    4,013Municipals
    
    
    10,481
    
    
    
    341
    
    
    
    9
    
    
    
    10,813Other
    
    
    1,001
    
    
    
    15
    
    
    
    
    
    
    
    1,016$
    75,145
    
    
    $
    424
    
    
    $
    864
    
    
    $
    74,705
 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
 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, 2004. All unrealized losses on investment securities are
a result of volatility in the market during 2004. For available for sale securities, the
unrealized losses relate to twenty-nine U.S. Government Agency bonds, nineteen mortgage-backed
securities and two municipals. For held to maturity securities, the unrealized losses relate to
eight U.S. Government Agency bonds, one mortgage-backed security and two municipals. All
unrealized losses on investment securities are considered by management to be temporarily impaired
given the credit ratings on these investment securities and managements intent and ability to hold
these securities until recovery. Page 61




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (4) INVESTMENT SECURITIES (Continued) 2004Less 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
    
    $
    36,720
    
    
    $
    274
    
    
    $
    
    
    
    $
    
    
    
    $
    36,720
    
    
    $
    274Mortgage-backed securities
    
    
    92,348
    
    
    
    947
    
    
    
    
    
    
    
    
    
    
    
    92,348
    
    
    
    947Municipals
    
    
    505
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    505
    
    
    
    2Total temporarily impaired
securities
    
    $
    129,573
    
    
    $
    1,223
    
    
    $
    
    
    
    $
    
    
    
    $
    129,573
    
    
    $
    1,223Securities held to maturity:U.S. government securities
    
    $
    52,293
    
    
    $
    851
    
    
    $
    
    
    
    $
    
    
    
    $
    52,293
    
    
    $
    851Mortgage-backed securities
    
    
    322
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    322
    
    
    
    4Municipals
    
    
    870
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    870
    
    
    
    9Total temporarily impaired
securities
    
    $
    53,485
    
    
    $
    864
    
    
    $
    
    
    
    $
    
    
    
    $
    53,485
    
    
    $
    864
 2003Less 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
 There were no sales of investment securities in 2004 or in 2003. 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. The amortized cost and fair values of securities available for sale and held to maturity at
December 31, 2004 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. Page 62




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (4) INVESTMENT SECURITIES (Continued) Securities Available for Sale
    
    
    Securities Held to MaturityAmortized
    
    
    Fair
    
    
    Amortized
    
    
    FairCost
    
    
    Value
    
    
    Cost
    
    
    Value(Amounts in thousands)Due within one year
    
    $
    2,727
    
    
    $
    2,750
    
    
    $
    2,053
    
    
    $
    2,075Due after one year through five years
    
    
    50,195
    
    
    
    49,948
    
    
    
    21,851
    
    
    
    21,904Due after five years through ten years
    
    
    17,058
    
    
    
    17,114
    
    
    
    25,984
    
    
    
    25,697Due after ten years
    
    
    17,693
    
    
    
    17,784
    
    
    
    21,286
    
    
    
    21,016Mortgage-backed securities
    
    
    150,282
    
    
    
    150,168
    
    
    
    3,971
    
    
    
    4,013$
    237,955
    
    
    $
    237,764
    
    
    $
    75,145
    
    
    $
    74,705
 Securities with carrying values of $24.3 million and $15.8 million and fair values of $24.2 million
and $16.3 million at December 31, 2004 and 2003, respectively, were pledged to secure public
deposits as required by law. Additionally, at December 31, 2004, securities with carrying values
of $157.9 million and fair values of $160.1 million were pledged to secure both the companys
borrowings from the FHLB and a repurchase agreement. Investments in Equity Securities Carried at Cost The aggregate of the companys cost method investments included in other available for sale
securities totaled $13.2 million and $6.3 million at December 31, 2004 and 2003, respectively. As
of year end 2004 these investments consist of Federal Home Loan Bank stock of $8.8 million, Federal
Reserve Bank stock of $4.0 million, and The Bankers Bank stock of $400,000. The bank estimates
that the fair value for these investments equals cost and that these investments were not impaired
at December 31, 2004. Page 63




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (5) LOANS Following is a summary of loans at December 31, 2004 and 2003: 2004
    
    
    2003(Amounts in thousands)Residential mortgage loans
    
    $
    238,454
    
    
    $
    150,312Commercial mortgage loans
    
    
    295,130
    
    
    
    186,758Construction loans
    
    
    102,282
    
    
    
    71,908Commercial and industrial loans
    
    
    127,432
    
    
    
    87,127Loans to individuals
    
    
    32,805
    
    
    
    23,641Total
    
    $
    796,103
    
    
    $
    519,746
 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, 2004 and 2003 are loans held for sale
totaling approximately $3.6 million and $1.1 million, respectively. The following is a summary of nonperforming assets at December 31, 2004 and 2003: 2004
    
    
    2003(Amounts in thousands)Nonaccrual loans
    
    $
    2,174
    
    
    $
    769Foreclosed assets
    
    
    1,085
    
    
    
    272Total
    
    $
    3,259
    
    
    $
    1,041
 At December 31, 2004, the recorded investment in loans considered impaired in accordance with SFAS
No. 114 totaled $10.0 million, of which $2.2 million consisted of nonaccrual loans. The
corresponding valuation allowance for the impaired loans amounted to $3.3 million. For the year
ended December 31, 2004, the average recorded investment in impaired loans was approximately $5.7
million. The amount of interest recognized on impaired loans during the portion of the year that
they were impaired was approximately $250,000. 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. 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, 2003
    
    $
    18,296Loans to directors and officers of acquired entities
    
    
    3,468Disbursements during year ended December 31, 2004
    
    
    6,955Amounts collected during year ended December 31, 2004
    
    
    (9,113
    )Loans to directors and officers as a group (12) at December 31, 2004
    
    $
    19,606
 Page 64




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (5) LOANS (Continued) At December 31, 2004, the company had pre-approved but unused lines of credit totaling $2.0 million
to executive officers, directors and their affiliates. (6) ALLOWANCE FOR LOAN LOSSES An analysis of the allowance for loan losses follows: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Balance at beginning of year
    
    $
    7,275
    
    
    $
    6,342
    
    
    $
    5,400Provision charged to operations
    
    
    2,239
    
    
    
    2,285
    
    
    
    1,655Charge-offs
    
    
    (1,574
    )
    
    
    (1,420
    )
    
    
    (758
    )Recoveries
    
    
    150
    
    
    
    68
    
    
    
    45Net charge-offs
    
    
    (1,424
    )
    
    
    (1,352
    )
    
    
    (713
    )Allowance for loans acquired in
purchase transactions, net
    
    
    4,447
    
    
    
    
    
    
    
    Balance at end of year
    
    $
    12,537
    
    
    $
    7,275
    
    
    $
    6,342
 (7) PREMISES AND EQUIPMENT Following is a summary of premises and equipment at December 31, 2004 and 2003: 2004
    
    
    2003{(Amounts in thousands)Land
    
    $
    5,356
    
    
    $
    3,214Buildings and leasehold improvements
    
    
    18,457
    
    
    
    12,039Furniture and equipment
    
    
    13,740
    
    
    
    6,47237,553
    
    
    
    21,725Less accumulated depreciation
    
    
    (9,228
    )
    
    
    (4,388
    )Total
    
    $
    28,325
    
    
    $
    17,337
 Depreciation and amortization amounting to $2.4 million in 2004, $1.6 million in 2003, and $1.2
million in 2002, is included in occupancy and equipment expense. Page 65




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SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (8) GOODWILL AND OTHER INTANGIBLES The following is a summary of goodwill and other intangible assets at December 31, 2004 and 2003: 2004
    
    
    2003(Amounts in thousands)Goodwill  gross
    
    $
    50,135
    
    
    $
    Less accumulated amortization
    
    
    
    
    
    
    Goodwill  net
    
    $
    50,135
    
    
    $
    Other intangibles  gross
    
    
    2,627
    
    
    
    Less accumulated amortization
    
    
    208
    
    
    
    Other intangibles  net
    
    $
    2,419
    
    
    $
    
 The following table presents estimated amortization expense for other intangibles. Estimated Amortization Expense(Amounts in thousands)For the Year Ended December 31:2005
    
    $
    3422006
    
    
    3422007
    
    
    3342008
    
    
    2932009
    
    
    218Thereafter
    
    
    890$
    2,419
 (9) DEPOSITS Time deposits in denominations of $100,000 or more were approximately $281.4 million and $182.2
million at
December 31, 2004 and 2003, respectively. At December 31, 2004, the scheduled maturities of
certificates of deposit are as follows: $100,000
    
    
    Underand Over
    
    
    $100,000
    
    
    Total(Amounts in thousands)2005
    
    $
    132,325
    
    
    $
    181,732
    
    
    $
    314,0572006
    
    
    43,902
    
    
    
    35,900
    
    
    
    79,8022007
    
    
    45,410
    
    
    
    7,954
    
    
    
    53,3642008
    
    
    12,261
    
    
    
    2,576
    
    
    
    14,8372009
    
    
    31,979
    
    
    
    1,048
    
    
    
    33,027Thereafter
    
    
    15,500
    
    
    
    
    
    
    
    15,500Total
    
    $
    281,377
    
    
    $
    229,210
    
    
    $
    510,587
 Page 66




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (10) BORROWINGS The company has a $304.2 million credit line availability with the Federal Home Loan Bank for
advances. These advances are secured by both loans with a carrying value of $188.2 million and
pledged investment securities with a market value of $128.1 million. At December 31, 2004, the companys Federal Home Loan Bank advances of $147.8 million mature
through 2017. At December 31, 2004 and 2003, the interest rate on these advances ranged from 0.50%
to 4.43% and from 1.21% to 5.35%, respectively. At December 31, 2004 and 2003, the weighted
average interest rates on the advances were 3.05% and 3.03%, respectively. The contractual maturities of the Federal Home Loan Bank advances at December 31, 2004 are as
follows: 2004(Amounts in thousands)Due in 2005
    
    $
    20,000Due in 2006
    
    
    Due in 2007
    
    
    45,000Due in 2008
    
    
    5,250Due in 2009
    
    
    10,000Thereafter
    
    
    67,590$
    147,840
 In addition to the above advances, the company also has a repurchase agreement with an outstanding
balance of $30.6 million, at December 31, 2004, of which $10.6 million were for customer
accommodations. 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 $130.0 million from various institutions, which must be
adequately collateralized. In addition to the above advances, the company has lines of credit of $73.0 million from various
correspondent banks to purchase federal funds on a short-term basis. The company has $19.0 million
outstanding as of December 31, 2004. Aggregate borrowings at December 31, 2004 amounted to $233.1 million, including $69.6 million that
is due within one year and classified as short-term borrowings and $163.5 million due after one
year that is classified as long-term debt in the accompanying consolidated balance sheet. The following table provides a summary of our borrowings. 2004(In thousands)Short -term borrowingsFHLB
    
    $
    20,000Federal funds purchased
    
    
    19,001Repurchase agreements
    
    
    30,646$
    69,647Long-term borrowingsFHLB
    
    $
    127,840Junior subordinate debentures
    
    
    35,653$
    163,493
 Page 67




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (11) JUNIOR SUBORDINATED DEBENTURES In November of 2003, Southern Community Capital Trust II (Trust II), wholly owned by 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 approximately 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 junior subordinated debentures outstanding at December 31, 2004 and 2003 is as
follows (in thousands): Carrying value atShares
    
    
    Interest
    
    
    Maturity
    
    
    December 31,Issuing Entity
    
    outstanding
    
    
    Rate
    
    
    date
    
    
    2004
    
    
    2003Southern Community Capital Trust I
    
    
    1,707,500
    
    
    
    7.25
    %
    
    
    3/31/32
    
    
    $
    
    
    
    $
    17,075Southern Community Capital Trust II
    
    
    3,450,000
    
    
    
    7.95
    %
    
    
    12/31/33
    
    
    
    35,653
    
    
    
    34,577$
    35,653
    
    
    $
    51,652
 Page 68




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) EMPLOYEE AND DIRECTOR BENEFIT PLANS 401(k) Retirement Plan The company maintains a qualified profit sharing 401(k) Plan for employees of age 21 years or over
with at least three months of service. Under the plan, employees may contribute up to an annual
maximum as determined under the Internal Revenue Code. The Bank matches 100% of such contributions
not exceeding 6% of the participants compensation. In addition, the board of directors can
authorize additional discretionary contributions to the plan. The plan provides that employees
contributions are 100% vested at all times and the companys contributions vest at 20% each year of
participation in the plan. The expense related to this plan for the years ended December 31, 2004,
2003 and 2002 totaled approximately $611,000, $355,000 and $315,000, respectively. Employment Agreements The company had 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. Defined Benefit Pension Plan The company also has a non-contributory Defined Benefit Pension Plan covering substantially all
employees of one of its latest acquisitions, The Community Bank. This plan was assumed as part of
the purchase of The Community Bank in January, 2004. Benefits under the plan are based on length
of service and qualifying compensation during the final years of employment. Contributions to the
plan are based upon the projected unit credit actuarial funding method to comply with the funding
requirements of the Employee Retirement Income Security Act. Contributions are intended to provide
not only for benefits attributed to service to date but also for those expected to be earned in the
future. No contribution was made for the year ended December 31, 2004. The plan was frozen
effective May 1, 2004 and the company does not expect to contribute to the plan in 2005. The
changes in benefit obligations and plan assets, as well as the funded status, actuarial assumptions
and components of net periodic pension cost of these plans at December 31 were: Page 69




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued) Defined Benefit Pension Plan (Continued) Change in Projected Benefit Obligation: 2004(In thousands)Beginning of year
    
    $
    920Actuarial loss
    
    
    72Service cost
    
    
    101Interest cost
    
    
    73Settlement
    
    
    (381
    )Benefits paid
    
    
    (10
    )End of year
    
    $
    775
 Change in Plan Assets Fair Value: 2004(In thousands)Beginning of year
    
    $
    1,014Benefits paid
    
    
    (10
    )Contributions
    
    
    Return on assets
    
    
    30End of year
    
    $
    1,034Funded status
    
    $
    259Unrecognized gain
    
    
    Unrecognized prior service cost
    
    
    Prepaid pension cost recognized
    
    $
    259
 Actuarial assumptions used in accounting for net periodic
pension cost were: 2004Weighted average discount rate
    
    
    6.50
    %Weighted average rate of increase in
compensation level
    
    
    5.00
    %Weighted average expected long-term
rate of return on plan assets
    
    
    7.50
    %
 Page 70




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued) Defined Benefit Pension Plan (Continued) Components of Net Periodic Pension Cost 2004(In thousands)Service cost
    
    
    101Interest cost
    
    
    73Expected return on plan assets
    
    
    (76
    )Loss
    
    
    5Amortization of prior service cost
    
    
    7Net periodic pension cost
    
    $
    110Curtailments/special benefits
    
    
    Settlements
    
    
    Total benefit cost
    
    $
    110
 The measurement date used for the plan was December 31, 2004. As of that date, the pension plan
experienced plan assets in excess of accumulated projected benefit obligations, for which the
projected benefit obligation, accumulated benefit obligation and fair value of plan assets were
$775,000, $775,000 and $1.0 million respectively. The overall expected long-term rate of return on assets assumption is based on: (1) the target
asset allocation for plan assets, (2) long-term capital markets forecasts for asset classes
employed, and (3) active management excess return expectations to the extent asset classes are
actively managed. Plan assets are invested using allocation guidelines as established by the Plan. The primary
objective is to provide long-term capital appreciation through investments in equities and fixed
income securities. These guidelines ensure risk control by maintaining minimum and maximum
exposure in equity and fixed income/cash equivalents portfolios. The minimum equity and fixed
income/cash equivalents investment exposure is 35% and 25%, respectively. The maximum equity and
fixed income/cash equivalents investment exposure is 75% and 65%, respectively. The current asset
allocation is 64% equity securities and 36% fixed income/cash equivalents securities, which meets
the criteria established by the Plan. Allowable investment types include both U.S. and international equity and fixed income funds. The
equity fund is composed of common stocks, convertible notes and bonds, convertible preferred stocks
and ADRs of non U.S. companies as well as various mutual funds, including government and corporate
bonds, large to mid cap value, growth and world/international equity funds and index funds. The
fixed income/cash equivalents fund is composed of money market funds, commercial paper,
certificates of deposit, U.S. Government and agency securities, corporate notes and bonds,
preferred stock and fixed income securities of foreign governments and corporations. The plans weighted-average asset allocations at December 31, 2004, by asset category are as
follows: 2004Asset categoryU.S. equity securities
    
    
    63
    %Fixed income investments
    
    
    37
    %
 Page 71




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) EMPLOYEE AND DIRECTOR BENEFIT PLANS (Continued) Estimated future benefits payments which reflect future service, as appropriate, are shown below: Year
    
    Pension Benefits2005
    
    $
    32,5572006
    
    
    33,8962007
    
    
    37,8662008
    
    
    37,2622009
    
    
    36,6002010  2014
    
    
    335,533
 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 $477,000
in 2004, $217,000 in 2003, and $142,000 in 2002 were expensed for future benefits to be provided
under this plan. The corresponding liability related to this plan was approximately $800,000 and
$384,000 as of December 31, 2004 and 2003, respectively. During 1994 The Community Bank had established an unfunded Supplemental Executive Retirement Plan,
which is a nonqualified plan that provides additional retirement benefits to certain key management
personnel. The corresponding liability related to this plan was approximately $850,000 at December
31, 2004, and is shown as a corresponding liability on the consolidated balance sheet. Total
expense for this plan aggregated $92,000, for year ended December 31, 2004. In 2005, the company
plans to merge this plan into its existing non-qualifying deferred compensation plan for certain
key executive and senior officers. 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. For the years ended December 31, 2004 and 2003, employees of the company purchased 22,350, and 0
shares, respectively, under the ESPP. Page 72




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) 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 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, 2004, 2003 and 2002, 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, 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
    
    
    
    4.79Options authorized
    
    
    297,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options granted/vested
    
    
    (604,336
    )
    
    
    604,336
    
    
    
    10.15
    
    
    
    200,593
    
    
    
    8.13Options exercised
    
    
    
    
    
    
    (323,710
    )
    
    
    4.47
    
    
    
    (323,710
    )
    
    
    4.47Options forfeited
    
    
    24,543
    
    
    
    (24,543
    )
    
    
    8.99
    
    
    
    (24,543
    )
    
    
    8.99At December 31, 2004
    
    
    211,007
    
    
    
    1,628,094
    
    
    $
    7.25
    
    
    
    1,002,638
    
    
    $
    5.37
 Page 73




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (12) EMPLOYEE AND DIRECTOR BENEFIT PLAN (Continued) Stock Option Plans (Continued) The weighted average remaining life of options outstanding at December 31, 2004 is 6 years. The
range of exercise prices for options outstanding at December 31, 2004 is $3.05 to $14.64.
Information pertaining to options outstanding at December 31, 2004 is as follows: Number of
    
    
    Number ofRange of Exercise Prices
    
    Options Outstanding
    
    
    Options Exercisable$3.05 - $6.66
    
    
    810,090
    
    
    
    766,597$6.67 - $8.90
    
    
    141,470
    
    
    
    114,208$8.91 - $14.64
    
    
    676,534
    
    
    
    121,833Outstanding at end of year
    
    
    1,628,094
    
    
    
    1,002,638
 The estimated average per share fair value of options granted, together with the assumptions used
in estimating those fair values, are displayed below: 2004
    
    
    2003
    
    
    2002Estimated fair value of options granted
    
    $
    4.70
    
    
    $
    4.54
    
    
    $
    2.30Assumptions in estimating average option values:Risk-free interest rate
    
    
    3.47
    %
    
    
    3.00
    %
    
    
    3.50
    %Dividend yield
    
    
    1.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Volatility
    
    
    33.00
    %
    
    
    39.00
    %
    
    
    22.00
    %Expected life
    
    7 years
    
    7 years
    
    7 years
 (13) 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): 2005
    
    $
    5642006
    
    
    3582007
    
    
    3062008
    
    
    2992009
    
    
    206Thereafter
    
    
    445Total
    
    $
    2,178
 Total rental expense under operating leases was $432,000 in 2004, $414,000 in 2003, and $461,000 in
2002. Page 74




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (14) INCOME TAXES The significant components of the provision for income taxes for the years ended December 31, 2004,
2003 and 2002 are as follows: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Current tax provision:Federal
    
    $
    3,163
    
    
    $
    1,952
    
    
    $
    2,074State
    
    
    561
    
    
    
    377
    
    
    
    1333,724
    
    
    
    2,329
    
    
    
    2,207Deferred tax provision:Federal
    
    
    665
    
    
    
    (231
    )
    
    
    (380
    )State
    
    
    155
    
    
    
    (126
    )
    
    
    (72
    )820
    
    
    
    (357
    )
    
    
    (452
    )Net provision for income taxes
    
    $
    4,544
    
    
    $
    1,972
    
    
    $
    1,755
 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: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Tax computed at the statutory federal rate
    
    $
    4,300
    
    
    $
    1,915
    
    
    $
    1,689Increase (decrease) resulting from:State income taxes, net of federal benefit
    
    
    473
    
    
    
    166
    
    
    
    40Tax exempt income
    
    
    (520
    )
    
    
    (77
    )
    
    
    (75
    )Valuation allowance
    
    
    227
    
    
    
    
    
    
    
    Other permanent differences
    
    
    64
    
    
    
    (32
    )
    
    
    101244
    
    
    
    57
    
    
    
    66Provision for income taxes included in operations
    
    $
    4,544
    
    
    $
    1,972
    
    
    $
    1,755
 Page 75




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (14) INCOME TAXES (Continued) 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, 2004 and 2003 are as
follows: 2004
    
    
    2003(Amounts in thousands)Deferred tax assets relating to:Allowance for loan losses
    
    $
    4,513
    
    
    $
    2,682Deferred compensation
    
    
    365
    
    
    
    148SERP accrual
    
    
    636
    
    
    
    NEL carryforward
    
    
    227
    
    
    
    Other
    
    
    760
    
    
    
    120Total deferred tax assets
    
    
    6,501
    
    
    
    2,950Less: valuation allowance
    
    
    227
    
    
    
    Tot net deferred tax assets
    
    
    6,274
    
    
    
    2,950Deferred tax liabilities relating to:Property and equipment
    
    
    (1,542
    )
    
    
    (436
    )Loan fees and costs
    
    
    (473
    )
    
    
    (356
    )Core deposits
    
    
    (762
    )
    
    
    Other comprehensive income
    
    
    (15
    )
    
    
    (643
    )Prepaid expenses
    
    
    (249
    )
    
    
    Other
    
    
    (661
    )
    
    
    (5
    )Total deferred tax liabilities
    
    
    (3,702
    )
    
    
    (1,440
    )Net recorded deferred tax asset
    
    $
    2,572
    
    
    $
    1,510
 The company established a valuation allowance of $227,000 for the deferred tax asset attributable
to the parents net loss carry-forward for state income tax purposes. Management determined that
it is likely that the operations at the parent level would not generate sufficient taxable income
to realize the deferred tax asset. The company had no valuation allowance at December 31, 2003
because management had determined that it was more likely than not that the results of future
operations would generate sufficient taxable income to realize the deferred tax assets. Page 76




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (15) NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE The major components of non-interest income for the years ended December 31, 2004, 2003 and 2002
are as follows: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Service charges and fees on deposit accounts
    
    $
    3,502
    
    
    $
    1,442
    
    
    $
    1,121Presold mortgage loan fees
    
    
    750
    
    
    
    1,350
    
    
    
    1,310Investment brokerage fees
    
    
    712
    
    
    
    947
    
    
    
    333SBIC management fees
    
    
    552
    
    
    
    562
    
    
    
    542Gain on sale of investment securities
    
    
    
    
    
    
    
    
    
    
    70Other
    
    
    1,890
    
    
    
    684
    
    
    
    551Total
    
    $
    7,406
    
    
    $
    4,985
    
    
    $
    3,927
 The major components of other non-interest expense for the years ended December 31, 2004, 2003 and
2002 are as follows: 2004
    
    
    2003
    
    
    2002(Amounts in thousands)Postage, printing and office supplies
    
    $
    875
    
    
    $
    383
    
    
    $
    313Advertising and promotion
    
    
    776
    
    
    
    862
    
    
    
    566Data processing and other outsourced services
    
    
    2,331
    
    
    
    1,317
    
    
    
    1,177Professional services
    
    
    895
    
    
    
    706
    
    
    
    260Other
    
    
    4,542
    
    
    
    2,417
    
    
    
    2,199Total
    
    $
    9,419
    
    
    $
    5,685
    
    
    $
    4,515
 Page 77




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (16) 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. 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, 2004 and 2003,
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, 2004:Total Capital (to Risk-Weighted Assets)
    
    $
    110,699
    
    
    
    11.70
    %
    
    $
    75,700
    
    
    
    8.00
    %
    
    $
    94,650
    
    
    
    10.00
    %Tier I Capital (to Risk-Weighted Assets)
    
    
    98,860
    
    
    
    10.45
    %
    
    
    37,850
    
    
    
    4.00
    %
    
    
    56,810
    
    
    
    6.00
    %Tier I Capital (to Average Assets)
    
    
    98,860
    
    
    
    8.55
    %
    
    
    46,200
    
    
    
    4.00
    %
    
    
    47,350
    
    
    
    5.00
    %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
    %
 The company is also subject to these capital requirements. At December 31, 2004, the
companys total capital to risk-weighted assets, Tier I capital to risk-weighted assets and Tier I
capital to average assets were 13.82%, 11.79% and 9.68%, respectively. Page 78




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (17) 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. 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. Page 79




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (17) DERIVATIVES (Continued) 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, 2004, the information pertaining to outstanding interest rate swap agreements used
to hedge variable rate loans is as follows (amounts in thousands): 2004
    
    
    2003Notional amount
    
    $
    
    
    
    $
    10,000Weighted average pay rate
    
    
    
    
    
    
    4.00
    %Weighted average receive rate
    
    
    
    
    
    
    6.21
    %Weighted average maturity in years
    
    
    
    
    
    
    .3Unrealized gain relating to interest rate swaps
    
    $
    
    
    
    $
    111Deferred gain from early termination
    
    $
    219
    
    
    $
    701
 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, 2004 and 2003, the companys interest rate swaps used to hedge variable rate loans
reflected an unrealized gain of $219,000 and $812,000, respectively, which included deferred gains
from the early termination of two interest rate swaps in the amount of $219,000 and $701,000,
respectively. This deferred gain is realized by the company over the residual life of the original
contract. One of the two contracts which had been terminated early had a maturity date of May
2004. The second will mature in 2005 and the remaining unrecognized gain of $219,000 at December
31, 2004 will be included in income over a six-month period in 2005. The total recognized portion
of the gains from early termination, which was $482,000 for 2004 and $406,000 for 2003, is included
in interest income in the accompanying consolidated statements of operations. A third interest
rate contract which had not been terminated, matured in May of 2004 and provided $78,000 of
interest income during the year. Risk management results for the years ended December 31, 2004 and 2003 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. Page 80




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (17) DERIVATIVES (Continued) Interest Rate Risk Management  Fair Value Hedging Instruments During 2004 and in prior periods, 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,
2004, the ineffective portion of the fair value hedge amounted to $2,000 and is included in
non-interest income. At December 31, 2004, the information pertaining to outstanding interest rate swap agreements used
to hedge fixed-rate funding is as follows (amounts in thousands): Notional amount
    
    $
    48,500Weighted average pay rate
    
    
    2.40
    %Weighted average receive rate
    
    
    5.03
    %Weighted average maturity in years
    
    
    14.3Unrealized loss relating to interest rate swaps
    
    $
    188
 One interest rate swap agreements used to hedge fixed-rate funding were terminated during 2004. At
December 31, 2004, the unrealized loss relating to use of interest rate swaps was recorded in other
liabilities. (18) 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 81




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002 
 (18) 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, 2004 and 2003 is as follows (amounts in thousands): 2004
    
    
    2003Financial instruments whose contract amounts represent credit risk:Loan commitments and undisbursed lines of credit
    
    $
    174,970
    
    
    $
    146,414Undisbursed standby letters of credit
    
    
    500
    
    
    
    4,749Undisbursed portion of construction loans
    
    
    48,938
    
    
    
    33,508
 (19) 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.  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. Page 82




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002  (19) DISCLOSURES ABOUT FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued) 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. Repurchase agreement The carrying amount is a reasonable estimate of fair value. 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 18, 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, 2004 and 2003: 2004
    
    
    2003Carrying
    
    
    Estimated
    
    
    Carrying
    
    
    Estimatedamount
    
    
    fair value
    
    
    amount
    
    
    fair value(In thousands)Financial assets:Cash and due from banks
    
    $
    17,758
    
    
    $
    17,758
    
    
    $
    22,929
    
    
    $
    22,929Federal funds sold
    
    
    80
    
    
    
    80
    
    
    
    271
    
    
    
    271Investment securities available for sale
    
    
    237,764
    
    
    
    237,764
    
    
    
    168,500
    
    
    
    168,500Investment securities held to maturity
    
    
    75,145
    
    
    
    74,705
    
    
    
    62,257
    
    
    
    61,044Loans, net
    
    
    783,566
    
    
    
    801,075
    
    
    
    512,471
    
    
    
    513,566Investment in life insurance
    
    
    10,263
    
    
    
    10,263
    
    
    
    2,895
    
    
    
    2,895Accrued interest receivable
    
    
    4,928
    
    
    
    4,928
    
    
    
    3,430
    
    
    
    3,430Financial liabilities:Deposits
    
    
    845,228
    
    
    
    831,200
    
    
    
    575,218
    
    
    
    575,885Short-term borrowings
    
    
    69,647
    
    
    
    69,607
    
    
    
    51,900
    
    
    
    51,900Long-term debt
    
    
    163,493
    
    
    
    167,328
    
    
    
    117,627
    
    
    
    125,052Accrued interest payable
    
    
    2,260
    
    
    
    2,260
    
    
    
    1,324
    
    
    
    1,324On-balance sheet derivative financial instruments:Interest rate swap agreements:Liabilities, net
    
    
    (188
    )
    
    
    (188
    )
    
    
    (29
    )
    
    
    (29
    )
 Page 83




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2004, 2003 and 2002  (20) PARENT COMPANY FINANCIAL DATA Southern Community Financial Corporations condensed balance sheets as of December 31, 2004 and
2003, and its related condensed statements of operations and cash flows for each of the years in
the three-year period ended December 31, 2004 are as follows: Condensed Balance Sheets
December 31, 2004 and 2003
(Amounts in thousands) 2004
    
    
    2003Asset:Cash and due from banks
    
    $
    14,612
    
    
    $
    384Investment in subsidiaries
    
    
    150,848
    
    
    
    58,574Receivable from subsidiaries
    
    
    
    
    
    
    39,000Investment securities available for sale
    
    
    298
    
    
    
    70Other assets
    
    
    6,810
    
    
    
    6,116Total assets
    
    $
    172,568
    
    
    $
    104,144Liabilities:Junior subordinated debentures
    
    $
    35,654
    
    
    $
    53,253Other liabilities
    
    
    8
    
    
    
    Total liabilities
    
    $
    35,662
    
    
    $
    53,253Stockholders equity:Common stock
    
    
    125,200
    
    
    
    44,378Retained earnings
    
    
    11,693
    
    
    
    5,492Accumulated other comprehensive income
    
    
    13
    
    
    
    1,021Total stockholders equity
    
    
    136,906
    
    
    
    50,891Total liabilities and stockholders equity
    
    $
    172,568
    
    
    $
    104,144
 Condensed Statements of Operations
Years Ended December 31, 2004, 2003 and 2002
(Amounts in thousands) 2004
    
    
    2003
    
    
    2002Equity in income of subsidiaries
    
    $
    9,662
    
    
    $
    4,634
    
    
    $
    3,890Interest income
    
    
    542
    
    
    
    232
    
    
    
    171Other income
    
    
    
    
    
    
    4
    
    
    
    90Interest expense
    
    
    (1,999
    )
    
    
    (1,543
    )
    
    
    (1,131
    )Other expense
    
    
    (890
    )
    
    
    (312
    )
    
    
    (154
    )Income tax benefit
    
    
    787
    
    
    
    648
    
    
    
    348Net income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214
 Page 84




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002  (20) PARENT COMPANY FINANCIAL DATA (Continued) Condensed Statements of Cash Flows
Years Ended December 31, 2004, 2003 and 2002
(Amounts in thousands) 2004
    
    
    2003
    
    
    2002Operating activities:Net income
    
    $
    8,102
    
    
    $
    3,663
    
    
    $
    3,214Equity in income of subsidiaries
    
    
    (9,662
    )
    
    
    (4,634
    )
    
    
    (3,890
    )Amortization of debt issuance costs
    
    
    61
    
    
    
    44
    
    
    
    33(Increase) decrease in receivable from subsidiaries
    
    
    39,000
    
    
    
    (31,350
    )
    
    
    (316
    )(Increase) decrease in other assets
    
    
    (774
    )
    
    
    (1,468
    )
    
    
    (203
    )36,727
    
    
    
    (33,745
    )
    
    
    (1,162
    )Investing activities:Investment in subsidiaries
    
    
    (21,985
    )
    
    
    
    
    
    
    (14,716
    )Purchase of investments
    
    
    (228
    )
    
    
    
    
    
    
    (70
    )(22,213
    )
    
    
    
    
    
    
    (14,786
    )Financing activities:Proceeds from junior subordinated debentures,
net of debt issuance costs
    
    
    
    
    
    
    33,292
    
    
    
    15,923Proceeds from exercise of stock options
    
    
    1,616
    
    
    
    770
    
    
    
    105Cash dividend paid
    
    
    (1,902
    )
    
    
    
    
    
    
    Cash paid in lieu of fractional shares on
5% stock dividend
    
    
    
    
    
    
    
    
    
    
    (13
    )(286
    )
    
    
    34,062
    
    
    
    16,015Net increase in cash
    
    
    14,228
    
    
    
    317
    
    
    
    67Cash, beginning of year
    
    
    384
    
    
    
    67
    
    
    
    Cash, end of year
    
    $
    14,612
    
    
    $
    384
    
    
    $
    67
 (21) SUBSEQUENT EVENTS (unaudited) On January 20, 2005, the company announced the declaration of its second consecutive annual cash
dividend of $0.12 per share of its common stock, which was paid on March 15, 2005, to shareholders
of record on February 22, 2005. On February 5, 2005, Richard M. Cobb, Executive Vice President, Chief Operating Officer and Chief
Financial Officer of Southern Community Financial Corporation, announced his resignation from the
Company effective February 7, 2005. Mr. Cobb notified the Companys Chairman that he was resigning
to pursue other interests. He had served as Chief Financial Officer of Southern Community Bank and
Trust, the Companys subsidiary and its predecessor, since its incorporation. As a result of Mr.
Cobbs departure, the company will take a onetime charge of approximately $300,000 in the first
quarter relating to supplemental retirement benefits. Page 85




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##### 



SOUTHERN COMMUNITY FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2004, 2003 and 2002  (21) SUBSEQUENT EVENTS (unaudited) (Continued) On February 18, 2005, a borrower included in our impaired loans disclosure in Note 5, filed Chapter
11 Bankruptcy. The loan has been placed on nonaccrual status and we are working through the
bankruptcy process to collect our loan. The bank has total exposure of $4.4 million to this
customer with $4.0 million outstanding as of the March 7, 2005. The loan is secured by real
estate, accounts receivable, inventory and equipment. Management had previously established a
specific reserve that is estimated to be sufficient to absorb losses in excess of the liquidation
value of our collateral position. In addition, subsequent to year-end another borrower, also included in our impaired loans
disclosure Note 5, defaulted on their agreement. The banks current exposure to this counterparty
is approximately $2.2 million. The loan is secured by real estate. Upon default by the borrower
management placed the loan on nonaccrual status, initiated demand letters and has begun foreclosure
proceedings. Based on our collateral position, management believes that any losses on this credit
will be minimal. Due to the pending adoption of SFAS No. 123 (revised), on March 8, 2005, the Compensation Committee
of the Board voted to immediately vest all outstanding unvested options. As a result of this
change, the Company will take an estimated one-time charge of less than $200,000 during the first
quarter of 2005. Page 86




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##### 



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures In June 2004, the Community subsidiary transitioned core processing systems. On October 18, 2004
in conjunction with the merger of Community and the bank, the bank completed its transition to the
in-house platform from a third party vendor. This core processing includes all subsidiary
processing systems, including deposits and lending, and general ledger functions. In conjunction with this transition, several control activities were modified to accommodate new
reporting mechanisms or changes in software processes in the fourth quarter. While most processes
remained the same, the methodologies to complete those processes required adjustment. Separate
reconciliations of similar accounts that were performed by staff of each bank prior to October 18,
were transitioned to combined reconciliations performed by staff of the merged bank in the fourth
quarter. Southern Community Financial Corporations management, with the participation of the its Chief
Executive Officer and its Senior Vice President, Controller and acting Chief Financial Officer, has
evaluated the effectiveness of the companys disclosure controls and procedures as of December 31,
2004. Based on that evaluation, the companys Chief Executive Officer and Senior Vice President,
Controller and acting Chief Financial Officer concluded that the companys disclosure controls and
procedures were effective as of December 31, 2004. Managements report on internal control over financial reporting, required by Item 308(a) of
Regulation S-K, and the related attestation report of the registered public accounting firm,
required by Item 308(b) of Regulation S-K, will be filed by amendment to this Annual Report on Form
10-K in accordance with Release No. 34-50754 no later than May 2, 2005. Item 9B. Other Information 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 24, 2005. 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 24, 2005. 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 24, 2005. Page 87




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##### 



The following table sets forth equity compensation plan information at December 31, 2004. Equity Compensation Plan Information Number of securitiesremaining available forNumber of securities
    
    
    
    
    
    
    
    
    future issuance underto be issued
    
    
    
    Weighted-average
    
    
    
    equity compensationupon exercise of
    
    
    
    exercise price of
    
    
    
    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 holders
Stock Option Plans
    
    
    
    1,628,094
    
    
    
    $
    7.25
    
    
    
    
    211,007Employee StockPurchase Plan
    
    
    
    18,835
    
    
    
    $
    10.28
    
    
    
    
    958,815Equity compensation
plans not approved
by security holders
    
    
    NA
    
    
    
    NA
    
    
    
    NATotal
    
    
    
    1,646,929
    
    
    
    $
    7.28
    
    
    
    
    1,169,822
 PART III (Continued) 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 24, 2005. 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 24, 2005. Page 88




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##### 



PART IV Item 15. Exhibits, Financial Statement Schedules (a)(1) Financial Statements. The following financial statements and supplementary data are included
in Item 8 of this report. Financial Statements
    
    Form 10-K PageReport of Independent Registered Public Accounting Firm
    
    
    46Consolidated Balance Sheets as of December 31, 2004 and 2003
    
    
    47Consolidated Statements of Operations for the years ended
December 31, 2004, 2003 and 2002
    
    
    48Consolidated Statements of Comprehensive Income for the years ended
December 31, 2004, 2003 and 2002
    
    
    49Consolidated Statements of Changes in Stockholders Equity for the years ended
December 31, 2004, 2003 and 2002
    
    
    50Consolidated Statements of Cash Flows for the years ended
December 31, 2004, 2003 and 2002
    
    
    51Notes to Consolidated Financial Statements
    
    
    52-86
  (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. Page 89




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##### 



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 7.95% 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 4.3:
    
    Form of Certificate for 7.95% Trust Preferred Security of Southern Community Capital Trust II (incorporated by
reference to Exhibit 4.6 to the S-3 Registration Statement)Exhibit 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
on Form S-2 dated January 10, 2002, Registration Number 333-74084 (the Amended S-2 Registration Statement))Exhibit 10.2:
    
    1997 Non-Statutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 10.2 to the Amended S-2 Registration Statement)Exhibit 10.3:
    
    2002 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 10.7 to the Annual Report on Form 10K for the year ended December 31, 2003 (2003 Annual Report))Exhibit 10.4:
    
    2002 Non-Statutory Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 10.8 to the 2003 Annual Report)Exhibit 10.5:
    
    Indenture with respect to the Companys 7.95% Convertible Junior Subordinated Debentures (incorporated by
reference to Exhibit 10.9 to the 2003 Annual Report)Exhibit 10.6:
    
    Amended and Restated Trust Agreement of Southern Community Capital Trust II (incorporated by reference to
Exhibit 10.10 to the 2003 Annual Report)Exhibit 10.7:
    
    Guarantee Agreement for Southern Community Capital Trust II (incorporated by reference to Exhibit 10.11 to the
2003 Annual Report)Exhibit 10.8:
    
    Agreement as to Expenses and Liabilities with respect to Southern Community Capital Trust II (incorporated by
reference to Exhibit 10.12 to the 2003 Annual Report)Exhibit 10.9:
    
    2002 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.13 to the 2003 Annual Report)Exhibit 10.10
    
    The Community Bank Amended and Restated Stock Option Plan for Key Employees (incorporated by reference to
Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114997)Exhibit 10.11:
    
    2001 Incentive Stock Option Plan of Southern Community Financial Corporation (incorporated by reference to
Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114993)Exhibit 10.12:
    
    2001 Stock Option Plan for Directors of Southern Community Financial Corporation (incorporated by reference to
Exhibit 4.2 to the Registration Statement on Form S-8 dated April 29, 2004, Registration Number 333-114991)Exhibit 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 acting Chief Financial OfficerExhibit 32:
    
    Section 1350 Certifications
 Page 90




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##### 



SIGNATURES Pursuant to the requirements of 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 28, 2005
    
    By:
    
    /s/ F. Scott BauerF. Scott BauerChairman and Chief Executive 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
    
    Chairman of the Board and ChiefF. Scott Bauer
    
    Executive Officer
    
    March 28, 2005/s/ Scott C. McLean
    
    Senior Vice President, ControllerScott C. McLean
    
    and acting Chief Financial Officer
    
    March 28, 2005/s/ James O. Frye
    
    Vice Chairman of the Board
    
    March 28, 2005James O. Frye/s/ Don Gray Angell
    
    Director
    
    March 28, 2005Don Gray Angell/s/ Zack W. Blackmon, Sr.
    
    Director
    
    March 28, 2005Zack W. Blackmon, Sr./s/ Edward T. Brown
    
    Director
    
    March 28, 2005Edward T. Brown/s/ Charles R. Bokesch
    
    Director
    
    March 28, 2005Charles R. Bokesch/s/ James G. Chrysson
    
    Director
    
    March 28, 2005James G. Chrysson
 Page 91




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##### 



SIGNATURE
    
    TITLE
    
    DATE/s/ Matthew G. Gallins
    
    Director
    
    March 28, 2005Matthew G. Gallins/s/ Lynn L. Lane
    
    Director
    
    March 28, 2005Lynn L. Lane/s/ H. Lee Merritt, Jr.
    
    Director
    
    March 28, 2005H. Lee Merritt, Jr./s/ Durward A. Smith, Jr.
    
    Director
    
    March 28, 2005Durward A. Smith, Jr./s/ William G. Ward, Sr., M.D.
    
    Director
    
    March 28, 2005William G. Ward, Sr., M.D.
 Page 92