**United
States**


**Securities
and Exchange Commission**


**Washington,
D.C. 20549**





___________________


**FORM
10-K**


**ANNUAL
REPORT**


___________________


Pursuant
to Section 13 or 15(d) of the Securities Exchange Act of 1934








For
      the Fiscal Year Ended December 31, 2004
    
    Commission
      File No. 000-21383





**Appalachian
Bancshares, Inc.**


(Exact
Name of Registrant as Specified in Its Charter)





**Georgia**
    
    **58-2242407**(State
      of Incorporation)
    
    (I.R.S.
      Employer Identification Number)








**829
      Industrial Boulevard****Ellijay,
      Georgia**
    
    **30540**(Address
      of Principal Executive Offices)
    
    (Zip
      Code)


**(706)
276-8000**


(Issuer’s
Telephone Number, Including Area Code)





**Securities
registered under Section 12(b) of the Exchange Act:**





**Title
      of Each Class**
    
    **Name
      of Each Exchange on Which Registered**None
    
    None





**Securities
registered under Section 12(g) of the Exchange Act:**





Common
Stock, $0.01 par value


(Title of
Class)





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





Indicate
by check mark if disclosure of delinquent filers pursuant 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
Exchange Act Rule 12b-2):    Yes oNo x




There is
no established trading market for the registrant’s capital stock. The aggregate
market value of the stock held by non-affiliates of the registrant at June 30,
2004 was $56,041,185, based on a per share price of $15 of the registrant’s
Common Stock, which is the price of the last trade of which management is aware
on or before such date. Although directors and executive officers of the
registrant were assumed to be “affiliates” of the registrant for purposes of
this calculation, the classification is not to be interpreted as an admission of
such status.





At March
14, 2005, there were 3,812,999 shares of the registrant’s Common Stock
outstanding.








**Documents
Incorporated by Reference**





Portions
of the registrant’s definitive Proxy Statement for the 2005 Annual Meeting of
Shareholders are incorporated by reference into Part III of this
report.







Table of Contents





**APPALACHIAN
BANCSHARES, INC.**





**2004
Form 10-K Annual Report**








**TABLE OF CONTENTS**







**Item
      Number**
    
    
    
    **Page
      or****in
      Form 10-K**
    
    **Description**
    
    **Location****PART
      I**Item
      1.
    
    Business
    
    2Item
      2.
    
    Properties
    
    8Item
      3.
    
    Legal Proceedings
    
    9Item
      4.
    
    Submission of Matters to a Vote of Security
      Holders
    
    9**PART
      II**Item
      5.
    
    Market for the Registrant’s Common Equity, Related
      Stockholder Matters and Issuer Purchases of Equity
      Securities
    
    9Item
      6.
    
    Selected Financial Data
    
    12Item
      7.
    
    Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
    
    13Item
      7A.
    
    Quantitative and Qualitative Disclosures About Market
      Risk
    
    33Item
      8.
    
    Financial Statements and Supplementary
      Data
    
    33Item
      9.
    
    Changes in and Disagreements with Accountants on
      Accounting and Financial Disclosure
    
    68Item
      9A.
    
    Controls and Procedures
    
    68Item
      9B.
    
    Other Information
    
    68**PART
      III**Item
      10.
    
    Directors and Executive Officers of the
      Registrant
    
    68Item
      11.
    
    Executive Compensation
    
    68Item
      12.
    
    Security Ownership of Certain Beneficial Owners and
      Management
    
    68Item
      13.
    
    Certain Relationships and Related
      Transactions
    
    68Item
      14.
    
    Principal Accountant Fees and
    Services
    
    68**PART
      IV**Item
      15.
    
    Exhibits and Financial Statement
      Schedules
    
    69**Signatures**




1
 Table of Contents





**PART
I**





**ITEM
      1.**
    **BUSINESS**





**General**





Appalachian
Bancshares, Inc. (the “Company”) is a bank holding company which was formed in
May 1996 as a Georgia corporation. The Company’s executive office is located at
829 Industrial Boulevard, Ellijay, Georgia, and its telephone number at such
location is (706) 276-8000. The Company offers a full range of banking services
through Appalachian Community Bank, its commercial bank subsidiary (the “Bank”).
The Bank is a Georgia banking corporation and a wholly owned subsidiary of the
Company. As of December 31, 2004, the assets of the Bank constituted virtually
all of the assets of the Company.





During
2001, the Bank (f/k/a Gilmer County Bank) was merged with and into Appalachian
Community Bank and simultaneously changed its name to Appalachian Community
Bank. The merger was consummated to facilitate greater cost efficiencies of
operations, centralized management, consistency of regulatory compliance, and to
provide a stronger capital base from which to offer a range of services to
individuals and small to medium sized businesses in north Georgia. The name
change of Gilmer County Bank, from Gilmer County Bank to Appalachian Community
Bank, was desired to more clearly depict the overall geographic region which the
Bank services. For the immediate future, however, those branches of the Bank
that are located in Gilmer County continue to operate under the trade name of
“Gilmer County Bank.”





The
Company is authorized to engage in any activity in which a corporation is
permitted, by law, to engage, subject to applicable federal and state regulatory
restrictions on the activities of bank holding companies. The Company’s holding
company structure provides it with the flexibility to expand and diversify its
business activities through newly formed subsidiaries or through acquisitions.
While management of the Company has no present plans to engage in any other
business activities, management may, from time to time, study the feasibility of
establishing or acquiring subsidiaries to engage in other business activities to
the extent permitted by law.





**Banking
Services and Operations**





The Bank
conducts business from four locations in three adjacent north Georgia counties
(Gilmer, Fannin and Union) and has correspondent relationships with several
banks, including The Bankers Bank, SunTrust Bank, SouthTrust Bank, National Bank
of Commerce of Birmingham, Synovus and the Federal Home Loan Bank of Atlanta.
The Bank’s deposits are insured by the Federal Deposit Insurance Corporation
(the “FDIC”).





The Bank
performs banking services customary for full service banks of similar size and
character. Such services include the receipt of demand and time deposit
accounts, the extension of personal and commercial loans and the furnishing of
personal and commercial checking accounts. The Bank draws most of its customer
deposits, and conducts most of its lending transactions, from and within a
primary service area encompassing Gilmer County, Fannin County, Union County,
Towns County, northern Pickens County, western Dawson County and southeastern
Murray County, Georgia.





The
principal business of the Bank is to attract and accept deposits from the public
and to make loans and other investments. The principal sources of funds for the
Bank’s loans and investments are: (i) demand, time, savings, and other deposits
(including negotiable order of withdrawal (“NOW”) accounts); (ii) amortization
and prepayment of loans granted, (iii) sales to other lenders or institutions of
loans or participation in loans; (iv) fees paid by other lenders or institutions
for servicing loans sold by the Bank to such lenders or institutions; and (v)
borrowings. The principal sources of income for the Bank are interest and fees
collected on loans, including fees received for servicing loans sold to other
lenders or institutions and, to a lesser extent, interest and dividends
collected on other investments. The principal expenses of the Bank are: (i)
interest paid on savings and other deposits (including NOW accounts); (ii)
interest paid on borrowings by the Bank; (iii) employee compensation; (iv)
office expenses; and (v) other overhead expenses.





**Employees**





Except
for the officers of the Company, who are also officers of the Bank, the Company
does not have any employees. At December 31, 2004, the Bank had a total of 153
employees, 135 of which were full-time employees. The Company and the Bank are
not parties to any collective bargaining agreements with employees, and
management believes that employee relations are generally good.




2
 Table of Contents





**Lending
Activities**





*General.* The Bank
is authorized to make both secured and unsecured commercial and consumer loans
to individuals, partnerships, corporations and other entities. The Bank’s
lending business consists principally of making secured real estate loans,
including residential and commercial construction loans, and primary and
secondary mortgage loans for the acquisition or improvement of personal
residences. In addition, the Bank makes consumer loans to individuals and
commercial loans to small and medium-sized businesses and professional concerns.
Loans to the construction industry constituted approximately 22.2% of the Bank’s
total loans at December 31, 2004. Loans to the poultry industry constituted
approximately 5.2% of the Bank’s total loans at December 31, 2004. Loans to the
Hotel/Motel industry constituted approximately 5.1% of the Bank’s total loans at
December 31, 2004.





The Bank
has engaged in secondary-market mortgage activities, obtaining commitments,
through intermediaries, from secondary mortgage purchasers to purchase mortgage
loans originated by the Bank. Based on these commitments, the Bank originates
mortgage loans on terms corresponding to such commitments and generates fee
income to supplement its interest income. No mortgage loans are held by the Bank
for resale nor are any loans held for mortgage servicing.





*Real
Estate Loans.* Loans
secured by real estate are the primary component of the Bank’s loan portfolio,
constituting approximately $320 million, or 84.7%, of the Bank’s total loans at
December 31, 2004. These loans consist of commercial real estate loans,
construction and development loans and residential real estate
loans.





*Commercial
Loans.* The Bank
makes loans for commercial purposes to various lines of businesses. At
December 31, 2004, the Bank held approximately $32 million, or 8.5% of the
Bank’s total loans, in commercial loans, excluding for these purposes commercial
loans secured by real estate which are included in the real estate category
above.





*Consumer
Loans.* The Bank
makes a variety of loans to individuals for personal and household purposes,
including secured and unsecured installment and term loans, home equity loans
and lines of credit, and revolving lines of credit such as credit cards. At
December 31, 2004, the Bank held approximately $21 million in consumer loans,
representing 5.6% of the Bank’s total loans.





*Loan
Approval and Review.* The
Bank’s loan approval policies provide for various levels of officer lending
authority. When the aggregate amount of outstanding loans to a single borrower
exceeds that individual officer's lending authority, the loan request must be
considered and approved by an officer with a higher lending limit or the
officers’ loan committee. Individual officers’ lending limits range from $15,000
to $500,000, depending on seniority and the type of loan. The officers’ loan
committee, which consists of the president, executive vice president and senior
vice president of the Bank, has a lending limit of $1,000,000 secured and up to
$100,000 unsecured. Loans exceeding $1,000,000 require the approval of the
majority of the directors’ loan committee, which is made up of six of the Bank’s
directors.





The Bank
has a continuous loan review procedure, involving multiple officers of the Bank,
designed to promote early identification of credit quality problems. All loan
officers are charged with the responsibility of rating their loans and reviewing
those loans on a periodic basis, the frequency of which increases as the quality
of the loan decreases. The Bank has contracted with a specialist for an
independent assessment of the loan portfolio. The specialist reviews loans on a
quarterly basis.





**Deposits**





The Bank
offers a variety of deposit programs to individuals and to small to medium-sized
businesses and other organizations at interest rates generally consistent with
local market conditions. The Bank is authorized to accept and pay interest on
deposits from individuals, corporations, partnerships and any other types of
legal entities, including fiduciaries (such as private trusts). Qualified
deposits are insured by the FDIC in an amount up to $100,000.




3
 Table of Contents





The
following table sets forth the mix of depository accounts at the Bank as a
percentage of total deposits at December 31, 2004.





**Deposit
      Mix**December
      31, 2004Non-interest
      bearing demand
    
    
    8.62
    %Interest-bearing
      demand
    
    
    21.18
    %Savings
    
    
    17.50
    %Time
      deposits
    
    
    24.20
    %Certificates
      of deposit of $100,000 or more
    
    
    28.50
    %Total
    
    
    100.00
    %





The Bank
is a member of the Star ATM network of automated teller machines, which permits
the Bank’s customers to perform certain transactions in numerous cities
throughout Georgia and in other states. The Bank’s charter provides for trust
powers but only upon application to the Georgia Department of Banking and
Finance (the “DBF”). To date, the Bank has not submitted, and has no plans to
submit, such an application.





**Competition**





The
banking business is highly competitive. The Bank competes with other commercial
banks, thrift institutions, credit unions, and money market mutual fund
providers operating in Ellijay, Georgia (Gilmer County), Blue Ridge, Georgia
(Fannin County), Blairsville, Georgia (Union County) and elsewhere. Some of
these competitors have significantly greater resources and higher lending limits
(by virtue of their greater capitalization). Credit unions and money market
mutual fund providers with which the Bank competes may have competitive
advantages as a result of being subject to different, and possibly less
stringent, regulatory requirements .





As of
December 31, 2004, one locally owned bank and three non-locally-owned banks had
offices in Gilmer County, two locally-owned banks and one non-locally-owned bank
had offices in Blairsville (Union County), and four non-locally-owned banks had
offices in Fannin County. In addition, many local businesses and individuals
have deposits outside the primary service area of the Bank.





**Monetary
Policies**





The
results of operations of the Company and the Bank are significantly affected by
the credit policies of monetary authorities, particularly the Board of Governors
of the Federal Reserve System (the “Federal Reserve”). The instruments of
monetary policy employed by the Federal Reserve include open market operations
in U.S. government securities, changes in discount rates on member bank
borrowings, and changes in reserve requirements against bank deposits. In view
of changing conditions in the national economy and in the money markets, as well
as the effect of action by monetary and fiscal authorities, including the
Federal Reserve, 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.








**Supervision
and Regulation**





The
following discussion is only intended to provide brief summaries of significant
statutes and regulations that affect the banking industry and therefore is not
complete. Changes in applicable laws or regulations, and in the policies of
regulators, may have a material effect on the Company’s business and prospects.
Management cannot accurately predict the nature or extent of the effects on the
Company’s business and earnings that fiscal or monetary policies, or new federal
or state laws, may have in the future.





**The
Company**





*General.* As a bank
holding company, the Company is regulated under the Bank Holding Company Act of
1956 (the “BHC Act”), as well as other federal and state laws governing the
banking business. The Board of Governors of the Federal Reserve is the primary
regulator of the Company, and supervises the Company’s activities on a continual
basis. The Bank is also subject to regulation and supervision by various
regulatory authorities, including the DBF and the FDIC. The Company must file
annual reports with the Federal Reserve and must provide it with such additional
information as it may require. In addition, the Federal Reserve periodically
examines the Company and the Bank.




4
 Table of Contents





*Bank
Holding Company Regulation.* In
general, the BHC Act limits bank holding company business to owning or
controlling banks and engaging in other banking-related activities. Bank holding
companies must obtain the Federal Reserve Board's approval before
they:





·
    acquire
      direct or indirect ownership or control of any voting shares of any bank
      that results in total ownership or control, directly or indirectly, of
      more than 5% of the voting shares of such
bank;


·
    merge
      or consolidate with another bank holding company;
or


·
    acquire
      substantially all of the assets of any additional
banks.




Subject
to certain state laws, a bank holding company that is adequately capitalized and
adequately managed may acquire the assets of both in-state and out-of-state
banks. With certain exceptions, the Bank Holding Company Act prohibits bank
holding companies from acquiring direct or indirect ownership or control of
voting shares in any company that is not a bank or a bank holding company unless
the Federal Reserve Board determines such activities are incidental or closely
related to the business of banking.





The
Change in Bank Control Act of 1978 requires a person (or group of persons acting
in concert) acquiring "control" of a bank holding company to provide the Federal
Reserve Board with 60 days' prior written notice of the proposed acquisition.
Following receipt of this notice, the Federal Reserve Board has 60 days (or up
to 90 days if extended) within which to issue a notice disapproving the proposed
acquisition. In addition, any "company" must obtain the Federal Reserve Board's
approval before acquiring 25% (5% if the "company" is a bank holding company) or
more of the outstanding shares or otherwise obtaining control over the Company. ****





*Financial
Services Modernization* . The
Gramm-Leach-Bliley Financial Modernization Act of 1999 (the “Modernization
Act”), enacted on November 12, 1999, amended the BHC Act and:





·
    allows
      bank holding companies that qualify as “financial holding companies” to
      engage in a substantially broader range of non-banking activities than was
      permissible under prior law;


·
    allows
      insurers and other financial services companies to acquire
      banks;


·
    allows
      national banks, and some state banks, either directly or through operating
      subsidiaries, to engage in certain non-banking financial
      activities;


·
    removes
      various restrictions that applied to bank holding company ownership of
      securities firms and mutual fund advisory companies;
and


·
    establishes
      the overall regulatory structure applicable to bank holding companies that
      also engage in insurance and securities
operations.





If the
Company, which has not obtained qualification as a “financial holding company,”
were to do so in the future, the Company would be eligible to engage in, or
acquire companies engaged in, the broader range of activities that are permitted
by the Modernization Act, provided that if any of the Company’s banking
subsidiaries were to cease to be “well capitalized” or “well managed” under
applicable regulatory standards, the Federal Reserve Board could, among other
things, place limitations on the Company’s ability to conduct these broader
financial activities or, if the deficiencies persisted, require the Company to
divest the banking subsidiary. In addition, if the Company were to be qualified
as a financial holding company and any of its banking subsidiaries were to
receive a rating of less than satisfactory under the Community Reinvestment Act
of 1977 (the “CRA”), the Company would be prohibited from engaging in any
additional activities other than those permissible for bank holding companies
that are not financial holding companies. The broader range of activities that
financial holding companies are eligible to engage in includes those that are
determined to be “financial in nature”, including insurance underwriting,
securities underwriting and dealing, and making merchant banking investments in
commercial and financial companies.





*Transactions
with Affiliates* . The
Company and the Bank are deemed to be affiliates within the meaning of the
Federal Reserve Act, and transactions between affiliates are subject to certain
restrictions. Generally, the Federal Reserve Act limits the extent to which a
financial institution or its subsidiaries may engage in “covered transactions”
with an affiliate. It also requires all transactions with an affiliate, whether
or not “covered transactions,” to be on terms substantially the same, or at
least as favorable to the institution or subsidiary, as those provided to a
non-affiliate. The term “covered transaction” includes the making of loans,
purchase of assets, issuance of a guarantee and other similar types of
transactions.




5
 Table of Contents





*Tie-In
Arrangements* . The
Company and the Bank cannot engage in certain tie-in arrangements in connection
with any extension of credit, sale or lease of property or furnishing of
services. For example, with certain exceptions, neither the Company nor the Bank
may condition an extension of credit on either a requirement that the customer
obtain additional services provided by either the Company or the Bank, or an
agreement by the customer to refrain from obtaining other services from a
competitor. The Federal Reserve Board has adopted exceptions to its anti-tying
rules that allow banks greater flexibility to package products with their
affiliates. These exceptions were designed to enhance competition in banking and
non-banking products and to allow banks and their affiliates to provide more
efficient, lower cost service to their customers.





*Source
of Strength* . Under
Federal Reserve Board policy, the Company is expected to act as a source of
financial strength to the Bank and to commit resources to support the Bank. This
support may be required at times when, absent that Federal Reserve Board policy,
the Company may not find itself able to provide it. Capital loans by a bank
holding company to any of its subsidiary banks are subordinate in right of
payment to deposits and to certain other indebtedness of such subsidiary banks.
In the event of a bank holding company’s bankruptcy, any commitment by the bank
holding company to a federal bank regulatory agency to maintain the capital of a
subsidiary bank will be assumed by the bankruptcy trustee and entitled to a
priority of payment.





*Subsidiary
Dividends* . The
Company is a legal entity separate and distinct from the Bank. A major portion
of the Company’s revenues results from amounts paid as dividends to the Company
by the Bank. The DBF’s approval must be obtained before the Bank may pay cash
dividends out of retained earnings if (i) the total classified assets at the
most recent examination of the Bank exceeded 80% of the equity capital, (ii) the
aggregate amount of dividends declared or anticipated to be declared in the
calendar year exceeds 50% of the net profits, after taxes but before dividends
for the previous calendar year, or (iii) the ratio of equity capital to adjusted
assets is less than 6%.





In
addition, the Company and the Bank are subject to various general regulatory
policies and requirements relating to the payment of dividends, including
requirements to maintain adequate capital above regulatory minimums. The
appropriate federal regulatory authority is authorized to determine under
certain circumstances relating to the financial condition of a bank or bank
holding company that the payment of dividends would be an unsafe or unsound
practice and to prohibit payment thereof. The appropriate federal regulatory
authorities have indicated that paying dividends that deplete a bank’s capital
base to an inadequate level would be an unsound and unsafe banking practice and
that banking organizations should generally pay dividends only out of current
operating earnings.





*State
Law Restrictions.* As a
Georgia business corporation, the Company may be subject to certain limitations
and restrictions under applicable Georgia corporate law.





**The
Bank**





*General* . The
Bank, as a Georgia state-chartered bank, is subject to regulation and
examination by the State of Georgia DBF, as well as the FDIC. Georgia state laws
regulate, among other things, the scope of the Bank’s business, its investments,
its payment of dividends to the Company, its required legal reserves and the
nature, lending limit, maximum interest charged and amount of and collateral for
loans. The laws and regulations governing the Bank generally have been
promulgated by Georgia to protect depositors and not to protect shareholders of
the Company or the Bank.





*Community
Reinvestment Act.* The
Community Reinvestment Act requires that, in connection with examinations of
financial institutions within their jurisdiction, the FDIC evaluate the record
of the financial institutions in meeting the credit needs of their local
communities, including low and moderate income neighborhoods, consistent with
the safe and sound operation of those banks. These factors are also considered
in evaluating mergers, acquisitions, and applications to open a branch or
facility.





*Insider
Credit Transactions* . Banks
are also subject to certain restrictions imposed by the Federal Reserve Act on
extensions of credit to executive officers, directors, principal shareholders,
or any related interests of such persons. Extensions of credit must be made on
substantially the same terms, including interest rates and collateral, and
follow credit underwriting procedures that are not less stringent than those
prevailing at the time for comparable transactions with persons not covered
above and who are not employees. Also, such extensions of credit must not
involve more than the normal risk of repayment or present other unfavorable
features.




6
 Table of Contents





*Federal
Deposit Insurance Corporation Improvement Act* . Under
the Federal Deposit Insurance Corporation Improvement Act of 1991 (the
“FDICIA”), each federal banking agency has prescribed, by regulation, noncapital
safety and soundness standards for institutions under its authority. These
standards cover internal controls, information systems, and internal audit
systems, loan documentation, credit underwriting, interest rate exposure, asset
growth, compensation, fees and benefits, such other operational and managerial
standards as the agency determines to be appropriate, and standards for asset
quality, earnings and stock valuation. Management believes that the Bank meets
all such standards.





*Interstate
Banking and Branching.* The
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
“IBBEA”) permits nationwide interstate banking and branching under certain
circumstances. This legislation generally authorizes interstate branching and
relaxes federal law restrictions on interstate banking. Currently, bank holding
companies may purchase banks in any state, and states may not prohibit such
purchases. Additionally, banks are permitted to merge with banks in other states
as long as the home state of neither merging bank has “opted out.” The IBBEA
requires regulators to consult with community organizations before permitting an
interstate institution to close a branch in a low-income area. The IBBEA also
prohibits the interstate acquisition of a bank if, as a result, the bank holding
company would control more than ten percent of the total United States insured
depository deposits or more than thirty percent, or the applicable state law
limit, of deposits in the acquired bank’s state. Under recent FDIC regulations,
banks are prohibited from using their interstate branches primarily for deposit
production. The FDIC has accordingly implemented a loan-to-deposit ratio screen
to ensure compliance with this prohibition.





Georgia
has “opted in” to the IBBEA and allows in-state banks to merge with out-of-state
banks subject to certain requirements. Georgia law generally authorizes the
acquisition of an in-state bank by an out-of-state bank by merger with a Georgia
financial institution that has been in existence for at least 3 years prior to
the acquisition. With regard to interstate bank branching, out-of-state banks
that do not already operate a branch in Georgia may not establish de novo
branches in Georgia.





*Deposit
Insurance* . The
deposits of the Bank are currently insured to a maximum of $100,000 per
depositor through a fund administered by the FDIC. All insured banks are
required to pay semi-annual deposit insurance premium assessments to the FDIC.





**Capital
Adequacy**





Federal
bank regulatory agencies use capital adequacy guidelines in the examination and
regulation of bank holding companies and banks. If capital falls below minimum
guideline levels, the holding company or bank may be denied approval to acquire
or establish additional banks or nonbank businesses or to open new facilities.





The FDIC
and Federal Reserve use risk-based capital guidelines for banks and bank holding
companies. These are designed to make such capital requirements more sensitive
to differences in risk profiles among banks and bank holding companies, to
account for off-balance sheet exposure and to minimize disincentives for holding
liquid assets. Assets and off-balance sheet items are assigned to broad risk
categories, each with appropriate weights. The resulting capital ratios
represent capital as a percentage of total risk-weighted assets and off-balance
sheet items. The guidelines are minimums, and the Federal Reserve has noted that
bank holding companies contemplating significant expansion programs should not
allow expansion to diminish their capital ratios and should maintain ratios well
in excess of the minimum. The current guidelines require all bank holding
companies and federally-regulated banks to maintain a minimum risk-based total
capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1
capital for bank holding companies includes common shareholders' equity, certain
qualifying perpetual preferred stock and minority interests in equity accounts
of consolidated subsidiaries, less intangibles except as described above.





The FDIC
and Federal Reserve also employ a leverage ratio, which is Tier 1 capital as a
percentage of total assets less intangibles, to be used as a supplement to
risk-based guidelines. The principal objective of the leverage ratio is to
constrain the maximum degree to which a bank holding company or bank may
leverage its equity capital base. A minimum leverage ratio of 3% is required for
the most highly rated bank holding companies and banks. Other bank holding
companies, banks and bank holding companies seeking to expand, however, are
required to maintain minimum leverage ratios of at least 4% to 5%.




7
 Table of Contents





The
FDICIA created a statutory framework of supervisory actions indexed to the
capital level of the individual institution. Under regulations adopted by the
FDIC and the Federal Reserve, an institution is assigned to one of five capital
categories depending on its total risk-based capital ratio, Tier 1 risk-based
capital ratio, and leverage ratio, together with certain subjective factors.
Institutions which are deemed to be "undercapitalized" depending on the category
to which they are assigned are subject to certain mandatory supervisory
corrective actions.





**Recent
Significant Changes in Banking Laws and Regulations**





*International
Money Laundering Abatement and Anti-Terrorist Financing Act of 2001.* On
October 26, 2001, the USA PATRIOT Act was enacted. It includes the International
Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 (the
“IMLAFA”) and strong measures to prevent, detect and prosecute terrorism and
international money laundering. As required by the IMLAFA, the federal banking
agencies, in cooperation with the U.S. Treasury Department, established rules
that generally apply to insured depository institutions and U.S. branches and
agencies of foreign banks.





Among
other things, the new rules require that financial institutions implement
reasonable procedures to (1) verify the identity of any person opening an
account; (2) maintain records of the information used to verify the person's
identity; and (3) determine whether the person appears on any list of known or
suspected terrorists or terrorist organizations. The rules also prohibit banks
from establishing correspondent accounts with foreign shell banks with no
physical presence and encourage cooperation among financial institutions, their
regulators and law enforcement to share information regarding individuals,
entities and organizations engaged in terrorist acts or money laundering
activities. The rules also limit a financial institution's liability for
submitting a report of suspicious activity and for voluntarily disclosing a
possible violation of law to law enforcement.





*Sarbanes-Oxley
Act of 2002* . The
Sarbanes-Oxley Act of 2002 (the “SOA”) was enacted to address corporate and
accounting fraud. It established a new accounting oversight board that enforces
auditing standards and restricts the scope of services that accounting firms may
provide to their public company audit clients. Among other things, it also (i)
requires chief executive officers and chief financial officers to certify to the
accuracy of periodic reports filed with the Securities and Exchange Commission
(the “SEC”); (ii) imposes new disclosure requirements regarding internal
controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures;
(iii) accelerates the time frame for reporting of insider transactions and
periodic disclosures by certain public companies; and (iv) requires companies to
disclose whether or not they have adopted a code of ethics for senior financial
officers and whether the audit committee includes at least one “audit committee
financial expert.”





The SOA
requires the SEC, based on certain enumerated factors, to regularly and
systematically review corporate filings. To deter wrongdoing, it (i) subjects
bonuses issued to top executives to disgorgement if a restatement of a company’s
financial statements was due to corporate misconduct; (ii) prohibits an officer
or director from misleading or coercing an auditor; (iii) prohibits insider
trades during pension fund “blackout periods”; (iv) imposes new criminal
penalties for fraud and other wrongful acts; and (v) extends the period during
which certain securities fraud lawsuits can be brought against a company or its
officers.





*Future
Legislation* . Changes
to federal and state laws and regulations can affect the operating environment
of bank holding companies and their subsidiaries in substantial and
unpredictable ways. From time to time, various legislative and regulatory
proposals are introduced. These proposals, if codified, may change banking
statutes and regulations and the Company’s operating environment in substantial
and unpredictable ways. If codified, these proposals could increase or decrease
the cost of doing business, limit or expand permissible activities or affect the
competitive balance among banks, savings associations, credit unions and other
financial institutions. The Company cannot accurately predict whether those
changes in laws and regulations will occur, and, if those changes occur, the
ultimate effect they would have upon the Company’s financial condition or
results of operation.





**ITEM
      2.**
    **PROPERTIES**





T he
Company's main office is located at 829 Industrial Boulevard, Ellijay, Georgia,
between the business districts of Ellijay and East Ellijay. The 9,780 square
foot building is located on approximately 1.22 acres and is owned by the Bank.
The building includes five teller stations, twenty offices, three drive-in
stations and an ATM. This location houses the Company’s and the Bank’s offices
and storage areas. The Bank branch at this location operates under the trade
name “Gilmer County Bank.” Adjacent to this location, the Bank constructed a
community building on leased property. This building is used for a meeting area,
as well as for the Bank’s customers to use for various community functions. The
Bank pays annual rent of $600 for this property. This lease will be up for
renewal in 2006.




8
 Table of Contents





The
Bank’s branch located on Highway 515 in Blairsville, Georgia has a drive-in
window, five teller stations, eleven offices and an ATM. The building is owned
by the Bank. The second floor of this location is vacant and may be used by the
Bank for future expansion.





The
Bank’s branch located in East Ellijay, Georgia, which operates under the trade
name “Gilmer County Bank,” has three teller stations, a drive-in window and an
ATM. The Bank has a long-term lease for this location in which the rent
increases two percent annually. In 2004, the Bank paid $31,848 in annual rent.





The
Bank’s Blue Ridge, Georgia branch moved into its permanent location in July
2004. This branch has a drive-in window, six teller stations, eight offices, and
an ATM. There is also a community building at this location that is available
for the Bank to use as a meeting area, as well as for its customers to use for
various community functions. The buildings sit on approximately 2.6 acres and
are owned by the Bank.





The
Bank’s operations center is located in a building owned by the Bank located at 9
Russell Drive, Ellijay, Georgia, which houses the Bank’s computer center,
accounting, bookkeeping and data processing services. In addition, the building
contains an additional 8,000 approximate square feet of commercial space, which
is leased by the Bank to two separate third parties for a total of $67,200 per
year. One of these leases will be up for renewal in 2005 for a negotiable
payment. The Bank also leases a building directly behind the operations
building, which contains additional operations employees. The Bank has a
two-year lease for this space and pays annual rent of $16,800. During 2004, the
Bank purchased approximately 6.3 acres of land and entered into a contract to
construct a new operations center directly across from the main office.
Completion of this building is expected in December 2005.





In August
2004, the Company purchased additional property in East Ellijay to be used for a
new branch office. There are no plans for construction of this office at
present. An ATM has been placed at this location. The property consists of
approximately 2 acres located on Highway 515 South in the new Highlands Shopping
Center.





Management
believes that the physical facilities maintained by the Company and the Bank are
suitable for their current operations.








**ITEM
      3.**
    **LEGAL PROCEEDINGS**





The
Company is not aware of any material pending legal proceedings to which the
Company or the Bank are a party or to which any of their property is subject,
other than ordinary routine legal proceedings incidental to the business of the
Bank.








**ITEM
      4.**
    **SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS**





No
matters were submitted to a vote of shareholders of the Company during the
fourth quarter of the fiscal year covered by this report.








**PART
II**





**ITEM
      5.**
    **MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED
      STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
      SECURITIES**





**Market
Information**





There is
no established trading market for the Company’s common stock, $0.01 par value
per share (the “Common Stock”), which has been traded inactively in private
transactions. In 1998, Wachovia Securities, Inc. was approved as a market maker
for the Company’s Common Stock.




9
 Table of Contents





In July
2003, the Company paid a ten percent stock dividend (the “Stock Dividend”) to
shareholders of record as of May 27, 2003. All amounts presented in this Form
10-K and in the Consolidated Financial Statements have been adjusted to reflect
the Stock Dividend. The Stock Dividend created a small decrease in shareholders’
equity as a result of cash paid in lieu of fractional shares in the amount of
$1,931. There were no stock dividends paid in 2004.





Management
has reviewed the limited information available as to the ranges at which the
Common Stock has been sold and is aware of trades that occurred during 2004. To
the best of management’s knowledge, the last trade in December 2004 was executed
at a price of $16.00 per share. The per share price data regarding the Common
Stock is provided for information purposes only and should not be viewed as
indicative of the actual or market value of the Common Stock.





Estimated
      PriceRange
      Per ShareHigh
    
    Low**2004:****First
      Quarter**
    
    **$**
    **15.00**
    
    **$**
    **14.50****Second
      Quarter**
    
    
    **15.00**
    
    
    **15.00****Third
      Quarter**
    
    
    **16.00**
    
    
    **16.00****Fourth
      Quarter**
    
    
    **17.00**
    
    
    **16.00**2003:First
      Quarter
    
    $
    16.00
    
    $
    15.00Second
      Quarter
    
    
    15.00
    
    
    15.00Third
      Quarter
    
    
    15.00
    
    
    15.00Fourth
      Quarter
    
    
    15.00
    
    
    13.37





**Holders**





At March
14, 2005, the Company had 3,812,999 shares of Common Stock outstanding held by
approximately 1,408 shareholders of record.





**Dividends**





The Bank
is subject to restrictions on the payment of dividends under Georgia law and the
regulations of the DBF. The Company is also subject to limits on payment of
dividends by the rules, regulations and policies of federal banking authorities.
The primary source of funds available for the payment of cash dividends by the
Company are dividends from the Bank. There are various statutory and regulatory
limitations on the payment of dividends by the Bank, as well as by the Company
to its shareholders. No assurance can be given that any dividends will be
declared by the Company in the future, or if declared, what amounts would be
declared or whether such dividends would continue. The Company has not paid any
cash dividends to date. The Company paid a 10% stock dividend on July 1,
2003.







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10
 Table of Contents





**Securities
Authorized for Issuance Under Equity Compensation Plans**





At a
prior Annual Meeting, the Company’s shareholders adopted a Stock Compensation
Program (the “Stock Program”). The following table reflects the number of shares
to be issued upon the exercise of options granted under the Stock Program, the
weighted-average exercise price of all such options, and the total number of
shares of Common Stock reserved for the issuance upon the exercise of
authorized, but not-yet-granted options, as of December 31, 2004.





*(a)*
    
    *(b)*
    
    *(c)*Number
      ofEquity
      SecuritiesRemainingAvailable
      forNumber
      of
    
    
    
    Future
      IssuanceSecurities
    
    
    
    Under
      theto
      be Issued
    
    Weighted-average
    
    Stock
      ProgramsUpon
      the Exercise
    
    Exercise
      Price
    
    (Excluding
      Securitiesof
      Outstanding
    
    of
      Outstanding
    
    Reflected
      in ColumnPlan
      Category
    
    Options
    
    Options
    
    *(a)*)Equity
      Compensation PlansApproved
      by Shareholders
    
    
    360,300
    
    $
    6.07
    
    
    228,900Equity
      Compensation PlansNot
      Approved by Shareholders
    
    
    —
    
    
    —
    
    
    —Total
    
    
    360,300
    
    $
    6.07
    
    
    228,900














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11
 Table of Contents





**ITEM
      6.**
    **SELECTED FINANCIAL DATA**





The
following table sets forth selected consolidated financial data of the Company
for the year ended December 31, 2004, and the previous four years. All averages
are daily averages.





Years
      Ended December 31,2004
    
    2003
    
    2002
    
    2001
    
    2000(In
      thousands except per share data)**Earnings
      Summary**Interest
      income
    
    $
    25,736
    
    $
    23,090
    
    $
    22,892
    
    $
    23,890
    
    $
    21,970Interest
      expense
    
    
    7,558
    
    
    8,257
    
    
    11,425
    
    
    13,675
    
    
    13,325Net
      interest income
    
    
    18,178
    
    
    14,833
    
    
    11,467
    
    
    10,215
    
    
    8,645Provision
      for loan losses
    
    
    1,235
    
    
    1,465
    
    
    1,028
    
    
    1,294
    
    
    922Noninterest
      income
    
    
    2,829
    
    
    2,703
    
    
    2,937
    
    
    2,411
    
    
    1,159Noninterest
      expense
    
    
    13,840
    
    
    11,732
    
    
    9,702
    
    
    7,831
    
    
    6,381Income
      tax expense
    
    
    1,885
    
    
    1,253
    
    
    1,006
    
    
    963
    
    
    872Net
      income
    
    
    4,047
    
    
    3,086
    
    
    2,668
    
    
    2,538
    
    
    1,629**Per
      Share Data**(Adjusted
      to give effect to stock splits/dividends)Net
      income - basic
    
    $
    1.09
    
    $
    0.86
    
    $
    0.81
    
    $
    0.81
    
    $
    0.54Net
      income - diluted
    
    
    1.04
    
    
    0.81
    
    
    0.76
    
    
    0.75
    
    
    0.50Cash
      dividends declared per common share
    
    
    0.00
    
    
    0.00
    
    
    0.00
    
    
    0.00
    
    
    0.00**Selected
      Period End Balances**Total
      assets
    
    $
    472,811
    
    $
    409,617
    
    $
    384,024
    
    $
    319,679
    
    $
    270,943Loans
    
    
    377,352
    
    
    332,307
    
    
    298,063
    
    
    250,569
    
    
    214,124Securities
    
    
    64,655
    
    
    55,363
    
    
    40,375
    
    
    49,394
    
    
    32,541Earning
      assets
    
    
    444,566
    
    
    388,530
    
    
    354,593
    
    
    303,923
    
    
    253,263Deposits
    
    
    381,498
    
    
    332,919
    
    
    316,283
    
    
    264,028
    
    
    214,169Long-term
      borrowings
    
    
    38,136
    
    
    36,879
    
    
    34,736
    
    
    29,654
    
    
    34,539Shareholders’
      equity
    
    
    36,083
    
    
    31,082
    
    
    25,619
    
    
    20,591
    
    
    17,669Shares
      outstanding
    
    
    3,765
    
    
    3,659
    
    
    3,439
    
    
    3,170
    
    
    3,143**Selected
      Average Balances**Total
      assets
    
    $
    446,074
    
    $
    393,553
    
    $
    354,164
    
    $
    299,167
    
    $
    259,799Loans
    
    
    360,261
    
    
    316,605
    
    
    276,733
    
    
    234,031
    
    
    204,436Securities
    
    
    56,981
    
    
    49,951
    
    
    50,933
    
    
    40,462
    
    
    34,393Earning
      assets
    
    
    419,586
    
    
    370,654
    
    
    333,777
    
    
    280,884
    
    
    243,038Deposits
    
    
    362,316
    
    
    320,833
    
    
    290,961
    
    
    241,933
    
    
    206,787Long-term
      borrowings
    
    
    30,946
    
    
    35,782
    
    
    34,017
    
    
    33,028
    
    
    29,024Shareholders’
      equity
    
    
    33,102
    
    
    28,447
    
    
    22,454
    
    
    19,821
    
    
    15,045Shares
      outstanding - basic
    
    
    3,724
    
    
    3,610
    
    
    3,278
    
    
    3,146
    
    
    3,031**Ratios**Return
      on average assets
    
    
    0.91
    %
    
    0.78
    %
    
    0.75
    %
    
    0.85
    %
    
    0.63
    %Return
      on average equity
    
    
    12.23
    
    
    10.85
    
    
    11.88
    
    
    12.80
    
    
    10.83Net
      interest spread
    
    
    4.23
    
    
    3.93
    
    
    3.32
    
    
    3.75
    
    
    3.39Total
      capital
    
    
    11.45
    
    
    11.55
    
    
    8.59
    
    
    8.32
    
    
    8.25Tier
      1 capital
    
    
    10.32
    
    
    10.46
    
    
    7.54
    
    
    7.16
    
    
    7.22Leverage
      ratio
    
    
    8.53
    
    
    8.58
    
    
    6.07
    
    
    5.87
    
    
    5.72Average
      equity to average assets
    
    
    7.42
    
    
    7.23
    
    
    6.34
    
    
    6.63
    
    
    5.79




12
 Table of Contents





**ITEM
      7.**
    **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
      CONDITION AND RESULTS OF
OPERATIONS**





The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations (the “MD&A”) is intended to address information
relating to the financial condition and results of operations of the Company
that may not be readily apparent from a review of the Consolidated Financial
Statements and notes thereto. Therefore, the MD&A should be read in
conjunction with information provided in the Company’s Consolidated Financial
Statements and notes thereto. Unless otherwise noted, the discussion of net
interest income in this financial review is presented on a taxable equivalent
basis to facilitate performance comparisons among various taxable and tax-exempt
assets.





***Forward-Looking
Statements***





Certain
of the statements made in this Form 10-K and in documents incorporated by
reference herein, including matters discussed in the MD&A, as well as oral
statements made by the Company or its officers, directors or employees, may
constitute forward-looking statements within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”). Such
forward-looking statements are based on management’s beliefs, current
expectations, estimates and projections about the financial services industry,
the economy and about the Company and the Bank. The words “expect,”
“anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and similar
expressions are intended to identify such forward-looking statements. Such
forward-looking statements are not guarantees of future performance and are
subject to risks, uncertainties and other factors that may cause the actual
results, performance or achievements of the Company to differ materially from
historical results or from any results expressed or implied by such
forward-looking statements. Such factors include, without
limitation:





·
    increased
      competition with other financial
institutions;


·
    lack
      of sustained economic growth in Georgia, in particular Gilmer, Fannin and
      Union Counties;


·
    rapid
      fluctuations in interest rates;


·
    the
      inability of the Bank to maintain regulatory capital standards;
      and


·
    changes
      in the legislative and regulatory environment.





Many of
these factors are beyond the Company’s ability to control or predict, and
readers are cautioned not to put undue reliance on such forward-looking
statements. The Company disclaims any obligation to update or revise any
forward-looking statements contained in this Report, whether as a result of new
information, future events or otherwise.





**Summary**





The
Company’s net income of $4,047,014 for the year ended December 31, 2004
represents an increase of $960,434 or 31.1% from 2003. The Company’s net income
of $3,086,580 for the year ended December 31, 2003, represents an increase
of $418,572 or 15.7% from 2002. The Company’s net income of $2,668,008 for the
year ended December 31, 2002, represented an increase of $129,910 or 5.1%
from 2001. The increase in net income for these periods relates to: (i)
increased loan growth; (ii) management funding through the use of local
deposits; and (iii) alternative funding sources.





Earnings
per share increased to $1.09 ($1.04 on a diluted basis) in 2004, up from $0.86
($0.81 on a diluted basis) in 2003, and $0.81 ($0.76 on a diluted basis) in
2002. Return on average assets, which reflects the Bank’s ability to utilize its
assets, was 0.91% in 2004, compared to 0.78% in 2003, and 0.75% in 2002. Return
on average shareholders’ equity increased to 12.23% in 2004 after having
decreased to 10.85% in 2003, and compared to 11.88% in 2002. This increase in
2004 was due to management’s focus on using net income to fund growth. The
increase in the net interest margin was the main factor in generating the income
internally to fund the growth. The decline in 2003 was due to the sale of
128,240 shares of treasury stock to improve the Company’s capital position as
well as prepare for the anticipated growth. The effects of the stock-based
compensation expense as well as the exercise of 72,340 options in 2004 and
82,170 options in 2003 generated proceeds of $502,209 and $529,330,
respectively. During 2004, the Company issued and sold 33,546 shares to its
401(k) plan for $503,191. There were no shares sold to the 401(k) plan during
2003, and during 2002, the Company issued and sold 12,859 shares to its 401(k)
plan for $163,660. During 2002 and 2003, the Company sold an aggregate of
180,687 shares of common stock for net proceeds of $2,710,306 to support future
expansion.




13
 Table of Contents





The
Company plans to continue its objectives of maintaining asset quality and
providing superior service to its customers. The Company’s strategic plan in the
short run includes controlled growth with a focus on developing banking
relationships. The Company strives to provide the best value in deposit services
and loan products to its customers. The Company continues to place a strong
focus on improving its net interest margin. In 2003, pricing models were put in
place to assist loan officers with structuring loan products to fit our
customers’ needs, as well as deposit pricing models to assist with funds
management. The Company is also taking advantage of alternative funding sources
when needed, including but not limited to the national CD market, brokered CD
market, the Federal Home Loan Bank and repurchase agreements.





**Critical
Accounting Policies**





The
Company has established various accounting policies which govern the application
of generally accepted accounting principles in the preparation of the
Consolidated Financial Statements. Certain accounting policies involve
significant judgments and assumptions by management that have a material impact
on the carrying value of certain assets and liabilities. Management considers
such accounting policies to be critical. The judgments and assumptions used by
management are based on historical experience and other factors, which
management believes to be reasonable under the circumstances. Because of the
nature of the judgments and assumptions made by management, actual results could
differ from these judgments and assumptions, which could have a material impact
on the carrying values of assets and liabilities and the results of operations
of the Company. The Company believes the allowance for loan losses is a critical
accounting policy that requires the most significant judgments and estimates
used in the preparation of the Consolidated Financial Statements. Refer to Note
1, *Summary
of Significant Accounting Policies* , and
Note 6, *Allowances
for Loan Losses* , in the
Consolidated Financial Statements, and this Item 7 for a description of the
estimation processes and methodology related to the allowance for loan
losses.





**Financial
Condition**





**Earning
Assets**





The
Bank’s earning assets, which include deposits with other banks, federal funds
sold, securities and loans, averaged $419,586,000, or 94.1% of average total
assets in 2004, $370,654,000, or 94.2% of average total assets, in 2003, and
$333,777,000, or 94.2% of average total assets, in 2002. The mix of average
earning assets comprised the following percentages:





December
      31,2004
    
    2003
    
    2002Deposits
      with other banks
    
    
    0.08
    %
    
    0.21
    %
    
    0.30
    %Federal
      funds sold
    
    
    0.48
    
    
    0.89
    
    
    1.53Investment
      securities
    
    
    13.58
    
    
    13.48
    
    
    15.26Loans
    
    
    85.86
    
    
    85.42
    
    
    82.91





The mix
of average earning assets reflects management’s attempt to maximize interest
income while maintaining acceptable levels of risk.








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14
 Table of Contents




The
management of the Company considers many criteria in managing earning assets,
including creditworthiness, diversification, maturity, and interest rate
sensitivity. The following table sets forth the Company’s interest-earning
assets by category at December 31 in each of the last three years.





December
      31,2004
    
    2003
    
    2002(In
      thousands)Interest-bearing
      deposits with banks
    
    $
    403
    
    $
    274
    
    $
    8,399Securities
    
    
    64,655
    
    
    55,363
    
    
    40,375Federal
      funds sold
    
    
    2,156
    
    
    586
    
    
    7,756Loans:Real
      estate
    
    
    319,543
    
    
    271,217
    
    
    238,768Commercial
      and other
    
    
    57,809
    
    
    61,090
    
    
    59,295Total
      loans
    
    
    377,352
    
    
    332,307
    
    
    298,063Interest-earning
      assets
    
    $
    444,566
    
    $
    388,530
    
    $
    354,593





The Bank
has intentionally avoided the growing national market in loans to finance
leveraged buy-outs, and has participated in no nationally syndicated leveraged
buy-out loans. It has also avoided exposure to lesser developed country (“LDC”)
debt, and has no LDC loans in its portfolio.





**Federal
Funds Sold**





Management
maintains federal funds sold as a tool in managing the Bank’s daily cash needs.
Federal funds sold at December 31, 2004 and 2003 were $2,156,000 and $586,000,
respectively. Average federal funds sold for 2004 was approximately $1,994,000,
or 0.48% of average earning assets, and for 2003 was approximately $3,314,000,
or 0.89% of average earning assets. The federal funds sold account is a daily
clearing account. The increase in year-end federal funds resulted from the
timing of funding loan demand. The Bank continues to try to minimize federal
funds sold in this low rate environment to maximize its use of earning
assets.





**Securities
Portfolio**





At
December 31, 2004 and 2003, all of the Bank’s securities were classified as
available-for-sale.





The
composition of the Bank’s securities portfolio reflects the Company’s investment
strategy of maximizing portfolio yields subject to risk and liquidity
considerations. The primary objectives of the Company’s investment strategy are
to maintain an appropriate level of liquidity, and to provide a tool with which
to control the Bank’s interest rate position while, at the same time, producing
adequate levels of interest income. Management of the maturity of the portfolio
is necessary to provide liquidity and to control interest rate risk. During
2004, gross securities sales were $4,283,834 and maturities were $12,472,586,
representing 7.52% and 21.89%, respectively, of the average portfolio for the
year. Net losses associated with sales and maturities totaled $22,633 in 2004.
Gross unrealized gains in the portfolio amounted to $909,432 at year-end 2004
and unrealized losses amounted to $336,721. During 2003, gross securities sales
were $5,385,808 and maturities were $23,121,518, representing 9.25% and 46.29%,
respectively, of the average portfolio for the year. Net losses associated with
sales and maturities totaled $16,978 in 2003. Gross unrealized gains in the
portfolio amounted to $966,919 at year-end 2003 and unrealized losses amounted
to $316,263.





Mortgage-backed
securities have varying degrees of risk of impairment of principal, as opposed
to U.S. Treasury and U.S. government agency obligations, which are considered to
contain virtually no default or prepayment risk. Impairment risk is primarily
associated with accelerated prepayments, particularly with respect to longer
maturities purchased at a premium and interest-only strip securities. The Bank’s
purchases of mortgage-backed securities during 2004, 2003 and 2002 did not
include securities with these characteristics. The recoverability of the Bank’s
investments in mortgage-backed securities is reviewed periodically, and the
Company intends to make appropriate adjustments to income for impaired
values.




15
 Table of Contents





The
following table presents the carrying amounts of the securities portfolio at
December 31 in each of the last three years.





**Securities
Portfolio**





December
      31,2004
    
    2003
    
    2002(In
      thousands)**Securities
      Available-for-Sale:**U.S.
      treasury and government agencies
    
    $
    31,744
    
    $
    20,074
    
    $
    8,579State
      and municipal securities
    
    
    14,277
    
    
    19,205
    
    
    14,759Mortgage-backed
      securities
    
    
    14,927
    
    
    14,355
    
    
    15,314Equity
      securities
    
    
    3,707
    
    
    1,729
    
    
    1,723Total
    
    $
    64,655
    
    $
    55,363
    
    $
    40,375








In 2004,
average taxable securities were 75.1% of the portfolio, compared to 69.9% in
2003 and 68.2% in 2002.





The
maturities and weighted average yields of the investments in the 2004 portfolio
of securities are presented below. The average maturity of the securities
portfolio at December 31, 2004 was 8.95 years with an average yield of 5.05%.
Taxable equivalent adjustments (using a 34 percent tax rate) have been made in
calculating yields on tax-exempt obligations.





**Security
Portfolio Maturity Schedule**





MaturingWithin
    
    After
      One But
    
    After
      Five But
    
    AfterOne
      Year
    
    Within
      Five Years
    
    Within
      Ten Years
    
    Ten
      YearsAmount
    
    Yield
    
    Amount
    
    Yield
    
    Amount
    
    Yield
    
    Amount
    
    Yield(Amounts
      in thousands, except percentages)**Securities
      Available-for-Sale**U.S.
      Government agencies
    
    $
    —
    
    
    0.00
    %
    $
    28,751
    
    
    3.23
    %
    $
    2,993
    
    
    3.38
    %
    $
    —
    
    
    0.00
    %State
      and municipal
    
    
    —
    
    
    0.00
    
    
    356
    
    
    6.74
    
    
    2,617
    
    
    20.41
    
    
    11,304
    
    
    7.42Mortgage-backed
      securities
    
    
    —
    
    
    0.00
    
    
    213
    
    
    5.66
    
    
    1,215
    
    
    4.46
    
    
    13,499
    
    
    3.89Equity
      securities
    
    
    —
    
    
    0.00
    
    
    —
    
    
    0.00
    
    
    —
    
    
    0.00
    
    
    3,707
    
    
    2.70**Total
      Securities**
    
    $
    —
    
    
    0.00
    
    $
    29,320
    
    
    3.29
    
    $
    6,825
    
    
    10.10
    
    $
    28,510
    
    
    5.14





There
were no securities held by the Company of which the aggregate value on December
31, 2004 exceeded ten percent of shareholders’ equity at that date. (Securities
which are payable from and secured by the same source of revenue or taxing
authority are considered to be securities of a single issuer. Securities of the
U.S. Government and U.S. Government agencies and corporations are not
included.)





There has
been no significant impact on the Company’s Consolidated Financial Statements as
a result of the provisions of Statement of Financial Accounting Standards No.
119, *Disclosure
about Derivative Financial Instruments and Fair Value of Financial Instruments.*





**Loan
Portfolio**





Loans
make up the largest component of the Bank’s earning assets. At December 31,
2004, the Bank’s total loans were $377,351,501, compared to total loans of
$332,306,446 at the end of 2003. In 2004, average net loans represented 84.9% of
average earning assets and 79.8% of total average assets, while in 2003 average
net loans represented 85.4% of average earning assets and 80.4% of total average
assets. This was the result of continued strong loan demand and the expansion of
the Bank’s branch in Blue Ridge, Georgia. The ratio of total loans to total
deposits was 98.9% in 2004 and 99.8% in 2003.




16
 Table of Contents





The
following table shows the classification of loans by major category at December
31, 2004, and for each of the preceding four years.





**Loan
Portfolio**




December
      31,2004
    
    2003
    
    2002
    
    2001
    
    2000Percent
    
    
    
    Percent
    
    
    
    Percent
    
    
    
    Percent
    
    
    
    PercentAmount
    
    of
      Total
    
    Amount
    
    of
      Total
    
    Amount
    
    of
      Total
    
    Amount
    
    of
      Total
    
    Amount
    
    of
      Total(Dollars
      in thousands)Commercial,
      financial and agricultural
    
    $
    31,920
    
    
    8.5
    %
    $
    34,613
    
    
    10.4
    %
    $
    33,449
    
    
    11.2
    %
    $
    29,092
    
    
    11.6
    %
    $
    36,320
    
    
    17.0
    %Real
      estate - construction
    
    
    145,588
    
    
    38.6
    
    
    104,619
    
    
    31.5
    
    
    73,242
    
    
    24.6
    
    
    54,255
    
    
    21.7
    
    
    22,057
    
    
    10.3Real
      estate - other (1)
    
    
    173,955
    
    
    46.1
    
    
    166,598
    
    
    50.1
    
    
    165,526
    
    
    55.5
    
    
    147,852
    
    
    59.0
    
    
    136,718
    
    
    63.8Consumer
    
    
    20,957
    
    
    5.6
    
    
    20,535
    
    
    6.2
    
    
    20,296
    
    
    6.8
    
    
    19,370
    
    
    7.7
    
    
    17,254
    
    
    8.1Other
      loans
    
    
    4,932
    
    
    1.2
    
    
    5,942
    
    
    1.8
    
    
    5,550
    
    
    1.9
    
    
    —
    
    
    0.0
    
    
    1,775
    
    
    0.8377,352
    
    
    100.0
    %
    
    332,307
    
    
    100.0
    %
    
    298,063
    
    
    100.0
    %
    
    250,569
    
    
    100.0
    %
    
    214,124
    
    
    100.0
    %Allowance
      for loan losses
    
    
    (4,349
    )
    
    
    
    
    (3,610
    )
    
    
    
    
    (3,238
    )
    
    
    
    
    (2,995
    )
    
    
    
    
    (2,211
    )Net
      loans
    
    $
    373,003
    
    
    
    
    $
    328,697
    
    
    
    
    $
    294,825
    
    
    
    
    $
    247,574
    
    
    
    
    $
    211,913


(1)
    The
      “real estate - other” category includes multi-family residential, home
      equity, commercial real estate and undeveloped agricultural real estate
      loans.





The
following table shows the maturity distribution of selected loan classifications
at December 31, 2004, and an analysis of these loans maturing in over one
year.





**Selected
Loan Maturity and Interest Rate Sensitivity**





Rate
      Structure for LoansMaturity
    
    Maturing
      Over One YearOver
      OneOne
    
    Year
    
    Over
    
    
    
    Predetermined
    
    Floating
      orYear
      or
    
    Through
    
    Five
    
    
    
    Interest
    
    AdjustableLess
    
    Five
      Years
    
    Years
    
    Total
    
    Rate
    
    Rate(Dollars
      in thousands)Commercial,
      financial and
      agricultural
    
    $
    25,464
    
    $
    6,018
    
    $
    438
    
    $
    31,920
    
    $
    5,318
    
    $
    1,138Real
      estate - construction
    
    
    129,541
    
    
    15,965
    
    
    82
    
    
    145,588
    
    
    13,436
    
    
    2,611Total
    
    $
    155,005
    
    $
    21,983
    
    $
    520
    
    $
    177,508
    
    $
    18,754
    
    $
    3,749





For the
purposes of this schedule, loans that have reached the fixed contractual floor
rate are treated as having a pre-determined interest rate.





**Summary
of Loan Loss Experience**





The
provision for loan losses, which is charged to operating results, is based on
the growth of the loan portfolio, the amount of net loan losses incurred and
management’s estimation of potential future losses based on an evaluation of the
risk in the loan portfolio. Management believes that the $4,348,618 in the
allowance for loan losses at December 31, 2004, (1.15% of total net outstanding
loans at that date) was adequate to absorb known risks in the portfolio, based
upon the Bank’s historical experience. No assurance can be given, however, that
increased loan volume, adverse economic conditions or other circumstances will
not result in increased losses in the Bank’s loan portfolio.














[The
remainder of this page intentionally left blank]




17
 Table of Contents





The
following table sets forth certain information with respect to the Bank’s loans,
net of unearned income, and the allowance for loan losses for 2004, and for each
of the preceding four years.








**Analysis
of Loan Loss Experience**




Year
      ended December 31,2004
    
    2003
    
    2002
    
    2001
    
    2000(Dollars
      in thousands)Allowance
      for loan losses at beginning of year
    
    $
    3,610
    
    $
    3,238
    
    $
    2,995
    
    $
    2,211
    
    $
    1,849Loans
      charged off:Commercial,
      financial, and agricultural
    
    
    30
    
    
    277
    
    
    89
    
    
    240
    
    
    404Real
      estate-construction
    
    
    240
    
    
    28
    
    
    50
    
    
    —
    
    
    —Real
      estate - other
    
    
    158
    
    
    638
    
    
    427
    
    
    134
    
    
    49Consumer
    
    
    127
    
    
    265
    
    
    250
    
    
    170
    
    
    138Total
      loans charged off
    
    
    555
    
    
    1,208
    
    
    816
    
    
    544
    
    
    591Recoveries
      on loans previously charged off:Commercial,
      financial, and agricultural
    
    
    35
    
    
    25
    
    
    5
    
    
    8
    
    
    9Real
      estate-construction
    
    
    —
    
    
    3
    
    
    —
    
    
    —
    
    
    —Real
      estate-other
    
    
    2
    
    
    50
    
    
    —
    
    
    6
    
    
    —Consumer
    
    
    22
    
    
    37
    
    
    26
    
    
    20
    
    
    22Total
      recoveries on loans previously charged off
    
    
    59
    
    
    115
    
    
    31
    
    
    34
    
    
    31Net
      loans charged off
    
    
    496
    
    
    1,093
    
    
    785
    
    
    510
    
    
    560Provision
      for loan losses
    
    
    1,235
    
    
    1,465
    
    
    1,028
    
    
    1,294
    
    
    922Allowance
      for loan losses, at end of period
    
    $
    4,349
    
    $
    3,610
    
    $
    3,238
    
    $
    2,995
    
    $
    2,211Loans,
      net of unearned income, at end of period
    
    $
    377,352
    
    $
    332,307
    
    $
    298,063
    
    $
    250,569
    
    $
    214,124Average
      loans, net of unearned income,
      outstanding
      for the period
    
    $
    360,261
    
    $
    316,605
    
    $
    276,733
    
    $
    234,031
    
    $
    204,436Ratios:Allowance
      at end of period to loans, net of unearned income
    
    
    1.15
    %
    
    1.09
    %
    
    1.09
    %
    
    1.20
    %
    
    1.03
    %Allowance
      at end of period to average loans, net of unearned income
    
    
    1.21
    
    
    1.14
    
    
    1.17
    
    
    1.28
    
    
    1.08Net
      charge-offs to average loans, net of unearned income
    
    
    0.14
    
    
    0.35
    
    
    0.28
    
    
    0.22
    
    
    0.27Net
      charge-offs to allowance at end of period
    
    
    11.40
    
    
    30.28
    
    
    24.24
    
    
    17.03
    
    
    25.33Recoveries
      to prior year charge-offs
    
    
    4.88
    
    
    14.09
    
    
    5.70
    
    
    5.75
    
    
    4.07




In
assessing adequacy, management relies predominantly on its ongoing review of the
loan portfolio, which is undertaken both to ascertain whether there are probable
losses that must be charged off and to assess the risk characteristics of the
portfolio in the aggregate. This review takes into consideration the judgments
of the responsible lending officers and senior management, and also those of
bank regulatory agencies that review the loan portfolio as part of the regular
bank examination process. In evaluating the allowance, management also considers
the loan loss experience of the Bank, the amount of past due and nonperforming
loans, current and anticipated economic conditions, lender requirements and
other appropriate information.





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remainder of this page intentionally left blank]




18
 Table of Contents





Management
allocated the allowance for loan losses to specific loan classes as
follows:





**Allocation
of Allowance for Loan Losses**




December
      31,2004
    
    2003
    
    2002
    
    2001
    
    2000Percent
    
    
    
    Percent
    
    
    
    Percent
    
    
    
    Percent
    
    
    
    Percentof
      Loans
    
    
    
    of
      Loans
    
    
    
    of
      Loans
    
    
    
    of
      Loans
    
    
    
    of
      Loansin
      Each
    
    
    
    in
      Each
    
    
    
    in
      Each
    
    
    
    in
      Each
    
    
    
    in
      EachCategory
    
    
    
    Category
    
    
    
    Category
    
    
    
    Category
    
    
    
    Categoryto
      Total
    
    
    
    to
      Total
    
    
    
    to
      Total
    
    
    
    to
      Total
    
    
    
    to
      TotalAmount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    Loans
    
    Amount
    
    Loans(Dollars
      in thousands)**Domestic
      Loans (1)**Commercial,
      financial and
      agricultural
    
    $
    548
    
    
    8
    %
    $
    1,257
    
    
    10
    %
    $
    1,615
    
    
    11
    %
    $
    807
    
    
    12
    %
    $
    387
    
    
    17
    %Real
      estate - construction
    
    
    421
    
    
    39
    
    
    184
    
    
    32
    
    
    85
    
    
    25
    
    
    193
    
    
    22
    
    
    199
    
    
    10Real
      estate - other
    
    
    2,138
    
    
    46
    
    
    1,277
    
    
    50
    
    
    1,044
    
    
    55
    
    
    1,760
    
    
    59
    
    
    1,381
    
    
    64Consumer
    
    
    425
    
    
    6
    
    
    267
    
    
    6
    
    
    168
    
    
    7
    
    
    235
    
    
    7
    
    
    244
    
    
    8Other
    
    
    817
    
    
    1
    
    
    625
    
    
    2
    
    
    326
    
    
    2
    
    
    —
    
    
    —
    
    
    —
    
    
    1Total
    
    $
    4,349
    
    
    100
    %
    $
    3,610
    
    
    100
    %
    $
    3,238
    
    
    100
    %
    $
    2,995
    
    
    100
    %
    $
    2,211
    
    
    100
    %
 
 ________________
 (1)  The Bank
had no foreign loans.





**Nonperforming
Assets**





Nonperforming
assets include nonperforming loans and foreclosed real estate held for sale.
Nonperforming loans include loans classified as nonaccrual or renegotiated. The
Bank’s policy is to place a loan on nonaccrual status when it is contractually
past due 90 days or more as to payment of principal or interest, unless the
collateral value is greater than both the principal due and the accrued
interest. At the time a loan is placed on nonaccrual status, interest previously
accrued but not collected is reversed and charged against current earnings.
Recognition of any interest after a loan has been placed on nonaccrual status is
accounted for on a cash basis.





The
following table presents information concerning outstanding balances of
nonperforming assets at December 31, 2004, and for each of the preceding four
years.





**Nonperforming
Assets** ****


December
      31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(Dollars
      in thousands)Nonaccruing
      loans
    
    $
    1,524
    
    $
    1,127
    
    $
    4,823
    
    $
    1,642
    
    $
    385Loans
      past due 90 days or more
    
    
    34
    
    
    521
    
    
    334
    
    
    12
    
    
    24Restructured
      loans
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Total
      nonperforming loans
    
    
    1,558
    
    
    1,648
    
    
    5,157
    
    
    1,654
    
    
    409Nonaccruing
      securities
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Other
      real estate
    
    
    516
    
    
    737
    
    
    986
    
    
    133
    
    
    147Total
      nonperforming assets
    
    $
    2,074
    
    $
    2,385
    
    $
    6,143
    
    $
    1,787
    
    $
    556Ratios:Loan
      loss allowance to total nonperforming assets
    
    
    2.10
    
    
    1.51
    
    
    0.53
    
    
    1.68
    
    
    3.98Total
      nonperforming loans to total loans(net
      of unearned interest)
    
    
    0.41
    %
    
    0.50
    %
    
    1.73
    %
    
    0.66
    %
    
    0.26
    %Total
      nonperforming assets to total assets
    
    
    0.44
    %
    
    0.58
    %
    
    1.60
    %
    
    0.56
    %
    
    0.21
    %




19
 Table of Contents





It is the
general policy of the Bank to stop accruing interest income and place the
recognition of interest on a cash basis when any commercial, industrial or real
estate loan is past due as to principal or interest and the ultimate collection
of either is in doubt. Accrual of interest income on consumer installment loans
is suspended when any payment of principal or interest, or both, is more than
ninety days delinquent. When a loan is placed on a nonaccrual basis, any
interest previously accrued but not collected is reversed against current income
unless the collateral for the loan is sufficient to cover the accrued interest
or a guarantor assures payment of interest. For each of the five years in the
period ended December 31, 2004, the difference between gross interest income
that would have been recorded in such period, if the nonaccruing loans had been
current in accordance with their original terms, and the amount of interest
income on those loans, that was included in such period’s net income, was
negligible.





There has
been no significant impact on the Company’s consolidated financial statements as
a result of the provisions of Statement of Financial Accounting Standards No.
114, *Accounting
by Creditors for Impairment of a Loan* , or
Statement of Accounting Standards No. 118, *Accounting
by Creditors for Impairment of a Loan - Income Recognition and
Disclosures* .





**Deposits**





The
Company’s primary source of funds is derived from deposits of the Bank’s
customers. Average deposits increased 12.9%, from approximately $320,833,000 in
2003 to approximately $362,316,000 in 2004. At December 31, 2004, total
deposits were $381,498,171, of which $348,601,825 (91.4%) were interest bearing;
at December 31, 2003, total deposits were $332,918,948, of which $309,123,161
(92.9%) were interest bearing; and at December 31, 2002, total deposits were
$316,282,756, of which $294,385,698 (93.1%) were interest bearing. The continued
growth of the Bank fueled the growth in the deposit base. The Company intends to
emphasize internal deposit growth in order to expand the consumer bases of the
Bank and to continue to fund asset growth when appropriate. Alternative funding
sources such as national CDs and brokered deposits were used to supplement
funding sources. Brokered deposits were $23,371,264 at December 31,
2004.





The
average amounts of, and the average rate paid on, each of the following
categories of deposits, for the years ended December 31, 2004, 2003 and 2002,
are as follows:





Years
      ended December 31,2004
    
    2003
    
    2002Amount
    
    Rate
    
    Amount
    
    Rate
    
    Amount
    
    Rate(Dollars
      in thousands)Noninterest-bearing
      demand
      deposits
    
    $
    30,840
    
    
    0.00
    %
    $
    22,056
    
    
    0.00
    %
    $
    19,549
    
    
    0.00
    %Interest-bearing
      demand deposits
    
    
    82,617
    
    
    1.15
    
    
    83,040
    
    
    1.42
    
    
    62,492
    
    
    1.93Savings
      deposits
    
    
    61,281
    
    
    1.16
    
    
    45,318
    
    
    0.92
    
    
    41,359
    
    
    1.72Time
      deposits
    
    
    187,578
    
    
    2.42
    
    
    170,419
    
    
    3.15
    
    
    167,561
    
    
    4.44Total
      interest-bearing deposits
    
    
    331,476
    
    
    1.87
    
    
    298,777
    
    
    2.33
    
    
    271,412
    
    
    3.45Total
      average deposits
    
    $
    362,316
    
    
    1.71
    
    $
    320,833
    
    
    2.17
    
    $
    290,961
    
    
    3.21





The two
categories of lowest cost deposits comprised the following percentages of
average total deposits during 2004: average noninterest-bearing demand deposits,
8.51 percent; and average savings deposits, 8.59 percent. Of average time
deposits, approximately 49.64 percent were large denomination certificates of
deposit. The maturities of the time certificates of deposit of $100,000 or more,
issued by the Bank at December 31, 2004, are summarized in the table
below.





**Maturities
of Large Time Deposits**





TimeCertificatesof
      Deposit(Amounts
      inthousands)Three
      months or less
    
    $
    22,555Over
      three through six months
    
    
    12,721Over
      six through twelve months
    
    
    50,034Over
      twelve months
    
    
    23,378Total
    
    $
    108,688




20
 Table of Contents





**Short-term
Borrowings**





Securities
sold under agreements to repurchase amounted to $6,263,790 at December 31, 2004,
compared to $4,085,992 at December 31, 2003, and $5,928,624 at December 31,
2002. The weighted average rates were 1.36%, 1.23% and 1.60% for 2004, 2003 and
2002, respectively. Securities sold under agreements to repurchase averaged
$6,093,745 during 2004, $5,488,443 during 2003, and $4,061,294 during 2002. The
maximum amount outstanding at any month end during 2004 was $13,018,035, during
2003 was $8,211,269, and during 2002 was $5,928,624. The total amount of
securities sold under agreements to repurchase are associated with the cash flow
needs of the Bank’s corporate customers who participate in repurchase
agreements. The Company also had a short-term line of credit with the Federal
Home Loan Bank with balances of $9,205,750, $5,000,000 and $-0- at December 31,
2004, 2003 and 2002, respectively. The short-term line of credit with the
Federal Home Loan Bank is in the form of a daily rate credit. It floats daily
based on the overnight funds market. The line of credit has a one year term and
matures in May of each year. At December 31, 2004, the Bank had $24,000,000 in
available lines to purchase Federal Funds, on an unsecured basis, from
commercial banks. The Bank had federal funds purchased that amounted to $-0- at
year-end 2004, and $3,000,000 at year-end 2003, compared to $-0- at year-end
2002.





**Long-term
Debt**





Borrowed
funds consist primarily of long-term debt. The Bank is approved to borrow up to
approximately $70,040,000 under various short-term and long-term programs
offered by the Federal Home Loan Bank of Atlanta. These borrowings are secured
under a blanket lien agreement on certain qualifying mortgage instruments in the
loan and securities portfolios. The unused portion of these available funds
amounted to approximately $29,000,000 at year-end 2004. Long-term debt consisted
of various commitments with scheduled maturities from one to six years. In
addition, during 2002 the Company borrowed $4.6 million from another financial
institution (See “Capital Resources: *Term
Loan* ” below).
This loan was repaid during 2003.





On August
28, 2003, Appalachian Capital Trust I (“the Trust”), a Delaware statutory trust
established by the Company, received $6,000,000 principal amount of the Trust’s
floating rate cumulative trust preferred securities (the “Trust Preferred
Securities”) in a trust preferred private placement. The proceeds of that
transaction were then used by the Trust to purchase an equal amount of floating
rate-subordinated debentures (the “Subordinated Debentures”) of the Company. The
Company has fully and unconditionally guaranteed all obligations of the Trust on
a subordinated basis with respect to the Trust Preferred Securities. In
accordance with the provisions of Financial Interpretation No. 46R, the Company
accounts for the Trust Preferred Securities as a long-term debt liability to the
Trust in the amount of $6,186,000. Subject to certain limitations, the Trust
Preferred Securities qualify as Tier 1 capital.





The sole
asset of the Trust is the Subordinated Debentures issued by the Company. Both
the Trust Preferred Securities and the Subordinated Debentures have
approximately 30-year lives. However, both the Company and the Trust have
options to call their respective securities after five years, subject to
regulatory capital requirements. Interest that the bank plans to pay on the
trust preferred securities debt is included in the table of maturities
below.





The
following table sets forth the expected debt service for the next five years
based on interest rates and repayment provisions as of December 31,
2004.





**Maturities
of Long-term Debt**


(In
thousands)





2005
    
    2006
    
    2007
    
    2008
    
    2009Interest
      on indebtedness
    
    $
    1,300
    
    $
    1,096
    
    $
    991
    
    $
    858
    
    $
    792Repayment
      of principal
    
    
    6,200
    
    
    2,700
    
    
    2,700
    
    
    5,350
    
    
    5,000$
    7,500
    
    $
    3,796
    
    $
    3,691
    
    $
    6,208
    
    $
    5,792




21
 Table of Contents





**Shareholders’
Equity**





Shareholders’
equity increased $5,000,969, from December 31, 2003 to December 31, 2004,
due in part to net earnings of $4,047,014. The Company issued 33,546 shares of
stock to its 401(k) Plan during 2004 for $503,191. In addition, the effects of
the stock-based compensation expense as well as the exercise of 72,340 options
during 2004 increased equity by $502,209, including the tax
benefit.





All
amounts presented in this report and in the consolidated financial statements
are adjusted to reflect the 10% stock dividend effected in July 2003. See Item
5, “Market Information.”





**Return
on Equity and Assets**





The
following table summarizes certain financial ratios for the Company for the
years ended December 31, 2004, 2003 and 2002.





**Return
on Equity and Assets**





Year
      ended December 31,2004
    
    2003
    
    2002Return
      on average assets
    
    
    0.91
    %
    
    0.78
    %
    
    0.75
    %Return
      on average equity
    
    
    12.23
    
    
    10.85
    
    
    11.88Dividend
      payout ratio
    
    
    0.00
    
    
    0.00
    
    
    0.00Average
      equity to average assets ratio
    
    
    7.42
    
    
    7.23
    
    
    6.34





**Capital
Resources**





A strong
capital position is vital to the continued profitability of the Company because
it promotes depositor and investor confidence and provides a solid foundation
for future growth of the organization. A majority of the Company’s capital
requirements have come from proceeds from the Bank’s initial stock offering in
1994, proceeds of $2.65 million from a private placement of Common Stock in
November 1998, and proceeds of $4.4 million from a public offering in 2000. In
2002, capital requirements came from proceeds of $787,000 from a private
offering of Common Stock, proceeds of $1.0 million from the exercise of options,
and through the retention of earnings and the sale of Common Stock to the
Company’s 401(k) plan. In 2003, capital requirements were derived from proceeds
of $1.9 million from a private offering of Common Stock, proceeds of $529,000
from the effects of stock-based compensation expense and through the exercise of
options. In 2004 capital requirements were derived from proceeds from the sale
of Common Stock to the Company’s 401(k) plan for $503,000, as well as the
effects of stock-based compensation expense and from the exercise of options of
$502,000.





On August
28, 2003, Appalachian Capital Trust I (“the Trust”), a Delaware statutory trust
established by the Company, received $6,000,000 principal amount of the Trust’s
floating rate cumulative trust preferred securities (the “Trust Preferred
Securities”) in a trust preferred private placement. The proceeds of that
transaction were used by the Trust to purchase an equal amount of floating
rate-subordinated debentures (the “Subordinated Debentures”) of the Company. The
Company has fully and unconditionally guaranteed all obligations of the Trust on
a subordinated basis with respect to the Trust Preferred Securities. The Company
accounts for the Trust Preferred Securities as a minority interest of $186,000
and as a long-term debt liability in the amount of $6,186,000. Subject to
certain limitations, the Trust Preferred Securities qualify as Tier 1 capital
and are presented in the Consolidated Financial Statements as “Subordinated
long-term capital notes”.





The sole
asset of the Trust is the Subordinated Debentures issued by the Company. Both
the Trust Preferred securities and the Subordinated Debentures have
approximately 30-year lives. However, both the Company and the Trust have
options to call their respective securities after five years, subject to
regulatory capital requirements.





*Term
Loan* . On
April 3, 2002, the Company obtained a $4.6 million term loan under a Loan and
Stock Pledge Agreement and a Promissory Note (collectively, the “Term Loan”)
with Crescent Bank and Trust Company. The Company used $4.6 million of the
proceeds of the Term Loan to repay that certain loan and stock pledge agreement,
dated April 3, 2000, previously entered into by and between the Company and
Crescent Bank and Trust Company. Interest on the outstanding amounts under the
Term Loan was payable quarterly, commencing July 1, 2002, at the prime rate (as
defined in the Promissory Note) less twenty-five (25) basis points. The Company
began making interest payments on July 1, 2002. Principal was due in seven equal
annual installments, each in the amount of $657,000, beginning on March 31,
2003. The entire outstanding balance of the Term Loan, together with all accrued
and unpaid interest, would have been due and payable in a final installment on
March 31, 2010. The Term Loan contained certain affirmative and negative
covenants, including, but not limited to, requiring the Company to cause the
Bank at all times to maintain certain minimum capital ratios, and to maintain a
minimum ratio of loan and lease losses to gross loans. In September 2003, the
Company paid off this entire balance with part of the proceeds from the trust
preferred issuance.




22
 Table of Contents





*Federal
Capital Standards* . The
Federal Deposit Insurance Corporation Improvement Act establishes risk-based
capital guidelines that take into consideration risk factors, as defined by
regulators, associated with various categories of assets, both on and off the
balance sheet. Under the guidelines, capital strength is measured in two tiers,
which are used in conjunction with risk-adjusted assets to determine the
risk-based capital ratios. The Company’s Tier 1 capital, which consists of
common equity, paid-in capital, retained earnings and qualifying trust preferred
securities (less intangible assets and treasury stock), amounted to $39.7
million at December 31, 2004. Tier 2 capital components include supplemental
capital components such as qualifying allowance for loan losses and trust
preferred securities not qualified for Tier 1 capital. Tier 1 capital, plus the
Tier 2 capital components, is referred to as Total Capital and was $44.1 million
at year-end 2004. The Company’s percentage ratios as calculated under regulatory
guidelines were 10.32% and 11.45% for Tier 1 and Total Capital, respectively, at
year-end 2004. The Company’s Tier 1 Capital and Total Capital exceeded the
minimum ratios of 4% and 8%, respectively.





Another
important indicator of capital adequacy in the banking industry is the leverage
ratio. The leverage ratio is defined as the ratio which shareholders’ equity,
minus intangibles, bears to total assets minus intangibles. At December 31,
2004, the Company’s leverage ratio was 8.53%, exceeding the regulatory minimum
requirement of 4%.





The table
below illustrates the Company’s regulatory capital ratios under federal
guidelines at December 31, 2004, 2003 and 2002:





**Capital
Adequacy Ratios**





Statutory
    
    Years
      ended December 31,Minimum
    
    2004
    
    2003
    
    2002(Dollars
      in thousands)Tier
      1 Capital
    
    
    
    
    $
    39,713
    
    $
    34,681
    
    $
    23,089Tier
      2 Capital
    
    
    
    
    
    4,349
    
    
    3,610
    
    
    3,238Total
      Qualifying Capital
    
    
    
    
    $
    44,062
    
    $
    38,291
    
    $
    26,327Risk
      Adjusted Total Assets (includingoff-balance sheet
      exposures)
    
    
    
    
    $
    384,847
    
    $
    331,638
    
    $
    306,405Tier
      1 Risk-Based Capital Ratio
    
    
    4.0
    %
    
    10.32
    %
    
    10.46
    %
    
    7.54
    %Total
      Risk-Basked Capital Ratio
    
    
    8.0
    
    
    11.45
    
    
    11.55
    
    
    8.59Leverage
      Ratio
    
    
    4.0
    
    
    8.53
    
    
    8.58
    
    
    6.07





There
were no dividends paid by the Bank to the Company for the years 2004, 2003 and
2002.





**Liquidity
Management**





Liquidity
is defined as the ability of a company to convert assets into cash or cash
equivalents without significant loss. Liquidity management involves maintaining
the Bank’s abilities to meet the day-to-day cash flow requirements of its
customers, whether they are depositors wishing to withdraw funds or borrowers
requiring funds to meet their credit needs. Without proper liquidity management,
the Bank would not be able to perform its primary function as financial
intermediary and, therefore, would not be able to meet the production and growth
needs of the communities it serves.




23
 Table of Contents





The
primary purpose of management of assets and liabilities is not only to assure
adequate liquidity in order for the Bank to meet the needs of its customers, but
also to maintain an appropriate balance between interest-sensitive assets and
interest-sensitive liabilities so that the Company can also meet the investment
requirements of its shareholders. Daily monitoring of the sources and uses of
funds is necessary to maintain an acceptable cash position that meets both
requirements. In the banking environment, both assets and liabilities are
considered sources of liquidity funding; therefore, both are monitored on a
daily basis.





The asset
portion of the balance sheet provides liquidity primarily through loan principal
repayments or sales of investment and trading account securities. Real estate
construction and commercial, financial and agricultural loans that mature in one
year or less equaled approximately $155 million or 41.1% of the total loan
portfolio at December 31, 2004, and there were no investment securities
maturing in one year or less at December 31, 2004.





The
liability portion of the balance sheet provides liquidity through various
customers’ interest-bearing and noninterest-bearing deposit accounts. At the end
of fiscal 2004, funds were also available through the purchase of federal funds
from correspondent commercial banks from available lines of up to an aggregate
of $24,000,000.





In an
effort to maintain and improve the liquidity position of the Bank, management
applied for membership with the Federal Home Loan Bank of Atlanta. As a member
of the Federal Home Loan Bank, the Bank is able to improve its ability to manage
liquidity and reduce interest rate risk by having a funding source to match
longer term loans. The Bank’s credit line stands at approximately $70,040,000 as
of December 31, 2004. This line is subject to collateral availability. At
December 31, 2004, the outstanding balance of the Bank’s credit line was
approximately $31,950,000. See Note 11 to the Notes to Consolidated Financial
Statements herein.





**Off-Balance
Sheet Arrangements**





In the
normal course of business, the Bank offers a variety of financial products to
its customers to aid them in meeting their requirements for liquidity, credit
enhancement, and interest rate protection. Generally accepted accounting
principles recognize these transactions as contingent liabilities and,
accordingly, they are not reflected in the Consolidated Financial Statements.
Commitments to extend credit, credit card arrangements, commercial letters of
credit, and standby letters of credit all include exposure to some credit loss
in the event of nonperformance of the customer. The Bank uses the same credit
policies and underwriting procedures for making off-balance sheet credit
commitments and financial guarantees as it does for on-balance sheet extensions
of credit. Because these instruments have fixed maturity dates, and because many
of them expire without being drawn upon, they do not generally present any
significant liquidity risk to the Bank. Management conducts regular reviews of
these instruments on an individual customer basis, and the results are
considered in assessing the adequacy of the Bank’s allowance for loan losses.
Management does not anticipate any material losses as a result of these
commitments.





Following
is a discussion of these commitments:





Standby
Letters of Credit : These
agreements are used by the Bank’s customers as a means of improving their credit
standings in their dealings with others. Under these agreements, the Bank agrees
to honor certain financial commitments in the event that its customers are
unable to do so. The amount of credit risk involved in issuing letters of credit
in the event of nonperformance by the other party is the contract amount. As of
December 31, 2004 and 2003, the Bank has issued standby letters of credit of
approximately $1,403,000 and $1,111,000. The Bank
records the contract amount of the letters of credit as an asset and records a
corresponding liability in the same amount until the letters of credit are
exercised. Upon exercise, the amount exercised is recorded as a
loan.





Loan
Commitments : As of
December 31, 2004 and 2003, the Bank had commitments outstanding to extend
credit totaling approximately $59,005,000 and $43,436,000, respectively. These
commitments generally require the customers to maintain certain credit
standards. Management does not anticipate any material losses as a result of
these commitments.





Contract : On
November 10, 2004, the Company’s wholly owned subsidiary, Appalachian Community
Bank, entered into an agreement for construction of the Bank’s new operations
building in Ellijay, Georgia. The total cost of the construction of the building
is expected to be approximately $2,715,000. The building is expected to be
completed in December 2005.




24
 Table of Contents





**Contractual
Obligations**





The
Company and the Bank have various contractual obligations that they must fund as
part of their normal operations. The following table shows aggregate information
about their contractual obligations, including interest, and the periods in
which payments are due. The amounts and time periods are measured from December
31, 2004.





Payments
      due by period (in thousands)Less
      than
    
    
    
    
    
    More
      thanTotal
    
    1
      year
    
    1-3
      years
    
    3-5
      years
    
    5
      yearsLong-Term
      Debt
    
    $
    44,461
    
    $
    7,500
    
    $
    7,487
    
    $
    12,000
    
    $
    17,474Capital
      Lease Obligations
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Operating
      Lease Obligations
    
    
    1,010
    
    
    48
    
    
    72
    
    
    71
    
    
    819Time
      Deposits
    
    
    206,652
    
    
    156,027
    
    
    43,863
    
    
    6,762
    
    
    —Other
      Long-Term Liabilities
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Total
    
    $
    252,123
    
    $
    163,575
    
    $
    51,422
    
    $
    18,833
    
    $
    18,293





**Interest
Rate Sensitivity Management**





Interest
rate sensitivity is a function of the repricing characteristics of the Bank’s
portfolios of assets and liabilities. These repricing characteristics are the
time frames within which the interest-bearing assets and liabilities are subject
to changes in interest rates, either at replacement or maturity during the life
of the instruments. Sensitivity is measured as the difference between the volume
of assets and liabilities in the Bank’s current portfolio that is subject to
repricing in future time periods. The differences are known as interest rate
sensitivity gaps and are usually calculated separately for segments of time,
ranging from zero to thirty days, thirty-one to ninety days, ninety-one days to
one year, one to five years, over five years and on a cumulative
basis.














[The
remainder of this page intentionally left blank]




25
 Table of Contents





The
following tables show interest rate sensitivity gaps for these different
intervals as of December 31, 2004.





**Interest
Rate Sensitivity Analysis**




0-30
    
    31-90
    
    90-365
    
    1-5
    
    Over
      5Days
    
    Days
    
    Days
    
    Years
    
    Years
    
    Total(In
      thousands, except ratios)Interest-earning
      assets (1)Loans
    
    $
    142,467
    
    $
    30,938
    
    $
    92,802
    
    $
    104,753
    
    $
    4,868
    
    $
    375,828Securities:Taxable
    
    
    11,194
    
    
    2,628
    
    
    17,760
    
    
    10,968
    
    
    7,828
    
    
    50,378Tax-exempt
    
    
    273
    
    
    306
    
    
    588
    
    
    7,805
    
    
    5,305
    
    
    14,277Time
      deposits in other banks
    
    
    403
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    403Federal
      funds sold
    
    
    2,156
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    2,156156,493
    
    
    33,872
    
    
    111,150
    
    
    123,526
    
    
    18,001
    
    
    443,042Interest-bearing
      liabilities (2)Demand
      deposits (3)
    
    
    26,932
    
    
    26,932
    
    
    26,932
    
    
    —
    
    
    —
    
    
    80,796Savings
      deposits (3)
    
    
    22,259
    
    
    22,259
    
    
    22,260
    
    
    —
    
    
    —
    
    
    66,778Time
      deposits
    
    
    20,999
    
    
    31,783
    
    
    101,222
    
    
    47,024
    
    
    —
    
    
    201,028Other
      short-term borrowings
    
    
    15,470
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    15,470Long-term
      debt
    
    
    100
    
    
    450
    
    
    5,650
    
    
    15,750
    
    
    16,186
    
    
    38,13685,760
    
    
    81,424
    
    
    156,064
    
    
    62,774
    
    
    16,186
    
    
    402,208Interest
      sensitivity gap
    
    $
    70,733
    
    $
    (47,552
    )
    $
    (44,914
    )
    $
    60,752
    
    $
    1,815
    
    $
    40,834Cumulative
      interest sensitivity gap
    
    $
    70,733
    
    $
    23,181
    
    $
    (21,733
    )
    $
    39,019
    
    $
    40,834Ratio
      of interest-earning assets to
      interest-bearing
      liabilities
    
    
    1.82
    
    
    0.42
    
    
    0.71
    
    
    1.97
    
    
    1.11Cumulative
      ratio
    
    
    1.82
    
    
    1.14
    
    
    0.93
    
    
    1.10
    
    
    1.10Ratio
      of cumulative gap to total
      interest-earning
      assets
    
    
    0.16
    
    
    0.05
    
    
    (0.05
    )
    
    0.09
    
    
    0**.**09
 
 (1)
    Excludes
      nonaccrual loans and securities.
 (2)
    Excludes
      matured certificates which have not been redeemed by the customer and on
      which no interest is accruing.
 (3)
    Demand
      and savings deposits are assumed to be subject to movement into other
      deposit instruments in equal amounts during the 0-30 day period, the 31-90
      day period, and the 91-365 day period.


The above
table indicates that, in a rising interest rate environment, the Company’s
earnings may be adversely affected in the 0-365 day periods where liabilities
will reprice faster than assets, if rates move simultaneously. As seen in the
preceding table, for the first 30 days of repricing opportunity, there is an
excess of earning assets over interest-bearing liabilities of approximately $71
million. For the first 365 days, interest-bearing liabilities exceed earning
assets by approximately $22 million. During this one-year time frame, 80.4% of
all interest-bearing liabilities will reprice compared to 68.1% of all
interest-earning assets. Changes in the mix of earning assets or supporting
liabilities can either increase or decrease the net interest margin without
affecting interest rate sensitivity. In addition, the interest rate spread
between an asset and its supporting liability can vary significantly while the
timing of repricing for both the asset and the liability remain the same, thus
impacting net interest income. It should be noted, therefore, that a matched
interest-sensitive position by itself would not ensure maximum net interest
income.





Management
continually evaluates the condition of the economy, the pattern of market
interest rates and other economic data to determine the types of investments
that should be made and at what maturities. Using this analysis, management from
time to time assumes calculated interest rate sensitivity gap positions to
maximize net interest income based upon anticipated movements in the general
level of interest rates.




26
 Table of Contents





The table
below shows, for the periods indicated, the daily average balances outstanding
for the major categories of interest-earning assets and interest-bearing
liabilities, and the average interest rate earned or paid thereon. Such yields
are calculated by dividing income or expense by the average balance of the
corresponding assets or liabilities.





**Average
Balances, Interest Income/Expense and Yields/Rates**


Taxable
Equivalent Basis




Years
      Ended December 31,2004
    
    2003
    
    2002Interest
    
    Average
    
    
    
    Interest
    
    Average
    
    
    
    Interest
    
    AverageAverage
    
    Income/
    
    Yields/
    
    Average
    
    Income/
    
    Yields/
    
    Average
    
    Income/
    
    Yields/Balance
    
    Expense
    
    Rates
    
    Balance
    
    Expense
    
    Rates
    
    Balance
    
    Expense
    
    Rates(Dollars
      in thousands)**Assets**Earning
      assets:Loans,
      net of unearned income (1)
    
    $
    360,261
    
    $
    23,669
    
    
    6.57
    %
    $
    316,605
    
    $
    21,321
    
    
    6.73
    %
    $
    276,733
    
    $
    20,420
    
    
    7.38
    %Securities:Taxable
    
    
    42,790
    
    
    1,402
    
    
    3.28
    
    
    34,938
    
    
    1,059
    
    
    3.03
    
    
    34,718
    
    
    1,647
    
    
    4.74Tax-exempt
    
    
    14,191
    
    
    989
    
    
    6.97
    
    
    15,013
    
    
    1,073
    
    
    7.15
    
    
    16,215
    
    
    1,201
    
    
    7.41Total
      securities
    
    
    56,981
    
    
    2,391
    
    
    4.20
    
    
    49,951
    
    
    2,132
    
    
    4.27
    
    
    50,933
    
    
    2,848
    
    
    5.59Interest-bearing
      deposits
    
    
    350
    
    
    5
    
    
    1.43
    
    
    784
    
    
    30
    
    
    3.83
    
    
    1,007
    
    
    13
    
    
    1.29Federal
      funds sold
    
    
    1,994
    
    
    26
    
    
    1.30
    
    
    3,314
    
    
    37
    
    
    1.12
    
    
    5,104
    
    
    79
    
    
    1.55Total
      interest- earning assets (2)
    
    
    419,586
    
    
    26,091
    
    
    6.22
    
    
    370,654
    
    
    23,520
    
    
    6.35
    
    
    333,777
    
    
    23,360
    
    
    7.00Non
      interest-earning assets:Cash
      and due from banks
    
    
    6,767
    
    
    
    
    
    
    
    
    8,118
    
    
    
    
    
    
    
    
    6,909Premises
      and equipment
    
    
    11,525
    
    
    
    
    
    
    
    
    8,795
    
    
    
    
    
    
    
    
    7,835Accrued
      interest and other assets
    
    
    12,290
    
    
    
    
    
    
    
    
    9,436
    
    
    
    
    
    
    
    
    8,790Allowance
      for loan losses
    
    
    (4,094
    )
    
    
    
    
    
    
    
    (3,450
    )
    
    
    
    
    
    
    
    (3,147
    )Total
      assets
    
    $
    446,074
    
    
    
    
    
    
    
    $
    393,553
    
    
    
    
    
    
    
    $
    354,164**Liabilities
      and Shareholders’ Equity**Interest-bearing
      liabilities:Demand
      deposits
    
    $
    82,617
    
    
    952
    
    
    1.15
    %
    $
    83,040
    
    
    1,178
    
    
    1.42
    %
    $
    62,492
    
    
    1,209
    
    
    1.93
    %Savings
      deposits
    
    
    61,281
    
    
    713
    
    
    1.16
    
    
    45,318
    
    
    418
    
    
    0.92
    
    
    41,359
    
    
    712
    
    
    1.72Time
      deposits
    
    
    187,578
    
    
    4,544
    
    
    2.42
    
    
    170,419
    
    
    5,363
    
    
    3.15
    
    
    167,561
    
    
    7,432
    
    
    4.44Total
      deposits
    
    
    331,476
    
    
    6,209
    
    
    1.87
    
    
    298,777
    
    
    6,959
    
    
    2.33
    
    
    271,412
    
    
    9,353
    
    
    3.45Other
      short-term borrowings
    
    
    17,953
    
    
    123
    
    
    0.69
    
    
    9,964
    
    
    83
    
    
    0.83
    
    
    4,667
    
    
    77
    
    
    1.65Long-term
      debt
    
    
    30,946
    
    
    1,226
    
    
    3.96
    
    
    32,240
    
    
    1,214
    
    
    3.77
    
    
    34,017
    
    
    1,995
    
    
    5.86Total
      interest- bearing liabilities
    
    
    380,375
    
    
    7,558
    
    
    1.99
    
    
    340,981
    
    
    8,256
    
    
    2.42
    
    
    310,096
    
    
    11,425
    
    
    3.68Noninterest-bearing
      liabilities:Demand
      deposits
    
    
    30,840
    
    
    
    
    
    
    
    
    22,056
    
    
    
    
    
    
    
    
    19,549Accrued
      interest and other liabilities
    
    
    1,757
    
    
    
    
    
    
    
    
    2,069
    
    
    
    
    
    
    
    
    2,065Shareholders’
      equity
    
    
    33,102
    
    
    
    
    
    
    
    
    28,447
    
    
    
    
    
    
    
    
    22,454Total
      liabilities and shareholders’ equity
    
    $
    446,074
    
    
    
    
    
    
    
    $
    393,553
    
    
    
    
    
    
    
    $
    354,164Net
      interest income/net interest spread
    
    
    
    
    
    18,533
    
    
    4.23
    %
    
    
    
    
    15,264
    
    
    3.93
    %
    
    
    
    
    11,935
    
    
    3.32
    %Net
      yield on earning assets
    
    
    
    
    
    
    
    
    4.42
    %
    
    
    
    
    
    
    
    4.12
    %
    
    
    
    
    
    
    
    3.58
    %Taxable
      equivalent adjustment:Loans
    
    
    
    
    
    17
    
    
    
    
    
    
    
    
    63
    
    
    
    
    
    
    
    
    57Investment
      securities
    
    
    
    
    
    338
    
    
    
    
    
    
    
    
    367
    
    
    
    
    
    
    
    
    411Total
      taxable equivalent adjustment
    
    
    
    
    
    355
    
    
    
    
    
    
    
    
    430
    
    
    
    
    
    
    
    
    468Net
      interest income
    
    
    
    
    $
    18,178
    
    
    
    
    
    
    
    $
    14,834
    
    
    
    
    
    
    
    $
    11,467
   (1)
    Average
      loans include nonaccrual loans. All loans and deposits are
      domestic.
 (2)
    Tax
      equivalent adjustments have been based on an assumed tax rate of 34
      percent, and do not give effect to the disallowance for federal income tax
      purpose of interest expense related to certain tax-exempt earning
      assets.


27
 Table of Contents





The
following tables set forth, for the years ended December 31, 2004, 2003 and
2002, a summary of the changes in interest income and interest expense resulting
from changes in interest rates and in changes in the volume of earning assets
and interest-bearing liabilities, segregated by category. The change due to
volume is calculated by multiplying the change in volume by the prior year’s
rate. The change due to rate is calculated by multiplying the change in rate by
the prior year’s volume. The change attributable to both volume and rate is
calculated by multiplying the change in volume by the change in rate. Figures
are presented on a taxable equivalent basis.





**Rate/Volume
Variance Analysis**


Taxable
Equivalent Basis





Average
      Volume
    
    Change
      in Volume
    
    Average
      Rate2004
    
    2003
    
    2002
    
    2004-2003
    
    2003-2002
    
    2004
    
    2003
    
    2002**Earning
      assets**:
    
    (Dollars
      in thousands)Loans,
      net of unearned income (1)
    
    $
    360,261
    
    $
    316,605
    
    $
    276,733
    
    $
    43,656
    
    $
    39,872
    
    
    6.57
    %
    
    6.73
    %
    
    7.38
    %Investment
      Securities:Taxable
    
    
    42,790
    
    
    34,938
    
    
    34,718
    
    
    7,852
    
    
    220
    
    
    3.28
    
    
    3.03
    
    
    4.74Tax
      exempt
    
    
    14,191
    
    
    15,013
    
    
    16,215
    
    
    (822
    )
    
    (1,202
    )
    
    6.97
    
    
    7.15
    
    
    7.41Total
      investment securities
    
    
    56,981
    
    
    49,951
    
    
    50,933
    
    
    7,030
    
    
    (982
    )
    
    4.20
    
    
    4.27
    
    
    5.59Interest-bearing
      deposits with other banks
    
    
    350
    
    
    784
    
    
    1,007
    
    
    (434
    )
    
    (223
    )
    
    1.43
    
    
    3.83
    
    
    1.29Federal
      funds sold
    
    
    1,994
    
    
    3,314
    
    
    5,104
    
    
    (1,320
    )
    
    (1,790
    )
    
    1.30
    
    
    1.12
    
    
    1.55Total
      earning assets
    
    $
    419,586
    
    $
    370,654
    
    $
    333,777
    
    $
    48,932
    
    $
    36,877
    
    
    6.22
    
    
    6.35
    
    
    7.00**Interest-bearing
      liabilities:**Deposits:Demand
    
    $
    82,617
    
    $
    83,040
    
    $
    62,492
    
    $
    29,728
    
    $
    20,548
    
    
    1.15
    
    
    1.42
    
    
    1.93Savings
    
    
    61,281
    
    
    45,318
    
    
    41,359
    
    
    (14,188
    )
    
    3,959
    
    
    1.16
    
    
    0.92
    
    
    1.72Time
    
    
    187,578
    
    
    170,419
    
    
    167,561
    
    
    17,159
    
    
    2,858
    
    
    2.42
    
    
    3.15
    
    
    4.44Total
      deposits
    
    
    331,476
    
    
    298,777
    
    
    271,412
    
    
    32,699
    
    
    27,365
    
    
    1.87
    
    
    2.33
    
    
    3.45Other
      short-term borrowings
    
    
    17,953
    
    
    6,422
    
    
    4,667
    
    
    7,989
    
    
    1,755
    
    
    0.69
    
    
    0.83
    
    
    1.65Long-term
      debt
    
    
    30,946
    
    
    35,782
    
    
    34,017
    
    
    (1,294
    )
    
    1,765
    
    
    3.96
    
    
    3.77
    
    
    5.86Total
      interest-bearing liabilities
    
    $
    380,375
    
    $
    340,981
    
    $
    310,096
    
    $
    39,394
    
    $
    30,885
    
    
    1.99
    
    
    2.42
    
    
    3.68Net
      interest income/net interest spread
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4.23
    
    
    3.93
    
    
    3.32Net
      yield on earning assets
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4.42
    
    
    4.12
    
    
    3.58Net
      cost of funds
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1.80
    
    
    2.23
    
    
    3.42





Interest
    
    
    
    
    
    Variance
      Attributed to (1)Income/Expense
    
    Variance
    
    2004
    
    20032004
    
    2003
    
    2002
    
    2004-2003
    
    2003-2002
    
    Volume
    
    Rate
    
    Volume
    
    Rate(Dollars
      in thousands)**Earning
      assets:**Loans,
      net of unearned income
    
    $
    23,669
    
    $
    21,321
    
    $
    20,420
    
    $
    2,348
    
    $
    901
    
    $
    2,879
    
    $
    (531
    )
    $
    2,782
    
    $
    (1,881
    )Investment
      Securities:Taxable
    
    
    1,402
    
    
    1,059
    
    
    1,647
    
    
    343
    
    
    (588
    )
    
    252
    
    
    91
    
    
    10
    
    
    (598
    )Tax
      exempt
    
    
    989
    
    
    1,073
    
    
    1,201
    
    
    (84
    )
    
    (128
    )
    
    (58
    )
    
    (26
    )
    
    (87
    )
    
    (41
    )Total
      investment securities
    
    
    2,391
    
    
    2,132
    
    
    2,848
    
    
    259
    
    
    (716
    )
    
    194
    
    
    65
    
    
    (77
    )
    
    (639
    )Interest-bearing
      deposits with other banks
    
    
    5
    
    
    30
    
    
    13
    
    
    (25
    )
    
    17
    
    
    (12
    )
    
    (13
    )
    
    (3
    )
    
    20Federal
      funds sold
    
    
    26
    
    
    37
    
    
    79
    
    
    (11
    )
    
    (42
    )
    
    (16
    )
    
    5
    
    
    (23
    )
    
    (19
    )Total
      earning assets
    
    
    26,091
    
    
    23,520
    
    
    23,360
    
    
    2,571
    
    
    160
    
    
    3,045
    
    
    (474
    )
    
    2,679
    
    
    (2,519
    )**Interest-bearing
      liabilities**:Deposits:Demand
    
    
    952
    
    
    1,178
    
    
    1,209
    
    
    (226
    )
    
    (31
    )
    
    (6
    )
    
    (220
    )
    
    339
    
    
    (370
    )Savings
    
    
    713
    
    
    418
    
    
    712
    
    
    295
    
    
    (294
    )
    
    169
    
    
    126
    
    
    63
    
    
    (357
    )Time
    
    
    4,544
    
    
    5,363
    
    
    7,432
    
    
    (819
    )
    
    (2,069
    )
    
    502
    
    
    (1,321
    )
    
    125
    
    
    (2,194
    )Total
      deposits
    
    
    6,209
    
    
    6,959
    
    
    9,353
    
    
    (750
    )
    
    (2,394
    )
    
    665
    
    
    (1,415
    )
    
    527
    
    
    (2,921
    )Other
      short-term borrowings
    
    
    123
    
    
    83
    
    
    77
    
    
    40
    
    
    6
    
    
    57
    
    
    (17
    )
    
    57
    
    
    (51
    )Long-term
      debt
    
    
    1,226
    
    
    1,214
    
    
    1,995
    
    
    12
    
    
    (781
    )
    
    (50
    )
    
    62
    
    
    (99
    )
    
    (682
    )Total
      interest-bearing liabilities
    
    
    7,558
    
    
    8,256
    
    
    11,425
    
    
    (698
    )
    
    (3,169
    )
    
    672
    
    
    (1,370
    )
    
    485
    
    
    (3,654
    )Net
      interest income/net interest spread
    
    $
    18,533
    
    $
    15,264
    
    $
    11,935
    
    $
    3,269
    
    $
    3,329
    
    $
    2,373
    
    $
    896
    
    $
    2,194
    
    $
    1,135





________________


(1)
    The
      change in interest due to both rate and volume has been allocated to
      volume and rate changes in proportion to the relationship of the absolute
      dollar amounts of the change in
each.


28
 Table of Contents





**Results
of Operations**





**Comparison
of Years Ended December 31, 2004, 2003, and 2002**





**Net
Interest Income**





Net
interest income is the principal source of the Company’s earnings stream and
represents the difference, or spread, between interest and fee income generated
from earning assets and the interest expense paid on deposits and borrowed
funds. Fluctuations in interest rates as well as volume and mix changes in
earning assets and interest-bearing liabilities materially impact net interest
income. Net interest income increased $3,269,852 or 21.4% to $18,533,832 for
2004, compared to $15,263,980 for 2003. Net interest income increased
$3,328,764, or 27.9% for the year ended December 31, 2003, compared to
$11,935,216 at December 31, 2002. The increase was attributable to the strong
loan demand in the local markets as well as the shift from high cost certificate
of deposit funding to lower cost core deposits and the use of alternative
funding. The shift began in 2003 and has continued through 2004. Currently,
certificates of deposits account for approximately 50% of the deposit funding.





Interest
and fees earned on loans increased 11.0% to $23,669,693 in 2004, compared to
$21,320,975 in 2003. The 2003 balance represented an increase of 4.4% compared
to $20,421,039 in 2002. These increases were primarily attributable to the
steady increase in the Bank’s loan portfolio, which increased 13.6% during
2004.





Interest
earned on taxable securities increased 32.4% to $1,401,522 in 2004 from
$1,058,688 in 2003, while interest earned on non-taxable securities decreased
from $1,073,295 to $988,739 during the same period. Interest earned on taxable
securities decreased 35.7% to $1,050,688 in 2003 from $1,646,592 in 2002, while
interest earned on non-taxable securities decreased from $1,200,993 to
$1,073,295 during the same period. The increase in interest earned on taxable
securities in 2004 is attributable to an overall increase in the portfolio of
16.8% for 2004 as well as actively managing it to meet liquidity needs of the
Bank.





The trend
in net interest income is also evaluated in terms of average rates using the net
interest margin and the interest rate spread. The net interest margin, or the
net yield on earning assets, is computed by dividing fully taxable equivalent
net interest income by average earning assets. This ratio represents the
difference between the average yield returned on average earning assets and the
average rate paid for funds used to support those earning assets, including both
interest-bearing and noninterest-bearing sources. The net interest margin for
2004 was 4.42% compared to a net interest margin of 4.12% in 2003 and 3.58% in
2002.





The
interest rate spread measures the difference between the average yield on
earning assets and the average rate paid on interest-bearing sources of funds.
The interest rate spread calculation provides a more direct perspective on the
effect of market interest rate movements. The net interest spread was 4.23% in
2004, compared to 3.93% in 2003 and 3.32% in 2002.








**Interest
Expense**





Total
interest expense for the years ended December 31, 2004, 2003, and 2002 was
$7,557,979, $8,256,564 and $11,425,388, respectively. This represents a decrease
of $698,585, or 8.5% from 2003 to 2004, and a decrease of $3,168,824, or 27.7%
from 2002 to 2003. The decreases were caused by the short-term nature of the
Bank’s certificate of deposits portfolio as well as a focus on core deposit
growth. Management has been focused on developing relationships with customers
to grow the noninterest-bearing as well as other core deposits. The average rate
paid on interest-bearing deposits in 2004, 2003 and 2002 was 1.87%, 2.33%, and
3.45%, respectively. The effect of these changes was to decrease the interest
expense on interest-bearing deposits to $6,209,262 in 2004, from $6,959,433 in
2003, and $9,352,768 in 2002. This was a decrease in the interest expense on
interest-bearing deposits from 2003 to 2004 of $750,171, or 10.8%, and a
decrease from 2002 to 2003 of 25.6%.




29
 Table of Contents





**Noninterest
Income**





Noninterest
income for 2004, 2003 and 2002 totaled $2,829,488, $2,703,395 and $2,937,144,
respectively. These amounts are primarily from customer service fees, insurance
commissions and fees on services to customers. Mortgage origination fees
increased from 1,049,443 in 2002 to $1,276,787 in 2003 then decreased to
$800,981 in 2004. These fluctuations were primarily due to a high volume of
mortgage refinancings in 2003 due to the historically low interest rates. The
subsequent rise in rates during 2004 caused some of the slowdown for the year.
Customer service fees decreased from 1,058,298 in 2002 to 844,669 in 2003, but
increased to 1,233,655 in 2004. The increase in customer service fees is related
to some of the new products rolled out during 2004. Management will continue to
work on increasing noninterest income in 2005.





**Noninterest
Expenses**





Noninterest
expenses totaled $13,840,008 in 2004, $11,731,985 in 2003, and $9,702,148 in
2002. Salaries and employee benefits increased $1,238,789, or 21.9% to 6,884,579
in 2004 and $790,885 or 16.3% to $5,645,790 from 2002 to 2003, due to the
opening of the new full service branch in Blue Ridge, Georgia as well as the
expense of complying with the Sarbanes-Oxley Act of 2002. Occupancy, furniture
and equipment expenses totaled $1,955,683 in 2004, an increase of 21.3% over
2003, due to the completion of construction of the new Blue Ridge branch.
Occupancy, furniture and equipment expenses increased $74,542, or 4.8% from 2002
to 2003 due to the fact that 2003 was the first full year of operations of the
original Blue Ridge branch. Advertising expenses increased $266,036, or 51.6% to
782,072 in 2004 and decreased $50,648 or 8.9% from 2002 to 2003. The advertising
expense increase for 2004 is related to the marketing of the new Blue Ridge
location as well as new products that were rolled out during 2004. Education
expenses are up 33.6% or $65,959 for 2004. This is due to a focus on utilizing
technology to serve our customers more efficiently. The FDIC and State
assessments are down due to the improved capital position of the Bank. The major
portion of the increase in other expenses of $353,606 during 2004 is due to
losses on disposal of repossessed property.





The table
below sets forth the Company’s noninterest expenses for the periods
indicated.





2004
    
    2003
    
    2002Salaries
      and employee benefits
    
    $
    6,885
    
    $
    5,646
    
    $
    4,855Occupancy,
      furniture and equipment expense
    
    
    1,956
    
    
    1,612
    
    
    1,538Professional
      fees
    
    
    987
    
    
    948
    
    
    678Advertising
    
    
    782
    
    
    516
    
    
    567Data
      processing
    
    
    537
    
    
    570
    
    
    84Director
      and committee fees
    
    
    427
    
    
    315
    
    
    306Stationery
      and supplies
    
    
    367
    
    
    338
    
    
    308Education
    
    
    262
    
    
    196
    
    
    95Postage
    
    
    163
    
    
    150
    
    
    164Taxes
      and licenses
    
    
    160
    
    
    276
    
    
    157FDIC
      and state assessments
    
    
    101
    
    
    179
    
    
    78Correspondent
      bank charges
    
    
    91
    
    
    90
    
    
    78Insurance
    
    
    72
    
    
    185
    
    
    119Dues
      and subscriptions
    
    
    58
    
    
    40
    
    
    46Checking
      account expense
    
    
    45
    
    
    41
    
    
    60Amortization
    
    
    41
    
    
    94
    
    
    76Other
    
    
    906
    
    
    536
    
    
    493Total
      noninterest expenses
    
    $
    13,840
    
    $
    11,732
    
    $
    9,702




30
 Table of Contents





**Income
Taxes**





Net
operating income of $5,932,346 in 2004 resulted in $1,885,332 of income tax
expense, which represents an income tax rate of 31.8%. The Company’s net
operating income of $4,339,895 in 2003 resulted in $1,253,315 of income tax
expense, which represented an income tax rate of 28.9%. The Company’s net
operating income of $3,673,948 in 2002 resulted in $1,005,940 of income tax
expense, which represented an income tax rate of 27.4%.





**Impact** **of Inflation and Changing Prices**





The asset
and liability structure of a bank is substantially different from that of an
industrial company in that virtually all assets and liabilities of a bank are
monetary in nature. Management believes the impact of inflation on financial
results depends upon the ability of the Bank to react to changes in interest
rates and by such reaction to reduce the inflationary impact on performance.
Interest rates do not necessarily move in the same direction, or at the same
magnitude, as the prices of other goods and services. As discussed previously,
management seeks to manage the relationship between interest-sensitive assets
and liabilities in order to protect against wide interest rate fluctuations,
including those resulting from inflation.





**Market
Risk**





Market
risk is the risk arising from adverse changes in the fair value of financial
instruments due to a change in interest rates, exchange rates and equity prices.
The Company’s primary market risk is interest rate risk.





The
primary objective of asset/liability management is to manage interest rate risk
and achieve reasonable stability in net interest income throughout interest rate
cycles. This is achieved by maintaining the proper balance of rate sensitive
earning assets and rate sensitive liabilities. The relationship of rate
sensitive earning assets to rate sensitive liabilities is the principal factor
in projecting the effect that fluctuating interest rates will have on future net
interest income. Rate sensitive earning assets and interest-bearing liabilities
are those that can be repriced to current market rates within a relatively short
time period. Management monitors the rate sensitivity of earning assets and
interest-bearing liabilities over the entire life of these instruments, but
places particular emphasis on the first year and through three years.





The
Company has not experienced a high level of volatility in net interest income
primarily because of the relatively large base of core deposits that do not
reprice on a contractual basis. These deposit products include regular savings,
interest-bearing transaction accounts and money market savings accounts.
Balances for these accounts are reported based on historical repricing. However,
the rates paid are typically not directly related to market interest rates,
since management has some discretion in adjusting these rates as market rates
change.





The
Company uses additional tools to monitor and manage interest rate sensitivity.
One of the primary tools is simulation analysis. Simulation analysis is the
primary method of estimating earnings at risk and capital at risk under varying
interest rate conditions. Simulation analysis is used to test the sensitivity of
the Company’s net interest income and shareholders’ equity to both the level of
interest rates and the slope of the yield curve. Simulation analysis accounts
for the expected timing and magnitude of assets and liability cash flows, as
well as the expected timing and magnitude of deposits that do not reprice on a
contractual basis. In addition, simulation analysis includes adjustments for the
lag between movements in market interest rates on loans and interest-bearing
deposits. These adjustments are made to reflect more accurately possible future
cash flows, repricing behavior and ultimately net interest income.





The
estimated impact on the Company’s net interest income before provision for loan
loss sensitivity over a one-year time horizon is shown below. Such analysis
assumes a sustained parallel shift in interest rates and the Company’s estimate
of how interest-bearing transaction accounts will reprice in each scenario.
Actual results will differ from simulated results due to timing, magnitude and
frequency of interest rate changes and changes in market conditions and
management’s strategies, among other factors.




31
 Table of Contents




Percentage
      Increase(Decrease)
      in InterestIncome/Expense
      GivenInterest
      Rate ShiftsDown
      200
    
    Up
      200Basis
      Points
    
    Basis
      PointsFor
      the Twelve Months After December 31, 2004Projected
      change in:Interest
      income
    
    
    (20.34
    )%
    
    17.91
    %Interest
      expense
    
    
    (35.26
    )
    
    38.43Net
      interest income
    
    
    (10.54
    )
    
    4.43





**Recently
Issued Accounting Standards**





In May
2003, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (“SFAS”) No. 150, *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* . This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires liability treatment for certain financial instruments which
had previously been recognized as equity. The provisions of this statement are
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise are effective at the beginning of the first interim period
beginning after June 15, 2003. It is to be implemented by reporting the
cumulative effect of a change in accounting principle for financial instruments
created before May 15, 2003, and still existing at the beginning of the interim
period of adoption. Restatement is not permitted. The adoption of the provisions
of this statement did not have a material effect on the Company’s consolidated
operating results or financial position.





In
December 2003, the FASB revised previously issued SFAS No. 132, *Employers’
Disclosures about Pensions and Other Postretirement* . This
statement revises employers’ disclosures about pension plans and other
postretirement benefit plans. It does not change the measurement or recognition
of those plans required by FASB Statements No. 87, *Employers’
Accounting for Pensions* , No. 88, *Employers’*  *Accounting
for Settlements and Curtailments of Defined*  *Benefit
Pension Plans and for Termination Benefits* , and No.
106, *Employers’
Accounting for Postretirement Benefits Other Than Pensions* . This
statement retains the disclosure requirements contained in FASB Statement No.
132, *Employers’
Disclosures about Pensions and Other Postretirement Benefits* , which
it replaces. It requires additional disclosures to those in the original
Statement 132 about the assets, obligations, cash flows, and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The required information should be provided separately for
pension plans and for other postretirement benefit plans. The provisions of this
statement are effective for financial statements with fiscal years ending after
December 15, 2003. The interim-period disclosures required by this statement are
effective for interim periods beginning after December 15, 2003. The
adoption of the provisions of this revised statement did not have a material
effect on the Company’s consolidated operating results or financial position.





In
December 2003, the FASB revised previously issued Financial Interpretation No.
(“FIN”) 46, *Consolidation
of Variable Interest Entities* , which
clarifies the application of Accounting Research Bulletin (“ARB”) 51, *Consolidated
Financial Statements,* to
certain entities (called variable interest entities) in which equity investors
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. The reporting and
disclosure requirements of this Interpretation are effective for all financial
statements of public companies for the first period ending after December 15,
2003 and for all other types of entities for periods ending after March 15,
2004. The adoption of this interpretation did not have a material impact on the
Company’s consolidated financial statements.





In
December 2003, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position (“SOP”)
03-3, *Accounting
for Certain Loans or Debt Securities Acquired in a Transfer* , which
addresses the accounting for differences between contractual cash flows and
expected cash flows for loans acquired in a transfer when those differences are
attributable at least in part to a decline in credit quality. The scope of SOP
03-3 includes loans where there is evidence of deterioration in credit quality
since origination, and includes loans acquired individually, in pools or as part
of a business combination. Under SOP 03-3, the difference between expected cash
flows and the purchase price is accreted as an adjustment to yield over the
life. The Company does not expect the application of SOP 03-03 to have a
material impact on our consolidated financial position or results of
operations.




32
 Table of Contents





In March
2004, the Emerging Issues Task Force (“EITF”) reached a consensus on the
remaining portions of EITF 03-01, *The
Meaning of Other-Than-Temporary Impairment and It’s Application to Certain
Investments* ,
effective for the first fiscal year or interim period beginning after June 15,
2004. EITF 03-01 provides guidance for determining when an investment is
considered impaired, whether impairment is other-than-temporary, and measurement
of an impairment loss. An investment is considered impaired if the fair value of
the investment is less than its cost. Generally, an impairment is considered
other-than-temporary unless: (1) the investor has the ability and intent to hold
an investment for a reasonable period of time sufficient for an anticipated
recovery of fair value up to (or beyond) the cost of the investment, and (2)
evidence indicating that the cost of the investment is recoverable within a
reasonable period of time outweighs evidence to the contrary. If impairment is
determined to be other-than-temporary, then an impairment loss should be
recognized equal to the difference between the investment’s cost and its fair
value. Certain disclosure requirements of EITF 03-01 were adopted in 2003 and
the Company began presenting the new disclosure requirements in its consolidated
financial statements for the year ended December 31, 2003. The recognition and
measurement provisions were initially effective for other-than-temporary
impairment evaluations in reporting periods beginning after June 15, 2004.
However in September 2004, the effective date of these provisions was delayed
until the finalization of a FASB Staff Position to provide additional
implementation guidance. Due to the recognition and measurement provisions being
suspended and the final rule delayed, the Company is not able to determine
whether the adoption of these new provisions will have a material impact on its
consolidated financial position or results of operations.





In March
2004, the Securities and Exchange Commission issued Staff Accounting Bulletin
(“SAB”) No. 105, *Application
of Accounting Principles to Loan Commitments* . SAB 105
requires that the fair value measurement of mortgage loan commitments, which are
derivatives, exclude any expected future cash flows related to the customer
relationship or servicing rights. The guidance in SAB 105 must be applied to
mortgage loan commitments entered into after March 31, 2004. The impact on the
Company is not material given the declines in mortgage banking volume, but could
be in the future. The impact is primarily the timing of when gains should be
recognized in the consolidated financial statements.





In
December 2004, the FASB issued SFAS No. 123 (revised 2004), entitled *Share-Based
Payment* (“SFAS
No. 123R”) that will require compensation costs related to share-based payment
transactions to be recognized in the financial statements. This Statement
eliminates the alternative to use Opinion 25’s intrinsic value method of
accounting that was provided in Statement 123 as originally issued. Under
Opinion 25, issuing stock options to employees generally resulted in recognition
of no compensation cost. This statement requires entities to recognize the cost
of employee services received in exchange for awards of equity instruments based
on the grant-date fair value of those awards (with limited exceptions).
Recognition of that compensation cost helps users of financial statements to
better understand the economic transactions affecting an entity and to make
better resource allocation decisions. Effective January 1, 2003, the Company
adopted the fair value recognition provisions of SFAS No. 123, *Accounting
for Stock-Based Compensation* , as
provided by SFAS No. 148, *Accounting
for Stock-Based Compensation - Transition and Disclosure* . SFAS
No. 148 allows for a prospective method of adoption of SFAS No. 123, whereby the
Company can prospectively account for the current expense of options granted
during 2003 and thereafter. The Company is currently evaluating the provisions
of SFAS No. 123R and will adopt it on July 1, 2005.











**ITEM
      7A.**
    **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
      MARKET RISK**





Information
in response to this Item 7A is incorporated by reference from the following
sections of Item 7 of this report: “Interest Rate Sensitivity Management” and
“Market Risk.”








**ITEM
      8.**
    **FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA**





The
consolidated financial statements and supplementary data required by Regulation
S-X and by Item 302 of Regulation S-K are set forth in the pages
below.




33
 Table of Contents





**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**





**Consolidated
Financial Statements**





Page(s)Report
      of Independent Registered Public Accounting Firm
    35Consolidated
      Statements of Financial Condition as of December 31, 2004 and
      2003
    36Consolidated
      Statements of Income for the Years EndedDecember
      31, 2004, 2003 and 2002
    37Consolidated
      Statements of Shareholders’ Equity for the Years EndedDecember
      31, 2004, 2003 and 2002
    38Consolidated
      Statements of Cash Flows for the Years EndedDecember
      31, 2004, 2003 and 2002
    39Notes
      to Consolidated Financial Statements
    40Quarterly
      Results (Unaudited)
    67




34
 Table of Contents




**Schauer Taylor Cox Vise & Morgan,
      P.C.****Certified Public Accountants and
    Consultants**











**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








To the
Board of Directors and Shareholders


Appalachian
Bancshares, Inc. and Subsidiaries


Ellijay,
Georgia





We have
audited the accompanying consolidated statements of financial condition of
Appalachian Bancshares, Inc. (a Georgia corporation) and subsidiaries (the
Company) as of December 31, 2004 and 2003, and the related consolidated
statements of income, shareholders’ equity and cash flows for each of the three
years in the 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
consolidated financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall consolidated 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 consolidated financial position of Appalachian
Bancshares, Inc. and subsidiaries as of December 31, 2004 and 2003, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2004, in conformity with United
States generally accepted accounting principles.











Birmingham,
      AlabamaMarch
      17, 2005**/s/
      Schauer Taylor Cox Vise & Morgan,
P.C.**








****
 **Telephone
      - 205.822.3488**
    
    ****150
      Olde Towne Road****
    
    **Wats
      - 800.466.3488****Fax
      - 205.822.3541 or 205.822.0645**
    
    **Birmingham,
      Alabama 35216**
    
    **Email
      -
Firm@schauertaylor.com**


35
 Table of Contents





**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**





**CONSOLIDATED
STATEMENTS OF FINANCIAL CONDITION**





**December
31, 2004 and 2003**








**2004**
    
    2003**Assets**Cash
      and due from banks
    
    **$**
    **4,953,563**
    
    $
    6,530,984Interest-bearing
      deposits with other banks
    
    
    **403,532**
    
    
    273,841Federal
      funds sold
    
    
    **2,156,000**
    
    
    586,000**Cash
      and Cash Equivalents**
    
    
    **7,513,095**
    
    
    7,390,825Securities
      available-for-sale
    
    
    **64,654,722**
    
    
    55,363,327Loans,
      net of unearned income
    
    
    **377,351,501**
    
    
    332,306,446Allowance
      for loan losses
    
    
    **(4,348,618******
    ******)**
    
    (3,609,794
    )**Net
      Loans**
    
    
    **373,002,883**
    
    
    328,696,652Premises
      and equipment, net
    
    
    **12,988,640**
    
    
    9,161,652Accrued
      interest
    
    
    **2,901,737**
    
    
    2,289,994Cash
      surrender value on life insurance
    
    
    **7,833,450**
    
    
    2,592,416Intangibles,
      net
    
    
    **2,116,558**
    
    
    2,157,433Other
      assets
    
    
    **1,800,043**
    
    
    1,965,179**Total
      Assets**
    
    **$**
    **472,811,128**
    
    $
    409,617,478**Liabilities
      and Shareholders’ Equity****Liabilities**Noninterest-bearing
      deposits
    
    **$**
    **32,896,346**
    
    $
    23,795,787Interest-bearing
      deposits.
    
    
    **348,601,825**
    
    
    309,123,161**Total
      Deposits**
    
    
    **381,498,171**
    
    
    332,918,948Short-term
      borrowings
    
    
    **15,469,540**
    
    
    12,085,992Accrued
      interest
    
    
    **540,217**
    
    
    670,614Long-term
      debt
    
    
    **31,950,000**
    
    
    25,692,858Subordinated
      long-term capital notes
    
    
    **6,186,000**
    
    
    6,186,000Other
      liabilities
    
    
    **1,083,878**
    
    
    980,713**Total
      Liabilities**
    
    
    **436,727,806**
    
    
    378,535,125**Shareholders’
      Equity**Preferred
      stock, 20,000,000 shares authorized, none issued
    
    
    **—**
    
    
    —Common
      stock, par value $0.01 per share, 20,000,000 shares
      authorized,3,840,572
      shares issued in 2004 and 3,734,686 shares issued in 2003
    
    
    **38,406**
    
    
    37,347Paid-in
      capital
    
    
    **23,731,549**
    
    
    22,727,208Retained
      earnings
    
    
    **12,635,174**
    
    
    8,588,160Accumulated
      other comprehensive income: net unrealized holdinggains
      (losses) on securities available-for-sale, net of deferred income
      tax
    
    
    **377,989**
    
    
    429,434Treasury
      stock, 75,973 shares at cost
    
    
    **(699,796******
    ******)**
    
    (699,796
    )**Total
      Shareholders’ Equity**
    
    
    **36,083,322**
    
    
    31,082,353**Total
      Liabilities and Shareholders’ Equity**
    
    **$**
    **472,811,128**
    
    $
    409,617,478




See notes to consolidated financial
statements




36
 Table of Contents


**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**





**CONSOLIDATED
STATEMENTS OF INCOME**





**Years
Ended December 31, 2004, 2003 and 2002**


**2004**
    
    2003
    
    2002**Interest
      Income**Interest
      and fees on loans
    
    **$**
    **23,652,087**
    
    $
    21,257,660
    
    $
    20,363,641Interest
      on investment securities:Taxable
      securities
    
    
    **1,401,522**
    
    
    1,058,688
    
    
    1,646,592Nontaxable
      securities
    
    
    **650,486**
    
    
    706,115
    
    
    790,127Interest
      on deposits with other banks
    
    
    **5,488**
    
    
    30,224
    
    
    13,039Interest
      on federal funds sold
    
    
    **26,369**
    
    
    37,362
    
    
    78,941**Total
      Interest Income**
    
    
    **25,735,952**
    
    
    23,090,049
    
    
    22,892,340**Interest
      Expense**Interest
      on deposits
    
    
    **6,209,262**
    
    
    6,959,433
    
    
    9,352,768Interest
      on federal funds purchased and securities sold under
      agreements to repurchase
    
    
    **123,282**
    
    
    82,722
    
    
    76,968Interest
      on long-term debt
    
    
    **941,835**
    
    
    1,129,209
    
    
    1,995,652Interest
      on subordinated long-term capital notes
    
    
    **283,600**
    
    
    85,200
    
    
    —**Total
      Interest Expense**
    
    
    **7,557,979**
    
    
    8,256,564
    
    
    11,425,388**Net
      Interest Income**
    
    
    **18,177,973**
    
    
    14,833,485
    
    
    11,466,952Provision
      for loan losses
    
    
    **1,235,107**
    
    
    1,465,000
    
    
    1,028,000**Net
      Interest Income After Provision For Loan Losses**
    
    
    **16,942,866**
    
    
    13,368,485
    
    
    10,438,952**Noninterest
      Income**Customer
      service fees
    
    
    **1,233,655**
    
    
    844,669
    
    
    1,058,298Insurance
      commissions.
    
    
    **47,760**
    
    
    61,824
    
    
    77,987Mortgage
      origination fees
    
    
    **800,981**
    
    
    1,276,787
    
    
    1,049,443Investment
      securities gains (losses)
    
    
    **(22,633**
    **)**
    
    (16,978
    )
    
    285,525Other
      operating income
    
    
    **769,725**
    
    
    537,093
    
    
    465,891**Total
      Noninterest Income**
    
    
    **2,829,488**
    
    
    2,703,395
    
    
    2,937,144**Noninterest
      Expenses**Salaries
      and employee benefits
    
    
    **6,884,579**
    
    
    5,645,790
    
    
    4,854,905Occupancy
      expense
    
    
    **814,868**
    
    
    631,235
    
    
    615,826Furniture
      and equipment expense
    
    
    **1,140,815**
    
    
    980,704
    
    
    921,571Other
      operating expenses
    
    
    **4,999,746**
    
    
    4,474,256
    
    
    3,309,846**Total
      Noninterest Expenses**
    
    
    **13,840,008**
    
    
    11,731,985
    
    
    9,702,148Income
      before income taxes
    
    
    **5,932,346**
    
    
    4,339,895
    
    
    3,673,948Income
      tax expense
    
    
    **1,885,332**
    
    
    1,253,315
    
    
    1,005,940**Net
      Income**
    
    **$**
    **4,047,014**
    
    $
    3,086,580
    
    $
    2,668,008**Earnings
      Per Common Share**Basic
    
    **$**
    **1.09**
    
    $
    0.86
    
    $
    0.81Diluted
    
    
    **1.04**
    
    
    0.81
    
    
    0.76**Cash
      Dividends Declared Per Common Share**
    
    
    **0.00**
    
    
    0.00
    
    
    0.00**Weighted
      Average Shares Outstanding**Basic
    
    
    **3,724,095**
    
    
    3,609,728
    
    
    3,277,787Diluted
    
    
    **3,885,490**
    
    
    3,809,625
    
    
    3,508,019


See notes to consolidated financial
statements


37
 Table of Contents





**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**





**CONSOLIDATED**  **STATEMENTS
OF SHAREHOLDERS’ EQUITY**





**Years
Ended December 31, 2004, 2003 and 2002**








AccumulatedOtherCompre-hensiveCommon
    
    Paid-in
    
    Retained
    
    Income
    
    TreasuryStock
    
    Capital
    
    Earnings
    
    (Loss)
    
    Stock
    
    TotalBalance
      at December 31, 2001
    
    $
    34,229
    
    $
    19,245,956
    
    $
    3,505,388
    
    $
    60,822
    
    $
    (2,255,205
    )
    $
    20,591,190Retroactive
      effect of 10% stock dividend
    
    
    244
    
    
    367,166
    
    
    (367,410
    )
    
    —
    
    
    —
    
    
    —Net
      income 2002
    
    
    —
    
    
    —
    
    
    2,668,008
    
    
    —
    
    
    —
    
    
    2,668,008Unrealized
      gains on available-for-sale securities, net
      of reclassification adjustment, net of tax of
      $199,997
    
    
    —
    
    
    —
    
    
    —
    
    
    388,228
    
    
    —
    
    
    388,228Comprehensive
      income
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    3,056,236Proceeds
      from sale of common stock to 401(k) plan
    
    
    117
    
    
    163,543
    
    
    —
    
    
    —
    
    
    —
    
    
    163,660Proceeds
      from exercise of options
    
    
    1,808
    
    
    1,019,690
    
    
    —
    
    
    —
    
    
    —
    
    
    1,021,498Proceeds
      from issuance of treasury stock
    
    
    —
    
    
    319,201
    
    
    —
    
    
    —
    
    
    467,504
    
    
    786,705Balance
      at December 31, 2002
    
    
    36,398
    
    
    21,115,556
    
    
    5,805,986
    
    
    449,050
    
    
    (1,787,701
    )
    
    25,619,289Retroactive
      effect of 10% stock dividend
    
    
    202
    
    
    302,273
    
    
    (304,406
    )
    
    —
    
    
    —
    
    
    (1,931
    )Net
      income 2003
    
    
    —
    
    
    —
    
    
    3,086,580
    
    
    —
    
    
    —
    
    
    3,086,580Unrealized
      losses on available-for-sale securities,
      net
      of reclassification adjustment, net of tax
      of ($10,107)
    
    
    —
    
    
    —
    
    
    —
    
    
    (19,616
    )
    
    —
    
    
    (19,616
    )Comprehensive
      income
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    3,066,964Effect
      of exercise and issuance of stock options
    
    
    747
    
    
    528,583
    
    
    —
    
    
    —
    
    
    —
    
    
    529,330Proceeds
      from issuance of treasury stock
    
    
    —
    
    
    780,796
    
    
    —
    
    
    —
    
    
    1,142,805
    
    
    1,923,601Acquisition
      of treasury stock
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    (54,900
    )
    
    (54,900
    )Balance
      at December 31, 2003
    
    
    37,347
    
    
    22,727,208
    
    
    8,588,160
    
    
    429,434
    
    
    (699,796
    )
    
    31,082,353**Net
      income 2004**
    
    
    **—**
    
    
    **—**
    
    
    **4,047,014**
    
    
    **—**
    
    
    **—**
    
    
    **4,047,014****Unrealized
      losses on available-for-sale**
      **securities,
      net of reclassification adjustment,**
      **net
      of tax of ($26,501)**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **(51,445**
    **)**
    
    **—**
    
    
    **(51,445******
    ******)****Comprehensive
      income**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **3,995,569****Proceeds
      from sale of common stock to 401(k) plan**
    
    
    **336**
    
    
    **502,855**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **503,191****Effect
      of exercise and issuance of****stock options**
    
    
    **723**
    
    
    **501,486**
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **502,209****Balance
      at December 31, 2004**
    
    **$**
    **38,406**
    
    **$**
    **23,731,549**
    
    **$**
    **12,635,174**
    
    **$**
    **377,989**
    
    **$******
    **(699,796******
    ******)**
    **$**
    **36,083,322**





See notes to consolidated financial
statements





38
 Table of Contents





**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**





**CONSOLIDATED
STATEMENTS OF CASH FLOWS**





**Years
Ended December 31, 2004, 2003 and 2002**




**2004**
    
    2003
    
    2002**Operating
      Activities**Net
      income
    
    **$**
    **4,047,014**
    
    $
    3,086,580
    
    $
    2,668,008Adjustments
      to reconcile net income to net cashprovided
      by operating activities:Depreciation,
      amortization, and accretion, net
    
    
    **1,039,402**
    
    
    1,312,067
    
    
    1,171,023Provision
      for loan losses
    
    
    **1,235,107**
    
    
    1,465,000
    
    
    1,028,000Deferred
      tax benefit
    
    
    **(22,000**
    **)**
    
    (20,000
    )
    
    (49,000
    )Realized
      security (gains) losses, net
    
    
    **22,633**
    
    
    16,978
    
    
    (285,525
    )Loss
      on disposition of other real estate
    
    
    **195,181**
    
    
    42,143
    
    
    40,757Increase
      in cash surrender value on life insurance
    
    
    **(241,034**
    **)**
    
    (109,173
    )
    
    (113,377
    )(Increase)
      decrease in accrued interest receivable
    
    
    **(611,743**
    **)**
    
    (49,074
    )
    
    258,072Decrease
      in accrued interest payable
    
    
    **(130,397**
    **)**
    
    (305,542
    )
    
    (290,790
    )Other,
      net
    
    
    **304,321**
    
    
    694,584
    
    
    (51,421
    )**Net
      Cash Provided By Operating Activities**
    
    
    **5,838,484**
    
    
    6,133,563
    
    
    4,375,747**Investing
      Activities**Proceeds
      from sales of securities available-for-sale
    
    
    **4,261,201**
    
    
    5,368,830
    
    
    12,597,325Proceeds
      from maturity, calls and paydown ofsecurities
      available-for-sale
    
    
    **12,472,586**
    
    
    23,121,518
    
    
    34,322,603Purchase
      of securities available-for-sale
    
    
    **(26,260,504**
    **)**
    
    (43,960,542
    )
    
    (37,442,014
    )Net
      increase in loans to customers
    
    
    **(46,311,074**
    **)**
    
    (36,321,605
    )
    
    (49,462,737
    )Capital
      expenditures, net
    
    
    **(4,959,258**
    **)**
    
    (1,211,594
    )
    
    (2,605,882
    )Proceeds
      from sales of premises and equipment
    
    
    **241,917**
    
    
    27,746
    
    
    —Purchase
      of insurance contracts
    
    
    **(5,000,000**
    **)**
    
    —
    
    
    —Proceeds
      from disposition of foreclosed real estate
    
    
    **806,763**
    
    
    1,248,201
    
    
    236,615**Net
      Cash Used In Investing Activities**
    
    
    **(64,748,369******
    ******)**
    
    (51,727,446
    )
    
    (42,354,090
    )**Financing
      Activities**Net
      increase in demand deposits, NOW accounts,and savings
      accounts
    
    
    **32,357,873**
    
    
    2,458,008
    
    
    45,209,010Net
      increase in certificates of deposit
    
    
    **16,221,350**
    
    
    14,178,184
    
    
    7,045,739Net
      increase in short-term borrowings
    
    
    **3,383,548**
    
    
    1,157,368
    
    
    2,263,925Issuance
      of long-term debt
    
    
    **13,500,000**
    
    
    33,736,000
    
    
    23,000,000Repayment
      of long-term debt
    
    
    **(7,242,858**
    **)**
    
    (31,592,858
    )
    
    (17,917,857
    )Compensation
      associated with issuance of stock options
    
    
    **42,301**
    
    
    21,739
    
    
    —Issuance
      of common stock
    
    
    **769,941**
    
    
    302,800
    
    
    889,260Sale
      of treasury stock
    
    
    **—**
    
    
    1,923,601
    
    
    786,705Purchase
      of treasury stock
    
    
    **—**
    
    
    (54,900
    )
    
    —Cash
      in lieu of fractional shares on stock dividend
    
    
    **—**
    
    
    (1,931
    )
    
    —**Net
      Cash Provided By Financing Activities**
    
    
    **59,032,155**
    
    
    22,128,011
    
    
    61,276,782**Net
      Increase (Decrease) in Cash and Cash Equivalents**
    
    
    **122,270**
    
    
    (23,465,872
    )
    
    23,298,439Cash
      and Cash Equivalents at Beginning of Year
    
    
    **7,390,825**
    
    
    30,856,697
    
    
    7,558,258**Cash
      and Cash Equivalents at End of Year**
    
    **$**
    **7,513,095**
    
    $
    7,390,825
    
    $
    30,856,697




See notes to consolidated financial
statements







39
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


Note 1 - Summary of Significant Accounting Policies





The
accompanying consolidated financial statements include the accounts of
Appalachian Bancshares, Inc. (the “Company”) (a Georgia corporation) and its
wholly-owned subsidiaries: Appalachian Community Bank (the “Bank”) and
Appalachian Information Management, Inc. (“AIM”). AIM was formed as a
wholly-owned subsidiary of the Bank. AIM provided in-house data services to the
Bank and offered data processing services to other institutions (see Note 2). In
August 2002, management decided to discontinue operations of AIM, which
operations ceased on November 12, 2002. Accordingly, the Bank entered into a
data processing agreement with Fiserv Solutions, Inc., whereby the Bank
outsourced those data services previously provided in-house by AIM. AIM has
ceased offering data processing services to other institutions; however, the
Bank continues to provide limited, administrative services, formerly provided by
AIM, to another bank on a subcontract basis. The discontinuance of AIM’s
operations has not had a material effect on the Company’s operations or
financial condition. All significant intercompany transactions and balances have
been eliminated in consolidation. Unless otherwise indicated herein, the
financial results of the Company refer to the Company and the Bank on a
consolidated basis. The Bank provides a full range of banking services to
individual and corporate customers in North Georgia and the surrounding
areas.





The
Company operates predominantly in the domestic commercial banking industry. The
accounting and reporting policies of the Company conform to generally accepted
accounting principles in the United States and to general practice within the
banking industry. The following summarizes the most significant of these
policies.





Use of
Estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles in the United States of America requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.





The
determination of the adequacy of the allowance for loan losses is based on
estimates that are particularly susceptible to significant changes in the
economic environment and market conditions. In connection with the determination
of the estimated losses on loans, management obtains independent appraisals for
significant collateral. While management uses available information to recognize
losses on loans, further reductions in the carrying amounts of loans may be
necessary based on changes in local economic conditions. In addition, regulatory
agencies, as an integral part of their examination process, periodically review
the estimated losses on loans. Such agencies may require the Bank to recognize
additional losses based on their judgments about information available to them
at the time of their examination. Because of these factors, it is reasonably
possible that the estimated losses on loans may change materially in the near
term. However, the amount of the change that is reasonably possible cannot be
estimated.





Securities





Securities
are classified as either held-to-maturity, available-for-sale or
trading.





Held-to-maturity
securities are securities for which management has the ability and intent to
hold until maturity. These securities are carried at amortized cost, adjusted
for amortization of premiums and accretion of discount, to the earlier of the
maturity or call date.




40
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies -
Continued**


Securities
available-for-sale represent those securities intended to be held for an
indefinite period of time, including securities that management intends to use
as part of its asset/liability strategy, or that may be sold in response to
changes in interest rates, changes in prepayment risk, the need to increase
regulatory capital, or other similar factors. Securities available-for-sale are
recorded at market value with unrealized gains and losses net of any tax effect,
added or deducted directly from shareholders’ equity.





Securities
carried in trading accounts are carried at market value with unrealized gains
and losses reflected in income.





Realized
and unrealized gains and losses are based on the specific identification
method.





Declines
in the fair value of individual held-to maturity and available-for-sale
securities below their cost that are other than temporary result in write-downs
of the individual securities to their fair value. The related write-downs are
included in earnings as realized losses.





The
Company has no trading or held-to-maturity securities.





Loans





Loans are
stated at unpaid principal balances, less the allowance for loan losses, net
deferred loan fees and unearned discounts.





Unearned
discounts on installment loans are recognized as income over the term of the
loans using a method that approximates the interest method.





Loan
origination and commitment fees, as well as certain origination costs, when
material, are deferred and amortized as a yield adjustment over the lives of the
related loans using the interest method.





Allowance
for Loan Losses





A loan is
considered impaired, based on current information and events, if it is probable
that the Bank will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement.
Uncollateralized loans are measured for impairment based on the present value of
expected future cash flows discounted at the historical effective interest rate,
while all collateral-dependent loans are measured for impairment based on the
fair value of the collateral. Smaller balance homogeneous loans, which consist
of residential mortgages and consumer loans, are evaluated collectively and
reserves are established based on historical loss experience.





The
allowance for loan losses is established through charges to earnings in the form
of a provision for loan losses. Increases and decreases in the allowance due to
changes in the measurement of the impaired loans are included in the provision
for loan losses. Loans continue to be classified as impaired unless they are
brought fully current and the collection of scheduled interest and principal is
considered probable. When a loan or portion of a loan is determined to be
uncollectable, the portion deemed uncollectable is charged against the allowance
and subsequent recoveries, if any, are credited to the allowance.





Management’s
periodic evaluation of the adequacy of the allowance is based on the Bank’s past
loan loss experience, known and inherent risks in the portfolio, adverse
situations that may affect the borrowers’ ability to repay ,
estimated value of any underlying collateral, and an analysis of current
economic conditions. While management believes that it has established the
allowance in accordance with generally accepted accounting principles and has
taken into account the views of its regulators and the current economic
environment, there can be no assurance that in the future the Bank’s regulators
or its economic environment will not require further increases in the
allowance.




41
 Table of Contents





**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies -
Continued**


Income
Recognition on Impaired and Nonaccrual Loans





Loans,
including impaired loans, are generally classified as nonaccrual if they are
past due as to maturity or payment of principal or interest for a period of more
than 90 days, unless such loans are well collateralized and in the process of
collection. If a loan or a portion of a loan is classified as doubtful or is
partially charged off, the loan is generally classified as nonaccrual. Loans
that are on a current payment status or past due less than 90 days may also be
classified as nonaccrual if repayment in full of principal and/or interest is in
doubt.





Loans may
be returned to accrual status when all principal and interest amounts
contractually due are reasonably assured of repayment within an acceptable
period of time, and there is a sustained period of repayment performance by the
borrower, in accordance with the contractual terms of interest and
principal.





While a
loan is classified as nonaccrual and the future collectability of the recorded
loan balance is doubtful, collections of interest and principal are generally
applied as a reduction to principal outstanding, except in the case of loans
with scheduled amortizations where the payment is generally applied to the
oldest payment due. When the future collectability of the recorded loan balance
is expected, interest income may be recognized on a cash basis. In the case
where a nonaccrual loan has been partially charged off, recognition of interest
on a cash basis is limited to that which would have been recognized on the
recorded loan balance at the contractual interest rate. Receipts in excess of
that amount are recorded as recoveries to the allowance for loan losses until
prior charge offs have been fully recovered. Interest income recognized on a
cash basis was immaterial for the years ended December 31, 2004, 2003 and
2002.





Premises
and Equipment





Land is
carried at cost. Other premises and equipment are carried at cost, net of
accumulated depreciation. Depreciation is provided generally by straight-line
methods based principally on the estimated useful lives of the respective
assets. Maintenance and repairs are expensed as incurred, while major additions
and improvements are capitalized. Gains and losses on dispositions are included
in current operations.





Foreclosed
Real Estate





Foreclosed
real estate includes both formally foreclosed property and in-substance
foreclosed property. In-substance foreclosed properties are those properties for
which the Bank has taken physical possession, regardless of whether formal
foreclosure proceedings have taken place.





At the
time of foreclosure, foreclosed real estate is recorded at the lower of the
carrying amount or fair value less cost to sell, which becomes the property’s
new basis. Any write-downs based on the asset’s fair value at date of
acquisition are charged to the allowance for loan losses. After foreclosure,
these assets are carried at the lower of their new cost basis or fair value less
cost to sell.





Costs
incurred in maintaining foreclosed real estate and subsequent adjustments to the
carrying amount of the property are included in income (loss) on foreclosed real
estate.




42
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


Advertising
Costs





The
Company’s policy is to expense advertising costs as incurred. Advertising
expense for the years ended December 31, 2004, 2003 and 2002 amounted to
approximately $782,000, $516,000 and $567,000, respectively.





Income
Taxes





Income
taxes are provided for the tax effects of the transactions reported in the
consolidated financial statements and consist of taxes currently due plus
deferred taxes related primarily to differences between the basis of
available-for-sale securities, allowance for loan losses, estimated losses on
foreclosed real estate, and accumulated depreciation for financial and income
tax reporting. The deferred tax assets and liabilities represent the future tax
return consequences of those differences, which will either be taxable or
deductible when the assets and liabilities are recovered or settled. Deferred
tax assets and liabilities are reflected at income tax rates applicable to the
period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
Company files consolidated income tax returns with its
subsidiaries.





Stock-Based
Compensation





At
December 31, 2004, the Company had a stock-based employee compensation plan,
which is more fully described in Note 18. Prior to 2003, the Company accounted
for this plan under the recognition and measurement provisions of APB No. 25, *Accounting
for Stock Issued to Employees* , and the
related Interpretations. Accordingly, no stock-based compensation cost was
included in net earnings for the year ended December 31, 2002, as all options
granted under this plan had an exercise price equal to the market value of the
underlying common stock on the date of grant. Effective January 1, 2003, the
Company adopted the fair value recognition provisions of Statement of Financial
Accounting Standards (“SFAS”) No. 123, *Accounting
for Stock-Based Compensation* , as
provided by SFAS No. 148, *Accounting
for Stock-Based Compensation - Transition and Disclosure.* SFAS No.
148 allows for a prospective method of adoption of SFAS No. 123, whereby the
Company can prospectively account for the current expense of options granted
during 2003 and thereafter. Results of prior years have not been restated. The
following table illustrates the effects on net income and earnings per share if
the fair value based method had been applied to all outstanding awards in each
period.





Years
      Ended December 31,**2004**
    
    2003
    
    2002Net
      Income, as reported
    
    **$**
    **4,047,014**
    
    $
    3,086,580
    
    $
    2,668,008Add:
      Stock-based compensation expenseincluded
      in net income, net of related taxes
    
    
    **42,301**
    
    
    21,739
    
    
    —Deduct:
      Total stock-based employeecompensation
      expense determined underthe
      fair value method for all awards,net
      of related taxes
    
    
    **(60,293******
    ******)**
    
    (63,350
    )
    
    (106,367
    )Pro
      Forma Net Income
    
    **$**
    **4,029,022**
    
    $
    ****3,044,969
    
    $
    ****2,561,641




43
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


Years
      Ended December 31,**2004**
    
    2003
    
    2002Basic
      Earnings per Common ShareAs
      reported
    
    **$**
    **1.09**
    
    $
    ****0.86
    
    $
    0.81Pro
      Forma
    
    
    **1.08**
    
    
    0.84
    
    
    0.78Diluted
      Earnings per Common ShareAs
      reported
    
    
    **1.04**
    
    
    0.81
    
    
    0.76Pro
      Forma
    
    
    **1.04**
    
    
    0.80
    
    
    0.73Weighted
      average fair value of options
      granted
      during the year
    
    
    **3.79**
    
    
    4.20
    
    
    —Assumptions:Average
      risk free interest rate
    
    
    **4.07**
    **%**
    
    4.95
    %
    
    —Average
      expected volatility
    
    
    **21.30**
    
    
    22.53
    
    
    —Expected
      dividend yield
    
    
    **1.90**
    
    
    1.90
    
    
    —Expected
      life
    
    
    **7.5
      years**
    
    
    7.5
      years
    
    
    —





The
effects of applying SFAS No. 123 as amended by SFAS No. 148 for providing pro
forma disclosures are not likely to be representative of the effects on reported
earnings for future years, nor are the dividend estimates representative of
commitments on the part of the Company’s Board.





Employee
Benefit Plan





The
Company has a 401(k) profit-sharing plan covering substantially all of its
employees. Eligible participating employees may elect to contribute tax-deferred
contributions. Company contributions to the plan are determined by the board of
directors.





Intangibles





Intangibles
consist primarily of goodwill, debt issuance costs, and noncompete agreements.
The goodwill intangible represents a premium paid on the purchase of assets and
deposit liabilities. The asset is stated at cost, net of accumulated
amortization, which was provided using the straight-line method over the
estimated useful life of 20 years, until the Financial Accounting Standards
Board (the “FASB”) issued SFAS No. 142, *Goodwill
and Other Intangible Assets,* in June
2001. Debt issuance costs represent costs incurred in the Trust Preferred
transaction which is more fully discussed in Note 12. The noncompete intangible
represents an amount paid to a former employee who agreed to certain
stipulations concerning future employment spelled out in a noncompete agreement.
The asset is stated at cost, net of accumulated amortization, which is provided
using the straight-line method over the estimated useful life of 2
years.





The
adoption of new accounting standards effective January 1, 2002 mandates the
discontinuance of periodic amortization and requires the Company to measure the
recorded goodwill for impairment as of January 1, 2002, and at least annually
thereafter. The initial assessment of the Company’s intangible asset (Goodwill)
as of January 1, 2002, and the annual assessments as of December 31, 2004 and
2003, indicate that no impairment of values existed at those dates.




44
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


Off-Balance
Sheet Financial Instruments





In the
ordinary course of business the Company has entered into off-balance sheet
financial instruments consisting of commitments to extend credit, commitments
under credit card arrangements, commercial letters of credit and standby letters
of credit. Such financial instruments are recorded in the consolidated financial
statements when they are funded. See Note 16 for a further discussion of these
financial instruments.





The
Company also has available as a source of short-term financing the purchase of
federal funds from other commercial banks from an available line of up to $24
million and a line of credit with the Federal Home Loan Bank (the “FHLB”) of up
to approximately $70,040,000 of which approximately $29,000,000 is available and
unused, subject to proper collateralization.





Segment
Information





All of
the Company’s offices offer similar products and services, are located in the
same geographic region, and serve the same customer segments of the market. As a
result, management considers all units as one operating segment and therefore
feels that the basic consolidated financial statements and related footnotes
provide details related to segment reporting.





Reclassifications





Certain
amounts in 2003 and 2002 have been reclassified to conform with the 2004
presentation.





Recently
Issued Accounting Standards





In May
2003, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (“SFAS”) No. 150, *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* . This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires liability treatment for certain financial instruments which
had previously been recognized as equity. The provisions of this statement are
effective for financial instruments entered into or modified after May 31, 2003,
and otherwise are effective at the beginning of the first interim period
beginning after June 15, 2003. It is to be implemented by reporting the
cumulative effect of a change in accounting principle for financial instruments
created before May 15, 2003, and still existing at the beginning of the interim
period of adoption. Restatement is not permitted. The adoption of the provisions
of this statement did not have a material effect on the Company’s consolidated
operating results or financial position.





In
December 2003, the FASB revised previously issued SFAS No. 132, *Employers’
Disclosures about Pensions and Other Postretirement* . This
statement revises employers’ disclosures about pension plans and other
postretirement benefit plans. It does not change the measurement or recognition
of those plans required by FASB Statements No. 87, *Employers’
Accounting for Pensions* , No. 88, *Employers’*  *Accounting
for Settlements and Curtailments of Defined*  *Benefit
Pension Plans and for Termination Benefits* , and No.
106, *Employers’
Accounting for Postretirement Benefits Other Than Pensions* . This
statement retains the disclosure requirements contained in FASB Statement No.
132, *Employers’
Disclosures about Pensions and Other Postretirement Benefits* , which
it replaces. It requires additional disclosures to those in the original
Statement 132 about the assets, obligations, cash flows, and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The required information should be provided separately for
pension plans and for other postretirement benefit plans. The provisions of this
statement are effective for financial statements with fiscal years ending after
December 15, 2003. The interim-period disclosures required by this statement are
effective for interim periods beginning after December 15, 2003. The
adoption of the provisions of this revised statement did not have a material
effect on the Company’s consolidated operating results or financial position.




45
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


In
December 2003, the FASB revised previously issued Financial Interpretation No.
(“FIN”) 46, *Consolidation
of Variable Interest Entities* , which
clarifies the application of Accounting Research Bulletin (“ARB”) 51, *Consolidated
Financial Statements,* to
certain entities (called variable interest entities) in which equity investors
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. The reporting and
disclosure requirements of this Interpretation are effective for all financial
statements of public companies for the first period ending after December 15,
2003 and for all other types of entities for periods ending after March 15,
2004. The adoption of this interpretation did not have a material impact on the
Company’s consolidated financial statements.





In
December 2003, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position (“SOP”)
03-3, *Accounting
for Certain Loans or Debt Securities Acquired in a Transfer* , which
addresses the accounting for differences between contractual cash flows and
expected cash flows for loans acquired in a transfer when those differences are
attributable at least in part to a decline in credit quality. The scope of SOP
03-3 includes loans where there is evidence of deterioration in credit quality
since origination, and includes loans acquired individually, in pools or as part
of a business combination. Under SOP 03-3, the difference between expected cash
flows and the purchase price is accreted as an adjustment to yield over the
life. The Company does not expect the application of SOP 03-03 to have a
material impact on our consolidated financial position or results of
operations.





In March
2004, the Emerging Issues Task Force (“EITF”) reached a consensus on the
remaining portions of EITF 03-01, *The
Meaning of Other-Than-Temporary Impairment and It’s Application to Certain
Investments* ,
effective for the first fiscal year or interim period beginning after June 15,
2004. EITF 03-01 provides guidance for determining when an investment is
considered impaired, whether impairment is other-than-temporary, and measurement
of an impairment loss. An investment is considered impaired if the fair value of
the investment is less than its cost. Generally, an impairment is considered
other-than-temporary unless: (1) the investor has the ability and intent to hold
an investment for a reasonable period of time sufficient for an anticipated
recovery of fair value up to (or beyond) the cost of the investment, and (2)
evidence indicating that the cost of the investment is recoverable within a
reasonable period of time outweighs evidence to the contrary. If impairment is
determined to be other-than-temporary, then an impairment loss should be
recognized equal to the difference between the investment’s cost and its fair
value. Certain disclosure requirements of EITF 03-01 were adopted in 2003 and
the Company began presenting the new disclosure requirements in its consolidated
financial statements for the year ended December 31, 2003. The recognition and
measurement provisions were initially effective for other-than-temporary
impairment evaluations in reporting periods beginning after June 15, 2004.
However in September 2004, the effective date of these provisions was delayed
until the finalization of a FASB Staff Position to provide additional
implementation guidance. Due to the recognition and measurement provisions being
suspended and the final rule delayed, the Company is not able to determine
whether the adoption of these new provisions will have a material impact on its
consolidated financial position or results of operations.





In March
2004, the Securities and Exchange Commission issued Staff Accounting Bulletin
(“SAB”) No. 105, *Application
of Accounting Principles to Loan Commitments* . SAB 105
requires that the fair value measurement of mortgage loan commitments, which are
derivatives, exclude any expected future cash flows related to the customer
relationship or servicing rights. The guidance in SAB 105 must be applied to
mortgage loan commitments entered into after March 31, 2004. The impact on the
Company is not material given the declines in mortgage banking volume, but could
be in the future. The impact is primarily the timing of when gains should be
recognized in the consolidated financial statements.




46
 Table of Contents




**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


In
December 2004, the FASB issued SFAS No. 123 (revised 2004), entitled *Share-Based
Payment* (“SFAS
No. 123R”) that will require compensation costs related to share-based payment
transactions to be recognized in the financial statements. This Statement
eliminates the alternative to use Opinion 25’s intrinsic value method of
accounting that was provided in Statement 123 as originally issued. Under
Opinion 25, issuing stock options to employees generally resulted in recognition
of no compensation cost. This statement requires entities to recognize the cost
of employee services received in exchange for awards of equity instruments based
on the grant-date fair value of those awards (with limited exceptions).
Recognition of that compensation cost helps users of financial statements to
better understand the economic transactions affecting an entity and to make
better resource allocation decisions. Effective January 1, 2003, the Company
adopted the fair value recognition provisions of SFAS No. 123, *Accounting
for Stock-Based Compensation* , as
provided by SFAS No. 148, *Accounting
for Stock-Based Compensation - Transition and Disclosure* . SFAS
No. 148 allows for a prospective method of adoption of SFAS No. 123, whereby the
Company can prospectively account for the current expense of options granted
during 2003 and thereafter. The Company is currently evaluating the provisions
of SFAS No. 123R and will adopt it on July 1, 2005.





Earnings
per Common Share





Basic
earnings per common share are computed by dividing earnings available to
stockholders by the weighted average number of common shares outstanding during
the period. Diluted earnings per share reflect per share amounts that would have
resulted if dilutive potential common stock had been converted to common stock,
as prescribed by SFAS No. 128, *Earnings
per Share* . In July
2003, the Company issued a 10% stock dividend. All per share amounts included in
these consolidated financial statements have been retroactively adjusted to give
effect to this dividend. The following reconciles the weighted average number of
shares outstanding:





**2004**
    
    2003
    
    2002Weighted
      average of common shares outstanding
    
    
    **3,724,095**
    
    
    3,609,728
    
    
    3,277,787Effect
      of dilutive options
    
    
    **161,395**
    
    
    199,897
    
    
    230,232Weighted
      average of common shares outstanding effected for dilution
    
    
    **3,885,490**
    
    
    3,809,625
    
    
    3,508,019














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47
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**APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 
 
 **Note
1 - Summary of Significant Accounting Policies - Continued**


Comprehensive
Income





Comprehensive
income is generally defined as the change in equity of a business enterprise
during a period from transactions and other events and circumstances from
non-owner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
Comprehensive income is the total of net income and all other non-owner changes
in equity. Items that are to be recognized under accounting standards as
components of comprehensive income are displayed in statements of shareholders’
equity.





In the
calculation of comprehensive income, certain reclassification adjustments are
made to avoid double counting items that are displayed as part of net income for
a period that also had been displayed as part of other comprehensive income in
that period or earlier periods. The disclosure of the reclassification amounts
and other details of other comprehensive income (loss) are as
follows:





Years
      Ended December 31,**2004**
    
    2003
    
    2002Unrealized
      gains (losses) on securitiesUnrealized
      holding gains (losses) arising during period
    
    **$**
    **(100,579**
    **)**
    $
    (46,701
    )
    $
    873,750Reclassification
      adjustments for (gains) losses included in net income
    
    
    **22,633**
    
    
    16,978
    
    
    (285,525
    )Net
      unrealized gains (losses)
    
    
    **(77,946**
    **)**
    
    (29,723
    )
    
    588,225Income
      tax related to items of other comprehensive income
    
    
    **26,501**
    
    
    10,107
    
    
    (199,997
    )Other
      comprehensive income (loss)
    
    **$******
    **(51,445******
    ******)**
    $
    (19,616
    )
    $
    388,228





Statements
of Cash Flows





The
Company includes cash, due from banks, and short-term investments as cash
equivalents in preparing the consolidated statements of cash flows. The
following is supplemental disclosure to the statements of cash flows for the
three years ended December 31, 2004.





Years
      Ended December 31,**2004**
    
    2003
    
    2002Cash
      paid during the year for interest
    
    **$**
    **7,688,376**
    
    $
    8,562,106
    
    $
    11,716,178Cash
      paid during the year for income taxes
    
    
    **1,690,000**
    
    
    836,039
    
    
    1,050,345Non-cash
      Disclosures:Loans
      transferred to foreclose real estate
    
    
    **1,563,178**
    
    
    1,517,302
    
    
    1,477,804Net
      increase (decrease) in unrealized gains and losses on securities
      available-for-sale
    
    
    **(77,946**
    **)**
    
    (29,723
    )
    
    588,225Proceeds
      from sales of foreclosed real estatefinanced
      through loans
    
    
    **793,442**
    
    
    532,192
    
    
    294,290Tax
      benefit of the exercise of non-qualified options
    
    
    **193,158**
    
    
    204,791
    
    
    295,898




48
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****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
2 - Discontinued Operations**





In August
2002, the Company announced its intentions to terminate the operations of its
subsidiary, Appalachian Information Management, Inc. (“AIM”). The operations of
AIM ceased on November 12, 2002.





Disposition
of the assets of the discontinued operations began in September 2002. At
December 31, 2004, the remaining assets (primarily fixed assets and prepaid
expenses) net of related reserves and other liabilities are included in premises
and equipment and other assets in the accompanying consolidated statements of
financial condition and continue to be held for productive use.





An
impairment loss of approximately $43,000 was recognized by the Company in the
year 2002 related to this discontinued function.





In light
of the Company discontinuing the operations of AIM, its data processing
provider, the Company signed a 5-year contract with Fiserv Solutions, Inc. to
provide the Company with data processing services. The contract contains a
3-year renewable option along with a detailed fee schedule for the different
services it is likely to perform.








**Note
3 - Restrictions On Cash and Due From Bank Accounts**





The
Company is required to maintain average reserve balances either in vault cash or
on deposit with the Federal Reserve Bank. At December 31, 2004 and 2003, the
average amount of the required reserves was $623,000 and $302,000, respectively.








**Note
4 - Securities**





The
carrying amounts of securities as shown in the consolidated statements of
financial condition of the Company and their approximate fair values at December
31, 2004 and 2003 are presented below.





Gross
    
    Gross
    
    EstimatedAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value**Securities
      Available-for-Sale****December
      31, 2004:****U.S.
      Government and agency securities**
    
    **$**
    **31,982,618**
    
    **$**
    **45,348**
    
    **$**
    **283,784**
    
    **$**
    **31,744,182****State
      and municipal securities**
    
    
    **13,458,279**
    
    
    **819,037**
    
    
    **—**
    
    
    **14,277,316****Mortgage-backed
      securities**
    
    
    **14,934,714**
    
    
    **45,047**
    
    
    **52,937**
    
    
    **14,926,824****Equity
      securities**
    
    
    **3,706,400**
    
    
    **—**
    
    
    **—**
    
    
    **3,706,400****$**
    **64,082,011**
    
    **$**
    **909,432**
    
    **$**
    **336,721**
    
    **$**
    **64,654,722**December
      31, 2003:U.S.
      Government and agency securities
    
    $
    20,273,622
    
    $
    69,052
    
    $
    268,234
    
    $
    20,074,440State
      and municipal securities
    
    
    13,572,237
    
    
    782,726
    
    
    —
    
    
    14,354,963Mortgage-backed
      securities
    
    
    19,137,512
    
    
    115,141
    
    
    48,029
    
    
    19,204,624Equity
      securities
    
    
    1,729,300
    
    
    —
    
    
    —
    
    
    1,729,300$
    54,712,671
    
    $
    966,919
    
    $
    316,263
    
    $
    55,363,327




49
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
4 - Securities - Continued**





At
December 31, 2004, the Company’s available-for-sale securities reflected net
unrealized gains of $572,711 that resulted in an increase in stockholders’
equity of $377,989 net of deferred tax liability. At December 31, 2003, the
Company’s available-for-sale securities reflected net unrealized gains of
$650,656, which resulted in an increase in stockholders’ equity of $429,434, net
of deferred tax liability.





The
following table shows the Company’s investments’ gross unrealized losses and
fair value, aggregated by investment category and length of time that individual
securities have been in a continuous unrealized loss position, at
December 31, 2004.





Less
      Than 12 Months
    
    12
      Months or More
    
    TotalGross
    
    
    
    Gross
    
    
    
    GrossFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedValue
    
    Losses
    
    Value
    
    Losses
    
    Value
    
    Losses**Securities
      Available-for-Sale**U.S.
      Government and agency securities
    
    $
    15,217,628
    
    $
    133,822
    
    $
    5,797,158
    
    $
    149,962
    
    $
    21,014,786
    
    $
    283,784Mortgage-backed
      securities
    
    
    10,496,622
    
    
    52,937
    
    
    —
    
    
    —
    
    
    10,496,622
    
    
    52,937$
    25,714,250
    
    $
    186,759
    
    $
    5,797,158
    
    $
    149,962
    
    $
    31,511,408
    
    $
    336,721





Management
evaluates securities for other-than-temporary impairment at least on a quarterly
basis, and more frequently when economic or market concerns warrant such
evaluation. Consideration is given to (1) the length of time and the extent to
which the fair value has been less than cost, (2) the financial condition and
near-term prospects of the issuer, and (3) the intent and ability of the Company
to retain its investment in the issuer for a period of time sufficient to allow
for any anticipated recovery in fair value. The losses are in four securities
that are insured agencies of the United States Government and the losses can be
attributable to changes in interest rates. Because the declines in value are not
attributed to credit quality and the Company has the ability and intent to hold
the securities until a market price recovery or maturity, these investments are
not considered other-than-temporarily impaired.





The
contractual maturities of securities available-for-sale at December 31, 2004 are
shown as follows. Expected maturities will differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.





Amortized
    
    EstimatedCost
    
    Fair
      Value**Securities
      Available-for-Sale**Due
      in one year or less
    
    $
    —
    
    $
    —Due
      after one year through five years
    
    
    29,536,735
    
    
    29,319,713Due
      after five years through ten years
    
    
    6,688,875
    
    
    6,825,309Due
      after ten years
    
    
    24,150,001
    
    
    24,803,300Equity
      securities
    
    
    3,706,400
    
    
    3,706,400$
    64,082,011
    
    $
    64,654,722





Mortgage-backed
securities have been included in the maturity table based upon the guaranteed
payoff date of each security.




50
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
4 - Securities - Continued**





Gross
realized gains and losses on the sale of securities available-for-sale for each
of the three years in the period ended December 31, 2004, were as
follows:





**2004**
    
    2003
    
    2002Gross
      realized gains
    
    **$**
    **—**
    
    $
    24,243
    
    $
    290,227Gross
      realized losses
    
    
    **22,633**
    
    
    41,221
    
    
    4,702





Equity
securities include a restricted investment in Federal Home Loan Bank stock,
which must be maintained to secure the available line of credit. The amount of
investment in this stock amounted to $2,670,400 and $1,543,300 at
December 31, 2004 and 2003, respectively. In addition to the restricted
investment in Federal Home Loan Bank, the Company also had an investment of
$850,000 in Federal Home Loan Bank preferred stock in 2004. Equity securities
also include an investment in Appalachian Capital Trust I. The amount of
investment in the trust amounted to $186,000 at December 31, 2004 and
2003.





The
carrying value of investment securities pledged to secure public funds on
deposit, securities sold under agreements to repurchase, and for other purposes
as required by law amounted to $44,354,611 and $24,912,754 at December 31, 2004
and 2003, respectively.








**Note
5 - Loans**





The
Company grants loans to customers primarily in the North Georgia area. The major
classifications of loans as of December 31, 2004 and 2003 were as
follows:





December
      31,**2004**
    
    2003Commercial,
      financial and agricultural
    
    **$**
    **31,919,880**
    
    $
    34,613,388Real
      estate - construction
    
    
    **145,587,858**
    
    
    104,619,438Real
      estate - mortgage
    
    
    **173,954,978**
    
    
    166,597,728Consumer
    
    
    **20,956,568**
    
    
    20,534,760Other
      loans
    
    
    **4,932,217**
    
    
    5,941,132**377,351,501**
    
    
    332,306,446Allowance
      for loan losses
    
    
    **(4,348,618******
    ******)**
    
    (3,609,794
    )Net
      loans
    
    **$**
    **373,002,883**
    
    $
    328,696,652





Total
loans which the Company considered to be impaired at December 31, 2004 and 2003
were $1,524,541 and $1,126,727, respectively. All of these loans were on
nonaccrual status and had related allowances of $546,016 and $169,009,
respectively. Impaired loans consisted primarily of real estate - mortgage loans
as of December 31, 2004 and 2003. The average recorded investment in impaired
loans for the years ended December 31, 2004 and 2003 was approximately
$1,353,000 and $2,248,000, respectively. No material amount of interest income
was recognized on impaired loans for the years ended December 31, 2004 and 2003.
For the year ended December 31, 2004, the difference between gross interest
income that would have been recorded in such period if the nonaccruing loans had
been current in accordance with their original terms and the amount of interest
income on those loans that was included in such period’s net income was
approximately $89,000. In the year ended December 31, 2003, the amount was
$148,000.





The
Company has no commitments to loan additional funds to the borrowers of
nonaccrual loans.





At
December 31, 2004 and 2003, the Company had loans past due 90 days or more and
still accruing interest of $34,263 and $520,741, respectively.




51
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
5 - Loans - Continued**





Commercial
and residential real estate loans pledged to secure Federal Home Loan Bank
advances and letters of credit amounted to $64,349,607 and $57,189,899 at
December 31, 2004 and 2003, respectively.








**Note
6 - Allowance for Loan Losses**





Changes
in the allowance for loan losses for each of the three years ended December 31,
2004, 2003 and 2002 are as follows:





December
      31,**2004**
    
    2003
    
    2002Balance
      at beginning of year
    
    **$**
    **3,609,794**
    
    $
    3,237,898
    
    $
    2,995,362Charge-offs
    
    
    **(555,779**
    **)**
    
    (1,207,788
    )
    
    (816,701
    )Recoveries
    
    
    **59,496**
    
    
    114,684
    
    
    31,237Net
      charge-offs
    
    
    **(496,283**
    **)**
    
    (1,093,104
    )
    
    (785,464
    )Provision
      for loan losses
    
    
    **1,235,107**
    
    
    1,465,000
    
    
    1,028,000Balance
      at end of year
    
    **$**
    **4,348,618**
    
    $
    3,609,794
    
    $
    3,237,898








**Note
7 - Premises and Equipment**





Premises
and equipment were as follows:





December
      31,**2004**
    
    2003Land
    
    **$**
    **3,853,534**
    
    $
    2,080,417Buildings
      and improvements
    
    
    **7,060,222**
    
    
    4,778,078Furniture
      and equipment
    
    
    **4,083,395**
    
    
    3,514,899Computer
      equipment and software
    
    
    **1,429,038**
    
    
    1,305,985Automobiles
    
    
    **175,971**
    
    
    175,524Construction
      in progress
    
    
    **272,637**
    
    
    676,613**16,874,797**
    
    
    12,531,516Allowance
      for depreciation
    
    
    **(3,886,157******
    ******)**
    
    (3,369,864
    )**$**
    **12,988,640**
    
    $
    9,161,652





The
provision for depreciation charged to occupancy and furniture and equipment
expense for the years ended December 31, 2004, 2003 and 2002 was $866,108,
$784,918 and $679,960, respectively.











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52
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
8 - Intangibles**





Acquired
goodwill and other intangible assets as of December 31, 2004 and 2003 are
detailed as follows:





Amortizable
Intangibles


Gross
    
    NetCarrying
    
    Accumulated
    
    CarryingAmount
    
    Amortization
    
    Amount**As
      of December 31, 2004:****Debt
      issuance costs**
    
    **$**
    **170,000**
    
    **$**
    **45,333**
    
    **$**
    **124,667****Total**
    
    **$**
    **170,000**
    
    **$**
    **45,333**
    
    **$**
    **124,667**As
      of December 31, 2003:Noncompete
      agreements
    
    $
    165,000
    
    $
    158,125
    
    $
    6,875Debt
      issuance costs
    
    
    170,000
    
    
    11,333
    
    
    158,667Total
    
    $
    335,000
    
    $
    169,458
    
    $
    165,542








Aggregate
amortization expense for amortizable intangible assets for the years ended
December 31, 2004, 2003 and 2002 was $40,875, $93,831 and $75,627, respectively.
Estimated annual amortization expense for the following years ending December 31
is as follows:


2005
    
    2006
    
    2007
    
    2008
    
    2009Estimated
      annual amortization expense
    
    $
    34,000
    
    $
    34,000
    
    $
    34,000
    
    $
    22,667
    
    $
    —





Acquired
      Goodwill:**2004**
    
    2003Goodwill
      from bank acquisition
    
    **$**
    **1,991,891**
    
    $
    1,991,891














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53
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****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
9 - Deposits**





The
aggregate amounts of time deposits of $100,000 or more, including certificates
of deposit of $100,000 or more at December 31, 2004 and 2003 were $108,687,921
and $86,556,043, respectively. Time deposits of less than $100,000 totaled
$92,340,003 and $98,250,531 at December 31, 2004 and 2003, respectively. Demand
deposits reclassified as loan balances as of December 31, 2004 and 2003 amounted
to $143,076 and $117,253, respectively.





The
maturities of time certificates of deposit and other time deposits issued by the
Company at December 31, 2004, are as follows:





TimeCertificatesof
      DepositYears
      ending December 31,2005
    
    
    $
    153,951,9832006
    
    
    
    34,371,6512007
    
    
    
    7,011,0202008
    
    
    
    1,616,8182009
    
    
    
    4,076,452$
    201,027,924








**Note
10 - Short-term Borrowings**





Short-term
borrowings at December 31, 2004 and 2003 consist of the following:





**2004**
    
    2003Federal
      funds purchased
    
    **$**
    **—**
    
    $
    3,000,000Securities
      sold under agreements to repurchase
    
    
    **6,263,790**
    
    
    4,085,992FHLB
      line of credit
    
    
    **9,205,750**
    
    
    5,000,000**$**
    **15,469,540**
    
    $
    12,085,992





Securities
sold under agreements to repurchase are reflected at the amount of cash received
in connection with the transaction. Information concerning securities sold under
agreements to repurchase is summarized as follows:





**2004**
    
    2003Average
      balance during the year
    
    **$**
    **6,093,745**
    
    $
    5,488,443Average
      interest rate during the year
    
    
    **1.36**
    **%**
    
    1.23
    %Maximum
      month-end balance during the year
    
    **$**
    **13,018,035**
    
    $
    8,211,269





U.S.
Agency, municipal and mortgage-backed securities underlying  the
agreements at year end:





Carrying
      value
    
    **$**
    **5,296,047**
    
    $
    5,887,249Estimated
      fair value
    
    
    **5,296,047**
    
    
    5,887,249




54
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
11 - Long-term Debt**





At
December 31, 2004 and 2003, the Company had notes payable totaling $31,950,000
and $25,692,858, respectively.





Long-term
debt consists of the following at December 31:





**2004**
    
    2003Notes
      payable on line of credit at FHLB, with varying maturities;from
      June
      2005
      through December 2014, interest rate varies from 1.81% to
      6.93%,
      secured
      by residential mortgages
    
    **$**
    **31,950,000**
    
    $
    25,692,858





Maturities
of long-term debt following December 31, 2004 are as follows:





Years
      ending December 31,2005
    
    
    $
    4,600,0002006
    
    
    
    2,300,0002007
    
    
    
    3,500,0002008
    
    
    
    6,550,0002009
    
    
    
    5,000,000Thereafter
    
    
    
    10,000,000$
    31,950,000








**Note
12 - Subordinated Long-term Capital Notes**





On August
28, 2003, Appalachian Capital Trust I (“the Trust”), a Delaware statutory trust
established by the Company, received $6,000,000 principal amount of the Trust’s
floating rate cumulative trust preferred securities (the “Trust Preferred
Securities”) in a trust preferred private placement. The proceeds of that
transaction were then used by the Trust to purchase an equal amount of floating
rate-subordinated debentures (the “Subordinated Debentures”) of the Company. The
Company has fully and unconditionally guaranteed all obligations of the Trust on
a subordinated basis with respect to the Trust Preferred Securities. In
accordance with the provisions of FIN 46R, the Company accounts for the Trust
Preferred Securities as a long-term debt liability to the Trust in the amount of
$6,186,000. Subject to certain limitations, the Trust Preferred Securities
qualify as Tier 1 capital.





The sole
asset of the Trust is the Subordinated Debentures issued by the Company. Both
the Trust Preferred Securities and the Subordinated Debentures have
approximately 30-year lives. However, both the Company and the Trust have
options to call their respective securities after five years, subject to
regulatory capital requirements.








**Note
13 - Shareholders’ Equity**





At
December 31, 2004 and 2003, shareholders’ equity of the Company consisted of the
following:





Preferred
Stock : At
December 31, 2004 and 2003, 20,000,000 shares authorized, none issued and none
outstanding.





Common
Stock : At
December 31, 2004, 20,000,000 shares authorized, 3,840,572 shares issued and
3,764,599 outstanding with a par value of $0.01 per share. At December 31, 2003,
20,000,000 shares authorized, 3,734,686 shares issued and 3,658,713 outstanding
with a par value of $0.01 per share.




55
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
13 - Shareholders’ Equity - Continued**





Paid-in
Capital :
Represents the funds received in excess of par value upon the issuance of stock,
net of issuance costs, tax benefits of non-statutory stock options and the
capitalization out of retained earnings of stock dividends.





Retained
Earnings :
Represents the accumulated net earnings of the Company less capitalized stock
dividends.





Accumulated
Other Comprehensive Income :
Represents the change in equity during each period from the effects of
unrealized holding gains and losses on securities available-for-sale, net of
tax.





Treasury
Stock :
Represents 75,973 shares of common stock at December 31, 2004 and 2003, at cost.





In 2004,
the Company issued 33,546 shares of stock to its 401(k) Plan for aggregrate
proceeds of $503,191. In addition, the effects of the stock-based compensation
expense as well as the exercise of 72,340 options during 2004 increased equity
by $502,209, including tax benefit.





In 2003,
the Company purchased 3,660 shares of its common stock for a cost of $54,900,
which were added to treasury stock at cost. The Company also sold 128,240 shares
of its treasury stock for $1,923,601. In addition, 82,170 options were exercised
for an amount equaling $529,330, including tax benefit. A 10% stock dividend of
332,826 shares was also issued in 2003.





In 2002,
the Company issued 12,859 shares of stock (retroactively adjusted for 10% stock
dividend in 2003) to its 401(k) Plan for aggregate proceeds of $163,660. The
Company also sold 52,447 shares of its treasury stock for aggregate proceeds of
$786,705. In addition, 198,880 options (retroactively adjusted for 10% stock
dividend in 2003) were exercised for aggregate proceeds of $1,021,498, including
tax benefit.





The
Company is required to maintain minimum amounts of capital to total “risk
weighted” assets, as defined by the banking regulators. The Company’s ratios as
of December 31, 2004 and 2003 are disclosed in the regulatory matters note
following (see Note 19).





The board
of directors of any state-chartered bank in Georgia may declare and pay cash
dividends on its outstanding capital stock without any request for approval of
the Bank’s regulatory agency if the following conditions are met:





1.
    Total
      classified assets at the most recent examination of the Bank do not exceed
      80% of equity capital.





2.
    The
      aggregate amount of dividends declared in the calendar year does not
      exceed 50% of the prior year’s net income.





3.
    The
      ratio of equity capital to adjusted assets shall not be less than
      6%.





As of
December 31, 2004, the Bank could declare dividends of approximately $2,355,000
without regulatory consent, subject to the Bank’s compliance with regulatory
capital restrictions. It is anticipated that any such dividends would be used
for the payment of long-term debt service.











[The
remainder of this page intentionally left blank]




56
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
14 - Other Operating Expenses**





Other
operating expenses consist of the following:





**2004**
    
    2003
    
    2002Professional
      fees
    
    **$**
    **987,499**
    
    $
    948,335
    
    $
    675,728Advertising
    
    
    **782,072**
    
    
    516,036
    
    
    566,684Data
      processing
    
    
    **536,713**
    
    
    569,915
    
    
    83,572Director
      and committee fees
    
    
    **426,505**
    
    
    314,500
    
    
    306,282Stationery
      and supplies
    
    
    **367,507**
    
    
    337,712
    
    
    307,937Education
    
    
    **262,190**
    
    
    196,231
    
    
    95,107Postage
    
    
    **163,254**
    
    
    150,268
    
    
    163,746Taxes
      and licenses
    
    
    **159,515**
    
    
    275,528
    
    
    157,459FDIC
      and state assessments
    
    
    **101,191**
    
    
    178,917
    
    
    77,503Correspondent
      bank charges
    
    
    **91,251**
    
    
    90,461
    
    
    77,829Insurance
    
    
    **71,914**
    
    
    185,182
    
    
    118,670Dues
      and subscriptions
    
    
    **58,182**
    
    
    40,403
    
    
    45,594Checking
      account expense
    
    
    **44,924**
    
    
    41,311
    
    
    60,286Amortization
    
    
    **40,875**
    
    
    93,833
    
    
    75,624Other
    
    
    **906,154**
    
    
    535,624
    
    
    497,825Total
      other operating expenses
    
    **$**
    **4,999,746**
    
    $
    4,474,256
    
    $
    3,309,846








**Note
15 - Income Taxes**





Federal
and state income taxes receivable (payable) as of December 31, 2004 and 2003
included in other assets and other liabilities were as follows:





**2004**
    
    2003CurrentFederal
    
    **$**
    **73,358**
    
    $
    151,850State
    
    
    **59,763**
    
    
    (89,939
    )





The
components of the net deferred income tax asset included in other assets are as
follows:





**2004**
    
    2003Deferred
      tax asset:Federal
    
    **$**
    **1,216,681**
    
    $
    984,391State
    
    
    **110,632**
    
    
    87,399Total
      deferred income tax asset
    
    
    **1,327,313**
    
    
    1,071,790Deferred
      tax liability:Federal
    
    
    **(727,825**
    **)**
    
    (537,179
    )State
    
    
    **(65,210******
    ******)**
    
    (48,834
    )Total
      deferred income tax liability
    
    
    **(793,035******
    ******)**
    
    (586,013
    )Net
      deferred tax asset
    
    **$**
    **534,278**
    
    $
    485,777




57
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
15 - Income Taxes - Continued**





The tax
effects of each type of income and expense item that gave rise to deferred taxes
are:





**2004**
    
    2003Net
      unrealized gains on securities available-for-sale
    
    **$**
    **(194,722**
    **)**
    $
    (221,223
    )Depreciation
    
    
    **(595,580**
    **)**
    
    (364,790
    )Allowance
      for loan losses
    
    
    **1,223,341**
    
    
    975,477Deferred
      compensation
    
    
    **103,947**
    
    
    68,277Other
    
    
    **(2,708******
    ******)**
    
    28,036**$**
    **534,278**
    
    $
    485,777





The
components of income tax expense (benefit) for the years 2004, 2003 and 2002 are
as follows:





**2004**
    
    2003
    
    2002CurrentFederal
    
    **$**
    **1,717,676**
    
    $
    1,150,739
    
    $
    960,471State
    
    
    **189,656**
    
    
    122,576
    
    
    94,469DeferredFederal
    
    
    **(18,000**
    **)**
    
    (19,000
    )
    
    (45,000
    )State
    
    
    **(4,000******
    ******)**
    
    (1,000
    )
    
    (4,000
    )**$**
    **1,885,332**
    
    $
    1,253,315
    
    $
    1,005,940





Tax
effects of securities transactions resulted in an increase (decrease) in income
taxes for 2004, 2003 and 2002 of approximately $(7,695), $(5,773) and $97,079,
respectively.





The
principal reasons for the difference in the effective tax rate and the federal
statutory rate are as follows for the years ended December 31, 2004, 2003 and
2002.





**2004**
    
    2003
    
    2002Statutory
      federal income tax rate
    
    
    **34.0**
    ****%
    
    34.0
    %
    
    34.0
    %Effect
      on rate of:Tax-exempt
      securities
    
    
    **(3.7**
    **)**
    
    (5.4
    )
    
    (7.3
    )Tax-exempt
      loans
    
    
    **(0.2**
    **)**
    
    (1.0
    )
    
    (1.0
    )Interest
      expense disallowance
    
    
    **0.3**
    
    
    0.5
    
    
    0.9State
      income tax, net of federal tax
    
    
    **2.1**
    
    
    1.9
    
    
    1.6Other
    
    
    **(0.7******
    ******)**
    
    (1.1
    )
    
    (0.8
    )Effective
      income tax rate
    
    
    **31.8******
    ******%**
    
    28.9
    %
    
    27.4
    %




58
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
16 - Commitments and Contingencies**





In the
normal course of business, the Bank offers a variety of financial products to
its customers to aid them in meeting their requirements for liquidity, credit
enhancement, and interest rate protection. Generally accepted accounting
principles recognize these transactions as contingent liabilities and,
accordingly, they are not reflected in the Consolidated Financial Statements.
Commitments to extend credit, credit card arrangements, commercial letters of
credit, and standby letters of credit all include exposure to some credit loss
in the event of nonperformance of the customer. The Bank uses the same credit
policies and underwriting procedures for making off-balance sheet credit
commitments and financial guarantees as it does for on-balance sheet extensions
of credit. Because these instruments have fixed maturity dates, and because many
of them expire without being drawn upon, they do not generally present any
significant liquidity risk to the Bank. Management conducts regular reviews of
these instruments on an individual customer basis, and the results are
considered in assessing the adequacy of the Bank’s allowance for loan losses.
Management does not anticipate any material losses as a result of these
commitments.





Following
is a discussion of these commitments:





Standby
Letters of Credit : These
agreements are used by the Bank’s customers as a means of improving their credit
standings in their dealings with others. Under these agreements, the Bank agrees
to honor certain financial commitments in the event that its customers are
unable to do so. The amount of credit risk involved in issuing letters of credit
in the event of nonperformance by the other party is the contract amount. As of
December 31, 2004 and 2003, the Bank has issued standby letters of credit of
approximately $1,403,000 and $1,111,000. The Bank records the contract amount of
the letters of credit as an asset and records a corresponding liability in the
same amount until the letters of credit are exercised. Upon exercise, the amount
is recorded as a loan.





Loan
Commitments : As of
December 31, 2004 and 2003, the Bank had commitments outstanding to extend
credit totaling approximately $59,005,000 and $43,436,000, respectively. These
commitments generally require the customers to maintain certain credit
standards. Management does not anticipate any material losses as a result of
these commitments.





Litigation : The
Bank is party to litigation and claims arising in the normal course of business.
Management, after consultation with legal counsel, believes that the
liabilities, if any, arising from such litigation and claims are not material to
the consolidated financial statements.





Contract : On
November 10, 2004, the Company’s wholly owned subsidiary, Appalachian Community
Bank, entered into an agreement for construction of the Bank’s new operations
building in Ellijay, Georgia. The total cost of the construction of the building
is expected to be approximately $2,715,000. The building is expected to be
completed in December 2005.








**Note
17 - Concentrations of Credit**





All of
the Bank’s loans, commitments and standby letters of credit have been granted to
customers in the Bank’s market area. Substantially all such customers are
depositors of the Bank. The concentrations of credit by type of loan are set
forth in Note 6. The commitments to extend credit relate primarily to unused
real estate draw lines. Commercial and standby letters of credit were granted
primarily to commercial borrowers.





The Bank
maintains its cash accounts at various commercial banks in Georgia. The total
cash balances are insured by the FDIC up to $100,000. Total uninsured balances
held at other commercial banks amounted to $556,213 and $397,576 at December 31,
2004 and 2003, respectively.




59
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
18 - Stock Option Plans**





The
Company has adopted its 1997 Employee Stock Incentive Plan and its 1997
Directors’ Non-qualified Stock Option Plan and the 2003 Stock Option Plan under
which it has granted statutory and nonstatutory stock options to certain
directors and employees. The options granted provide for these directors and
employees to purchase shares of the Company’s $0.01 par value common stock at
the market value at the dates of grant. The options granted may be exercised
within ten years from the dates of grant subject to vesting requirements.





The
following sets forth certain information regarding stock options for the years
ended December 31, 2004, 2003 and 2002. Stock option shares and prices have been
adjusted to reflect the effects of the 10% stock dividend in 2003.





Fixed
Options





**2004**
    
    2003
    
    2002**Weighted**
    
    
    
    Weighted
    
    
    
    Weighted**Average**
    
    
    
    Average
    
    
    
    Average**Exercise**
    
    
    
    Exercise
    
    
    
    Exercise**Shares**
    
    **Price**
    
    Shares
    
    Price
    
    Shares
    
    PriceOutstanding
      at beginning of year
    
    
    **433,140**
    
    **$**
    **5.65**
    
    
    502,810
    
    $
    5.11
    
    
    702,790
    
    $
    4.71Granted
    
    
    **5,000**
    
    
    **15.00**
    
    
    18,000
    
    
    13.92
    
    
    —
    
    
    —Exercised
    
    
    **(72,340**
    **)**
    
    **3.68**
    
    
    (82,170
    )
    
    3.69
    
    
    (198,880
    )
    
    3.65Forfeited
    
    
    **(5,500******
    ******)**
    
    **12.73**
    
    
    (5,500
    )
    
    13.64
    
    
    (1,100
    )
    
    13.64Outstanding
      at end of year
    
    
    **360,300**
    
    
    **6.07**
    
    
    433,140
    
    
    5.65
    
    
    502,810
    
    
    5.11Exercisable
      at end of year
    
    
    **325,660**
    
    
    **5.29**
    
    
    362,780
    
    
    4.57
    
    
    417,230
    
    
    4.18Weighted
      average fair value of options granted
    
    **$**
    **3.79**
    
    
    
    
    $
    4.20
    
    
    
    
    $
    —








Information
pertaining to options outstanding at December 31, 2004 is as
follows:





Outstanding
    
    Expiration
    
    OptionsNumber
    
    Date
    
    Exercisable09/09/04
      Options with an Exercise Price of $15.00
    
    
    5,000
    
    
    09/09/14
    
    
    5,00010/07/03
      Options with an Exercise Price of $15.00
    
    
    2,500
    
    
    10/07/03
    
    
    50007/01/03
      Options with an Exercise Price of $15.00
    
    
    10,000
    
    
    07/01/13
    
    
    2,00001/16/03
      Options with an Exercise Price of $12.73
    
    
    5,500
    
    
    01/16/13
    
    
    1,10007/10/01
      Options with an Exercise Price of $12.73
    
    
    49,500
    
    
    07/10/11
    
    
    29,70006/30/00
      Options with an Exercise Price of $13.64
    
    
    2,200
    
    
    06/30/10
    
    
    1,76006/22/99
      Options with an Exercise Price of $5.45
    
    
    85,660
    
    
    06/22/09
    
    
    85,66006/01/97
      Options with an Exercise Price of $3.64
    
    
    199,940
    
    
    06/01/07
    
    
    199,940Total
      Options Issued
    
    
    360,300
    
    
    
    
    
    325,660





The
Company’s options outstanding have a weighted average contractual life of 3.89
years.




60
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
19 - Regulatory Matters**





The
Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly additional
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Company and the Bank and the consolidated financial
statements. Under capital adequacy guidelines and the regulatory framework from
prompt corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Bank’s capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors.





Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios (set forth in the
table below) of total and Tier 1 Capital (as defined in the regulations) to risk
weighted assets (as defined), and of Tier 1 Capital (as defined) to average
assets (as defined). Management believes, as of December 31, 2004, that the
Company and the Bank met all capital adequacy requirements to which they are
subject.





As of
December 31, 2004, the most recent notification from the applicable regulatory
agencies categorized the Bank as well capitalized under the regulatory framework
for prompt corrective action. To become well capitalized the Company the Bank
must maintain minimum Total Capital, Tier 1 Capital and Tier 1 Leverage ratios
as set forth in the table below.





The
Company’s and Bank’s actual capital amounts and ratios are also presented in the
table.





To
      Be Well CapitalizedUnder
      PromptFor
      Capital
    
    Corrective
      ActionActual
    
    Adequacy
      Purposes
    
    ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    Ratio(Dollars
      in thousands)**As
      of December 31, 2004:****Total
      Capital****Consolidated**
    
    **$**
    **44,062**
    
    
    **11.45**
    **%**
    **$**
    **30,788**
    
    
    **8.00**
    **%**
    
    **N/A**
    
    
    **N/A****Appalachian
      Community Bank**
    
    
    **41,586**
    
    
    **10.82**
    
    
    **30,752**
    
    
    **8.00**
    
    **$**
    **38,440**
    
    
    **10.00**
    **%****Tier
      1 Capital****Consolidated**
    
    
    **39,713**
    
    
    **10.32**
    
    
    **15,394**
    
    
    **4.00**
    
    
    **N/A**
    
    
    **N/A****Appalachian
      Community Bank**
    
    
    **37,237**
    
    
    **9.69**
    
    
    **15,376**
    
    
    **4.00**
    
    
    **23,064**
    
    
    **6.00****Tier
      1 Leverage****Consolidated**
    
    
    **39,713**
    
    
    **8.53**
    
    
    **18,618**
    
    
    **4.00**
    
    
    **N/A**
    
    
    **N/A****Appalachian
      Community Bank**
    
    
    **37,237**
    
    
    **8.01**
    
    
    **18,597**
    
    
    **4.00**
    
    
    **23,246**
    
    
    **5.00**As
      of December 31, 2003:Total
      CapitalConsolidated
    
    $
    38,291
    
    
    11.55
    %
    $
    26,531
    
    
    8.00
    %
    
    N/A
    
    
    N/AAppalachian
      Community Bank
    
    
    36,130
    
    
    10.91
    
    
    26,491
    
    
    8.00
    
    $
    33,114
    
    
    10.00
    %Tier
      1 CapitalConsolidated
    
    
    34,681
    
    
    10.46
    
    
    13,266
    
    
    4.00
    
    
    N/A
    
    
    N/AAppalachian
      Community Bank
    
    
    32,520
    
    
    9.82
    
    
    13,246
    
    
    4.00
    
    
    19,869
    
    
    6.00Tier
      1 LeverageConsolidated
    
    
    34,681
    
    
    8.58
    
    
    16,167
    
    
    4.00
    
    
    N/A
    
    
    N/AAppalachian
      Community Bank
    
    
    32,520
    
    
    8.30
    
    
    15,663
    
    
    4.00
    
    
    19,579
    
    
    5.00




61
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
20 - Employee Benefit Plan**





The
Company adopted a defined contribution plan covering substantially all
employees; that is qualified under Section 401(k) of the Internal Revenue Code.
Under the provisions of the plan, eligible participating employees may elect to
contribute up to the maximum amount of tax deferred contribution allowed by the
Internal Revenue Code. Employer and employee contributions may be made in the
form of cash or Company stock. The Company’s contribution to the plan is
determined by its board of directors. The Company made discretionary cash
contributions to the plan of approximately $313,200 in 2004, $300,238 in 2003
and $215,353 in 2002.





The
Company also has a non-qualified deferred compensation plan covering certain
employees and directors. Certain directors have a non-qualified director fee
deferral plan.





The
following table summarizes the benefit obligation, and expense of the
plans:





**2004**
    
    2003
    
    2002Change
      in Benefit Obligation:Benefit
      obligation at beginning of year
    
    **$**
    **191,088**
    
    $
    157,757
    
    $
    145,392Service
      cost
    
    
    **62,155**
    
    
    —
    
    
    —Interest
      cost
    
    
    **13,898**
    
    
    11,731
    
    
    11,173Participant
      contributions
    
    
    **21,600**
    
    
    21,600
    
    
    21,600Benefits
      paid
    
    
    **—**
    
    
    —
    
    
    (20,408
    )Benefit
      obligation at end of year
    
    **$**
    **288,741**
    
    $
    191,088
    
    $
    157,757





The
Company also has purchased single premium life insurance policies on certain
directors and employees of the bank. The Company is the owner of the policies
and the related cash surrender values thereon. The difference in the face value
and the cash surrender value of the policies is payable to the employees’
designated beneficiary. Policies with an aggregate cost of $5,000,000 were
purchased in 2004. There were no policies purchased in 2003. The cash surrender
values recorded as an asset of the Bank at December 31, 2004 and 2003 amounted
to $7,833,450 and $2,592,416, respectively.








**Note
21 - Leases**





The
Company has a number of operating lease agreements, involving land, buildings
and equipment. These leases are noncancellable and expire on various dates
through the year 2028. The leases provide for renewal options and generally
require the Company to pay maintenance, insurance and property taxes. For the
years ended December 31, 2004, 2003 and 2002, rental expense for operating
leases was approximately $90,248, $81,500 and $68,412, respectively.





Future
minimum lease payments under noncancellable operating leases at December 31,
2004, are as follows:





Years
      Ending December 31,2005
    
    
    $
    47,6852006
    
    
    
    36,3852007
    
    
    
    35,9982008
    
    
    
    35,0742009
    
    
    
    35,763Thereafter
    
    
    
    819,263Total
      minimum lease payments
    
    $
    1,010,168




62
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
22 - Related Party Transactions**





Loans : Certain
directors, executive officers and principal shareholders, including their
immediate families and associates were loan customers of the Bank during 2004
and 2003. Such loans are made in the ordinary course of business at normal
credit terms, including interest rates and collateral and do not represent more
than a normal risk of collection. A summary of activity and amounts outstanding
are as follows:





**2004**
    
    2003Balance
      at Beginning of Year
    
    **$**
    **7,988,488**
    
    $
    7,821,358New
      loans
    
    
    **11,237,794**
    
    
    1,273,989Repayments
    
    
    **(5,754,205**
    **)**
    
    (238,937
    )Participations
      sold
    
    
    **(2,234,343**
    **)**
    
    (1,011,183
    )Change
      in related parties
    
    
    **—**
    
    
    143,261Balance
      at End of Year
    
    **$**
    **11,237,734**
    
    $
    7,988,488





Deposits :
Deposits held from related parties were $3,117,444 and $2,224,390 at December
31, 2004 and 2003, respectively.





Lease : The
Bank leases a facility from a partnership which includes directors of the Bank.
The lease commenced in May 2001 and had an initial term of 24 months. The Bank
exercised its option to renew this lease during 2003 for a period of one year
for an annual expense of $33,000. The lease expired in May 2004. The Bank
continues to lease this property on a month-to-month basis. The Bank is
currently subleasing this property to an unrelated party.





Construction
contracts : During
2004, the Bank used as a construction contractor, a company owned by one of the
directors of the Company. Amounts paid to this construction contractor in 2004
amounted to $309,791. Also in 2004, the Bank committed to projects with this
construction contractor for approximately $431,000, to be paid in
2005.








**Note
23 - Litigation**





While the
Company and its subsidiaries are party to various legal proceedings arising from
the ordinary course of business, management believes after consultation with
legal counsel that there are no proceedings threatened or pending against the
Company that will, individually or in the aggregate, have a material adverse
effect on the business or financial condition of the Company.








**Note
24 - Fair Value of Financial Instruments**





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 Short-term Investments : For
those short-term instruments, the carrying amount is a reasonable estimate of
fair value.





Securities : For
securities and marketable equity securities held for investment purposes, fair
values are based on quoted market prices or dealer quotes. For other securities
held as investments, fair value equals quoted market price, if available. If a
quoted market price is not available, fair value is estimated using quoted
market prices for similar securities.




63
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
24 - Fair Value of Financial Instruments - Continued**





Loans : For
certain homogeneous categories of loans, such as some residential mortgages,
credit card receivables, and other consumer loans, 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.





Accrued
Interest Receivable : The
carrying amount of accrued interest receivable approximates its fair
value.





Deposits : The
fair value of demand deposits, savings accounts, and certain money market
deposits is the amount payable on demand at the reporting date. The fair value
of fixed-maturity certificates of deposit is estimated using the rates currently
offered for deposit of similar remaining maturities.





Accrued
Interest Payable : The
carrying amount of accrued interest payable approximates its fair
value.





Short-term
Borrowings : The
fair value of short-term borrowings, including securities sold under agreements
to repurchase, is estimated to be approximately the same as the carrying
amount.





Long-term
Debt : Rates
currently available to the Company for debt with similar terms and remaining
maturities are used to estimate fair value of existing debt.





Commitments
to Extend Credit, Letters of Credit, and Financial Guarantees
Written : The
fair value of commitments and letters of credit is estimated to be approximately
the fees charged for these arrangements.





The
estimated fair values of the Company’s financial instruments as of December 31,
2004 and 2003 are as follows:




**2004**
    
    2003**Carrying**
    
    **Fair**
    
    Carrying
    
    Fair**Amount**
    
    **Value**
    
    Amount
    
    Value(In
      thousands)**Financial
      Assets**Cash
      and short-term investments
    
    **$**
    **7,513**
    
    **$**
    **7,513**
    
    $
    7,391
    
    $
    7,391Securities
    
    
    **64,655**
    
    
    **64,655**
    
    
    55,363
    
    
    55,363Loans
    
    
    **377,352**
    
    
    **377,116**
    
    
    332,306
    
    
    332,859Accrued
      interest receivable
    
    
    **2,902**
    
    
    **2,902**
    
    
    2,290
    
    
    2,290**Total
      Financial Assets**
    
    **$**
    **452,422**
    
    **$**
    **452,186**
    
    $
    397,350
    
    $
    397,903**Financial
      Liabilities**Deposits
    
    **$**
    **381,498**
    
    **$**
    **367,583**
    
    $
    332,919
    
    $
    324,654Short-term
      borrowings
    
    
    **15,470**
    
    
    **15,470**
    
    
    12,086
    
    
    12,086Accrued
      interest payable
    
    
    **540**
    
    
    **540**
    
    
    671
    
    
    671Long-term
      debt
    
    
    **38,136**
    
    
    **38,048**
    
    
    31,879
    
    
    34,022**Total
      Financial Liabilities**
    
    **$**
    **435,644**
    
    **$**
    **421,641**
    
    $
    377,555
    
    $
    371,433**Unrecognized
      financial instruments**Commitments
      to extend credit
    
    **$**
    **59,005**
    
    **$**
    **236**
    
    $
    43,436
    
    $
    326Standby
      letters of credit
    
    
    **1,403**
    
    
    **6**
    
    
    1,111
    
    
    8**Total
      Unrecognized Financial****Instruments**
    
    **$**
    **60,408**
    
    **$**
    **242**
    
    $
    44,547
    
    $
    334




64
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**
 ****
 **Note
25 - Condensed Parent Information**





**Statements
of Financial Condition**





**December
      31,****2004**
    
    2003**Assets**Cash
      and due from banks
    
    **$**
    **2,150,693**
    
    $
    1,146,218Investment
      in subsidiaries (equity method) eliminated upon
    consolidation
    
    
    **39,607,384**
    
    
    34,948,116Securities
      available-for-sale
    
    
    **186,000**
    
    
    186,000Other
      assets
    
    
    **498,721**
    
    
    1,127,252**Total
      Assets**
    
    **$**
    **42,442,798**
    
    $
    37,407,586**Liabilities
      and Shareholders’ Equity**Subordinated
      long-term capital notes
    
    **$**
    **6,186,000**
    
    $
    6,186,000Other
      liabilities
    
    
    **173,476**
    
    
    139,233**Total
      Liabilities**
    
    
    **6,359,476**
    
    
    6,325,233**Total
      Shareholders’ Equity**
    
    
    **36,083,322**
    
    
    31,082,353**Total
      Liabilities and Shareholders’ Equity**
    
    **$**
    **42,442,798**
    
    $
    37,407,586








**Statements
of Income**





**Years
      ended December 31,****2004**
    
    2003
    
    2002**Income**Interest
    
    **$**
    ****—
    
    $
    —
    
    $
    —Dividends
      from subsidiaries-
      eliminated uponconsolidation
    
    
    —
    
    
    —
    
    
    —Other
      income
    
    
    **9,638**
    
    
    —
    
    
    —**9,638**
    
    
    —
    
    
    —**Expenses**Interest
    
    
    **283,600**
    
    
    201,454
    
    
    205,218Other
      expenses
    
    
    **755,571**
    
    
    729,245
    
    
    496,725**1,039,171**
    
    
    930,699
    
    
    701,943Loss
      before income taxes and equity in undistributed earnings of
      subsidiaries
    
    
    **(1,029,533**
    **)**
    
    (930,699
    )
    
    (701,943
    )Income
      tax benefits
    
    
    **365,835**
    
    
    378,685
    
    
    257,277Loss
      before equity in undistributed earnings of subsidiaries
    
    
    **(663,698**
    **)**
    
    (552,014
    )
    
    (444,666
    )Equity
      in undistributed earnings of subsidiaries
    
    
    **4,710,712**
    
    
    3,638,594
    
    
    3,112,674**Net
      Income**
    
    **$******
    ******4,047,014**
    
    $
    3,086,580
    
    $
    2,668,008




65
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
25 - Condensed Parent Information - Continued**





**Statements
of Cash Flow**





**Years
      ended December 31,****2004**
    
    2003
    
    2002**Operating
      Activities**Net
      Income
    
    **$**
    **4,047,014**
    
    $
    3,086,580
    
    $
    2,668,008Adjustments
      to reconcile net income to net cash provided by operating
      activities:Equity
      in undistributed income of subsidiaries
    
    
    **(4,710,712**
    **)**
    
    (3,638,594
    )
    
    (3,112,674
    )Increase
      (decrease) in accrued interest payable
    
    
    **(36,938**
    **)**
    
    85,200
    
    
    —Other
    
    
    **892,869**
    
    
    (483,620
    )
    
    (272,079
    )**Net
      Cash Provided by (Used In)****Operating
      Activities**
    
    
    **192,233**
    
    
    (950,434
    )
    
    (716,745
    )**Investing
      Activities**Investment
      in preferred securities trust
    
    
    **—**
    
    
    (186,000
    )
    
    —Capital
      injection in subsidiaries
    
    
    **—**
    
    
    (1,500,000
    )
    
    (1,150,000
    )**Net
      Cash Used In Investing Activities**
    
    
    **—**
    
    
    (1,686,000
    )
    
    (1,150,000
    )**Financing
      Activities**Proceeds
      from issuance of subordinated long-term capital notes
    
    
    **—**
    
    
    6,186,000
    
    
    —Repayment
      of long-term debt
    
    
    **—**
    
    
    (4,600,000
    )
    
    —Proceeds
      from issuance of common stock
    
    
    **769,941**
    
    
    302,800
    
    
    889,260Purchases
      of treasury stock
    
    
    **—**
    
    
    (54,900
    )
    
    —Compensation
      associated with issuance of options
    
    
    **42,301**
    
    
    21,739
    
    
    —Proceeds
      from issuance of treasury stock
    
    
    **—**
    
    
    1,923,601
    
    
    —Cash
      paid in lieu of fractional shares on stock dividend
    
    
    **—**
    
    
    (1,931
    )
    
    786,705**Net
      Cash Provided By Financing Activities**
    
    
    **812,242**
    
    
    3,777,309
    
    
    1,675,965**Net
      Increase (Decrease) in Cash and Cash Equivalents**
    
    
    **1,004,475**
    
    
    1,140,875
    
    
    (190,780
    )**Cash
      and Cash Equivalents at Beginning of Year**
    
    
    **1,146,218**
    
    
    5,343
    
    
    196,123**Cash
      and Cash Equivalents at End of Year**
    
    **$**
    **2,150,693**
    
    $
    1,146,218
    
    $
    5,343Cash
      paid during the year for:
      Interest
    
    **$**
    **320,538**
    
    $
    116,254
    
    $
    205,218











[The
remainder of this page intentionally left blank]




66
 Table of Contents


****
 **APPALACHIAN
BANCSHARES, INC. AND SUBSIDIARIES**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **December
31, 2004, 2003 and 2002**


**Note
26 - Quarterly Results of Operations (Unaudited)**





Selected
quarterly results of operations for the four quarters of each of the years ended
December 31, 2004, 2003 and 2002 are as follows:





First
    
    Second
    
    Third
    
    FourthQuarter
    
    Quarter
    
    Quarter
    
    Quarter
    
    Total(In
      thousands except per share data)**2004:****Total
      interest income**
    
    **$**
    **6,026**
    
    **$**
    **6,260**
    
    **$**
    **6,536**
    
    **$**
    **6,914**
    
    **$**
    **25,736****Total
      interest expense**
    
    
    **1,739**
    
    
    **1,793**
    
    
    **1,927**
    
    
    **2,099**
    
    
    **7,558****Provision
      for loan losses**
    
    
    **360**
    
    
    **291**
    
    
    **274**
    
    
    **310**
    
    
    **1,235****Net
      interest income after provision for loan losses**
    
    
    **3,927**
    
    
    **4,176**
    
    
    **4,335**
    
    
    **4,505**
    
    
    **16,943****Securities
      gains (losses)**
    
    
    **—**
    
    
    **(23**
    **)**
    
    **—**
    
    
    **—**
    
    
    **(23**
    **)****Total
      noninterest income**
    
    
    **675**
    
    
    **706**
    
    
    **726**
    
    
    **745**
    
    
    **2,852****Total
      noninterest expense**
    
    
    **3,279**
    
    
    **3,437**
    
    
    **3,508**
    
    
    **3,616**
    
    
    **13,840****Income
      tax expense**
    
    
    **427**
    
    
    **442**
    
    
    **485**
    
    
    **531**
    
    
    **1,885****Net
      income**
    
    
    **896**
    
    
    **980**
    
    
    **1,068**
    
    
    **1,103**
    
    
    **4,047****Per
      Common Share:****Basic
      earnings**
    
    
    **0.24**
    
    
    **0.26**
    
    
    **0.29**
    
    
    **0.30**
    
    
    **1.09****Diluted
      earnings**
    
    
    **0.23**
    
    
    **0.25**
    
    
    **0.27**
    
    
    **0.29**
    
    
    **1.04**2003:Total
      interest income
    
    $
    5,727
    
    $
    5,764
    
    $
    5,727
    
    $
    5,872
    
    $
    23,090Total
      interest expense
    
    
    2,416
    
    
    2,234
    
    
    1,897
    
    
    1,710
    
    
    8,257Provision
      for loan losses
    
    
    360
    
    
    360
    
    
    385
    
    
    360
    
    
    1,465Net
      interest income after provision for loan losses
    
    
    2,951
    
    
    3,170
    
    
    3,445
    
    
    3,802
    
    
    13,368Securities
      gains (losses)
    
    
    (17
    )
    
    —
    
    
    —
    
    
    —
    
    
    (17
    )Total
      noninterest income
    
    
    639
    
    
    733
    
    
    723
    
    
    625
    
    
    2,720Total
      noninterest expense
    
    
    2,690
    
    
    2,966
    
    
    3,006
    
    
    3,069
    
    
    11,731Income
      tax expense
    
    
    256
    
    
    291
    
    
    365
    
    
    341
    
    
    1,253Net
      income
    
    
    627
    
    
    646
    
    
    797
    
    
    1,017
    
    
    3,087Per
      Common Share:Basic
      earnings
    
    
    0.18
    
    
    0.18
    
    
    0.22
    
    
    0.28
    
    
    0.86Diluted
      earnings
    
    
    0.17
    
    
    0.17
    
    
    0.21
    
    
    0.26
    
    
    0.812002:Total
      interest income
    
    $
    5,455
    
    $
    5,614
    
    $
    5,883
    
    $
    5,940
    
    $
    22,892Total
      interest expense
    
    
    2,890
    
    
    2,825
    
    
    2,827
    
    
    2,883
    
    
    11,425Provision
      for loan losses
    
    
    146
    
    
    216
    
    
    306
    
    
    360
    
    
    1,028Net
      interest income after provision for loan losses
    
    
    2,419
    
    
    2,573
    
    
    2,750
    
    
    2,697
    
    
    10,439Securities
      gains (losses)
    
    
    20
    
    
    7
    
    
    1
    
    
    258
    
    
    286Total
      noninterest income
    
    
    602
    
    
    721
    
    
    881
    
    
    447
    
    
    2,651Total
      noninterest expense
    
    
    2,095
    
    
    2,594
    
    
    2,605
    
    
    2,408
    
    
    9,702Income
      tax expense
    
    
    295
    
    
    245
    
    
    351
    
    
    115
    
    
    1,006Net
      income
    
    
    651
    
    
    462
    
    
    676
    
    
    879
    
    
    2,668Per
      Common Share:Basic
      earnings
    
    
    0.20
    
    
    0.14
    
    
    0.21
    
    
    0.26
    
    
    0.81Diluted
      earnings
    
    
    0.18
    
    
    0.13
    
    
    0.19
    
    
    0.26
    
    
    0.76




67
 Table of Contents





**ITEM
      9.**
    **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
      ACCOUNTING AND FINANCIAL
DISCLOSURE**





None.








**ITEM
      9A.**
    **CONTROLS AND
PROCEDURES**





The
Company’s Chief Executive Officer and Chief Financial Officer have evaluated the
Company’s disclosure controls and procedures as of the end of the fiscal year
covered by this Report on Form 10-K and have concluded that the Company’s
disclosure controls and procedures are effective. During the fourth quarter of
2004, there were no changes in the Company’s internal control over financial
reporting that have materially affected, or that are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.





**ITEM
      9B.**
    **OTHER INFORMATION**





Not
applicable.





**PART
III**





**ITEM
      10.**
    **DIRECTORSAND EXECUTIVE OFFICERS OF THE
      REGISTRANT**





The
information appearing under the headings “Election of Directors,” “Executive
Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and
“Corporate Governance and Board Matters” in the Proxy Statement (the “2005 Proxy
Statement”) relating to the Company’s 2005 annual meeting of shareholders is
incorporated herein by reference. The Company has adopted a code of ethics that
applies to the Company’s chief executive officer and senior financial officers,
a copy of which is filed as Exhibit 14 to the Company’s Annual Report on Form
10-K for the fiscal year ended December 31, 2003.








**ITEM
      11.**
    **EXECUTIVE
COMPENSATION**





The
information appearing under the heading “Compensation of Executive Officers and
Directors” in the 2005 Proxy Statement is incorporated herein by
reference.








**ITEM
      12.**
    **SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT**





The
information appearing under the heading “Ownership of Common Stock” in the 2005
Proxy Statement is incorporated herein by reference.








**ITEM
      13.**
    **CERTAIN RELATIONSHIPS AND RELATED
      TRANSACTIONS**





The
information appearing under the caption “Related Party Transactions” in the 2005
Proxy Statement is incorporated herein by reference.








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





The
information appearing under the caption “Independent Public Accountants” in the
2005 Proxy Statement is incorporated herein by reference.




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**PART
IV**





**ITEM
      15.**
    **EXHIBITS AND FINANCIAL STATEMENT
      SCHEDULES**





(a)
    1.
    Financial
      Statements.The
      following consolidated financial statements are located in Item 8 of this
      Report:Report
      of Independent Registered Public Accounting FirmConsolidated
      Statements of Financial Condition as of December 31, 2004 and
      2003Consolidated
      Statements of Income for the Years Ended December 31, 2004, 2003 and
      2002Consolidated
      Statements of Shareholders’ Equity for the Years Ended December 31, 2004,
      2003 and 2002Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and
      2002Notes
      to Consolidated Financial StatementsQuarterly
      Results (Unaudited)2.
    Financial
      Statement Schedules.Schedules
      to the consolidated financial statements are omitted, as the required
      information is not applicable.3.
    Exhibits.The
      following exhibits are filed or incorporated by reference as part of this
      Report:





**Exhibit
      Number**
    
    **Description
      of Exhibit**3.1
    
    Articles
      of Incorporation of the Company, as Restated (included as Exhibit 3.1 to
      the Company’s Quarterly Report on Form 10-Q, dated August 15, 2003 and
      incorporated herein by reference). (With regard to applicable cross
      references in this Annual Report on Form 10-K, the Company’s Current,
      Quarterly, and Annual Reports, unless otherwise noted, are filed with the
      Commission under File No. 001-15571 and incorporated herein by
      reference).3.2
    
    Bylaws
      of the Company, as Restated (included as Exhibit 3.2 to the Company’s
      Quarterly Report on Form 10-Q, dated August 15, 2003, previously filed
      with the Commission and incorporated herein by
  reference).10.1
    
    1997
      Directors’ Non-Qualified Stock Option Plan (included as Exhibit 10.1 to
      the Company’s Annual Report on Form 10-KSB for the fiscal year ended
      December 31, 1996 (File No. 000-21383) and incorporated herein by
      reference).*10.2
    
    1997
      Employee Incentive Stock Incentive Plan (included as Exhibit 10.2 to the
      Company’s Annual Report on Form 10-KSB for the fiscal year ended December
      31, 1996 (File No. 000-21383) and incorporated herein by
      reference).*10.3
    
    Adoption
      Agreement for the Appalachian Bancshares, Inc. Employees’ Savings &
      Profit Sharing Plan (the “Plan”) (filed as Exhibit 10.1 to the Plan’s
      Annual Report on Form 11-K for the fiscal year ended December 31, 2001 and
      incorporated herein by reference).




69
 Table of Contents








**Exhibit
      Number**
    
    **Description
      of Exhibit**10.4
    
    Pentegra
      Services, Inc. Employees’ Savings & Profit Sharing Plan Basic Plan
      Document, and the following related documents: Trust Agreement by and
      between Appalachian Bancshares, Inc. and the Bank of New York; Custody
      Agreement by and between Tracy R. Newton, Kent W. Sanford and Joseph
      Hensley, as Trustee on behalf of the Appalachian Bancshares, Inc.
      Employees' Savings & Profit Sharing Plan, and the Bank of New York
      (with Letter Notification to the Bank of New York providing an updated
      list of members of the Administrative Committee); and the Internal Revenue
      Service Favorable Approval Letter of the Pentegra Services, Inc. Prototype
      Non-Standardized Profit Sharing Plan (filed as Exhibit 10.2 to the Plan’s
      Annual Report on Form 11-K for the fiscal year ended December 31, 2001 and
      incorporated herein by reference).10.5
    
    Form
      of Deferred Fee Agreement between Gilmer County Bank and certain directors
      and executive officers, with addendum (filed as Exhibit 10.6 to the
      Company’s Quarterly Report on Form 10-QSB for the period ended June 30,
      1997 (File No. 000-21383) and incorporated herein by
      reference).10.6
    
    Loan
      and Stock Pledge Agreement, dated as of April 3, 2002, between the Company
      and Crescent Bank and Trust Company (filed as Exhibit 10.1 to the
      Company’s Quarterly Report on Form 10-Q for the period ended September 30,
      2002 and incorporated herein by reference).10.7
    
    Promissory
      Note, dated April 3, 2002, issued by the Company to Crescent Bank and
      Trust Company (filed as Exhibit 10.2 to the Company’s Quarterly Report on
      Form 10-Q for the period ended September 30, 2002 and incorporated herein
      by reference).10.8
    
    Form
      of Data Processing Agreement by and between Appalachian Community Bank and
      Fiserv Solutions, Inc., effective as of July 26, 2002 (filed as Exhibit
      10.3 to the Company’s Quarterly Report on Form 10-Q for the period ended
      September 30, 2002 and incorporated herein by reference).10.9
    
    2003
      Stock Option Plan (included as Exhibit 10.1 to the Company’s Quarterly
      Report on Form 10-Q for the period ended June 30, 2003 and incorporated
      herein by reference).*10.10
    
    Form
      of Stock Option Agreement (included as Exhibit 10.2 to the Company's
      Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 and
      incorporated herein by reference).*10.11
    
    Form
      of Change in Control Agreement for Named Executive Officers (and
      description of benefits for each Named Executive Officer) (included as
      Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2004 and incorporated herein by
      reference).*




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 Table of Contents




**Exhibit
      Number**
    
    **Description
      of Exhibit**10.12
    
    Form
      of Salary Continuation Agreement for Named Executive Officers (and
      description of benefits for each Named Executive Officer) (included as
      Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2004 and incorporated herein by
      reference).*10.13
    
    Form
      of Salary Continuation Agreement for the Directors of Appalachian
      Community Bank (and description of benefits for each of the Directors)
      (included as Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q
      for the quarter ended June 30, 2004 and incorporated herein by
      reference).*11
    
    Statement
      re: Computation of Per Share Earnings12
    
    Statement
      re: Computation of Ratios14
    
    Code
      of Ethics for CEO and Senior Financial Officers (included as Exhibit 14 to
      the Company’s Annual Report on Form 10-K for the fiscal year ended
      December 31, 2003 and incorporated herein by
reference).21
    
    Subsidiaries
      of the Registrant23
    
    Consent
      of Schauer, Taylor, Cox, Vise & Morgan, P.C.31.1
    
    Certification
      of President and Chief Executive Officer Pursuant to Section 302 of
      Sarbanes-Oxley Act of 2002.31.2
    
    Certification
      of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
      of 2002.32
    
    Certifications
      Pursuant to Section 906 of Sarbanes-Oxley Act of
2002.





* The
referenced exhibit is a compensatory contract, plan or arrangement.




71
 Table of Contents





**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 its behalf by
the undersigned, thereunto duly authorized, on the 29th day of March,
2005.








APPALACHIAN
      BANCSHARES, INC.By:/s/ Tracy R. NewtonTracy
      R. NewtonPresident
      and Chief Executive OfficerBy:/s/
      Darren M. CantlayDarren
      M. CantlayChief
      Financial Officer








In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.





/s/
      Tracy R. Newton
    
    Date:
      March 29, 2005Tracy
      R. Newton, President, ChiefExecutive
      Officer and Director/s/
      Alan S. Dover
    
    Date:
      March 29, 2005Alan
      S. Dover, Director/s/
      Charles A. Edmondson
    
    Date:
      March 29, 2005Charles
      A. Edmondson, Director/s/
      Roger E. Futch
    
    Date:
      March 29, 2005Roger
      E. Futch, Director/s/
      Joseph C. Hensley
    
    Date:
      March 29, 2005Joseph
      C. Hensley, Director/s/
      Frank E. Jones
    
    Date:
      March 29, 2005Frank
      E. Jones, Director/s/
      J. Ronald Knight
    
    Date:
      March 29, 2005J.
      Ronald Knight, Director/s/
      P. Joe Sisson
    
    Date:
      March 29, 2005P.
      Joe Sisson, Director/s/
      Kenneth D. Warren
    
    Date:
      March 29, 2005Kenneth
      D. Warren, Director




72
 Table of Contents





**EXHIBIT
INDEX**





The
following exhibits are filed as part of this report (in addition to those
exhibits listed in Item 15 which are filed as a part of this report and
incorporated by reference):








**Exhibit
      Number**
    
    **Description
      of Exhibit**11
    
    Statement
      re: Computation of Per Share Earnings12
    
    Statement
      re: Computation of Ratios21
    
    Subsidiaries
      of the Registrant23
    
    Consent
      of Schauer, Taylor, Cox, Vise & Morgan, P.C.31.1
    
    Certification
      of President and Chief Executive Officer Pursuant to Section 302 of
      Sarbanes-Oxley Act of 2002.31.2
    
    Certification
      of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
      of 2002.32
    
    Certifications
      Pursuant to Section 906 of Sarbanes-Oxley Act of
2002.






73