<PAGE>   1

                                   FORM 10-KSB

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

[X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
         EXCHANGE ACT OF 1934

                   For the fiscal year ended December 31, 1998
                                       OR

[ ]      TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
         ACT OF 1934

                        Commission file number 000-24675

                       STATE OF FRANKLIN BANCSHARES, INC.
                 (Name of small business issuer in its charter)


          TENNESSEE                                  62-1607709
(State or other jurisdiction of                   (I.R.S. Employer 
 incorporation or organization)                   Identification No.)

                             1907 NORTH ROAN STREET
                          JOHNSON CITY, TENNESSEE 37604
              (Address of principal executive offices and Zip Code)

                    Issuer's telephone number (423) 926-3300

Securities registered under Section 12(b) of the Exchange Act:  NONE
Securities registered under Section 12(g) of the Exchange Act: COMMON STOCK

         Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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
                                                                      ---  ---
         Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB
or any amendment to this Form 10-KSB. [X]

         THE REGISTRANT'S REVENUES FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1998
WERE $7,987,923.

         THE AGGREGATE MARKET VALUE OF THE SHARES OF COMMON STOCK HELD BY
NONAFFILIATES OF THE REGISTRANT AS OF MARCH 15, 1999 IS APPROXIMATELY
$8.7 MILLION. (For purposes of this calculation only, all executive officers and
directors are classified as affiliates.)

Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date. OUTSTANDING AT MARCH 15, 1999,
COMMON STOCK, $1.00 PAR VALUE, 1,190,363.

                    Documents Incorporated by Reference: NONE



<PAGE>   2



                                     PART I

ITEM 1. DESCRIPTION OF BUSINESS

THE COMPANY

         State of Franklin Bancshares, Inc. (the "Company") is a registered bank
holding company organized under the laws of Tennessee. Effective May 15, 1998,
the Company exchanged its shares of common stock with holders of the shares of
common stock of State of Franklin Savings Bank (the "Savings Bank"). As a
result, the Savings Bank became the wholly owned subsidiary of the Company. The
Company, with consolidated total assets of approximately $118 million at
December 31, 1998, is headquartered in Johnson City, Tennessee and conducts its
operations through its subsidiary, the Savings Bank. The Company believes it can
present an alternative to recent mergers of large financial institutions by
offering local ownership, local decision making and other personalized service
characteristics of local, community-based financial institutions. State of
Franklin Leasing Corporation is a wholly owned subsidiary of the Company
conducting the business of lease financing. The holding company structure
provides flexibility for expansion of the Company's banking business through
acquisition of other financial institutions and provision of additional
banking-related services which the traditional commercial bank may not provide
under present laws.

THE SAVINGS BANK

         The Savings Bank was incorporated under the laws of the State of
Tennessee and commenced business on February 26, 1996, as a Tennessee-chartered
savings bank whose deposits are insured by the Federal Deposit Insurance
Corporation's ("FDIC") Bank Insurance Fund ("BIF"). The Savings Bank is
regulated by the Tennessee Department of Financial Institutions (the
"Department") and the FDIC. The Savings Bank operates a main office and two
branches in Johnson City, Washington County, Tennessee, and one branch in
Kingsport, Sullivan County, Tennessee. The Savings Bank owns John Sevier Title
Services Inc., a Tennessee-chartered and regulated title insurance company.

SERVICES

         The Company provides a wide range of personal and corporate banking
services. Its principal business is to accept demand and savings deposits from
the general public and to invest such funds in residential mortgage loans and,
to a lesser extent, in commercial and consumer loans in the Company's market
area. The Company seeks savings deposits and transaction accounts from
households and businesses by offering a full range of savings accounts,
retirement and professional accounts, checking accounts and time certificates.
The Company offers 24-hour automated teller machines and other financial
services.

MARKETS

                  The Company competes with other commercial banks, savings and
loan associations, credit unions and finance companies operating in Washington
and Sullivan counties and elsewhere in the Tri-Cities region. The Company is
subject to substantial competition in all aspects of its business. Intense
competition for loans and deposits comes from other financial institutions in
the market area. In certain aspects of its business, the Company also competes
with credit unions, small loan companies, insurance companies, mortgage
companies, finance companies, brokerage houses and other financial institutions,
some of which are not subject to the same degree of regulation and restriction
as the Company and some of which have financial resources greater than those of
the Company. The future success of the Company will depend primarily upon the
difference between the cost of its borrowing (primarily interest paid on
deposits) and income from operations (primarily interest or fees earned on
loans, sales of loans and investments). The Company competes for funds with
other institutions, which, in most cases, are significantly larger and are able
to provide a greater variety of services than the Company and thus may obtain
deposits at lower rates of interest. Customers of the Company are primarily
individuals and households and small-to-medium sized businesses, as well as
physicians and other professionals.




                                      - 2 -


<PAGE>   3




NET INTEREST INCOME

         The following table sets forth weighted average yields earned by the
Company on its earning assets and the weighted average rates paid on its average
deposits and other interest-bearing liabilities for the years indicated, and
certain other information:

<TABLE>
<CAPTION>
                                                               1998                              1997
                                             --------------------------------------- -------------------------------
(Fully taxable equivalent)                                    Interest       Average           Interest      Average
(Dollars in thousands)                         Average         Income/       Yields/   Average    Income/      Yields/
                                                Balance        Expense        Rate     Balance    Expense        Rate
                                                -------        -------        ----     -------    -------        ----
<S>                                              <C>           <C>             <C>     <C>        <C>              <C> 
ASSETS:

Interest-earning assets:

Loans net of unearned income................    $ 68,732        $5,757      8.4%        $33,907    $ 2,729          8.0%
U.S. Treasury and other U.S. government
  agencies..................................      13,946           978      7.0%         14,892      1,569         10.5%
Other earning assets .......................       3,206           195      6.1%            481         51         10.6%
Federal funds sold..........................       8,258           453      5.5%          7,659        257          3.4%
                                                --------        ------                  -------     ------
    Total interest-earning assets/
      interest income.......................      94,142         7,383      7.8%         56,939      4,606          8.1%
                                                --------        ------                  -------     ------
Cash and due from banks.....................       2,414                                  1,993
Other assets................................       4,641                                  3,002
Allowance for loan losses...................        (493)                                  (243)
                                                --------                                -------
    Total...................................    $100,704                                $61,691
                                                ========                                =======

LIABILITIES AND STOCKHOLDERS' EQUITY:

Interest-bearing liabilities:

Demand deposits.............................    $ 13,529        $  546      4.0%        $ 6,231     $  273          4.4%
Savings.....................................       4,699           192      4.1%          2,157        117          5.4%
Individual retirement accounts..............       4,336           269      6.2%          2,490        161          6.5%
Time certificates...........................      55,398         3,451      6.2%         37,653      2,425          6.4%
Note payable................................       4,844           304      6.3%             --         --            --
                                                --------        ------                  -------     ------
    Total interest-bearing liabilities/
      interest expense......................      82,806         4,762      5.8%         48,531      2,976          6.1%
                                                --------        ------                  -------     ------
Non-interest bearing demand deposits........       6,343                                  4,700
Other liabilities...........................         319                                    284
Stockholders' equity........................      11,236                                  8,176
                                                --------                                -------
    Total...................................    $100,704                                $61,691
                                                ========                                =======
Net interest earnings.......................                    $2,621                              $1,630
                                                                ======                              ======
Net interest on interest-earning assets.....                                2.8%                                    2.9%

Return on average assets....................                               0.49%                                   0.09%
Return on average equity....................                               4.42%                                   0.70%
Cash dividends declared.....................                                  --                                      --
Dividend payout ratio.......................                                  --                                      --
</TABLE>




                                      - 3 -


<PAGE>   4



         The following table presents a summary of changes in interest income,
interest expense, and the interest rate differential aggregated by the changes
in volumes and rates:

<TABLE>
<CAPTION>
                                                                   December 31, 1998                     December 31, 1997
                                                                         versus                                versus
                                                                    December 31, 1997                     December 31, 1996
                                                                   Increase (Decrease)                   Increase (Decrease)
                                                                    Change Due to: (1)                   Change Due to: (1)
                                                              ---------------------------------      -----------------------------
(Dollars in Thousands)                                        Volume        Rate        Total        Volume     Rate        Total
                                                              -------      -------      -------      ------     -----      -------
<S>                                                           <C>          <C>          <C>          <C>        <C>        <C>    
Increase (decrease) in(2):
Loans, net of unearned income ...........................     $ 2,892      $   136      $ 3,028      $2,048     $ 111      $ 2,159
U.S. Treasury and other U.S. government agency securities         (70)        (521)        (591)        863       574        1,437
Other earning assets ....................................         166          (22)         144          10         5           15
Federal funds sold ......................................          35          161          196         167      (196)         (29)
                                                              -------      -------      -------      ------     -----      -------
         Total interest income ..........................                                 2,777                              3,582
                                                                                        =======                            =======
Increase (decrease) in(2):
Demand deposits .........................................         298          (25)         273         190        17          207
Savings deposits ........................................         103          (28)          75          89        (3)          86
Individual retirement accounts ..........................         113           (7)         108         124        11          135
Time certificates .......................................       1,101          (75)       1,026       1,600       260        1,860
Note payable ............................................         304           --          304          --        --           --
                                                              -------      -------      -------      ------     -----      -------
         Total interest expense .........................                                 1,786                              2,288
                                                                                        -------                            -------
Increase (decrease) in net interest income ..............                               $   991                            $ 1,294
                                                                                        =======                            =======
</TABLE>

----------

(1)      Increases (decreases) are attributable to volume changes and rate
         changes on the following basis: Volume Change equals change in volume
         times prior year rate. Rate Change equals change in rate times prior
         year volume. Changes that are not due solely to volume or rate changes
         are allocated to volume.

(2)      For purposes of this schedule, non-accruing loans are included in the
         average balances and tax exempt income is reflected on a tax equivalent
         basis. As tax exempt income is exempt only for Federal income tax
         purposes and not Tennessee purposes, tax equivalent income is based
         upon an effective 34% tax rate. Loan fees included in interest income
         are not material to the presentation.

LIABILITY AND ASSET MANAGEMENT

         A committee composed of officers and directors of the Company is
responsible for managing the assets and liabilities of the Company. The chairman
of the committee is Chairman of the Board, Charles E. Allen, Jr. The committee
attempts to manage asset growth, liquidity and capital in order to maximize
income and reduce interest rate risk. The committee directs the Company's
overall acquisition and allocation of funds. The committee reviews and discusses
the Company's assets and liability funds budget in relation to the actual flow
of funds. The committee also reviews and discusses peer group comparisons, the
ratio of the amount of rate-sensitive assets to the amount of rate-sensitive
liabilities; the ratio of allowance for loan losses to outstanding and
nonperforming loans; and other variables, such as expected loan demand,
investment opportunities, core deposit growth within specific categories,
regulatory changes, monetary policy adjustments, and the overall state of the
local and national economies.

         The matching of assets and liabilities may be analyzed by examining the
extent to which such assets and liabilities are "interest rate sensitive" and by
monitoring an institution's interest rate sensitivity "gap." An asset or
liability is said to be interest rate sensitive within a specific time period if
it will mature or reprice within that time period. The interest rate sensitivity
gap is defined as the difference between the amount of interest-earning assets
maturing or repricing within a specific time period and the amount of
interest-bearing liabilities maturing or repricing within that time period. A
gap is considered positive when the amount of interest rate sensitive assets
exceeds the amount of interest rate sensitive liabilities. A gap is considered
negative when the amount of interest rate sensitive liabilities exceeds the
amount of interest rate sensitive assets. During a period of rising interest
rates, a negative gap would tend to adversely affect net interest income while a
positive gap would tend to result in an increase in net interest income. During
a period of falling interest rates, a negative





                                     - 4 -
<PAGE>   5

gap would tend to result in an increase in net interest income while a positive
gap would tend to adversely affect net interest income.

         The following table represents an interest sensitivity profile for the
Savings Bank as of December 31, 1998 and 1997. The table represents a static
point in time and does not consider other variables, such as changing spread
relationships or interest rate levels. "Net repricing gap" is the difference
between total earning assets and total interest-bearing liabilities repricing in
any given period and "cumulative gap" is the sum of the net repricing gap from
period to period. Interest-bearing demand, savings and money market account
deposits are presented as repricing in the earliest period presented.

<TABLE>
<CAPTION>
                                                                    December 31, 1998
                                      --------------------------------------------------------------------------
                                        Within      After 3 months   After 12 months
                                       3 months    Within 12 months  Within 5 years  After 5 years       Total
                                       --------    ----------------  --------------  -------------      --------
(Dollars in thousands)
<S>                                    <C>          <C>              <C>             <C>               <C>     
EARNING ASSETS:
Loans ...........................       $16,424        $  7,443         $ 38,406         $14,286        $ 86,559
Investment securities:
     Available for sale .........                                             36          12,045          12,081
     Held to maturity ...........                                                                             --
Federal funds sold ..............         6,421                                                            6,421
Interest-bearing deposits .......         5,113                                                            5,113
                                        -------        --------         --------         -------        --------
         Total earning assets ...       $37,958        $  7,443         $ 38,442         $26,331        $116,174
                                        =======        ========         ========         =======        ========

INTEREST-BEARING LIABILITIES:
Interest-bearing deposits .......       $22,879        $ 24,515         $ 43,534         $              $ 90,928
Long-term debt ..................                         3,000            6,000                           9,000
                                        -------        --------         --------         -------        --------
         Total interest-bearing
           liabilities ..........       $22,879        $ 27,515         $ 49,534         $    --        $ 99,928
                                        =======        ========         ========         =======        ========
Cumulative net repricing gap ....       $15,079        $(20,072)        $(11,092)        $26,331        $ 10,246
Rate sensitivity gap:
Net repricing gap as a percentage
  of total earning assets .......         13.69%         (18.22)%         (10.07)%         23.90%           9.30%
Cumulative gap ..................       $15,079        $ (4,993)        $(16,085)        $10,246        $ 10,246
Cumulative gap as a percentage of
  total earning assets ..........         13.69%          (4.53)%         (14.60)%          9.30%           9.30%
</TABLE>









                                      - 5 -


<PAGE>   6



<TABLE>
<CAPTION>
                                                                    December 31, 1997
                                      --------------------------------------------------------------------------
                                        Within      After 3 months   After 12 months
                                       3 months    Within 12 months  Within 5 years  After 5 years       Total
                                       --------    ----------------  --------------  -------------      --------
(Dollars in thousands)
<S>                                    <C>          <C>              <C>             <C>               <C>     
EARNING ASSETS:
Loans ...........................       $  8,116         $  6,945         $ 11,882         $23,843        $50,786
Investment securities:
     Available for sale .........              4               --            1,930           4,530          6,464
     Held to maturity ...........             --               --            2,300           7,700         10,000
Federal funds sold ..............         10,094               --               --              --         10,094
                                        --------         --------         --------         -------        -------
         Total earning assets ...       $ 18,214         $  6,945         $ 16,112         $36,073        $77,344
                                        ========         ========         ========         =======        =======

INTEREST-BEARING LIABILITIES:
Interest-bearing deposits .......       $ 21,379         $ 24,977         $ 18,742         $    --        $65,098
                                        --------         --------         --------         -------        -------
         Total interest-bearing
           liabilities ..........       $ 21,379         $ 24,977         $ 18,742         $    --        $65,098
                                        ========         ========         ========         =======        =======
Net repricing gap ...............       $ (3,165)        $(18,032)        $ (2,630)        $36,073        $12,246
Rate sensitivity gap:
Net repricing gap as a percentage
  of total earning assets .......          (4.09)%         (23.31)%          (3.40)%         46.64%         15.83%
Cumulative gap ..................       $ (3,165)        $(21,197)        $(23,827)        $12,246        $12,246
Cumulative gap as a percentage of
  total earning assets ..........          (4.09)%         (27.41)%         (30,81)%         15.83%         15.83%
</TABLE>


Management has made the following assumptions in the above analysis:

(a)      Assets and liabilities are generally assigned to a period based upon
         their earliest repricing period when the repricing is less than the
         contractual maturity.

(b)      Nonaccrual loans are included in the loan category.

(c)      Investment securities available for sale are currently treated in the
         same manner as comparable securities in the investment securities held
         to maturity portfolio in that they are scheduled according to the
         earlier of their contractual maturities or earliest repricing dates;
         however, the maturities of callable agency securities are scheduled
         according to their call dates when valued at a premium to par.

(d)      Money market deposits and savings deposits that have no contractual
         maturities are scheduled in the within 3 months category.

DEPOSITS

         The Company offers a full range of depositor accounts and services to
both consumers and businesses. None of these deposits were brokered. The
Company's primary sources of funds are interest-bearing deposits. The following
table sets forth the Company's deposit structure at December 31, 1998 and
1997(in thousands).

<TABLE>
<CAPTION>
                                                      1998          1997
                                                     -------       -------
<S>                                                  <C>           <C>    
Non interest-bearing deposits:
Individuals, partnerships and corporations ...       $ 4,346       $ 5,838
Certified and official checks ................         1,292         1,309
                                                     -------       -------
  Total non interest-bearing deposits ........         5,638         7,147

Interest-bearing deposits:
Interest-bearing demand accounts .............        18,306         8,648
Savings accounts .............................         6,108         3,291
Certificates of deposit, less than $100,000 ..        49,587        40,306
Certificates of deposit, greater than $100,000        16,725        12,852
                                                     -------       -------
  Total interest-bearing deposits ............        90,726        65,097
                                                     -------       -------
  Total deposits .............................       $96,364       $72,244
                                                     =======       =======
</TABLE>


                                      - 6 -


<PAGE>   7



         The following table presents a breakdown by category of the weighted
average rate on deposits and the average amount of deposits for the periods as
indicated:

<TABLE>
<CAPTION>
                                                                                    December 31,
                                                                  ----------------------------------------------------
                                                                        1998                              1997
                                                                  -----------------                -------------------
(In Thousands)
<S>                                                               <C>      <C>                     <C>        <C>     
Non interest-bearing commercial deposits............              0.00%    $  4,365                0.00%      $  6,653
Savings deposits....................................              4.25%       6,108                4.25%         3,291
Money market deposits ..............................              4.48%      13,730                4.31%         6,102
Time deposits.......................................              5.65%      66,312                5.89%        53,158
Interest-bearing and non interest-bearing 
  demand deposits                                                 1.64%       5,849                1.79%         3,040
                                                                            -------                            -------
         Total deposits.............................                        $96,364                            $72,244
                                                                            =======                            =======
</TABLE>


         At December 31, 1998 and 1997, time deposits greater than $100,000
aggregated approximately $16.7 million and $12.9 million, respectively. The
following table indicates, as of December 31, 1998 and 1997, the dollar amount
of $100,000 or more deposits by the time remaining until maturity (in
thousands):

<TABLE>
<CAPTION>
                                        1998                                              1997
                       ------------------------------------------      ---------------------------------------------
                                              1 Year                                              1 Year                
                       3 Months    3 to 12    through                  3 Months        3 to 12    through    
                       or less      Months    5 years       Total       or less        Months     5 years      Total
                       -------      ------    -------       -----       -------        ------     -------      -----

<S>                    <C>          <C>        <C>         <C>           <C>           <C>       <C>        <C>    
Time certificates      $6,271       $5,670     $4,784      $16,725       $2,786        $6,495    $3,571     $12,852
</TABLE>

ASSETS

         Management of the Company considers many criteria in managing assets,
including creditworthiness, diversification and structural characteristics,
maturity and interest rate sensitivity. The following table sets forth the
Company's interest earning assets by category at December 31, 1998 and 1997.

<TABLE>
<CAPTION>
                                                 1998          1997
                                               --------       -------
         (In Thousands)
<S>                                            <C>            <C>    
         Investment securities:
           Available for sale ..........       $ 12,249       $ 6,463
           Held to maturity ............         10,000
         Federal funds sold ............          6,421        10,094
         Loans:
           Real estate .................         51,311        32,456
           Commercial and other ........         35,494        18,326
                                               --------       -------
             Total loans ...............         86,805        50,782
            Less unearned income .......             68            53
                                               --------       -------
           Loans, net of unearned income         86,737        50,729
                                               --------       -------
         Interest earning assets .......       $105,407       $77,286
                                               ========       =======
</TABLE>

INVESTMENT PORTFOLIO

         For a description of the composition of the carrying value of the
Company's investment portfolio at December 31, 1998 and 1997, see Note 13 to the
Notes to Consolidated Financial Statements attached hereto.





                                      - 7 -


<PAGE>   8



         The following table presents the maturity distribution of the amortized
cost and estimated market value of the Company's investment portfolio at
December 31, 1998 and 1997. The weighted average yields on these instruments are
presented based on final maturity. Yields on obligations of states and political
subdivisions have not been adjusted to a fully-taxable equivalent basis.

<TABLE>
<CAPTION>
                                                              1998                                   1997
                                              -------------------------------------  -------------------------------------
                                                            Estimated      Weighted               Estimated       Weighted
                                              Amortized       Market        Average  Amortized      Market         Average
                                                 Cost         Value          Yield      Cost        Value           Yield
                                                 ----         -----          -----      ----        -----           -----
(Dollars in Thousands) 
<S>                                            <C>           <C>              <C>      <C>          <C>              <C>  
Held to maturity:
Obligations of U.S. Government agencies:
  Due after 1 year but within 5 years ..                                              $ 2,300       $ 2,295          6.88%
  Due after 5 years but within 10 years                                                 7,700         7,728          7.27%
                                                                                      -------       -------
     Total .............................                                              $10,000       $10,023          6.71%
                                                                                      =======       =======
Available for sale:
Obligations of U.S. Government agencies:
  Due within 1 year ....................       $    36       $    36          7.20%   $    68       $   73           7.13%
  Due after 1 year but within 5 years ..                                                1,858        1,857           6.76%
  Due after 5 years but within 10 years         10,555        10,613          6.68%     3,500        3,467           7.31%
  Due after 10 years ...................           999         1,001          7.06%     1,000        1,004           8.02%
                                               -------       -------                   ------       ------           ---- 
     Total .............................       $11,590       $11,650          6.71%    $6,426       $6,401           7.22%
                                               =======       =======                   ======       ======           ==== 
</TABLE>

INVESTMENT POLICY

         The Company's investment portfolio policy is designed to provide
guidelines by which the funds not otherwise needed to meet loan demand of the
Company's market area can best be invested to meet fluctuations in the loan
demand and deposit structure. The Company's investment officer, Chairman Allen,
seeks to balance the market and credit risk against the potential investment
return, make investments compatible with the pledging requirements of the
Company's deposits of public funds, maintain compliance with regulatory
investment requirements and assist the various local public entities with their
financing needs. The Investment Policy is reviewed annually by the Directors.
Chairman Allen reports monthly to the Directors.

LOAN PORTFOLIO

         The following table sets forth the composition of the Company's loan
portfolio at December 31, 1998 and 1997.

<TABLE>
<CAPTION>
                                                1998               1997
                                               -------            -------
(In Thousands)
<S>                                            <C>                <C>    
Real estate loans:
  Construction and land development            $ 2,013            $   551
  Secured by residential properties             51,821             34,176
  Commercial real estate loans ....              9,104              6,447
                                               -------            -------
     Total real estate loans ......             62,938             41,174
Commercial and industrial loans ...             13,784              6,193
Installment loans .................              9,424              3,176
Other consumer loans ..............                396                239
All other loans ...................                 17                  4
                                               -------            -------

    Total loans ...................            $86,559            $50,786
                                               =======            =======
</TABLE>


                                      - 8 -


<PAGE>   9



         The following table sets forth the maturities of the loan portfolio and
the sensitivity to interest rate changes of that portion of the Company's loan
portfolio that matures after one year.

<TABLE>
<CAPTION>
                                                                December 31, 1998
                                          ----------------------------------------------------------------
                                                                  Maturity Range
                                          ----------------------------------------------------------------
                                          One Year        One Through            Over
(In Thousands)                            or Less          Five Years         Five Years            Total
--------------                            -------          ----------         ----------           -------
<S>                                        <C>               <C>                <C>                <C>    
Real estate construction loans             $1,024            $   989            $    --            $ 2,013
Commercial and industrial loans             5,452              6,943              1,389             13,734
All other loans ...............             1,558             17,555             51,649             70,762
                                           ------            -------            -------            -------
  Total loans .................            $8,034            $25,487            $53,038            $86,559
                                           ======            =======            =======            =======
</TABLE>

         The sensitivity to interest rate changes of that portion of the
Company's loan portfolio that matures after one year is set forth below.

Real estate and commercial and industrial loans maturing after one year as of
December 31, 1998 (in thousands):

<TABLE>
<S>                                                     <C>    
Fixed rate .................................            $ 8,863
Floating rate ..............................             51,719

Other loans maturing after one year:

Fixed rate .................................             16,398
Floating rate ..............................              1,545
                                                        -------
         Total loans maturing after one year            $78,525
                                                        =======
</TABLE>

LENDING POLICY

         While the ultimate authority to approve loans rests with the Board of
Directors of the Company, lending authority is delegated by the Directors to
loan officers and loan committees of the Company, each of whom is limited as to
the amount of secured and unsecured loans that he or she can make to a single
borrower or related group of borrowers. Lending limits of individual officers
are documented in the respective personnel files and are reviewed annually by
the Directors. Loan officers discuss with a senior officer any loan request
which exceeds their individual lending limit. The loan must have the joint
approval from the originating officer and a senior officer. The president/CEO of
the Company has the authority to approve first mortgages for one-to-four family
residential loans which conform to the guidelines of the Farmers Home
Administration ("FHA"), the Veterans Administration ("VA"), and the Tennessee
Housing Development Authority ("THDA"), and other conventional investors in any
amount.

         The Company's Lending Policy provides written guidelines for lending
activities and is reviewed at least annually by the Directors. The Directors
recognize that, from time to time, it is in the best interest of the Company to
deviate from the established, written credit policy and have established
guidelines for granting exceptions to the policy. Situations in which such
exceptions might be granted include the waiving of requirements for independent
audited financial statements when a comfort level with respect to the financial
statements of the borrower can be otherwise obtained; and when it is desirable
to meet the terms offered by a competitor. All exceptions granted are documented
in the loan committee's minutes.

         The Company's primary business lies in making real estate mortgage
loans in the market area. Real estate loans made outside the market area must be
in compliance with the exception-to-policy guidelines. Lending activities in the
real estate area tend to fall into the four general categories of (i)
acquisition and development, (ii) construction, (iii) permanent financing, and
(iv) home equity. As a general rule, the Company seeks to maintain
loan-to-collateral value ratios of at least 80% of the actual purchase price or
the appraised value, whichever is less. This limit is reduced for certain types
of real estate loans in 




                                      - 9 -


<PAGE>   10



conformity to industry and regulatory guidelines. The following
standards, established by inter-agency guidelines by the federal bank
regulators, including the FDIC, went into effect on March 19, 1993:

<TABLE>
<CAPTION>
                                                                      Maximum Allowable
         Loan Category                                               Loan-to-Value Ratio
         -------------                                               -------------------

<S>                                                                  <C>
Land....................................................................     65%
Land development........................................................     75%
Owner-occupied land development.........................................     75%
Construction
         Commercial, multifamily and other nonresidential...............     80%
         1-4 family residential.........................................     85%
Improved property.......................................................     85%
Owner-occupied 1-4 family and home equity...............................     85%
</TABLE>

----------

(1)      Multifamily construction includes condominiums and cooperatives.

(2)      A loan-to-value limit has not been established for permanent mortgage
         or home equity loans or owner-occupied, 1-4 family residential
         property. However, for any such loan with a loan-to-value ratio that
         equals or exceeds 90% at origination, appropriate credit enhancement in
         the form of either mortgage insurance or readily marketable collateral
         is required.

LOAN REVIEW AND NONPERFORMING ASSETS

         The Company has an internal loan review system to determine
deficiencies and corrective action to be taken. Loans are graded as follows:

                  CLASS A. Prime loans based upon liquid collateral with
adequate margin or supported by strong financial statement of recent date.
Character and repayment ability of borrower are excellent and unquestioned.
Position of company in its industry and in its community is excellent. High
liquidity, minimum risk, good ratios, low handling cost.

                  CLASS B. Desirable loans of somewhat less stature than Class
A, but with strong financial statements, and/or secured by strong collateral
position. Probability of serious financial deterioration is unlikely.

                  CLASS C. Satisfactory loans of average or mediocre strength;
having some deficiency or vulnerability to changing economic or industry
conditions, but currently collectible. Secured loans lacking in margin or
liquidity. Loans to individuals, perhaps supported in dollars of net worth but
whose supporting assets are illiquid. Sometimes used as a temporary
classification for untested borrowers or where information is incomplete.

                  CLASS O. First classification that has relevancy to bank
examiners. A warning classification which portrays one or more deficiencies that
cannot be tolerated even in the short run. Regulatory classification "Other
Assets Especially Mentioned ("OAEM").

                  CLASS D. Substandard credits for their steadiness or other
deficient nature. Company or individual loans with no evident future, which are
unfavorable, affecting loan-to-deposit ratio or cost of funds. Heavy leveraged
accounts, with no immediate relief or compensating features. Accounts requiring
attention of loan officer due to lack of borrower cooperation.

                  CLASS E. Doubtful credits with weaknesses demanding full
attention of loan officer. Collection or liquidation in full is highly
questionable. Serious problems exist to the point where a partial loss of
principal is likely.

                  CLASS F. Loans where an element of probable loss is present.
Critical credits requiring immediate and drastic action. Loan should probably be
charged off. Bank examiners will probably classify such loans as "Loss."

         Loans graded "D", "E" or "F" will automatically be referred to
management for inclusion on the Company's "watch list." The Company also employs
an outside bank consulting firm to perform an independent annual loan review.







                                     - 10 -


<PAGE>   11



         Nonperforming loans are placed on non-accrual basis of accounting if
(i) there is deterioration in the financial condition of the borrower; (ii)
payment in full of principal or interest is not expected; or (iii) principal or
interest has been in default for 90 days or more, unless the obligation is well
secured and in the process of collection. The three categories of nonperforming
loans are non-accrual status loans, renegotiated debt, and loans in Chapter 13
bankruptcy unless a repayment schedule is adopted that pays out the loan.

CREDIT RISK MANAGEMENT AND RESERVE FOR LOAN LOSSES

         Credit risk and exposure to loss are inherent parts of the banking
business. Management seeks to manage and minimize these risks through its loan
and investment policies and loan review procedures. Management establishes and
continually reviews lending and investment criteria and approval procedures that
it believes reflect the risk sensitive nature of the Company. The loan review
procedures are set to monitor adherence to the established criteria and to
ensure that on a continuing basis such standards are enforced and maintained.
Management's objective in establishing lending and investment standards is to
manage the risk of loss and provide for income generation through pricing
policies. To effectuate this policy, management meets weekly to review and
approve loans and meets monthly to review investments.

         The loan portfolio is regularly reviewed and management determines the
amount of loans to be charged-off. In addition, such factors as the Company's
previous loan loss experience, prevailing and anticipated economic conditions,
industry concentrations and the overall quality of the loan portfolio are
considered. While management uses available information to recognize losses on
loans and real estate owned, future additions to the allowance may be necessary
based on changes in economic conditions. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
the allowances for losses on loans and real estate owned. Such agencies may
require the Company to recognize additions to the allowances based on their
judgments about information available at the time of their examinations. In
addition, any loan or portion thereof which is classified as a "loss" by
regulatory examiners is charged-off.

         The reserve for loan losses is increased by provisions charged to
operating expense. The reserve is reduced by charging off loans or portions of
loans at the time they are deemed by management to be uncollectible and
increased when loans previously charged off are recovered. The resulting reserve
for loan losses is viewed by management as a single, unallocated reserve
available for all loans and, in management's opinion, is adequate to provide for
reasonably foreseeable potential loan losses. Rules and formulas relative to the
adequacy of the reserve, although useful as guidelines to management, are not
rigidly applied. The reserve for loan losses was $630,000 at year end 1998, or
0.7% of loans outstanding, net of unearned income, compared to $355,000 or 0.7%
at year end 1997. The following table presents data related to the Company's
reserve for loan losses for the years ended December 31, 1998 and 1997.

<TABLE>
<CAPTION>
                                                                                                  1998          1997
                                                                                                  ----          ----
(Dollars In Thousands)
<S>                                                                                               <C>           <C> 
Balance at beginning of period ..........................................................         $355          $130
Charge offs:
  Commercial ............................................................................           --            --
  Real estate mortgage ..................................................................           --            --
  Installment loans to individuals ......................................................           --             1
                                                                                                  ----          ----
Recoveries:
  Commercial ............................................................................           --            --
  Real estate mortgage ..................................................................           --            --
  Installment loans to individuals ......................................................           --            --
                                                                                                  ----          ----
Net charge offs
Additions to reserve charged to operations ..............................................          275           226
                                                                                                  ----          ----
Balance at end of period ................................................................         $630          $355
                                                                                                  ====          ====

Ratio of net charge offs during the period to average loans outstanding during the period          0.0%          0.0%
Average allowance for loan losses to average total loans ................................          0.7%          0.7%
</TABLE>






                                     - 11 -
<PAGE>   12

         At December 31, 1998 and 1997, the allowance for loan losses was
allocated as follows:

<TABLE>
<CAPTION>
(Dollars in thousands)
                                                      1998                                             1997
                                       -------------------------------------          ---------------------------------------
                                                    Percent of loans in each                         Percent of loans in each
                                       Amount        category to total loans          Amount         category to total loans
                                       ------        -----------------------          ------         -----------------------
<S>                                    <C>          <C>                               <C>            <C>
Commercial .........                    $ 15                      2%                    $ 12                     12%
Real estate mortgage                     460                     73%                     288                     81%
All other ..........                     155                     25%                      55                      7%
                                        ----                    ---                     ----                    ---
   Total ...........                    $630                    100%                    $355                    100%
                                        ====                    ===                     ====                    ===
</TABLE>

         The allocation of the allowance is presented based in part on
evaluations of past history and composition of the loan portfolio. Since these
factors are subject to change, the current allocation of the allowance is not
necessarily indicative of the breakdown of future losses.

         The following table sets forth information with respect to
nonperforming loans of the Company on the dates indicated. Accrual of interest
is discontinued when there is reasonable doubt as to the full, timely
collections of interest or principal. When a loan becomes contractually past due
90 days with respect to interest or principal, it is reviewed and a
determination is made as to whether it should be placed on nonaccrual status.
When a loan is placed on nonaccrual status, all interest previously accrued but
not collected is reversed against current period interest income. Income on such
loans is then recognized only to the extent that cash is received and where the
future collection of principal is probable. Interest accruals are resumed on
such loans only when they are brought fully current with respect to principal
and interest and when, in the judgment of management, the loans are estimated to
be fully collectible as to principal and interest. Restructured loans are those
loans on which concessions in terms have been granted because of a borrower's
financial difficulty. Interest is generally accrued on such loans in accordance
with the new terms.

<TABLE>
<CAPTION>
Nonperforming assets (Dollars in thousands):                                                       December 31,
                                                                                                -------------------
                                                                                                1998           1997
                                                                                                ----           ----
<S>                                                                                            <C>              <C> 
Nonaccrual loans......................................................................              --            --
Restructured loans....................................................................              --            --
Other loans past due 90 days or more to principal or interest payments................          $    2          $242
Nonperforming loans as a percentage of net loans before allowance for loan losses.....           0.00%         0.48%
Allowance for loan losses as a percentage of nonperforming loans......................         31,500%          248%
</TABLE>

CAPITAL RESOURCES/LIQUIDITY

         Liquidity. Of primary importance to depositors, creditors and
regulators is the ability to have readily available funds sufficient to repay
fully maturing liabilities. The Company's liquidity, represented by cash and
cash due from banks, is a result of its operating, investing and financing
activities. In order to insure funds are available at all times, the Company
devotes resources to projecting on a monthly basis the amount of funds which
will be required and maintains relationships with a diversified customer base so
funds are accessible. Liquidity requirements can also be met through short-term
borrowings or the disposition of short-term assets which are generally matched
to correspond to the maturity of liabilities.

         Although the Company has no formal liquidity policy, in the opinion of
management, its liquidity levels are considered adequate. Neither the Company
nor the Company is subject to any specific liquidity requirements imposed by
regulatory orders. Management believes its liquidity ratios meet or exceed
regulatory guidelines. Management does not know of any trends or demands which
are reasonably likely to result in liquidity increasing or decreasing in any
material manner.

         The following table sets forth liquidity ratios for the periods
indicated:

<TABLE>
<CAPTION>
                                                 1998               1997
                                          ------------------ -----------
<S>                                             <C>                <C>  
Average loans to average deposits........       81.5%              63.7%
</TABLE>

         Impact of Inflation and Changing Prices. The consolidated financial
statements and related consolidated financial data presented herein have been
prepared in accordance with generally accepted accounting principles which
require the 





                                     - 12 -
<PAGE>   13

measurement of financial position and operating results in terms of historical
dollars without considering the changes in the relative purchasing power of
money over time and due to inflation. The impact of inflation on operations of
the Company is reflected in increased operating costs. Unlike most industrial
companies, virtually all of the assets and liabilities of the Company are
monetary in nature. As a result, interest rates have a more significant impact
on the Company's performance than the effects of general levels of inflation.
Interest rates do not necessarily move in the same direction or in the same
magnitude as the price of goods and services.

CAPITAL ADEQUACY

         Capital adequacy refers to the level of capital required to sustain
asset growth over time and to absorb losses. The objective of the Company's
management is to maintain a level of capitalization that is sufficient to take
advantage of profitable growth opportunities while meeting regulatory
requirements. This is achieved by improving profitability through effectively
allocating resources to more profitable businesses, improving asset quality,
strengthening service quality, and streamlining costs. The primary measures used
by management to monitor the results of these efforts are the ratios of average
equity to average assets, average tangible equity to average tangible assets,
and average equity to net loans.

         Capital guidelines require the maintenance of an amount of capital
based on risk-adjusted assets so that categories of assets with potentially
higher credit risk will require more capital backing than assets with lower
risk. In addition, financial institutions and their holding companies are
required to maintain capital to support, on a risk-adjusted basis, certain
off-balance sheet activities such as loan commitments.

         The capital guidelines classify capital into two tiers, referred to as
Tier I and Tier II. Under risk-based capital requirements, total capital
consists of Tier I capital which is generally common stockholders' equity less
goodwill and Tier II capital which is primarily a portion of the allowance for
loan losses and certain qualifying debt instruments. In determining risk-based
capital requirements, assets are assigned risk-weights of 0% to 100%, depending
primarily on the regulatory assigned levels of credit risk associated with such
assets. Off-balance sheet items are considered in the calculation of
risk-adjusted assets through conversion factors established by the regulators.
The framework for calculating risk-based capital requires financial institutions
to meet the regulatory minimums of 4% Tier I and 8% total risk-based capital and
prepare a leveraged computation comparing Tier I capital to total average assets
less goodwill.

         The Company's consolidated capital ratios are set forth below.

<TABLE>
<CAPTION>
                                                                                        December 31, 1998     December 31, 1997
                                                                                        -----------------     -----------------
(Dollars in Thousands)
<S>                                                                                           <C>                  <C>    
CAPITAL:
Tier I capital:
         Stockholders' common equity .............................................            $ 11,570             $10,554
         Less unrealized (loss) gain in securities ...............................                  40                  25
         Less disallowed intangibles .............................................                  --                  --
                                                                                              --------             -------
                  Total Tier I capital ...........................................              11,530              10,529
Tier II capital:
         Qualifying allowance for loan losses ....................................                 919                 566
                                                                                              --------             -------
                  Total capital ..................................................              12,449              11,095
Risk-adjusted assets .............................................................              74,160              45,237
Quarterly average assets .........................................................             108,452              77,462
RATIOS:
Tier I capital to risk-adjusted assets ...........................................               15.55%              23.28%
Tier II capital to risk-adjusted assets ..........................................                1.24%               1.25%
Total capital to risk-adjusted assets ............................................               16.79%              24.53%
Leverage--Tier I capital to quarterly average assets less disallowed intangibles                 10.63%              13.60%
</TABLE>

         On December 31, 1998, the Company exceeded the regulatory minimums and
qualified as a well-capitalized institution under the regulations.





                                     - 13 -
<PAGE>   14

SUPERVISION AND REGULATION

GENERAL

         As a Tennessee-chartered, federally-insured savings bank, the Savings
Bank is subject to extensive regulation. Lending activities and other
investments must comply with various statutory and regulatory requirements,
including prescribed minimum capital standards. The Savings Bank is regularly
examined by the FDIC and the Department and files periodic reports concerning
its activities and financial conditions with its regulators. The Savings Bank's
relationship with depositors and borrowers is also regulated to a great extent
by both federal law and the laws of the State of Tennessee, especially in such
matters as the ownership of accounts and the form and content of mortgage
documents.

         Federal and state banking laws and regulations govern all areas of the
operation of the Savings Bank, including reserves, loans, mortgages, capital,
issuance of securities, payment of dividends and establishment of branches.
Federal and state bank regulatory agencies also have the general authority to
limit the dividends paid by insured banks if such payments should be deemed to
constitute an unsafe and unsound practice. Both the Department and the FDIC have
the authority to impose penalties, initiate civil and administrative actions and
take other steps intended to prevent banks from engaging in unsafe or unsound
practices.

TENNESSEE SUPERVISION AND REGULATION

         As a Tennessee-chartered savings bank, the Savings Bank is subject to
various state laws and regulations which limit the amount that can be loaned to
a single borrower, the type of permissible investments, and geographic
expansion, among other things. The Savings Bank must submit an application and
receive the approval of the Department before opening a new branch office or
merging with another financial institution. The Commissioner of the Department
("Commissioner") has the authority to enforce state laws and regulations by
ordering a director, officer or employee of the Savings Bank to cease and desist
from violating a law or regulation and from engaging in unsafe or unsound
banking practices.

         The Savings Bank is chartered under the Savings Bank Chartering Act of
1991 ("Savings Bank Act"). The Department has not yet promulgated any
regulations governing the operation of savings banks. However, the Savings Bank
Act contains a "parity provision" that authorizes the Department to promulgate
regulations authorizing savings banks to make any investment or engage in any
activity that is permissible for federally-chartered savings banks, subject to
the same limitations applicable to federally-chartered savings bank, upon the
Commissioner's determination that Tennessee-chartered savings banks would be at
a competitive disadvantage absent such authorization.

FEDERAL REGULATION

         Deposit Insurance. The Company's deposit accounts are insured by the
FDIC up to applicable limits by the BIF. The BIF was designated as an insurance
fund pursuant to the Financial Institutions Reform, Recovery and Enforcement Act
of 1989 ("FIRREA"). As insurer, the FDIC issues regulations, conducts
examinations, requires the filing of reports and generally supervises and
regulates the operations of state-chartered banks that are not members of the
Federal Reserve System. FDIC approval is required prior to any merger or
consolidation involving state, nonmember banks, or the establishment or
relocation of an office facility thereof. FDIC supervision and regulation is
intended primarily for the protection of depositors and the FDIC insurance
funds.

         Pursuant to the Federal Deposit Insurance Act ("FDIA"), as amended by
FIRREA, all BIF-insured banks must pay semiannual insurance assessments to
recapitalize the BIF to a 1.25% of insured deposits ratio. In August 1995, the
FDIC substantially reduced deposit insurance premiums for well-capitalized,
well-managed BIF-insured institutions to the lowest assessment rate of 4 basis
points per $100 of assessable deposits. The BIF premium reduction became
effective in September 1995. Any insured bank which does not operate in
accordance with or conform to FDIC regulations, policies and directives may be
sanctioned for non-compliance. For example, proceedings may be instituted
against any insured bank or any director, officer or employee of such bank who
engages in unsafe and unsound practices, including the violation of applicable
laws and regulations. The FDIC has the authority to terminate deposit insurance
pursuant to procedures established for that purpose.

         At December 31, 1997, the Company's deposit base for purposes of FDIC
premiums was $72,245,000. The Company paid FDIC insurance premiums of $0 in
1996; and $4,552 in 1997.







                                     - 14 -
<PAGE>   15

         Prompt Corrective Action. Under Section 38 of the FDIA, as amended by
the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"),
each federal banking agency is required to implement a system of prompt
corrective action for institutions which it regulates. The federal banking
agencies have promulgated substantially similar regulations to implement this
system of prompt corrective action. Under the regulations, an institution shall
be deemed to be: (i) "well capitalized" if it has a total risk-based capital
ratio of 10.0% or more, has a Tier 1 risk-based capital ratio of 6.0% or more,
has a Tier 1 leverage capital ratio of 5.0% or more and is not subject to
specified requirements to met and maintain a specific capital level for any
capital measure; (ii) "adequately capitalized" if it has a total risk-based
capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio that is less
than 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0% or a Tier 1
leverage capital ratio that is less than 4.0% (3.0% under certain
circumstances); (iv) "significantly undercapitalized" if it has a total
risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital
ratio that is less than 3.0% or a Tier 1 leverage capital ratio that is less
than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible
equity to total assets that is equal to or less than 2.0%.

         Section 38 of the FDIA and the implementing regulations also provide
that a federal banking agency may, after notice and an opportunity for a
hearing, reclassify a well-capitalized institution as adequately capitalized and
may require an adequately capitalized institution or an undercapitalized
institution to comply with supervisory actions as it were in the next lower
category if the institution is an unsafe or unsound condition or engaging in an
unsafe or unsound practice. (The FDIC may not, however, reclassify a
significantly undercapitalized institution as critically undercapitalized).

         An institution generally must file a written capital restoration plan
which meets specified requirements, as well as performance guaranty by each
company that controls the institution, with the appropriate federal banking
agency within 45 days of the date that the institution receives notice or is
deemed to have notice that it is undercapitalized, significantly
undercapitalized or critically undercapitalized. Immediately upon becoming
undercapitalized, an institution shall become subject to the provisions of
Section 38 of the FDIA, which set forth various mandatory and discretionary
restrictions on its operations.

         Standards for Safety and Soundness. The FDIA requires the federal
banking regulatory agencies to prescribe, by regulation, standards for all
insured depository institutions relating to: (i) internal controls, information
systems and internal audit systems; (ii) loan documentation; (iii) credit
underwriting; (iv) interest rate risk exposure; (v) asset growth; and (vi)
compensation, fees and benefits. The federal banking agencies have adopted
regulations and Interagency Guidelines Prescribing Standards for Safety and
Soundness ("Guidelines") to implement safety and soundness standards required by
the FDIA. The Guidelines set forth the safety and soundness standards that the
federal banking agencies use to identify and address problems at insured
depository institutions before capital becomes impaired. The agencies also
adopted asset quality and earnings standards which are part of the Guidelines.
Under the regulations, if the FDIC determines that the Company fails to meet any
standards prescribed by the Guidelines, the agency may require the Company to
submit to the agency an acceptable plan to achieve compliance with the standard,
as required by the FDIA. The final regulations establish deadlines for the
submission and review of such safety and soundness compliance plans.

         Capital Requirements. The FDIC's minimum capital standards applicable
to FDIC-regulated banks and savings bank require the most highly-rated
institutions to meet a "Tier 1" leverage capital ratio of at least 3.0% of total
assets. Tier 1 (or "core capital") consists of common stockholders' equity,
noncumulative perpetual preferred stock and minority interests in consolidated
subsidiaries minus all intangible assets other than limited amounts of purchased
mortgage servicing rights and certain other accounting adjustments. All other
banks must have a Tier 1 leverage ratio of at least 100-200 basis points about
the 3% minimum. The FDIC capital regulations establish a minimum leverage ratio
of not less than 4% for banks that are not highly rated or are anticipating or
experiencing significant growth.

         FDIC capital regulations require higher capital levels for banks which
exhibit more than a moderate degree of risk or exhibit other characteristics
which necessitate that higher than minimum levels of capital be maintained. Any
insured bank with a Tier 1 capital to total assets ratio of less than 2% is
deemed to be operating in an unsafe and unsound condition pursuant to Section
8(a) of the FDIA unless the insured bank enters into a written agreement, to
which the FDIC is a party, to correct its capital deficiency. Insured banks
operating with Tier 1 capital levels below 2% (and which have not entered into a
written agreement) are subject to an insurance removal action. Insured banks
operating with lower than the prescribed 





                                     - 15 -
<PAGE>   16

minimum capital levels generally will not receive approval of applications
submitted to the FDIC. Also, inadequately capitalized state nonmember banks will
be subject to such administrative action as the FDIC deems necessary.

         FDIC regulations also require that savings banks meet a risk-based
capital standard. The risk-based capital standard requires the maintenance of
total capital (which is defined as Tier 1 capital and Tier 2 or supplementary
capital) to risk weighted assets of 8% and Tier 1 capital to risk-weighted
assets of 4%. In determining the amount of risk- weighted assets, all assets,
plus certain off balance sheet items, are multiplied by a risk-weight of 0% to
100%, based on the risks the FDIC believes are inherent in the type of asset or
item. The components of Tier 1 capital are equivalent to those discussed above
under the 3% leverage requirement. The components of mandatory convertible
securities, term subordinated debt, intermediate-term preferred stock and
allowance for possible loan and lease losses. Allowance for possible loan and
lease losses includable in supplementary capital is limited to a maximum of
1.25% of risk-weighted assets. Overall, the amount of capital counted toward
supplementary capital cannot exceed 100% of Tier 1 capital. The FDIC includes in
its evaluation of a bank's capital adequacy an assessment of risk-based capital
focusing principally on broad categories of credit risk. No measurement
framework for assessing the level of a bank's interest rate risk exposure has
been codified but, effective board and senior management oversight of the banks
tolerance for interest rate risk is required.

         The FDIC has adopted the Federal Financial Institutions Examination
Council's recommendation regarding the adoption of Statement of Financial
Accounting Standard No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." Specifically, the agencies determined that net unrealized
holding gains or losses on available for sale debt and equity securities should
not be included when calculating core and risk-based capital ratios.

         FDIC capital requirements are designated as the minimum acceptable
standards for banks whose overall financial condition is fundamentally sound,
which are well-managed and have no material or significant financial weakness.
The FDIC capital regulations state that, where the FDIC determines that the
financial history or condition, including off-balance sheet risk, managerial
resources and/or the future earnings prospects of a bank are not adequate and/or
a bank has a significant volume of assets classified substandard, doubtful or
loss or otherwise criticized, the FDIC may determine that the minimum adequate
amount of capital for that bank is greater than the minimum standards
established in the regulation.

         The Company believes that, under the current regulations, the Savings
Bank has sufficient capital to meet its minimum capital requirements. However,
events beyond the control of the Savings Bank, such as a downturn in the economy
in areas where the Savings Bank has most of its loans, could adversely affect
future earnings and, consequently, the ability of the Savings Bank to meet its
capital requirements.

         Activities and Investments of Insured State-Chartered Banks. Section 24
of the FDIA, as amended by the FDICIA, generally limits the activities and
equity investments of FDIC-insured, state-chartered banks so those that are
permissible for national banks. Under regulations dealing with equity
investments, an insured state bank generally may not directly or indirectly
acquire or retain any equity investment of a type, or in an amount, that is not
permissible for a national bank. An insured state bank is not prohibited from,
among other things, (ir) acquiring or retaining majority interest in a
subsidiary, (ii) investing as a limited partner in a partnership the sole
purpose of which is direct or indirect investment in the acquisition,
rehabilitation or new construction of a qualified housing project, provided that
such limited partnership investment may not exceed 2% of the bank's total
assets, (iii) acquiring up to 10% of the voting stock of a company that solely
provides or reinsures directors', trustees' and officers' liability insurance
coverage or bankers' blanket bond group insurance coverage for insured
depository institutions, and (iv) acquiring or retaining the voting shares of a
depository institution if certain requirements are met. State law also provides
that the Savings Bank may invest in any investment permissible by federally
chartered savings banks, subject to the restrictions for such entities.

         In addition, an insured state bank (i) that is located in a state which
authorized as September 30, 1991 investment in common or preferred stock listed
on a national securities exchange ("listed stock") or shares of a registered
investment company ("registered shares"), and (ii) which during the period
beginning September 30, 1990 through November 26, 1991 ("measurement period")
made or maintained investments in listed stocks and registered shares, may
retain whatever shares that were lawfully acquired or held prior to December 19,
1991 and continue to acquire listed stock and registered shares, provided that
the bank does not convert its charter to another form or undergo a change in
control. In order to acquire or retain any listed stock or registered shares,
however, the bank must file a one-time notice with the FDIC which meets







                                     - 16 -
<PAGE>   17

specified requirements and which sets forth the bank's intention to acquire and
retain stocks or shares, and the FDIC must determine that acquiring or retaining
the listed stocks or registered shares will not pose a significant risk to the
deposit insurance fund of which the banks is a member.

         FDIC regulations implementing Section 24 of the FDIA provide that an
insured state-chartered bank may not, directly, or indirectly through a
subsidiary, engage as "principal" in any activity that is not permissible for a
national bank unless the FDIC has determined that such activities would pose no
risk to the insurance fund of which it is a member and the bank is in compliance
with applicable regulatory capital requirements. Any insured state-chartered
bank or savings bank directly or indirectly engaged in any activity that is not
permitted for a national bank must cease the impermissible activity.

         Loans-to-One-Borrower. The aggregate amount of loans that the Company
is permitted to make under applicable regulations to any one borrower, including
related entities, is the greater of 25% of unimpaired capital with Board
approval. Based on the Company's current capitalization of $11.6 million, the
Company's loans-to-one borrower limit is approximately $2.9 million.

         Federal Reserve System. In 1980, Congress enacted legislation which
imposed Federal Reserve requirements (under "Regulation D") on all depository
institutions that maintain transaction accounts or non-personal time deposits.
These reserves may be in the form of cash or non-interest-bearing deposits with
the regional Federal Reserve Bank. NOW accounts and other types of accounts that
permit payments or transfers to third parties fall within the definition of
transaction accounts and are subject to Regulation D reserve requirements, as
are any non-personal time deposits at a bank.

         Community Reinvestment Act. The Company is also subject to the
provisions of the Community Reinvestment Act of 1977, which requires the
appropriate federal bank regulatory agency, in connection with its regular
examination of a bank, to assess the bank's record in meeting the credit needs
of the community serviced by the bank, including low and moderate income
neighborhoods. The regulatory agency's assessment of the bank's record is made
available to the public. Further, such assessment is required of any bank which
has applied, among other things, to establish a new branch office that will
accept deposits, relocate an existing office or merge or consolidate with, or
acquire the assets or assume the liabilities of, a federally regulated financial
institution. As a component of its Community Reinvestment Act outreach, the
Company has instituted an affordable home loan program for first-time home
buyers and low to moderate income borrowers.

         Interstate Banking. On September 29, 1994, the Federal government
enacted the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
(the "1994 Act"). The provisions of the 1994 Act became effective on September
29, 1995, at which time eligible bank holding companies in any state were
permitted, with Federal Reserve approval, to acquire organizations in any other
state. As such, all existing regional compacts and substantially all existing
regional limitations on interstate acquisitions of banking organizations have
been eliminated.

         The 1994 Act also removed substantially all of the existing
prohibitions on interstate branching by banks. On and after June 1, 1997, a bank
operating in any state may establish one or more branches within any other state
without, as currently required, the establishment of a separate banking
structure within the other state. Interstate branching is allowed earlier than
the automatic phase-in date of June 1, 1997, as long as the legislatures of both
states involved have adopted statutes expressly permitting such branching to
take place at an earlier date.

         Under the Tennessee Bank Reform Act of 1996 that amended the Tennessee
Banking Act, the acquisition of Tennessee banks and bank holding companies by,
and mergers with, out-of-state banks and bank holding companies is permitted
with the prior approval of the Department subject to the requirements of the
Act. An amendment to the Bank Reform Act of 1996, effective June 1, 1997, also
permits Tennessee state banks and savings banks, with prior approval of the
Department, to operate branches outside the state of Tennessee. Although this
legislation has the potential to increase the number of competitors in the
market place of the Company, the Company cannot predict the actual impact of
such legislation on the competitive position of the Company. Out-of-state banks
may not, under current Tennessee law, branch de novo into Tennessee nor may
out-of-state banks or bank holding companies enter Tennessee through
"branch-only" acquisition.








                                     - 17 -
<PAGE>   18

CHANGE IN CONTROL RESTRICTIONS

         Statutory Provisions. The Change in Bank Control Act requires the
written consent of the FDIC be obtained prior to any person or company acquiring
"control" of a state-chartered savings bank. Tennessee law also requires the
prior written consent of the Department to acquire control of a
Tennessee-chartered savings bank. Upon acquiring control, a company will be
deemed to be a bank holding company and must register with the Federal Reserve.
Conclusive control is presumed to exist if, among other things, an individual or
company acquires more than 25% of any class of voting stock of the Company.
Rebuttable control is presumed to exist if, among other things, a person
acquires more than 10% of any class of voting stock and the issuer's securities
are registered under Section 12 of the Exchange Act (the Common Stock is not
expected to be so registered) or the person would be the single largest
stockholder. Restrictions applicable to the operations of a bank holding company
and conditions that may be imposed by the Federal Reserve in connection with its
approval of a company to become a bank holding company may deter companies from
seeking to obtain control of the Company.

         Other. While not directly restricting efforts to acquire control of the
Company, certain other characteristics of the Company's organization may
discourage attempts to acquire control of the Company. The Company's By-Laws
provide that approximately one-third of its Board of Directors are elected each
year (see "MANAGEMENT--Classification of Directors"), thereby making it more
difficult for a potential acquirer of control of the Company to replace the
members of the Board of Directors than it would be if directors were elected at
more frequent intervals or if a greater percentage of directors were elected at
any one time.

         The restrictions contained in the Change of Bank Control Act and the
regulations promulgated thereunder will apply to acquisitions of the Common
Stock in the Offering. In addition, as a result of all of the foregoing
restrictions on acquisitions, the Company is a less attractive target for a
"takeover" attempt than other less-highly regulated companies generally.
Accordingly, these restrictions might deter offers to purchase the Company which
stockholders may consider to be in their best interests, and may make it more
difficult to remove incumbent management.

REGULATION OF BANK HOLDING COMPANIES

         The Company is subject to regulation by the Federal Reserve and is
required to file with the Federal Reserve annual reports and other information
regarding its business operations and the business operations of its
subsidiaries. It is also subject to examination by the Federal Reserve and is
required to obtain Federal Reserve approval prior to acquiring, directly or
indirectly, ownership or control of voting shares of any bank if, after such
acquisition, it will own or control, directly or indirectly, more than 5% of the
voting stock of such bank. In addition, pursuant to the provisions of the Bank
Holding Company Act of 1956, as amended, and regulations promulgated by the
Federal Reserve thereunder, the bank holding company is only able to engage in,
or own or control companies that engage in, activities deemed by the Federal
Reserve to be so closely related to banking as to be a proper incident thereto.

DIVIDENDS

         During the first three years of the Savings Bank's operation it has
been precluded from declaring and paying dividends in accordance with the
requirements of the Department. Earnings generated from the operation of the
Savings Bank have been used to finance the growth of the Savings Bank and have
not been paid to shareholders. Following the mandatory initial three-year
moratorium on the payment of dividends imposed by regulatory authorities, the
Directors will determine whether dividends on the Common Stock will be declared
and paid, taking into consideration the Company's operating results, financial
condition, tax considerations, future capital requirements and other relevant
factors. The Directors may declare a no-cash dividend if, after considering the
above factors, it appears prudent to do so. The Directors are not, however,
obligated to pay any such dividend and will only do so if it appears to be in
the best interest of the Company.

         Tennessee law requires that dividends be paid only from retained
earnings (or undivided profits), except that dividends may be paid from capital
surplus with the prior, written consent of the Department. Tennessee laws
regulating savings banks require certain charges against and transfers from an
institution's undivided profits account before undivided profits can be made
available for the payment of dividends. The Department generally prohibits a
newly chartered institution from paying dividends during its first three years
of operation without the Department's prior approval.







                                     - 18 -
<PAGE>   19

MONETARY POLICY

         The Company, like other depository institutions, is affected by the
monetary policies implemented by the Federal Reserve. The Federal Reserve has
the power to restrict or expand the money supply through open market operations,
including the purchase and sale of government securities and the adjustment of
reserve requirements. These actions may result in significant fluctuations in
market interest rates, which could adversely affect the operations of the
Company, such as its ability to make loans and attract deposits, as well as
market demand for loans.

CAPITAL ADEQUACY

         See "Capital Adequacy" above for a discussion of bank regulatory
agencies' capital adequacy requirements.

RECENT LEGISLATION

         Bills are presently pending before the United States Congress, and
additional bills may be introduced in the future in the Congress and the
Tennessee General Assembly, to alter the structure, regulation and competitive
relationships of the nation's financial institutions. On December 19, 1991,
President Bush signed the Federal Deposit Insurance Corporation's Improvement
Act of 1991 ("FDICIA"), the principal initial effect of which was to permit the
Bank Insurance Fund (the "BIF") to borrow up to $30 billion from the U.S.
Treasury (to be repaid through deposit insurance premiums over 15 years) and to
permit the BIF to borrow working capital from the Federal Financing Bank in an
amount up to 90 percent of the value of the assets the FDIC has acquired from
failed banks, which it is estimated would yield approximately $40 billion in
working capital. The bill followed a year-long effort initiated by the Bush
Administration to enact major banking legislation. Virtually none of the
Administration's major systemic proposals, including nationwide interstate
banking and branching or ownership of financial institutions by commercial
entities, were included in the final bill. However, a number of additional
pervasive supervisory measures, some of which are described below, were included
in the FDICIA. The effect of these measures will be to a great extent dependent
on the manner in which bank regulatory authorities choose to enforce regulations
which have been recently issued pursuant to the FDICIA.

         The additional supervisory powers and regulations mandated by the
FDICIA, include a "prompt corrective action" program based upon five regulatory
zones for banks, in which all banks are placed, largely based on their capital
positions. Regulators are permitted to take increasingly harsh action as a
bank's financial condition declines. Regulators are also empowered to place in
receivership or require the sale of a bank to another depository institution
when a bank's capital leverage ratio reaches two percent. Better capitalized
institutions are generally subject to less onerous regulation and supervision
than banks with lesser amounts of capital. The FDIC has adopted regulations
implementing the prompt corrective action provisions of the FDICIA, which place
financial institutions in the following five categories based upon
capitalization ratios: (1) a "well capitalized" institution has a total
risk-based capital ratio of at least 10%, a Tier 1 risk-based ratio of at least
6% and a leverage ratio of at least 5%; (2) an "adequately capitalized"
institution has a total risk-based ratio of at least 8%, a Tier 1 risk-based
ratio of at least 4% and a leverage ratio of at least 4%; (3) an
"undercapitalized" institution has a total risk-based capital ratio of under 8%,
a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%;
(4) a "significantly undercapitalized" institution has a total risk-based
capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage
ratio of under 3%; and (5) a "critically undercapitalized" institution has a
leverage ratio of 2% or less. Institutions in any of the three undercapitalized
categories would be prohibited from declaring dividends or making capital
distributions. The proposed regulations also establish procedures for
"downgrading" an institution to a lower capital category based on supervisory
factors other than capita. At March 31, 1998, under these regulations the
Company would be deemed to be a "well-capitalized" institution if solely viewed
on the basis of capital ratios. Various other sections of the FDICIA will impose
substantial new audit and reporting requirements and will increase the role of
independent accountants and outside directors. Set forth below is a list
containing certain significant provisions of the FDICIA:

         (i) annual on-site examinations by regulators (except for smaller,
well-capitalized banks with high management ratings, which must be examined
every 18 months);

         (ii) mandated annual independent audits by independent public
accountants and an independent audit committee of outside directors for
institutions with more than $500,000,000 in assets;







                                     - 19 -
<PAGE>   20

         (iii) new uniform disclosure requirements for interest rates and terms
of deposit accounts;

         (iv) a requirement that the FDIC establish a risk-based deposit
insurance assessment system by 1994;

         (v) authorization for the FDIC to impose one or more special
assessments on its insured banks to recapitalize the BIF;

         (vi) a requirement that each institution submit to its primary
regulators an annual report on its financial condition and management, which
report will be available to the public;

         (vii) a ban on the acceptance of brokered deposits except by well
capitalized institutions and by adequately capitalized institutions with the
permission of the FDIC and the regulation of the brokered deposit market by the
FDIC;

         (viii) restrictions on the activities engaged in by state banks and
their subsidiaries as principal, including insurance underwriting, to the same
activities permissible for national banks and their subsidiaries unless the
state bank is well capitalized and a determination is made by the FDIC that the
activities do not pose a significant risk to the insurance fund;

         (ix) a review by each regulatory agency of accounting principles
applicable to reports or statements required to be filed with federal banking
agencies and a mandate to devise uniform requirements for all such filings;

         (x) the institution by each regulatory agency of noncapital safety and
soundness standards for each institution it regulates which cover (1) internal
controls, (2) loan documentation, (3) credit underwriting, (4) interest rate
expense, (5) asset growth, (6) compensation, fees and benefits paid to
employees, officers and directors, (7) operational and managerial standards, and
(8) asset quality, earnings and stock valuation standards for preserving a
minimum ratio of market value to book value for publicly traded shares (if
feasible);

         (xi) uniform regulations regarding real estate lending; and

         (xii) a review by each regulatory agency of the risk-based capital
rules to ensure they take into account adequate interest rate risk,
concentration of credit risk, and the risks of non-traditional activities.

EMPLOYEES

         At December 31, 1998, the Company had a total of 44 employees with 29
of those employed on a full-time basis.

ITEM 2.  DESCRIPTION OF PROPERTY

         The Company's principal office is located at 1907 North Roan Street,
Johnson City, Washington County, Tennessee. The Savings Bank owns the land and
the approximately 36,000 square foot building, 18,000 feet of which is leasable
space. This property serves as the main office of the Savings Bank. The Savings
Bank also operates branch offices at 3300 Browns Mill Road and 612 West Walnut
Street, Johnson City, Tennessee; and 240 West Center Street, Kingsport, Sullivan
County, Tennessee. The Savings Bank owns the land and the buildings in
Kingsport. The Savings Bank leases the Browns Mill Road office from Allen
Properties, Inc. Charles E. Allen, Jr., chairman and chief financial officer of
the Savings Bank is a principal of Allen Properties, Inc. The lease was
negotiated at arm's length and was approved by the Department and the FDIC. Rent
for the 2,625 square foot building for the first three years is $30,600
annually. This amount includes taxes, insurance and maintenance costs. The West
Walnut branch is owned by the Savings Bank.

          All facilities have improvements including drive-through tellers,
vaults, night depository and certain facilities have safe deposit boxes.








                                     - 20 -
<PAGE>   21

ITEM 3.  LEGAL PROCEEDINGS

         There are no material pending legal proceedings to which the Company or
the Savings Bank is a party or of which any of their properties are subject; nor
are there material proceedings known to the Company to be contemplated by any
governmental authority; nor are there material proceedings known to the Company,
pending or contemplated, in which any director, officer or affiliate or any
principal security holder of the Company, or any associate of any of the
foregoing, is a party or has an interest adverse to the Company or the Bank.

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

         None





                                     - 21 -
<PAGE>   22



                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         There is no established public trading market for the shares.
Management of the Company is aware that isolated transactions in the Common
Stock occur from time to time. To the best of the knowledge of the Company the
most recent transactions in the Common Stock were in February 1998 and were for
prices ranging from $11.00 to $12.00 per share.

         There were 938 holders of record of the Common Stock as of March 15,
1999.

         The Company currently intends to retain its earnings, if any, for use
in the business and does not anticipate paying any cash dividends in the
foreseeable future. The board of directors cannot predict when such dividends,
if any, will ever be made. The payment of dividends, if any, shall at all times
be subject to the payment of the Company's expenses, the maintenance of
reasonable working capital and risk reserves, and minimum capitalization
requirements for banks.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

GENERAL

The following discussion and analysis is intended to assist in understanding the
financial condition and the results of operations of the Company. References to
the "Company" include State of Franklin Bancshares, Inc. and/or State of
Franklin Savings Bank.

FOR THE YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31,
1997

EARNINGS REVIEW

Total net income of the Company for the year ended December 31, 1998 was
$496,489, an increase of $439,454 over the year ended December 31, 1997 total
net income of $57,035. Net income per common share was $0.44 compared to per
share income of $0.05 in 1997. Return on average assets was 0.49% and the return
on average equity was 4.42% for the year period ended December 31, 1998.

Operating results in 1998 reflected higher net interest income and noninterest
income. Net interest income of $2.8 million for the year ended December 31, 1998
was up 66% over the 1997 period. Loans increased 71% and deposits increased 33%.
The 1998 provision for possible loan losses was $275,127. Noninterest income
increased $71,556, or 21%, with other fees and service charges and net rental
income responsible for most of the increase over the year ended December 31,
1997. Noninterest expense was $2.4 million for the 1998 period, an increase of
36% over the 1997 period, primarily resulting from increased salaries and
benefits, data processing and other expenses as a result of the opening of an
additional location and the overall growth of the Company.

NET INTEREST INCOME AND MARGIN

Net interest income increased $1.1 million or 66% for the year ended December
31, 1998 to $2.8 million compared to $1.7 million for the year ended December
31, 1997. Total loans outstanding increased $35.7 million or 71% over total
loans at December 31, 1997.

Average deposits increased by 54% or $28.6 million to $81.8 million in 1998
compared to $53.2 million in 1997. The rate paid on average interest-bearing
liabilities decreased 16 basis points during the year ended December 31, 1998 to
5.44%.

PROVISION FOR LOAN LOSSES

During the year ended December 31, 1998, the provision for possible loan losses
was $275,127. There were $277 in charge-offs during the year ended December 31,
1998 and $1,335 for the year ended December 31, 1997. The allowance 






                                     - 22 -
<PAGE>   23

for possible loan losses represented 0.73% of total loans, net of mortgage loans
held-for-sale, at December 31, 1998, compared to 0.70% at December 31, 1997. A
mortgage loan of $246,000 was made on the sale of real estate owned.

PROVISION FOR INCOME TAXES

For the year ended December 31, 1998, the provision for federal income taxes was
$52,206, an increase of $57,283 from 1997, primarily due to the increase in
income before income taxes.

NONINTEREST INCOME

The Company's noninterest income was $411,155 during the year ended December 31,
1998, an increase of $71,556 or 21% over the comparable 1997 period. The
increase was attributable to increases in other fees and service charges, net
gain on loans sold, insurance commission and income, and net rental income of
$89,217, $31,042, $2,344, and $65,491, respectively, which were offset by
decreases in other income and net gain on sale and maturity of securities of
$7,262 and $109,276, respectively.

NONINTEREST EXPENSE

Noninterest expense totaled $2.4 million for the period ending December 31,
1998, an increase of $642,298. Compensation and related benefits of $1.0 million
accounted for 44% of the total compared to $782,029 or 44% for the year ended
December 31, 1997.

FOR THE YEAR ENDED DECEMBER 31, 1997 COMPARED TO THE PERIOD FEBRUARY 13, 1996
(DATE OF INCEPTION) TO DECEMBER 31, 1996

EARNINGS REVIEW

Total net income of the Company for the year ended December 31, 1997 was $57,035
compared to a loss of $(450,732) for the period from inception to December 31,
1996. Net income per common share was $0.05 compared to $(0.74) in 1996. Return
on average assets was 0.09% and the return on average equity was 0.70% for the
year ended December 31, 1997.

Operating results in 1997 reflected higher net interest income and noninterest
income. Net interest income of $1.7 million for the year ended December 31, 1997
was up 231% over the 1996 period. The 1997 provision for possible loan losses
was $226,095. Noninterest income increased $255,844, or 305%, with significant
increases in all categories of other income including other fees and service
charges, net gain on sale and maturity of securities, insurance commission
income and rental income. Noninterest expense was $1.8 million for the 1997
period, an increase of 80% over the 1996 period, primarily resulting from
increased salaries and benefits. Expenses also increased due to the opening of
an additional location.

NET INTEREST INCOME AND MARGIN

Net interest income increased $1.2 million or 231% for the year ended December
31, 1997 to $1.7 million compared to $512,773 in the period ended December 31,
1996.

PROVISION FOR LOAN LOSSES

During the year ended December 31, 1997, the provision for possible loan losses
was $226,095. There were $1,335 charge-offs during the year ended December 31,
1997 and no charge-offs for the period ended December 31, 1996. The allowance
for possible loan losses represented .70% of total loans, net of mortgage loans
held-for-sale, at December 31, 1997, compared to .76% at December 31, 1996.








                                     - 23 -
<PAGE>   24

PROVISION FOR INCOME TAXES

For the year ended December 31, 1997, the provision for federal income taxes was
($5,077,) an increase of $58,366 from ($63,443) in 1996, primarily due to an
increased effective tax rate in 1997 and the use of the NOL carryforward.

NONINTEREST INCOME

The Company's noninterest income was $339,599 during the year ended December 31,
1997, an increase of $255,844 or 305% over the comparable 1996 period. The
increase was attributable to increases in all categories of noninterest income.

NONINTEREST EXPENSE

Noninterest expense totaled $1.8 million for the year ended December 31, 1997,
an increase of $780,680. Compensation and related benefits of $782,029 accounted
for 44% of the total compared to $482,684 or 49% for the period ended December
31, 1996.

BALANCE SHEET REVIEW

The Company places an emphasis on an integrated approach to its balance sheet
management. Significant balance sheet components of investment securities, loans
and sources of funds are managed in an integrated manner with the management of
interest rate risk, liquidity and capital. These components are examined below.

INVESTMENT SECURITIES

Investment securities totaled $12.2 million at December 31, 1998. The majority
of the holdings are backed by U. S. Government or Federal Agency guarantees
limiting the credit risk associated with these securities. At December 31, 1998,
all of the investment securities were held as available-for-sale compared to
$6.5 million at December 31, 1997.

LOANS

Loans outstanding totaled $86.1 million at December 31, 1998. This represented
an increase of 71% from the December 31, 1997 outstanding loans of $50.3
million.

Consumer loans increased to $7.7 million at December 31, 1998, an increase of
62% from $4.8 million at December 31, 1997. Real estate construction lending
totaled $22.0 million and $11.9 million at December 31, 1998 and 1997,
respectively. Commercial loans of $26.6 million at December 31, 1998 increased
117% from $12.3 million at December 31, 1997.

NON-PERFORMING ASSETS

There were no non-performing assets or nonaccrual loans at December 31, 1998 and
December 31, 1997. The allowance for possible loan losses was $630,324 and
$355,474 at December 31, 1998 and 1997, respectively. Management believes the
allowance for possible loan losses is adequate to provide for potential loan
losses.

DEPOSITS

Total deposits at December 31, 1998 of $96.4 million, represented an increase of
$24.1 million or a 33% increase from $72.2 million at December 31, 1997.
Non-interest bearing demand deposits totaled $5.6 million at December 31, 1998,
a decrease of $1.5 million from December 31, 1997. Interest bearing demand and
money market deposits increased $9.7 million to $18.4 million at December 31,
1998. Savings deposits increased $2.8 million to $6.1 million at December 31,
1998. Time deposits of $66.3 million increased from $53.2 million at December
31, 1997.








                                     - 24 -
<PAGE>   25

CAPITAL

Equity capital at December 31, 1998 was $11.6 million, an increase of $0.7
million from $10.9 million at December 31, 1997. A $5,000 dividend was paid by
the Savings Bank to the Company in connection with the reorganization. This
special one time dividend was approved by the Commissioner of the Tennessee
Department of Financial Institutions.

At December 31, 1998, all capital ratios were in excess of the regulatory
minimums, with the Company's Tier 1, total risk-based and leverage ratio of
16.24%, 14.98% and 9.44%, respectively.

LIQUIDITY

The purpose of liquidity management is to ensure that there is sufficient cash
flow to satisfy demands for credit, deposit withdrawals, and other corporate
needs. Traditional sources of liquidity include asset maturities and growth in
core deposits. Other sources of funds such as securities sold under agreements
to repurchase, negotiable certificates of deposit and other liabilities are
sources of liquidity which the Company has not significantly used. The Company
had unused sources of liquidity in the form of unused federal funds lines of
credit and a line of credit for the Federal Home Loan Bank of Cincinnati
totaling $12.9 million at December 31, 1998.

EFFECTS OF INFLATION AND CHANGING PRICES

The consolidated financial statements and related financial data presented
herein have been prepared in accordance with generally accepted accounting
principles, which require the measurement of financial position and operating
results in terms of historical dollars, without considering changes in relative
purchasing power over time due to inflation.

Unlike most industrial companies, virtually all of the assets and liabilities of
a financial institution are monetary in nature. As a result, interest rates
generally have a more significant impact on a financial institution's
performance than does the effect of inflation. In the current interest rate
environment, the liquidity and maturity structures of the Company's assets and
liabilities are critical to maintenance of acceptable performance levels.

YEAR 2000 COMPLIANCE

The Year 2000 poses serious challenges to the banking industry. Many experts
believe that even the most prepared organizations may encounter some
implementation problems. The federal banking agencies are concerned that
financial institutions avoid major disruptions to service and operations. All
banks are required to have an action plan to address Year 2000 issues which must
include an indication of management awareness of the problems and the commitment
to solutions; identification of external risks; and operational issues that are
relevant to a bank's Year 2000 planning.

The Federal Financial Institutions Examination Council ("FFIEC") has issued
guidelines and target time frames to accomplish critical actions concerning Year
2000 compliance:

         * By September 30, 1997, all banks should have identified affected
applications and databases. Mission critical applications should be identified
and an action plan set for Year 2000 work.

         * By December 31, 1997, code enhancements and revisions, hardware
upgrades, and other associated changes should be largely completed by all banks.
In addition, for mission critical applications, programming changes should be
largely completed and testing should be well underway.

         * Between January 1, 1999 and December 31, 1999, banks should be
testing and implementing their Year 2000 conversion programs.

         External factors which may adversely affect the Company include
reliance on vendors, such as third-party data processing services and software
and hardware vendors; electronic data-sensitive exchange among other financial
institutions which may not be Year 2000 compliant; corporate customers of the
Company and other debtors.








                                     - 25 -
<PAGE>   26

         The Company has been assessing its state of readiness by evaluating its
information technology ("IT") and non- IT systems. IT systems commonly include
data processing, accounting and telephone systems. with respect to its IT
systems, the Company estimates that its Year 2000 identification, assessment and
remediation efforts are substantial complete. during 1999, further testing will
be carried out in order to ensure that all systems are working properly. the
company has assessed its Year 2000 status in regard to non-IT systems and has
determined that no material risk exists.

         The Company has communicated with its significant vendors in order to
determine the extent to which interfaces with such entities are vulnerable to
Year 2000 issues and whether the products and services purchased from such
entities are Year 2000 compliant. The Company has received either verbal or
written assurance from these vendors that they expect to address all their
significant Year 2000 issues on a timely basis. With respect to significant
borrowers and depositors, the Company does not anticipate any material Year 2000
issues.

         The Company has expended $15,000 in connection with its Year 2000
readiness and believes the cost of its further Year 2000 identification,
assessment, remediation and testing efforts will not exceed $10,000.

ITEM 7.  FINANCIAL STATEMENTS

         The consolidated financial statements of the Company are set forth
below.








                                     - 26 -
<PAGE>   27
                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                              INDEX TO AUDIT REPORT
                           DECEMBER 31, 1998 AND 1997


<TABLE>
<CAPTION>
AUDITED CONSOLIDATED FINANCIAL STATEMENTS:                                 PAGES
                                                                           -----
<S>                                                                        <C>
      Independent Auditor's Report                                              7

      Consolidated Statements of Financial Condition                           28

      Consolidated Statements of Income                                        29

      Consolidated Statements of Changes in Stockholders' Equity               30

      Consolidated Statements of Cash Flows                                 31-32

      Notes to Consolidated Financial Statements                            33-35

      Statement of Management Responsibility                                  56
</TABLE>




<PAGE>   28

<TABLE>
<S>                                  <C>                                               <C>
                                                BAYLOR AND BACKUS                 
   D.G. LEONARD, CPA                      CERTIFIED PUBLIC ACCOUNTANTS                 E.N. BACKUS, CPA (1907-1971)
   R.F. VANHOY, CPA                          2112 NORTH ROAN STREET                    T.E. HULSE, CPA (1927-1975)
     ------------                    FIRST TENNESSEE BUILDING, EIGHTH FLOOR            E.R. BAYLOR, CPA (1894-1982)
                                                  P.O. BOX 1736                        A.C. NICKELL, CPA (1921-1983)
   T.S. JOHNSON, CPA                      JOHNSON CITY, TENNESSEE 37605                W.E. MORELOCK, CPA (1927-1985)
   C.J. STAMPFLI, CPA                            (423) 282-9000                        H.L. SIENKNECHT, CPA (1917-1990)
</TABLE>






                          INDEPENDENT AUDITOR'S REPORT



To the Stockholders and
  the Board of Directors
State of Franklin Bancshares, Inc.
Johnson City, Tennessee

We have audited the accompanying consolidated statements of financial condition
of State of Franklin Bancshares, Inc. (a Tennessee corporation) and subsidiaries
as of December 31, 1998 and 1997, and the related consolidated statements of
income, changes in stockholders' equity and cash flows for the years ended
December 31, 1998 and 1997, and the period February 15, 1996 (date of inception)
to December 31, 1996. These consolidated financial statements are the
responsibility of State of Franklin Bancshares, Inc.'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 generally accepted auditing
standards. 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
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of State of Franklin
Bancshares, Inc. and subsidiaries as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for the years ended December
31, 1998 and 1997, and the period February 15, 1996 (date of inception) to
December 31, 1996 in conformity with generally accepted accounting principles.




BAYLOR AND BACKUS
Certified Public Accountants

Johnson City, Tennessee

February 26, 1999









    MEMBERS OF AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS & TENNESSEE
                    SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS





                                     - 27 -
<PAGE>   29

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
                           DECEMBER 31, 1998 AND 1997

                                   A S S E T S

<TABLE>
<CAPTION>
                                                         1998           1997
                                                  -----------    -----------
<S>                                               <C>            <C> 
Cash and Cash Equivalents                          13,928,172     12,415,800
Investments - Held-To-Maturity
  (Estimated Market 1998 - $-0-)
  (Estimated Market 1997 - $10,023,214)                    --     10,000,000
Investments - Available-for-Sale                   12,248,572      6,462,901
Loans Receivable, Net                              86,104,974     50,374,093
Accrued Interest Receivable, Net                      685,963        400,760
Land, Buildings and Equipment at Cost Less
  Accumulated Depreciation of $347,134 in 1998
  and $146,286 in 1997                              4,117,351      3,568,281
Prepaid Expense and Accounts Receivable                48,218         80,110
Receivable from ESOP                                  108,286             --
FHLB Stock                                            471,200             --
Leases Receivable, Net                                120,999             --
Investment in Service Bureau at Cost                   15,000         15,000
Deferred Tax Assets                                   186,946         55,445
                                                  -----------    -----------
         Total Assets                             118,035,681     83,372,390
                                                  ===========    ===========

   L I A B I L I T I E S  A N D  S T O C K H O L D E R S'  E Q U I T Y

Liabilities:

Deposits                                           96,364,077     72,243,884
Advances by Borrowers for Taxes and Insurance          98,784         59,911
Accrued Interest on Deposits                          103,769         43,469
Accounts Payable and Accrued Expenses                 189,379        122,026
Notes Payable                                         687,925             --
FHLB Advances                                       9,000,000             --
Deferred Gain on REO                                   21,448             --
                                                  -----------    -----------
Total Liabilities                                 106,465,382     72,469,290
                                                  -----------    -----------

Stockholders' Equity:

Common Stock, $1.00 Par Value,
  Authorized: 3,000,000 Shares; Issued: 1,180,152
    Shares at December 31, 1998 and 1,111,280 
    Shares at December 31, 1997                     1,180,152      1,111,280
Common Stock Subscribed                                 6,996             --
Paid-In Capital                                    10,905,359     10,160,136
Accumulated Other Comprehensive Income                 39,820         25,381

Retained Earnings                                     102,792       (393,697)
Less: Employee Stock Ownership                       (664,820)            --
                                                  -----------    -----------
Total Stockholders' Equity                         11,570,299     10,903,100
                                                  -----------    -----------
         Total Liabilities and Stockholders' 
               Equity                             118,035,681     83,372,390
                                                  ===========    ===========
</TABLE>


                   The accompanying notes are an integral part
                   of the consolidated financial statements.


                                     - 28 -
<PAGE>   30

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                        CONSOLIDATED STATEMENTS OF INCOME
               FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997, AND
      THE PERIOD FEBRUARY 15, 1996 (DATE OF INCEPTION) TO DECEMBER 31, 1996


<TABLE>
<CAPTION>
                                                                     1998         1997          1996
                                                                ---------    ---------     ---------
<S>                                                             <C>          <C>           <C>
Interest Income
   Interest on Loans                                            5,756,736    2,729,255       570,212
   Interest on Cash Equivalents and Investments                 1,820,032    1,946,194       629,918
                                                                ---------    ---------     ---------
         Total Interest Income                                  7,576,768    4,675,449     1,200,130
                                                                ---------    ---------     ---------
Interest Expense
   Interest on Deposits                                         4,457,203    2,975,541       687,357
   Other Interest                                                 303,932          786            --
                                                                ---------    ---------     ---------
         Total Interest Expense                                 4,761,135    2,976,327       687,357
                                                                ---------    ---------     ---------

Net Interest Income Before Provision for Loan Losses            2,815,633    1,699,122       512,773
Provision for Loan Losses                                        (275,127)    (226,095)     (130,715)
                                                                ---------    ---------     ---------

         Net Interest Income After Provision for Loan Losses    2,540,506    1,473,027       382,058
                                                                ---------    ---------     ---------
Other Income
   Other Fees and Service Charges                                 176,455       87,238        17,557
   Net Gain on Loans Sold                                          46,180       15,138            --
   Net Gain on Sale and Maturity of Securities                     38,769      148,045        58,125
   Insurance Commission Income                                     37,120       34,776            --
   Rental Income, Net                                             102,330       36,839            --
   Other                                                           10,301       17,563         8,073
                                                                ---------    ---------     ---------
         Total Other Income                                       411,155      339,599        83,755
                                                                ---------    ---------     ---------
Other Expenses
   Compensation and Related Benefits                            1,048,393      782,029       482,684
   Occupancy Expenses                                             246,437      190,762        45,658
   Furniture and Equipment Expenses                               183,905       98,439        45,740
   Advertising                                                    118,102      132,316       100,342
   Data Processing Expense                                        218,251      121,240        53,107
   Other                                                          587,878      435,882       252,457
                                                                ---------    ---------     ---------
         Total Other Expenses                                   2,402,966    1,760,668       979,988
                                                                ---------    ---------     ---------
Income (Loss) Before Income Taxes                                 548,695       51,958      (514,175)
Provision for Income Taxes                                        (52,206)       5,077        63,443
                                                                ---------    ---------     ---------
Net Income (Loss)                                                 496,489       57,035      (450,732)
                                                                =========    =========     =========
Basic and Diluted Earnings (Loss) Per Share                          0.44         0.05         (0.74)
                                                                     ====         ====          ====

</TABLE>


                   The accompanying notes are an integral part
                   of the consolidated financial statements.





                                     - 29 -
<PAGE>   31

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
               FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997, AND
      THE PERIOD FEBRUARY 15, 1996 (DATE OF INCEPTION) TO DECEMBER 31, 1996


<TABLE>
<CAPTION>
                                                                                Accumulated
                                                    Common                         Other                    Employee
                                        Common       Stock       Paid-In       Comprehensive   Retained       Stock
                                        Stock      Subscribed    Capital          Income       Earnings     Ownership      Total 
                                      ---------    ----------   ----------     -------------   --------     ---------    ----------
<S>                                   <C>          <C>          <C>            <C>             <C>          <C>          <C>   
Net Proceeds
  from Initial Stock Offering           610,000         --      5,230,415              --           --            --      5,840,415
                                                                                                                         ----------

Comprehensive Income
   Other Comprehensive Income,
    Net of Tax:
     Unrealized Gains on Securities
      Available-For-Sale:
       Unrealized Holding Gains
        Arising During the Period            --         --             --          58,997           --            --         58,997

   Net Loss                                  --         --             --              --     (450,732)           --       (450,732)
                                                                                                                         ----------

         Total Comprehensive Income          --         --             --              --           --            --       (391,735)
                                      ---------      -----     ----------          ------      -------      --------     ----------
Balance at December 31, 1996            610,000         --      5,230,415          58,997     (450,732)           --      5,448,680
                                                                                                                         ----------

Net Proceeds
  from Secondary Stock Offering         501,280         --      4,929,721              --           --            --      5,431,001
                                                                                                                         ----------

Comprehensive Income
   Other Comprehensive Income,
    Net of Tax:
     Unrealized Gains on Securities
      Available-For-Sale:
       Unrealized Holding Gains
        Arising During the Period
          (Net of $61,152
            Income Tax)                      --         --             --          59,709           --            --         59,709
       Less:
         Reclassification Adjustment
           (Net of $48,076
             Income Tax)                     --         --             --         (93,325)          --            --        (93,325)
                                                                                                                         ----------

                                             --         --             --              --           --            --        (33,616)

         Net Income                          --         --             --              --       57,035            --         57,035
                                                                                                                         ----------
         Total Comprehensive Income          --         --             --              --           --            --         23,419
                                      ---------      -----     ----------          ------      -------      --------     ----------
Balance at December 31, 1997          1,111,280         --     10,160,136          25,381     (393,697)           --     10,903,100
                                                                                                                         ----------

Net Proceeds
  from Sale of Stock                     68,872      6,996        745,223              --           --      (700,000)       121,091
                                                                                                                         ----------
ESOP Shares Allocated                        --         --             --              --           --        35,180         35,180
                                                                                                                         ----------
Comprehensive Income
   Other Comprehensive Income,
    Net of Tax:
     Unrealized Gains on Securities
      Available-For-Sale:
       Unrealized Holding Gains
        Arising During the Period
          (Net of $20,496
            Income Tax)                      --         --             --          39,820           --            --         39,820
       Less:
         Reclassification Adjustment
           (Net of $14,520
             Income Tax)                     --         --             --         (25,381)          --            --        (25,381)
                                                                                                                         ----------

                                             --         --             --              --           --            --         14,439

   Net Income                                --         --             --              --      496,489            --        496,489
                                                                                                                         ----------

         Total Comprehensive Income          --         --             --              --           --            --        510,928
                                      ---------      -----     ----------          ------      -------      --------     ----------
Balance at December 31, 1998          1,180,152      6,996     10,905,359          39,820      102,792      (664,820)    11,570,299
                                      =========      =====     ==========          ======      =======      ========     ==========
</TABLE>

                   The accompanying notes are an integral part
                   of the consolidated financial statements.




                                     - 30 -
<PAGE>   32
                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
               FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997, AND
      THE PERIOD FEBRUARY 15, 1996 (DATE OF INCEPTION) TO DECEMBER 31, 1996




<TABLE>
<CAPTION>
                                                                     1998            1997            1996
                                                              -----------     -----------     -----------
<S>                                                           <C>             <C>             <C> 
Cash Flows from Operating Activities
  Net Income (Loss)                                               496,489          57,035        (450,732)
  Items Not Affecting Cash and Cash Equivalents:
     Depreciation                                                 200,848         107,624          38,662
     (Increase) in Accrued Interest                              (285,203)       (238,330)       (162,430)
     Deferred Tax Assets                                         (139,229)         (5,077)        (63,443)
     Provisions for Loan Losses, Net                              274,850         224,759         130,715
     (Increase) Decrease in Prepaid Expenses
       and Accounts Receivable                                        568         (44,510)        (35,600)
     Increase in Interest Payable                                  60,300          21,845          21,623
     Increase (Decrease) in Accounts Payable
       and Accrued Expenses                                        67,353        (180,007)        302,033
     Increase in Deferred Loan Fees, Net                           14,873          35,042          17,647
     (Gain) on Sale of Investments                                (38,769)       (148,045)        (58,125)
     Discount Accretion                                            (9,097)        (23,559)             --
     Earned ESOP Shares                                            35,180              --              --
     FHLB Stock Dividends                                         (20,359)             --              --
     (Increase) in Leases Receivable, Net                        (120,999)             --              --
                                                              -----------     -----------     -----------

       Net Cash Provided (Used) by Operating Activities           536,805        (193,223)       (259,650)
                                                              -----------     -----------     -----------




Cash Flows from Investing Activities
  Purchase of Investments                                     (20,233,390)    (16,284,843)    (20,095,654)
  Proceeds from Maturities of Held-to-Maturity Investments     10,000,000              --       2,166,002
  Proceeds from Sale of Available-for-Sale Investments          6,874,235      12,683,359       3,514,062
  Proceeds from Maturities of Available-for-Sale Investments    7,500,000       1,500,000         250,000
  Principal Payments on Mortgage-Backed Securities
    Available-for-Sale                                            143,676          72,359              --
  Increase in Loans Receivable, Net                           (35,999,155)    (33,680,751)    (17,101,505)
  Purchases of Premises and Equipment                            (749,918)     (2,068,063)     (1,646,504)
  Investment in Service Bureau                                         --              --         (15,000)
  Purchase of FHLB Stock                                         (451,000)             --              --
                                                              -----------     -----------     -----------

       Net Cash Used by Investing Activities                  (32,915,552)    (37,777,939)    (32,928,599)
                                                              -----------     -----------     -----------

</TABLE>






                                     - 31 -
<PAGE>   33






<TABLE>
<CAPTION>
                                                                               1998           1997           1996
                                                                        -----------     ----------    -----------
<S>                                                                     <C>             <C>           <C>
Cash Flows from Financing Activities
  Net Increase in Deposits                                               24,120,193     38,026,675     34,217,209
  Net Increase in Advances by Borrowers
    for Taxes and Insurance                                                  38,873         40,303         19,608
  Issuance of Common Stock, Net                                              55,483      5,431,001      6,100,000
  Organization Costs                                                        (11,355)            --       (259,585)
  Proceeds from Debt                                                     10,300,000             --             --
  Repayments of Debt                                                       (612,075)            --             --
                                                                        -----------     ----------    -----------

       Net Cash Provided by Financing Activities                         33,891,119     43,497,979     40,077,232
                                                                        -----------     ----------    -----------

         Net Increase in Cash and Cash Equivalents                        1,512,372      5,526,817      6,888,983

Cash and Cash Equivalents at Beginning of Period                         12,415,800      6,888,983             --
                                                                        -----------     ----------    -----------

         Cash and Cash Equivalents at End of Period                      13,928,172     12,415,800      6,888,983
                                                                        ===========     ==========    ===========




Supplemental Schedule of Noncash Investing and Financing Activities:

  Acquisition of Operating Equipment for Contributed Capital                     --         16,500             --
  Acquisition of Real Estate Property through Foreclosure
    of Related Loan                                                         241,600             --             --
  Origination of Mortgage Loan to Finance the Sale
    of Foreclosed Real Estate                                               270,000             --             --
                                                                        ===========     ==========    ===========



Supplemental Disclosures of Cash Flow Information:

Cash Paid During the Period for:

     Taxes                                                                  170,415             --             --

     Interest                                                             4,700,835      2,954,482        665,733
                                                                        ===========     ==========    ===========

</TABLE>


                   The accompanying notes are an integral part
                   of the consolidated financial statements.





                                     - 32 -
<PAGE>   34

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 1     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

           INCORPORATION AND OPERATIONS

           State of Franklin Bancshares, Inc. (Company) was incorporated under
           the laws of the State of Tennessee for the purpose of becoming the
           holding company of State of Franklin Savings Bank (Savings Bank). The
           stockholders of the Savings Bank exchanged their shares for the
           shares of the Company, whereby the Savings Bank became a wholly owned
           subsidiary of the Company. State of Franklin Leasing Corporation
           (Leasing Corp) was incorporated under the laws of the State of
           Tennessee for the purpose of lease financing. The Leasing Corp is a
           wholly owned subsidiary of the Company. John Sevier Title services,
           Inc. (Title Company) is the wholly owned subsidiary of the Savings
           Bank.

           The State of Franklin Savings Bank (Savings Bank), headquartered in
           Johnson City, Tennessee, was incorporated on February 15, 1996, and
           was the first Tennessee Chartered Stock Savings Bank under the
           Savings Bank Chartering Act of 1991 (Savings Bank Act). The Savings
           Bank's application to the Federal Deposit Insurance Corporation
           (FDIC) to obtain federal deposit insurance for the Savings Bank's
           deposit accounts under the Bank Insurance Fund (BIF) was approved on
           February 9, 1996. The Tennessee Department of Financial Institutions
           (Department) approved the Savings Bank's registration on February 15,
           1996.

           The Savings Bank's initial stock offering of 610,000 shares was 
           completely subscribed. All shares were purchased as of March 31, 
           1996, the end of the initial offering period.

           A private placement offering was conducted in 1997 with 501,280
           shares of subscribed common stock sold for $11 per share. The date of
           the offering was April 7, 1997, expiring on September 30, 1997. Total
           proceeds received related to the offering were $5,495,380 and a
           receivable of $18,700 was due from Individual Retirement Account
           transfers at December 31, 1997. Expenses relating to the offering
           were $83,079. The net proceeds of $5,431,001 were used to provide
           capital to support future operations.

           The State of Franklin Savings Bank's primary market area is
           Washington and Sullivan Counties and their immediate vicinity in
           Tennessee. The Savings Bank has three branches in Johnson City,
           Tennessee, and one branch in Kingsport, Tennessee.

           The principal business of the Savings Bank is to accept savings
           deposits from the general public and to invest such funds in
           residential mortgage loans and, to a lesser extent, consumer and
           commercial loans. The Savings Bank provides a wide variety of
           financial services to its customers.

           A summary of significant accounting policies of the Company follows:

           BASIS OF FINANCIAL STATEMENT PRESENTATION

           The consolidated financial statements include the accounts of the
           Company and its subsidiaries. All significant intercompany accounts
           and transactions have been eliminated. The consolidated financial
           statements of the Company have been prepared in conformity with
           generally accepted accounting principles and reflect the accrual
           method of accounting. In preparing the consolidated financial
           statements, management is required to make estimates and assumptions
           that affect the reported amounts of assets and liabilities as of the
           date of the consolidated financial statements and the reported
           amounts of revenues and expenses during the reporting period. Actual
           results could differ significantly from those estimates.

           Material estimates that are particularly susceptible to significant 
           change relate to the determination of the allowance for losses on 
           loans.
           




                                     - 33 -
<PAGE>   35
                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 1     Continued

           A substantial portion of the Savings Bank's loans are secured by real
           estate in local markets. Accordingly, the ultimate collectibility of
           a substantial portion of the Savings Bank's loan portfolio is
           susceptible to changes in local market conditions.

           Management believes the allowance for loan losses is adequate.

           While management uses available information to recognize losses on
           loans, future additions to the allowances 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 Saving Bank's allowances for losses on loans.
           Such agencies may require the Savings Bank to recognize additions to
           the allowance based on their judgments about information available to
           them at the time of their examination.

           LAND, BUILDINGS AND EQUIPMENT

           Land is carried at cost. Buildings and equipment, including leasehold
           improvements, are carried at cost and are being depreciated over
           their estimated useful lives on the straight line method. Repairs and
           maintenance items are expensed and improvements are capitalized. Upon
           retirement or sale, any gain or loss will be charged to operations.

           CASH EQUIVALENTS

           For the purposes of the consolidated statement of cash flows, the
           Company considers all highly liquid debt instruments purchased with a
           maturity of three months or less to be cash equivalents.

           LOANS RECEIVABLE

           Loans receivable are stated at unpaid principal balances, less the
           allowance for loan losses and net deferred loan origination 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 direct
           origination costs, are deferred and amortized as a yield adjustment
           over the lives of the related loans using the interest method.
           Amortization of deferred loan fees is discontinued when a loan is
           placed on nonaccrual status.

           Loans are placed on nonaccrual when principal or interest is
           delinquent for 90 days or more. Any unpaid interest previously
           accrued on those loans is reversed from income, and thereafter
           interest is recognized only to the extent of payments received.

           The allowance for loan losses is maintained at a level which, in
           management's judgment, is adequate to absorb credit losses inherent
           in the loan portfolio. Management's periodic evaluation of the
           adequacy of the allowance is based on the Savings Bank's past loan
           loss experience, known and inherent risks in the portfolio, adverse
           situations that may affect the borrower's ability to repay, estimated
           value of any underlying collateral, and current economic conditions.
           The allowance for loan losses is increased by a provision for loan
           losses, which is charged to expense, and decreased by charge-offs
           (net of recoveries).





                                     - 34 -
<PAGE>   36

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 1     Continued

           INVESTMENT AND MORTGAGE-BACKED SECURITIES

           The Company is subject to Statement of Financial Accounting Standards
           (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity
           Securities.  Accordingly, investment and mortgage-backed securities 
           are categorized as either held-to-maturity, trading account or
           available-for-sale securities.

           Held-to-maturity securities are bonds, notes and debentures for which
           the Savings Bank has the positive intent and ability to hold to
           maturity and are reported at cost, adjusted for premiums and
           discounts that are recognized in interest income using the interest
           method over the period to maturity.

           Trading account securities are investments held principally for
           resale in the near term and mortgage-backed securities held for sale
           in conjunction with mortgage banking activities. Trading account
           securities would be recorded at their fair values. Unrealized gains
           and losses on trading account securities would be included
           immediately in other income. The Savings Bank has no securities in
           this classification at year end.

           Available-for-sale securities consist of bonds, notes, debentures,
           and certain equity securities not classified as trading securities or
           as held-to-maturity securities. The change in unrealized holding
           gains and losses, net of tax, on available-for-sale securities are
           reported as a separate component of other comprehensive income until
           realized. Realized gains (losses) on available-for-sale securities
           are included in other income (expense) and, when applicable, are
           reported as a reclassification adjustment, net of tax, in other
           comprehensive income. Gains and losses on the sale of
           available-for-sale securities are determined using the
           specific-identification method. The amortization of premiums and the
           accretion of discounts are recognized in interest income using
           methods approximating the interest method over the period of
           maturity.

           Declines in the fair value of individual held-to-maturity and
           available-for-sale securities below their cost that are other than
           temporary would have resulted in write-downs of the individual
           securities to their fair value. No write-downs have been included in
           earnings as realized losses.


           FEDERAL HOME LOAN BANK STOCK

           Federal Home Loan Bank (FHLB) stock is a required investment for
           institutions that are members of the Federal Home Loan Bank system.
           The required investment in the common stock is based on a
           predetermined formula and is carried at cost on the statement of
           financial condition.


           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 institution 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.






                                     - 35 -
<PAGE>   37

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 1     Continued

           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 and
           allowance for loan losses 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.

           DIVIDENDS

           As was anticipated, for at least the first three years of operations,
           all earnings which were generated from the operations of the Savings
           Bank were used to finance the growth of the Savings Bank and were not
           available to be paid to outside stockholders as dividends. Hereafter,
           in determining whether dividends will be declared on the Common
           Stock, the Board of Directors will take into account the Company's
           operating results, financial constitution, tax considerations, future
           capital and cash flow requirements, and other relevant factors.

           Tennessee law requires that dividends be paid only from retained
           earnings (or undivided profits), except that dividends may be paid
           from capital surplus with the prior written consent of the Tennessee
           Department of Financial Institutions. Tennessee laws regulating
           savings banks require certain charges against and transfers from an
           institution's undivided profits account before undivided profits can
           be made available for the payment of dividends. In addition, the
           Department generally prohibits a newly chartered institution from
           paying dividends during its first three years of operations without
           the Department's prior approval.

           On August 21,1998, the Savings Bank paid a special one-time dividend
           of $5,000 to the Company. This dividend was used to pay expenses
           related to the formation of the Holding Company. The Savings Bank had
           received approval from the State of Tennessee Department of Financial
           Institutions.

           RECLASSIFICATIONS

           In instances where required, amounts reported in prior year's
           financial statements included herein have been reclassified to put
           them on a comparable basis to the amounts reported in the December
           31, 1998 consolidated financial statements.


NOTE 2     CASH AND CASH EQUIVALENTS

           At December 31, 1998, 1997 and 1996, cash and cash equivalents were
           as follows:

<TABLE>
<CAPTION>
                                                                            
                                                1998         1997        1996
                                          ----------   ----------   ---------
           <S>                            <C>          <C>          <C> 
           Cash Working Funds                314,605      319,216     182,648
           Federal Funds Sold              6,421,000   10,094,000   5,224,956
           Due from Banks                  2,192,567    2,002,584   1,481,379
           Short-Term Interest Bearing
             Deposits                      5,000,000           --          --
                                          ----------   ----------   ---------
                                          13,928,172   12,415,800   6,888,983
                                          ==========   ==========   =========
</TABLE>




                                     - 36 -
<PAGE>   38

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 3     LAND, BUILDINGS AND EQUIPMENT

           Fixed assets at December 31, 1998, 1997 and 1996 are summarized as
           follows:

<TABLE>
<CAPTION>
                                                                1998         1997         1996
                                                           ---------    ---------    ---------
           <S>                                             <C>          <C>          <C>                             
           Land                                              850,000      850,000      100,000
           Buildings and Leasehold Improvements            2,213,345    1,964,431    1,007,406
           Furniture, Fixtures and Equipment               1,401,140      900,136      539,098
                                                           ---------    ---------    ---------
                                                           4,464,485    3,714,567    1,646,504
           Less: Accumulated Depreciation                    347,134      146,286       38,662
                                                           ---------    ---------    ---------
                                                           4,117,351    3,568,281    1,607,842
                                                           =========    =========    =========
</TABLE>

NOTE 4     LOANS RECEIVABLE

           Loans receivable at December 31, 1998, 1997 and 1996 consist of the
           following:

<TABLE>
<CAPTION>
                                                                                                                            
                                                                  1998           1997           1996
                                                           -----------    -----------    -----------
               <S>                                         <C>            <C>            <C> 
               First Mortgage Loans                         36,823,269     24,984,570     11,356,572
               Construction Loans                           22,024,861     11,859,068      4,217,400
               Consumer Loans                                7,726,136      4,764,911      2,107,552
               Participation Loans, Net                        863,162        873,263             --
               Commercial Loans                             26,603,529     12,256,079      2,439,451
               Savings Account Loans                           545,011        193,130         81,178
               Credit Line Advances                            396,618        239,115         14,324
                                                           -----------    -----------    -----------
                 Gross Loans Receivable                     94,982,586     55,170,136     20,216,477
                                                           -----------    -----------    -----------

               Less:
                 Undisbursed Portion of Loans in Process    (8,179,727)    (4,387,881)    (3,114,972)
                 Net Deferred Loan Origination Fees            (67,561)       (52,688)       (17,647)
                 Accumulated General Loan Loss Reserves       (630,324)      (355,474)      (130,715)
                                                           -----------    -----------    -----------
                                                            (8,877,612)    (4,796,043)    (3,263,334)
                                                           -----------    -----------    -----------
               Loans Receivable as Determined in
                 Accordance with Generally Accepted
                 Accounting Principles                      86,104,974     50,374,093     16,953,143
                                                           ===========    ===========    ===========

               An analysis of the allowance for loan losses
                 is as follows:

                 Balance - Beginning of Period                 355,474        130,715             --

                 Provision for Losses                          275,127        226,094        130,715
                 Actual Loan Losses                               (277)        (1,335)            --
                                                           -----------    -----------    -----------

                 Balance - End of Period                       630,324        355,474        130,715
                                                           ===========    ===========    ===========

</TABLE>


              The gross amount of participation loans serviced by State of 
              Franklin Savings Bank is $1,220,000.





                                     - 37 -
<PAGE>   39
                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 5     SUPERVISION AND REGULATION

           GENERAL

           As a Tennessee-chartered federally insured savings bank, the Savings
           Bank is subject to extensive regulation. Lending activities and other
           investments must comply with various statutory and regulatory
           requirements, including prescribed minimum capital standards. The
           Savings Bank is regularly examined by the FDIC and the Tennessee
           Department of Financial Institutions and files periodic reports
           concerning its activities and financial condition with its
           regulators. The Savings Bank's relationship with depositors and
           borrowers also is regulated to a great extent by both federal law and
           the laws of the State of Tennessee, especially in such matters as the
           ownership of savings accounts and the form and content of mortgage
           documents.

           Federal and state banking laws and regulations govern all areas of
           the operation of the Savings Bank, including reserves, loans,
           mortgages, capital, issuance of securities, payment of dividends and
           establishment of branches. Federal and state bank regulatory agencies
           also have the general authority to limit the dividends paid by
           insured banks if such payments should be deemed to constitute an
           unsafe and unsound practice. The primary federal regulator of the
           Savings Bank, the FDIC, has authority to impose penalties, initiate
           civil and administrative actions and take other steps intended to
           prevent banks from engaging in unsafe or unsound practices.

           Tennessee law permits the Savings Bank to become a member of the
           Federal Reserve System or the Federal Home Loan Bank System. The
           Savings Bank is a member of the Federal Home Loan Bank of Cincinnati.
           The FHLB of Cincinnati functions as a central reserve bank which
           provides credit for member institutions. The Savings Bank, as a
           member of the FHLB of Cincinnati, is required to own capital stock in
           the FHLB of Cincinnati. Provided certain standards related to
           creditworthiness continue to be met, the Savings Bank will be
           authorized to apply for additional advances on the security of such
           stock and on certain of its residential mortgage loans and other
           assets (principally, securities which are obligations of, or
           guaranteed by, the United States). The Savings Bank's current
           advances from FHLB are disclosed in Note 10.

           TENNESSEE SUPERVISION AND REGULATION

           As a Tennessee-chartered savings bank, the Savings Bank is subject to
           various state laws and regulations which limit the amount that can be
           loaned to a single borrower, the type of permissible investments, and
           geographic expansion, among other things. The Savings Bank must
           submit an application and receive the approval of the Department
           before opening a new branch office or merging with another financial
           institution. The Commissioner of the Department (Commissioner) has
           the authority to enforce state laws and regulations by ordering a
           director, officer or employee of the Savings Bank to cease and desist
           from violating a law or regulation and unsafe and unsound banking
           practices.

           FEDERAL REGULATION

           The Savings Bank was approved by the FDIC to have its deposit
           accounts insured up to applicable limits by the Bank Insurance Fund.
           The BIF was designated as an insurance fund pursuant to the Financial
           Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).
           As insurer, the FDIC issues regulations, conducts examinations,
           requires the filing of reports and generally supervises and regulates
           the operations of state-chartered banks that are not members of the
           Federal Reserve System. FDIC approval is required prior to any merger
           or consolidation involving state, nonmember banks, or the
           establishment or relocation of an office facility thereof. FDIC
           supervision and regulation is intended primarily for the protection
           of depositors and the FDIC insurance funds.






                                     - 38 -
<PAGE>   40

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 5     Continued

           Any insured bank which does not operate in accordance with or conform
           to FDIC regulations, policies and directives may be sanctioned for
           noncompliance. For example, proceedings may be instituted against any
           insured bank or any director, officer, or employee of such bank who
           engages in unsafe and unsound practices, including the violation of
           applicable laws and regulations. The FDIC has the authority to
           terminate deposit insurance pursuant to procedures established for
           that purpose. 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 Savings Bank's financial statements.
           Under capital adequacy guidelines and the regulatory framework for
           prompt corrective action, the Savings Bank must meet specific capital
           guidelines that involve quantitative measures of the Savings Bank's
           assets, liabilities, and certain off-balance-sheet items as
           calculated under regulatory accounting practices. The Savings 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 Savings 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
           Tier 1 capital (as defined) to average assets (as defined).
           Management believes, as of December 31, 1998, that the Savings Bank
           meets all capital adequacy requirements to which it is subject.

           As of December 31, 1998, the most recent notification from the FDIC
           categorized the Savings Bank as well-capitalized under the regulatory
           framework for prompt corrective action. The "prompt corrective
           action" regulations established five categories of depository
           institutions: (1) well-capitalized, (2) adequately capitalized, (3)
           under-capitalized, (4) significantly under-capitalized, and (5)
           critically under-capitalized. Each category relates to the level of
           capital for the depository institution. A "well-capitalized"
           institution meets the minimum level required by regulation (i.e.,
           total risk-based capital ratio of 10% or greater, a Tier 1 risk-based
           capital ratio of 6% or greater and a leverage ratio of 5% or
           greater). To be categorized as well-capitalized, the Savings Bank
           must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1
           leverage ratios as set forth in the table. There are no conditions or
           events since that notification that management believes have changed
           the institution's category.

<TABLE>
<CAPTION>
                                                                                  For Capital
                                                                               Adequacy Purposes
                                                                                 And To Be Well
                                                                               Capitalized Under
                                                                               Prompt Corrective
                                                          Actual               Action Provisions     
                                                     -----------------         -----------------
              In Thousands (Unaudited)               Amount      Ratio         Amount      Ratio
           ------------------------------            -----------------         -----------------
           <S>                                       <C>         <C>           <C>         <C>
           As of December 31, 1998:               
                Total Risk-Based Capital
                  (to Risk-Weighted Assets)          11,908      16.24%        >7,334       10.0%
                                                                               -
                Tier 1 Capital
                  (to Risk-Weighted Assets)          10,989      14.98%        >4,400        6.0%
                                                                               -
                Tier 1 Capital
                  (to Adjusted Total Assets)         10,989       9.44%        >5,823        5.0%
                                                                               -
           As of December 31, 1997:
                Total Risk-Based Capital
                  (to Risk-Weighted Assets)          11,095      24.5%         >4,524       10.0%
                                                                               -
                Tier 1 Capital
                  (to Risk-Weighted Assets)          10,529      23.3%         >2,714        6.0%
                                                                               -
                Tier 1 Capital
                  (to Adjusted Total Assets)         10,529      13.6%         >3,873        5.0%
                                                                               -
</TABLE>




                                     - 39 -
<PAGE>   41

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 6     MORTGAGE-BACKED SECURITIES

           Mortgage-backed securities represent participating interests in pools
           of long-term first mortgage loans originated and serviced by issuers
           of the securities. Mortgage-backed securities are classified as
           available-for-sale securities and carried at fair value. Premiums and
           discounts are amortized using methods approximating the interest
           method over the remaining period to contractual maturity, adjusted
           for anticipated prepayments. Expected maturities will differ from
           contractual maturities because borrowers may have the right to call
           or prepay obligations without call or prepayment penalties.


NOTE 7     EMPLOYEE AND DIRECTOR BENEFIT PLANS

           RETIREMENT PLAN

           The Savings Bank had a noncontributory retirement plan for all
           eligible employees. The benefits were funded by an annual payment
           into each employee's Individual Retirement Account. The cost of the
           plan was $0, $0 and $36,557 for the periods ended December 31, 1998,
           1997 and 1996, respectively. The employees were 100% vested in the
           plan. The plan was terminated as of January 1, 1997.

           EMPLOYEE STOCK OWNERSHIP PLAN

           The company has an employee stock ownership plan (ESOP) for those
           employees who meet the eligibility requirements of the plan. The ESOP
           was established and funded for 1997. On February 28, 1998, 5,236
           shares of the Savings Bank with a fair value of $57,600 were issued
           for the 1997 contribution. The Savings Bank stock was exchanged for
           Company stock as discussed in Note 1. During the third quarter of
           1998, the ESOP borrowed $700,000 from the Company and used the funds
           to purchase 63,636 shares of common stock of the Company at $11 per
           share. This increased the ESOP's shares from 5,236 to 68,872. Note
           payments are $8,218 per month for ten years with a fixed interest
           rate of 7.25%. The note balances outstanding at December 31, 1998,
           1997 and 1996 were $692,022, $0 and $0, respectively.

           A related loan was obtained for the purpose of leveraging the ESOP in
           the amount of $700,000 with similar terms and collaterized with
           stock. The note balances outstanding at December 31, 1998, 1997 and
           1996 were $687,925, $0 and $0, respectively.

           ESOP shares are maintained in a suspense account until released and
           allocated to participants' accounts. The release of shares from the
           suspense account is based on the principal paid in the year in
           proportion to the total of current year and remaining outstanding
           debt. Allocation of released shares to participants' accounts is done
           as of December 31. Shares allocated and remaining in suspense were as
           follows:

<TABLE>
<CAPTION>
                                                                December 31,
                                                            1998           1997
                                                         -------        -------
           <S>                                           <C>            <C>
           Number of Shares
                  Released and allocated                   6,333             --
                  Committed to be Released                 2,101          5,236
                  Suspense                                60,438             --

           Fair Value
                  Released and allocated                  69,663             --
                  Committed to be Released                23,111         57,600
                  Suspense                               664,820             --
</TABLE>






                                     - 40 -
<PAGE>   42

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 7     Continued

           The expense recorded by the Company is based on cash contributed to
           the ESOP during the year in amounts determined by the Board of
           Directors, plus the excess of fair value of shares released and
           allocated over the ESOP's cost of those shares. The Company's ESOP
           compensation costs exclude interest which is classified as such on
           the statement of income. Contributions to the ESOP are as follows:

<TABLE>
<CAPTION>
                                                            December 31,
                                                         1998           1997
                                                       ------         ------
           <S>                                         <C>            <C>
           Compensation Expense                        76,222         57,600
           Contributions                               76,222         57,600
</TABLE>

           No dividends have been declared on the Company's stock. If dividends
           are paid, the ESOP administrators will determine whether dividends on
           allocated and unallocated shares will be used for debt service. Any
           allocated dividends used will be replaced with common stock of equal
           value. For the purpose of computing earnings per share, all ESOP
           shares committed to be released will be considered outstanding.

           The released Company stock will be allocated to employees based on
           their salaries. Generally, all employees who work over 1,000 hours
           are eligible for the plan after one year of service. Employees will
           be vested after seven years of service. This plan includes a 401(k)
           feature that began in 1998, which allows employees to defer up to 6%
           of their salary and is matched by the Company up to the maximum
           allowed amount.

           In connection with the 401(k) provision and the Company contribution,
           there were 6,996 shares of common stock subscribed at December 31, 
           1998.


           STOCK OPTION PLANS

           On December 21, 1996, the Savings Bank's Board of Directors approved
           the Stock Option Plan for Directors and the Stock Option Plan for
           Management. A total of 15% of the original stock offering (91,500
           shares) was reserved for these plans. These plans were retroactively
           amended after year end.

           Under the amended stock option plan for the outside directors,
           one-third of the total shares were granted to the outside directors
           as compensation for directors' fees over the next five years.
           Beginning when the Savings Bank had annual profitability, the options
           will vest at 20% per year to each director. This will total 2,346
           shares per director. The exercise price of the options is $10 per
           share. The vested portion of the options may be exercised at any
           time. There is no termination date on the options, but in the event
           of death, the estate must exercise the options within twelve months.
           If the Savings Bank is sold or merged, the options become 100%
           vested.

           Under the stock option plan for management, the remaining 61,000
           shares were granted to management as an incentive in the Savings
           Bank's performance. The options retroactively began to vest after
           three consecutive quarters of profitability. The options will vest at
           20% per year for five years. The exercise price of the options is $10
           per share. The vested portion of the options may be exercised at any
           time. There is no termination date on the options, but in the event
           of death, the estate must exercise the options within twelve months.
           If the individual leaves the service of the Savings Bank, the options
           must be exercised within three months, although this requirement may
           be waived by the board. If the Savings Bank is sold or merged, the
           options become 100% vested.



                                     - 41 -
<PAGE>   43

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 7     Continued

           The stock option plans for outside directors and for management were
           amended again, effective April 17, 1998, for 15% of the secondary
           offering (75,192 shares). One-third of these shares was allocated to
           outside directors and the remaining to management. Exercise price of
           these options was set at $11 per share. The other terms of these
           options are the same as the terms of the original options.


<TABLE>
<CAPTION>
                                                                                                    Weighted
                                                                                                     Average
                                                                           Awarded                  Exercise
                                                                             And                      Price
                                                                         Unexercised      Vested       Per
                                                                           Options        Options     Share   
                                                                         ------------------------------------
           <S>                                       <C>                 <C>              <C>       <C>
           Options Granted - Outside Directors       January 1, 1998        30,500         5,630        $10

                                                     During 1998            25,064         5,012        $11

           Options Granted - Management              January 1, 1998        61,000        12,200        $10

                                                     During 1998            50,128        10,025        $11

           Options Expired - Outside Directors                              (2,346)           --
                                                                           -------        ------

           Options Outstanding - December 31, 1998                         164,346        32,867        $10.46
                                                                           =======        ======
</TABLE>


           The State of Franklin Savings Bank accounts for these plans under APB
           Opinion No. 25, Accounting for Stock Issued to Employees, under which
           no compensation cost has been recognized. Had compensation cost for
           these plans been determined consistent with Statement of Financial
           Accounting Standard No. 123, Accounting for Stock-based Compensation,
           (SFAS No. 123), the Savings Bank's net income and earnings per share
           would not have changed. SFAS No. 123 requires compensation cost to be
           calculated by the fair value based method. However, it is not
           possible to estimate the fair value of the options at the grant date.
           Therefore, the estimates of compensation cost have been determined by
           the intrinsic value based method.







                                     - 42 -
<PAGE>   44

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 8        DEPOSITS

              Savings deposit balances are summarized as follows:


<TABLE>
<CAPTION>
                                                           December 31, 1998                         December 31, 1997          
                                                -------------------------------------    --------------------------------------
                                                 Average                                  Average
                                                  Rate           Amount       Percent      Rate            Amount       Percent
                                                -------        ----------     -------     -------        ----------     ------- 
              <S>                               <C>            <C>            <C>         <C>            <C>            <C> 
              Passbook                            4.25          6,083,930        6.31       4.25          3,285,536       4.55

              Commercial Checking                 0.00          4,365,719        4.53       0.00          6,653,254       9.21

              Christmas Club                      4.25             24,198        0.03       4.25              5,048       0.01

              NOW                                 1.64          5,848,650        6.07       1.79          3,040,127       4.21

              Money Market Deposit                4.48         13,730,025       14.25       4.31          6,102,285       8.44
                                                               ----------     -------                   -----------     ------
                                                               30,052,522       31.19                    19,086,250      26.42
                                                               ----------     -------                   -----------     ------
              Fixed Term Certificate Accounts
                365 Day IRA                       5.27            832,859        0.86       5.75            914,838       1.27
                18 Month IRA                      5.34              8,058        0.01       5.97             46,188       0.06
                30 Month IRA                      5.12            384,998        0.40       6.04            357,024       0.49
                30 Month IRA (and Keogh)          6.09          3,446,063        3.58       6.12          2,542,476       3.52
                30 Month                          6.04         10,566,996       10.97       6.08         10,241,112      14.18
                12 Month Roth IRA                 4.3              99,665        0.10         --                 --         --
                18 Month Roth IRA                 4.9              32,773        0.03         --                 --         --
                30 Month Roth IRA                 5.69              6,866        0.01         --                 --         --
                7 Month                           5.5          10,396,334       10.79         --                 --         --
                30 Month Educational IRA          5.5                  79        0.00         --                 --         --
                9 Month                           5.49          3,195,279        3.31         --                 --         --
                1 Year                            5.39         11,280,906       11.71       5.83         15,543,368      21.52
                3 Year                            6.15          3,256,713        3.38       6.12          1,133,764       1.57
                Jumbo                             5.83          9,481,823        9.84       5.98          8,241,110      11.41
                2 Year                            5.8           6,059,613        6.29       6.07          3,368,326       4.66
                4 Year                            6.14            459,645        0.48       6.18            334,226       0.46
                5 Year                            5.92            372,264        0.38       6.09            140,270       0.19
                18 Month                          5.44          2,331,932        2.42       6.05          2,170,999       3.00
                182 Day Money Market              4.67          4,078,315        4.23       5.44          8,104,350      11.22
                90 Day Money Market               3.4              20,374        0.02       4.00             19,583       0.03
                                                               ----------      ------                    ----------     ------
                                                               66,311,555       68.81                    53,157,634      73.58
                                                               ----------      ------                    ----------     ------
                                                               96,364,077      100.00                    72,243,884     100.00
                                                               ==========      ======                    ==========     ======
</TABLE>

              The contractual maturity of certificate accounts at December 31,
              1998 and 1997, is as follows:

<TABLE>
<CAPTION>
              Year Ending December 31, 1998                Year Ending December 31, 1997
              -----------------------------                -----------------------------
              <S>                <C>                       <C>                <C>
              1999               47,393,530                1998               34,415,114
              2000               13,584,484                1999               11,801,483
              2001                4,341,244                2000                6,422,470
              2002                  355,992                2001                  285,217
              2003 and After        636,305                2002 and After        233,350
                                 ----------                                   ----------
                                 66,311,555                                   53,157,634
                                 ==========                                   ==========
</TABLE>





                                     - 43 -
<PAGE>   45

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 9         ACCRUED INTEREST RECEIVABLE, NET

<TABLE>
<CAPTION>
                                                                                     1998            1997
                                                                                  -------         -------
               <S>                                                                <C>             <C>
               Loans (net of allowance for uncollected interest of $0)            471,133         251,986
               Mortgage Backed Securities                                             210           1,048
               Investment Securities                                              206,606         147,726
               Cash and Due from Banks                                              8,014              --
                                                                                  -------         -------
                                                                                  685,963         400,760
                                                                                  =======         =======
</TABLE>


NOTE 10        FEDERAL HOME LOAN BANK ADVANCES

               Advances from FHLB are summarized as follows for the periods
               ended December 31, 1998 and 1997:

<TABLE>
<CAPTION>
               Contractual Maturity                            1998              1997
               --------------------                       ---------         ---------
               <S>                                        <C>               <C>
               Within 10 Years:
                 Fixed Rate                               9,000,000                --
                                                          =========         =========

               Weighted Average Rate                           5.42%               --%
</TABLE>

               The Savings Bank pledges as collateral for these borrowings
               selected qualifying mortgage loans (as defined) under an
               agreement with the FHLB. Loans pledged at December 31, 1998 and
               1997 were approximately $13,500,000 and $0, respectively.


NOTE 11        OTHER NONINTEREST EXPENSE

               Other noninterest expense amounts are summarized as follows for
               the periods ended December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>
                                                                               1998         1997         1996
                                                                            -------      -------      -------
               <S>                                                          <C>          <C>          <C> 
               Other Noninterest Expense:
                  Seminars and Education Expenses                            36,343       24,308       15,218
                  Insurance Expense                                          32,241       32,322       21,213
                  Professional Expenses and Supervisory Examinations         99,748       61,133       48,304
                  Office Supplies and Postage                               149,478      144,851       98,719
                  Telephone                                                  82,512       43,638       17,703
                  Other                                                     187,556      129,630       51,300
                                                                            -------      -------     --------
                                                                            587,878      435,882      252,457
                                                                            =======      =======      =======
</TABLE>





                                     - 44 -
<PAGE>   46

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996




NOTE 12        ORGANIZATION EXPENSE

               The following organization expenses were netted against paid-in
               capital:

<TABLE>
<CAPTION>                                                                                    
                                                                1998         1997          1996
                                                              ------       ------       -------
                  <S>                                         <C>          <C>          <C>
                  Compensation and Related Benefits               --           --       147,984
                  Supplies                                        --           --        15,535
                  Telephone                                       --           --         3,199
                  Advertising                                     --           --         3,954
                  Other                                       11,355           --        88,913
                                                              ------       ------       -------

                                                              11,355           --       259,585
                                                              ======       ======       =======
</TABLE>


NOTE 13      INVESTMENT SECURITIES

             The amortized cost and fair value of investment securities
             held-to-maturity and Available-for-Sale at December 31, 1998 and
             1997, by contractual maturity, are shown below. Expected maturities
             will differ from contractual maturities because issuers may have
             the right to call or prepay obligations without call or prepayment
             penalties.


<TABLE>
<CAPTION>
             December 31, 1998:
             ------------------
                                                                                Gross              Gross         Estimated
                                                             Amortized        Unrealized        Unrealized         Market
                                                                Cost             Gains            Losses            Value     
                                                             ---------        ----------        ----------       ---------
             <S>                                             <C>              <C>               <C>              <C>
             Available-for-Sale: 
                United States Government
                  Agency Securities Maturing:
                   After one year
                     but within five years                    5,989,785           20,515                --        6,010,300
                   After five years
                     but within ten years                     5,564,386           39,557                --        5,603,943
                Mortgage Backed Securities:
                   Corporate issue                               35,947              211                --           36,158
                Other
                   Within one year                              598,171               --                --          598,171
                                                             ----------           ------         ---------       ----------

                          Total                              12,188,289           60,283                --       12,248,572
                                                             ==========           ======         =========       ==========
</TABLE>






                                     - 45 -
<PAGE>   47


                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 13      CONTINUED


             December 31, 1997:
             ------------------

<TABLE>
<CAPTION>                                                                        Gross              Gross        Estimated
                                                             Amortized        Unrealized          Unrealized       Market
                                                                Cost             Gains              Losses         Value     
                                                             ---------        ----------          ----------     ---------
             <S>                                             <C>              <C>                 <C>            <C>
             Held-to-Maturity:
                United States Government
                  Agency Securities Maturing:
                   After one year
                     but within five years                    2,300,000               --             4,656        2,295,344
                   After five years
                     but within ten years                     7,700,000           27,870                --        7,727,870
                                                             ----------           ------             -----       ----------

                          Total                              10,000,000           27,870             4,656       10,023,214
                                                             ==========           ======             =====       ==========

             Available-for-Sale:
                United States Government
                  Agency Securities Maturing:
                   After one year
                     but within five years                    1,500,000               --               981        1,499,019
                   After five years
                     but within ten years                     3,739,063           35,890                --        3,774,953
                   After ten years                            1,000,000            4,330                --        1,004,330
                Mortgage Backed Securities:
                   Corporate issue                              179,304            1,407                --          180,711
                Other
                   Within one year                                3,888               --                --            3,888
                                                             ----------           ------             -----       ----------

                          Total                               6,422,255           41,627               981        6,462,901
                                                             ==========           ======             =====       ==========
</TABLE>


             Gross proceeds from sales of investment securities
             available-for-sale for the period ended December 31, 1998, 1997 and
             1996 were $14,374,235, $14,183,359 and $3,764,062, respectively,
             resulting in gross gains of $38,769, $148,045 and $58,125,
             respectively.


NOTE 14      LEGAL PROCEEDINGS

             The Company and its subsidiaries are periodically involved in legal
             proceedings that are generally incidental to their businesses. At
             December 31, 1998, there were no legal proceedings that were
             expected to have a material impact on the Company's financial
             statements.





                                     - 46 -
<PAGE>   48

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 15      RELATED PARTY TRANSACTIONS

             The Savings Bank has granted loans to its officers and directors.
             Management believes that such loans were made in the ordinary
             course of business with normal credit terms, including interest
             rates and collateral and do not represent more than a normal risk
             of collection. Activity with related parties during 1998, 1997 and
             1996 was as follows:

<TABLE>
<CAPTION>
                                                                       1998              1997            1996
                                                                  ---------         ---------         ------- 
             <S>                                                  <C>               <C>               <C> 
             Loan Balances at the Beginning of the Period         2,046,056           555,432              --
             New Loans                                            2,514,787         1,656,131         580,362
             Repayments                                            (442,278)         (165,507)        (24,930)
                                                                  ----------        ---------         -------
             Loan Balances at the End of the Period               4,118,565         2,046,056         555,432
                                                                  =========         =========         =======
</TABLE>

             Officers and directors have unsecured lines of credit that have not
             been used in the amount of $49,501, $56,500 and $6,781 at December
             31, 1998, 1997 and 1996, respectively.

             Officers and directors also have unsecured overdraft protection
             accounts with available balances in the amount of $83,892, $26,518
             and $34,641 at December 31, 1998, 1997 and 1996, respectively.
             Secured home-equity lines of credit for officers and directors have
             an available amount of $39,579, $15,170 and $199,468 at December
             31, 1998, 1997 and 1996, respectively.

             Two individuals, one a director and the other an officer and
             director, are also partners in a partnership in which the following
             significant transaction occurred:

             The Savings Bank leases the Browns Mill Office in Johnson City from
             the partnership. The monthly lease payments were $2,550 per month 
             in both 1998 and 1997 and $3,400 per month in 1996.

NOTE 16      COMMITMENTS

             In the normal course of business, State of Franklin Savings Bank
             has various outstanding commitments and contingent liabilities that
             are not reflected in the accompanying consolidated financial
             statements. The principal commitments of the Savings Bank are as
             follows:

<TABLE>
<CAPTION>
                                                      December 31, 1998                              December 31, 1997              
                                            --------------------------------------         -------------------------------------
                                            Fixed        Variable                          Fixed       Variable
                                             Rate          Rate            Total            Rate         Rate            Total
                                            -------      ---------       ---------         ------      ---------       ---------
             <S>                            <C>          <C>             <C>               <C>         <C>             <C>
             Mortgage Loans
               to Originate                      --        294,400         294,400             --      1,008,200       1,008,200
             Unsecured Lines
               of Credit                         --        511,287         511,287             --        673,794         673,794
             Overdraft Protection
               Accounts                     260,595             --         260,595         89,091             --          89,091
             Home Equity
               Lines of Credit                   --      2,498,854       2,498,854             --      1,633,350       1,633,350
             Commercial                          --      2,451,831       2,451,831             --      1,377,724       1,377,724
                                            -------      ---------       ---------         ------      ---------       ---------
                                            260,595      5,756,372       6,016,967         89,091      4,693,068       4,782,159
                                            =======      =========       =========         ======      =========       =========
</TABLE>

             Commitments under standby letters of credit totaled approximately 
             $292,133 and $965,000 at December 31, 1998 and 1997, respectively.






                                     - 47 -
<PAGE>   49


                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996




NOTE 16      Continued

             At December 31, 1998, the Savings Bank had unused lines of credit
             for funds purchases and daylight overdrafts with two banks. The
             lines total $1,500,000 each and have variable interest rates based
             on the lending bank's daily federal funds rate. The Savings Bank
             also has unused lines of credit with FHLB in the amount of
             $7,902,000.

             The Savings Bank is engaged in the sale of mortgage loans on the
             secondary market. These loans are sold outright and are not
             serviced by the Savings Bank. There were no loan sales in the year
             of 1996. The gain on the sale of these mortgage loans is as
             follows:

<TABLE>
<CAPTION>
                                                           1998             1997
                                                      ---------        ---------
                <S>                                   <C>              <C>
                Selling Price                         5,083,213        1,161,502
                Less: Carrying Value                  5,016,375        1,140,479
                      Loan Cost                          20,658            5,885
                                                      ---------        ---------
                Net Gain on Loans Sold                   46,180           15,138
                                                      =========        =========
</TABLE>

             At December 31, 1998 and 1997, the Savings Bank had mortgage loans
             committed to be sold totaling $1,627,400 and $180,300,
             respectively. Commitments to originate loans to be sold on the
             secondary market were $1,758,740 and $62,400 at December 31, 1998
             and 1997, respectively.

             The Savings Bank leases office space at the Browns Mill Road,
             Johnson City, branch location under an operating lease expiring on
             August 31, 1999 with an option to renew and extend for another
             three years. The Savings Bank has two automobile leases that expire
             on June 15, 2000. The Savings Bank also leases storage space at the
             Browns Mill Road, Johnson City, branch location under a
             month-to-month operating lease.

             Management expects as operating leases expire in the normal course
             of business, they will be renewed or replaced by leases on other
             properties at current market rental rates at the time of renewal.

             Approximate minimum future rentals to be paid under the cancelable
             and noncancelable leases for five years subsequent to December 31,
             1998 are as follows:

<TABLE>
<CAPTION>
                                                              Noncancelable          Cancelable
                Years Ended                                      Leases-               Leases -
               December 31,                                  Building & Auto          Building   
             ----------------------------------------------------------------------------------- 
             <S>                                             <C>                     <C>
                  1999                                            49,426                1,560
                  2000                                            40,013                1,560
                  2001                                            30,600                1,560
                  2002                                            30,600                1,560
                  2003                                            30,600                1,560
                                                                 -------                -----
                  Total Minimum Future Rentals                   181,239                7,800
                                                                 =======                =====
</TABLE>





                                     - 48 -
<PAGE>   50
                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996




NOTE 17      FAIR VALUE OF FINANCIAL INSTRUMENTS

             The fair value of financial instruments is disclosed to comply with
             SFAS No. 107, Disclosure about Fair Value of Financial Instruments.
             The following tables present estimates of fair value for the Saving
             Bank's financial instruments at December 31, 1998 and 1997:

<TABLE>
<CAPTION>
             December 31, 1998:
             ------------------
                                                                     Carrying                  Fair
                                                                       Amount                 Value
                                                                   ----------            ----------
             <S>                                                   <C>                   <C>
             Financial Assets:
               Cash and Cash Equivalents                           13,928,172            13,928,172
               Investment Securities                               12,248,572            12,248,572
               Loans                                               86,104,974            86,876,374
               Accrued Interest Receivable                            685,963               685,963
               Leases Receivable, Net                                 120,999               120,999

             Financial Liabilities:
               Deposits                                            96,364,077            96,684,783
               Advance Payments by Borrowers
                 for Taxes and Insurance (Escrows)                     98,784                98,784
               Accrued Interest on Deposits                           103,769               103,769
               Notes Payable                                          687,925               673,283
               FHLB Advances                                        9,000,000             9,000,000

<CAPTION>

             December 31, 1997:
             ------------------
                                                                     Carrying                  Fair
                                                                       Amount                 Value
                                                                   ----------            ----------
             <S>                                                   <C>                   <C>
             Financial Assets:
               Cash and Cash Equivalents                           12,415,800            12,415,800
               Investment Securities                               16,462,901            16,486,116
               Loans                                               50,374,093            50,449,261
               Accrued Interest Receivable                            400,760               400,760

             Financial Liabilities:
               Deposits                                            72,243,884            72,271,957
               Advance Payments by Borrowers
                 for Taxes and Insurance (Escrows)                     59,911                59,911
               Accrued Interest on Deposits                            43,469                43,469
</TABLE>


             The carrying amounts in the preceding table are included in the
             consolidated statements of financial condition under the applicable
             captions. The contract or notional amounts of the Company's
             financial instruments with off-balance-sheet risk are disclosed in
             Note 16. No derivatives were held by the Company. It is not
             practicable to estimate the fair value of Federal Home Loan Bank
             stock because it is not marketable. The carrying amount of that
             investment is reported at cost in the consolidated statements of
             financial condition.




                                     - 49 -
<PAGE>   51


                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996




NOTE 17      Continued

             The following describes the assumptions and methodologies used to
             calculate the fair value for financial instruments.


             FAIR VALUES OF FINANCIAL INSTRUMENTS: Statement of Financial
             Accounting Standards No. 107, Disclosures about Fair Value of
             Financial Instruments, requires disclosure of fair value
             information about financial instruments, whether or not recognized
             in the balance sheet, for which it is practicable to estimate that
             value. In cases where quoted market prices are not available, fair
             values are based on estimates using present value or other
             valuation techniques. Those techniques are significantly affected
             by the assumptions used, including the discount rate and estimates
             of future cash flows. In that regard, the derived fair value
             estimates cannot be substantiated by comparison to independent
             markets and, in many cases, could not be realized in immediate
             settlement of the instruments. Statement No. 107 excludes certain
             financial instruments and all nonfinancial instruments from its
             disclosure requirements. Accordingly, the aggregate fair value
             amounts presented do not represent the underlying value of the
             Company.


             FLOATING RATE LOANS: Floating rate 1-4 family residential mortgage
             loans reprice periodically and will lag movements in market rates.
             The fair value for floating rate mortgage loans is calculated by
             discounting future cash flows to their present value. Future cash
             flows, consisting of principal payments, interest payments, and
             repricings, are discounted with current Savings Bank prices for
             similar instruments applicable to the remaining maturity.
             Prepayment assumptions based on historical prepayment speeds have
             been applied to the 1-4 family residential floating rate mortgage
             portfolio.


             FIXED RATE LOANS AND LEASES: The fair value for fixed rate loans
             and leases is calculated by discounting future cash flows to their
             present value. Future cash flows, consisting of both principal and
             interest payments, are discounted with current Savings Bank prices
             for similar instruments applicable to the remaining maturity.
             Prepayment assumptions based on historical prepayment speeds have
             been applied to the fixed rate mortgage and installment loan
             portfolios.


             ALLOWANCE FOR LOAN LOSSES: The fair value of the allowance for loan
             losses is approximated by the book value. Additionally, the credit
             exposure known to exist in the loan portfolio is embodied in the
             allowance for loan losses.


             CASH AND CASH EQUIVALENTS: The fair value of cash and cash
             equivalents are approximated by the book value.






                                     - 50 -
<PAGE>   52

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 17      Continued

             INVESTMENT SECURITIES: Market quotes, when available, are used for
             the fair value of investment securities.


             DEFINED MATURITY DEPOSITS: The fair value for defined maturity
             deposits is calculated by discounting future cash flows to their
             present value. Future cash flows, consisting of both principal and
             interest payments, are discounted with Savings Bank prices for
             similar instruments applicable to the remaining maturity. For the
             purpose of this disclosure, defined maturity deposits include all
             certificates of deposit and other time deposits.


             UNDEFINED MATURITY DEPOSITS: The fair value of undefined maturity
             deposits is required by the statement to equal the book value. For
             the purpose of this disclosure, undefined maturity deposits include
             demand deposits, checking interest accounts, savings accounts, and
             money market accounts.


             LONG-TERM DEBT: The fair value of long-term debt instruments and
             Federal Home Loan Bank advances is estimated using a discounted
             cash flow calculation, based on current rates for similar debt.


             LIMITATIONS: The foregoing fair value estimates are made at a
             specific point in time, based on pertinent market data and relevant
             information on the financial instrument. These estimates do not
             include any premium or discount that could result from an offer to
             sell, at one time, the Savings Bank's entire holdings of a
             particular financial instrument or category thereof. Since no
             market exists for a substantial portion of the Savings Bank's
             financial instruments, fair value estimates were necessarily based
             on judgments with respect to future expected loss experience,
             current economic conditions, risk assessments of various financial
             instruments involving a myriad of individual borrowers, and other
             factors. Given the innately subjective nature of these estimates,
             the uncertainties surrounding them and the matters of significant
             judgment that must be applied, these fair value estimations cannot
             be calculated with precision. Modifications in such assumptions
             could meaningfully alter these estimates.


             Since these fair value approximations were made solely for on- and
             off-balance sheet financial instruments, no attempt was made to
             estimate the value of anticipated future business and the value of
             nonfinancial statement assets and liabilities. Other important
             elements which are not deemed to be financial assets or liabilities
             include the value of the Savings Bank's existing core deposit base,
             premises and equipment, and goodwill. Further, certain tax
             implications related to the realization of the unrealized gains and
             losses could have a substantial impact on these fair value
             estimates and have not been incorporated into any of the estimates.










                                     - 51 -
<PAGE>   53

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 18      FEDERAL INCOME TAX

             A reconciliation between the effective income tax expense or
             benefit and the amount computed by multiplying the projected
             statutory federal income tax rate for the period ended December 31,
             1998, 1997 and 1996 is as follows:

<TABLE>
<CAPTION>
                                                                            1998             1997              1996
                                                                         -------           ------            ------
             <S>                                                        <C>               <C>               <C>
             Computed "Expected" Tax (Expense) Benefit                  (186,556)          (7,794)           77,126
             Bad Debt Deduction                                          110,492          (73,785)          (19,607)
             Amortization of Organization Expense                         17,845           16,943             6,489
             Other                                                          (855)           1,101              (565)
             Reversal of Allowance for Deferred Tax Assets                    --           68,612                --
             FHLB Dividends                                                6,868               --                --
                                                                         -------           ------           -------

             Provision for Income Taxes                                  (52,206)           5,077            63,443
                                                                         =======           ======           =======

             Current Income Tax (Expense) Benefit                       (183,707)          13,075                --
             Deferred Income Tax (Expense) Benefit                       131,501           (7,998)           63,443
                                                                         -------           ------           -------

             Provision for Income Taxes                                  (52,206)           5,077            63,443
                                                                         =======           ======           =======

             Deferred Tax Assets:
               Due to Net Operating Loss Carryforward                         --           68,521           132,055
               Due to Unrealized Gains on Investments                    (20,496)         (13,076)               --
               Due to FHLB Dividends                                      (6,868)              --                --
               Due to Reserve for Loan Losses                            214,310               --                --
                                                                         -------           ------           -------

                                                                         186,946           55,445           132,055
                                                                         -------           ------           -------
             Reserve for Deferred Tax Assets:
               Beginning Balance                                              --          (68,612)               --
               Amount Reserved                                                --               --           (68,612)
               Reversal of Reserved Amount                                    --           68,612                --
                                                                         -------           ------           -------

                    Ending Balance                                            --               --           (68,612)
                                                                         -------           ------           -------

             Deferred Tax Assets - Net                                   186,946           55,445            63,443
                                                                         =======           ======           =======
</TABLE>

             The Savings Bank had a net operating loss carryforward of $195,157
             which was used to offset federal taxable income in 1998.

             In assessing the realizability of the related deferred tax asset,
             management considers whether it is more likely than not that some
             portion or all of the deferred tax asset will not be realized. The
             ultimate realization of deferred tax assets is dependent upon the
             existence of, or generation of, taxable income in the periods which
             those temporary differences are deductible. Management considers
             the projected future taxable income and tax planning strategies in
             making this assessment. Based upon the projection for future
             taxable income over the periods which the deferred tax asset is
             deductible, at December 31, 1998, management believes it is more
             likely than not that the Savings Bank will realize the benefits of
             these deductible differences.

NOTE 19      COMPREHENSIVE INCOME

             In June of 1997, the Financial Accounting Standards Board issued
             Statement of Financial Accounting Standards No. 130, (SFAS No.
             130), Reporting Comprehensive Income. This new statement
             establishes standards for reporting and displaying comprehensive
             income and its components in a basic set of financial statements.
             The purpose of reporting comprehensive income is to report a
             measure of all changes in equity of an enterprise that results from
             recognized transactions and other economic events of the period
             other than transactions with owners in their capacity as owners.






                                     - 52 -
<PAGE>   54

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 19      CONTINUED

             Comprehensive income is defined as the change in equity of a
             business enterprise during a period from transactions and other
             events and circumstances from nonowner sources. It includes all
             changes in equity during a period except those resulting from
             investments by owners and distributions to owners.

             Reclassification adjustments are made to avoid counting in
             comprehensive income 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. For
             example, gains on investment securities that were realized and
             included in net income of the current period that also had been
             included in other comprehensive income as unrealized holding gains
             in the period in which they arose must be deducted through other
             comprehensive income of the period in which they are included in
             net income to avoid including them in comprehensive income twice.

             State of Franklin Savings Bank adopted SFAS No. 130 effective
             December 31, 1997 and restated the previous year's financial
             statements to comply with the new reporting requirements.

NOTE 20      EARNINGS (LOSS) PER SHARE

             Statement of Financial Accounting Standards No. 128 (SFAS No. 128),
             Earnings Per Share, is effective for fiscal years ending after
             December 15, 1997. This statement presents standards for computing
             and presenting earnings per share (EPS) and applies to entities
             with publicly held common stock or potential common stock. SFAS No.
             128 simplifies previous standards for computing EPS and makes them
             comparable to international EPS standards. It replaces the
             presentation of primary EPS with the presentation of basic EPS.
             Basic EPS excludes dilution and is computed by dividing income
             available to common stockholders by the weighted-average number of
             common shares outstanding for the period. Diluted EPS reflects the
             potential dilution that could occur if securities or other
             contracts to issue common stock were exercised or converted into
             common stock or resulted in the issuance of common stock that then
             shared in the earnings of the entity. Diluted EPS is computed
             similarly to fully diluted EPS.

             The Savings Bank adopted SFAS No. 128 effective January 1, 1997 and
             restated the previous year's financial statements to comply with
             the new reporting requirements.

<TABLE>
<CAPTION>
                                                                      1998             1997            1996
                                                                 ---------        ---------         -------
             <S>                                                 <C>              <C>               <C>
             Net Income Available to Common Shareholders           496,489           57,035        (450,733)
                                                                 =========        =========         =======

             Average Shares
                Average Shares - Basic                           1,117,270        1,111,280         610,000
                Effect of Dilutive Common Stock Options              6,484            8,316              --
                                                                 ---------        ---------         -------

                Average Shares - Diluted                         1,123,754        1,119,596         610,000
                                                                 =========        =========         =======

             Basic Earnings (Loss) Per Share                          0.44             0.05           (0.74)
                                                                      ====             ====            ====

             Diluted Earnings (Loss) Per Share                        0.44             0.05           (0.74)
                                                                      ====             ====            ====
</TABLE>






                                     - 53 -
<PAGE>   55

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996

NOTE 21      CONDENSED PARENT COMPANY ONLY FINANCIAL STATEMENTS

             STATEMENT OF FINANCIAL POSITION

<TABLE>
<CAPTION>

                                                                              December 31,
                                                                                      1998
                                                                              ------------
             <S>                                                              <C> 
             Assets: 

             Cash and Cash Equivalents                                                 897
             Investments - Available-for-Sale                                      593,164
             Receivable from ESOP                                                  108,286
             Investments in Subsidiaries                                        11,565,733
                                                                                ----------
                 Total Assets                                                   12,268,080
                                                                                ==========
             Liabilities:

             Short Term Borrowings - Subsidiary                                      2,743
             Notes Payable                                                         687,925
                                                                                ----------
                 Total Liabilities                                                 690,668
                                                                                ----------

             Stockholders' Equity:

             Common Stock, $1.00 Par Value,
               Authorized: 3,000,000 Shares; Issued: 1,180,152 Shares            1,180,152
             Common Stock Subscribed                                                 6,996
             Paid-In Capital                                                    10,907,472
             Accumulated Other Comprehensive Income                                 39,820

             Retained Earnings                                                     107,792
             Less: Employee Stock Ownership                                       (664,820)
                                                                                ----------
               Total Stockholders' Equity                                       11,577,412
                                                                                ---------- 
                    Total Liabilities and Stockholders' Equity                  12,268,080
                                                                                ==========
</TABLE>


             STATEMENT OF INCOME

<TABLE>
<CAPTION>
                                                                                                 Period Ended
                                                                                                 December 31,
                                                                                                         1998
                                                                                                 ------------
             <S>                                                                                 <C>
             Interest Income                                                                            8,634
             Dividends from Banking Subsidiary                                                          5,000
                                                                                                      -------
             Income Before Income Taxes and Equity in Undistributed Earnings of Subsidiaries           13,634
             Provision for Income Taxes                                                                (2,743)
                                                                                                      -------

             Income before Equity in Undistributed Earnings of Subsidiaries                            10,891

             Equity in undistributed Earnings of Subsidiaries                                         485,598
                                                                                                      -------
             Net Income                                                                               496,489
                                                                                                      =======
</TABLE>





                                     - 54 -
<PAGE>   56

                       STATE OF FRANKLIN BANCSHARES, INC.
                             JOHNSON CITY, TENNESSEE
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1998, 1997 AND 1996



NOTE 21      Continued

             STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                      Period Ended
                                                                      December 31,
                                                                              1998
                                                                      ------------
             <S>                                                      <C>
             Cash Flows from Operating Activities
               Net Income                                                  496,489
               Items Not Affecting Cash and Cash Equivalents:
                  Equity in Undistributed Earnings of Subsidiaries        (485,598)
                  Increase in Payable to Subsidiary                          2,743
                                                                           -------
                    Net Cash Provided by Operating Activities               13,634
                                                                           -------

             Cash Flows from Investing Activities
               Purchase of Investments                                    (707,634)
               Proceeds from Sale of Available-for-Sale Investments        114,470
               Investment in Subsidiary                                   (100,000)
                                                                           -------

                    Net Cash Used by Investing Activities                 (693,164)
                                                                           -------

             Cash Flows from Financing Activities
               Issuance of Common Stock, Net                                 3,857
               Organization Costs                                          (11,355)
               Proceeds from Debt                                          700,000
               Repayments of Debt                                          (12,075)
                                                                           -------

                    Net Cash Provided by Financing Activities              680,427
                                                                           -------

                    Net Increase in Cash and Cash Equivalents                  897

             Cash and Cash Equivalents at Beginning of Period                   --
                                                                           -------

                    Cash and Cash Equivalents at End of Period                 897
                                                                           =======
</TABLE>


                                     - 55 -
<PAGE>   57



                       STATE OF FRANKLIN BANCSHARES, INC.
                     STATEMENT OF MANAGEMENT RESPONSIBILITY



The management of State of Franklin Bancshares, Inc. and its subsidiaries is
responsible for the preparation, content and integrity of the consolidated
financial statements and all other information included in this annual report.
The consolidated financial statements, which include management's best estimates
where judgment is required, are prepared in accordance with generally accepted
accounting principles applied on a consistent basis and meet the requirements of
the appropriate regulatory agencies.

The Company has established and maintains a system of internal controls designed
to provide reasonable assurance as to the integrity and reliability of the
consolidated financial statements and related information, the protection of
assets and customer deposits from material loss or misuse, and the detection of
fraudulent financial reporting. The Company's system of internal controls
includes written policies and procedures, proper delegation of authority and
organizational division of responsibilities, and the careful selection and
training of qualified personnel. In addition, independent certified public
accountants periodically test the system of internal controls.

Management recognizes that the cost of a system of internal controls should not
exceed the benefits derived and that there are inherent limitations to be
considered in the potential effectiveness of any system. However, management
believes that the system of internal controls provides reasonable assurances
that financial transactions are recorded properly to permit the preparation of
reliable consolidated financial statements.

Management also recognizes its responsibility for conducting the Company's
affairs in an ethical and socially responsible manner. This responsibility is
characterized and reflected in key policy statements covering, among other
subjects, proper conduct of business practices. The Company maintains a
systematic program to communicate, review and assess compliance with these
policies.

The Audit Committee of the Board of Directors, composed solely of outside
directors, has the responsibility for the recommendation of the independent
certified public accountants for the Company. The Board of Directors, through
its audit committee, is responsible for ensuring that both management and the
independent certified public accountants fulfill their respective
responsibilities with regard to the financial statements. The independent
certified public accountants have free access to the Audit Committee.

The Company's consolidated financial statements have been audited by Baylor and
Backus. Their responsibility is to express an opinion on the Company's
consolidated financial statements and, in performing their audit, to evaluate
the Company's internal control system to the extent they deem necessary in order
to issue an opinion on the Company's consolidated financial statements. As
described further in their report, their opinion is based on their audits, which
were conducted in accordance with generally accepted auditing standards and is
believed by them to provide a reasonable basis for their opinion.




Charles E. Allen, Jr.                            Randal R. Greene
Chairman of the Board of Directors               President and
and Chief Financial Officer                      Chief Executive Officer





                                     - 56 -
<PAGE>   58



ITEM 8.

         CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

         None

ITEM 9.

         DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS

This item is incorporated by reference to Pages 2 through 4 of the Company's
Proxy Statement related to its Annual Meeting.

ITEM 10.

         EXECUTIVE COMPENSATION.

This item is incorporated by reference to Pages 5 and 6 of the Company's Proxy
Statement related to its Annual Meeting.

ITEM 11.

         SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

This item is incorporated by reference to Pages 6 and 7 of the Company's Proxy
Statement related to its Annual Meeting.

ITEM 12.

         CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

This item is incorporated by reference to Page 7 of the Company's Proxy
Statement related to its Annual Meeting.

ITEM 13.

         EXHIBITS AND REPORTS ON FORM 8-K

(1) Exhibits 

Exhibit 
Number   Description
------   -----------

 3.1     Charter of State of Franklin Bancshares, Inc.
 3.2     Bylaws of State of Franklin Bancshares, Inc.
21.1     List of subsidiaries
27       Financial Data Schedule (For SEC use only)

(2) Reports on Form 8-K

         No reports on Form 8-K were filed during the quarter ended December 31,
1998.


<PAGE>   59



         In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant has caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

                                      STATE OF FRANKLIN BANCSHARES, INC.

                                      By: /s/ Charles E. Allen, Jr.
                                        Chairman of the Board and Chief 
                                        Financial Officer

                                      Date: March 19, 1999

         In accordance with the requirements of 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.

<TABLE>
<CAPTION>
Signature                           Capacity                                                  Date
---------                           --------                                                  ----
<S>                                 <C>                                                       <C> 
 /s/ Charles E. Allen, Jr.          Chairman of the Board, Chief Financial Officer  and       March 19, 1999
                                    Director (principal executive, financial and 
                                    accounting officer)

 /s/ Randal R. Greene               President, Chief Executive Office and Director            March 19, 1999
                                    (principal executive officer)


Stephen Gross                       Director                                                  March __, 1999

Donald R. Jeanes                    Director                                                  March __, 1999

 /s/ Henry J. Williams, M.D.        Director                                                  March 19, 1999


 /s/ Kenneth E. Cutshall, M.D.      Director                                                  March 19, 1999


 /s/ Charles E. Allen, Sr.          Director                                                  March 19, 1999


/s/ Richard S. Venable              Director                                                  March 19, 1999

/s/ Verrill M. Norwood, Jr.         Director                                                  March 19, 1999


 /s/ Cameron E. Perry               Director                                                  March 19, 1999


 /s/ Vance W. Cheek                 Director                                                  March 19, 1999
</TABLE>